Tag: behaviors

Essays

Size Really Does Matter

ESSAY

Size Really Does Matter

Smart Thinking: A Skill Versus Luck Essay Series | Issue 8

Written by Michael A. Ervolini

5 min read

Size Really Does Matter

DOWNLOAD ESSAY PDF

INTRODUCTION

Position Sizing is a crucial fund manager skill. It determines if the alpha from great buys is effectively harvested and if questionable purchases are restricted in the damage they inflict. Alternatively, chronically underweighting the strongest positions and overweighting the weakest holdings is a headwind if not a surefire path to underperformance. While the asset management industry expends vast amounts of time and energy discussing this activity surprisingly little is known about which managers size positions effectively, which don’t, and how to tell them apart. Fortunately, this situation is changing for the better. The improvement is due to the growing number of firms providing decision-based skill analytics.[1]

POSITION SIZING

One such firm is Alpha Theory. They are laser focused on position sizing. This includes quantification of a manager’s sizing skill, helping managers improve their sizing processes for greater alpha capture, and supporting asset owners/investors in assessing a manager’s sizing acumen. Alpha Theory has analyzed well over 200 equity funds involving more than 14 years of historical data. Their research indicates far more sizing opportunity than success currently, as they relate in their 2025 Year In Review: “Active sizing, the activity managers devote enormous amounts of energy to, reduces returns on average in our dataset.” [2] Specifically, they have uncovered: “Across the past 14 years, the Optimal portfolio has outperformed Actual by an average of +3.9% annualized.” Alpha Theory attributes the lost opportunity to process shortfalls: “The result is a persistent gap between research conviction and capital allocation.”

The way Alpha Theory computes its results is to compare a fund’s actual returns to a counterfactual portfolio in which positions are sized optimally based on Alpha Theory’s proprietary analytics. The latter approach is referred to as “optimum position sizing.” In constructing the counterfactual portfolio Alpha Theory uses all of the manager’s actual decisions of when to buy (open a position) and sell (close a position). Alpha Theory then adjusts how positions are sized to take full advantage of all the information available to the manager. As they describe it: “The Optimal portfolio is not an outside model or black box optimizer. Instead, it’s the manager’s own price targets, probabilities, conviction levels, and risk constraints applied consistently and without the behavioral noise that creeps into day-to-day sizing decisions.” This method assures that the counterfactual constructed reflects realistic and achievable sizing levels bespoke to each fund.

The Alpha Theory research indicates that the results are persistent over time as well. Their report states: “On average, the Optimal portfolio has outperformed Actual in 13 of 14 years — a 93%-win rate.” Interestingly the research shows that higher success is mostly about doing better at the margins: “By Position: Optimal sizing wins 57% of the time — a modest edge per position, but powerful at scale.” This finding underscores the importance of both having an effective process and actually adhering to it.

UPSHOT

Achieving benchmark-beating results is difficult. Doing so requires that each skill is well understood, contributing positively to alpha, and is likely to continue doing so going forward. The work done by Alpha Theory enables asset owners and allocators to formulate a deeper understanding of how well the manager is capitalizing on their best buys. With 4% hanging in the wings this type of analysis is invaluable.

CONCLUSION

Position sizing can be either a source of incremental alpha or a risk factor. Developing and then relying upon a sound sizing process is what makes the difference, according to research from Alpha Theory. Their findings are confirmed by other decision-based analytics investigations.[3] Interestingly, Alpha Theory found that on average the funds studied would have performed better even if the positions were equally weighted. However, managers can do much better than this they encourage: “The solution is not to abandon sizing, but to structure it. In our dataset, when those same research insights are applied through a disciplined sizing framework, they outperform equal weight by an additional 2.2%. That is the real advantage: not better stock selection, but better alignment between capital and conviction.”

Decision-based analytics such as those provided by Alpha Theory are substantially improving the industry’s understanding of manager skill. These newer analytics can rigorously quantify individual skills like sizing and compute its consistency. This information supports stronger allocation decisions and enables fund managers to become more self-aware and improve.

ENDNOTES

Michael A. Ervolini, Skill Versus Luck: Taking The Guessing Out Of Equity Fund Selection, MIT Press, February 2026, Chapter Three.
Cameron Hight and Justin Olson, “Alpha Theory 2025 Year in Review: Position Sizing as a Persistent Edge.” The full text is available at: https://www.alphatheory.com/blog/alpha-theory-2025-year-in-review-position-sizing-as-a-persistent-edge
Michael A. Ervolini, Skill Versus Luck: Taking The Guessing Out Of Equity Fund Selection, MIT Press, February 2026, Chapter Thirteen.

