It would be easy to assume that the brightest minds in high-stakes professional trading don’t suffer from the same behavioural mistakes as regular investors. But that’s not actually true. Research shows that high testosterone - which has traditionally been a ‘must-have’ in hedge fund management - is actually responsible for some of the worst decisions.
It turns out that some classic alpha male attributes can lead to risky and potentially costly choices. Among them are picking ‘lottery-type’ stocks, hanging on to underperforming trades and selling winning positions too soon.
These are some of the classic hallmarks of overconfidence, which leads to rash decision making and overtrading. These problems can affect private and professional investors alike - although women, for biological reasons, are apparently better at resisting them.
The trouble with hedge funds
In Warren Buffett’s latest letter to Berkshire Hathaway shareholders, he spends time reflecting on a 10-year charity bet that finished in late 2017. As part of the wager, he predicted that a low-cost index fund would outperform the results of most investment professionals over time.
His bet was taken up by a fund advisor called Protégé Partners, which went head-to-head with the index fund by selecting five funds-of-hedge-funds. In total, Protégé’s capital ended up being spread across more than 200 hedge funds.
To cut a 10-year story short, Buffett won this bet long before it finished. In nine out of the 10 years the funds-of-funds as a whole trailed the Samp;P index. Not only that, but in every one of those years they charged costs at an average of 2.5 percent of assets.
As Buffett remarked: “Making money in that environment should have been easy.” But the hedge funds still managed to underperform overall, while charging high costs for the privilege.
Costs in the hedge fund industry have long divided opinion. The typical ‘2 and 20’ fee model (2 percent on assets and 20 percent on outperformance) has come under pressure in recent years, but the fees are still controversially high. So it’s little wonder that this promotes a testosterone-fuelled environment that attracts strong characters with forthright views.
If your face fits…
High testosterone, of course, is linked with a number of benefits. They range from increased physical strength and fearlessness to higher military rank and superior executive leadership. But some research has also found that it can lead people to make irrational risk-reward trade-offs. Indeed, a new study suggests that high testosterone could actually be problematic in investing.
Work by researchers from the University of Central Florida and Singapore Management University found that high-testosterone hedge fund managers “significantly underperform low-testosterone hedge fund managers after adjusting for risk”.
To figure this out they used what’s known as the facial width-to-height ratio (fWHR). This is an increasingly used measure in behavioural research because a high fWHR has been shown to be a marker of high testosterone.
The team went on to investigate the performance of 3,228 male hedge fund managers over a 22-year period. Between the top and bottom deciles in the sample (based on the fWHR), those with high testosterone underperformed those with low testosterone by a notable 5.8 percent each year.
What causes the underperformance?
In the words of the researchers Yan Lu and Melvyn Teo, “testosterone can shape trading behavior and lead to sub-optimal decisions”. In particular, the underperforming hedge fund managers apparently had a stronger preference for lottery-like stocks, and were more likely to succumb to the disposition effect (of holding underperforming stocks and selling winning stocks).
Both of these behavioural traits are well known for being a drag on investment performance. For a start, stocks that promise lottery-like payoffs tend to have a statistically low success rate. Yet the blistering gains they very occasionally generate are enough to seduce investors hoping for huge profits in short order. (This was the key finding of research in this area back in 2009).
In Stockopedia’s StockRank Styles framework, lottery-like stocks are known as Sucker Stocks, because they tend to have low exposure to Quality Value and Momentum. In other words, they tend to be low financial strength, relatively expensively priced and deteriorating. But they almost always have a great story behind them, which is often enough to win the loyalty of a large following.
Stockopedia users will know the chart below well. It shows the overall returns of regularly rebalanced baskets of stocks based on their exposure to those three Quality, Value and Momentum factors. The deciles with the lowest exposures - those that are more likely to lottery-like Sucker Stocks - consistently underperform.
In addition to lottery-like stocks, the disposition effect is regularly highlighted as a damaging investment mistake that can destroy both self-esteem and profits. We’ve written about this in the past, but the disposition effect is linked to how, as humans, we make choices between risky prospects and how we categorise them based on different outcomes.
In the context of investing, these theories show that investors treat the probability of a loss differently to that of a gain. As a result, they irrationally sell winners and hold losers even though it often makes no economic sense and is tax inefficient.
The disposition effect has been studied at length. Much of it has pinpointed specific mental drivers for not running winners whilst clinging on to losers. They include regret aversion, mental accounting and a lack of self-control.
Resisting alpha male tendencies
The upshot of all this is that some of the traits you’d assume to be desirable in professional fund management could actually be counter-productive. The mould of the traditional hedge fund manager as testosterone-fuelled, super-aggressive, competitive and instinctive are features that actually provoke some of the best known investing mistakes. So trying to imitate the same buccaneering style could well be an error.
An interesting postscript is the finding of a study back in 2001 that found men tend to trade far more than women. The research by Brad Barber and Terrance Odean looked at the trading accounts of 35,000 households at a U.S. brokerage. It discovered that men traded 45 percent more than women and racked up more damaging tradings costs as a result. They blamed this almost entirely on overconfidence. While there was no mention of testosterone in that study, it’s very likely that hormones played a big role.