Portfolio Managers at long short discretionary hedge funds are Risk Averse (rather than Risk Seeking) in December and January.
1) The calendar year ends on December 31st for nearly all of the long-short discretionary Hedge Funds. This means that whatever a Portfolio Manager’s YTD PnL is at the end of that day, is what his or her final payout for that year is going to be based.
2) The closer they get to Dec 31st, the more "real" the money is to them. If they are up then they don't want to risk it. If they are down or flat AND, particularly, if they have deferred or claw backs in place from the fund, then why would they put that money at risk so close to the finish line when they finally get it?
3) No PM wants to start January down money (in the hole) because it becomes incredibly difficult (psychologically) to trade the rest of the year with a "monkey on your back." Plus if they start off down too much, they may get their capital cut which is the slow death version for a PM who now has to make back the same dollar losses but with less capital to do it.
Now that I identified why a PM is much more likely to be Risk Averse during December and January, let's consider if it changes whether the PM is Up, Flat or Down coming into December. Based on my applied coaching work, I have found that it does not change in any of these three scenarios.
1) PM is Up.
2) PM is Flat.
3) PM is Down.
ALL 3 have the same outcome: Increased Probability of Taking Less Risk in December.
And here is why.
PM is Up for 2014
A PM who is up money right now does not want to risk giving it back because the psychological impact of giving profits back in a few short weeks after a full year of work is devastating. This creates an awful risk/reward situation so they end up taking less risk in the markets during this time.
PM is Flat
A PM who is flat right now doesn't want to risk losing money because even if he makes a little money back he is probably just covering some of his costs that were accumulated throughout the year. But if he loses money, he starts 2015 in the hole and has to make it back before he can get paid for 2015. (I.e finishing down 2% in 2014 means if he makes 7% in 2015, he will only get paid out on 5%, after expenses, in Jan/Feb 2016)...and that is a long time to wait to get paid - especially if you have a family to support.
PM is Down (has two viable scenarios)
a) If he is down a little, say 1.5%, then the risk of losing another 1.5% and finishing the year down 3% is much worse than the benefit he gains by making 1.5% and finishing the year flat. This is because of what is known in the Psychology field as Weber’s Law, which states that the perception of a situation changes even though the ratio is the same. I have found this effect to be magnified by two other variables: (1) if there are clawbacks in place that the PM is waiting to collect and (2) having to make back a loss of 3% before you get paid again is psychologically a lot worse than only having to make back 1.5% (which is viewed by a PM as ‘close to flat’ anyway).
b) If he is down a lot and close to his yearly stop out level, he is probably worried he is going to get fired so you would think he should be incentivized to just "go for it" because he has nothing to lose and everything to gain at this point. But there is another side to this, especially if he plans on having a future career in this business.
If he swings big and misses, he is unemployable at another hedge fund because he will have earned the reputation as an irresponsible risk taker who strayed from his process and decided to throw a "Hail Mary" pass to try to win the game on the last play. No risk manager wants that guy on their team because even if he DOES complete the Hail Mary pass - while he made back his losses this time - everyone knows throwing Hail Mary's is not a sustainable investment strategy. In fact, given a larger sample size, it will more likely lead to blow ups and rogue trading catastrophes down the line.
Process Leads to Profits,