BOSTON – It turns out that mutual-fund managers aren't so different from the rest of us, at least when it comes to impulsive investment decisions.
Even professional investors are prone to make poor trades when ingrained habits lead them astray. That's especially true in volatile markets, where keeping a cool head is a challenging but crucial requirement.
Since mental traps can lead to underperformance, some investment pros are enlisting a Boston-based consulting firm to teach them better behavior. Cabot Research pledges to help portfolio managers improve investment performance by making them "aware of persistent tendencies they exhibit when they buy and sell securities," said Mike Ervolini, the firm's chief executive.
Nearly all decisions, conclusions and actions people make are formulated in the subconscious brain, Ervolini says. "We help managers understand whether those persistent decisions are taking them farther down the road toward good decisions, or if they lead them astray," he said.
For investors, the seeds of personal growth are planted in the field of behavioral finance, a discipline that studies the effects of emotions on people's investment choices. Cabot Research relies heavily on behavioral finance theory to spotlight managers' foibles. These judgment errors include overconfidence, selling winners too early, and giving themselves too much credit.
Overconfidence is perhaps investors' biggest mistake, Ervolini says. The sense that you're right more often than not inhibits the healthy practice of reflecting on past mistakes, he noted.
Investors are also prone to "self attribution" — taking credit for decisions that go well and avoiding responsibility for those that don't. Self attribution, Ervolini said, disregards the fact that "some successes are based on discipline and skill, while others are based on chance or luck."
Yet another blunder is the so-called disposition effect — selling winning stocks to book a profit rather than unloading poor performers to cut losses.
"It feels good to acknowledge being a winner, and it feels bad being a loser," Ervolini observed.
Although Ervolini declined to name specific clients, he says Cabot has advised funds with "multiple billions of dollars" under management and is currently advising seven funds in production.
The firm did provide a case study of a successful, unnamed $5 billion large-cap stock fund in which the managers were at times too cautious. During periods when the fund's returns exceeded the benchmarks, the managers bought low-volatility "safe" stocks to protect their gains. Cabot found the managers would have performed better if they hadn't altered their approach or appetite for risk during times of higher performance.
In a study of another thriving stock fund — this one a small-cap portfolio — Cabot discovered that the managers sold their winning stocks much more quickly than the average position — the "disposition effect" in action. They would have done better by holding the winners longer with the added benefit of lower turnover, Cabot found.
Lessons for individual investors
Cabot attempts to identify the manager's or team's unique investing behaviors. It analyzes the fund's trading history, and then interviews the managers to determine the root causes. To determine if certain tendencies are beneficial or harmful, Cabot looks at how a portfolio would have performed if the managers didn't engage in a specific type of behavior.
Investors can also benefit by studying the behavior of money managers to avoid similar pitfalls. Vulnerability to mistakes is particularly acute during bull markets, says Meir Statman, a professor at the University of Santa Clara in California and an expert on behavioral finance.
"Individuals have a tendency to get optimistic after the market has gone up and increase their expectations for future returns," Statman said. People also have a greater propensity to trade during these times, he adds, but research shows more trading lowers their rate of return since most investors are poor market timers.
Statman used a tennis analogy to describe many investors' flawed perception about how markets work.
Armed with a hot stock tip they've seen on television or read in the paper, they buy a company without considering who is taking the other side of the trade — the equivalent of hitting a tennis ball against a practice wall.
"What hurts them most is not understanding the nature of the game. There is someone on the other side of the net who probably has the same information and is more skilled," Statman explained.
Investors need to ask themselves if they have an advantage or special non-inside information that isn't accessible to everyone.
"If they answer honestly, the answer is no," Statman said. "Investors focus way too much on trying to beat the market."
Robert Shiller, an economics professor at Yale University and another well-known researcher in the field, agreed that cockiness is a common stumbling point for individuals.
"Before, investors thought they could pick stocks. Now some people are understanding they should leave stock picking to the experts, but they're trying to select winning mutual funds," Shiller said. "It's just hard for investors to get past the idea that they can outsmart everyone."
Copyright (c) 2007 MarketWatch, Inc.