Nickels versus Black Swans: Reputation, Trading Strategies and Asset Prices

This paper analyzes a model of fund managers' reputation concerns. It explains why "Nickel strategies" (strategies that earn small positive returns most of the time but occasionally lead to dramatic losses) are more popular among managers than the opposite "Black Swan strategies," (strategies that generate small losses most of the time but occasionally lead to large profits). A novel insight from the model is the fragile nature of the economy with reputation concerns: The interaction between managers' reputation concern and investors' perception of managers' strategy choices may lead to multiple self-fulfilling equilibria. When the economy is in one equilibrium, managers have no incentive to change their strategies unless investors change their perceptions, and vice versa. This coordination problem implies slow-moving capital and may leave profitable opportunities unexploited for an extended period of time. Once the coordination problem is broken, however, the economy switches to the other equilibrium, leading to drastic capital relocation and price movements in the absence of news on fundamentals. This model sheds light on a number of stylized facts documented in the literature and also provides some new testable implications.