A preliminary study into the physiology of fund managers shows significant emotional responses whe...
A preliminary study into the physiology of fund managers shows significant emotional responses when they trade, belying the myth that a manager's stock selection is an unemotional process.
Andrew Lo, Harris & Harris Group professor and a director at MIT Laboratory for Financial Engineering, said he is still seeking traders to take part in the experiment, which is aiming to see if the physiology of managers is different to that of other professions.
Risk seeking on losses and risk averse on gains is the typical reaction of most investors, but with most of the managers being tested, the opposite is true, he said. The only group to choose differently when given a set of scenarios illustrating risk aversion was securities traders.
Risk management is a contradictory term as it is a necessity for creating investment performance and a source of it, Lo noted.
'Risk management can be a source of alpha,' he said, noting this can be difficult to establish. 'Loss aversion is deeply engrained and sometimes can lead us to make harmful choices.'
He highlighted this using the example of a fund achieving annual returns of 5% with 75% volatility. By adding a layer of risk management which would prevent losses greater than 10%, the expected return on that fund would rise from 5% to 22%, he said.
Investors should not look solely at statistics as they prove little when it comes to actual performance, he said.
Probability can lead a manager in a large universe of funds to outperform, making it difficult to ascertain by statistics alone whether a fund manager has luck or skill.
He cited the example of Peter Lynch, formerly of the Magellen fund, who outperformed the S&P 500 for 11 years out of 13.
Using the example of achieving heads or tails when flipping a coin, Lo asked the 700-strong audience at the Borsa Italiana Milan conference to flip a coin 13 times. The probability of it landing heads 11 times out of 13 was one in 100, he said.
While he admitted in the case of Lynch it probably was more skill than luck, Lo said in a universe of funds, one manager producing 11 years of outperformance out of 13 is almost guaranteed in a universe of 500 funds.
Track records can also be deceiving as the strategy behind the returns is sometimes masking a riskier approach than investors would want.
'Managers must provide risk transparency and to do this they need new tools, something academia is working on. Investors also need more training.'
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