Nothing is more fun for students than playing investment games. It teaches them valuable lessons. And not only the students, but also professional investors can learn from it.
Being a tutor to young, enthusiastic students is one of the nicest parts of my professorship. Every year, we let a group of nearly-graduates manage an investment portfolio in real time. The best way I know to spot talent.
A fixed part of the annual cycle is playing an investment game together. The students play the role of portfolio manager and immediately experience the biggest pitfalls of investing. For example, they learn that it can take a while before you get what you want (if you get it at all). And that the cost effects cannot be underestimated. But also, that investors often take their profits (too) quickly, hoping that the losses will soon be compensated.
Before they start as portfolio managers, the students receive some assignments. For example, they must clearly describe the investment philosophy. Practice shows that even experienced hands have difficulty doing this. However, it is a crucial step. Managers who are able to do this well perform better.
I always refer to the seminal article of Minahan (2006) in which it is stated that a portfolio manager should ask himself or herself some crucial questions. These questions, from which experienced investors and portfolio managers can benefit, can be summarized in three parts.
Prices in markets
The first series of questions is about the security pricing mechanism. The underlying theory? And what it is about this mechanism that sometimes causes securities to be mispriced?
The second set of questions is about the manager’s competitive advantage in exploiting this mispricing. Why would he be able to this more clearly than anyone else?
The third set is about the way to make money for clients. How can these beliefs be exploited to generate ‘alpha’?
I have just read and graded the investment plans of my students. They have become good stories. Are you reading this column as a portfolio manager? Can I wake you up in the middle of the night to get the answer to the questions above? Are you reading this column as an investor? Then ask these questions. And should your manager fail to have the answers, then give your money to my students, because they do.