The Cost of Investment Hubris

Many active investors engage in stock selection and market timing. Some may have genuine abilities in doing so. But what is the cost of these activities for investors who believe they possess such abilities but actually don’t? The author derives analytical expressions for these costs, above and beyond direct trading costs, and finds that the risk-adjusted cost of uninformed market timing is quadratic in the market expected return and is about 1.3% per annum. The cost of uninformed stock selection is inversely proportional to the number of stocks held: For N = 20 stocks, it is about 0.8% per annum. These results should serve as a warning for active managers and investment boards: Getting it right half of the time does not yield average performance, but much less.