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Luck vs. Skill: State Street’s Center for Applied Research Finds Investors’ Devotion to Alpha is Hindering Investment Success

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Investment professionals are failing to deliver alpha and investors are failing to achieve their long-term goals, according to new research published today by the Center for Applied Research, the independent think-tank of State Street (NYSE:STT) . The research, titled “The Folklore of Finance: How Beliefs and Behaviors Sabotage Success in the Investment Management Industry” explores the concept of investment success and the impact of common beliefs and biases within the investment management industry.

While more than 60 percent of the industry’s capital is spent on the pursuit of alpha, a growing skepticism has emerged. Only 53 percent of individual investors and 42 percent of investment professionals believe that alpha production is primarily driven by skill. In addition, when questioned about whether they were prepared to meet their investment goals, only 12 percent of individual investors could say with confidence that they were.

“The models for success in the investment management industry are broken,” said Kelly McKenna, global head of the Center for Applied Research, State Street. “Investment professionals pay significantly more attention to activities that they believe will contribute value to alpha. While some of these are helpful, many are of limited value. True success includes not only achieving alpha, it also requires helping investors achieve their long-term goals, sustainably, over time.”

Influencing this are the shared beliefs, rooted in human bias, that govern both investment professionals’ and investors’ behaviors. The report investigates those beliefs, which can be broken down into three major categories, two of which can be described as conscious and one that is unconscious and hidden.

The Conscious “Folklore of Time and False Comfort”:

Individual investors and investment professionals are overly reliant on past performance when making investment decisions despite the fact that past performance is not an indication of future results. They also consistently fail to focus on long-term goals when evaluating short-term performance.

  • Nearly 60% of investment professionals use a timeframe of just one to three years to assess performance. In addition, more than 60% of individual investors say they would consider moving to a more conservative investment strategy if their portfolio declined by 20% in a year, of those 90% would make the change in less than three months.
  • Only 22% of institutional investors define success based on achieving long-term investment goals and instead, the vast majority (63%) measure success against benchmarks.
  • Additionally, less than 30% of individual investors define success as achieving their long- term goals and instead cite implausible or irrelevant success metrics like making gains and having no losses, outperforming the market and achieving short-term investment goals.

The Unconscious “Folklore of Knowledge”:

The majority of portfolio managers surveyed exhibit an unconscious ‘self-attribution’ bias. Without realizing it, they credit themselves for their success, but blame external factors for their failures. Similarly, individual investors demonstrate significant overconfidence in their own abilities.

  • Seventy-seven percent of asset managers and 47% of intermediaries cited “experience and analytical process” as the top reason they outperform, but when asked to explain underperformance, were more likely to blame market conditions, clients’ expectations or the senior management of companies they invested in.
  • Nearly two-thirds of individual investors believe their current level of financial sophistication is advanced; however, when asked to complete a financial literacy test, the global financial literacy average score was just 61%.
  • Despite this, 93% of individual investors believe they should make investment decisions themselves and two-thirds think their best investment was entirely their own decision.

“While conscious and unconscious biases are one of the primary reasons investment professionals and individual investors are failing to achieve true success, an awareness of those biases is part of the solution,” said Suzanne Duncan, global head of research, Center for Applied Research, State Street. “It’s time to rewrite the story. By reconditioning the industry’s behavior, there’s an opportunity to reinforce the values necessary to achieve true success.”

The Center for Applied Research obtained input for this study through surveys of 3,744 investors, investment providers, government officials and regulators across 19 countries. The research was completed over a period of 18 months.

To view the report click here.

About State Street Corporation

State Street Corporation (NYSE:STT) is one of the world’s leading providers of financial services to institutional investors including investment servicing, investment management and investment research and trading. With $28.47 trillion in assets under custody and administration and $2.42 trillion* in assets under management as of September 30, 2014, State Street operates in more than 100 geographic markets worldwide, including the US, Canada, Europe, the Middle East and Asia. For more information, visit State Street’s web site at www.statestreet.com.

* Assets under management include the assets of the SPDR(R) Gold ETF (approximately $30 billion as of September 30, 2014), for which State Street Global Markets, LLC, an affiliate of SSgA, serves as the distribution agent.

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