Managing Equity Portfolios

Managing Equity Portfolios: A Behavioral Approach to Improving Skills and Investment Processes

Michael A. Ervolini
Foreword by Terrance Odean
Copyright Date: 2014
Published by: MIT Press
Pages: 304
https://www.jstor.org/stable/j.ctt9qf6fb
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  • Book Info
    Managing Equity Portfolios
    Book Description:

    Portfolio management is a tough business. Each day, managers face the challenges of an ever-changing and unforgiving market, where strategies and processes that worked yesterday may not work today, or tomorrow. The usual advice for improving portfolio performance -- refining your strategy, staying within your style, doing better research, trading more efficiently -- is important, but doesn't seem to affect outcomes sufficiently. This book, by an experienced advisor to institutional money managers, goes beyond conventional thinking to offer a new analytic framework that enables investors to improve their performance confidently, deliberately, and simply, by applying the principles of behavioral finance.W. Edwards Deming observed that you can't improve what you don't measure. Active portfolio management lacks methods for measuring key inputs to management success like skills, process, and behavioral tendencies. Michael Ervolini offers a conceptually straightforward and well-tested framework that does just that, with evidence of how it helps managers enhance self-awareness and become better investors. In a series of short, accessible chapters, Ervolini investigates a range of topics from psychology and neuroscience, describing their relevance to the challenges of portfolio management. Finally, Ervolini offers seven ideas for improving. These range from maintaining an investment diary to performing rudimentary calculations that quantify basic skills; each idea, or "project," helps managers gain a deeper understanding of their strengths and shortcomings and how to use this knowledge to improve investment performance.

    eISBN: 978-0-262-32301-7
    Subjects: Finance

Table of Contents

  1. Front Matter
    (pp. i-vi)
  2. Table of Contents
    (pp. vii-viii)
  3. Foreword
    (pp. ix-xiv)
    Terrance Odean

    In 1995, Don Keim and Ananth Madhavan published a study of 62,000 equity orders placed by 21 institutional investors. Three of the institutions were indexers. Of the remaining 18 active managers, 15 sold stocks that, on average, had outperformed the market the week before the sale. This finding was hardly puzzling if managers used price targets to trigger trades. What surprised Keim and Madhavan was that “some traders appear to adopt different strategies on the buy and sell sides.” Six of the managers who were selling recent winners were also buying recent winners, and two of the three who were...

  4. Preface
    (pp. xv-xvi)
  5. Acknowledgments
    (pp. xvii-xviii)
  6. Introduction
    (pp. xix-xxii)

    Is there anything new to say about equity portfolio management? Yes, and it has to do with improving. Not the usual stuff about developing your strategy, staying within your style, doing better research, and trading more efficiently. These things are important, of course, but they don’t get to the heart of improving. And that is what this book does. It lays out a new framework that enables you to improve confidently, simply, and deliberately. But I’m getting ahead of myself, so I’d better back up and explain why I wrote this book.

    Cabot Research LLC has been helping equity portfolio...

  7. Part One: Game Change
    • 1 Industry Challenges
      (pp. 3-18)

      The debate over skill within the active equity management industry is alive and robust. Proponents point to portfolios that have beaten their benchmarks for three, five, seven years or more as ample evidence that skill exists. The opponents harrumph that the majority of actively managed funds underperform year after year. The truth, as with so many topics that arouse strong emotions, lies somewhere between these polar positions, as will be explained.

      This chapter provides a sobering look at the state of the active equity industry, particularly regarding investment performance. Rather than being presented as an indictment of active management, these...

    • 2 Why Johnny Can’t Improve
      (pp. 19-38)

      Equity portfolio managers have every incentive to beat their benchmarks, yet few are able to do so. In attempting to do better, managers spend several billion dollars each year on enhancing their stock screening, refining portfolio construction, tightening position sizing and risk management, achieving stronger trade execution, and so on. Yet consistently delivering benchmark-beating results remains elusive for many managers. This chapter considers why improving is so difficult for active managers, with particular focus on the inadequacies of traditional portfolio analytics, the importance of harnessing intuitions, and the need to use a scientific approach to improving.

      Chronic dissatisfaction with the...

