The placebo effect is both fascinating and real, with compelling evidence of its impact in both a medical and marketing context.  Whilst it is in these areas that discussion around placebos tends to focus; the notion that something can make us feel better, even if there is no logical reason for it do so, seems relevant to much investment activity.

The definition of the ‘placebo effect’ from Google is as follows:

“A beneficial effect produced by a placebo drug or treatment, which cannot be attributed to the properties of the placebo itself, and must therefore be due to the patient’s belief in that treatment”.

We can reframe this slightly and create an ‘investment placebo’:

“A beneficial effect felt by an investor by a certain investment activity, which is unlikely to be attributed to the properties of the action itself, and must therefore be due the investor’s belief in that activity”.

What kind of activities might be captured by the above definition (not a definitive list):

– Short-term trading / market timing.

– Trading on macro-economic news.

– Performance chasing in active mutual funds.

The idea of an investment placebo is somewhat distinct from that which is widely discussed in medicine[i] or marketing[ii] – the activity or treatment undertaken in investment is not designed to be inert, rather on average such activities are likely to have a negligible or, indeed, negative impact.  Furthermore, placebos in other areas can actually deliver positive end outcomes – patients can experience improved health following such treatments and consumers get greater enjoyment from drinking a more expensive wine.  In investments, these ineffective activities do not assist in us meeting our end objectives, but simply make us feel better at the time they are administered.

But why do certain investment actions make us feel better, even when there is limited evidence that they will have a positive impact on our long-run outcomes? There are a multitude of factors at play here, but one interesting notion is the idea of an action bias, the phenomenon where in certain situations opting for action over inaction is heavily favoured. As an example of this, a group of psychologists studied the behaviour of goalkeepers during penalty kicks in football (soccer) and found that goalkeepers tend to jump left or right in order to save the penalty, wherein the optimal strategy is to stay in the middle of the goal[iii].

The researchers in the study argue that the tendency of the goalkeepers to dive in a certain direction is because the norm is for action, and their experience of a bad outcome (conceding a goal from the penalty kick) would be worse if they had ignored the norm and simply stood in the centre of the goal.  It would appear as if they did not take any action to prevent the bad outcome.

Now, I think there is a problem with this study – it argues that the best decision for a goalkeeper is not to move (they would save more penalties if they stood stock-still).  This is, however, founded upon the assumption that the penalty taker has not decided to kick the ball into the centre of the goal after seeing the goalkeeper move first.  In fact it is common for high quality penalty takers to wait for the goalkeeper to move and then strike the ball.

Even with this caveat*, the study makes a valid point about behavioural norms and how, in certain situations, we will view the simple act of doing something more favourably than doing nothing, despite there often being no compelling evidence that such activity will be beneficial to us.

In the investment industry, it seems irrefutable that there is a preference for action over inaction – amidst the incessant newsflow, erratic price fluctuations and obsession with the latest headline risk, the urge to do something can be irresistible – what if I miss out?  What if things go wrong and I have done nothing? How can I just sit here when all of this is happening? What will clients think?

The stress and anxiety created by such an environment mean that actions of questionable validity (on average) can prove a powerful short-term ameliorative – making changes based on what is happening now will likely feel good, for a time. The problem is they will often come at a long-term cost.

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* Never let reality get in the way of an academic reference.

[i] http://sitn.hms.harvard.edu/flash/2016/just-sugar-pill-placebo-effect-real/

[ii] Shiv, B., Carmon, Z., & Ariely, D. (2005). Placebo effects of marketing actions: Consumers may get what they pay for. Journal of marketing Research, 42(4), 383-393.

[iii] Bar-Eli, M., Azar, O. H., Ritov, I., Keidar-Levin, Y., & Schein, G. (2007). Action bias among elite soccer goalkeepers: The case of penalty kicks. Journal of economic psychology, 28(5), 606-621.

For the purposes of this post, I will ask you to suspend your disbelief for a few minutes.

Assume I am talented fund selector and can differentiate between skilful* and unskilful active fund managers with a 65% success rate**.  I have an investable universe containing 500 active funds.  Of these 500 funds, 30% of the managers possess skill (if only).  If I select a manager from this universe, what is the probability that I can correctly identify whether they have skill?

There are four possible scenarios:

a) The manager has skill, which I correctly identify: 19.5% chance

b) The manager has skill, which I mistake for no skill: 10.5% chance

c) The manager has no skill which I correctly identify: 45.5% chance

d) The manager has no skill, which I mistake for skill: 24.5% chance

Despite having an edge in the identification of skill in active management, and the universe having a reasonably high proportion of skilful operators (compared to certain areas), the probability of me achieving my primary goal is only 19.5%.  More concerning is the differential between correctly identifying a skilful manager (a) and incorrectly identifying a manager with no skill as being skilful (d).  There is more chance of a false positive.

The crucial point here is that even if we believe that we have skill in a particular activity, we need to be acutely aware of the environment in which we are operating.   We tend to focus too much on how good we think we are at something when assessing our chances of success, and neglect the importance of the broader backdrop – what we might consider to be an outside view or base rate.  If we are operating in a barren opportunity set then the odds may be stacked against us even if we have expertise – the abundance of gold in a given area matters greatly for the success rate of even a highly skilled prospector.

In this simplified, one shot, example I have neglected a few important elements that are also crucial to success in active manager selection.  I have conflated skill and excess returns – the possession of fund management skill doesn’t necessarily result in the delivery of excess returns; it should certainly increase the probability, but there are no guarantees and the shorter the time horizon the more randomness will be the dominant influence in outcomes.  The possibility of bad luck is not insignificant.

There are also a host of acute behavioural issues that are likely to weigh on our ability to generate excess returns even if we identify a manager with skill***.  We are prone to invest in active managers following an abnormally strong period of returns, and mean reversion may then overwhelm any ‘alpha’ that can be derived from the manager’s skill.  We are also likely to sell at the wrong time – skilful managers will not generate consistent returns and during their more fallow periods the urge to capitulate will often be overwhelming.  Will you continue to believe a manager has skill even if performance is ‘telling you’ otherwise?

Even if you do not agree with the numbers I have used to create the above scenario; when deciding upon whether to participate in an activity that may involve skill it remains imperative that three issues are addressed:

Opportunity set: How much does skill influence outcomes? What are the chances of success if I have no skill?

Competition: If it is a zero sum game, it is crucial to know who the other competitors are – in the gold prospector example above, how many other people are doing the same thing and how good they are both crucial pieces of information. Michael Mauboussin has written extensively on this[i].

Level of skill: What would be an achievable and positive success rate?

Our tendency is to take an insular approach, focusing on our own perceived level of skill (which is often inflated), whilst ignoring the crucial external factors that will inevitably have a material influence on our outcomes.  This leads to us placing bets when the odds are not in our favour.

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* For the purpose of this post, we can define skill in a very broad sense – fund managers with an approach that directly increases the probability that they can deliver excess returns ahead of their benchmark, other things being equal.

**  It is often said that a ‘hit rate’ for a stock picker above 50% is good enough to deliver excess returns – is this similar for fund selectors?

*** Let’s assume that skill is stable and persistent (even though it isn’t).

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[i] Mauboussin, M. J. (2012). The success equation: Untangling skill and luck in business, sports, and investing. Harvard Business Press.