Heroes & Villains

Heroes & Villains

Photo by Mark Asthoff on Unsplash

I was listening to an episode of Patrick O’Shaughnessy’s podcast recently, in which he interviewed his father, Jim O’Shaughnessy (that’s not as weird as it sounds – it’s a great interview).  Jim was a pioneer in quantitative equity research and factor investing back in the 1980s and 90s and during the interview he made the following comment:

“If you can’t master your emotions, all the data in the world will not save you.”

You might assume that he was referring to individual investors, who are constantly being told that their behaviour is the biggest destroyer of their returns.  Whilst it certainly applies to individual investors, in fact he was referencing professional fund managers who consistently under-performed cloned versions of their own funds because they allowed emotion to override their investment process.

It might seem a little strange that professional fund managers could be subject to the same behavioural biases as individual investors, but none of us is immune from our most basic evolutionary traits.

In 2012, the CFA Institute published a book entitled ‘Fund Management: An Emotional Finance Perspective’, by David Tuckett, a psychoanalyst, and Richard Taffler, a professor of finance and accounting.  The book documents their research, carried out in 2007, when they conducted a series of in-depth interviews with 52 fund managers in the largest international investment firms across the US and Europe.  To be considered for the study, fund managers had to have at least 10 years of fund management experience and, in most cases, to be personally managing more than $1 billion.

In aggregate, those interviewed were responsible for managing $503 billion.  On average, they had been managing funds for 15 years and had held the same position for eight years.  Two thirds had outperformed their benchmarks (before costs) over the previous three years.

The aim of the book was to increase understanding of what it is like to be a professional fund manager, the challenges they face and the role that their emotions play in their decision-making process.

Finance theory has three major strands: the first was the traditional economists’ assumption that investors are rational decisionmakers.  That theory was subsequently challenged by (amongst others) psychologists Amos Tversky and Daniel Kahneman and also last year’s Nobel Prize for Economics winner, Richard Thaler, who argued that investors are subject to cognitive biases which affect their decision making.  This strand became known as behavioural finance.  The third strand is emotional finance – which considers how our emotions, both conscious and unconscious, affect our decisions.  It is this third strand which was examined in this book.

The interviews carried out highlighted five recurring factors common to fund managers:

They must be exceptional –  fund managers are expected to beat their benchmarks on a consistent basis;

Fund managers are expected to make decisions with incomplete information – and that information can be interpreted in many ways, meaning there is no clear-cut decision obvious to the fund manager;

Fund managers know that asset values are based on the collective views of market participants – and that, in the short term, prices can deviate from those views.  There is no reliable means, however, of determining by how much and for how long those deviations will persist;

Fund managers know that all their assumptions are uncertain – and that they make decisions based on informed guesswork;

Fund managers have highly emotional relationships with the stocks they own – in their interviews, the words ‘love’ and ‘hate’ were frequently used.

Pressure to perform

The interviewees were all aware that the academic evidence indicates that it is incredibly difficult for fund managers to consistently outperform.  Nevertheless, they are expected to do so and must deal with the pressure their clients place on them to do so both in the short term and the long term.  This often leads to conflicting and inconsistent demands on therm.

As a result, even though they often argued that their long term investment strategy gave them an advantage, they also admitted to checking the performance of their funds daily, if not more frequently.

As one interviewee stated:

“Unfortunately, we live in a world where you get measured on a daily basis, sometimes… so, yes, there’s definitely a certain amount of pressure.  It affects morale; it affects your sleep, a lot of things.”

This pressure to perform in the short term led another to comment that when he is interviewing graduates thinking of joining the firm, he asks them, “Why on earth do you want to go into an industry where you’re almost doomed to failure even if you’re good?”

Fund managers are well aware of the tenuous nature of their position, and that the average tenure for a fund manager at one fund is only five years.  Yet in spite of this there is evidence that the fund managers themselves perpetuate this short termism in the teams they manage.  One interviewee was asked how he dealt with measuring performance, and from that determining skill, in his team.

He claimed to judge them over the long term, but then stated,

‘I always say to the guys, “You’ve got three years.”  And I’m quite honest when I recruit people: “I’m not short term; you’re going to get three years.”  … Basically, in three years, you should know if someone’s any good or not.’

Clearly, he somehow missed the memo about separating skill from luck, something you cannot possibly determine in such a short time frame.

Using storytelling to make decisions with incomplete information

The use of stories to lend conviction to their decision making was a recurring theme amongst the interviewees.  This should come as no surprise given that, as a race, we constantly indulge in storytelling to explain and validate our actions.  Morgan Housel wrote a great piece just before Christmas about the stories we tell ourselves.

