Is it possible to learn investment skill? And if you’re good, how do you get better?
A couple of interesting papers have been discussed in our Tuesday Markets Meetings over the past few weeks. Both of them seek to establish what makes a good trader. It’s part of an increasingly nuanced and systematically rigorous field of academic study, which looks at the complex and often chaotic financial markets and seeks to understand what characteristics distinguish the best performers. It’s something we think a lot about at Man Group, particularly in our Skills team, which sits on the trading floor and seeks to identify and optimize key drivers of performance in our teams of portfolio managers. Think Wendy Rhoades in ‘Billions’ (although in a VERY different culture), with a focus not just on coaching and psychological insight, but also in helping at a granular level to improve the specifics of each trader’s investment process.
In their paper ‘What Makes a Good Trader? On the Role of Intuition and Reflection on Trader Performance’, Brice Corgnet et et al. undertook an extensive “laboratory” study of traders in an effort to understand what psychological traits play the most significant role in success. They identify three critical elements: fluid intelligence, cognitive reflection and theory of mind.
· Fluid intelligence is defined as one’s ability to conduct mental simulations and engage in abstract reasoning. Those with high fluid intelligence are able to move nimbly through the markets, avoiding behavioral biases and absorbing and assessing the flow of market information.
· Cognitive reflection is the ability to engage in effortful reasoning: adds to fluid intelligence because it helps individuals avoid commonly-observed heuristics and biases, in particular conservatism bias, which is the propensity to stick with one’s priors. The great behavioral economist Richard Thaler has written brilliantly on this.
· Theory of mind might be thought of as a measure of psychological maturity, the ability to be empathetic, to understand that others may have different perspectives and express these perspectives in different ways in the markets. As the paper says: “one’s capacity to infer others’ intentions… is key to detect the informational content of trading.”
The chart below shows the top vs bottom quartile performance of traders in the study according to the three measures (and then in combination). Raven refers to the test for fluid intelligence, CRT is the Cognitive Reasoning Test and ToM is Theory of Mind test as – fun fact – developed by Ali G’s dad, Simon Baron-Cohen.
The other paper that got us talking was Professor Andrew Clare et al.’s ‘Manager Characteristics: Predicting Fund Performance’. The paper took a cohort of managers and their long-term returns (in some cases total career returns) and sought to ascertain what characteristics, and particularly which qualifications, made the difference between the best and worst traders. A few observations before we go on to whether my MBA was worth the year of late nights and essay crises…
1) The cohort studied was overwhelmingly (almost 90%) male; nonetheless, gender was not a meaningful indicator for performance.
2) Where gender was an interesting differentiator was in style tilts. As the chart below shows, female investors were less likely to be allocated to broad market factors or Small Cap, while they were significantly more exposed to Value. A T-Stat of +/- 2 means that the figure is statistically significant. In the gender column, a negative figure reflects a female bias, positive is male.
3) Some other sometimes surprising observations from the data… When Tenure (time in one firm), Experience (total time in market) and Age are analyzed in combination, it’s Experience that matters (although in isolation they are each statistically significant). Interestingly, team size is an important indicator, with larger teams delivering significantly worse performance. This is likely an indicator of the dangers of groupthink. As a wise market mentor of mine used to say: bad ideas travel faster than good ones, particularly in teams.
4) Finally, then, education. It’s striking (and, I have to admit, somewhat depressing) that neither my MBA nor the CFAs that are held by many of our portfolio managers is statistically significant. Indeed, the only really powerful data point when it comes to education is what a powerfully negative indicator of performance a PhD is. Too smart for their own good, perhaps? Or – more likely – an indicator of managers who are exploring the outer edges of the financial markets and whose occasional failures are the price paid for evolution and discovery.
I spoke about these papers with George Whicheloe, who runs our Skills team, and we came up with the following 5 rules for investment success. They draw on our deep engagement with the academic theory, as well as George’s work engaging day-by-day with our portfolio managers, helping them to understand and optimize the drivers of their performance.
1. Know Your Role: Are You the House or the Player?
- In the casino of financial markets, the house and the player operate on different strategies – and knowing which one you are is critical.
- If you’re the house (think high-frequency or systematic strategies), you win small but often, with the occasional big loss being the price of doing business. Consistency is key, with a high hit rate but low payoff per trade.
- On the other hand, if you’re the player (think long-term fundamental discretionary), you might endure long stretches of average returns, hoping for that rare but outsized success. Low hit rate, big payoff.
- Decide which side you’re on and embrace the quirks: the house accepts small, frequent wins, while the player aims for that one giant score that makes up for everything else.
2. Idea Generation: More is More
- You’re only going to get about half your investment ideas right (on a good day). So, what’s the answer? Generate more ideas, and better ones.
- Why? High idea throughput increases your odds of finding that one winner. It’s not about throwing spaghetti at the wall – it’s about maximizing your chances to seize asymmetric opportunities.
- Research shows alpha is juiciest at the inception of ideas, so acting fast and scaling up winners is key. Don’t just find the good ones – get big in them, quickly.
3. Beware of Unintentional Bets
- Hidden factor risks can sneak into your portfolio and wreak havoc.
- Timing market factors – like betting on momentum or volatility – rarely pays off. They can quietly drag on performance or cause sudden reversals that leave you off your game.
- Focus instead on idiosyncratic returns – what you can control through stock selection. Factor bets are a bit like leaving your chips on the table when you’ve already won a round – walk away while you’re ahead.
4. Time is Money (Literally)
- Everyone talks about return on capital, but return on time is just as important.
- If you don’t have the skill (or time) to size positions correctly, consider equal-weighting your portfolio. It’s a simple way to increase diversification and focus your energy on higher-value tasks, like generating new ideas.
- Don’t burn hours obsessing over position sizing if it’s not your strength. You could use that time for deeper research or improving your process.
5. Make the Process Part of the Process
- The best investors don’t just review their results – they obsess over their process.
- Embrace behavioral analytics. Use data to track biases in your decision-making. This can help you identify and eliminate blind spots, making your process more efficient and less emotionally driven.
- Read the papers: not just the financial press, but the academic papers that delve deeply into the key drivers of investment returns. An hour or two a week on SSRN will make you a smarter person and, we believe, a better trader.
Investing is as much about refining your approach as it is about picking the right stocks. By understanding whether you’re the house or the player, ramping up your idea generation, avoiding hidden risks, optimizing your time, and continuously improving your process, you can navigate the markets more effectively. Success in investing doesn’t come from getting it right every time – it comes from improving how you think about the game.
Read the full article here
