Inside Your Asset Manager’s Brain

Two specific strengths are necessary for success in trading, according to University of Zurich and Yale researchers.

Does your asset manager have the mental ability to outperform in their investments?

Researchers from the University of Zurich and Yale School of Management have suggested that success in asset management requires two kinds of intellectual strengths: analytical and ‘mentalizing’.

Analytical ability refers to a “person’s grasp of the quantitative aspects of a decision problem,” including “logical reasoning and mathematical or probabilistic calculations,” explained Andreas Hefti, Steve Heinke, and Frédéric Schneider. ‘Mentalizing’ capability, meanwhile, is rooted in empathy and psychology: It explains the ability to “understand others’ beliefs and intentions, which helps to predict their actions.”

Both, the authors argued, are necessary for high performance in investing.

“To correctly understand the fundamental value of an asset, a trader needs analytical ability, and to correctly judge market sentiments, she needs ‘mentalizing’ ability,” they wrote.

To prove this theory, the researchers divided managers into classifications depending on their ability in each of the two areas: “technocratic” investors—highly analytical with low ‘mentalizing’ capability; “semiotic” types—“keenly aware of others’ behavioral patterns” but lacking “a conceptual understanding of the decision situation”; and “sophisticated” investors—strong both analytically and behaviorally. The fourth group—“featureless”—was weak in both areas.

These investors then made trades over 15 periods of an asset-market game which eventually resulted in a price bubble.

The technocrats largely traded on fundamentals—buying cheap and selling high. While these investors made money from the dividend, they “miss out on the profits from speculating on the bubble,” the authors noted.

Semiotic investors, meanwhile, followed the rising asset price, with holdings peaking just after prices peaked.

“These types make the largest losses as they are unable to unload their shares profitably after the peak,” the paper said.

Sophisticates, who anticipated both the rising and the bursting of the bubble, made the most money by having the best market timing.

“A purely ‘fundamentalist’ approach to asset trading, without an understanding of the psychology of the market,” the researchers concluded, “may not yield maximum profits.”

Read the full report, “Mental Capabilities, Trading Styles, and Asset Market Bubbles: Theory and Experiment.”

Related: High 3i: Personality Metrics of Strong Asset Managers & Reading Hedge Fund Managers’ Body Language