    • 3 New Analytic Framework
      (pp. 39-50)

      This chapter sets out a new analytic framework for isolating and quantifying investment skills. Rather than working backward from outcomes to infer what happened, the new framework builds insights from the bottom up by using each decision that goes into a portfolio to compute skills. It provides both rigor and granularity in investigating which decisions are consistently adding alpha to the portfolio and which are not. In chapter 4, the same framework demonstrates both how investment processes can be rigorously defined, codified, and improved, and how to identify, quantify, and overcome behavioral tendencies. The framework can be implemented robustly as...

    • 4 Process and Behaviors
      (pp. 51-66)

      This chapter builds upon the new analytic framework developed in chapter 3, providing robust methods to investigate, quantify, and improve investment processes and behavioral tendencies. The primary method introduced for supporting investment processes is context analysis. Context analysis supports codifying the processes being used and identifies clear opportunities for improving. This section concludes with an example of how to improve the buy process. The new framework is then applied to analyzing behavioral tendencies using the adjusted portfolios that were introduced in chapter 3. The analytic framework is extended to introduce out-ofsample simulations to confirm the persistence and statistical significance of...

    • 5 Feedback in Action
      (pp. 67-76)

      This chapter describes how some equity portfolio managers today are learning and improving with better feedback. Armed with clear insights into their personal strengths and shortcomings and supported with up-to-themoment decision-making information, these professionals are building stronger skills, refining their investment processes, and eliminating unproductive behavioral tendencies. While their specific circumstances may be unique, the underlying issues and opportunities discussed here are prevalent throughout the industry.

      The managers discussed in this chapter represent a cross-section of strategies and styles. All of them are fundamentally bottom-up investors, although some rely upon straightforward factor screens or alpha models to support their process....

    • 6 Phantastic Risks
      (pp. 77-84)

      It comes as no surprise that active management necessitates taking on risk. While the financial literature is brimming over with materials about risk measurement, portfolio construction, portfolio optimization, and value at risk (VAR), precious little has been written on the relationship between emotions and risk. Yet emotions find their way into the portfolio through the buy, sell, and sizing decisions that managers make daily. In this chapter we expand the discussion of the unconscious and consider its impact on portfolio risk.

      Some managers make their decisions guided primarily by models, while others prefer a bottom-up fundamental approach. And there is...

  8. Part Two: Behavioral Matters
    • [Part Two: Introduction]
      (pp. 85-86)

      Facts, illusions, analysis, and emotions equally conspire to shape your worldview and the judgments you make. Consequently, knowing when your thoughts are being driven more by your desires than your intentions is proving to be an important and untapped source of alpha for professional investors. The ability to distinguish financial merit from fantasy while engaging in the exciting and analytically demanding world of investing requires a tremendous level of self-awareness, the kind that is built on more than self-reflection and a glance at one or two recent decisions. It involves developing a working knowledge of the mental pitfalls that are...

    • 7 What Drives Selling?
      (pp. 87-90)

      Most portfolio managers claim to follow an explicit selling discipline—just look at any pitch book. These statements of sell discipline tend to include phrases such as “sell when full value is recognized”; “sell when fundamentals erode”; or “sell opportunistically when stronger uses for the capital become available.” The process of selling is, in practice, much less rigorous—especially in comparison to buying. From the classic bottom-up investor to those supported with quantitative tools, two facts about selling are clear: It’s highly judgmental, and its effectiveness is less understood than investment practitioners generally believe. This essay looks at the results...

    • 8 Sell the Way You Buy—Strategically
      (pp. 91-94)

      Effective selling is paramount to delivering consistent long-term performance. Good sells, in effect, are how managers capture the performance generated from their buys. Yet little serious attention is given to the practice of selling, as evidenced by the paucity of professional and academic journal articles on this topic. This essay focuses on the inadequate attention given to selling and how this overlooked skill may be undermining the active management industry generally.

      Practitioners and academics alike know intuitively that selling is important to portfolio performance. Nevertheless, very little has been studied or written about this skill. In one of the very...

    • 9 Bearing Up in a Bear Market
      (pp. 95-98)

      As Baron Rothschild’s maxim suggests, market turmoil can present equity managers with extraordinary buying opportunities. Capitalizing on such opportunities, however, requires that managers create liquidity within their portfolios—and that means knowing the best stocks to sell.

      Selling, as has been discussed in previous essays, is prone to behavioral influences. Research suggests that behaviorally motivated sell decisions increase when a manager is facing an underperforming portfolio or riding out a turbulent market. A few ideas to help you check your own behavioral tendencies during these times are presented below.

      No one likes being wrong or the feelings it evokes. The...

