Sensation-seeking is a personality trait that can be described as the seeking of varied, novel, complex and intense sensations and experiences, and the willingness to take physical, social, legal and financial risks for the sake of such experiences. Does sensation-seeking affect the behavior of financial market participants, such as professional fund managers?
That’s exactly the question that Stephen Brown, Yan Lu, Sugata Ray and Melvyn Teo, the authors of the December 2016 paper “Sensation Seeking, Sports Cars, and Hedge Funds,” attempt to answer.
The field of behavioral finance has provided us with some important insights on the subject. For example, the research has found that individuals prefer stocks with low nominal prices, high volatility (and high beta) and high positive skewness (in which returns to the right of, or more than, the mean are fewer, but further from it, then returns to the left of, or less than, the mean, like a lottery ticket). In other words, they have a preference for gambling. Research has also found that investors with gambling preferences trade actively.
What A 'Sensational' Car Suggests
Brown, Lu, Ray and Teo contribute to the literature by examining professional hedge fund investors. Their study used data on hedge fund managers’ automobile ownership to gauge their proclivity for sensation-seeking and then analyzed the impact on behavior and performance. The authors examined the characteristics of vehicles the managers purchased, such as body style, maximum horsepower, maximum torque, passenger volume and safety ratings.
Their working hypothesis was that “the purchase of a powerful sports car, more often than not, conveys the intent to drive in a spirited fashion and therefore signals an inclination for sensation seeking. Conversely … the acquisition of a practical but unexciting minivan reflects an aversion to sensation seeking.”
The study covered the period 994 through 2012 and nearly 50,000 hedge funds. To quote the authors, “the empirical results are striking.” Specifically:
- Hedge fund managers who purchase performance cars take on more investment risk than fund managers who eschew performance cars.
- Sports car drivers deliver returns that are 1.80 percentage points per annum more volatile than nonsports-car drivers, a 16.6% increase in volatility over that of drivers who shun sports cars. Similarly, drivers of high-horsepower and high-torque automobiles exhibit 1.14 percentage points and 1.25 percentage points per annum more volatility, respectively, in the funds that they manage than drivers of low-horsepower and low-torque automobiles.
- Managers who acquire practical but unexciting cars take on lower investment risk relative to managers who shun such cars. For instance, minivan owners generate returns 1.28 percentage points per annum less volatile than other owners, an 11.74% reduction in risk relative to managers who eschew minivans.
- Managers who purchase cars with high passenger volumes and excellent safety ratings also deliver returns that are, on an annualized basis, 1.59 percentage points and 0.97 percentage points less volatile, respectively, than managers who purchase cars with low passenger volumes and poor safety ratings.
- Sensation-seeking hedge fund managers trade more frequently (hurting performance, and suggesting overconfidence), have higher active shares (are less diversified, again suggesting overconfidence) and engage in more unconventional strategies. The opposite holds true for owners of cars with anti-sensation attributes.
- These results were both economically and statistically significant, and were robust to various controls (such as age, marital status and age of the fund).
Sensation-Seeking Signals Underperformance
Unfortunately, the results also showed that, despite taking more investment risk, fund managers who purchase performance cars do not generate greater returns than fund managers who eschew those cars.
The authors write: “Buyers of cars with pro-sensation attributes deliver lower Sharpe ratios than do buyers of cars with anti-sensation attributes. For example, a one standard deviation increase in vehicle maximum horsepower is associated with a decrease in fund annualized Sharpe ratio of 0.18. This represents a 21.43% reduction relative to the Sharpe ratio of the average fund in our sample. In contrast, a one standard deviation increase in vehicle passenger volume is associated with a 0.18 increase in fund annualized Sharpe ratio.”
Brown, Lu, Ray and Teo also found that “the sensation seeking story further predicts that the incremental risk taking by sensation seekers extends beyond financial markets.” They found “that managers who acquire cars with pro-sensation attributes exhibit heightened operational risk while managers who acquire cars with anti-sensation attributes exhibit lower operational risk.
Specifically, controlling for a variety of factors that may affect fund behavior, performance car drivers are more likely to terminate their funds and report regulatory, civil, and criminal violations on their Form ADVs. Conversely, drivers of practical but unexciting cars are less likely to shut down their funds and report violations on their Form ADVs.” Clearly, “innate personality traits such as sensation seeking can engender operational risk.”
The authors concluded: “Empirical results broadly validate the advice given by hedge fund allocators to avoid managers who purchase fancy sports cars.”
The study has implications well beyond a decision on what kind of due diligence you should pursue when choosing a hedge fund manager. It begs the question: What type of car do you drive? The research suggests that it will tend to convey information on your own investment behavior, behavior that may be damaging to your investment results. Forewarned is forearmed.
By the way, I drive a staid Lexus 430.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.