The fundamental law of active portfolio management is a widely used framework that helps investors assess the performance of a portfolio manager. According to this model, the success of an actively managed portfolio depends on two main factors: the manager's skill in generating excess returns (known as the information coefficient or IC), and the number of independent investment opportunities pursued (known as breadth, or BR). The relationship between these factors is captured by the information ratio (IR), which measures the manager's ability to generate returns relative to the level of risk taken. Specifically, the formula for IR is:
IR = IC ⋅ √BR
Source: Kahn, R. N., & Grinold, R. C. (2019). Advances in Active Portfolio Management: New Developments in Quantitative Investing. McGraw-Hill Education.
Within this framework the performance of the portfolio is positively correlated to the quality of decisions taken by the portfolio manager. In decision theory (a branch of mathematics that studies how individuals and groups make decisions under uncertainty), bias risk refers to the possibility that biases can distort the decision-making process, leading to suboptimal outcomes. A fair amount of research into the theory of behavioural finance has been dedicated to identifying, understanding, and, most importantly, proposing methods to correct for the many biases that individual managers are faced with.
In today's age of information overload and widespread access to financial markets, generating an investment thesis based on a collection of supposed facts has become relatively easy for almost anyone. However, relying solely on one's own interpretation of the information provided may increase the bias risk in investment decisions, potentially compromising portfolio performance in the long term. Investing is a complex and ever-changing landscape that requires a multifaceted approach and a comprehensive understanding of the market. Consistently approaching the market as an individual without checking our biases can limit our perspective and undermine our decision-making abilities.
A fair amount of the methods proposed by behavioural finance to assist individuals in isolating potentially harmful personal biases from the decision-making process relies on individuals possessing the inclination to continuously and objectively examine their own reasoning and consider all relevant information (which, if we are being honest, is not so easy). In my personal opinion, the best method of reducing this bias risk is best articulated by the famous phrase coined by author John C. Maxell: “Teamwork makes the dream work”.
To mitigate bias risk and improve decision-making quality, an effective solution could be to build a well-integrated team of investment professionals that can provide diverse perspectives, challenge assumptions, and collaborate to make more informed and objective investment decisions. This can help reduce the effects of biases and increase the likelihood of achieving superior investment performance, as proposed by the fundamental law of active portfolio management.
Though the ideas presented so far may seemingly apply exclusively to portfolio managers, I believe that the ideas put forth are just as important to individuals or institutions trying to decide on which manager to allocate to. Since past returns alone are by no means an effective criterion to measure the future performance of a manager (though a good starting point), understanding the internal drivers unique to the manager and how they could result in consistently beating the market could prove to be a worthwhile exercise. Obtaining a sense of the manager’s team and how they contribute to the decision-making process may be a criterion of great importance since, as we all now know, though there may exist an “I” in bias, there’s still no “I” in team.