Practical analysis for investment professionals
22 March 2017

The Active Equity Renaissance: Understanding the Cult of Emotion

“I know you are afraid and you should be afraid. I will invest you in products that will not stir up your fears.”

This sentiment is applied over and over again in the investment industry in one form or another.

It is the mantra of what my co-author Jason Voss, CFA, and I call the “Cult of Emotion.” The Cult is so pervasive, investment professionals are hardly aware how it affects virtually every investment decision we make. It has been institutionalized through regulation, platforms, gatekeepers, advisers, analysts, consultants, and even modern portfolio theory (MPT), the underlying paradigm of the investment industry.

Two Choices: Cater to or Mitigate Emotions

Investors experience powerful emotions as portfolios decline in value and then reverse course and head back up. Drawdowns are especially gut-wrenching, as hard-earned money disappears before a client’s eyes.

Investors are prone to a host of cognitive errors when in thrall to these emotions. The two most prominent are myopic loss aversion and social validation. Myopic loss aversion research demonstrates that people experience the negative feelings associated with losses almost twice as acutely as the pleasure of gains. Social validation, on the other hand, is our innate desire to follow and be a part of the herd.

As investment professionals, we can do little to turn off these emotions. But we can decide how we respond to our clients when they experience them in the growth portion of their portfolios.

There are two choices: We either cater to clients’ emotions, or we strive to mitigate the damage inflicted by investment decisions made based on those emotions. Investors left to their own devices will let their feelings drive their investment choices. And that will end up costing them hundreds of thousands — if not millions — of dollars in long-term wealth. By helping to short-circuit these cognitive errors, advisers and analysts can add value for their clients.

To be clear, investors are fearful and their fears need to be addressed by their investment advisers. And the truth is some investors can’t be talked out of their fears. But we need to do all we can to help clients avoid these expensive mistakes.

Catering to Emotions

Sadly, the industry encourages us to cater to — to humor — rather than mitigate client emotions. For example, current practice is to diversify across multiple asset classes regardless of the expected return. The result is a trade-off between short-term emotional comfort and long-horizon wealth. The Cult of Emotion sanctions this practice, so we tend not to recognize the damage it inflicts on client growth portfolios.

A considerable swath of the industry is influenced by the suitability standard. Clients are required to complete a “risk assessment” and are then categorized as conservative, moderate, or aggressive. The growth portion of a portfolio is then constructed to fit this classification.

But suitability is an emotional assessment of clients — and a poor one, at that — not a risk assessment of their portfolios. This is an absolutely critical distinction. Suitability legitimizes the construction of low-return portfolios for temporary peace of mind and consequently denies clients substantial long-horizon wealth.

The Cult views tracking error as risk. It’s not. It is an emotional trigger for investors. Because of myopic loss aversion, short-term underperformance serves as a signal to sell a fund and invest in another with better recent performance. So the industry requires low tracking error. But truly active funds can’t be successful without tracking error. Accommodating the feelings evoked by tracking error costs investors dearly.

Parenthetically, this discussion brings up another problem with tracking error that is covered in “Alpha Wounds: Bad Adjunct Methodologies.” It is an active investment manager’s job to outperform the benchmark and by a wide margin. Tracking error presupposes a successful asset allocation strategy put into place by an independent third party, for which there is actually very little evidence of success.

Cult Enforcers

Cult Enforcers dominate the investment industry. But just who are they? Advisers who construct the entire client portfolio based on the suitability standard, rather than specific needs. Analyst gatekeepers who use annual volatility, Sharpe ratio, tracking error, and the like to determine long-horizon investments.

There are three forces that shape the Enforcer’s mentality:

  1. The widespread use of MPT tools — volatility as risk and efficient frontiers — strongly encourages a trade-off between temporary emotional comfort and long-term wealth.
  2. The business risk funds face when investors make emotional investing decisions based on short-term performance encourages internal sales and marketing to work hand in hand with the external gatekeepers to enforce the Cult’s dogma.
  3. The many regulations imposed on the industry to reduce emotional triggers limit the investment choices available to investors. And, of course, the trial lawyers are not far behind, enforcing the prudent man rule and other regulations, thus stirring up concern if not outright fear among industry professionals.

