Last week I participated in a webcastWall Street Journal | It is a bit over a half an hour in length. that was part of “The Experts,” a Wall Street Journal initiative. The video, “How to Tame Your Emotions When Investing,” featured professors Meir Statman and Terrance Odean and was moderated by Jason Zweig.
There was a fair bit of discussion about the traps that individuals can fall into and the dangers they run competing against professional investors. I interjected that those professional investors are prone to the same behavioral errors as individuals — and that a good investment process should be designed to minimize them.
A day after that exchange I left on a trip, bringing along Fund Management: An Emotional Finance Perspective, a monograph published by the Research Foundation of CFA Institute in 2012.CFA Institute | The PDF is provided free by the Research Foundation. It speaks directly to the issues that I raised and is an eye-opener for those who think that fund managers operate apart from the emotional fray.
The authors, David Tuckett and Richard Taffler, started with a simple question: “What is it like to be a fund manager?” Emotionally, that is. To find out, they conducted in-depth qualitative one-on-one interviews, which are uncommon in the study of finance. (I admit to a bias in favor of their method, since that is at the core of how I analyze investment organizations.)
Someone who has been in the business for a while will find himself nodding in agreement at many of the passages, recognizing his own experience (and being quick to identify the behavior of others). For example, the relative performance game that most asset managers are playing leads to a different kind of emotional framework than a manager’s client is likely to have. The manager is insulated to a great extent from the jarring impact of large losses in absolute terms, instead having a focus on relative positioning that results in competing anxieties — caused by straying away from consensus on one hand or clinging to it on the other. (And if the manager has a nice lead on his benchmark as the end of the performance review period approaches, he might just hit “the index key” and lock it in.)
Much of the book is about the storytelling that permeates the business and its role in the emotional life of a fund manager. The authors quote another academic study that said that the work of fund managers is in essence “an interpretive or sense-making process,” adding that “brokers, consultants, public relations firms, journalists, economists, and just about everyone else in financial markets” are, in fact, telling stories to each other day in and day out.
These stories fall into the classical types, with epics and tragedies being dominant, the epics told by managers (to themselves and to others) about the triumph of analysis, while the tragedies involve some random outcome that would have been impossible to foresee. Interestingly, the authors see these stories as coping mechanisms, helping professional investors make some sense of an uncertain world. When we win, it’s an heroic effort; when we lose, the fates of market life have done us in.
Frequent players in these stories are the corporate managers that lead the companies in which portfolio managers invest. Attempts are made to sort “good” managements from “bad,” although as relationships develop between the parties, it becomes harder to be objective. Ultimately, the most powerful relationships can develop not with the managements, but with the investments themselves. Fund managers fall in and out of love with these “phantastic objects” (see the explanation of that spelling on page 85) over and over again. (In turn, investment managers can become phantastic objects themselves, gurus to adoring investors until their performance disappoints.) All of this would sound like psychobabble if it weren’t so recognizable.
As told through the words of interviewees, the authors document the ways in which the emotional lives of investment managers in response to the task at hand lead to actions that fit neither standard financial theory or the expectations of other investors.
The monograph touches on screen watching, obsessing over performance, the disconnect between client expectations and stated beliefs, distortions from incentive structures, cycles of giddiness and despondency, the “stories” of quantitative managers, career risk, “groupfeel,” and the difficulty of doing something truly different. That may seem like a lot, but the monograph is less than a hundred pages. It should be read by all chief investment officers and other leaders in the industry, but I fear it will be read by very few, because it relates to the “soft” aspects of the business, which tend to be assumed away rather than acknowledged.
Even if you don’t buy the thesis of the authors, the words of the fund managers themselves can be striking. The most memorable for me were from one who avoided the WorldCom and Enron disasters because he had “ploughed through the numbers.” But he missed the upside before the fall and the underperformance (and pain) from not owning them when they were winners is what he remembers: “They hurt me forever.”
Tuckett and Taffler believe that the “emotional triptych” of greed, fear, and hope thought to be the drivers of investment decisions don’t describe what’s really going on, that we are instead motivated by excitement, anxiety, and denial. Their monograph describes an emotional finance that is rarely discussed but critically important.