the folklore of finance

The

FOLKLOREof FINANCE

How beliefs and behaviors sabotagesuccess in the investment

management industry

Center for Applied Research

Global assets under management, net revenues and profit margins have risen consistently.

However, we asked:

IS THE INVESTMENT MANAGEMENTINDUSTRY SUCCESSFUL?

The industry continues to be ranked among the most profitable in the world.

JUST BECAUSE THE INDUSTRY IS PROFITABLE, DOESN’T MEAN IT’S

SUCCESSFUL.

TRUE SUCCESS includes not only producing alpha — perhaps more importantly, it also requires helping investors achieve their long-term goals.

THE INDUSTRY’S MODELS FOR SUCCESS ARE BROKEN

The industry as a whole cannot produce alpha, because it is a zero-sum game.

INVESTORS ARE NOT ACHIEVING TRUE SUCCESS.Investment professionals are not:

consistently delivering alpha, despite being thoroughly devoted to it.

delivering results consistent with the long-term goals of investors.

THE ALLURE OF ALPHAThe industry spends 60% of its capital on the production of alpha …

… But alpha has become harder to produce.

INDUSTRY PARTICIPANTS ARE SKEPTICAL.

Only 53% of retail investors believe alpha is primarily based on skill rather than luck.

Only 42% of investment professionals believe alpha is primarily based on skill rather than luck.

THE UNBALANCED PURSUIT OF ALPHA IS A HUGE PROBLEM IN

OUR INDUSTRY

THE BIGGER PROBLEM?INVESTORS ARE FAILING TO

ACHIEVE THEIR GOALS.

FAILING THE INVESTORS WE SERVEThe reason the industry exists is not only to produce alpha … it is to help investors achieve their long-term goals.

1. Investors consider achieving long-term goals to be very important.

2. Yet they aren’t achieving their long-term goals.

FACING A NEW CRISIS: THE 3 DSThe industry is facing a new crisis — not a financial crisis — a crisis of faith:

Driving the crisis: a deep DISTRUST of the industry that leads to DISSATISFACTION, which ultimately leads to DISINTERMEDIATION.

INVESTORS BELIEVE THEY CAN DO THE JOB OF INVESTMENT

PROFESSIONALS BETTER, ANDFOR LESS COST.

?

1 Harvard University, Fang, Ivanshina, Lerner “The Disintermediation of Financial Markets: Direct Investing in Private Equity” October 2012.2 Note that this refers specifically to investors’ attitudes regarding defined contribution plans.

All data throughout this document which is not specifically cited originates from Center for Applied Research Study 2014 — “Folklore of Finance; How Beliefs and Behaviors Sabotage Success in the Investment Management Industry”

All data throughout this document which is not specifically cited originates from Center for Applied Research Study 2014 — “Folklore of Finance; How Beliefs and Behaviors Sabotage Success in the Investment Management Industry”

The total capital invested indirect deals increased nearly

8xover the last 20 years.1

93%of retail investors believe they should make

investment decisions themselves.2

2/3rds said their best investment to date was

entirely their decision. believe technology will do a better job

meeting their needs than humans.

Globally,

40%of the average investor’s portfolio is held in cash.

2 3STATE STREET CENTER FOR APPLIED RESEARCH | THE FOLKLORE OF FINANCE STATE STREET CENTER FOR APPLIED RESEARCH | THE FOLKLORE OF FINANCE

THE FOLKLORE OF TIME: We rely on past

performance despite the fact that past performance is not an indication of future expected returns.

We over-rely on forecasting despite poor accuracy rates.3

We rely on short-term results because they are easier to measure and incent: The majority of industry participants measure success over a 1-3 year timeframe.

THE FOLKLORE OF FALSE COMFORT:The most destructive form of false comfort has to do with investors’ definition of success.

Only 22% of institutional investors define success as achieving their long-term goals.

Instead, they define success as outperforming a (largely irrelevant) index or outperforming their peers.

Only 29% of retail investors define suc-cess as achieving their long-term goals.

How do they define success? Outperforming the market, making gains

and having no losses, and achieving short-term investment goals.

What unifies these definitions of success is that investors feel comfortable with their concreteness. Achieving long-term goals is more abstract.

Our industry’s entire infrastructure provides us with false comfort.

Our industry has produced “artifacts” over the last 50 years — we have many concrete yet incorrect ways to classify, measure, and document investments.

With additional regulation, we are also in the process of creating a lot more folklore…under the guise of transparency.

THE FOLKLORE OF KNOWLEDGEThe Folklore of Knowledge involves that which investment professionals and investors don’t know, but think they do.