Leaving the Cult

To pave the way for the active equity renaissance, the Cult of Emotion must be left behind. The Cult is ubiquitous, so this won’t be an easy task. But it is essential. The Cult makes successful active management nearly impossible.

Each of us can begin this transition on our own. The hope is that the industry eventually sheds the Cult and returns its focus to delivering client value.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images/Jim Zuckerman

About the Author(s)
C. Thomas Howard

C. Thomas Howard is the co-founder, chief investment officer, and director of research at AthenaInvest. Building upon the Nobel Prize-winning research of Daniel Kahneman, Howard is a pioneer in the application of behavioral finance for investment management. He is a professor emeritus at the Reiman School of Finance, Daniels College of Business, University of Denver, where he taught courses and published articles in the areas of investment management and international finance. He is the author of Behavioral Portfolio Management. Howard holds a BS in mechanical engineering from the University of Idaho, an MS in management science from Oregon State University, and a PhD in finance from the University of Washington.

Jason Voss, CFA

Jason Voss, CFA, tirelessly focuses on improving the ability of investors to better serve end clients. He is the author of the Foreword Reviews Business Book of the Year Finalist, The Intuitive Investor and the CEO of Active Investment Management (AIM) Consulting. Voss also sub-contracts for the well known firm, Focus Consulting Group. Previously, he was a portfolio manager at Davis Selected Advisers, L.P., where he co-managed the Davis Appreciation and Income Fund to noteworthy returns. Voss holds a BA in economics and an MBA in finance and accounting from the University of Colorado.

Ethics Statement

My statement of ethics is very simple, really: I treat others as I would like to be treated. In my opinion, all systems of ethics distill to this simple statement. If you believe I have deviated from this standard, I would love to hear from you: [email protected]

30 thoughts on “The Active Equity Renaissance: Understanding the Cult of Emotion”

  1. Lilly says:

    Excellent article. The difficulty is that even when clients describe themselves as “long term investors” they become (panicked?) “short term investors” at the speed of sound when there is “too much” volatility on the downside. It is my experience of 35 years that MPT and diversification are often-not always-more effective at keeping clients in the market at all vs taking concentrated, long term positions that cause clients to panic. Just one person’s opinion. CIMA 1993

    1. Hello,

      Thank you for taking the time to share your thoughts about the piece. This kind of feedback is valuable to both Tom and me. Thank you also for sharing your story.

      We believe that as an industry we all need to start focusing on our end clients, even if this means difficult, non-expedient changes are in order.

      Yours, in service,


  2. Peter says:

    Not enough is being written about investment advisor bias, in my opinion. We talk a lot about how retail investors are poor, lost sheep who will be swayed by any emotion. But I have seen investment committees and professionals get all worked up over the latest news and allow it to influence their decision making. We should start to turn the spotlight on ourselves, publicly.

    1. Lilly says:

      Investment committees can be the worst, especially if they are loaded up with retail brokers with no clue as to UPMIFA or other fiduciary standards

      1. Hello Lilly,

        Thank you for sharing your thoughts about investment committees. Would you care to elaborate on them at all?

        Yours, in service,


        1. Lilly says:

          In my long experience working with fiduciaries, it has been uniformly my experience that the boards are made up of retail investors and retail brokers. Even investment consultants who are trained and proficient in the various fiduciary standards (UPMIFA, ERISA, etc.) have a very difficult time overcoming board members’ preconceived notion that they can invest fiduciary funds the same way that they invest their 401(k) or personal taxable funds.
          Asset owners do not do nearly enough to learn about or insist that their board members learn about their own *personal* financial liability under fiduciary statutes.

