Reading 36 Investment manager selection 2.2.2. Performanance Implications of Type 1 & Type 2 errors

CFA Level III Portfolio Management
#1

Hi All

Could someone explain what the below lines in the topic Performanance Implications of Type 1 & Type 2 errors in Volume 6 Page 250

The extent to which markets are mean-reverting also has a bearing on the cost of Type I and Type II errors. If performance is mean reverting, firing a poor performer (or hiring a strong performer) only to see a reversion in performance results is a Type I error. A Type II error would be not trimming strong performers and avoiding hiring managers with weaker short-term track records, which can be costly

My question is How can firing a poor performer be a type 1 error when the markets are mean reverting , type 1 error is you reject the null hypothesis when it is true ie you hire or retain a manager who is unskilled but the statement says firing a poor manager

Similarly Not Trimming a strong manager is type 2 error as per the book but type 2 error is firing a manager when he is indeed skilled.

Could someone please explain this. Thanks.

#2

When I teach, I trim it to:

Hiring/Retaining strong performers only to see reversion in performance --> keeping the bad ones --> Type I error

Firing/Avoid hiring a poor performer only to see reversion in performance --> not keeping the good ones --> Type II error

#3

Thanks Fino will follow the same , the paragraph is very confusing.

1 Like
#4

thanks. but the curriculum says…

If markets are mean-reverting, Type I errors can occur when firing a manager with poor performance, only to have performance improve subsequently because of mean reversion…

HOW CAN FIRING A MANAGER WITH POOR PERFORMANCE RESULT IN TYPE 1??

#5

I replied to an another thread that you started related to this topic.
To put it simple, if the word “not” exist in a sentence, like “did not fire”, “did not promote”, “did not retain”, then it is type II, otherwise, it will be type I.

#6

yeah. i saw it. thanks a lot