MICHAEL A. ERVOLINI, AUTHOR

The ideas expressed on this website are developed and/or curated by Michael Ervolini. Mike has spent his entire 35 year + career leading efforts to improve and strengthen active management.

Tags analytics, behaviors, fund selection

Essays

Unconscious Deliberation

ESSAY

Behavioral Matters: Insights from the application of Behavioral Finance | Issue 6

Written by Michael A. Ervolini

8 min read

Unconscious Deliberation

“The idea that conscious deliberation before making a decision is always good is simply one of those illusions consciousness creates for us.”

– Ap Dijksterhuis

DOWNLOAD ESSAY PDF

INTRODUCTION

Awareness is a double-edged concept. Conscious thinking is essential to successful decision making, up to a point. Strategy, discipline and process are devices that professional investors use to consciously hone their decisions. Objective research, analytic stock scoring and backtesting are some of the tools that strengthen these efforts. But more is going into your buys and sells than you think.

Much of our thinking happens before it hits our consciousness, driving most of our decisions, from the inconsequential to the highly important. And while it may be easier to dismiss the idea of thoughts erupting from the unconscious, we do so at peril to performance. By understanding the relationship between conscious and unconscious thinking, we can harness the latter to strengthen the former.

In this essay we examine the relationship between conscious and unconscious thinking and consider how harnessing the latter can strengthen the former.

JURASSIC MARKET

Cognitive science tells us that ninety five percent of all decisions are made by our auto-pilot, our unconscious. The unconscious brain is so dominant because there are too many stimuli in the world and too many decisions to make consciously. When early man was threatened by a giant raptor he did not make a conscious plan to survive, he just ran. Those who ran fastest from the raptor became our ancestors. The others became dinner. We commonly call such decisions instinct, though they are really part of our unconscious thinking.

Today, the unconscious still makes decisions automatically. Only instead of reacting to a giant raptor it reacts to market volatility, company news and other investment information. Heuristics, Over Confidence and Premature Dismissal are just a few manifestations of unconscious thinking that may lurk among portfolio management instincts. Unmeasured and unmanaged, modern instinctive decisions can lead to being eaten alive by the market — without our understanding what creature ate us.

OF TWO MINDS

The unconscious brain is very powerful and extremely fast. A recent study led by Professor John-Dylan Haynes at the Max Planck Institute for Human Cognitive and Brain Sciences (Leipzig, Germany) using Functional Magnetic Resonance Imaging (FMRI) found that the unconscious brain arrives at decisions 7 to 10 seconds before we are consciously aware that a decision is even needed. Even more striking, the study showed that participants’ conscious decisions could be predicted with 70 percent accuracy by studying their unconscious brain activity. Both findings underscore the power and persistence of unconscious thinking.

Yet the idea of decisions being made or influenced by the unconscious is new to professional investing. Our industry’s traditional dogma includes concepts like, “totally objective,” “completely by the numbers,” and “facts, not emotion.” Nonetheless, companies such as Goldman Sachs, Morgan Stanley and Fidelity Management & Research have behavioral economists on staff today. These leaders are making conscious decisions to manage unconscious decisions.

SOMETIMES LESS THINKING IS SMARTER

Intuitively, people might assume that simple choices are best left to auto-pilot while more complex decisions require more sophisticated thought. Not so. Scientists in The Netherlands have shown that we are generally satisfied with consciously deliberated decisions about simple or very familiar choices. But when it comes to complicated decisions – those with many criteria or that we make infrequently – we are better off following our gut.

An interesting example regards purchasing a house. We often elevate living space or square footage to a top house hunting criterion. Yet, research shows that our lives are rarely affected by a few square feet one way or the other. A terrible commute, on the other hand, can make life hell. And, we often do not even consider this factor carefully when purchasing a house. The researchers believe that our conscious efforts nudge us towards emphasizing square footage because it is familiar and easily measured. Commuting difficulty is, by comparison, less accessible to our conscious deliberation and also harder to quantify. They suggest we might be better off buying the house that feels right over the one that scores highest in our decision matrix.

Decision satisfaction is not the same as portfolio return. But, this research does point out that our unconscious brain can be a powerful ally in helping us arrive at our best decisions.