          1. Hello Lilly,

            ‘Tis also true in my experience.

            Yours, in service,


    2. Hello Peter,

      I couldn’t agree with you more, and on each of your statements. Thanks for taking the time to share your thoughts.

      Yours, in service,


  3. Brad Case, PhD, CFA, CAIA says:

    Excellent thought piece, Tom and Jason.
    There’s one effect of the Cult of Emotion that has been particularly damaging to investors, especially the largest (and supposedly most sophisticated) institutional investors: that’s the growth of high-cost investing in private equity, private real estate, and hedge funds. The attraction of illiquid investments is that they’re Level 3 assets whose values cannot be measured accurately on the basis of frequent transactions in liquid markets, so instead they are measured inaccurately by managers in a way that systematically understates their volatility, their correlations with other assets, and their other risks. In effect, investors have paid an enormous cost–in fees, in underperformance, and in hidden risks–for the legal right to understate the risks to which they’ve exposed themselves.
    The real shame is that the cost of this accuracy-avoiding behavior is borne not by the investment decision-makers (pension fund managers, endowment managers, foundation managers) but by those people who are supposed to be the beneficiaries of the investment decisions: retirees, financial aid recipients, people who might otherwise have benefited from foundation grants, etc. (not to mention taxpayers who must make up the difference).

    1. Hello Brad,

      Thank you, as always, for taking the time to share your thoughts and for contributing to the conversation. I believe your examples meaningfully add to the conversation.

      Yours, in service,


  4. Krishna Kumar says:

    Excellent Piece of Article.
    i do agree that time has come to include behavioral finance insight with MPT while constructing clients’s portfolio. The biggest culprits is creation of Clients’s optimal portfolio (risk free Asset + Market Portfolio) considering Investor’s indiffernce curve. However – Investor’s indifference curve is derived out of risk assessment profile – which is faulty (as author has highlighted). Only Behavioral finance can provide insight why a risk averse client – who buys insurance to protect his wealth as well buys a lottery .
    My recommendation will be to get rid of risk questionnaire (which is based on template – blame it upon laziness of Institutional approach – one size fits all) and gain insight based on Investor’s past financial decision. It could have been difficult in past – but with recent technology trends / data science fundamentals – It will not be difficult to derive a subjective client specific view based on his past trading decisions (fo obvious reasons, One need to separate his current repetitive decisions, trading decisions, checking / balance accounts, use of mortgages / debts , 401 or IRA account decisions and other factors). This is expected to rationalize true risk assessment of client .
    Once again – this was an excellent read and thanks for this insight.

    1. Tom Howard says:


      Thanks for your comment and a very interesting approach to dealing with client emotions.

      An important step for advisors is to implement a needs based planning framework. This allows for funding a specific need (liquidity, income, growth) with a specific portfolio. Volatility is avoided completely in the liquidity portfolio. Volatility plays a small role in the income portfolio as the focus in on growing income to offset inflation.

      It is in the growth portfolio, where we need to get clients comfortable with the emotions generated by volatility, where your suggested approach would yield the greatest benefit in terms of building long horizon wealth.

      1. Brad Case, PhD, CFA, CAIA says:

        Tom, I’m not sure I understand the points you’re making about volatility. Could you elaborate? Thanks.

        1. Hi Brad,

          I don’t want to speak for Tom. But in our conversations, his and mine, we believe that volatility in security price reflects, yes, adjustments to new information, but mostly the short-term emotions of market participants. Real risk is something that jeopardizes a security issuer’s ability to deliver on the value proposition of the security. This opens up the number of risks to be evaluated, and not all of them are necessarily captured in a single number, or even quantifiable for that matter.

          Further, since equities, in the aggregate, over long periods of time deliver price appreciation in excess of inflation and relative to other securities, Tom believes volatility should be ignored when choosing securities. He and I will be discussing this more in the fourth piece in this series.

          Hope that helps!


