In the recent Research Foundation of CFA Institute publication, Fund Management: An Emotional Finance Perspective, coauthors David Tuckett and Richard J. Taffler tell a compelling story about the myriad emotional stresses confronted by both analysts and portfolio managers. What they find stands in stark contrast to the world of perfectly rational decision making assumed by the efficient market hypothesis (EMH) and modern portfolio theory (MPT). Furthermore, the authors’ emotional finance perspective reveals that unless the fund management industry begins to accommodate the emotional stresses of the job, underperformance will continue.

One stress revealed, and one that will come as no surprise to a practicing money manager, is the unrelenting pressure to perform. Money managers feel the pressure to perform coming from all corners, including clients, employers, peers, and even from themselves. Even though many investors and investment firms purport to take a long-term view of investing, most managers readily admit that they feel an implicit pressure to outperform on an almost daily basis. These feelings exist even though multiple researchers have found that the most successful money managers usually experience lengthy periods of underperformance.

Indicative of the stresses resulting from the collision of long-term performance strategies with short-term performance demands is that most money managers look at computer screens daily, if not more frequently. In fact, two-thirds of managers report monitoring their fund’s performance at least once daily, with 11% monitoring performance every several hours. Investors confessed that screen-watching is addictive and that it is “an emotional roller coaster” that stimulates a feeling of jittery anxiety when they are down, but a high when they are up, relatively speaking.

These intense pressures to perform lead to dysfunctional coping behaviors that seem only to increase anxiety and stress. In fact, Tuckett and Taffler describe a money manager attitude they characterize as “pervasive distrustful pragmatism” that leads to feelings of resentment and loneliness as they battle against seemingly impossible demands. These feelings suffuse manager lives even when they are outperforming, as anxiousness about underperformance and the loss of one’s livelihood are never very far away.

Another source of stress for fund managers is that, on average, half of pay comes in the form of a subjective, or discretionary, bonus. For most of the managers interviewed for the monograph, compensation was based on:

1. the overall success of the fund management firm;
2. the manager’s current investment performance;
3. the amount of new business generated.

That the success of these compensation criteria are often outside of the control of fund managers leads Tuckett and Taffler to suggest that bonus regimes likely lead to additional anxieties and a tendency to “game” the system.

Investment managers are acutely aware that fund sponsors chase returns, even though it is well known that doing so does not deliver alpha. Ajay Khorana, of the Georgia Institute of Technology, found in 1996 that the probability of a manager being fired is mostly a function of recent short-term underperformance; in particular, managers in the lowest performing decile were four times more likely to be replaced than managers in the highest-performing decile.

Tuckett and Taffler report that to deal with these severe emotional stresses analysts and portfolio managers frequently use one or more of the following coping strategies:

1. Rationalizing performance by selectively interpreting it.
2. Taking protective measures that smooth performance.
3. Reinventing what they do to maintain confidence in tough times so that they may believe in a better future.

Selective Interpretation

One way of dealing with contradictory demands that can lead to conflicting emotional states is to not really “know” one has them. Here money managers emotionally invest in a small part of a story that otherwise would cause a conflicting experience.

One example of selective interpretation cited in Fund Management: An Emotional Finance Perspective comes from a manager who oversees slightly under $1 billion of equities: “[We] try to encourage people to benchmark our performance over a three-year period because anything shorter than that is at the whim of the market.” Here the story is that any short-term volatility is outside the control of the manager. Left out of the discussion is what would constitute a better benchmark. Understandably the manager is trying to cope with clients’ likely nervousness over short-term performance volatility, as well as his own emotions around the same events.

Investment pros diversify their emotional portfolios by avoiding putting all of their emotional eggs in one basket. Instead they do things like frame investment performance over multiple funds, or say things like, “A benchmark is only a reference point,” which leaves open the option of underperformance.

Another form of stress relief through selective interpretation is leaving the asset allocation decision up to clients. Here the manager says things like, “My job is to manage small-cap value; it’s up to the client to build a diversified portfolio.”

Unfortunately, selective interpretation leaves money managers out of accord with reality. In turn, this distorted view of reality may lead to faulty perception, and hence, bad decisions. Further, selective interpretation has an asymmetrical emotional effect, because feelings around underperformance are avoided by making them impersonal (“at the whim of the market”), whereas money managers frequently take credit for exceptional performance.

Taking Protective Measures

By definition, as an investment manager, if you do what everybody else is doing then there is no opportunity for outperformance. Yet this realization comes with its own stresses. If managers are not in alignment with consensus then they are nervous that their choices will result in underperformance. But conversely, when they are in line with consensus, they are also nervous. Why? Because they know that it is impossible to outperform.

One form of the “taking protective measures” is locking in your gains. That is, if managers are having a good year through the third quarter they may shift their portfolio so that it more closely tracks the index for the remainder of the year. There is also a “playing with house money” effect in which portfolio managers who have generated alpha will frequently make bigger, or riskier, bets, feeling that they have some built in alpha tolerance for failed investments. Obviously both of these coping mechanisms can have a detrimental effect on performance and have more to do with emotional management than portfolio management.

Reinventing the Investment Narrative

When a portfolio underperforms investment pros have a difficult time accepting that their investment philosophy is not working. Instead they reassure themselves and others that they are staying true to their investment philosophy. An example of such a narrative is, “Our investment style has been out of favor for four of the last five years, but so far this year things look pretty good.” Another story of this ilk is, “My stocks had two years worth of performance in just one, and now they are taking a break.”

In conclusion, portfolio management is stressful and can result in many painful emotions that lead to coping mechanisms. Unfortunately, the fund management industry scarcely acknowledges these difficulties. Yet addressing these very human issues just might lead to not only greater money manager satisfaction, but also greater alpha, too.

Originally published on CFA Institute’s  Enterprising Investor.