How beliefs and behaviors sabotage success in the investment management industry.

1. The
FOLKLORE
of
FINANCE
How beliefs and behaviors sabotage
success in the investment
management industry
Center for Applied Research

2. Global assets under management, net
revenues and profit margins have risen
consistently.
However, we asked:
IS THE INVESTMENT MANAGEMENT
INDUSTRY 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 ALPHA
The 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 BIGGERPROBLEM?
INVESTORS ARE FAILING TO
ACHIEVE THEIR GOALS.
FAILING THE INVESTORS WE SERVE
The 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 DS
The 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, AND
FOR 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 in
direct 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

3. 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 KNOWLEDGE
The 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 KNOWLEDGE
investment acumen versus actual financial
literacy
IF THESE BEHAVIORS ARE SO
DETRIMENTALTO SUCCESS,
THEN WHYARE 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.
?
2/3rds
of retail investors believe
their current level of financial
sophistication is advanced
The average retail investor
scored just
61%
on a financial literacy test...which
is barely above a failing grade
Folklore
Behavi
orsAct
ivities
The Folklore
of Time
FOLKLORE DOMINATES DECISION-MAKING
The Folklore of
Knowledge
The Folklore of
False Comfort
UNCONSCIOUS
CONSCIOUS
WHAT’S DRIVING THESE
FAILURES?
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”
4 5STATE STREET CENTER FOR APPLIED RESEARCH | THE FOLKLORE OF FINANCE STATE STREET CENTER FOR APPLIED RESEARCH | THE FOLKLORE OF FINANCE
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.

4. Asaresultof folklore,theindustryspends
farmoretime,moneyandenergyon
activitiesthatcontributevaluetoalpha,
butwhichyieldlittleimpactonvalueto
theinvestors’goals(upperleft).
What’salsoclearisthattheindustry
allocatesadisproportionateamount
of resourcesonactivitiesthatdo
notcontributesignificantlytoalpha
productionorinvestorvalue.(lowerleft)
TheFolkloreofFinancedrivestheunder-re-
sourcingofactivitiesthatcontributevalue
toinvestors’long-termgoals,whichwould
otherwiseseemsurprisinggivenhow
manyofthoseactivitiesalsocontribute
significantlytoalpha(upperright)
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
Realistic
Self-Assessment
Effective
Information
Processing
Low
HighPotentialValuetoAlpha
Potential Value to Investors’ Long-Term Goals
Bubble Size=Current level of industry focus
Bubble Location=Potential value of activity
High
External
Source
Reliance
Low
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
Realistic
Self-Assessment
Effective
Information
Processing
Bubble Size=Future level of industry focus
Bubble 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
HighPotentialValuetoAlpha
Potential Value to Investors’ Long-Term Goals High
Low
HOW CAN WE ACHIEVE TRUE SUCCESS?
6 7STATE STREET CENTER FOR APPLIED RESEARCH | THE FOLKLORE OF FINANCE STATE STREET CENTER FOR APPLIED RESEARCH | THE FOLKLORE OF FINANCE
PLANNING FOR A NEW FOLKLORE OF FINANCE: TACTICS
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 information contained above is for illustrative purposes only.

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