    • 10 Aching Conviction
      (pp. 99-102)

      The term “conviction” is used universally among professional investors to suggest that rigorous thinking has preceded a buy or sell decision. What is really backing up conviction? Does conviction reflect knowledge and wisdom accumulated over years, or is it merely bluster? Understanding the nature of conviction, and how this can help portfolio performance, are the subject of this essay.

      The dictionary defines “conviction” as a “fixed or firm belief.” How are beliefs formed? Are people aware of their complete set of beliefs? Can we consciously edit or manage beliefs? The answer to the last two questions is a resounding no....

    • 11 Unconscious Deliberation
      (pp. 103-106)

      Conscious thinking plays an important role in many choices and decisions we make—but it is a bit player in comparison to the unconscious brain. Neuroscience makes clear that the vast majority of the thoughts, ideas, and choices that enter our minds and direct our actions are the result of unconscious thinking. This essay looks at the role of the unconscious brain in investment decision-making and how the unconscious can be harnessed for better results.

      Strategy, discipline, and process are the means that professional investors use to consciously direct their decisions. And it is through objective research, analytic stock scoring,...

    • 12 Investing in Self-Awareness
      (pp. 107-110)

      Self-awareness is quickly becoming a mainstream concept within money management companies. That is because active management requires judgment and its exercise is most successful when all the facts and influences are known. As discussed in previous essays, selling is less disciplined than buying and, therefore, is far more susceptible to behavioral influences. In this essay we examine the role of self-awareness and its potential for helping you make better sell decisions.

      Self-awareness begins with accurate feedback. Without adequate information about decisions they have made and how they worked out, portfolio managers are severely hampered when trying to improve. Consider the...

    • 13 Stressing Performance
      (pp. 111-114)

      No one has to tell you what stress feels like. It is your job to make the tough decisions about which names stay in the portfolio and which go. This is a burdensome responsibility, even in the best of times. But these are not the best of times. Your normal processes are being wrecked by a market slump well outside your career experience, combined with outflows that can be unnerving. If you are sensing in yourself a few raw nerve endings, that is only natural. It is one thing to survive stressful times and quite another to excel during them...

    • 14 Thesis, Narrative, or Just Another Disappointing Story
      (pp. 115-118)

      Stocks are often managed on the basis of a thesis. This has come to mean that the manager has a clear expectation of how a stock will add alpha to the portfolio and she can express it in a tight sentence or two. The mere existence of a thesis is intended to suggest thoughtfulness, conviction, and discipline. However, the dictionary defines “thesis” as “an unproved statement or argument put forward as a premise.” Too often the tentative nature of a stock’s thesis is lost, inviting behaviorally motivated decisions that undermine performance. In this essay, we examine the nature of the...

    • 15 Dreaming of Alpha
      (pp. 119-122)

      Investment decisions reflect the strategy, research, process, and discipline consciously developed over many years. They also, as we have seen, reflect influences from the unconscious brain—even inadequate sleep. Sleep deprivation is epidemic in America. Among stressed-out portfolio managers, sleep seems to be a rare asset. Beyond making you feel drowsy or in need of caffeine, insufficient sleep heightens behavioral responses, inhibits learning, and weakens decision-making. This essay looks at new research about “running on empty” and how it can undermine your performance.

      Everyone knows what it’s like to be sleep-deprived. Depending on how many hours are lost, and for...

    • 16 Motivated Reasoning
      (pp. 123-126)

      Confronting our own mistakes in judgment is painful. It is one reason we rationalize. Rationalization can alter our interpretation of facts and lead to ineffective decisions. It is, therefore, one of the powerful unconscious forces that will drive you toward behavioral investing. In this essay we discuss rationalization, motivated reasoning, and five simple ideas for greater self-awareness.

      Rationalization is something we all do. You might even think of it as wishful thinking. By either name, it’s the tendency individuals have to fit perceptions of reality into a mold that is heavily influenced by desire. It underlies why we are highly...

    • 17 Regrettable Choices
      (pp. 127-130)

      Equity investing requires the ability to price uncertainty. But at what emotional costs? Having to live with a poor outcome or the knowledge of a missed opportunity makes even the best of us want to kick ourselves. This essay examines how, if left unchecked, these feelings influence investment decisions in unintended ways.

