Stock-Pickers Don’t Know How to Sell
They actually do OK figuring out what to buy. But they need to do a better job unloading stuff.
Bloomberg, January 15, 2019
I usually excerpt my column here; but there was so much good stuff in the topic I discussed that below are additional details that space prevented me from including in the original Bloomberg post. It was so interesting, and the research conclusions so powerful, I felt the need to expand on the column topic.
Academic finance papers tend to be dry, dull affairs, filled with indecipherable formulas (aka physics penis envy). Sometimes the methodology used is less than robust, occasionally the data set is questionable. Conclusions can be based on marginal changes indistinguishable from randomness.
Every now and again, a paper hits all the right notes: good data, robust methodology, clever analysis, big and bold conclusion.
Just that sort of paper is our discussion topic for today: “Selling Fast and Buying Slow: Heuristics and Trading Performance of Institutional Investors.” 1 It goes beyond the usual underperformance critiques of active management in an attempt to decipher the question “why do the majority of active managers underperform?”
The research data suggests managers actually create value when buying, but destroy value when selling. Thats what my column is about today. But there was so much good stuff in the research paper that I wanted to share it. The paper’s four authors 2 include a number of other observations about institutional managers that are worth sharing,
Most significant of all is a conclusion that might be of help for active managers in their battle against the rise of passive indexing: Fund managers would be better off (and in some cases MUCH better off) merely selling holdings completely at random:
Ironically, the traditionally negative academic criticism about active management, according to the findings of this research, might actually understate the extent of the active manager’s performance problem. The standard pro-indexing, anti-active management argument is premised on 4 key ideas:
- Markets are an efficient, zero-sum game. There are winners and losers but the net of all trading is (must be) zero;
- This is before we account for the impact of biases and cognitive errors on manager decision-making;
- The effect of management fees and trading costs, plus the occasional error-laden decision, is that over the course of a decade, the advantage shown by nearly all of the winners fade to zero;
- Given all of the above, identifying out-performing managers in advance is all but impossible;
We can now add one more element to this: many, perhaps even most managers exhibit little if any skill when it comes to selling any of their holdings. Indeed, the most common reason to sell seems to be to buy the next “great” idea. This has been a recipe for disaster for both returns and the active management business model.
The biggest difference between buying and selling skills is explained in part by a 2013 paper 4 cited by the study, which observed that buying and selling are driven by two distinct psychological processes: purchase decisions are forward looking while sales are backward looking. It is the backwards looking process that seems to be most ripe for the behavioral biases and cognitive errors exhibited by professional and non-professional investors alike.
Other significant observations include:
-Sophisticated professional market participants suffer similar biases and heurisitics to those of retail investors and day traders.
-Managers have substantially greater propensities to sell positions with extreme returns: both the worst and best performing assets in the portfolio are sold at rates more than 50% percent higher than assets that just under or over performed;
-There is an asymmetric allocation of cognitive resources, particularly attention.
-PMs do not lack the fundamental skills to sell well, they are just not paying attention. When relevant information is salient and readily available – on earnings announcement days – the investors are able to effectively incorporate it into their selling decisions which end up outperforming the counterfactual.
Almost none of the above made it into today’s column, but I thought it was significant and worth sharing . . .
1. Akepanidtaworn, Klakow and Di Mascio, Rick and Imas, Alex and Schmidt, Lawrence, Selling Fast and Buying Slow: Heuristics and Trading Performance of Institutional Investors (December 2018). Available at SSRN: https://ssrn.com/abstract=3301277 or http://dx.doi.org/10.2139/ssrn.3301277
2. The authors are Klakow Akepanidtaworn and Rick Di Mascio from the Booth School of Business, University of Chicagol; Alex Imas from the Social and Decision Sciences, Carnegie Mellon University; and Lawrence Schmidt from the Sloan School of Management, Massachusetts Institute of Technology.
3. Barber and Odean (2013): “The behavior of individual investors,” in Handbook of the Economics of Finance, Elsevier, vol. 2, 1533–1570. See also “The Role of Beliefs in Trading Decisions,” Grosshans, D., F. Langnickel, and S. Zeisberger (2018).