RECOGNIZING THE UNCONSCIOUS

Evolution has refined the potent and aggressive unconscious that frequently guides our judgment – even when we don’t “think” we are using judgment. Consider this: When 10 stocks are on the buy list, how do you get down to the 4 or 6 you will buy? If you need liquidity to finance a purchase, which stocks do you sell? We all rely on judgment to make professional decisions. That’s no judgment on you… just a fact.

ENDNOTES

The Emotional Brain, Simon & Schuster, 1996, by Joseph Ledoux.
“Unconscious determinants of free decisions in the human brain”, Nature Neuroscience, April 13, 2008, by Chun Siong Soon, Marcel Brass, Hans-Jochen Heinze, and John-Dylan Haynes.
“Deliberation Without Attention”, Science, Vol. 311. no. 5763, February 17, 2006, by Ap Dijksterhuis, Maarten W. Bos, Loran F. Nordgren, and Rick B. van Baaren.
“Get Out of Your Own Way”, Wall Street Journal, June 27, 2008.

MICHAEL A. ERVOLINI, AUTHOR

The ideas expressed on this website are developed and/or curated by Michael Ervolini. Mike has spent his entire 35 year + career leading efforts to improve and strengthen active management.

Tags active management, behaviors, equity management

Essays

Aching Conviction

Post author By Kyra Spradlin
Post date May 29, 2024

ESSAY

Behavioral Matters: Insights from the application of Behavioral Finance | Issue 4

Written by Michael A. Ervolini

8 min read

Aching Conviction

“Doubt is not a pleasant condition, but certainty is absurd.”

– Voltaire

DOWNLOAD ESSAY PDF

INTRODUCTION

The term conviction is used universally among professional investors to suggest that rigorous thinking has preceded a buy or sell decision. What is really backing up conviction? Does conviction reflect knowledge and wisdom accumulated over years or is it merely bluster? Understanding the nature of conviction is essential to improving any investment discipline.

BELIEF OR NOT

The dictionary defines conviction as a “fixed or firm belief”. How are beliefs formed? Are people aware of their complete set of beliefs? Can we consciously edit or manage beliefs?

Beliefs are created, stored and managed almost entirely within the unconscious part of the brain, according to modern Cognitive Science. In commenting on beliefs Harvard Psychologist Daniel Gilbert points out that “research suggests that people are typically unaware of the reasons why they are doing what they are doing, but when asked for a reason, they readily supply one.” Hersh Shefrin, the noted Behavioral Economist, suggests “… we like to think that we are thinking, when often we are just really feeling. That goes on all of the time in the investment business …”

The unconscious, and the beliefs residing there, are credited for roughly 95% of all our daily decisions. These unconsciously driven decisions occur and are being implemented well before we are even consciously aware that a decision is required. The lightening fast processing of the unconscious, together with its content being obscured from ready analysis, call in to question our dependence on conviction.

I SELL, THEREFORE I HAVE CONVICTION

Selling is a relatively unstudied aspect of investing. Few managers, if any, know how well their selling works. Yet, sell they must. Some selling is pragmatic — initiated to satisfy outflows. Creating liquidity to fund new buys is among the most commonly cited motivations for selling. Others include invoking a stop-loss, portfolio rebalancing and reacting to news about a company.

But what about strategic selling? Those sells driven purely to achieve enhanced performance. Author and financial writer Jason Zweig says “… I’ve yet to have anyone provide evidence that their sell discipline works. Performance, even above the benchmark, is not proof that your selling is good.“

The absence of objective analysis on selling effectiveness leaves much to chance. To fill the void “Managers and analysts rely on crude heuristics to measure fundamental value …” says Hirsh Shefrin. Less rigorous by their very nature, these efforts are highly susceptible to shortcomings in cognition and biases.

In his highly acclaimed book The Black Swan, Nassim Nicholas Taleb says about conviction “First, we are demonstrably arrogant about what we think we know.” One factor undercutting conviction he explains this way, “much of what we ascribe to skills is an after-the-fact attribution,” which leaves managers with the duel problem of perhaps making behaviorally motivated decisions initially and then rationalizing the decisions afterward. With such an active unconscious protecting us from thinking or feeling badly about ourselves just how can a manager develop bankable conviction?

QUESTION YOUR CONVICTION

Understanding how effective your convictions are requires that you both question them regularly and, perhaps more importantly, measure exactly how well they work. Questioning conviction or judgment on the fly is difficult. It requires that you suspend all of the natural impulses driving you at the moment (those unconscious forces) and take stock of what, other than strategy and discipline, might be propelling your decision. Rigorous measurement, on the other hand, can be approached with greater dispassion and yield elements of self-knowledge that can be capitalized upon and lead to higher performance.

