Does Doubling Down Work?
- Jonathan Rhinesmith
- A version of the paper can be found here.
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I demonstrate that when investment fund managers “double down” on positions that have run against them, they outperform. Specifically, I find that a portfolio formed of the U.S. equity positions that hedge fund managers add to after recent stock-level underperformance generates significant annualized risk-adjusted outperformance of between 5% and 15%. This finding is not the result of a simple reversal effect, of a fund’s best ideas (large positions), or of the general informativeness of fund trades. My results are consistent with a career risks mechanism for this phenomenon. By adding to a losing position — the opposite of window dressing — managers are making their losses particularly salient. I demonstrate in a panel regression that investment managers avoid adding to losing positions. Furthermore, managers outperform by more when they double down after greater past losses in a position. These findings suggest a position-level limits to arbitrage effect. Even when an asset decreases in price for non-fundamental reasons, some of the investment managers with the most relevant knowledge of that asset may be particularly hesitant to add to their positions because they have already suffered losses in that asset.
When you hold a stock that plummets, you have three choices:
- sell and get rid of it — stop the losses
- hold and see what happens — disposition effect
- double down and buy more — believe there is a short-term mispricing and hope for a promising comeback
Under the pressure of career risks, mutual/hedge fund managers tend to “window-dress” before disclosing performances to clients, especially at the end of quarter/year. To “paint” a clean portfolio picture, and dress their window, managers sell those stocks with large losses, and buy stocks that have done well. Due to window-dressing pressures (which can also be due to tax efficiency or momentum signals), managers are sometimes hesitant to add more to a losing position.
In this paper, the author finds that despite these pressures, fund managers sometimes do make the tough decision and “double down.”
When fund managers “double down” on recent losing positions, those portfolios tend to outperform!
- With a sample from 1/1990 to 12/2013, the paper finds that a portfolio formed of the positions that fund managers add to after recent stock-level underperformance generates significant annualized risk-adjusted outperformance of between 5% to 15% (Table below shows the monthly performances). Double down portfolios perform best with around a 6 to 9 month holding period.
* Note the underlined sentences define the doubling down portfolios in this paper.
How to explain the “doubling down” effect?
The paper then constructs a variety of control portfolios to demonstrate that the “doubling down” effect is not explained by a simple reversal effect, or by the general informativeness of fund trades. Rather, the author contributes this effect to “career risk” of fund managers. The paper measures managers’ portfolio returns over recent quarters, and compares them to returns earned by other managers. If a manager has outperformed recently versus peers, the manager is assumed to have relatively lower career risk. If a manager has underperformed recently versus peers, the manager is assumed to have relatively higher career risk. The paper finds some evidence that managers who have done well recently (lower career risk) are more likely to double down as compared with managers who have done worse recently (more career risk). These lower performing managers might be more inclined to window dress and less inclined to double down due to the career risks they face. Perversely, a manager’s recent underperformance may drive him to make more bad decisions. By contrast, a high performing manager, who is more secure in his job, may have more confidence to double down on a position that has moved against him.
To be specific:
- By adding to a loser, fund managers usually call more attention to their decisions. So the doubling down decisions represent a clear demonstration of the information content of a fund manger’s decisions.
One potential downfall from a double down strategy — overconfidence.
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