      Regret is the emotion we experience when confronted by a mistake, especially one for which we feel responsible or can easily imagine better options. Regret springs from poor results and foregone opportunities. The consequences can be severe, as in the case of the man who killed himself when,...

    • 18 Endowing Success
      (pp. 131-134)

      Holding winners well past their alpha generation is a tendency regularly observed among professional investors. These once highly productive buys inevitably devolve toward reversion to the mean, yet they seem to hold a special place in the minds (or is it hearts?) of the managers. One explanation for holding winners too long is the endowment effect—valuing items higher when we possess them, which makes it more difficult to find a clearing price. This essay takes a look at the endowment effect and how it can impact the management of portfolio positions.

      The endowment effect stifles selling. Richard Thaler first...

    • 19 Counterfactual Investing
      (pp. 135-138)

      Imagination and creativity, when calibrated, help turn good ideas into winning strategies and great stock picks. Imagination also can push investors toward unproductive decisions—ones that feel right while lowering performance. One form of runaway imagination is known as counterfactual thinking. This type of deliberation can negatively affect your interpretation of information, adversely influencing the buys and sells you make. This essay looks at counterfactuals and how they might affect your performance.

      Emotional responses to outcomes often are influenced by what might have been. Counterfactual thinking, as such thoughts are known, often ends in regret. As discussed in chapter 17,...

    • 20 Great Investing Is Not Natural
      (pp. 139-142)

      Success in active management demands skill. But where does this skill come from? Some believe it is innate, as Warren Buffett suggested when he said, “I was born at the right time and place, where the ability to allocate capital really counts. … I won the ovarian lottery. I got the ball that said, ‘capital allocator—United States.’”¹ A growing body of evidence, however, points to nurture, not nature, as the source of greatness in all manner of performance. This essay examines the importance of improving deliberately in order to achieve top performance.

      Remarkable talent is no longer attributed solely...

    • 21 Inside-Out Investing
      (pp. 143-146)

      Analysis is fundamental to equity investing. Deep dives require that you apply extensive energy and talent into understanding a company and its ability to deliver excess returns. Yet this activity can awaken behavioral tendencies that short-circuit your analytic processes. Consequently, rigorous analysis can heighten the potential for over optimism at exactly the moment when greater objectivity is needed. This essay examines the importance of calibrating judgments as a critical element of self-awareness and honing investment skill.

      The greater the opportunity or risk associated with a decision, typically the more analysis is performed. Investors commonly employ a process or framework to...

    • 22 Beware Phantastic Investments
      (pp. 147-152)

      By its very nature, investing requires making estimates about future events. These estimates reflect the manager’s analysis of facts combined with imagining likely but unsure outcomes. Imagination is what enables skilled investors to see opportunities ahead of the crowd. It can also excite emotions that make it difficult to distinguish real investment opportunities from “phantastic” ones.

      The theory of emotional finance examines investor tendencies through the lens of Freudian psychoanalysis. Sigmund Freud suggested that thoughts cause people to experience two basic types of feelings, pleasurable or painful. Pleasurable feelings, understandably, are sought out, and painful ones are avoided or repressed....

    • 23 Thanks for the Memories
      (pp. 153-156)

      The bedrocks of professional investing—experience, judgment, intuition, and deliberation—rely heavily on the use of memory. Though it is fundamental to learning and making effective choices, memory is also highly imperfect. While memories are sometimes cherished, they can push you toward investing misadventures. This essay examines how experts look at memory and its potential for generating investing shortfalls.

      Memory is the result of how information is captured, stored and retrieved. Most of what we remember after an experience (visual, auditory, etc.), happens automatically and pretty much involuntarily. Supporting this process, the brain chooses to capture information it finds interesting,...

    • 24 Skills, Process, and Behaviors
      (pp. 157-160)

      Skill is what separates top-performing managers from the pack. Ironically, little is known about investment skill, how it is developed, how to measure it, or how to improve it. The inability to isolate and measure, or even knowledgably discuss, specific investment skills has inhibited professional development. A new framework for evaluating investment skills can quantify strengths and weaknesses, calibrate their interaction with management processes, and identify behavioral tendencies. In this essay we discuss the potential of a new framework to help managers achieve their best.

      Professional performance requires deliberate practice—the kind that identifies and improves specific skills. For instance,...

    • 25 Processing Success
      (pp. 161-164)

      Managers should love their process, not the stocks they hold: This is the wisdom handed down by great investors over the ages. The more defined and effective the process, and the more it is adhered to, the better and more repeatable the decisions. Yet evidence suggests that process is not implemented to the same degree that it is talked about. This essay discusses the nature of mistakes and how to avoid them by using a checklist.

