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Last Updated : Oct 28, 2020 10:53 AM IST | Source: Moneycontrol.com

How personal biases and random fund manager actions can hurt your investment decisions

Many naïve investors love to assume the role of an analyst and make investing decisions by themselves with the available data

Nirav R Karkera

“In 2060, the US will have a president who will serve till he is assassinated by a gunshot to the head on a Friday. The President, during his lifetime, will be concerned about civil rights and will be succeeded by his Vice President. The Vice President will hail from the South and has already taken birth in 2008. The Vice President will have ‘Johnson’ as a part of his name.”

No, this is not an attempt at prophecy. Here is a line of thought and information that lead to this forecast.

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Abraham Lincoln was elected to the congress in 1846 and made President in 1860. Exactly a century later, in 1946, John F. Kennedy was elected to the congress and assumed Presidential responsibilities in 1960.  Both were assassinated by a gunshot to the head on a Friday. During their lifetime, both have been actively concerned about civil rights. Both were succeeded by their Vice Presidents who were Southerners. Andrew Johnson (Lincoln’s successor) was born in 1808 and Lyndon Johnson (Kennedy’s successor) was born in 1908 – again, exactly 100 years apart!

Hence, given the evidence that history repeats itself (at least in the case of US Presidents) every hundred years, the next repetition is scheduled for the election year 2060!

Is the forecast, in fact, logical? Or is it all simple coincidence? There are just too many correlated data points leading up to a common premise. It sure must be more than mere coincidence. Or is it?

Hold onto the thought.

Cut to the Texas Sharpshooter’s deal.

The Texas Sharpshooter is a logical fallacy that draws upon a metaphor where a gunman in Texas fires random gunshots to the side of a barn and then goes on to paint a bull’s eye around the tightest cluster of gunshot holes. Visitors, unaware of the sequence of events, marvel at the gunman’s shooting skills. The gunman goes on to be revered as an accomplished sharpshooter.

The Texas Sharpshooter fallacy, also called as a clustering illusion, talks about how the human mind forces itself to find similarities that can be attributed to a common cause, while completely ignoring the differences and turning a blind eye to the probability of randomness.

Many naïve investors love to assume the role of an analyst and make investing decisions by themselves with the available data. Most would look at how funds have performed across trailing periods of one, three, five and ten-year periods and, in some cases, since inception. Typically, the funds that continue to appear in the arbitrarily decided top ranks across periods will be considered to be high performers. Sounds like hindsight bias, no?

Next, some would try to even look up the ratings issued to the funds by a couple of agencies. Here, it doesn’t matter what the fund is rated as long as there are a few stars against its name. Enter confirmation bias.

The entire exercise, whether done by an investor himself or done by an acquaintance attempting to sell an idea, will be based on cherry-picked clusters of information. When aligned, these select clusters of information will paint the picture the proposer wants the consumer to perceive.

Claiming credit for outcomes

It is possible that some investment managers would have been able to book profits and perhaps hedge some positions just before the 2008 Global Financial Crisis – either because he was lucky or as a part of standard fund management process. But here’s the surprising element: every single investment manager who, either through luck or process, managed to book profits before the crisis hit will claim to have predicted the crisis!

You know, it is possible to paint a bull’s eye around random gunshots.

The biggest mistake that an investor can make is believe that the same process, strategy or manager will be able to circumvent the next financial crisis.

Remember the way we attempted to predict the 2060 US Presidential election?

At the heart of the fallacy is a combination of deeper cognitive biases. If hindsight bias and confirmation bias had a child, it must be the Texas Sharpshooter.

The Texas Sharpshooter fallacy applies to all walks of life, including personal, professional and investment decisions where random events are forcibly perceived as coherent strategies. Like almost every other cognitive bias, even this fallacy results in a high degree of disillusionment and decisions based on hazy perceptions.

Investors can avoid falling for this fallacy by improving their conceptual understanding of the subject matter, gaining access to high-quality information, and setting rules for objective evaluation.

 (The author is Head - Research at fisdom)
First Published on Oct 28, 2020 10:53 am
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