          1. Brad Case, PhD, CFA, CAIA says:

            That’s helpful, Jason. I believe I agree with your second point, and I believe that’s the important one. Most investors–supposedly “sophisticated” institutional investors at least as much as supposedly “unsophisticated” retail investors–seem to be inordinately afraid of volatility even when they claim to be long-term investors, which would imply that they can tolerate short-term volatility and earn a significant long-term reward for doing so. For example, Robert Arnott ( and others) has pointed out that most of the uncertainty associated with long-term investments in volatile asset classes is UPSIDE uncertainty: that is, how much richer we’ll become if we take the higher returns that are compensation for higher volatility.
            I disagree with your first point, which I regard as less important; I’ll write a separate response to it.

          2. Brad Case, PhD, CFA, CAIA says:

            Hi Jason,
            You (and Tom) distinguish between “adjustments to new information” and “short-term emotions.” I don’t think they’re different, and I think it’s a cognitive mistake to dismiss volatility as merely the result of short-term emotions.
            The value of any asset can be modeled as the present-discounted value of the future stream of cash flows generated by that asset. Of course nobody can know the future, so the value of any asset is determined by each market participants current expectations regarding both the future stream of cash flows that will be produced by that asset (under that market participant’s ownership, if the cash flows are owner-dependent) and the future stream of discount rates that will apply to that owner. Market participants are constantly re-evaluating their current expectations regarding both of those streams of future values. “Emotion” is simply a dismissive way of describing how market participants revise their expectations in response to the arrival of new information. For example, if something increases uncertainty, then market participants will tend to revise downward their expectations regarding future cash flows (because of risk aversion) and similarly will tend to revise upward their expectations regarding future discount rates–resulting in a downward revision of their estimate of the asset’s value. Volatility, then, is simply a real-time revelation of the market’s process of incorporating new information–not a false signal generated by mere “emotion.”

          3. Tom Howard says:


            That is certainly the theory: investors carefully discount future cash flows and price changes are the result of this evaluation process. But empirical tests of this proposition are unable to identify a link between changes in fundamentals and price changes.

            The best known is the research stream launched by Shiller in 1981 which concludes that almost all market volatility is noise. This implies one can safely ignore all current economic and market news when making investment decisions.

            Noise is even more pervasive when considering individual stocks.

            Brad, we will have to agree to disagree on this issue.

          4. Hi Brad,

            Your comments inspire several responses.

            First, most all of the money invested in almost all assets is from passive strategies. Surely, they are not engaged in an estimate of future cash flows and valuation. Instead, as they receive new monies they simply purchase a proportionate share of them in whatever index they are tracking. The end investor, usually retail, also surely is not engaged in any form of discounting. Most retail investors, a) do not have the time in their lives to evaluate investments in the classical way you describe, b) do not have the skill set to do it. I think it is a pretty safe conclusion that much of passive investment money is a reflection of how people feel about ‘the Market’ now.

            Second, if what I wrote above is true, that most passive money is neutral, ranging to emotional in response to news, then prices, which are set at the margin, are being set by active investors. However, there is not better news there, in my opinion. In a world of 100%+ average turnover among active managers can you really count on investors rolling up their sleeves, putting on their green eye shades and cooly, rationally valuing the future prospects of businesses? There is pretty strong evidence (e.g. in turnover ratios) that most investors are basing their decisions more on momentum or growth factors that valuation.

            Third, Tom and I acknowledged that some volatility is adjusting to new information that hits the market. However, I think much of it is emotional, not rational responses to news.

            Fourth, you may appreciate the work of Denise Shull of ReThink Group (whom I have featured on EI before). She tracks developments in neuroscience around decision-making. In short, neuroscience demonstrates that all decisions are emotional decisions. Yes, facts weigh in on and affect decisions, but the “to do, or not to do” always involves the emotional portions of the brain. How can we simultaneously grant the power of bias, as enumerated by the behavioral finance community, along with the neuroscience, and then say that volatility predominately is a reflection of differing rational views about the price of an asset?