      The nature of errors in professional decision-making was pondered by philosophers Samuel Gorovitz and Alasdair MacIntyre.¹ Ignorance and ineptitude were the primary reasons for...

    • 26 Primed for Success
      (pp. 165-170)

      All decisions can be explained, but few are motivated for the reasons believed. That’s because unconscious forces motivate behavior in ways that are both subtle and stunning. Priming is one mechanism that shapes our thoughts, feelings, and actions. This essay examines the power of priming on financial decision-making and suggests basic steps you can add to your investment process to manage its effects.

      Priming is a mechanism that influences decisions unconsciously. As defined by researchers Dalia Gilad and Doron Kliger: “Priming is a process of activating particular connections or associations in memory prior to carrying out an action or task.”²...

    • 27 Fear, Anger, and Risk
      (pp. 171-174)

      Risk management is as much about emotions as it is about math. Yet emotions are seldom, if ever, discussed at risk conferences or in risk literature. It’s a bias, of course, in that the elements of risk are viewed as wholly outside of the decision maker—to be managed analytically like pieces on a chessboard. Decision research says otherwise. Feelings of fear, anger, and sadness can propel you toward risk-seeking or risk-averting behaviors, deftly overriding conscious intent. This essay considers a key element absent from modern risk models—the emotional factor.

      Risk-adjusted thinking is not natural. Humans are predisposed to...

    • 28 Successful Choices
      (pp. 175-178)

      Portfolios are collections of choices. It is through the act of choosing that positions move into and out of the portfolio. Thanks to the unconscious, however, the act of choosing is more fragile than generally thought. It ignites emotions that can push decisions in unexpected directions. This essay looks at choice, its challenges, and what you can do to make more of your best decisions.

      People are wired to make choices rather than accept someone else’s. This desire is more than obstinacy or even the need for freedom; it’s rooted in survival. If people did not believe they could think...

    • 29 Changing for the Better
      (pp. 179-182)

      Learning, adapting, and improving are the building blocks of successful investing. And whether you are sharpening skills, adhering more carefully to process, or taming behavioral tendencies, the ability to stay competitive demands change, which is easier said than done. This essay examines changing, its challenges, and how you can go about it more effectively.

      Changing behavior is hard, even when it’s a matter of life or death. “If you look at people after coronary-artery bypass grafting two years later, 90% of them have not changed their lifestyle,” according to Dr. Edward Miller, the dean of the medical school and CEO...

    • 30 Portfolio Thinking
      (pp. 183-186)

      Actively managed portfolios are collections of ideas and decisions. New research suggests that teams are better than individuals at generating both ideas and decisions, but only when their behavior enables them to think and act as an integrated alpha source. Ineffective groups, in contrast, may struggle to deliver beta. Attributes of highly effective teams are becoming clear, making it possible for groups to improve deliberately. This essay looks at how small changes to process and behavior might help yield more from your investment team.

      Anita Williams Woolley and her colleagues investigate what drives group performance. They have conducted extensive research...

    • 31 Promiscuous Thinking
      (pp. 187-190)

      Introspection is uniquely human. People are, as far as we know, the only species that thinks about thinking and how we feel. But all reflections may not lead to smarter decisions. When trying to articulate why we like this over that, we are apt to describe what’s reasonable rather than what we believe. The results include mislearning and confusion about motivation. This essay looks at issues surrounding introspection and the reasons it is no substitute for rigorous analysis and effective investment processes.

      Contemplation before making decisions can help managers make smart decisions, but only when emotions and assessment are aligned....

    • 32 Getting in the Flow
      (pp. 191-194)

      Investing combines discipline, process, and rules with the ability to sense the market and the opportunities it offers. Finding and maintaining the balance between the yin and yang of expert decision-making is not easy. Scientists who study these times of peak mental performance refer to them as “flow experiences.” This essay considers how flow can help research analysts and portfolio managers improve their focus and make more of their best decisions.

      Professor Mihaly Csikszentmihalyi, who coined the term “flow,” initially observed that elite performers seemed to do their best when they were enjoying what they did. He then studied top...

