The Active Equity Renaissance: Understanding The Cult Of Emotion

by: CFA Institute Contributors

By C. Thomas Howard and Jason Voss, CFA

"I know you are afraid and you should be afraid. I will invest you in products that will not stir up your fears."

This sentiment is applied over and over again in the investment industry in one form or another.

It is the mantra of what my co-author Jason Voss, CFA, and I call the "Cult of Emotion." The Cult is so pervasive, investment professionals are hardly aware how it affects virtually every investment decision we make. It has been institutionalized through regulation, platforms, gatekeepers, advisors, analysts, consultants, and even modern portfolio theory (MPT), the underlying paradigm of the investment industry.

Two Choices: Cater to or Mitigate Emotions

Investors experience powerful emotions as portfolios decline in value and then reverse course and head back up. Drawdowns are especially gut-wrenching, as hard-earned money disappears before a client's eyes.

Investors are prone to a host of cognitive errors when in thrall to these emotions. The two most prominent are myopic loss aversion and social validation. Myopic loss aversion research demonstrates that people experience the negative feelings associated with losses almost twice as acutely as the pleasure of gains. Social validation, on the other hand, is our innate desire to follow and be a part of the herd.

As investment professionals, we can do little to turn off these emotions. But we can decide how we respond to our clients when they experience them in the growth portion of their portfolios.

There are two choices: We either cater to clients' emotions, or we strive to mitigate the damage inflicted by investment decisions made based on those emotions. Investors left to their own devices will let their feelings drive their investment choices. And that will end up costing them hundreds of thousands - if not millions - of dollars in long-term wealth. By helping to short-circuit these cognitive errors, advisors and analysts can add value for their clients.

To be clear, investors are fearful and their fears need to be addressed by their investment advisors. And the truth is some investors can't be talked out of their fears. But we need to do all we can to help clients avoid these expensive mistakes.

Catering to Emotions

Sadly, the industry encourages us to cater to - to humor - rather than mitigate client emotions. For example, current practice is to diversify across multiple asset classes regardless of the expected return. The result is a trade-off between short-term emotional comfort and long-horizon wealth. The Cult of Emotion sanctions this practice, so we tend not to recognize the damage it inflicts on client growth portfolios.

A considerable swath of the industry is influenced by the suitability standard. Clients are required to complete a "risk assessment" and are then categorized as conservative, moderate, or aggressive. The growth portion of a portfolio is then constructed to fit this classification.

But suitability is an emotional assessment of clients - and a poor one, at that - not a risk assessment of their portfolios. This is an absolutely critical distinction. Suitability legitimizes the construction of low-return portfolios for temporary peace of mind and consequently denies clients substantial long-horizon wealth.

The Cult views tracking error as risk. It's not. It is an emotional trigger for investors. Because of myopic loss aversion, short-term underperformance serves as a signal to sell a fund and invest in another with better recent performance. So the industry requires low tracking error. But truly active funds can't be successful without tracking error. Accommodating the feelings evoked by tracking error costs investors dearly.

Parenthetically, this discussion brings up another problem with tracking error that is covered in "Alpha Wounds: Bad Adjunct Methodologies." It is an active investment manager's job to outperform the benchmark and by a wide margin. Tracking error presupposes a successful asset allocation strategy put into place by an independent third party, for which there is actually very little evidence of success.

Cult Enforcers

Cult Enforcers dominate the investment industry. But just who are they? Advisors who construct the entire client portfolio based on the suitability standard, rather than specific needs. Analyst gatekeepers who use annual volatility, Sharpe ratio, tracking error, and the like to determine long-horizon investments.

There are three forces that shape the Enforcer's mentality:

  1. The widespread use of MPT tools - volatility as risk and efficient frontiers - strongly encourages a trade-off between temporary emotional comfort and long-term wealth.
  2. The business risk funds face when investors make emotional investing decisions based on short-term performance encourages internal sales and marketing to work hand in hand with the external gatekeepers to enforce the Cult's dogma.
  3. The many regulations imposed on the industry to reduce emotional triggers limit the investment choices available to investors. And, of course, the trial lawyers are not far behind, enforcing the prudent man rule and other regulations, thus stirring up concern if not outright fear among industry professionals.

Leaving the Cult

To pave the way for the active equity renaissance, the Cult of Emotion must be left behind. The Cult is ubiquitous, so this won't be an easy task. But it is essential. The Cult makes successful active management nearly impossible.

Each of us can begin this transition on our own. The hope is that the industry eventually sheds the Cult and returns its focus to delivering client value.