What Did The Bear Do To Your Brain?

April 22, 2009

 

In areas such as investing we are prone to make a different mistake because we believe that skill is involved. We tend to follow the trend. When a particular money manager or strategy outperforms the stock market, we are tempted to place our money with that manager or into that strategy thinking that the trend of outperformance will continue.

When friends, neighbors, family members, media persons or investment managers come to you bragging about their brilliant foresight in predicting this recent downturn, smile and then politely change the topic of conversation. Research shows that those who attempt to market-time do poorly, so let's examine why their overconfidence should be ignored.

These people will question the merits of staying the course and attempt to make you feel foolish for doing so because they believe their getting out of the market was a skillful move. By the way, their telling you this is the result of another bias people experience when making decisions; they do not like to be alone in their views. In these types of situations, treat them as you would a neighbor who won the lottery. You may be happy for them and tempted to buy a ticket yourself. But you would not purchase lottery tickets with your life savings because you would realize they were just lucky, not skilled in lottery number selection.

In the same way, investors should not abandon a sound investment strategy because they feel the market decline was predictable. We are excellent "deletion" creatures who make wrong predictions frequently yet don't realize it because we quickly delete those wrong predictions from our memories. Only the past inclinations we had that become a reality rise to the forefront of our minds, leading us to believe we are right more than we really are.

Lastly, we need to consider what academics call survivorship bias when we think predicting markets is easy. For example, you only hear from the neighbor who won the lottery—not the overwhelming majority of those neighbors who lost. The same is true of those who happen to call the market correctly on a specific occasion, including ourselves.

Let's look at one last illustration demonstrating how winners will always emerge by pure chance without a pattern of consistency being present. If we filled a stadium with 10,000 coin flippers and conducted a series of 10 flips (think of 10 years of market returns), with those getting heads staying in the contest (winners or market beaters) and those getting tails getting dropped from the contest.

In the first flip we would expect 5,000 people to remain in the contest; the second flip 2,500 and so on. After the 10th flip we would expect close to 10 people to remain who have flipped 10 heads in a row. It would be false to assume these people have skill in coin tossing. However, if they were investors, the press would herald these 10 people as market gurus; these lucky individuals may even start money management firms and write columns in Forbes magazine attracting large amounts of investor money.

Hopefully, we all see that it would not be wise to invest our money in a strategy put forward by these 10 coin flippers in spite of past success. Remember, over a one-year period (or the first flip) we would expect 5,000 coin flippers to win. There is a high probability that a large number of people avoided some of the market decline. The problem is we would expect that by chance, and those people now have to know when to get back in the market in order to win over the long run.

Further, they have to be able to repeat this process over time. We should no more listen to those lucky coin flippers than our friends or opportunistic money managers who tell us they avoided the down market last year.


Kenneth Smith is chief executive of Seattle-based Empirical Wealth Management. He welcomes suggestions and comments for future columns at

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