    • 33 Believing Is Seeing
      (pp. 195-200)

      Facts submitted to a rigorous process are the quintessential definition of disciplined investing. But facts aren’t always what they appear. The mere act of looking can alter the fact before you. Visual illusions occur when the brain recognizes something not there, or perhaps it is there but not in the way it is seen. This essay examines vision, how it works, why it’s easily distorted, and what impact this can have on investment choices.

      Much of what we consciously perceive as seeing actually happens deep inside the brain. Light enters the eyes and is transmitted by the optic nerves to...

    • 34 A Storied Portfolio
      (pp. 201-206)

      Portfolio management is built on intentions—expressed by the theses of positions held over time. Each buy, hold, and sell decision comes with a story describing and defending the position’s role in the portfolio. Though research analysts and portfolio managers consider the thesis to be the objective assessment of an asset, the actual arc of these stories over the life of a position often tells a different tale. New research suggests that what goes into a thesis is more emotional than generally acknowledged—reflecting deep desires, not just facts, triggered by the need to resolve unsettling uncertainty. This essay discusses...

    • 35 The Trouble with Improving
      (pp. 207-210)

      Portfolio managers want to improve. The motivation is simple—the market is forever evolving and underperformance is poorly tolerated. Nevertheless, improving is tricky business, as evidenced by the vast amount of time, energy, and capital invested toward this goal year after year with relatively modest results. This essay considers why improving is so elusive and what steps you can take to more confidently become your best.

      Don’t look now, but the portfolio manager next to you is trying to figure out how to be a bit better this year, as are the tens of thousands with whom you compete. Their drive...

    • 36 Tired Investing
      (pp. 211-214)

      Love may make the world go round, but psychic energy is what makes portfolio performance rock. It is essential for making critical judgments—the kind that guide buy, sell, and sizing decisions. Research shows that judgment is highly dependent upon the availability of psychic energy, the same energy that fuels conscious thinking, self-control, and perseverance. As reserves of psychic energy swing from full to depleted, the choices we make substantially shift, unintentionally. This essay examines the role that decision fatigue plays in investing and describes how self-awareness and process can keep your portfolio energized.

      Freud coined the term “ego” to...

    • 37 That Winning Feeling
      (pp. 215-218)

      Owning winners is not always what it’s cracked up to be, especially if you have the tendency to hold them well past their productive lives. Interestingly, it is fear more than greed that can motivate holding winners well after they have given their best. This essay examines the theory underlying this behavior and discusses new findings on the prevalence and cost of this tendency.

      Over a century ago, Sigmund Freud observed that most human behavior is related to seeking pleasure and avoiding pain. The wisdom of this idea continues to unfold, especially regarding investment behaviors. In the 1970s psychologists Daniel...

    • 38 Hold That Thought
      (pp. 219-222)

      Procrastination can boost portfolio performance. This is one of the unorthodox conclusions found in new research into the interplay among skill, process, judgment, and time. In a world increasingly measured in milliseconds, the thought of delaying may hit you as either heresy or a siren song. But we’re not talking about good old-fashioned loafing. Rather, the research suggests that knowing when to go fast and when to go slow is how top professionals achieve their personal best. This essay considers how building time into your process to slow down at critical moments can speed you toward higher performance.

      Speed does...

    • 39 Overcoming Overconfidence
      (pp. 223-226)

      Having a sense of conviction about decisions we’ve made, assets we own, or theses we manage is generally viewed as positive. Yet it is not easy to distinguish well-reasoned conviction from mere bluster. Chief among the biases that can nudge professional managers and analysts toward the latter is overconfidence. This small spark of emotion can turn a potentially great idea into a disappointing folly. In this essay we examine the impact of overconfidence on investment decision-making and steps that can be employed to reign it in.

      According to psychological research, individuals tend to be overconfident about their skills, their knowledge,...

    • 40 The Power of Vulnerability
      (pp. 227-230)

      Discussions about company culture often have the effect of a sleep-inducing hypnotic. It is one of the softest aspects of business and the one regularly given the shortest shrift. Yet the behaviors, actions, and reactions that are encouraged or discouraged within a company have a profound impact on how individuals feel and perform. In the fast-paced, high-energy, sometimes heated discussions that surround investing, a thoughtless comment can leave its recipient feeling hurt, isolated, and disengaged. The result is lowered self-esteem, diminished creativity, and disappointing performance. This essay looks at the importance of fostering vulnerability within teams and why reducing opportunities...

