Research Findings

Broad types of asset class a fund includes in a portfolio and proportion they represent have a profound effect on the variability of returns.

Summary

In order to delineate investment responsibility and measure performance contribution, pension plan sponsors and investment managers need a clear and relevant method of attributing returns to those activities that compose the investment management process—investment policy, market timing, and security selection. The authors provide a simple framework based on a passive, benchmark portfolio representing the plan’s long-term asset classes, weighted by their long-term allocations. Returns on this “investment policy” portfolio are compared with the actual returns resulting from the combination of investment policy plus market timing (over- or under weighting within an asset class). Data from 91 large U.S. pension plans over the 1974-83 period indicate that investment policy dominates investment strategy (market timing and security selection), explaining on average 95.6 percent of the variation in total plan return. The actual mean average total return on the portfolio over the period was 9.01 percent, versus 10.11 percent for the benchmark portfolio. Active management cost the average plan 1.10 percent per year, although its effects on individual plans varied greatly, adding as much as 3.69 percent per year. Although investment strategy can result in significant returns, these are dwarfed by the return contribution from investment policy—the selection of asset classes and their normal weights.

Reference

Brinson, G., Hood, L. and Beebower, G. (1995). Determinants of Portfolio Performance. Financial Analysts Journal, 51(1), pp.133-138.

Research Findings

The paper presented a brief overview of value investing. Although there is no question that there is a value premium, there are conflicting explanations as to why it exists. Psychologists suggest that when decision makers find themselves with limited capacity to deal with complex data and high degrees of uncertainty (as in making investment decisions) they resort to the use of heuristics as a simplifying tool. We developed a value investing heuristic and applied it to stock selection using
the Toronto Stock Exchange S&P/TSX 60 as the stock universe. A presentation of some pertinent descriptive statistics shows that the value portfolio based on the heuristic ranks above the other portfolios. Thus this heuristic could potentially be used as a valid tool for making value investing decisions. Moreover, given the simplicity of the heuristic and that it can be implemented using only publicly available data, this process is accessible to all investors.

Summary

Investment decisions are subject to error due to cognitive biases of the decision makers. One method for preventing cognitive biases from influencing decisions is to specify the algorithm for the decision in advance and to apply it dispassionately. Heuristics are useful practical tools for simplifying decision making in a complex environment due to uncertainty, limited information and bounded rationality. We develop a simple heuristic for making value investing decisions based on profitability, financial stability, susceptibility to bankruptcy, and margin of safety. This achieves two goals. First, it simplifies the decision-making process without compromising quality, and second, it enables the decision maker to avoid potential cognitive bias problems.

Reference

Otuteye, E. and Siddiquee, M. (2015). Overcoming Cognitive Biases: A Heuristic for Making Value Investing Decisions. Journal of Behavioral Finance, 16(2), pp.140-149.