Skills, Process and Behaviors

"Discovery consists of seeing what everybody has seen and thinking what nobody has thought."
-von Szent Gyorgyi

Skill is what separates top performing managers from the pack. Ironically, little is known about investment skill, how it is developed, how to measure it or how to improve it. The inability to isolate and measure, or even knowledgably discuss, specific investment skills has inhibited professional development. A new framework for evaluating investment skills can quantify strengths and weaknesses, calibrate their interaction with management processes and identify behavioral tendencies. In this essay we discuss the potential of a new framework to help managers realize their best.

Eagle, Bogey or Mulligan

Professional performance requires deliberate practice — the kind that identifies and improves specific skills. For instance in golf, deliberate practice means more than just hitting balls at the driving range. Instead, it takes dedicated time with each club learning to drop the ball within a target range. Skilled golfers that draw crowds at tournaments can consistently hit the right shot in any situation.

Portfolio managers face equally high expectations. Yet their ability to improve is restricted by inadequate feedback. Return, relative return and alpha, performance attribution and factor loading... that's it. These values tell you how you performed overall, but offer little insight for improving. The latter two analytics in particular focus on outcomes of position weights, not the investment decisions themselves. This level of feedback is equivalent to a golfer playing with a blindfold and only being told the final score. Its impossible to know what part of the game is working — driving, irons or putting — and where improvement is needed. Without this insight, golfers will rely on hindsight and what feels right. Professional investors face exactly this same dilemma.

Oddly many professional investors don't recognize this vacuum in skills awareness. Their uncertainty is displaced by false confidence built on fuzzy hindsight that morphed their memory of iffy choices into recollections of effective decision-making. The trick is to drill down and confirm skills while making sure certain decisions are not behaviorally motivated.

Your Choice

Investing is built on three basic skills: buying, selling and position sizing. Familiar as these terms are, few professionals measure or understand their skill at each. Thinking about performance as a portfolio of decisions, rather than holdings, is at the heart of one new analytical framework. Behavioral tendencies are seen here as the unconscious exerting itself wherever skills and process are insufficient.

Buying is all about name selection. Skilled buyers choose names that outperform — more often than not. Their picks tend to lift up portfolio performance.

Hindsight Bias can dampen buying. For example, a value manager is good at buying beaten up stocks but has trouble beating the benchmark. The manager "remembers" strong reasons for each buy. The right analysis can uncover that the manager is highly effective at buying negative momentum stocks up to a point, but when reaching for those deep discount names the picks usually don't work out.

Selling is about capturing the alpha from great buys and limiting losses. Selling winners involves pushing them out as they reach exhaustion, not afterwards. Effectively managing losers requires correctly assessing the likelihood that under performing stocks will either bounce back in a reasonable time or continue to drag down performance.

Risk Aversion involves regularly selling winners well before they reach their full potential. Typically it is motivated by a fear that the market will take back the gains. This habit can be quite expensive as phenomenal buys are pushed out prematurely.

Loss Aversion describes regularly holding onto losers too long. It can reflect the manager unconsciously avoiding the negative feelings that accompany realizing a loss. These positions hurt performance with possible further declines and by limiting the ability to purchase new and more productive stocks.

The Endowment Effect is the tendency to keep older winners well past their productive time. These old favorites have stopped producing but have earned a special place in the manager's mind. They tend to stay at the back of the line when sell candidates are being considered.

Sizing is evaluated separately from buying or selling in this framework. Having the right amount of capital invested in each position can turn good buys into great positions. The proper shape to your sizing decisions can help reach full position weight in time for the run up. This skill requires knowing if your typical winner tends to be a slow starter or perform fast out of the gate. Analysis of sizing also helps expose whether adds and trims provide a net gain or loss. The better your sizing, the more alpha captured from the positions held.

Regret Aversion is the tendency to hesitate in adding to winning positions. It’s thought that once the stock begins to take off, the manager mentally kicks himself for not having purchased more when the price was cheaper. The stock takes off without ever reaching adequate investment size.

Conclusion

What distinguishes delivering professional results from merely being a professional is skill. Portfolio managers have not been well supported in understanding or honing their skills. Knowing how well buys, sells and sizing add to performance is the first step in awareness and improvement. Skills analysis and accurate feedback are key ways to reframe your practice and to keep behavioral biases at bay. Of course, you could just hope that the rest of the field keeps on hitting mulligans.

References:
The ideas expressed here are those of Cabot Research LLC. They reflect the research and pioneering analytics formulated during the development of Cabot Behavioral Analysis® (Patent pending).