There’s a lesson for investors in all those stories about how England’s success at the World Cup has supposedly made us fall in love with the national team again.
It lies in something called the outcome bias. This is our tendency to infer from good results that there was genuine skill behind them and to neglect the role of luck. Victories cause us to exaggerate a team’s qualities, and defeats make us overestimate its defects.
This bias lies behind celebrations of England’s performance. They could easily have lost that penalty shoot-out to Colombia: David Ospina came close to saving each penalty. And it was only some good saves by Jordan Pickford that gave them victory over a very poor Swedish team. These results glossed over weaknesses such as an inability to create chances from open play, and the fact that – as expected – England lost every time they played a half-decent side.
With slightly different luck, England might easily have exited the tournament early, leading to the usual brickbats rather than celebrations. As it was, good results distracted people from the fact that the team wasn’t very good.
Much the same happens when investors pick unit trusts. They see good returns and infer from these that the fund manager has genuine skill. Often, however, he doesn’t. Andrew Clare and Nick Motson at Cass Business School have found that funds’ returns over a six-month period are strongly correlated with subsequent buying of those funds, but that such buying leads to poor returns.
This is consistent with research by Keith Cuthbertson, Dirk Nitzsche and Niall O'Sullivan which shows that only a handful of funds (mostly in the equity income sector) have the sort of persistently good performance we’d expect if fund managers had skill.
It’s also consistent with another finding. Economists at the University of Mannheim show that investors “confuse risk taking with manager skill and are thus likely to over-allocate capital to lucky past winners”.
Investors therefore lose money because they wrongly infer from good results that there’s lots of skill involved when in fact there’s luck instead. That’s the outcome bias.
It’s reinforced by something else – the narrative fallacy. We have an urge to tell stories to explain events, and these stories downplay randomness and chance – as we see in biographies that claim that their subjects were “destined for success from an early age”: such stories are only written after the success has been achieved.
This isn’t to say we should ignore funds’ performance entirely; there is some evidence that bad performance tends to persist. It’s just that it’s easy to infer too much from it. Good returns might be due to taking risks (whether deliberately or not) that happen to have paid off. We shouldn't infer that will continue.
I suspect we see a similar thing in attitudes to business. We infer from high profits or (worse still) a high and rising share price that there is good management or a good business model, and underplay the possibility that the company has been lucky, or mispriced, or just operating in an unusually favourable environment. (Again, psychologists have a name for the latter; they call it the fundamental attribution error.) Fred Goodwin, James Crosby and Philip Green were all knighted because of their business acumen – but subsequent events showed this to be more questionable than thought at the time.
The error might be more common that that. Over the very long term, growth stocks have underperformed value ones; highly priced shares (relative to dividends or book value) have done worse than lowly priced ones. This is weird because the collapse in bond yields this century should have greatly boosted growth stocks – because these offer more future cash flows than value ones, and a lower bond yield should reduce the discount rate applied to those cash flows. There are many possible reasons for this underperformance, not all of them mutually exclusive. One could be that investors are prone to a form of outcome bias. They see a high price and infer too strongly that there is good management or a sustainable business model behind it when in fact there might be mispricing or temporarily favourable economic conditions – and so pay too much for the shares.
If we tend to commit the outcome bias as football fans we are perhaps even more prone to do so as investors. As fans, we can see a team’s performance independently of its results. As investors, however, we often can’t. It’s hard to tell, in advance of a fund’s returns, whether its manager really does have a good stock-picking method. And it’s difficult for outsiders to tell whether company management really is good or not.
When faced with limited information there is always a danger of over-estimating the value of the few facts we do have. And this might lead us to infer too much from results – especially because short-term performance is usually more noise than signal. We fail to heed the words of the book of Ecclesiastes – that “time and chance happeneth to them all”.