            In summary, I think it is a classic fiction of markets that they are objective. In theory, yes, they are objective, even if the individual participants are subjective. I too have read and understood Adam Smith. Markets are better than trusting a central authority, granted. But that does not mean they are perfect and deserving of unquestioning devotion. As a final point: Adam Smith was not a mathematician, nor a scientist, but a natural philosopher.

            Yours, in service,


          5. Brad Case, PhD, CFA, CAIA says:

            Hi Tom,
            Yes, I’m aware of Shiller’s extremely important empirical work on this topic. (He was my dissertation advisor.) But Shiller’s work related asset price changes to changes in future fundamentals, not to changes in discount rates. Meanwhile, other research (which I can’t find at the moment) has suggested that longer-term volatility is related to changes in cash flows (i.e., fundamentals) whereas short-term volatility is more closely related to changes in discount rates.
            Basically what I’m saying is that there are two competing ways of explaining short-term volatility: one that says it reflects the arrival of new information–regarding the future course of discount rates as well as the future course of cash flows–and another that says it reflects thoughtlessness on the part of market participants. Let’s not conclude too quickly that investors are stupid.
            p.s. Also, let’s not “agree to disagree” too quickly. The whole point of a blog is to sharpen our thinking by trading ideas. If we “agree to disagree,” then basically we’re agreeing not to examine our own arguments and learn from others’ arguments. For me, that back-and-forth is basically the whole value of Enterprising Investor and other blogs like it. Thanks.

          6. Tom Howard says:


            I as well as others have taken a close look at this issue and found little to hang our hat on. I included interest rates in my analysis and found a weak relationship with stock prices.

            So while there is some evidence, it is not enough to dissuade me that volatility is mostly noise. This is at the market level, at the individual stock level there is even less evidence.

            I am open to additional empirical evidence on this topic.

          7. Brad Case, PhD, CFA, CAIA says:

            Hi Tom,
            The empirical research that I was thinking about is from “The Divergence of High- and Low-Frequency Estimation: Implications for Performance Measurement,” published in Journal of Portfolio Management 41(3):14-21, Spring 2015. Here’s the relevant passage:
            “We hypothesize that high-frequency variability arises from changes in discount rates, whereas low-frequency variability is caused by differences in cash flows. Changes in discount rates occur relatively often because a constant flow of new information causes investors to reassess the riskiness of a stream of cash flows, which therefore leads to high-frequency variability. In addition, the value of a portfolio or strategy may gradually appreciate or erode over a long horizon, because the drift of cash flows shifts upward or downward as fundamentals change. This process introduces low-frequency variability.”

          8. Tom Howard says:

            Thanks Brad. Will take a look at this article. Always interested in good empirical stock market research.

          9. Brad Case, PhD, CFA, CAIA says:

            Kinlaw, Kritzman & Turkington [2015] continues:
            “We test this hypothesis by analyzing the returns of 10 U.S. sectors from December 1978 through December 2013. Each month, we regress the cross-section of monthly, three-year, and ten-year sector returns on the cross-section of changes in earnings during the same periods. We also regress the cross-section of monthly, three-year, and ten-year sector returns on…a proxy for sector discount rates.” The empirical results “reveal rather starkly that high-frequency returns are more strongly related to changes in discount rates than to changes in earnings, whereas the opposite is true for relatively lower-frequency returns.”

