Finance 101 – The Outcome Bias
Imagine two financial thrill seekers that take their life savings to the casino. They end up at the roulette table, with one betting the house (literally) on black and the other favouring red. One will walk out having doubled their money whilst the other won’t have enough to pay for their bus fare to Centrelink.
Although the subjects of our example made equally foolish decisions, we tend to view the unlucky gambler more harshly than the lucky gambler. This is a result of the outcome bias, where we judge the quality of a decision by its end result rather than by the process used to arrive at the decision. The bias is particularly dangerous for investors, as luck and randomness play an uncomfortably large role in investment performance (e.g. was your average Sydney home buyer in 2010 smart or just lucky?).
When selecting money managers, many investors use recent performance as a proxy for the quality of the product. The issue with this is that a portfolio of stocks chosen by a toddler can outperform a portfolio chosen by Warren Buffett for weeks, months, or even years. In the long run, however, good luck tends to run out, so investors should place higher significance on the strategy and decision making process of a manager than their short-term relative performance.
As our Chief Investment Officer Ashley Owen said in a recent seminar, our goal at Stanford Brown is to help you avoid this guy!