Connect with us

Companies

Behavioural Finance: Coaching for Fund Managers 

 7 min read / 

Behavioural finance is a fascinating field and it plays a very important role in modern finance. It can directly affect investment decisions, and the way in which investors manage the investment portfolios. Behavioural finance might impact the way investment managers are coached. We all know what a coach does. For example, in sports field such as tennis, a coach doesn’t just tell you whether you won or lost. A good coach will tell you what was good and what was bad about the game. What strokes worked and what strokes didn’t. This is different from the kind of feedback that investment managers get. They nearly get told whether they gained or lost, and whether they managed to beat the market or failed to do so as it’s more common. There is now a fascinating move to brake down the way in which we invest to enable people to be coached to improve their fundamental skills in investing. One of the leading companies in Boston U.S.A. focusing on this subject is Cabot Research lead by Chief Executive Michael Ervolini.

Let’s take into account the feedback. What kind of feedback is it that investment managers actually need rather than the basic performance data that they get at the moment? Well, the feedback they all live with now are outcomes and outcomes just aren’t enough to improve. Therefore we have to go below the outcomes in order to improve. Information about skills needs to be found and investigated. Just like the tennis player I referenced at the beginning of this article, who has a serve, a grand stroke and a net game, investors on the other hand, have buying, selling and sizing as their principal skills. In each of these three major groups, there are sub kills and with the right kind of feedback and some analytics, portfolio managers around the world are learning where the sweet spot is in their buying, selling and sizing. Managers also learn where opportunities to improve exist, and how to work on achieving those improvements, whilst maintaining and doing more of they already do well.

For many finance professionals specialising in other areas of the financial industry and may not have direct contact or strong knowledge of behavioural finance or investing, I will try and put some flesh on the bones in these concepts from the figure below relating to the process of identification of a manager’s sweetspot, and explain into more detail how this initiative works and what it means by using recent research released by Cabot Research in Boston, U.S.A. A global leader in helping managers understand their investment skills, process and behavioural tendencies.

The main objective is to enable investors to use their deeper knowledge to make better investment decisions, avoid behavioural investing and stay more aligned and focused to the investment process. The above diagram breaks decisions into wining, buying and losing buys. The questions is how you do you get to understand and differentiate between decisions which have worked out and those who haven’t, and how you can actually change things. Well, keep in mind that the types of managers we are talking about are fundamental managers. They are not driven by models, but yet some rigour can help them learn about what they do well and don’t. What Cabot Research in Boston does according to its Chief Executive Michael Ervolini, is to identify each time a manager begins a new position in their portfolio and the first time the name comes into the portfolio. They observe certain characteristics about that stock as shown in the exhibit above and they vary from fund to fund and from manager to manager.

At first, the idea is to identify, what the typical position looks like when a manager enters it, and that is the irregular shape polygon in the figure above. Secondly, since time has gone by, either of the characteristics associated with stocks that for you, a particular manager, tend to outperform versus underperform. The green and red areas represent this. Once the green areas have been identified, the characteristics of stocks that fit your process, your skills and your judgement the best, than we can use that to build a simple screen to help you as a manager to fish more in a highly productive pond, for your abilities.

It is crucial for managers to be able to identify and avoid repeating the most common errors and mistakes. What are the most common mistakes that portfolio managers tend to do? What are the mistakes investors typically make? Selling tends to be more of problem than buying to people hold on to their winners for too long, or do they sell to soon? Well, there’s no question that selling is the biggest area for improvement. If you look at any finance book, when they talk about strategy, it’s always about buying. When you look at investor materials about selling, it’s a discipline. Simply one is the strategy and one is the discipline, and they tell you a lot about the symmetry and attention that is given to each of these areas. Cabot Research has researched over 600bn of assets under management and they found that in 85% of portfolio situations there is a significant opportunity to improve selling. Unlike the general behavioural finance research that points to holding losers as the biggest problem, amongst professional investors and people managing more than a half a billion pounds or more. Cabot research argues and states that they have found that holding winners is the biggest problem.

Why is the research showing two different sides? Why is holding winners the biggest problem rather than holding losers? Is this because investors are too proud of them? Did investors fell in love with the companies that they’ve done well for them or they simply want to window dress their portfolios? I believe that there is some of that issue but there is also the fact that as individuals, we have something called as the endowment effect. We tend to value things that we own, or that are in our endowment more than the market does. This can make them sticky and make them hard to sell. The same with any other capital item such as a used car or home. Selling is a lot harder than it looks. Thinking for a moment at the theory used at the beginning of the article related to the tennis player, this is more like getting the tennis player to practice their drop shots. This is about prompting and telling people when they should be considering selling.

Let’s have a look at the chart where it shows the kind of improvements compared to the market the Cabot Research has managed to get out of people when they have started this process. This is an impressive result but would it be easier to adopt a quantitative model and let computers who don’t have the same rationales as we do, to carry on in this process instead? I don’t think this would be a solution for every firm out there. There are a few firms that have quantitative models that do brilliantly throughout cycles. Generally speaking, running a quantitative model is not that easy, and it’s not always a superior option to human judgement. What this particular graph shows, is that when managers engaged in delivering improvement, a persistent, consistent and dedicated focus with good feedback and over a period of a few years, can enable managers to dramatically improve. As you can see in the graph, these groups of managers totalling 85, improved by 250 basis points over a 5-year period. That’s just constantly chipping away, eliminating small problems, and doing more and more of what they do well. Cabot Research believes that there are a great number of managers who with delivered improvement can outperform according to Chief Executive Michael Ervolini.

That is a very interesting statement of intent, as I personally, often tend to be a very strong fan of passive management. That doesn’t mean that there isn’t a place for active management. It’s actually very important that we have active management. If active management is going to work, these are exactly the kind of issues that active managers need to work on.

Sign up to Mogul News.

Click to comment

Leave a Reply

Your email address will not be published. Required fields are marked *

Send this to a friend