By Joshua Thurston - Citywire
Although ‘past performance is not a guide to future returns’ is the familiar refrain trotted out, we continue to deify top-performing managers and many are willing to talk about the drop off in a fund’s track record being solely down to their investment style being out of favour.
However, what very few talk about, but perhaps should, is whether the emotional state of a manager following a period of great performance is linked to their downturn.
‘It is one of the trade secrets that we never talk about, the emotional rollercoaster that is the job,’ said Alan Custis, the Citywire A-rated Lazard Asset Management managing director and portfolio manager.
The first question worth asking is whether a fund manager’s overconfidence really can have an impact on returns.
‘Success does breed a degree of confidence. Time and again with high profile managers, if your stock selection has not been working, you intuitively become more risk averse; it is very difficult to stop yourself going that way,’ Custis said.
‘If you have had a good period of performance, you are more inclined to take more risk in the portfolio and those are effectively the seeds of the next downturn in your performance.’
Accept your limitations
In their discussion paper ‘Overconfidence in Investment Decisions: An Experimental Approach’, Dennis Dittrich, Werner Guth and Boris Maciejovsky, from the Max Planck Institute for Research into Economic Systems Strategic Interaction Group, stated that overconfident managers are often found to overestimate the precision of their knowledge. They are more confident of their predictions in fields in which they have self-declared expertise.
Latitude Investment Management’s Freddie Lait certainly thinks overconfidence can adversely affect managers.
‘What I often say is: overconfidence is quicksand for reason in the financial industry,’ he said.
‘When you become that overconfident and you have had some success, you stop doing the things that you knew were rational when you were struggling or when things were a little bit harder or more balanced.’
This is not to say he sees confidence in itself as necessarily a bad thing, however.
‘Confidence is very good, but overconfidence can be very bad, so what we say is we are highly confident in the process, but that does not mean that you should be overconfident in each individual investment.’
Trust the process
According to Lait, the way to avoid falling into the trap of overconfidence is by sticking to your investment process no matter what.
‘Suppose you and I have a £10 bet on the role of a die: if you roll one, two, three or four you win and if I roll a five or six I win, you should take that bet. But, on a single dice roll, you cannot be confident, because there is a third of a chance you will lose all of your money.
‘However, over 100 rolls you can be exceptionally confident and you could almost guarantee that you were going to win. That is the way we think about process.’
Dittrich, Guth and Maciejovsky’s findings seem to support Lait’s view on the importance of process. They demonstrated that the overconfidence of investment managers also increases with the complexity of a task. Therefore, it follows suit that sticking to a singular process can help fund managers rein this in.
Lait said: ‘We have a process that has all of the building blocks that should give us a better chance of success or should give us four out of six on that dice roll. That is how you conquer overconfidence, so you are detached from each individual investment.’
The right team
Beyond relying on a process, Waverton fund manager Will Hanbury says that surrounding a manager with the right team can really help.
‘We do suffer from confirmation bias; we tend to look for arguments that support our views,’ Hanbury explained.
‘People have a tendency to love or hate things and when you are in investing, this can be very damaging, especially with people holding stocks that have done very well.’
Hanbury is backed up by behavioural finance research which, as Arman Eshraghi and Richard Taffler explain in their ‘Fund manager overconfidence and investment performance: evidence from mutual funds’ study, assumes investors are often subject to behavioural biases that can negatively affect their financial decisions.
Eshraghi and Taffler go so far as to suggest ‘the investment industry as a whole, and fund trustees in particular, can also benefit from introducing some type of psychological screening in the fund manager selection process’.
They point out that the hiring of fund managers is traditionally heavily dependent on the manager’s past performance record, when more detailed profiling of individual’s thought processes and behaviours in different scenarios would be more beneficial.
‘We argue that by adding certain psychological attributes to the list of critical factors in hiring fund managers, investment companies can raise their chances of recruiting more “successful” managers,’ the pair wrote.
‘Psychometric tests attempt to measure the abilities, attributes, personality traits and various skills of the candidates under consideration for particular vacancies.’
Challenging established views
Aside from this, one way Hanbury highlighted to mitigate excessive self-confidence in fund managers is by having a team of analysts who can genuinely challenge their established views.
Custis agrees, pointing out that having an analyst’s input is clearly a counterweight, noting a committee of one is not as good as a committee made up of a number of people when it comes to making a decision.
Although the danger of becoming overconfident is present, Custis does see the job itself as self-regulating to an extent.
‘What you have is a job in which your periods of complacency are comparatively short, because as night follows day, you know what you have is going to stop working at some point.’
He said that even during a patch of good performance, managers can be certain that it will not last forever, as investing in the markets is like investing in a living organism and every-day things change.
‘So you are trying to constantly work out what it is that is going to change and how your portfolio will be impacted as a result of whatever changes keeps us/me awake at night. That’s the job,’ he added.