| New York Times | - |
They came up with a label for the beliefs that contributed to this failure: the folklore of finance.
The study, to be released on Monday, found that people were
overconfident in their investing ability, unable to focus on their
stated long-term goals ...
WHEN
most people think of folklore, they think of ancient stories passed
down through the ages. The tales may be instructive, amusing or both,
but few take them as entirely true. Still, they represent an oral
tradition that once helped people make sense of the world.
After
a nearly two-year study that aimed to answer the question, What does
true investment success look like?, Suzanne Duncan, global head of
research at State Street’s Center for Applied Research, and her team
found that the way individual and professional investors made investment
decisions was so skewed that achieving both high returns and long-term
objectives was nearly impossible.
They came up with a label for the beliefs that contributed to this failure: the folklore of finance. The study,
to be released on Monday, found that people were overconfident in their
investing ability, unable to focus on their stated long-term goals when
distracted by short-term noise in the markets, and had come to distrust
their advisers and lose interest in receiving professional investing
help. It also found that changing these behaviors in individual and
professional investors was going to be very difficult.
The study begins by trying to explain two very real disconnects in investing.
The
first is part of the debate over skill versus luck in investing.
Investors generally seek returns that beat a benchmark, known as alpha
in financial jargon. But the reality is that alpha barely exists today —
at least alpha that is achieved through skill and not luck.
In 1990, 14 percent of domestic equity mutual funds
achieved “true” alpha — which was defined in a University of Maryland
study as alpha that was not achieved by chance. In 2006, the number of
funds delivering true alpha was down to 0.6 percent, which is
statistically equivalent to zero. Five times as many funds operated in
2006 as in 1990.
Investors
are not oblivious to the difficulty. Only 53 percent of individuals say
they believe alpha is attainable by skill, while even fewer
professionals, only 42 percent, attribute any performance above the
benchmark to skill.
Why
this has happened is a paradox of our age: Investors have both greater
skill and more information to make outstanding performance more
challenging. (The study includes an online quiz
to test investing expertise). Think of it as standing up at a baseball
game. If you do it alone, you have a better view. If everyone stands,
only the tallest have a chance of seeing better than if everyone was
still seated.
Yet
the financial industry continues to search for alpha as if it were a
great white whale. The study found that financial services firms spent
60 percent of their capital expenditures on resources to help generate
short-term high performance. It is not for nothing: Active, as opposed
to passive, money managers received $600 billion in fees in 2014,
according to estimates State Street made from Boston Consulting Group’s
Global Asset Management 2014 report. That amount is nearly equal to the
gross domestic product of Switzerland.
The
solution to the mostly futile quest for alpha, though, is not to switch
to being a passive investor alone — which would mean investing in
index-tracking funds that would return whatever the index returned, for a
very low fee. Ms. Duncan called that reaction too simplistic. She
advocated for a system at firms that would challenge broadly accepted,
herdlike opinions.
What
should be more achievable is setting a financial goal and meeting it,
but the study found that this is not happening either. Individuals
failing to stick to their plan is nothing new, but in some cases
individual investors do not even understand what the plan is: 73 percent
of respondents to a State Street survey said they invested with
long-term goals in mind, including retiring comfortably and leaving an
inheritance, but only 12 percent of those investors said they were
confident they were prepared to meet those goals.
“Investors
are very short-term-oriented in the sense of how the markets are
performing,” Ms. Duncan said. “It’s all relative returns. That takes
away from their ability to stay the course.”
In
other words, if investors could focus on their long-term goals and
understand that it is not going to be a straight line to get there, they
would have a greater chance of achieving those goals. The study, of
course, is not the first to look at these problems. The field of
behavioral finance dates back to the 1970s. But the problems of chasing
returns and failing to stick to the investment plan are attracting more
attention. And the solution is often advisers who can spend more time
finding out what their clients want to achieve and less on moving them
among investments.
“It’s
not very hard to help individuals realize what they want to do,” said
Charles D. Ellis, founder of Greenwich Associates and a former chairman
of Yale University’s investment committee. “It does take some time. You
have to ask questions and find the answers that are acceptable.”
These
go beyond return expectations, Mr. Ellis pointed out. They go to the
core of person’s financial history, from how their parents fared
financially to what they want their own money to accomplish.
The
State Street study does not pull any punches in blaming the investment
management industry for the pickle investors are in. It criticizes
investment managers and advisers who are focused on short-term gains as a
way of proving their worth. Fifty-four percent of institutional
investors said they feared they could lose their job if they
underperformed for only 18 months; 45 percent of people managing money
at asset management firms said they felt the same.
“Career
risk is much more profound than we anticipated,” Ms. Duncan said. “It’s
difficult to change because it’s very much embedded in everything. It’s
the culture, the fee structure, it’s based on assets under management,
and they’re rewarded for this.”
Investors
are starting to wise up to this game. A 2012 State Street study found
that 65 percent of investors did not feel much loyalty to their investment adviser,
while 93 percent of respondents to another State Street survey said
they believed they would be better off investing on their own. After
all, a CFA Institute study found that investors trusted the financial
services industry less than they did the telecommunication, automotive,
pharmaceutical and technology industries.
But investors’ taking investment decisions into their own hands has not proved to be the solution either.
The
study found they look to markers like past performance or how others
are doing to measure their own investment success, a false comfort in
the study’s parlance. Only 29 percent of investors defined investing
success as reaching their long-term goals; most preferred short-term
markers, like their portfolio’s return versus that of a benchmark.
Another
disconnect revolves around time. Investors want to invest with a long
time horizon yet react to short-term swings that derail the strategy.
Think of investment return markers, like one, three and five years —
hardly the time needed to get people from their first job to retirement.
Yet
these are at least conscious acts. People under the sway of what the
study called the folklore of knowledge do not even realize how
overconfidence, to take one example, is hurting their investment
decisions.
“Are these myths? No, myths mean false,” Ms. Duncan said.
More to blame is people’s overreliance on measures like mutual fund
performance ratings, she said. “Morningstar gives us false comfort,”
she said. “There’s some truth to Morningstar’s ratings. But there is
untruth. Dart-throwing monkeys outperform market-cap-weighted indices.”
So what is to be done to change this?
One
way the report suggests is to think of decision making — and the biases
that derail it — as a boomerang. At the curved section of the
boomerang, the study pointed to the most desired behaviors that
professional investors and advisers could get their clients to embrace:
an effective decision-making process, a realistic self-assessment, a
tolerance for pain and goal ranking.
The
clients would, ideally, avoid focusing on past performance, traditional
benchmarks and looking to external sources of validation, like
comparing your returns to your friend’s.
If
advisers are going to help achieve those behavioral changes, they need
to check in regularly with clients. “They need to make sure that their
clients are on track with their long-term goals — something that could
be difficult to do if advisers can’t correct their own behavioral
biases,” Ms. Duncan said.
“We
avoid seeing behavioral problems because it’s hard and painful,” she
said. “One of our recommendations is to have a healthy pain tolerance.”
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