investment portfolios is straightforward but emotionally difficult. Making decisions based on price distortions created by the Emotional Crowd and ignoring short-term volatility when building long-horizon portfolios presents significant challenges for investment professionals. This is because such a strategy is frequently going against the Crowd, thus depriving the client of social validation, and in turn asking them to set aside the strong emotions associated with volatile prices.
Consequently, it is necessary to mitigate the impact of client emotions. Emotion mitigation is a fact of life in the investment industry and both advisors and investment managers should develop such skills. The goal is to be sensitive to the emotional reactions of clients while minimizing the damage to their portfolios. Developing an approach that keeps clients in their seats while building superior portfolios is important for clients, advisors and investment managers alike.
Endnotes
1 Daniel Kahneman, Thinking, Fast and Slow (Farrar, Straus and Giroux, 2012). [return to text]
2 Shefrin (2008) introduces the concept of “knife edge” market efficiency which exists only with the occurrence of a rare combination of wealth and investor emotions. Thus he argues stock prices rarely reflect underlying fundamentals. [return to text]
3 Robert Shiller, ‘From Efficient Market Theory to Behavioral Finance’, Journal of Economic Perspectives 17 (2003), pp. 83-104. [return to text]
4 R. Mehra and E. Prescott, ‘The equity premium: A puzzle’, Journal of Monetary Economics 15 (1985), pp. 145–161and R. Mehra and E. Prescott, ‘The Equity Premium in Retrospect’, NBER Working Paper No. 952 (February 2003). [return to text]
5 S. Benartzi and R. Thaler, ‘Myopic Loss Aversion and the Equity Premium Puzzle’, Quarterly Journal of Economics 110:1 (1995), pp. 73-92. [return to text]
6 Hersh Shefrin, Behavioralizing Finance (Now Publishers Inc., 2010). [return to text]
7 See the behavioral finance summaries in Shefrin (2010), Hirshleifer (2008), Barberis and Thaler (2003), Baker et al. (2007), and Subrahmanyam (2007). [return to text]
8 See articles by Alexander, Cici, and Gibson (2007); Baker, Litov, Wachter and Wurgler (2004); Chen, Hong, Jegadeesh, and Wermers (2000); Cohen, Polk and Silli (2010); Collins and Fabozzi (2000); Frey and Herbst (2010); Kacperczyk and Seru (2007); Keswani and Stolin (2008); Kosowski, Timermann, Wermers, and White (2006); Pomorski (2009); Shumway, Szeter, and Yuan (2009); and Wermers (2000). [return to text]
9 There is another research stream that shows truly active managers are able to earn superior returns. See Amihud and Goyenko (2013); Brands, Brown, and Gallagher (2006); Cremers and Petajisto (2009); Kacperczyk, Sialm, and Zheng (2005); and Wermers (2010). [return to text]
10 It is an open research question to determine the source of these excess returns, that is, what portion is due to harnessing behavioral factors and what portion is due to generating a superior information mosaic. It is difficult to untangle these two return drivers, so for now we are left with the plausible supposition that emotionally-driven prices are the most important source of excess returns for fund managers. [return to text]
11 See Bollen and Busse (2004); Brown and Goetzmann (1995); Carhart (1997); Elton, Gruber and Blake (1996); Hendricks, Patel, and Zeckhauser (1991); Jensen (1968); and Fama and French (2010). [return to text]
12 Other possible reasons why a fund might purchase other than best idea stocks, as the fund grows in size, is mimicking the index to lock in a past alpha and becoming a closet indexer to avoid style drift and tracking error. [return to text]
13 J. B. Berk and R. C. Green, ‘Mutual Fund Flows and Performance in Rational Markets’, Journal of Political Economy 112:6 (2004), pp. 1269-1295. [return to text]
14 See Chen, Hong, Huang, and Kubik (2004); Han, Noe, and Rebello (2008); and Pollet and Wilson (2006). [return to text]
15 H. Markowitz, ‘Portfolio Selection’, The Journal of Finance 7:1 (March 1952), pp. 77-91. [return to text]
16 Higher return variance lowers an investment’s long-term compound return, but this impact is small compared to the impact of investing in lower expected return markets. [return to text]
17 See French, Schwert and Stambaugh (1987). [return to text]
18 Several studies confirm that the typical equity mutual fund investor earns a return substantially less than the fund return because of poorly timed movements in and out of the fund. [return to text]
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