An individual decides to drive home after an evening out despite being knowingly over the legal alcohol limit; before completing their journey they are stopped by the police and charged with driving under the influence.  In a parallel universe, the same scenario occurs but with one key difference – prior to being pulled over by the police the individual’s intoxication leads to an accident that causes serious injuries for passengers in another car.  How should we view the perpetrator in these two incidents?

Our reaction from an ethical[i], and legal, standpoint is often to judge the second version more harshly – because the consequences were far more severe, but should this be the case? In both cases the main failing is identical – the initial flawed decision to drive after excessive alcohol intake.  The relative results, however, are due to luck; the individual in the first instance experienced good luck (comparatively), and the other bad.  Such judgements are often heavily influenced by the results, even if they are reliant on chance; an example of outcome bias[ii].

Our tendency to judge the quality of a decision by the ultimate consequence is a simple concept.  In many instances it is also a prudent one; results often provide a useful gauge of the value of the actions that led to them.  However, as with many things, once you add a healthy dose of randomness things start to become problematic.

“A good decision cannot guarantee a good outcome. All real decisions are made under uncertainty. A decision is therefore a bet, and evaluating it as good or not must depend on the stake and the odds, not on the outcome”[iii] (Ward Edwards)

Financial markets are the perfect breeding ground for outcome bias – results are obvious and easy to obtain, whilst judging process and decision quality is incredibly difficult, which means we rely heavily on the former.  We also grossly understate the sheer level of unpredictability, largely due to the wonders of hindsight bias and our susceptibility to a compelling narrative.

In reality, our faith in the information provided by any outcome, should be scaled by the amount of luck there is involved.  In certain endeavours results provide a good measure of decision quality; in others we hugely exaggerate the importance of outcomes.

Take chess as an example; it is a heavily structured game, dominated by skill, not chance, and with limited luck or randomness in its results.  If I played 100 chess matches with Magnus Carlsen, I would lose each one and these outcomes would prove an excellent indication of our relative abilities.  You wouldn’t need to watch each match to know this. Outcome bias is rarely a problem in such activities.

Now imagine that I had to enter a portfolio management competition against my seven year old son, where we each had to pick a portfolio of 30 stocks.  As much as I might like to believe that I would hold a significant advantage, I know the probability of my selections outperforming his over a single year are not much greater than 50%.  Whilst the odds may tilt in my favour as the time horizon extends there are no guarantees – maybe he has picked some stocks that go on to enjoy dramatic growth, or given his portfolio a factor tilt that is in vogue for a number of years.  Not only am I faced with prospect of my diligent investment decision making being improved upon by the haphazard selections of a child, but outcome bias means that my son’s investment success may see him appearing on Bloomberg and asked to give his opinion on the Fed’s next move.

Despite the problems of using results as a barometer of decision quality, it remains endemic in investment.  We use outcomes as a simple indicator and then weave narratives around these views. We take a difficult problem, simplify it (are results good or bad?) and then create a story to justify the outcome.  This pattern of behaviour is evident in a range of poor investment decisions, such as: susceptibility to financial frauds, participation in investment bubbles, performance chasing and excessive short-term trading.

There is an increasing drive by financial regulators to assess the value for money provided by investment professionals by using simple comparative performance metrics, whilst this is an understandable approach to dealing with a fiendishly difficult problem; it creates a situation where a fluky dart thrower is often perceived to have offered a superior service to someone diligent yet unfortunate.  These issues are also why performance fees for actively managed funds are so problematic – they egregiously reward the lucky and pay little heed to process or conscientiousness.   There are no easy solutions here but being a beholden to outcomes alone is by no means a panacea.

In an investment context it actually seems wrong to refer to outcome bias; rather we should talk about the outcome heuristic.  That is we use outcomes as a mental shortcut to simplify a highly complex and inherently unpredictable task.  The use of rules of thumb is smart and effective in some domains, using outcomes as a proxy for sound decision making in investment is anything but.

