Where Investment Performance Comes From
22 Pages Posted: 22 Jan 2018
Date Written: September 17, 2000
The source of investment performance is estimation error.
Estimation error leads investors to believe securities are mispriced when they are not. They respond by undiversifying to increase their portfolios’ estimated expected return. Since they are responding to estimation error, their actual expected return gain is likely to be much lower than anticipated. But their reduced diversification is realized. The probable result is at best a small expected return gain with considerably more risk, hence a lower reward/risk ratio. Superior investors have less estimation error than others, hence undiversify to a lesser degree. This leaves them with a higher reward/risk ratio than other investors. This picture is consistent with an analysis that doesn’t take into account investors’ impact on initial prices as they take positions.
Estimation error has an additional impact when the analysis takes into ac-count investors’ impact on initial prices as they take positions. Clearing the share market requires that initial security prices move in the direction dictated by the largest estimation errors. Now superior investors systematically gain at the expense of other investors. Superior investors undiversify and are rewarded with additional expected return. Inferior investors undiversify and suffer a decreased expected return. Superior investors increase their reward/risk ratio and gain a positive performance return. Inferior investors decrease their reward/risk ratio and acquire a negative performance return.
Keywords: investment performance, alpha, diversification, estimation error
JEL Classification: G10, G11, G12, G14
Suggested Citation: Suggested Citation