WE ASKED PORTFOLIO MANAGERS“WHAT ARE THE TOP REASONS

YOU OUTPERFORM?”

The most frequent response was “experience and analytical process” — their own superior skills.

When it came time to explain under-performance, however, they blamed external factors, such as “the markets”.

RETAIL INVESTORS ALSO SUFFER FROM THE FOLKLORE OF KNOWLEDGEinvestment acumen versus actual financial literacy

IF THESE BEHAVIORS ARE SO DETRIMENTAL TO SUCCESS,

THEN WHY ARE THEY SO COMMON?

Humans rely on folklore as a natural response for coping with uncertainty and fear.

About half of money managers think that if they underperformed over a period of just 18 months, it would threaten their job security.

Retail investors fear losses and regret — especially when their “nest egg” is at stake.

So what we’re left with is Folklore’s perpetuating cycle:

Folklore drives behaviors, and behaviors drive activities, which result in more folklore.

WHEN WE LOOK AT THE AMOUNT OF RESOURCES THE INDUSTRY

CONTRIBUTES TO VARIOUS ACTIVITIES, WE SEE A SIGNIFICANT

MISALLOCATION IN PLAY.

?

2/3rdsof retail investors believe

their current level of financial sophistication is advanced

The average retail investorscored just

61%on a financial literacy test...which

is barely above a failing grade

Folklore

BehaviorsActiviti

es

The Folklore of Time

FOLKLORE DOMINATES DECISION-MAKING

The Folklore of Knowledge

The Folklore of False Comfort

UNCONSCIOUS

CONSCIOUS

WHAT’S DRIVING THESEFAILURES?

3 Source: James Montier et al. Mind Matters: The dangers of DCF. Societe Generale Cross Asset Research. 9 September 2008: 2-4. All data throughout this document which is not specifically cited originates from Center for Applied Research Study 2014 -- “Folklore of Finance; How Beliefs and Behaviors Sabotage Success in the Investment Management Industry”


All data throughout this document which is not specifically cited originates from Center for Applied Research Study 2014 -- “Folklore of Finance; How Beliefs and Behaviors Sabotage Success in the Investment Management Industry”

Folklore reflects the shared beliefs, rooted in human bias, that govern both investment professionals’ and investors’ behavior.

As a result of folklore, the industry spends far more time, money and energy on

activities that contribute value to alpha, but which yield little impact on value to

the investors’ goals (upper left).

What’s also clear is that the industry allocates a disproportionate amount

of resources on activities that do not contribute significantly to alpha

production or investor value. (lower left)

The Folklore of Finance drives the under-re-sourcing of activities that contribute value

to investors’ long-term goals, which would otherwise seem surprising given how

many of those activities also contribute significantly to alpha (upper right)

FROM CURRENT FAILURE …Current Allocation of Time, Money and Energy

Future Allocation of Time, Money and Energy… TO FUTURE SUCCESS

Modeling and Valuation Focus

Past Performance Focus

Traditional Benchmark Focus

Goal Prioritization

Empathetic Communication

Tolerance for Pain

RealisticSelf-Assessment

EffectiveInformation Processing

Low

Hig

hPo

tent

ial

Val

ue to

Alp

ha

Potential Value to Investors’ Long-Term Goals

Bubble Size=Current level of industry focusBubble Location=Potential value of activity

High

External Source

RelianceLow

THIS IS THE FOLKLORE OF FINANCE AT WORK.

Modeling and Valuation Focus

Past Performance Focus

Traditional Benchmark Focus

Goal Prioritization

Empathetic Communication

Tolerance for Pain

RealisticSelf-Assessment

EffectiveInformation Processing

Bubble Size=Future level of industry focusBubble Location=Potential value of activity

Behavioral Boomerang:

allocate resources

here.

External Source

Reliance

Revise incentive structure Measure risk in multiple ways Deliver personal performance Foster financial literacy Improve internal culture

Establish effective feedback loop Beware of behavioral biases Incorporate client segmentation Increase active share Integrate trading discipline Recruit for emotional quotient (EQ) Offer a manageable number of investment options Draw comparisons Use checklists

Use challenge mechanism Keep records of decisions Use behaviorally modified asset allocation

1Year

1Quarter

1Week

Low

Hig

hPo

tent

ial V

alue

to A

lpha

Potential Value to Investors’ Long-Term Goals High

Low

HOW CAN WE ACHIEVE TRUE SUCCESS?


PLANNING FOR A NEW FOLKLORE OF FINANCE: TACTICS



The information contained above is for illustrative purposes only.

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