Ch 2: The art of make believe

Zen and the art of investing – simple stories to understand markets and our reaction to them!

Zen And The Art Of Investing

 

The Art Of Make Believe

Please read each sentence below and make a mental note of how many of them apply to you as a person.

You have a need for other people to like and admire you.

You have a tendency to be critical of yourself.

You have a great deal of unused capacity that you have not turned to your advantage.

While you have some personality weaknesses you are generally able to compensate for them.

Your sexual adjustments have presented a problem for you.

Disciplined and self-controlled on the outside, you tend to be worrisome and insecure on the inside.

At times you have serious doubts as to whether you have made the right decision or done the right thing.

You prefer a certain amount of change and variety and become dissatisfied when hemmed in by restrictions and limitations.

You pride yourself as an independent thinker, and do not accept others’ statements without satisfactory proof.

You have found it unwise to be too frank in revealing yourself to others.

At times you are extroverted, affable, and sociable, while at other times you are introverted, wary, and reserved.

Some of your aspirations tend to be rather unrealistic.

Security is one of your major goals in life.

 

We will come back to the above personality assessment in a bit.

 

It would be unfair to blame the financial commentators for our propensity to transact too often and to lose out on long term returns. A large part of the blame lies with us as we believe in these get rich schemes all too easily – we are the one’s following the advice. As the Pakistani poet, Hafeez Jalandhari, who wrote the lyrics for the National Anthem of Pakistan says –

 

I make up my mind, then I think and break my resolve.

What if this happens, what if this happens?

 

Most of us can be easily swayed by some scenario, some story on how not taking a decision today will cost us – either in foregone profits or even worse in sustained losses. So, we fall into the cycle of “What if’s” and take decisions based on recent stories or anecdotal evidence while discounting the long-term data driven investment strategies.

 

But how easy is it for someone to make us believe in such mumbo-jumbo?

 

Surprisingly easy, as it turns out.

 

In 1948, Bertam R Forer, an American Phycologist ran an experiment on 39 students in his introductory psychology class. He asked the students of his class to complete a personality test and informed them that they would be given a personality assessment as soon as the inputs were analyzed.

 

One week later each student was given a personality assessment with their name on it. Students were asked to rate the accuracy of the assessment on a scale of 1 (not accurate) to 5 (very accurate).

 

As it turns out almost all students found the assessment to be highly accurate about their personality, with an average accuracy score of 4.26.

 

But there was a catch!

 

All students had received the same personality assessment – the same 13 statements that you just read at the beginning. Even more interestingly, the assessment was not designed by Forer. Forer simply stringed together 13 statements from a newspaper’s astrology column.

 

In a paper that Forer wrote about this experiment, The fallacy of personal validation: a classroom validation of gullibility, he notes,

The experiment was performed as an object lesson to demonstrate the tendency to be overly impressed by vague statements and to endow the diagnostician with an unwarranted high degree of insight.

 

This effect named as Forer effect or the Barnum effect shows that people tend to accept generalized descriptions of their personalities without realizing that the same evaluation could apply to nearly anyone else, because people want the results to be true. The experiment has since been repeated many times with the average score being 4.2.

 

Now let’s look at a few sentences randomly selected from some financial dailies.

Back to back strong negative closes are suggesting that at least short-term reversal is in place from Friday’s high of 10,931 levels as Nifty50 was sold off on Monday when it opened with a mild positive tick.

Our growth drivers are in place, we need to work on that and deliver on that. India business is doing well and it will have good double-digit growth growing forward, we have a good presence in the UK and US markets.

XXX and YYYY among 10 stocks that could return up to 9% – 58% in short-to-medium term.

 

None of the above statements are evidence based. These or similar statements will hold true for many stocks and in many market conditions. They are beliefs and expectations but a gullible investor, blinded by 15 – 20% returns, can easily read them as evidence-based statements. For this investor the probability that the upside will manifest will be significantly higher than what past data should lead us to believe.

