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February 1, 2004

Investment Management: Portfolio Diversification, Risk, and Timing - Fact and Fiction

By Gregory Bresiger

Also in this article

  • Investment Management: Portfolio Diversification, Risk, and Timing - Fact and Fiction

by Robert L. Hagin

(Wiley Books, New York, 304 pages, $79.95)

Reviewed by Gregory Bresiger

Mr. trading hotshot - are you really doing so well? Maybe not.

Individual investors, who are notorious for jumping in and out of the popular investment, aren't the only ones who often turn in poor numbers. In fact, managers, traders and other securities professionals who think they are doing a great job, are probably not.

That's one of the disturbing themes of this book, which was written by a former executive at Morgan Stanley Investment Management. Trading professionals should take heed of the skeptical tone of this book, which is an interesting read. It is a work designed to challenge all manner of securities professionals. Why should traders be skeptics? That's because many of the professionals they deal with are not masters of the universe, even if they often appear to be so.

Above Average

"Most fund managers," Hagin writes, "believe they can produce above-average returns - despite being aware that active management must, on average, provide below average returns. Thus, they are motivated to trade by overconfidence, not cynicism." (page 229). And, left unsaid by Hagin, but I believed it is implied, these managers will blame others for their sub-par performances. And one of their goats will be traders.

Active management, the author argues, inevitably produces lots of losers - most managers don't beat benchmarks. How many managers, year in and year out, consistently rank in the top quartile? Part of the problem is that the active management style results in more and more trading. This, of course, generates high costs and leads to a vicious cycle of poor performances. But so many managers seem to have excuses to justify their existence.

"Half of the mutual fund manager breathren will always turn out to have been overconfident." (page 228). This is disturbing stuff and something that traders should consider because client disappointment inevitably follows many of the conclusions of this book.

Hagin also cites a study by Wayne Wagner of the Plexus Group that examined the cost of large institutional trades. Trading delays and market impact were found to be the biggest costs in a period surveyed in late 2001. And which situations aggravated market impact? Hagin says three:

When the number of shares in the buyer or seller initiated transaction is large relative to the stock's daily trading volume.

When the dollar amount of the buyer or seller-initiated transaction is large.

When the market and sectors within the market are moving in the opposite direction from the buyer or seller initiated transaction (that is, down for sellers, up for buyers).

Hagin's conclusion, which is backed up by considerable market data, is that the greatest mistake of professionals is not necessarily failed strategies. It is something much more basic: hubris. But, more interesting than the raw statistics of failure, which many of your clients know all too well, is the psychology of active management.

The Holy Grail