It’s been nearly a half-century since Chicago Booth’s Nobel laureate Eugene F. Fama published his landmark 1970 paper laying out the efficient-market hypothesis. Since then, it has become accepted wisdom that even professional investors can’t beat the market systematically and predictably over time.
The principal reason is believed to be cost. Although some research suggests professionals do generate superior returns, this advantage disappears when the cost of active management is factored in.
But there may be a different explanation for why professional investors underperform: they’re good at selecting and buying securities but not at selling them, according to research by Chicago Booth PhD candidate Klakow Akepanidtaworn, Carnegie Mellon’s Alex Imas, Inalytics’s Rick Di Mascio, and MIT’s Lawrence Schmidt.
To examine buying and selling strategies separately, the researchers used data from Inalytics, a research company that analyzes institutions’ investment decisions. They examined 2 million sell and 2.4 million buy decisions between 2000 and 2016,tracking 783 portfolios with an average value of $573 million. To measure the managers’ performance, the researchers constructed portfolios of randomly selected buys and sells. This allowed them to determine the actual value added or subtracted by professional managers compared with random trades.
The researchers find that the average stock bought by managers outperformed random trades by 75 basis points, or 0.75 percentage points, over one year and 99 basis points over two years. By contrast, the average value lost from sell trades was 70 basis points over one year compared with the random portfolios.
“We find very strong evidence that buy trades add value relative to our random buy [portfolio],” the researchers write. But “managers’ actual sell trades underperform a simple random selling strategy.”
Why such a huge divergence? It may come down to attention and resources, what the researchers call “an asymmetric allocation of cognitive resources.” Simply put, they hypothesize that institutional managers devote more resources to deciding what to buy than when to sell, and it isn’t a question of skill.
“Buying and selling decisions are fairly similar in their underlying fundamentals: Both require incorporating information to forecast the future performance of an asset,” they write. In fact, the researchers find that managers do a good job of selling around the time of earnings reports, which get a lot of attention and firm resources, but at other times they devote less time and effort to selling than to buying. Also, they tend to sell when a stock has gained or lost a lot rather than follow a disciplined, evidence-based selling strategy.
“Identifying new opportunities is seen as perhaps the most critical aspect of a [portfolio manager’s] role,” the researchers write, but “[managers] viewed selling as necessary in order to buy.” This may be the real reason so many active managers underperform—and why Warren Buffett has so often said Berkshire Hathaway’s ideal holding period for a stock is “forever.”