New studies indicate a tendency among pros to be biased or careless when making trading decisions
As developments in global economies and the financial markets create a cocktail of uncertainty, there’s a greater need for investors to tread carefully and avoid making biased or mistaken decisions. That advice applies mainly to amateur traders — though professionals might also have to check themselves.
“Several new studies show that the so-called smart money is prone to many of the same errors as amateurs,” wrote Wall Street Journal columnist Jason Zweig.
One of those studies comes from London-based Essentia Analytics, which provides investment managers with feedback based on portfolio and behavioural data. Based on 14 years of figures covering more than 9.000 round-trip investments, the firm found that managers held on to stocks far past their peak; the performance contribution from those positions reportedly slipped by an average of 0.07% from peak to final sale.
Essentia’s head of research, Chris Woodcock, chalked this tendency up to the so-called “endowment effect”: human beings — as well as portfolio managers, it seems — put a higher premium on what they own than what they don’t. They “put greater focus on positive rather than negative attributes” of the stocks they hold, Woodcock said, leading them to minimize potential bad news and put off ditching their erstwhile winners.
That squares with similar observations made by Cabot Investment Technology, a Boston-based firm that aims to help asset managers improve results. According to CEO Mike Ervoloni, around a third of the US$3.5 trillion in portfolios they have analysed hold on to winners too long, impairing returns by around 1% annually.
Another study focused on how investors, large and small, respond to news. Specifically, they examined how firms with similar market capitalizations, but different numbers of shares — one might have a higher number of shares selling at a lower price — are affected by important information. Theoretically, comparable news on matters like executive hires and new products should move either stock by around the same percentage.
But researchers found that stocks with lower share prices experience a bigger impact in percentage terms. “Even among firms with extremely high institutional ownership, the bias is strong and significant,” said Kelly Shue, a professor of finance at the Yale School of Management and one of the study’s co-authors.
Zweig cited one more piece of research that looked at over 250 companies with similar names or tickers. It found 5% that roughly 5% of their trading volume happened due to “mistaken identity,” where traders make a play on one stock when they meant to do so for another with a similar identifier.
“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 [as individual investors],” Zweig reported.
One charitable interpretation supposes that computer-driven trading firms detect spikes in trading volume driven by naïve investors’ confusion, so they exploit opportunities from those mistakes. But according to Andrei Nikiforov, co-author of the research and a finance professor at the Rutgers School of Business, that may not account for all the mis-targeted institutional trading.