Overconfidence, Anchoring, Belief Perseverance and Self Attribution are a few of the well documented behavioral traps that can become pseudo-conviction. All that stands between you and misplaced conviction is your own disbelief.

ENDNOTES

Stumbling On Happiness, Random House, 2006, by Daniel Gilbert.
Corporate Behavioral Finance, McGraw-Hill, 2007, by Hersh Shefrin.
“Mind Games”, “Welling@Weeden”, an on-line research journal, May 11, 2007, Volume 9, Issue 9, an interview with Jason Zweig.
Your Money and Your Brain, Simon & Schuster, 2007, by Jason Zweig.
The Black Swan – The Impact of the Highly Improbable, Random House, 2007, by Nassim Nicholas Taleb.

MICHAEL A. ERVOLINI, AUTHOR

The ideas expressed on this website are developed and/or curated by Michael Ervolini. Mike has spent his entire 35 year + career leading efforts to improve and strengthen active management.

RESOURCES

Thanks For The Memories

Post author By Kyra Spradlin
Post date April 23, 2024

ESSAY

Behavioral Matters: Insights from the application of Behavioral Finance | Issue 18

Written by Michael A. Ervolini

8 min read

Thanks For The Memories

“Memory itself is an internal rumour.”

– George Santayana, Philosopher

DOWNLOAD ESSAY PDF

INTRODUCTION

The bedrocks of professional investing — experience, judgment, intuition and deliberation — rely heavily on the use of memory. Though it is fundamental to learning and making effective choices, memory is also highly imperfect. While memories are sometimes cherished, they can push you toward investing misadventures. This essay examines how experts look at memory and its potential for generating investing shortfalls.

MOTIVATED MEMORY

Memory is the result of how information is captured, stored and retrieved. Most of what we remember after an experience (visual, auditory, etc.), happens automatically and pretty much involuntarily. Supporting this process the brain chooses to capture information it finds interesting, useful or that stimulates strong feelings. It encodes this information into long-term memory that sits in the unconscious brain. Unavailable for conscious or deliberate probing and review, memories are accessed and reconstructed upon demand, through either willful intent or involuntarily. Emotions affect both the encoding and retrieval of memories. Excitement about a series of great buys or pain from liquidation of deep losers can change how information is perceived, making it more vivid and stickier. Incorrect learning results from the deep encoding of such emotionally charged impressions. If such incorrect learning transforms into a strongly held belief, it can lead to repeated ineffective decisions.

Market turmoil and position volatility can cause stress and a high emotional state. When these emotions are present during the retrieval of memories they can limit the brain’s searching for information or answers, often pushing it toward simple and emotionally soothing solutions, rather than analyzing a more complete set of options.

MAKE MY MEMORY

False memories may help explain why ineffective tendencies creep into otherwise sound investment processes. Researcher Brian Gonsalves studied the formation of false memories using Functional Magnetic Resonance Imaging (FMRI) technology. Participants were shown images of certain objects and accompanying words, with some words matching the objects shown and other words being unrelated. The participants were asked to visualize the image represented by the words not the objects. What they remembered is fascinating. When asked what objects they were shown they tended to remember seeing objects related to the words they visualized, even if a picture of that object was never presented. What happened According to Gonsalves: “Many of the visual images that the subjects were asked to imagine were later misremembered as actually having been seen.” He points out: “A vividly imagined event can leave a memory trace in the brain that’s very similar to that of an experienced event.” Gonsalves and team were able to accurately predict when an imagined image would be remembered as having been seen because highly vivid imaginings stimulate the same part of the brain as do real experiences.

Memories can also be suggested, even impossible ones. Professor Elizabeth Loftus asked adults if they had met Mickey Mouse when they were children. Some were first shown a video of people having fun at Disney World. Recollection of this experience was significantly higher among those who saw the video. Loftus believes that when in a positive emotional state the participants’ old and fragile autobiographical memories were unconsciously rewritten to include a personal experience with Mickey that never happened. To confirm this phenomenon, another group was asked about whether they ever met Bugs Bunny instead of Mickey while at Disney Land. Among those shown the same Disney video, 16% recollected shaking hands with Bugs at Disney land, even though he is not a Disney character, but a Warner Brothers creation. They recalled an event that was not simply unlikely but impossible.

