New research study point out that fund managers seem to know which stocks to buy but don’t know when to sell. Perhaps this timing flaw is the reason why active managers don’t outperform the major market indices net of fees. Behavioural economics-finance experts (BEFI) study how decisions are made in the markets. They want to know more about the psychology of human fund managers in order to “cure” them of non-rational decision making that costs performance.
According to the work of Nobel Prize-winner Daniel Kahneman and Amos Tversky, people tend to take more risks when avoiding loss than they do in expanding profits. This disposition effect affects the decision of when to sell stocks. People often make the greatest efforts to preserve the capital they started with. For example, the prudent, low-risk investor’s capital preservation premise trumps everything else. People who make money in stocks may take the contrarian view by deciding to buy a stock when it’s inexpensive. They may decide to hold the stock indefinitely as it continues to rise steadily against consensus.
Deciding to sell is often a more emotional decision than deciding to buy:
–The decision to sell at a loss is an acknowledgement that the buyer’s original reasons for owning it were wrong. Selling is admission of a mistake that fund managers may be loath to have on their records forever.
–Conversely, when the manager books a gain, he or she may be sorry later as the stock continues to rise above market expectations.
Cynicism and active portfolio management
Evaluation of several years of active buy and sell decisions performed by a group of fund managers demonstrates the disposition effect. London-based investment research firm, Inalytics, analysed forty-five thousand trades made by pension funds from December 2003 to September 2006. The findings show that fund managers add value and improve average returns with stock selection when compared to the benchmark index, adding forty seven basis points before fees. Selling decision, on the other hand, created a negative effect of ninety-four basis points, or twice the positive effect of managers’ stock buy picks.
The firm’s research shows the best fund management performers tend to be cynics—they ask questions and evaluate worst-case scenarios whilst possessing the abilities to first identify buying opportunities. They must have the ability to convey enthusiasm about ideas behind stock selections to clients. Fund managers may lack selling skills—both as sellers of ideas and stock positions. And, importantly, most firms’ investment committee takes more time to vet portfolio buys. Selling decisions may not receive the same level of attention. And media tends to focus on “what to buy” rather than “what to sell.”
Emotions and Selling Risk
An effective active manager with the ability to outperform the benchmark net of fees is rare species. He or she must possess confidence about their decisions in a constantly-moving market conditions. It’s difficult to achieve a confident and balanced approach. Fund managers recommend that investors take a long-term view to investing, yet it’s human for managers to consider short-term factors in making buy and sell decisions. For that reason, hiring a sports or career coach can help keep individuals focused whilst raising self-awareness. Some effective coaches assist managers in “letting go” of losing positions and “holding on” to winning positions with more profit potential.
Some managers, such as Tom Howard (AthenaInvest), don’t allow the cost basis of an investment to sway future sales decisions. Howard doesn’t enter the price of stocks purchased and comments that the purchase price isn’t important. Rather, he makes decisions based upon the shares’ ability to perform in the future. Cost basis might tempt him to book profits too soon, and he wants investors to have the benefit of strong performers over the long-term. Although Howard’s approach isn’t one that most managers are likely to adopt, perhaps they should. AthenaInvest’s performance is notable: the fund appreciated a whopping sixty-six point six percent in 2013 vs. Russell 2000’s thirty-eight point eight percent return. The flagship fund returned sixteen point two percent on an annualised basis over the past decade, compared to benchmark Russell 2000 return of eight point five percent a year over the last ten years.