The Folklore of Finance: Beliefs That Contribute to Investors’ Failure
From: nytimes.com
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.
