Can anyone explain this to me? It really seems like the paragraph below conflicts with the chart above it. The longer I study this, the less I’m able to understand the differences… It seems non-intuititive.
Realization
Type 1 Error: Hire/Retain, Manager is below expectations:
Type 2: Not Hire/Fire, Manager ends up being better than expected.
If markets are mean-reverting, then Type I errors may occur when firing a poor performer, only to have performance improve subsequently or hiring a strong performer only to have performance deteriorate subsequently (Note: That is not a Type II error because the assumption is that the poor and strong performers have been accurately determined initially but it is the mean-reversion of the markets that leads to the Type I error). Type II errors occur in mean-reverting markets when strong managers are retained for too long (e.g., they subsequently underperform when the market goes down) or managers who have weaker short-term performance (but have sufficiently strong long-term performance) are not hired and they subsequently outperform when the market goes up.
Where did you get this from? CFAI Online practice questions?
Type 1 is hiring or retaining error. You have a bad mgr.
Type 2 is firing or not hiring error. You missed a good mgr.
Null hypothesis is the manager adds no value at all.
Everything else is blah blah blah in my humble opinion so don’t let poorly worded explanations cause you to get confused. If it’s more confusing than the above, it’s the explanation with the problem, not you. Don’t stress. Frankly speaking the recent CFA mocks on their website have a bunch of errors in them even. That’s a big wake up call, if the test makers’ official stuff isn’t all right then we hardly will be perfect either. So we will get some right some wrong, just trust the process and keep the big picture in focus. Cheers and good luck! Don’t let an awkwardly worded explanation of a relatively simple concept make you second guess yourself from the obvious on the exam. At least that’s my approach for whatever it’s worth.
With mean reversion, the whole thing is that the market is outperforming/underperforming at the moment and will reverse course to a long-term mean. So managers kicking butt now due to holding the outperforming stocks will be expected to perform worse in the future when their stocks reverse back to the mean. They seem to be talking about cookie cutter long holding managers here. If their performance is due to gains in a stock that’s now become overvalued, well the overvalued stock will drop and by keeping them or hiring them during the bull runup you’re setting yourself up to take the fall with them. You’re buying high selling low in effect. Opposite with type 1 errors. You missed hiring the manager who is going to kick butt when stocks revert to their mean, because you hired instead the guy who has been kicking butt in the stock runup but now that manager’s holdings are about to drop back to their mean while the other manager’s holdings might well be increasing or have been undervalued at the time you assessed the hiring decision. And blah blah etc.