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The Folklore of Finance, or Why Most Investors Fail

A new study by State Street’s Center for Applied Research coins a new term, the “Folklore of Finance,” which tries to explain why most investors don’t achieve their long-term financial goals. 

The New York Times wrote about the study and the folklore angle here. In short, investors tend to be overconfident, are constantly distracted by short-term events and so lack the ability to focus on long-term goals, and do not trust their advisors — eventually losing interested in getting help.

One of the fundamental questions State Street asked investors and industry professionals is whether they thought true alpha achieved by skill actually exists today. A University of Maryland study showed that while 14% of domestic equity mutual funds achieved true alpha in 1990, that percentage dropped below 1% in 2006. Today, the Times article notes, only 53% of investors and 42% of professionals believe that alpha is achievable by skill. 

With more skilled investors and access to more information, the results are paradoxical — as are actions by investors who paid active managers $600 billion, equivalent to the GDP of Switzerland, to managers to achieve alpha. Can you blame the 93% of investors who think they are better off on their own?

Part of the problem is that the industry tells people to think long-term but measures investments on one, three- and five-year returns, touting high Morningstar ratings that only look at past performance. 

The prescription? State Street recommends regular check-ins by advisors and teaching investors about four things:

  • effective decision making;
  • realistic self-assessments;
  • tolerance for pain; and
  • goal ranking.