Investment

Divorce, passive management, and family offices

It isn’t just a divorce settlement that damages your wealth. Research has proved that the fierce emotions generated by marital separation can hurt your investment performance, as well. 

The research also illustrates the role played by emotions in damaging the performance of active managers. Family offices would be forgiven for continuing to invest money in passive management, which avoids the problem. 

The divorce research, updated in December, was carried out by academics including a team from the University of Sydney. They used unique data available from Finland to show that top traders added 3.1% a year to portfolios when happily married but suffered losses of -2.0% in the years ahead of a divorce, equivalent to a negative swing of 5.1%.

Separate research from Singapore Management University says hedge fund investors suffered a 4% performance drain for six months either side of a divorce. Poor performance continued, at half the magnitude, over the next two years. 

The research also illustrates the role played by emotions in damaging the performance of active managers. Family offices would be forgiven for continuing to invest money in passive management, which avoids the problem

Yet more research, cited by Sydney University, has suggested that mutual fund managers are less willing to take risks in the wake of the death of a parent, potentially restricting their gains.

Some years back, Alan Miller quit as New Star Asset Management investment chief when his divorce coincided with a decline in his stellar performance. Later, he rose again and succeeded at his new firm, SCM Private, which he runs with his wife Gina. Soon after setting up SCM, he reflected that success by New Star’s marketing team had saddled him with too much money to manage. This burden can load stress on managers trying to invest the money sensibly, and many firms are now close to new business at a certain point. 

The impact of emotions on performance is enormous. According to Harvard professor Gerald Zaltman, 95% of cognition happens in the unconscious mind, guided by emotions that drive survival and wellbeing. 

If our emotions suggest an idea is beneficial, it may make its way to our logic centre for further processing.

When we work out a decent response to the idea we are happy and keen for more input. But if we are distracted by divorce or the receipt of too much business, we may not be in the mood to respond, or process, to any ideas. 

Consultant Willis Towers Watson has consistently pointed to emotional factors as a potential impediment to manager performance. Behaviour guru Daniel Kahneman warns that investors have as much faith in decisions driven by emotions, as those reached by logic. 

Investors are particularly averse to crystallising a loss and end up holding on to troubled stocks for too long, in the hope of recovery.  They often decide to sell in a hurry, in a panic, rather than using the detailed analysis which often backs up a purchase.

Overconfidence can results from strong performance in periods when managers are buoyed by client wins. When market styles shift, performance craters and optimism crumbles.

Growth managers have experienced this problem, of late, as a result of the prospect of higher interest rates and war in Ukraine. Cathie Wood’s renowned Ark Invest has seen a 50% fall in the value of its flagship. 

Resistance to changing tack impedes performance, as investors keep returning to their old way of picking stocks, rather than researching new ideas to deal with a changing market mood. Even when markets are gripped by crisis and the future is cloudy, managers will pay fees to shuffle their stocks around, because they feel they ought. 

In good times investors fall prey to FOMO – fear of missing out. In last year’s growth market, clients of the commission-free Robinhood trading system piled into meme stocks, whose giddy rise persuaded others to jump on board.  

That trade is now over. At $14.65, Robinhood’s stock has lost 60% of its IPO value after massive trading losses.  A growing lack of confidence is likely to reinforce risk-averse behaviour in months to come making investors concerned about FOLL – fear of losing lots – as they struggle with increasingly depressing conditions. 

Indexed managers can outperform because they track indices, mechanically, without being held back by emotion. This is because index valuations are struck on the stock prices which result from purchases and sales. This process nets off the emotions of buyers and sellers allowing the wisdom of crowds to prevail. 

After he freed himself from responsibilities towards a family wine business, Louis Bachelier was first to spell out this benefit in his thesis The Theory of Speculation, published in 1900: “It seems that the market, that is to say, the totality of speculators, must believe at a given instant neither in a price rise nor in a price fall since, for each quoted price, there are as many buyers as sellers.” 

Clients have developed faith in the process because it is a mechanical process, free of emotions. Occasionally, in a panic, you can see the folly of crowds. But passive investors tend to be more willing to remain invested, ending up with enough money invested in the market to take advantage of an upswing. The liquidity of ETFs in niche sectors like high-yield bonds tends to be rather higher than their underlying stocks.

It must be said that passive managers need an efficient index for the wisdom of crowds to deliver. In micro-cap, for example, there are often too few active managers to price the index effectively and active managers get their chance to outperform.

Consultants also like to point out that many active managers can come to terms with their emotions in a nurturing environment, where marketers, clients and the media 

help managers to leave their emotions at home. Mercer Australia published research in 2021 which showed top quartile institutional managers in their universe beat the index by 1.3 percentage points over five years. 

However, Mercer’s median manager struggled to beat the index, particularly after fees. Those outside its universe probably fared even worse.

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