The Emotional Economic Man
Investment decisions may look rational, but often they’re emotional responses to a job that demands the impossible.
Taffler, Spence, and Eshraghi (2017) shed light on the anxiety fund managers feel due to the inevitable uncertainty and the overwhelming evidence of the extreme difficulty—or impossibility—of ‘beating the market’ in investment decision-making.
Through 51 in-depth interviews with fund managers across prominent financial centers worldwide and using a psychoanalytic lens (you know, the theory that explores the unconscious mind founded by Sigmund Freud), the authors identify tools and mental defenses fund managers use to cope with anxiety, which directly influences their investment decision-making process. For instance, they argue that the faith and trust fund managers place in face-to-face meetings with the management teams of companies under consideration for investment can be seen as a mechanism for managing anxiety rather than serving a directly economic or rational purpose.
This aligns with an earlier Deeponomics post (The Qualitative Art of Valuation), which discussed the study by Barker et al. (2012) and their findings that company management meetings are considered the most valuable source of information by fund managers, even though no price-sensitive information is shared in these meetings. Once again, these meetings emerge as the most important means of alleviating anxiety. I don’t think this contradicts the earlier findings—I believe these meetings can serve both purposes: they can be valuable while not necessarily providing price-sensitive information, and they can instill enough comfort to help fund managers cope with uncertainty and the social pressure-induced anxiety they experience.
Setting the Scene
Let’s step back and provide some background from the introduction section of this paper to properly frame the authors’ reasoning and findings.
There is extensive research showing that it is nearly impossible for individual fund managers to outperform their peers or their benchmarks on a consistent basis after fees. Even so, the entire asset management industry is built around the ‘belief,’ if you will, that it is possible to ‘beat the market’ and ‘generate alpha.’ And even if a fund manager manages to outperform, distinguishing between skill and luck remains incredibly difficult.
This means that fund managers carry significant responsibility and are held accountable for their performance in an environment where they have little control. In essence, they sell the idea that they can do what, in reality, is not possible. Because we know that the uncertainty of the future cannot be controlled or managed. However, as the authors show, there are at least tools to manage or alleviate the anxiety stemming from that uncertainty—and perhaps from the knowledge of their inability to ‘beat the market.’
I like attention-grabbing quotes, and the following one neatly captures the fund manager’s dilemma:
“We argue that fund managers ‘know’ but ‘not know’ and ‘do’ but ‘not do.’ In other words, they know on one level that they cannot beat the market, but on another level have to deny or repress this to allow them to continue to do their job.” (Taffler et al., 2017, p. 54)
“Turning a blind eye to such uncomfortable facts” (Steiner, 1985, cited in Taffler et al., 2017, p.170).
Tools and Mental Defenses
The researchers identify several key tools and mental defenses used by fund managers:
1. Calculative techniques that are often bypassed or disregarded
For example, one fund manager who relies on a quant model for stock picking admitted:
“ … If the valuation metric really wasn’t reflecting reality … we just modify the ranking …” (Taffler et al., 2017, p. 59)
Hence, they trust but also do not trust the model. In the end, they rely on subjective, intuitive revisions of the model’s output (or structured process).
2. Blurring the distinction between risk and uncertainty
Fund managers construct psychological defenses against the reality that future returns are fundamentally unpredictable. Uncertainty, which cannot be quantified, is transformed into risk, making it appear measurable, thereby creating the illusion that the unknown has been circumvented. Through calculation, fund managers foster a sense of control over an inherently unpredictable future.
However, as Knight (1921) highlights, while risk can be mitigated through calculative routines, the broader and more unsettling concept of uncertainty remains beyond such reduction.
3. Establishing direct trust-based relationships with company management
Fund managers turn to the executives of the companies they invest in—or are considering investing in—to ease their concerns about future stock returns. By placing trust in management, they effectively delegate the responsibility of generating returns, allowing the executives to take the lead.
To build this trust, fund managers assess CEOs and CFOs based on qualities such as honesty, integrity, and competence. They believe they can evaluate these traits by observing executives closely—“looking into the whites of their eyes” and analyzing their body language.
The Emotional Side of Investing
The study’s interview material illustrates just how far fund managers move beyond the ostensibly rational domain of financial models and calculations in their efforts to manage uncertainty.
Interpreting the body language of company executives becomes a crucial mechanism for fostering trust, which, in turn, creates the conviction necessary to make investment decisions.
Fund managers do this to shift the responsibility for their investment performance, allowing them to relieve their anxiety and gain a sense of reassurance.
Therefore, despite the asset management industry’s claim that it operates on a rational basis, the authors argue that both conscious and unconscious emotions play a significant role in shaping investment behavior.
There’s always more to say, but I’ll wrap up with a quote from the paper that I think sums it up well:
“Fund managers perpetuate the myth of economic rationality in order to defend themselves against the uncomfortable reality that the future is ultimately unpredictable and unknowable.” (Taffler et al., 2017, p. 66)
References
Taffler, R.J., Spence, C. & Eshraghi, A., 2017. Emotional economic man: Calculation and anxiety in fund management. Accounting, Organizations and Society, 61, pp.53-67.
Knight, F. H. (1921). Risk, uncertainty and profit (Vol. 31). Houghton Mifflin.