Childhood trauma and the active fund manager
If you are in the market for an active fund manager, you might want to skip the usual questions about Sharpe ratios, investment philosophy and past track record.
Instead, consider asking about their childhood experiences, especially those that inflicted emotional stress or trauma. Did your parents divorce when you were young? Were there any premature deaths in the immediate family? How did you feel when Rover, after biting the mail carrier, was sent to that “farm” in the country?
At least, that is what some of the latest academic research suggests: experiences of loss or severe disruption during one's formative years tends to reduce a money manager's appetite for risk. But systematic research on the effect of personal experiences on decision-making and risk-taking in one's adult years has been limited, according to the paper, entitled Till Death (or Divorce) Do us Part: Early-Life Family Disruption and Fund Manager Behavior, at least until now. Psychologists have long known that stressful early life family disruption has long-lasting effects on an individual's personality. What is less well known is the impact those traumas have on risk-based decision-making later in life. Other research suggests collective economic trauma caused by recessions, market crashes and natural disasters can have a lasting impact on society. For example, students graduating during a recession tend to earn less during their careers than those who graduate into robust economies (although that unfortunate timing may have other positive effects).
A substantial share of America's adults have some kind of unsettling event in their background. About 40 per cent of all children in the US have experienced a parental divorce; 5 per cent of children 15 or younger have suffered the loss of a parent. Professionals working in the financial community and managing money are included in this demographic cohort.
Against that backdrop, the researchers looked at more than 500 mutual fund managers, all of whom were running active US equity funds. The study spanned the period from 1980 to 2017 — in other words, long enough to take in several normal market cycles, plus the dot-com crash and the financial crisis. US Census data and obituaries were included in the analysis. If childhood trauma played a role in how the study participants approached fund management, we should expect that to show up in the results.
The study's conclusion: fund managers with childhood trauma were more averse to risk. According to the study, they “invested in fewer ‘lottery' stocks, exhibited less tracking error, and had lower fund turnover.” The only surprising finding was that their risk-adjusted returns were “roughly equivalent to those of fund managers who took on more total fund risk.”
That is why this research matters to investors: we are often unaware of what drives our decision-making. Being born with a cognitive framework is a reality every investor must acknowledge. Learning about the inherent biases and predilections of our cognitive operating system is useful for investors. At the very least, it gives you an opportunity to avoid some of the more obvious errors. It gets much trickier when any investor might need to take into account personal childhood traumas and other subjective events.
Who knew the nature-versus-nurture debate was part of the pursuit of alpha (ie, above-market returns)?
Some of this makes intuitive sense. Academic research has found that when people come through life-threatening events with no ill effects, they are more likely to take on more risk in their careers. Perhaps this reflects a recalibration of their assessment of risk, finding that certain behaviours or activities are actually less risky than many people believe. This probably is understandable for people with a data set of one and a positive outcome from a high-risk event — never mind that the same favourable result might not come to pass if the experiment is repeated a number of times.
And maybe a lot of us know this, at least intuitively. With that in mind, perhaps it's no wonder that there has been a huge shift in assets from active to passive indexing. And with an index fund, at least you don't need to worry whether your fund manager bears the emotional scars of childhood trauma.
• Ritholtz is a Bloomberg Opinion columnist. He founded Ritholtz Wealth Management and was chief executive and director of equity research at FusionIQ, a quantitative research firm. He is the author of Bailout Nation