The stories the fund managers told themselves were a key requirement to their ability to make decisions.  A typical story would involve a fund manager researching a particular stock and coming up with numbers which indicated, to him, that the stock price was under-valued.  They then purchased the stock and benefited from its increase in price.  They would cast themselves in the role of ‘hero’, and their story would follow the typical ‘epic’ narrative.  This was despite the fact that the information ‘discovered’ by the fund manager could equally be discovered by anyone else crunching the numbers.  Furthermore, even if it had been discovered, there was no guarantee that enough other investors would perceive the same value and thus cause the market price to adjust accordingly.

The flip side to the ‘epic’ story was the ‘tragedy’.  In these stories, things did not work out as the fund manager had expected and their fund lost money.  In these cases, they portrayed themselves in the role of ‘victim’, often casting the company’s management in the role of ‘villain’.  In this way, the story enables the fund manager to believe that his course of action was the correct one but fate had intervened to prevent him reaping the rewards.

The conclusion drawn by the authors is that a fund manager requires the ability to tell convincing stories to himself and others to maintain his conviction in his decisions.  When things went wrong, the rationale behind the investment process or strategy, and the narratives employed to validate these, was never questioned.  The stories were used to explain why some decisions did not work out and even in cases where they apportioned blame to their own perceived shortcomings the narrative, and the belief that it is possible to outperform, remained intact.

Just over 20% of the respondents were quant fund managers, who primarily use a rules-based process for investing via computer algorithms.  Interestingly, they viewed themselves as less emotional than the other respondents as they were not picking individual stocks themselves.  The story they tell themselves is that they are pitting themselves against the ‘irrational market’ and that gives them a performance edge.  In fact, in those interviewed, their performance was pretty much in line with the benchmark.

Dealing with risk

One of the biggest worries expressed by the respondents was whether the information they had was accurate.  They displayed a fear that companies are liable to mislead them, whether deliberately or not.  Consequently the need to be able to trust the data plays a large role in whether a fund manager believes that they can deliver outperformance.  The problem is, they always have a sneaking suspicion that they may be being misled.  This can lead to sub-optimal decisions.

One interviewee described investing in a stock with a ‘good story’ only to see it fall slightly after seven or eight months.

“I don’t know exactly why… [we] got frustrated with it… [and] just sold it.  This was one where psychologically… you get tired of seeing a stock drift lower, so it’s purely an emotional sale, just sold out of frustration…  [You wonder] “What does the Street know that we don’t?  What are we missing?”  We just couldn’t come up with an answer, so we sold.”

The stock then went up by 50% over the following six months, and everything the fund manager had identified as being a ‘good story’ played out exactly as he had originally thought it would.  “We just didn’t give it enough time,” he said.  Interestingly, this story was recounted when the fund manager was explaining his own story, which was that he has an investment horizon of two to three years.

Even in cases where disaster had been averted, the fund manager will not always view it as a positive outcome.   One respondent explained he never held any stock in WorldCom or Enron but because he missed out while those stocks were making money he described them as companies that ‘hurt me forever’.

A frequent outcome of fund managers’ fear of the consequences of risk is a tendency to ‘hug the index’.  The risk of sticking their heads above the parapet by taking over- or underweight positions in stocks relative to the index is deemed too great a career risk.


Clearly, from the findings of the book, fund managers do not exhibit the same emotional behaviour in managing funds that an individual investor would when investing his own money.   However, that does not mean to say that professional money managers are immune from allowing their emotions to affect their behaviour.

Fund managers are under a particular kind of pressure – the pressure to outperform.  That’s a pressure they contend with on a daily basis, even though they know that the odds, and the academic evidence, are stacked against them.

We don’t pick stocks, we don’t market time and we have a robust, rules-based investment process but as the person at Bloomsbury responsible for managing our clients’ portfolios, I still felt physically sick every time I rebalanced our client portfolios during the 2007/09 credit crunch, even though, unlike the fund managers interviewed in the book, I am under absolutely no pressure to ‘outperform’.  Our clients are clear that, as evidence based investment managers, what we are trying to do for them is to capture the market returns that are available to everyone, at the lowest possible cost, not to outperform a benchmark.

Between July 2007 and March 2009, I rebalanced individual clients’ portfolios up to 11 times (under ‘normal’ market conditions we expect to rebalance maybe twice a year).  If I hadn’t had that rules-based process behind me I don’t see how I could have kept a clear head when the markets were basically in freefall at times.

By delegating the management of your money to a third party (either a fund manager or a discretionary portfolio manager) do not make the mistake of assuming they will be in control of their emotions any more than you are.  Do your homework.  Ask about their investment process.  If they can’t explain it in simple to understand terms within a couple of minutes find someone who has an investment process which they can explain.

Warm regards