When you’re distracted, your performance suffers. That’s true of surgeons – research suggests distraction in the operating room is a major factor in up to half of hospital errors. It’s true of drivers – according to one insurance survey, almost a quarter of UK drivers have been so distracted by roadside billboards of scantily-clad models that they veered dangerously out of their lanes. So here’s a question: is it true of investors? In a word: yes. A growing body of research shows investors should pay more attention to inattention. Both positive and negative stressors – marriage, divorce and buying a house, to name a few – can negatively affect investors, according to Sugata Ray, a finance professor at the University of Alabama who has co-written some novel research on the subject.
Marriage and divorce
Ray's interest was piqued by a comment from high-profile hedge fund manager Paul Tudor Jones in 2013, when he said among his "number one rules as an investor" is to "redeem immediately" if he finds out a manager is going through a divorce. The "emotional distraction" that comes from divorce is "overwhelming", said Jones, so much so you can "automatically subtract 10 to 20 per cent from any manager" if his marriage is ending.
It turns out Jones was overstating things, but he was on the right track – hedge fund returns fell by more than 7 per cent following a divorce, according to Ray’s paper, Limited Attention, Marital Events and Hedge Funds, with managers badly underperforming in the six-month period surrounding the divorce and the two-year period that followed. That’s not too surprising; after all, getting divorced is stressful. What’s especially notable, however, is that getting married was even worse for returns. The problem is that marriage and divorce are distracting, time-consuming events. As a result, underperformance was especially marked with busy managers “who can ill afford the distractions associated with such events”.
For example, managers running at least two funds did much worse than managers running one fund, just as managers running the show on their own did much worse than team-managed funds. Fund managers traded less actively in the period around marriages and divorces, were more likely to herd, and their portfolio took on a greater resemblance to benchmark indices – all behaviour consistent with the fact that they just didn’t have the same time to devote to their job. For the same reason, they tended to become less disciplined. In the six-month period surrounding a marriage, managers became noticeably prone to the disposition effect – a behavioural bias where investors sell winners and hold on to losing stocks. Divorces had a particularly durable impact in this regard, with managers more prone to the disposition effect “before, during, and after a divorce”.
That a divorce can continue to affect performance for a long period is “not surprising” as the process can drag on for a few years, especially when there are “disagreements over child custody or the division of matrimonial assets”.
Buying a house
If marriage and divorce can be problematic distractions, what about another costly and time-consuming event – buying a house? The same patterns are evident, according to a 2018 paper by Ray, How Do Personal Real Estate Transactions Affect Productivity and Risk Taking?
Performance is poorer after asset managers buy a house; they become less active and turnover plunges, they become much more susceptible to behavioural biases like the disposition effect. Importantly, these patterns are much more evident following large and expensive house purchases (buying a relatively small home “has no impact on returns”).
Similarly, managers running only one fund were “largely unaffected”, as were team-managed funds; the worst-affected investors were the busy managers running multiple funds or who were not working as part of a team. Separate research confirms that inattention drives underperformance. A study published earlier this year found fund managers are skilled at buying stocks but any advantage they have is lost due to lousy timing when it came to selling. The reason managers are bad at selling is they “are just not paying attention”, the study found. Most of their time is spent on finding the next stock to buy, with selling wrongly seen as a “cash-raising exercise for the next buying idea”. And inattention causes stocks to become mispriced during earnings season. “Psychological evidence indicates that it is hard to process multiple stimuli and perform multiple tasks at the same time,” writes behavioural finance expert Prof David Hirshleifer in his paper, Driven to Distraction: Extraneous Events and Underreaction to Earnings News.
For this reason, there is more likely to be a weaker investor response to breaking news on days where large numbers companies are reporting earnings.
Hirshleifer also found the same problem is evident on Fridays, when investors are looking ahead to the weekend. Investors miss out on key details and under react. Consequently, there tends to be a catch-up investor reaction in the days and weeks after Friday earnings announcements.
Companies are well aware investors can get distracted and have traditionally been much more likely to release bad news on Fridays compared to other days. Poor earnings are also more likely to be announced after trading hours, on busy days and on Fridays – all times when investors are less likely to be paying attention.
A limited resource
While professional investors tend to be undone by distraction and inattention, ordinary investors are more likely to pay attention to the wrong things.
“Attention is a limited resource, and it is attracted by the emotionally compelling traits of an asset – its vividness”, writes MarketPsych chief executive Dr Richard Peterson in his book Trading on Sentiment. “The more vivid an event or its potential outcome,” says Peterson, a psychiatrist who specialises in the psychology of financial decisions, “the more it influences judgment”.
As a result, financial TV stations like CNBC aim to create "emotionally compelling" stories to engage viewers. Peterson notes how one study found trading volumes increased fivefold when former CNBC presenter Maria Bartiromo mentioned a stock on her programme, while stocks mentioned by hyperactive CNBC presenter Jim Cramer have traditionally enjoyed outsized one-day price moves.
Separate research by behavioural finance experts Brad Barber and Terrance Odean shows ordinary investors tend to be drawn towards "attention-grabbing" companies – stocks that are in the news, experiencing unusually high trading volumes or extreme returns. It pays, then, to stay focused. Veteran hedge fund managers are well aware of this. Controversial hedge fund manager Steve Cohen has long employed a psychiatrist at his firms. Ray Dalio, founder of the world's biggest hedge fund, Bridgewater, has said meditation "has probably been the single most important reason" for his success and has made it available to the firm's employees. The importance of distraction shouldn't be underestimated, says Sugata Ray, who suggests researchers explore the impact of other major life events, such as the birth of a child or the death of a loved one, on investment performance. His message is clear: investors need to pay attention to inattention.