One Crucial Investing Mistake We All Might Commit

Imagine this. You’re in the swankiest casino in town with your best pal at the Blackjack table. The objective of the game is for a player to hit 21 points with five cards or less – you’ll lose if you exceed the point limit.

Every player’s given two cards at the start of a round, after which they decide on drawing more cards, or just keeping their hand. Your best pal, incidentally, has being dealt two 9s in his initial-hand for a total of 18 points. He feels lucky and decides to ask for a third card… and gets dealt a 3!

He makes 21 and wins the game! Everyone else around him pats him on the back for a job well done. But as a true friend, you’ll likely have chided him lightly for making a poor decision.

“Sure, you got lucky this time”, you tell your friend. “But what are the odds of making such a winning hand again, when the probability of drawing a card that will bust your hand is so much higher (any card with a face value higher or equal to 4 would have done the trick)?”

Most of you will likely read the above imagined-scenario and nod in agreement as you know the importance of stacking the odds in one’s favour in games that involve luck and chance, like Blackjack.

You know very well that your friend should not mistake luck for skill in subsequent hands; a continued-insistence on drawing cards when he already has 18 points in the long-run will only make him the swanky casino’s favourite client.

But, not many of us might realise that we are actually committing the same error of mistaking luck for skill in many other areas in life (which contrary to some beliefs, involve elements of luck), such as in business deals; in ethical decisions; and crucially, in the stock market.

Our Weird Brains

In a paper released by Swiss bank Credit Suisse titled Outcome Bias and the Interpreter: How Our Minds Confuse Skill and Luck, the authors Michael Mauboussin and Dan Callahan sought to explain the phenomenon that’s evident in the title.

Basically, we are hardwired in our minds to have an outcome-bias. When we’re assessing the decision made by a person, we often “take outcomes into account in a way that is irrelevant to the true quality of the decision.”

But what has this got to do with the stock market?

Let’s consider an experiment described in the paper. A bunch of finance students, who were schooled about randomness, were told that they would be receiving a certain pay-off in the outcome between two guessers who would be calling five coin tosses.

The first guesser had made correct calls in all five coin-tosses in a previous round. The second guesser had got his guesses all wrong. The finance students were first given $10 and told that they would receive $4 for a correct call, and lose $2 for an incorrect call based on the guesser they were assigned to.

All the finance students were automatically assigned to the second guesser but they were allowed to pay a fee (from the $10 they received) to change to the first guesser.

Now, it should make intuitive-sense that the first guesser was not any better than the second guesser in calling coin-tosses – their previous ‘good’ and ‘bad’ performance was purely an act of luck. There was no real financial incentive to switch between guessers.

But, these finance students paid an average of $3 to make the switch from the second guesser to the first guesser – that is clearly the outcome bias at work!

In the words of Mauboussin and Callahan, “our minds see an outcome and infer that the person making the decision has good or bad skill.” And this really is caused by a powerful agent in our minds that’s termed as the Interpreter by the authors.

In the paper, the authors talk about the Interpreter that’s present in the left hemisphere of our brains. It is the Interpreter that automatically tries to find a causal link with every phenomenon that it observes. And, it is a force that affects us all daily.

How our weird brains harms our investments

Coming back to the stock market, it does contain elements of luck, which allows the outcome bias to have negative impacts on investors’ decisions.

The outcome bias is what leads investors to blindly chase funds that have done well. They see good performance (the outcome), spin up a story automatically in their heads about how the good performance must be evidence of skill (the Interpreter at work), and then decide to plough their money into the fund after mistakenly equating good performance with good skill (the outcome bias).

This harms investors’ wallets, when according to Mauboussin and Callahan, “research shows that individual investors, on average, would have earned one percentage point more in returns if they had simply stayed put with their prior investments versus switching to new ones.”

What we can do to keep the outcome bias at bay

According to Mauboussin and Callahan, for activities that involve an element of luck – like investing in the stock market, for instance – a focus on the process is of vital importance to keep the outcome bias at bay.

There are some simple and crude guidelines on what’s really important in investing, such as a focus on the long-term and buying stocks at cheap valuations. And, those are the processes investors should focus on.

Let’s take Blumont Group (SGX: A33) and Asiasons Capital (SGX: 5ET) as an example.

The former had rose an astounding 3980% in slightly more than a year from six cents a share on Aug 2012 to S$2.45 on Sep 2013; the latter’s price grew 197% in just nineteen days from 1 Sep 2013 to 19 Sep 2013.

Punters who managed to catch even part of the rise in both shares and thought that they had the skill to continue riding the wave based on the outcome alone, might have been left holding the bag when both shares eventually lost more than 90% of their value in three trading days between 4 Oct 2013 and 8 Oct 2013.

Needless to say, the superlative short-term returns from both shares prior to their collapse would have trounced any of the Straits Times Index’s (SGX: ^STI) gains by a huge margin. But, a quick-glance at both companies’ valuations would have raised red-flags for a process-driven investor, regardless of how well their shares had done.

Near their peaks, Blumont’s shares were valued at 500 times trailing earnings and 60 times its book value while Asiasons’ shares carried a price earnings ratio of 583 times. Those are just absurd numbers, to put it mildly.

Foolish Bottom Line

Our minds have a marvellous capacity to imagine and create. But at the same time, it can cause great harm to our financial well-being. If you find yourself cheering every time your shares go up over the short-term (or raise your fists in anger each time your shares start dipping) without any fundamental changes in the business, you’re likely to be outcome-biased.

We all might have committed this mistake at some point, but it’s never too late to change.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chong Ser Jing doesn’t own shares in any companies mentioned.