Understanding and Identifying Investment Skill
Investment skill exists. Academic research has conclusively proven that fund managers have the skills to pick stocks and build portfolios. We’ve seen that even underperforming managers are able to analyse investments and demonstrate investment skill. Yet this creates a conundrum – if outperformance doesn’t necessarily indicate skill and underperformance doesn’t indicate a lack of skill, how can managers effectively evaluate their investment process? And why are some managers able to consistently pick stocks that outperform but are unable to identify those stocks in their portfolio that are likely to underperform?
This paper analyses 41 portfolios to measure the impact of behaviour on investment performance using two key metrics:
- Do decisions generate alpha?
- Is the sizing across the different stocks in the portfolio efficient such that the larger positions generate larger quantities of alpha?
The importance of the first is self-evident but the second criteria is crucial as it isn’t enough for managers to be able to generate good ideas and identify outperforming stocks. A key part of any investment performance review needs to assess whether managers are able to construct portfolios and size individual positions commensurate with the opportunity and risk.
The research found that, while even underperforming managers had the skills to analyse investments, pick good stocks, and build portfolios, they fell into a series of behavioural traps far more often than their successful colleagues. In particular, these managers were falling victim to the ‘Endowment Effect’, the behavioural finance term for the phenomenon of people tending to value objects more because they own them.
This phenomenon significantly impacts the investment decision success rate of these underperforming managers, as evidenced by the fact that, while they were seeing positive alpha from their overweight stocks, the impact on underweight stocks was largely negative and dragged down portfolio alpha.
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