Overly-confident investors, misplaced trust in past performance and an excess use of benchmarks, consultants and regulatory disclosures are all symptoms of a “folklore of finance”, a study says.

Overly-confident investors, misplaced trust in previous performance and an over-reliance on artefacts such as benchmarks and consultants are all symptoms of a “folklore of finance”, according to the Centre of Applied Research.

This leads to a misguided focus on chasing alpha as well as investors falling short of their long-term goals, the study from State Street’s independent think-tank claimed.

Titled The Folklore of Finance: How Beliefs and Behaviours Sabotage Success in the Investment Management Industry, the study questioned the achievement of alpha as a measure of success at a time where the skill required to generate this is no longer as much of a differentiator among financial professionals as it once was. Instead, success should not be seen as a blanket measure but instead personalised to each client and their goals, the research argued.

The study was conducted on 3,744 investment providers, government officials and regulators across 19 countries.

As technology has permeated the financial industry, so too has investment managers' access to information to give professionals an “intellectual edge” over their peers. While there has been a rise in “absolute skill” amongst professionals, “relative skill” has declined, the report states, instead meaning that generating alpha is in more instances down to luck than professional knack. Accordingly, only 53 percent of individual investors and 42 percent of investment professionals believe that alpha production is primarily driven by skill.

The report suggested that investment professionals should adapt their approach to success - instead taking more of a long-term and personalised goals-based investment outlook for their clients. The goals-based investing approach, with greater prevalence among wealth management firms in the US, seeks to fulfil certain purposes rather than beating the market, including income, retirement, education, impact investing and philanthropy. At present, only 22 per cent of institutional investors define success based on achieving long-term investment goals and instead, the vast majority (63 per cent) measure success against benchmarks.

Discussing why investment wisdom is still perceived the way it is, the study found that the industry is victim to a several “folklore” traditions.

The first of these ingrained beliefs used to guide decision-making is “the folklore of time”. Here, short-term results often take prevalence in decision-making over chasing long-term goals. Almost 60 per cent of respondents said they would consider moving to a more conservative investment strategy if their portfolio declined by 20 per cent in a year.

Secondly, there is the “folklore of false comfort”, where the industry relies on “innumerable, yet crucially tangible, ways to classify, measure and document investment choices”, as well as “overuse [of] consultants in the investment process”. Combined with pursuing short-term goals, there is a lack of connection between clients’ reasons for investing and definition of success.

“Investors take false comfort in these short-term benchmarks of success because they are easier to measure than progress towards than a long-term goal,” the report said.

The final is the “folklore of knowledge”, where investment professional display a self-attribution bias and investors are overconfident in their own financial skills.

The research found that over three-quarters of asset managers cited “experience and analytical process” as their reason for outperformance. However, when they underperformed, this was often blamed on market condition, clients’ expectations or the senior management of the companies they invested in.

According to the study it is not only professionals that have the ability to rate their own skill too highly. 93 per cent of investors asked claimed that they should make investment decisions themselves, and almost two-thirds believed their current level of financial sophistication is advanced. The Centre of Applied Research asked its participants to take a financial literacy test, where a pass was 60 per cent. The average score of respondents was only 61 per cent.

“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, Centre for Applied Research, State Street. “It’s time to rewrite the story.  By reconditioning the industry’s behaviour, there’s an opportunity to reinforce the values necessary to achieve true success.”