A seasoned investor mentioned to me not too long ago that you could be lucky for 5 years and folks and yourself may deemed that the outcome of your investing (your returns) proves that the process where you actively manage your investing may be due to luck more than your skills.
I don’t dispute this fact. There are days when some of the most unsure investments that I made did well for a prolong period. Good profits. But was it due to me punting or really making a good business case for it?
A close friend of mine always says that his early buy of Sarin at 40 cents looks shrewd but lucky. He does not hide the fact that he went with the analyst report and hunch and no real fact finding.
Well Sarin is now near 1.90, so it turned out ok.
The danger here is believing in that hype that you have a skill, your process is great and when your luck runs out, failed to get support from a good market trend, things will start unraveling.
The brain is patterns seeking
Consider two parties, the person making the decision and the person judging the decision. If the judge knows nothing of the information that decision maker had, it is reasonable to equate poor outcomes with poor decisions.
The judge has nothing else to go on.
But when the judge has access to the same information as the decision maker and still equates a good outcome with good skill and a bad outcome with bad skill, outcome bias is at work.
The bias is especially pronounced for decisions with outcomes that include a healthy dose of luck.
With split-brain patients, Gazzaniga could see where this tendency to search for patterns resides.
When the researchers presented the probability guessing experiment to the right hemisphere, they found that it was a maximizer just as the pigeons, rats, and little kids were.
But with the same experiment the left hemisphere acted as a frequency matcher. It is the part of your brain that is responsible for finding patterns.
Our left brain when join to the right brain (for most people I guess) tends to like to follow a pattern for truly random events.
We make beautiful stories to justify that we do not know everything
The interpreter will come up with a correct story if it has the proper information. But it is willing to make up a story, imposing order on the world, even if it doesn’t have all of the proper information.
This is a particular problem with human beings, especially financial bloggers.
As well as project managers.
An experiment closer to investing
The subjects in this experiment were students of finance who were explicitly taught about randomness.
Given that the coin tosses were truly left to chance, the subjects had no basis to switch.
This was especially true if they had to pay a price to do so. Yet 82 percent of group B (23 of 28) provided a price representing their willingness to pay to switch.
The players in group B who switched stated an average price of almost €3 to switch from a person who called none correct to one who called all five (see Exhibit 2).
We can interpret the result of this experiment as outcome bias. Our minds see an outcome and infer that the person making the decision has good or bad skill. You might be inclined to believe that such behavior wouldn’t persist in the business world.
But we see versions of it all the time.
The outcome of a stock price going up or going down largely infers a company is good or bad. So does a unit trust or mutual fund.
By no means is it truly random, but the lazy brain in most investors refuses to do the hard work quantitative and qualitatively and uses the price peak and through and spikes as indicators to switch.
Outcome Bias and Consumer performance chasing
Take, for instance, the evidence that individual and institutional investors have a clear tendency to shed funds or asset classes that have done poorly and buy those that have done well. Individuals have such a proclivity to buy what’s hot that academics have a name for it: “the dumb money effect.”
This research shows that individual investors, on average, would have earned one percentage point more in returns if they had simply stayed put with their prior investments versus switching to new ones.
Our brain have a way of making us lose money.
The myth of the star analyst
Another example is the decision to hire a star from another company. Boris Groysberg, a professor of organizational behavior at Harvard Business School, has examined this topic in detail.
One of his studies was of top-rated sell-side analysts, as determined by Institutional Investor, who switched from one firm to another.
Outcome bias would suggest that the excellent performance of the analysts was perceived to be solely a reflection of their skill. That skill, as a result, should be portable to another company.
Groysberg found that the performance of analysts who switched firms “plunged sharply.” Successful analysts benefit from the organization in which they work and likely a large dose of good luck.
Neither of those transfers from one firm to the next. This is the hiring version of the “dumb money effect.”
This is interesting and sort of draws similarities to active managers (like myself) who have a process and seem to be doing well.
The time comes when put in another context how well I would be doing.
How to guard against this
Measure the amount of luck in an activity
There are few sure things in life. Most events only happen with some probability. The first step is determining how much room there is for the interpreter to run. Where there is randomness, there is ample opportunity for the interpreter to get into mischief.
For realms where causality is hard to pinpoint and experts are poor at predicting outcomes, the interpreter requires close monitoring. In certain fields, there are reasonably precise methods for estimating the relative contributions of skill and luck.
Where there is luck, focus on the process
When skill exclusively determines results, outcomes alone are an accurate measure of skill. Think of the sprinter in a 100-meter dash or a concert pianist on stage.
The link from cause to effect is clear, and there is no reason to worry about outcome bias.
When luck contributes to results, you must consider the process by which the decision was made.
While a good process leads to the highest probability of good results over time, the link between process and outcome is loose in the short run.
This is the realm where you must diligently fend off outcome bias. The results should not color your assessment of the quality of the decision.
Note that if you don’t have full access to the decision maker’s process, your mind will associate poor results with poor skill.
A related point is that you should not assume that good results are a reflection of a good process. This is an important topic in ethics.
For instance, research shows that “people blame others too harshly for making sensible decisions that have unlucky outcomes,” and “we let ethically-questionable decisions slide for a long time until they result in negative outcomes, even in cases in which such outcomes are easily
Perhaps this is a reminder that you need to constantly evaluate your evaluation process, discern between when you are punting and making a business investment.
People do punt, and should not confuse that with you having a skill.
Active management of investing requires looking at stocks as businesses, prospecting based on all available information, actively sourcing for all information, having a qualitative and quantitative process of evaluation, peer review your business case and constantly evaluate the business even when it is doing well.
If we have no time for it, then perhaps we need to trim down our number of business we get invested in so that we can scruntize them better.
Or we should just passively manage them by keeping cost low.