  9. Part Three: Improving Right Away
    • Project 1: Embracing the Scientific Method
      (pp. 233-238)

      Active portfolio performance reflects choices—what to buy, how much to own, and when to sell. How those choices come about involves both deliberate processing (conscious thinking) and intuitive processing (unconscious thinking). At any moment, you’re unlikely to be aware of which type of thought process is most influencing a choice—it just happens. Consider winnowing down a list of potential buy candidates to a short list that will go on to receive in-depth analyses. Part of this screening involves the deliberate processing of current and historical data, including company revenues, income, cash flow, leverage, and other financial information. Simultaneously,...

    • Project 2: Maintaining a Diary
      (pp. 239-242)

      Memories can be vivid, detailed, and regularly recalled, but they are almost useless in helping you to understand investing skills or to establish an improvement plan. The reason is twofold, having to do with how memories are created and how they are recalled. Most memories are created passively, without conscious intent or purpose. Your unconscious chooses to collect an impression of an item or event, which is often far from totally accurate or complete. When memories are recalled, they are not fixed images like photographs, but instead are the recombination of some or all of the bits about the item...

    • Project 3: Accounting for Skill
      (pp. 243-248)

      Direct measures of skill have long been absent from equity portfolio management, as discussed in chapter 1. Conventional portfolio analytics primarily measure outcomes, which, while theresultof skills, are notmeasuresof skill itself. The absence of true measures of investment skill has greatly inhibited the ability of managers to improve. Assessing skills requires a new analytic framework, one that identifies specific actions that a manager executes and then quantifies how these actions affect portfolio performance. The three basic skills managers use to generate excess return are buying, selling, and position sizing. Quantifying the strength of these three skills...

    • Project 4: Learning about Buying Skill
      (pp. 249-252)

      A common belief among managers and their clients is that successful portfolio results are invariably built on strong buys. This belief is so ingrained that it has become an industry tautology: Buying is what makes great performance, and therefore great managers must be great buyers. The folklore that exists around buying as the driver of top performance is reinforced by conventional portfolio metrics. The single most common use of hit rates, for example, is to assess a manager’s buying (the shortcomings of this approach are spelled out in chapter 2). Likewise, although performance attribution measures the returns earned from holdings,...

    • Project 5: Measuring Your Sell Effectiveness
      (pp. 253-256)

      Selling is one of the least developed skills managers possess. One reason is that the majority of improvement efforts within the investment community have focused on buying. In addition, the feedback about selling effectiveness from conventional portfolio analytics is, with little exception, useless in supporting improvement. Finally, there is a dearth of academic studies on sell effectiveness, whereas buying has been studied extensively over several decades. It should be no surprise then that a skill that is all but unattended to is so underdeveloped.

      Emotions may be part of the reason that selling has received such little analytic rigor or...

    • Project 6: Calibrating Sizing
      (pp. 257-260)

      Sizing decisions are driven mostly by judgment and intuition. Such choices typically reflect pearls of wisdom handed down from an earlier mentor, or rules that seem reasonable but have never been verified. So here you are again, enmeshed in a wicked learning environment (see project 1) where your skill level is uncertain and your investment process has shortcomings. It’s not surprising that your sizing decisions are ripe for behavioral influences. Recalling concepts from emotional finance (see chapter 1), it is easy to see where the desire to seek pleasure may motivate higher active weights (and short sells), while efforts to...

    • Project 7: Checklists
      (pp. 261-266)

      Equity portfolio management is a complex undertaking. As it has long been known, complex tasks need different approaches from tasks that are either simple or complicated. Simple challenges, like assembling knockdown furniture, require only following directions and little in the way of skill. Complicated activities, like building a house, can be broken down into smaller and more manageable subtasks and then matched to appropriate skills, wringing out considerable risk along the way. Complex tasks, on the other hand, involve learning from past successes, plus the agility to adapt quickly to an ever-changing environment, often necessitating that you go with your...

  10. Epilogue
    (pp. 267-270)

    It’s a sunny autumn day in Boston, and Joy, the lead manager of a successful emerging markets portfolio, is about to meet with a large university endowment that is considering a $200 million allocation to this category. She is pleased to be among the three finalists vying for the award. Joy knows that the other managers have been vetted by the same selection consultant, and therefore they have comparable track records and overall qualifications. At this point Joy needs to demonstrate that her services are different and that the differences are valuable to the prospective client. In the past she...

  11. Glossary
    (pp. 271-278)