Sponsored by American Portfolios
By Clifford T. Walsh, CFA
The due diligence that advisors undertake in selecting money managers to whom they entrust their clients’ assets is a cornerstone function for ensuring their clients’ long-term financial success.
While the research into the behavioral biases of individual investors is quite robust, there is less research into how behavioral biases manifest themselves in professional money managers. In a recent academic study, “Selling Fast and Buying Slow: Heuristics and Trading Performance of Institutional Investors,”1 researchers looked at 783 portfolios, with an average portfolio value of about $575 million, over the period of 2000 to 2016. Their primary conclusion was, “…while investors display clear skill in buying, their selling decisions underperform substantially—even relative to strategies involving no skill such as randomly selling existing positions.”2
The failure of portfolio managers to make good selling decisions may cost up to 70 bps a year in portfolio underperformance!3
Selling: The Stepchild of the Investment Discipline
The authors argue that the major reason for suboptimal selling outcomes is that professional asset managers typically devote less time and thought to the sell decision than they do to the purchase decision.
The paper suggests that portfolio managers have the ability to sell smartly; indeed the authors found that selling decisions based on informational events, such as earnings day announcements, did outperform non-fact based selling decisions.
Researchers found that assets with extreme past returns were 50 percent more likely to be sold than assets with zero benchmark-adjusted returns, despite the common knowledge that “past performance is not indicative of future results”; this bias relative to past returns was not seen in buying behavior.
There appears to be another bias at play hindering intelligent selling decision-making—buying decisions tend to be more forward-looking and conviction-based than selling decisions. Said differently, portfolio managers are generally more focused on finding the next “home run,” viewing selling simply as a mechanism to fund the new investment opportunity.
This proclivity might explain why sell decisions are based on past performance—if a portfolio manager needs cash to fund the next great idea, then positions with outsized gains or losses stand out as funding sources.
Application to Advisor Due Diligence
Any practical framework for problem solving or discovery, be it an investment process or a loan approval algorithm, is fraught with behavioral biases. Recognizing this, advisors may want to dedicate time in exploring historical selling decisions with candidate managers to ascertain whether their sell discipline is as thoughtful as their buy discipline.
As CIO, Clifford T. Walsh focuses on providing research, creating data and adding in-depth product support to all American Portfolios Advisors, Inc. (APA) advisors and sales support teams for all advisory products. He plays an integral part in the development, maintenance and promotion of a mutual fund select list for APA advisors to use in advisor-directed programs.
Sources:
1. papers.ssrn.com/sol3/papers.cfm?abstract_id=3301277
2. papers.ssrn.com/sol3/papers.cfm?abstract_id=3301277
3. papers.ssrn.com/sol3/papers.cfm?abstract_id=3301277
See referenced disclosure (2) and (3) at blog.americanportfolios.com/disclosures/
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