Actions Speak Louder Than (Past) Performance: The Relationship Between Professional Investors' Decision-Making Skill and Portfolio Returns

Abstract

The United States Securities and Exchange Commission cautions consumers that "Past performance does not necessarily predict future results", yet past performance is widely used as the metric for comparing portfolios. A novel avenue of research focuses on decision-making as a better metric for comparing portfolio managers. However, the precise relationship between a generalized measure of financial decision-making skill and portfolio performance has remained out of reach. Here, we show that a professional investor's decision-making is directly linked to their portfolio's performance. Using the daily holdings of professional investors, we show that part of a portfolio's performance is explained by its Behavioral Alpha (BA) Score. Moreover, a portfolio with a BA Score > 50 is more likely to have positive relative returns the following year than a portfolio with a BA Score < 50. Our results highlight that decision-making skill is likely to contribute to a portfolio's overall performance and can act as an important factor for distinguishing skilled from lucky investors. Importantly, investors have agency over this factor, and can take action to improve this skill.

Keywords: Behavioral Finance, Financial Decision Making, Decisions from experience, Behavioral bias

JEL Classification: G11, G40, G41