 

It is not just our gullibility to treat generic statements as insights that we should be worried of.  In a final twist, Forer ran another experiment three weeks later. He told his class that he had erased their names from the rating sheets as he had promised. Forer then mentioned that he would have liked to see how the rating would have correlated to students test score so he would need the students to recall what rating they provided in the personality assessment. As one would expect the rating recall didn’t match the original rating provided, which Forer never really erased. He noted that as many as 50% of ratings that were initially 5 were lowered to 4 and to 3. No one recalled giving a higher rating than initially given. Clearly students were recalling a lower rating to convince themselves that they were not tricked as much as the others.

 

In his paper, Forer elaborates,

When self-esteem is threatened, memory functions operate in such a manner as to avert the threat and enhance self-esteem. Such memory changes are defensive distortion of recall rather than simply forgetting.

 

No wonder all we seem to remember and discuss are our winners. We use selective recall, especially when discussing past returns in a group, to protect and enhance our self-esteem. It might also lead to a feeling of “why is my portfolio not performing as well as everyone else’s?” amongst your friends.

 

Sometimes the “make believe” gets institutionalized.

 

Enter Mutual Fund ratings.

 

Your adviser will tom-tom the 5-star rating of the funds she recommends. Investors look for rating data to decide which funds to buy. A few apps prominently display mutual fund rating information to make it easier for investors to choose funds. All of this would make you believe mutual fund star ratings are a sure shot way to decide which funds to invest in. Look at 5-star Mutual Funds that meet your needs and voila, you are done. Sit back and watch them outperform.

 

There is one problem, though, in the hunky dory Mutual Fund rating story. It is what we call the story of the missing data. To understand this, let’s start with an equally interesting anecdote from World War 2.

 

In World War 2, USA assembled a bunch of statisticians to evaluate which parts of the fighter planes needed more armor. As planes would come back from soirees, they would count which part of the plane (engine, fuselage, etc) had been hit by how many bullet holes.

 

They found that, on the planes that returned, the engine area had 1.11 bullet holes per square foot while the fuselage had 1.73 bullet holes per square foot. The common wisdom was to add more armor where the planes were getting hit more, and since the fuselage was getting hit 1.73 bullet holes per square foot it needed more protection.

 

That’s when a brilliant statistician, Abraham Wald, came with the insight, the extra armor does not go where there are more holes (fuselage), but where there are fewer holes (engine). The insight was simple, planes were able to survive hits on the fuselage and were returning. But those planes which were getting hit more on the engines were not returning at all. The missing planes and the missing holes were the keys to solving the problem.

 

So, what is the missing data in the Mutual Fund star rating show?

 

Say you are the CEO of one of the rating agencies and your Chief Statistician or Chief Information Officer comes to you and says – “Hey boss, we have conclusive data that our 5 star rated funds outperform our 4 star rated funds by 3% annually over a 5-year holding period”.

 

What would you do?

 

You would, of course, publicize this as much as you could, make the ratings very expensive to buy and earn a lot of money from them. Or maybe open your own hedge fund and invest based on your rating methodology.

 

All the rating agencies employ a lot of smart statisticians and investment professionals and if they had the above data, they would be publishing it, updating it and talking about it every quarter. It’s not that they are not looking for this data, it is just that what they have does not show any out performance of higher rated funds. This is the missing data in the Mutual Fund star rating show.

 

If your ratings are so good, where is the data that 5-star funds outperform 4-star funds?

 

So, what do we have instead?

 

Well, Morningstar says,

We have always been very clear that it’s not intended to predict future performance.

 

Similarly, Valueresearch Online says,

The assessment does not reflect Value Research’s opinion of the future potential of any fund. It only gives a quick summary of how a fund has performed historically relative to its peers.

 

Both Morningstar and Value Research Online also disclose that star ratings are completely mathematical with no subjective inputs and represent a fund’s risk-adjusted return over the past 3y and 5y with the best performers receiving 5 Stars.

 

Hmm… so another fancy way to talk about past performance, as if 3y and 5y return and information and Sharpe ratio were not enough. Just like returns then, maybe the rating’s should also come with their own disclosure, Ratings are subject to market risk and past ratings do not predict future returns.

