Off-track betting

PROFESSIONAL cycling is not the obvious place to look for lessons in investing. But in the past year several big British investment firms, including GLG Partners, J.O. Hambro and Schroders, have used the services of Shane Sutton, the technical director of Britain’s cycling team. Mr Sutton, they hope, will teach managers to steer clear of biased hunches and performance-sapping habits.

Mr Sutton’s coaching insights range from the mundane—12-hour days offer diminishing returns—to the arresting: he discovered that one trader made his most profitable decisions outside the office, making him the rare employee who could plausibly claim to be adding value on the golf course. He sent one trader home for a week to break a losing streak.

Mr Sutton works with a firm called Inalytics, which uses data to look for other foibles among its clients. The most common is the tendency to sell winners too early, cashing in a profit only to see the stock gain further (economists call this “the disposition effect”). The firm has crunched 12m individual trades going back to 2002, across 900 portfolios, to examine the performance of winning stocks—those worth more when sold than when bought. In all but a tiny number of cases, returns would have improved by 1-2% a year if the stocks had been held for a further 12 months.

Holding onto losers that you should have sold in the hope that they will recover is the flipside of the disposition effect, and means portfolios tend to contain more losers than winners. A study conducted in 2006 by Andrea Frazzini, an academic and investor, found that managers of American mutual funds sold an average of 3% more winners than losers from 1980 to 2003. But the impact on performance of holding losers is harder to measure: they frequently turn into winners when the price of a stock recovers, even though the manager might have done better to take the loss and reallocate the money to another stock.

Investors should be especially wary of two portfolio techniques that act as Trojan horses for such biases. The first is top-slicing, whereby managers sell part of a money-making position. They may claim this is to avoid holding too much of a single stock or in order to manage portfolio risk; frequently they are just selling winners. The second is the practice of building up a position slowly: buying a small amount of the stock, waiting to see if it goes up, then buying more if it does, thereby missing out on a portion of the initial gain.

In his pep talks, Mr Sutton reminds traders of such pitfalls. He is surprised by how much they rely on gut instinct, he says. Their employers, however, are “starting to embrace the idea that anything can be coached”. Investors might benefit from coaching, too. The hope of picking winners leads customers to active funds, when passive ones tend to do even better.