Beware of outcome bias while investing

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Beware of outcome bias: Focusing on process pays higher dividends

There is a human tendency to focus entirely on the outcome and not on the process. Someone scoring good marks, someone winning a game, election, fight, etc. has a lot to do with overall context under which the results came. Many times we underestimate the power of context which plays a major role in driving any kind of outcome. Many people also avoid understanding the context because in most cases it requires time and effort.

OUTCOME BIAS

We see on a day to day basis in our lives that how media hype the outcome and create narratives that may not be necessarily played a major role in the outcome. Let us see some examples to understand this subject.

Shweta has appeared for an entrance examination held by one of the colleges. She secured national level rank and immediately the media rushed in for the interviews to inquire about her preparation strategies and tips for students appearing for the exam next year. But the reality is that just a day before the exam, Shweta studied some sample papers from not so popular coaching class close to her house from which, coincidently, 90% of the paper came as it is. Luck also played a major role in what Shweta had scored. This is an example of outcome bias where the media is hyped about the outcome instead of the process that led to the outcome.

In another example, two friends Deepak and Ravi decided to invest in the stock market which was rising rapidly. Deepak came to know that one of his managers in his software company is getting huge returns from the market in a very short span by putting money in small caps.

Deepak suggested Ravi that they replicate the portfolio of his manager so that they can also reap huge benefits. Ravi declined the proposal by stating that the manager might be making profits in the stocks because of randomness & luck and they should take help of a professional adviser.

“Since a rising tide lifts all the boats, even junk stocks appear gold during market euphoria”

Deepak decided to replicate his manager’s portfolio whereas Ravi took the help of a professional adviser. When the tide turned, Deepak saw his portfolio value declining by 70% of the original investment amount whereas Ravi‘s portfolio suffered only a 10% loss. This tendency of Deepak to wrongly contribute his manager’s success to skill and underestimating the role of randomness is referred to as Outcome Bias.

 Therefore, it is always advisable to invest based on a well-defined process and not solely on the outcome. The outcome of the investment returns in the past depends on the process and other market dynamics which may or may not repeat. Unfortunately, the single most factor investor focuses on deciding to invest in a mutual fund scheme is its past performance while paying no attention to understand the process that leads to those returns and if the environment is favorable for the same process in future. Thus, focusing only on past performance and not understanding the process could be a misleading indicator of future returns.

To avoid the outcome bias investors should be aware of the randomness in the market. They should resist the tendency to invest when the market is overvalued and redeem when the market has crashed. Establishing an investment philosophy and investment process based on thorough research & testing will help investors make the right investment decisions.

For a further understanding of the concept, watch the video below by Rolf Dobelli, author of the book “Art of thinking clearly”.

 

Good Read: Do you need social proof to invest?

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