Pop Quiz: Checking our cognitive biases

When we make decisions, our brain takes lots of shortcuts. Kind of makes sense considering our brains operate on about 20 watts. For reference, the dimmest bulb in your house probably uses twice that.

Essentially, our brains have developed shortcuts to reduce computational complexity and still make decently sound decisions. The thing is, we kind of need these biases. If we analyzed every circumstance in high detail as if it was the first time, we would probably be overwhelmed by too much information. These shortcuts are known as cognitive biases.

We tend to operate within a certain paradigm, or rather, an entire collection of beliefs grounded in some key assumptions.  For this article, let’s go read an article on 5 tips in picking mutual funds and see if we can spot the issues. Did you read it? Okay tell me if this sounds a bit crazy.

Testing your cognitive biases

Many studies have found that the average actively managed fund trails its benchmark over long periods. Over the last three years, managers across all domestic stock categories trailed their index, according to S&P Dow Jones Indices.

Doesn’t sound good. Do you really think you can beat the average, or would it be smarter to devise a plan where averages are taken into account? This article acknowledges that over the long term, our mutual fund investments have little chance of beating the indexes. And yet, everyone around us seems to encourage us to buy them.

Even if a fund falls short for a year or two, it may wind up outperforming over a full market cycle, including bull and bear markets. And while there’s no magic formula for picking a winning fund, there are clues that can boost your chances.

This can be read the other way around. For every market cycle we should expect a year or two where the fund falls short. This article presents it as perfectly acceptable, but doesn’t seem to discuss the real effect. If that had shown some numbers how this doesn’t really have a drastic effect, I would be more open to accepting their opinion. But instead they kind of slide by this point and don’t offer any numbers because they aren’t there!

Mutual funds take a hit about every ten years, and the impacts on wealth creation are terrible! Repeated studies show that people panic, sell their holdings, and force mutual fund managers to sell, locking in losses. This causes funds to take hits. And if it’s too bad, the fund is shut down with all assets allocated to another fund. This form of survivor bias tends to hide the real history of how bad mutual funds are. If you go searching for the mutual funds from ten years ago, things don’t appear quite as bleak as they really were, because many of the bad funds have been deleted from history.

Unfortunately, performance data only takes you so far. The evidence is mixed on whether past performance has any predictive value.

Evidence of performance should be a primary component of investment choices! This quote implies that investing is partly based on evidence and partly a matter of luck. Look at the 40-year history of Berkshire Hathaway, which has had 500,000% total growth, and tell me that past performance ISN’T a predictor of future value. So why do mutual funds put that famous clause “past performance is not a prediction of future performance” on every prospectus? Because the underlying practices in managing mutual funds is inherently flawed. People like Warren Buffett, who know what they’re doing, are able to do very well. Or look at real estate, a key investment of the rich, and tell me it it’s a crap shoot. That’s not the case. People that use sound tactics of buying quality property in well researched locations and hold sufficient cash reserves to mitigate risk have a consistently higher wealth building history.

“You’re lucky if you can get three to four years of outperformance,” says Wermers. “Longer term, it’s almost universally found that there’s no persistence in performance.”

And yet, financial advisers keep telling us to invest in mutual funds long term, because they have reduced the risk. This author seems to imply that we should only expect the real growth for 3-4 years. If we are moving investments around every few years, imagine the costs involved. Is this better for us, or the brokers? This is when I remember reading Where are customers’ yachts?  It’s a humorous book written in the 1940s about how only the brokers tend to profit from Wall Street. One astounding and still true point is that even brokers can’t resist their emotions. They make great money in fees, but when the market gets boring, they are prone to invest in the market and let their cognitive biases lose them money.

Did you know people have a strong tendency to jump on a mutual fund after it shoots up. It’s called the bandwagon effect. In investor-speak, we call that buying high. But when fund take a hit, people panic and sell after the drop. That is selling low. Both of these cause your mutual fund performance to nosedive.

Finally, check out that last sentence: longer term, it’s almost universally found that there’s no persistence in performance. If that didn’t leap out at you, then you are still stuck amongst the herd of mutual fund investors.

Funds that don’t mirror their index may be a better bet.

What?!? The article opened pointing out that the average actively-managed fund underperforms the index over the long haul.  If that isn’t a blatant contradiction, I don’t know what is.

Conclusion

This article is full of contradictions. The author implies each tip will help you pick better funds, but each one is laden with caveats that point out how mutual funds are loaded up with luck. If you didn’t stumble over them, it’s a sign of the psychology the sales force of Wall Street has deployed to ease your mind on investing in mutual funds.

The proper way to approach investing in Wall Street is understand the fundamental business you are investing in. Do you really think mutual fund managers read every financial statement from the 100-200 stocks they invest in? Or perhaps they spend more time read charts, looking at stock price statistics, and other things to “guess” how well the stock will do. (BTW, Where are the customers’ yachts? likened stock chart readers to astrologers.)

When Warren Buffett invests in companies, he looks at how they make money. He depends on good CEOs that show evidence of knowing how to run businesses. And he also only buys things he can get a good deal on. To get a glimmer of the evidence-driven manner he makes decision, go and read this year’s letter to the shareholders. Do that, and you’ll probably understand more than many analysts.

Here at the Wealth Building Society, we learn how to shake off Wall Street’s salesmen and instead understand learn the fundamentals of business and other vehicles, instead of depending on others.

Leave a Reply

Your email address will not be published. Required fields are marked *