close menu

The "Folklore of Finance" - How beliefs and behaviours sabotage success in the investment management industry

by Mike Abbott | Dec 11, 2014
  • I’d like to share with you a very interesting study released by the State Street Center for Applied Research. The report is titled “The Folklore of Finance - How beliefs and Behaviours Sabotage Success in the investment management industry”.
    the-folklore-of-finance
    Over the past year or two here at Sable International we’ve also become increasingly sceptical of the value add offered by the traditional stock picker fund manager. This is especially true in large developed markets. We’re not sold on the pure passive tracker model either but that’s a story for another day.

    The survey in question interviewed 3,744 investors, investment providers, retail investors, fund managers, regulators and government officials across 19 countries. The findings support many other academic papers that have questioned the so-called "outperformance" on offer from top fund managers. The report finds that pursuit of success by fund managers and retail investors alike results in certain shared beliefs that govern behaviours. We’ll call these beliefs the Folklores of Finance. These false beliefs result in the industry spending 60% of its capital expenditure chasing an alpha performance that industry professionals themselves admit is more likely to result from luck than skill.

    However, the allure of "alpha" remains strong. To remind ourselves, alpha is an outperformance over a defined benchmark over time. Before we address the opaqueness of benchmark selection (which is a topic in and of itself!), let’s remember the well-known truism of behavioural finance - absolute personal wealth is far less important than relative personal wealth. Your neighbour or colleague's financial good fortune has a far bigger effect on your perception of your own wellbeing than your absolute wealth. Our irrationality as humans requires that we always be better than average. Average or below is an unacceptably uncomfortable place to find oneself in this era of the super individual.

    The industry’s devotion to alpha is reminiscent of the research of professor Taffler and Tuckett, who defined “Phantastic” objects: “attractive objects that stimulate high excitement and almost automatic idealisation and so, a powerful wish to possess.”

    And so it is that the industry propagates numerous false beliefs in the attempt to convince themselves and their investors that it is possible to be on the right side of a zero sum game all of the time. So why is it so hard for a fund manager to "outperform"? The report cites a few quite obvious reasons:

    1. Information efficiency: 90% of the world’s information was produced in the last two years. So the information edge any one fund manager has erodes every day.
    2. Competition: The absolute skill level of each fund manager is increasing (partly because of the information effect above) but the standard deviation of his skill is falling. So absolute skill rises and relative skill falls - a phenomenon known as the “Paradox of Skill”.

    Interestingly, the fund manager industry itself seems aware of this issue. Only 42% of fund managers believe alpha performance is primarily down to skill but 53% of individual investors believe the same!

    "The brain is terribly adept at substituting emotions for facts in order to make a financial decision that feels right." - Cabot Research

    The report does a good job of highlighting what we believe to be the primary issue around investment - the meeting of long term goals. That process is what we would call financial planning. Investment management is only one aspect of the financial planning picture and meeting long term goals requires the management of many moving parts including the pursuit of alpha within investment portfolios. It’s clear from the quoted survey that focusing on alpha is counter-productive and should never overshadow the meeting of long term financial goals for the client. If there’s a message from today’s letter it is exactly that - find an adviser to work with and work on the long-term goals.


    For more information on the topics covered in this post, or for any other wealth-related queries, you can contact us on +44 (0) 20 7759 7519 or email our wealth team.

    We are a professional services company that specialises in cross-border financial and immigration advice and solutions.

    Our teams in the UK, South Africa and Australia can ensure that when you decide to move overseas, invest offshore or expand your business internationally, you’ll do so with the backing of experienced local experts.

    • House rent protection
      Rental guarantees: What lenders think about rent protection schemes
      Apr 24, 2019  |  by Bill Monty
    • blended-families
      How “yours, mine and ours” complicates the estate planning process: Advice for blended families
      Apr 17, 2019  |  by Sherron Alexander-Bedingfield
    • Mortgage Concept
      The perfect time to secure a better interest rate on your remortgage
      Apr 03, 2019  |  by Ian Henning
    • growing tree
      The boom behind ESG investing – what’s actually driving the demand
      Mar 26, 2019  |  by Mike Abbott
    • Lightbulb working
      South Africa’s Retail Distribution Review – slow but important changes for investors and advisors
      Mar 05, 2019  |  by Mike Abbott
    • English-house
      Common mistakes that first-time homebuyers make
      Dec 06, 2018  |  by Ian Henning
    • Man-on-a-rocket
      Are you a UK contractor? Maximise tax-efficiency by using your pension
      Sep 25, 2018  |  by Bill Monty
    • terraced-houses-in-london
      Are you a UK contractor? Here’s how to get your mortgage approved
      Sep 12, 2018  |  by Marlon Borez
    • property-feud
      The hidden dangers of not having a will in the UK
      Sep 07, 2018  |  by Sherron Alexander-Bedingfield
    • typical-english-house
      You can receive your rental income tax-free if you don’t live in the UK
      Jul 12, 2018  |  by Ian Henning
     
     

    South Africa

    Cape Town

    Regent Square
    Doncaster Road
    Kenilworth 7708 +27 (0) 21 657 2120

    Durban

    25 Richefond Circle
    Ridgeside
    Umhlanga 4320 +27 (0) 31 536 8843

    United Kingdom

    Croydon

    One Croydon
    12-16 Addiscombe Road
    Croydon CR0 0XT +44 (0) 20 7759 7514

    Australia

    Melbourne

    9 Yarra Street
    South Yarra
    VIC 3141 +613 (0) 8651 4500

    Sable International is a trading name of 1st Contact Money Limited (company number 07070528), registered in England and Wales. We are authorised and regulated by the Financial Conduct Authority in the UK (FCA no. 517570), the Financial Services Conduct Authority in South Africa (1st Contact Money [PTY] Ltd - FSP no. 41900) and hold an Australian Financial Services Licence issued by ASIC to deal in foreign exchange (1st Contact Group - AFS Licence number 335 126).

    We use cookies to provide the best website experience for you. Using this website means that you agree to this. How we use cookies.