This post by Michael Pompian first appeared on Morningstar US website.
Let’s explore the effect behavior has on markets and the economy as a whole and how advisers who understand this relationship can work more effectively with their clients.
Outcome bias, an information processing bias, refers to the tendency of individuals to decide to take a course of action based on the outcome of past events, rather than by observing the process by which the outcome came about in order to make a decision.
Here's an example of outcome bias taken from everyday life.
Ann's friends just returned from an amazing tropical beach vacation in Phuket, Thailand. The weather was glorious, full of sunny days, mild temperatures, and calm, crystal-clear water. Ann is enchanted by their stories, so several months later, she decides to go see Phuket for herself. Ann has a miserable time, because she's there during monsoon season when the seas are choppy and it rains almost constantly. She made her decision to visit based on the positive outcome her friends had months earlier, rather than doing her own homework and figuring out the best time of the year to holiday in Thailand. This is a classic example of the outcome bias in action.
The investment implications of outcome bias are that investors can make poor decisions about their investments because they only look at one piece of the puzzle, based on an outcome from the past.
For example, an investor may buy a mutual fund based on its past track record, thinking: "This manager had a fantastic five years; I am going to invest with her." In this case, the investor isn't taking the time to understand the risks the fund manager may have taken to achieve those returns, nor why the returns generated by other managers might not have had such good results over the past five years. Advisers know that investment managers that have produced good returns often experience mean reversion--which means subsequent periods of underperformance. As a result, the investor needs to understand why the manager is performing well to know if performance can persist.
At the macro level, outcome bias occurs ubiquitously--especially at the asset-class level. For example, some investors make a decision to invest in overvalued asset classes based on recent outcomes, such as strong performance in U.S. stocks, real estate, or any other "hot" area. By doing so, they are not paying heed to current asset valuations or past price history of the asset class in question, and as a result, they're exposing themselves to the risk that the asset class may be peaking, which can be hazardous to one's wealth. When thousands and even millions of investors engage in outcome bias, the market can experience bubbles, such as the real estate crisis of 2008 or the internet stock bubble of the late 90s.
One of the most basic mistakes in investing is focusing on the investment outcome without regard to the process used to create the outcome. Investors need to pay attention to valuations and historical prices, not just most recent returns/performance.
Advisers have a great opportunity to gain trust and credibility by steering their clients away from the outcome bias that can lead investors to favor overvalued assets. In short, my advice is to always ensure you and your clients examine the factors that account for an investment's results, consider the process used to create the outcome, and include a longer perspective rather than only recent outcomes.
Michael M. Pompian, CFA, CAIA, CFP, is the founder and chief investment officer of Sunpointe Investments, an investment adviser to family offices based in St. Louis, Missouri. His book, Behavioral Finance and Wealth Management, is helping thousands of financial advisers globally build better relationships with their clients. Contact Michael at michael@sunpointeinvestments.com.