Are You Allured by That Active Fund Manager’s Great Performance Last Year?

“Almost everyone’s instinct is to be overconfident and read way too much into a hot or cold streak.”
–Nate Silver

When I was at West Point, the powers-that-be decided that it was a good idea to offer all of the juniors a $14,000 loan at a low interest rate. It was called the cow loan, or more commonly, the car loan, since most people who took the loan bought themselves nice new cars. Since I already had a trusty beater, I wasn’t particularly concerned about getting another car, especially since we could only drive after classes when we didn’t have drill or intramurals or on the weekends, and only when we were seniors. Utility / cost = low number.

Instead, I decided that I’d try to do the responsible thing and invest the money into mutual funds. This was back in 1994, when there simply weren’t many indexed funds around, and I certainly had never heard of indexing in the first place. So, I called up my bank and asked if I could invest with them. They sent me a bunch of prospectuses (prospecti?) from their funds and I divvied up my $14,000 and invested in four funds.

How did I choose the funds?

I picked the four funds that had the highest performance in the recent past.

I figured, like most people would, that if the fund manager did well the previous year, he was probably going to do well in the next year.

The market went up the next year, and so did my funds. I can’t remember now if the funds actually outperformed the market, but they went up, so I was happy. In fact, I was convinced that, because I’d picked funds that performed well, I knew what I was doing in the stock market, planting the seed that would later become the investing story I tell in “Get Rich (Somewhat) Quick.”

Unfortunately, as research from Arizona State’s Zhen Shi and Na Wang show, I had fallen for the Twin Terrors of investing behavioral biases. Actually, it’s one behavioral bias, which we’ll explain momentarily, but that one bias creates a terrible hydra that will do its utmost to consume your portfolio.

What is this bias?

How the Attribution Bias Attrits Your Portfolio

Attribution bias is, in a nutshell, our tendency to use the wrong causes to explain outcomes. It has several biases that fall under the overall umbrella of attribution bias. In summary, Monkey Brain likes to think that people act because that’s the way that they are, as opposed to because something might have caused those people to act the way that they did. But, when he looks in the mirror, Monkey Brain will ascribe good outcomes to what we did and bad outcomes to anything but us.

For those of you who are new to us, Monkey Brain is what I call our limbic system. Once upon a time, when woolly mammoths roamed the plains, we lived hand to mouth and just focused on survival every day. We needed to quickly determine whether to run from the mammoth or to try to kill and eat it. We didn’t have time to ponder the philosophical underpinnings of mammothery, because if we hesitated, we were lost. Thus, our limbic systems ruled the roost. Once we settled down and became civilized, we were able to think about a future beyond the next 30 minutes, and our prefrontal cortices took over. However, the limbic system didn’t go down without a fight, and often those “inexplicable” behaviors that cause us to do what we know we shouldn’t do can be explained by our limbic systems – the same part of the brain that monkeys have. Hence, I call your limbic system Monkey Brain.

Attribution bias in our own investments

When we invest money, particularly when we invest in something other than passive indexing, we are taking a bet on our own skill. At least, that’s what we tell ourselves. However, as the previously mentioned research shows, when we invest in a bull market and our investments go up, we fall prey to an attribution bias called the self-serving bias. The self-serving bias means that when something goes right, we look in the mirror, beat our chests, eat a banana, and tell ourselves how smart we are. We refuse to acknowledge that, perhaps, we got caught up in the rising tide of a bull market that lifts all ships, and we were just fortunate to invest in a good time to invest rather than being skillful.

Because we see our portfolios going up, we become overconfident about our own abilities.

In a bull market, we can fall victim to attribution bias, thinking that we were the ones who did something good, not just playing in a rising market or getting lucky.

When we fall for attribution bias, we think that we’re better than we are. We become overconfident. We trade more. Shi and Wang’s data shows that investors trade more in a bull market. They also buy more stocks rather than selling, and they get bitten in the rear end by their confidence. One month after the additional trades, their buys underperform their sells (meaning that they sold a stock that winds up outperforming the stock they bought) by 0.47%, and three months later, their trades have cost them 0.75%. That’s $750 worse per $100,000 invested.

Self-serving bias has another side, though, which is also borne out in the research. When things don’t go well for us, we ascribe the cause to anything other than ourselves – in a bear market, we say that we lost money because it was a bear market rather than because we’re not good at trading. We trade less because we’re afraid of the market, and, as a result, statistically perform the same in buying and selling.

But, individual traders aren’t the only ones who fall prey to attribution bias.

How fundamental attribution error affects actively managed mutual funds

Fundamental attribution error is a cousin to self-serving bias; they are both forms of attribution biases. When we commit a fundamental attribution error, we think that who or what a person is causes them to act a certain way rather than the circumstances causing them to do something. The classical demonstration of this bias is when students were told to read two essays: a pro-Castro essay and an anti-Castro essay (regarding Cuban dictator Fidel Castro). When told that the writers volunteered to write the essays, the students expressed favoritism towards the anti-Castro writer. However, when told that the writers flipped a coin to determine who wrote which essay, the students did not change their attitudes about the quality of the work. They failed to take into account the circumstances that caused the writers to write their essays and, instead, assumed that one was pro-Castro and the other was anti-Castro.

When we look at actively managed mutual funds, Monkey Brain makes the same error. When he looks at a list of the managers who performed the best in the past year, he simply assumes that they’re good managers rather than taking into account the high probability that they were simply lucky.

Furthermore, the active fund manager who did well the year before is going to see a surge of money coming into the fund. He’ll be tempted by the self-attribution bias to think that he has the investing Midas touch, and he’ll trade more, particularly since he now has all of this extra money to put to work.

So, instead of simply reverting back to the mean, these fund managers are courting disaster by overtrading.

The subsequent performance shows. The top ¼ of funds between 2002 and 2006 then, in the following five years, fell dramatically. Only 18% of them stayed in the top half of performance. 67% of them were in the bottom half.

The smart math whizzes out there will wonder why those two numbers don’t add up to 100%.

It’s because the other 15% didn’t survive.

Top of the world to kicked to the curb. Ouch.

If you want to play with the data yourself, it’s available here.

So, when you’re tempted to either trade yourself or to follow the “hot hand” in actively managed funds, think twice. Objects in the rearview mirror may be distorted.

Do you think you can ride a hot hand in investing? Let’s talk about it in the comments below!