Chasing Past Performance: A Poor Investment Habit You Should Break
Why Pursuing Success in the Short-Term Often Leads to a Long-Term Cost
We live in a world with unpredictable financial markets, with the truism that past performance is never a guarantee of future results. Why, then, do we collectively continue to chase historical success by selling our holdings in slow-to-perform active fund managers and investing in recent winners instead?
The answer is largely psychological, in that we are ruled by a combination of outcome bias and an overemphasis on the power of skill over randomness. Taken together, this leads many investors down the damaging path of chasing past performance – and ultimately ending up disappointed.
Understanding Outcome Bias
Evaluating the outcomes of an active fund manager and weighing the relative success or failure of investment strategy is both useful and important. Human beings are evaluative by nature and it’s a trait that helps us learn from the past. However, outcome bias exploits an inherent error we make in evaluating the quality of a decision or process when we already know the outcome. In short: a positive result gives us overconfidence in the quality of the decision-making that leads to it, and a negative result causes us to undervalue the quality of decision-making that leads to the poor outcome.
In the financial world, operating with an outcome bias can bring us success in the short-term, but it almost always costs us in the end. Consider the example of Jayesh Manek.
Manek was born in Uganda in 1956 and moved to the UK for his higher education. He studied pharmacy and opened his own successful chain of stores, Dallas Chemists. Despite his success, though, his true passion was investing. To that end, Manek entered a fantasy fund management competition hosted by The Sunday Times in 1994, which offered a significant monetary prize. His proclivity for small-cap growth companies in the technology sector served him well, and he beat out thousands of other contestants by managing to turn an initial $10 million into more than $500 million. Remarkably, he repeated his success in 1995 and, suddenly, the world was paying attention to the small-time pharmacist who seemed to be a big-time investing talent.
After taking home the title of champion investor two years running, Manek launched his own fund. Many investors wanted to take advantage of his seeming brilliance, and he received hundreds of millions in investment. Unfortunately, though his fund performed well for two years, it peaked quickly and then fell in value by 75 percent, never to recover.
The eventual crash and burn of Manek’s fund offers a clear example of how misleading past performance can be in chasing future success. His investors made dangerous inferences about his skill based on two years of success in a fund management competition. They were, in essence, hoodwinked by their own confirmation bias and it led to a dramatic failure and considerable financial loss.
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A Look at the Research
Clearly, Manek’s story confirms that past performance can be misleading, which is why it’s dangerous to rely on it when choosing active fund managers. Still, most investors will unconsciously chase past success simply due to human nature.
Outcome bias changes the way the human brain perceives relative success or failure and has a material influence on our choices even when outcomes should be inconsequential. This is true outside of financial decision-making, too. Consider a 1998 study by Jonathan Baron and John Hershey:
Participants were asked to rate the quality of a hypothetical medical decision in which a 55-year-old man was offered a bypass operation that would improve his heart condition and his quality of life, while also extending his life expectancy. The catch was that 8 percent of patients who underwent this particular operation died. In this hypothetical scenario, the man’s doctor chose to do the operation.
Study participants were first presented with the result of the patient dying on the operating table, then later with the result of a successful procedure. Although the outcome was completely irrelevant to the quality of the doctor’s decision, the participants rated it as significantly superior in the scenario where the patient lived.
Numerous academic studies have sought to determine just how strongly outcome bias plays into investment decision-making. As it turns out, both inexperienced, individual investors and large, sophisticated institutions are susceptible to making damaging decisions and poor judgments by valuing outcomes more than decision-making or skill. This is particularly dangerous when outcomes are subject to randomness.
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The Dual Problems of Outcome Bias and Randomness
In some ways, outcome bias is useful because it provides a shortcut for making quick judgments when we have limited time or information. It can allow us to put trust in a decision or process when we see that it has produced consistently positive results. However, the efficacy of this shortcut becomes convoluted when outcomes are subject to randomness, and we can easily be misled.
In a famous 1975 study of Yale University students, researcher Ellen Langer showed that outcome bias impacts us even when potential outcomes are completely random and have nothing whatsoever to do with skill. Langer and fellow researcher Jane Roth asked students to predict a sequence of coin tosses, allowing some of them to have early success while others would struggle early on. Overall, the outcome was fixed so that each student would predict heads or tails correctly 50 percent of the time, but the students who enjoyed early success were shown to consistently overvalue their abilities. The students also believed they could improve their rate of prediction over time with experience, although no amount of practice could change the coins’ probability of landing on either heads or tails 50 percent of the time.
This research is an example of the human brain’s problem with the illusion of control. That is, we can be led to believe that we can control or influence events that are actually totally random. Thinking that we can influence the result of a coin toss – which is completely random – shows just how prejudiced we are when it comes to believing we, or others, can influence a volatile financial market where skill is also involved.
Breaking the Habit: How to Stop Performance Chasing
So, how do we overcome the dual issues of outcome bias and the illusion of control and break the habit of performance chasing? It requires taking the following steps to override our natural instincts:
- Create Rules
If you want to stop performance chasing, create a set of decision rules for yourself that prohibit your natural inclinations. For example, you might make a rule that you never purchase a fund that has outperformed its benchmark by double digits over the last two years.
- Don’t Rely on Performance Screens
In the investment industry, mutual fund performance screens are a pervasive means to rank funds. While they differ based on metrics and time horizons, they are all accomplishing the same goal of assessing a fund based on its past performance – and relying on outcome bias for decision-making.
- Identify Where Skill Exists
Investing with an active manager is a choice we make because we believe the manager has skills that will lead to success. However, to overcome outcome bias and the illusion of control, we need to identify specifically where we believe skill exists. For example, rather than saying an active manager is skilled in outperforming the market, we should look for particular advantages, such as the ability to spot companies with potential earnings growth over and above market expectations.
- Know When Randomness is a Factor
In any given activity, you should be able to gauge how much randomness will impact outcomes. There’s a simple test for this, authored by Michael Mauboussin, to mete out the impact of luck versus skill. You simply ask yourself whether it is possible to fail on purpose. For example, it is impossible to purposefully fail at playing the lottery because the probability of success is completely arbitrary. In a game of chess, on the other hand, we know skill plays a much larger role because it’s entirely possible to lose a game intentionally by making reckless moves.
- Extend Your Assessment Period
Investment management is always a mixture of luck and skill, but our innate outcome bias is influenced by the time horizons we use. If we’re only looking at one day, performance success could easily be pure luck. If we look at a longer period, however, skill begins to exert more influence. Longer time horizons won’t negate the influence of randomness, but outcomes are less influenced by chance over time.
Outcome bias and the illusion of control impact us in our daily lives, but they can be particularly troublesome in investment decisions like active manager selection – especially when they keep us chasing past performance. Of course, outcomes do matter and making thoughtful inferences is part of sound decision-making. We just need to be mindful that the quality of investment decisions is far more important than yesterday’s performance.