To err is human; to get paid for it is divine.
That could be the motto of professional portfolio managers who rack up high fees for results that a blindfolded chimpanzee would be ashamed of—if chimps could blush. Several new studies show that the so-called smart money is prone to many of the same errors as amateurs. Everyone can learn from such mistakes.
Professional investors hold stocks too long. They react erratically to stock splits. They may even buy one stock when they intended to purchase a different one—almost as often as supposedly clueless individual investors make the same kind of blunder.
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In a study released this week, Essentia Analytics, a London-based firm that studies portfolio and behavioral data to give investment managers feedback on their decisions, looked at whether professionals sell stocks at the right time.
Analyzing 14 years of data on more than 9,000 round-trip investments, Essentia found that managers held on to stocks well past their peak—reducing the performance contribution from those positions by an average of 0.07% from peak to final sale.
That might not sound like much. But 0.07% is more than twice the total annual expenses of popular exchange-traded index funds from iShares,
and Vanguard Group.
The problem, says Essentia’s head of research, Chris Woodcock, is what psychologists call the “endowment effect.” This is the automatic tendency to put a higher value on what you own than what you don’t—and to become reluctant to part with something merely because it is yours.
Therefore, he says, portfolio managers “put greater focus on positive rather than negative attributes” of the stocks they own. That leads them to minimize potential bad news and to hang on too long.
A case of mistaken identity: In 2013, when Twitter Inc. filed for its IPO, Tweeter Home Entertainment Group Inc., a bankrupt electronics retailer, rose 1,800% in a day.
Mike Ervolini, chief executive of Cabot Investment Technology, a Boston firm that seeks to help asset managers improve results, says about one-third of the $3.5 trillion in portfolios Cabot has analyzed hold on to winners too long. On average, he says, that impairs returns by about one percentage point annually—although that is “easily reversed” with better feedback on how to refine their process and judgments.
To help counteract the problem, investors can set predetermined price levels—say, a price move of 25%—at which they must re-evaluate a stock. And they should use a blank slate, asking whether they would buy the stock at the latest price if they had never owned a share.
Another new study of investors, large and small, looks at how they respond to news.
Imagine two highly similar firms with the same market capitalization, but one has a greater number of shares trading at a lower price per share. Important information—the hiring of a CEO, the introduction of a product—should move either stock by about the same percentage.
In practice, comparable news turns out to have a bigger impact on stocks with lower share prices. It’s as if investors, instead of thinking in percentage terms, are telling themselves something along the lines of “this news is worth $1 per share.”
Professionals wouldn’t do that. Would they? “Even among firms with extremely high institutional ownership,” says Kelly Shue, a professor of finance at the Yale School of Management and co-author of the study, “the bias is still strong and significant.” That may cause stocks with low share prices to fluctuate more sharply than the facts justify.
Let’s consider another oddity. In April, tiny Zoom Technologies Inc. soared when traders bought its stock instead of Zoom Video Communications Inc., the hot initial public offering they thought they were getting. In 2013, when
filed for its IPO, Tweeter Home Entertainment Group Inc., a bankrupt electronics retailer, rose 1,800% in a day.
Surely such blunders can be committed only by naive individual investors mashing away on phones or laptops.
Surely you jest.
A new study looks at more than 250 companies with similar names or tickers and estimates that 5% of their total trading volume consists of such cases of mistaken identity. Andrei Nikiforov, co-author of the research and a finance professor at the Rutgers School of Business in Camden, N.J., says he assumed individual investors must be solely responsible.
He was wrong. Sorting the trades by size, and by whether the stock exchange identified them as originating from retail investors, showed that institutions made such trades roughly as often.
Some of that could be deliberate.
Computer-driven trading firms may be detecting a spike in trading volume when naive investors confuse one ticker or stock name for another; the machines then buy the same shares automatically to catch a further rise. Because it takes roughly a week, on average, for such stock prices to revert to normal, mechanically buying on the basis of someone else’s mistake might not be a mistake.
But that may not account for all the mistaken institutional trading, says Prof. Nikiforov. Some professional investors could be buying, say,
Helmerich & Payne
) thinking they’re getting HP Inc. (ticker: HPQ).
In that case, however rare it might be, a cynical quip from the late Martin Whitman, founder of the Third Avenue funds, might apply: “When you use the word ‘professional’ on Wall Street, it doesn’t mean they know anything. All it means is that they do it for money.”
Write to Jason Zweig at email@example.com
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