[i] Gino, F., Moore, D. A., & Bazerman, M. H. (2009). No harm, no foul: The outcome bias in ethical judgments.

[ii] Baron, J., & Hershey, J. C. (1988). Outcome bias in decision evaluation. Journal of personality and social psychology, 54(4), 569.

[iii] Vlek, C., Edwards, W., Kiss, I., Majone, G., & Toda, M. (1984). What constitutes” a good decision”?. Acta Psychologica.

 

There is an excellent conversation detailed on the Farnam Street website between Shane Parrish and Adam Robinson about stupidity[i]; in particular, why we make decisions that seemingly lack intelligence, common sense or both.  I was particularly taken with the definition used for stupidity:

“Stupidity is overlooking or dismissing conspicuously crucial information.”

This clearly has resonance when we consider investment decision making – although financial markets are awash with randomness and uncertainty, there are obvious, vital and, often simple, cues that as investors we seemingly choose to ignore or disregard.  This results in poor choices and often disappointing outcomes.

We know that buying assets or funds after unusually strong performance is typically a bad idea, yet we still do it.  We understand the challenges of short-term trading and the benefits of long-term compounding, but can rarely resist the urge to react to what is happening right now.  These issues are not hidden from our view and they are paramount to our overall investment outcomes yet we often neglect them – but why?

Robinson notes seven factors, which can create situations where stupidity can flourish.  I consider each of these from an investment perspective below, whilst adding two additional issues, which I believe can also lead us toward ‘sub-optimal’ investment decisions:

– Outside circle of competence: Economists predicting equity market moves, stock picking fund managers pontificating about macro-economics, amateur investors day trading.  There are seemingly no boundaries in investment – if you are involved then you can (and must) have a view on every aspect.  Investing is difficult enough without making decisions in areas in which you have no discernible skill, or where there is no evidence of anyone exhibiting consistently high levels of skill.

– Stress:  If we engage with the constantly shifting narratives and random price fluctuations of financial markets it is almost inevitable that pressure and anxiety will lead us into decisions that are detrimental to our long-term goals.

– Rushing or urgency: The hyperbolic and frenetic reporting around financial news means that we often feel the urge to act immediately.  We make decisions that will make us feel good in the very short-term, but come with a significant long-term cost.

– Outcome fixation: The problem of outcome bias is particularly pernicious in financial markets – this is because of the inherent level of randomness in results (particularly over short-time periods) which means that sensible decisions can often appear quite the reverse. Sometimes stupidity is rewarded.

– Information overload: There is simply too much noise in investment markets.  It is a struggle to work out which information is relevant (the vast majority of it is not) or how we should use it.  Given the sheer volume of data, our tendency is to react to it in an unpredictable fashion – considering information to be pertinent based on its salience, prominence, or availability.

– Group / social cohesion: We often make investment decisions in a group context, and what other people are doing matters greatly to us.  Even if their judgements are seemingly irrational we will often seek to conform.

– Presence of authority (expertise): Perhaps in no other field do we behold such an array of experts.  Each offers confident forecasts and compelling trade ideas – they are intelligent and confident, surely we should follow them?

– Overconfidence / Ego: We are often aware of the crucial information, but do not believe it applies to us.  Even where the odds are stacked against us, we feel we have an uncanny ability to overcome them.

– External justification: For professionals to justify their role and fees we must be seen to act frequently, being a busy fool is often more highly valued than ‘doing nothing’.

There is possibly no more fruitful setting for stupid decisions than financial markets.  Not only does the decision making environment lure us into mistakes, but the feedback we get is erratic.  Stupid decisions sometimes work and work enough to keep us coming back (like a slot machine giving you enough small wins to keep you interested). Furthermore, for every sensible investment rule there are inevitable exceptions – survivorship bias and tiny samples (n=1)  make us believe that either the evidence is erroneous or that we are the exception. We are not.

[i] https://fs.blog/2019/01/how-not-to-be-stupid/