 

The data that exists, confirms that ratings are not predictive of future outperformance. The Wall Street Journal in a review called “The Morningstar Mirage” concluded,

Investors everywhere think a 5-star rating from Morningstar means a mutual fund will be a top performer—it doesn’t.

 

A similar study by Advisor Perspectives finds that the probability that a randomly selected five-star fund will outperform a randomly selected four-star fund is only 50.6%. Essentially a coin flip.

 

If ratings do not predict future returns, and rating agencies universally disclaim that ratings are not predictive, then how did they come to be so important in the Mutual Fund ecosystem?

 

The answer lies in human psychology. No one ever fired an adviser or a broker for recommending a 5-star fund. The ratings then are both a safety net and a shiny badge for the adviser to be sold to the investor. And if a 5-star fund under-performs, well no one else saw that coming. But if you picked a lower rated fund which under-performed, then you are not a good adviser.

 

From the same Wall Street Journal piece,

Advisers get in trouble when they go against the grain. You isolate yourself more if you sell something else rather than just go with what research recommends.

 

Since most advisors go with the grain and recommend 5-star funds, these funds see huge inflows creating reasons for AMC with such funds to unofficially bless the ratings in their own investor materials. And thus, the make believe of the Mutual Fund star rating continues.

What should an investor do? How do we know if the information presented to us has any value or not in improving our future investment results?

A simple rule of thumb is to reduce the evidence to the core. It is easier to explain through some examples –

 

Advisor – Invest in this fund as it is 5 star rated?

Question to ask – Do 5 star rated funds subsequently outperform the market or other lower star rated funds?

 

Advisor – Invest in this fund because this fund manager has a fantastic track record?

Question to ask – Does a fantastic track record predict that the fund manager will continue to beat the market and provide out sized returns in the future? 

 

Advisor – Invest in this fund because it has a long history?

Question to ask – Does a fund with long history subsequently out perform a fund with shorter history? 

 

Advisor – Invest in this fund as it has a large AUM?

Question to ask – Do large AUM funds subsequently outperform small AUM funds?

 

Do you see the pattern?

Advisor – Invest in this fund because of “X”

Question to ask – Does “X” actually predict future out performance for funds?

 

Don’t just ask, do some google research to find out for yourself. You will soon realize that there is enough market research that proves that most “X” that advisers tout, including all of the examples above, don’t actually predict any out performance of the fund in the future.

Happy investing.

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5 Responses

  1. Kshitiz says:

    Quite an informative read.

  2. Raman says:

    Very informative article.. Thanks for giving good insight about star rating of mutual funds.

  3. Nikhil says:

    Interesting. But then how to select the fund? Agreed past performance is no guarantee of future performance. But is there a guarantee anyone can provide?

    If the Indian selectors were to pick the team for the World Cup, how would they pick other than past performance?

    Please do enlighten.

    • Gaurav Rastogi says:

      A very good example. It brings out some good points on how to select a portfolio and of course, has some drawbacks too.

      Good cricket team – the balance of batsmen(openers, middle order, pinch hitters), bowlers (fast, medium, spin)
      Good portfolio – diversification in equity (large cap, international, value) and debt

      The most important thing for a team to win is the ability to play together. That’s covariance in portfolio world or simply put portfolio overlap. 5 Sehwag’s won’t make a good batting lineup. So make sure your equity funds don’t have much overlap amongst themselves.

      Finally, a cricket selector should and will look at past performance because cricketing talent is quite predictable. Good cricketers do not suddenly become bad cricketers and vice versa. But funds do, all the time. Good performing funds fail, and bad performers have a lights out year. This is where the analogy fails.

      For a portfolio, the important things are
      1. Overall Asset allocation (how much should you invest in equity?)
      2. Next level Asset allocation (within equity how much in large-cap, international, value etc)
      3. How do you rebalance over time as you get closer to your goals

      None of these depends on past performance. We hold that in each category buying an index or an index proxy is the best outcome.

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