Interestingly, participants in both studies that viewed the video overwhelmingly denied it affected their recollections. Suggesting that not only is memory malleable but internal defenses refuse to accept this proven quality. Loftus concludes: “These studies show that with suggestion and imagination, a significant minority of people can be led to believe that they had experiences that were manufactured, and many of them elaborated upon those false experiences with idiosyncratically produced details.”

THESIS, PROCESS AND DISCIPLINE REMEMBERED

Despite its known flaws, memory remains a primary tool used by managers for learning about their strengths and shortcomings. Other conventional sources of portfolio information like return and attribution help some, but using them to improve is like a golfer playing at night using only the total score for feedback. Whether hitting above or below par, the golfer can’t see where performance is strongest or where it needs refinement.

Over relying on their memories, managers have no choice but to imagine where their alpha comes from. They commonly misidentify which skills are strongest and which need improvement or precisely how to improve. And this leads to missed opportunities regardless of the quintile they are in. Studies of actual portfolios conducted by Cabot show that:

Some strong buyers can and do consistently sell winners prematurely — giving away alpha in the process.
Managers that pick great names often do not feed them sufficiently — reluctant to pay up for a stock on the run.
Selling winners tends to be difficult — they are often held well past their ability to generate excess returns and drag down performance.

Ineffective decisions such as these can start with a faulty memory. These memories then go on to produce flawed beliefs and rules-of-thumb, which then are used to make investment decisions. In addition, critical analysis of skills and process is hampered as recollections reflect motivations as well as facts. You see only what your memories allow and your decisions integrate half-truths as if they were rigorously constructed data.

CONCLUSION

Memory defines who you are and what you think. It is, however, imperfect, fragile and quite capable of making falsehoods seem like facts. Memory recall can range from consistent and complete, to partial and irregular.

As reliable as memories may seem, their flaws can hurt portfolio performance. This can be the result of false memories that tilt decisions toward ineffective choices. Faulty Memories may be the product of weak encoding, retrieval or both. Comparing your treasured recollections to verifiable information is one straightforward antidote to ineffective memories. The alternative may position you as a prisoner of a past that never really happened.

REFERENCES

Brian Gonsalves, Paul J. Reber Darren R. Gitelman Todd B. Parrish Marsel Mesulam and Ken A. Paller, “Neural Evidence That Vivid Imagining Can Lead To False Remembering”, Psychological Science, October2004.
Elizabeth F. Loftus, Kathryn A. Braun and Rhiannon Ellis, “Make My Memory: How Advertising Can Change Our Memories of the Past”, Psychology & Marketing, John Wiley & Sons, Inc, 2002.
Tim R. Holcomb, R. Duane Ireland, R. Michael Holmes, Jr. and Michael A. Hitt, “Architecture of entrepreneurial learning: exploring the link among heuristics, knowledge, and action”, Entrepreneurship: Theory and Practice, Jan, 2009.
“Motivated Reasoning”, A Behavioral Matters essay, April 15, 2009, available at http://www.cabotresearch.com.

MICHAEL A. ERVOLINI, AUTHOR

The ideas expressed on this website are developed and/or curated by Michael Ervolini. Mike has spent his entire 35 year + career leading efforts to improve and strengthen active management.

RESOURCES

When Unconscious Desires Motivate Fund Selection

Post author By Kyra Spradlin
Post date May 10, 2023

ARTICLE

Journal of Investing | May 2023

Written by Michael A. Ervolini and Andrew R. Tuttle

2 min read

When Unconscious Desires Motivate Fund Selection: Active Share and Position Count May Do More To Relieve Angst Than Identify Skill

Article Abstract

Identifying equity funds likely to outperform remains a daunting task for capital allocators. Traditional portfolio analyses provide useful insights into how a fund is being managed while offering little clarity on the potential for ongoing success. Active share and position count were introduced as metrics that identify funds that will generate excess returns via skilled management. This paper argues that these metrics provide no information regarding future fund performance or manager skill. It is further proposed that active share and position count do more to relieve unconscious anxiety provoked during the allocation process rather than enhance rigorous judgment.

Three Key Takeaways:

Allocators remain committed to active equities but struggle in identifying skilled managers.

Recent emphasis on high conviction does a poor job at identifying skilled managers.

Metrics such as active share and position count do more to relieve angst than to support allocation decisions.

SEE FULL ARTICLE

MICHAEL A. ERVOLINI, AUTHOR

The ideas expressed on this website are developed and/or curated by Michael Ervolini. Mike has spent his entire 35+ year career leading efforts to improve and strengthen active management.

RESOURCES