          10. Brad Case, PhD, CFA, CAIA says:

            Hi Jason,
            I think I failed to express my point clearly. I certainly don’t believe that the discounted cash flow model is a description of the actual process that investors–whether primarily passive or primarily active–go through in terms of collecting data, predicting future cash flows, predicting future discount rates, and calculating the present-discounted value. It’s a model. It’s a mathematical simplification that reflects the salient features about how real-world information is translated into asset values through transactions in markets. A map is not a city: it is a model, a simplification that reflects the salient features of the city. The fact that investors don’t “roll up their sleeves and put on their green eye shades” does not mean that the discounted cash flow model is not an accurate way of describing the relationship between information and asset values.
            Similarly, I have never said that emotion plays no part in making investment decisions, and I would never say so: witness the stupendous amounts of money that are wasted in private equity and hedge fund investments because investors (most of them supposedly sophisticated) are trying to avoid the emotions triggered by perfectly rational changes in asset values!
            Rather, my point was to caution you (and Tom) against the mistake of dismissing changes in asset values as “merely” the product of emotional decisions. The fact is that discount rates do change, throughout every day, and because that DOES happen, asset values DO change accordingly. When you mention “how people feel about ‘the Market’ right now,” you are describing their discount rates, not “mere” emotion.
            One last thing, Jason: you seem fixated on the idea that I believe markets “are perfect and deserving of unquestioning devotion.” I don’t believe I have ever said or written anything that should have led you to that conclusion, so please let it go. Thanks,

    2. Hello Krishna,

      Very interesting ideas. My own belief is that volatility is not risk; see our forthcoming part four of this series. Volatility of security price is capturing short-term emotions on the part of investors and price adjustments to new information.

      However, if advisers seem wedded to wanting to truly understand the emotional profile of their clients then there are solutions just waiting to be developed using off-the-shelf brain monitors, such as that offered by Muse. This headband could be adapted using an application that puts people in scenarios where their assets fluctuate wildly, or where they read about events that commonly affect portfolio value.

      The approach you suggest is also valid, and interesting. Search here on The Enterprising Investor for Essentia Analytics and/or Claire Flynn-Levy. Her company examines past trading data for behavioral bias and errors and creates alerts in real time for investors. Note: this would work for advisers, prop traders, investment company traders, and others, too.

      We are just at the very beginnings of meaningful conversations about emotions, volatility, and actual risk. Let’s keep the conversation happening!

      Yours, in service,


  5. Krishna Kumar, CFA says:

    Excellent Piece of Article.
    I do agree that time has come to include behavioral finance insight with MPT while constructing clients’s portfolio. The biggest culprits is creation of Clients’s optimal portfolio (risk free Asset + Market Portfolio) considering Investor’s indiffernce curve. However – Investor’s indifference curve is derived out of risk assessment profile – which is faulty (as author has highlighted). Only Behavioral finance can provide insight why a risk averse client – who buys insurance to protect his wealth as well buys a lottery .
    My recommendation will be to get rid of risk questionnaire (which is based on template – blame it upon laziness of Institutional approach – one size fits all) and gain insight based on Investor’s past financial decision. It could have been difficult in past – but with recent technology trends / data science fundamentals – It will not be difficult to derive a subjective client specific view based on his past trading decisions (fo obvious reasons, One need to separate his current repetitive decisions, trading decisions, checking / balance accounts, use of mortgages / debts , 401 or IRA account decisions and other factors). This is expected to rationalize true risk assessment of client .
    Once again – this was an excellent read and thanks for this insight.

  6. HENRY LESTER says:

    There are two problems with the argument that short-term volatility or downside risk should be, in effect, ignored, if emotions are managed. First, the implicit assumption of time diversification or that stocks will come back after a decline. There have been numerous articles in the FAJ, which I believe show, that you can’t insure this will be the case. And, of course, in some countries and periods of time the market never came back (i.e. Europe). Secondly, the amount of time until the market comes back (for example, the post 1929 crash) could be beyond the duration (in the bond sense) of many investor’s retirement funding liability.

    1. Tom Howard says:


      Thanks for your comment.

      We agree with you that these are true risks faced by investors. Our contention is that short-term volatility and draw downs do not capture these risks but instead are driven by the short-term collective emotions of investors.

      In an upcoming post, we will discuss what we believe are superior measures of real risk that are not based on volatility or prices, which are both dominated by short-term emotions.

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