Saturday, 10 October, 2009

Why individuals have an edge over Fund managers - Prisoners' Dilemma

Why individuals have an edge over Fund managers - Prisoners' Dilemma

For your benefit, let me explain the old but eternally relevant concept of "Prisoners' Dilemma":

Imagine that you and another armed man have been arrested and charged with jointly carrying out a robbery. The two of you are being held and questioned separately, with no means of communicating. You know that, if you both confess, each of you will get ten years in jail, whereas if you both deny the crime you will be charged only with the lesser offense of gun possession, which carries a sentence of just three years in jail. The best scenario for you is if you confess and your partner doesn't: you'll be rewarded for your betrayal by being released, and he'll get a sentence of fifteen years. The worst scenario, accordingly, is if you keep quiet and he confesses.

What should you do? The optimal joint result would require the two of you to keep quiet, so that you both got a light sentence, amounting to a combined six years of jail time. Any other strategy means more collective jail time. But you know that you're risking the maximum penalty if you keep quiet, because your partner could seize a chance for freedom and betray you. And you know that your partner is bound to be making the same calculation. Hence, the rational strategy, for both of you, is to confess, and serve ten years in jail. In the language of game theory, confessing is a "dominant strategy," even though it leads to a disastrous outcome.

If we extend the analogy to Fund managers of mutual funds, we'll comprehend their compulsions:

  • Logically speaking, investors like consistent, long-term outperformance vis-a-vis peers and the benchmark indices
  • However, magazines, newspapers, business channels tend to publish comparive performance data on a weekly, monthly, quarterly basis. This creates a lot of "noise"
  • Fund managers need to be evaluated for determining their increments, bonuses, promotions at least once every six months - this would again involve comparing their relative performance over short durations of time such as a quarter or six months.
  • Hence, fund managers are forced to think of an investment horizon of less than six months, even while advocating a long-term view for investors
  • This results in a peculiar situation where:
    • If the market is overheated according to the fund manager, he may be fully aware that any minor negative trigger can cause a significant downfall. However, he'll be equally conscious that if he is in cash and the other fund houses stay invested and there is no negative trigger for a couple of months or thereabouts, markets are likely to continue to rise with irrational exuberance for quite some time. If your fund manager wants his increments, bonuses (and even his job), he is forced to go against his own better judgement and remain invested in the market - with the hope and prayer that he'll be successful in bailing out at the very peak
    • If there is a savage bear market, the fund manager may be aware of huge upside potential over a longer time horizon. Many scrips will be available at mouth-watering levels. However, if he invests and the market continues to tank  and other fund managers remain in cash, he'll underperform his peers in the forthcoming quarter. And in bearish times, he can ill-afford - He may be out of a job before he can say "Long-term".

If you're an individual investor, you must be conscious of these compulsions of typical fund managers before investing in mutual funds.

Mutual funds will be relevant for you if and only if:

  1. If you lack the skills or
  2. Can't afford the time or
  3. Don't have an inclination
to study and invest directly in the markets.



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