Conviction enables fund managers to overcome the uncertainty of investment outcomes and is seen as a driving force in successful decision-making. We analysed fund performance to understand the role played by conviction and discovered it was one of the strongest indicators of investment success. In this article, we share our insights into the importance of conviction and explore how managers can improve performance by recognising the influence of bias.

Main takeaways

Strong belief pays: High conviction positions generated positive returns in 80% of the portfolios we examined.
Reasons for strong returns: High conviction positions benefit from both thorough research and an increased focus on maximising gains and minimising losses.
Performance killer: Lower conviction positions generated positive returns in only 18% of the portfolios we examined.
Long-term erosion: 25% of investment performance is actually lost through maintaining weaker conviction positions.
Unlikely transformation: Weak conviction trades will only evolve into high conviction positions in less than 10% of cases.
Conviction versus concentration: There are significant differences between high conviction and high concentration; they are not the same.

Conviction versus concentration

Let’s start by looking at two terms that can be confused – but which are not the same.

A high conviction investment is one in which a manager has strong belief and a willingness to invest meaningful capital. It reflects their research, discipline, and ability to scale positions effectively. Concentration refers to a portfolio with a smaller number of holdings. A concentrated portfolio may contain fewer stocks, but that doesn’t necessarily mean each position is driven by strong conviction.

More broadly, concentration is rooted in the empirical evidence that the performance of major market indices is mainly driven by a handful of stocks. There have been times when this approach has been extremely successful.

While it’s used as a way to force strong conviction in a portfolio, there’s no guarantee of success. Highly concentrated portfolios will also display varying levels of conviction. For example, a fund may have a high concentration in a particular position due to a higher weight in the market index used as a benchmark. Convenience and a lack of viable options are other possibilities.

Of course, managers must strike a balance between ensuring that conviction drives portfolio construction while avoiding overexposure to individual risks.

High conviction pays off

Example of portfolio ranking across different skills

To explore the role played by conviction, we analysed 130 portfolios in which we were confident that the weights were a good proxy for the level of conviction held.

The key finding was a very powerful statistic: 80% of high conviction positions contributed positively to investment performance.

In addition, half of the outperformance generated in high conviction trades can be traced to strong skill in identifying winning strategies (Hit Ratio) and half to limiting their losses (Win-Loss Ratio). This indicates that not only do fund managers tend to be right with the high conviction calls made, but that those positions receive more attention to help maximise gains and minimise losses.

Weak conviction damages portfolios

The flip side to our discovery about high conviction positions is the fact that those in which managers have lower conviction only generated positive returns 18% of the time.

In fact, low conviction strategies can actually have a very detrimental effect on returns, eating up 25% of the total performance generated by the manager.

Example of a team shifting from predominantly scaling up positions to scaling down, indicating a potential decrease in conviction within the portfolio.

We have strong evidence that managers tend to neglect lower conviction trades and fail to actively manage losses, which serves to exacerbate their negative influence on portfolio performance.

This means identifying a lack of conviction is just as important as recognising strong conviction and there are a number of key indicators:

A shift from scaling up positions to predominantly scaling down
Slower idea generation, signalling hesitation or uncertainty
A rising number of lower-weighted positions, indicating a lack of strong bets.

Does starting small lead to stronger conviction?

How often a low conviction evolves to high conviction

Many fund managers assume that starting with a small position in a stock enables them to build conviction over time – but we don’t believe that’s the case. Our analysis revealed that weak conviction trades only evolve into high conviction positions in less than 10% of cases.

Most of the time, a weak conviction will remain that way and end up draining portfolio performance without ever becoming a strong winner for the fund.

How managers can prevent damaging calls

Our analysis revealed that portfolios often underperform due to the presence of lower conviction positions – but this presents a significant opportunity for improvement. While retaining weaker positions may indicate a flawed strategy, it also highlights areas where fund managers can enhance their decision-making.

Of course, some may suggest that concentration within portfolios is the only solution but that’s not something with which we’d agree. While concentrating portfolios can seem attractive due to potentially higher gains, this strategy also increases volatility and reduces the diversification necessary to mitigate risks. Therefore, maintaining a balanced approach is crucial.

By addressing cognitive bias, loss aversion, and hesitation in position adjustments, managers can also greatly improve their investment outcomes. Adopting a disciplined approach to reviewing and adjusting conviction levels across all holdings can lead to more informed trading decisions.

This is where SkillMetrics® is invaluable. Our solution offers deep behavioural analysis that exposes the biases leading to weak conviction. These insights can enable managers to strengthen risk control measures and ensure investment decisions are driven by performance metrics, rather than emotion.

This proactive approach not only mitigates risks but also optimises portfolio performance, proving essential in a fiercely competitive marketplace.

Conclusion

Our study confirms high conviction is a critical driver of investment success, with 80% of such positions contributing positively to performance. However, the challenge is optimising weaker positions that can adversely affect overall performance and the key lies in behavioural management.

Actively monitoring conviction levels and understanding the reasons behind hesitations in scaling or exiting positions enables fund managers to align their strategies with performance objectives. SkillMetrics® offers the tools necessary for managers to achieve this alignment as it gives managers confidence that every decision contributes positively in a market where marginal gains are crucial.

If you’d like to understand how SkillMetrics® can help you or your team, please get in touch

About:
SkillMetrics® revolutionises investment expertise by providing advanced behavioural insights tailored for portfolio managers. Our cloud platform identifies strengths, weaknesses, and behavioural biases, leading to improved performance. CIOs/CEOs can coach teams to enhance results by focusing on the investment process. Fund Selectors benefit from skill monitoring and behavioural diversification.

Investing with conviction: the key to outperforming the market