This is the second part of a series on Leadership Potential.
I have a number of friends who manage their own stock portfolio. They track company news and economic trends and actively trade stock on a near daily basis. Most of them feel they are getting a better return than investing in an index fund, but the odds are not in their favour.
The average individual investor underperforms the market by about 9 percent. Overall, 75 percent of individual investors underperform market indexes. Worse, the investors who trade their stocks most frequently underperform the market by 42 percent.1
Why do individual investors underperform the market?1, 2
- Overconfidence. They are overconfident, leading to more frequent trading and "going along with the crowd"
- Hold Losing Investments. They hold their losing investments, which continue to go down, in the hopes that the investment will recover and minimise loss
- Measures and Metrics. They invest based on commonly used metrics that don't actually predict future stock performance
Challenges of Picking Potential
Managers make similar mistakes when they nominate employees as high potentials. Although they rate these employees on competencies and performance, their final decisions are often full of error. Because of these errors, up to 45 percent of a company's high potential list can change from one year to the next.
Overconfidence. Like traders, managers are more likely to select an individual that has a strong recent performance trend. Managers then unintentionally overrate the individual's competencies to support their decision. This overconfidence in an individual is one reason so many 9-box grid ratings line up in a diagonal. Managers have a hard time distinguishing their positive view of performance from potential.
Hold Losing Investments. Some managers leave individuals on a high potential list despite contrary evidence. They may do this because of a personal commitment to the individual, they may fear the individual will quit if taken off the list, or they may feel they have put their neck on the line for the individual and want to give the person a chance to recover. This is one reason so many high potential calls change when the employee moves to report to a new manager.
Bad Measures. To improve decision making, some managers use 360o reports when they rate potential. However, this metric is full of error and does not reflect actual competency levels. Like traders, they use a commonly available metric that does not necessarily predict future potential.
Improving Your Success Rate
Professional trading firms improve their stock picks by looking at a much larger set of metrics.2 They do this to increase the probability that the stocks they pick will increase in value. They know that they can never be 100 percent accurate, but want to maximise the likelihood of success.
Similarly, companies can improve the probability that the leaders they select will move into more senior level jobs in future. Based on academic research and best practice, we recommend a basket of measures to select high potential leaders:
- Foundation Measures. These are relatively stable measures and include Cognitive Ability and Personality, which are some of the most important predictors for future success. Personality tools have become more popular in companies recently, but cognitive ability measures are often underused. EQ is also a foundation measure, but be careful, as EQ is not as important in predicting success as is popularly believed.
- Growth Measures. These measures facilitate development of an individual and include measures of Resilience, Motivation, and Learning. Measures of resilience are especially important in emerging markets with challenging goals and operating environments.
- Team Performance Measures. These measures indicate whether an individual can successfully lead a team to accomplish a goal. These include quantitative Team Performance metrics (e.g., revenue), Employee Turnover/Retention, Engagement scores, and Customer Satisfaction scores.
- Job Fit. These measures indicate whether a person has potential for a specific job or set of jobs. Measures include Career Experiences, Functional Knowledge, Cultural Agility, Culture/Values Fit, and Decision Making Styles. The importance of each of these varies. For example, financial functional knowledge and commercial experience may be very important for GM jobs. Cultural Agility may be more important for jobs managing across countries.
Selecting and using the right set of metrics is important. Remember these tips when considering how to improve your potential assessment:
- Avoid Silver Bullets. If someone is trying to sell you the "one assessment you need," they are not likely familiar with the science around potential assessment. Consider both the assessments and the future jobs when deciding how to measure potential.
- Use Multiple Methods. Some vendors sell assessment centres and others sell behavioural interviews as the best predictors of potential. Both can be useful instruments. However, test batteries have similar predictive capability as assessment centres and are cheaper to administer. The interview is not as strong of a predictor as either an assessment centre or a test battery. Understand the type of assessment and its value before deciding on a methodology. Ideally, you should use multiple methods (e.g., tests, simulations, role play, job samples, interview) to assess potential.
Research shows that people are generally confident in their ability to make good judgement calls. Amateur traders believe they can beat the market and managers believe they can pick high potentials. Both of these groups make good decisions and both make mistakes. By looking at the right set of valid metrics, they can reduce error in their decision making and improve their success rate. By using the best of science and practice, companies can help their managers make good decisions and build their leadership pipeline in the process.
1Barber, B.M. & Odean, T. (2000). Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors. The Journal of Finance, 2, 773-806.
2Davis, J., Aliaga-Díaz, R., & Thomas, C.J. (2012). Forecasting stock returns: What signals matter, and what do they say now?. Vanguard Research.