Outcome Bias, Diversification, Data, & Your Investments

By LRG Wealth Advisors on October 29, 2019

“Be fearful when others are greedy and greedy when others are fearful.” – Warren Buffett

The above quote from the Oracle of Omaha, Warren Buffett, begins most of our research notes because it reminds us of the strategy the wealthy used to get wealthy and the strategy the wealthy use to stay wealthy. Unfortunately, generations of learned behavior and genetic coding taught us humans the survival instincts that compel us to:

• Flee danger;
• Find protection in crowds.

When hunted, these instincts served us well. When investing, they harm us, often irreparably. Data irrefutably teach us that opportunities abound in danger and that the crowds, often, get ‘it’ wrong. Fighting our instincts requires work, trust, and rugged individualism. When investing, safety in numbers will not provide the result one desires.

Only the rare investor heeds the Oracle of Omaha’s sage advice. Many investors, unfortunately, do the opposite of Warren’s advice. For the rest of us, diversification allows us to hold risk assets through the inevitable large, negative market event. We find it curious that at market tops when storm clouds abound, investors lose interest in diversifying strategies [anti-Oracle thinking]. I suppose they feel that a lost opportunity does not justify the cost. An analogy may illustrate the irrationality of abandoning diversifying strategies:

We accept as gospel that wearing seatbelts saves lives. I am old enough to remember that until governments legislated wearing seatbelts, most drivers and passengers did not use them! That seems absurd today. But according to Quora, the average drive results in an accident 5.6% of the time. That seems higher than I would have thought, so I’m glad I wear my seatbelt. However, most of us do not wear our seatbelt in a taxi or in an Uber or a Lyft. Do we assume that our Lyft driver is a professional, so it’s safer? Is it a stretch, then, to believe that most would not wear their seatbelt were it not for the ubiquitous “Click It or Ticket” signs I see in New York warning of financial consequences of ignoring seatbelt laws? After all, most passengers in the rear of a taxi or ride hailing service automobile have no financial consequences for going unbelted, so they do not, generally, heed the accident data.

I find the parallel to abandoning diversifying strategies eerily similar. After markets have a long bull market run with significant signs of worry, I liken this behavior to the unbelted courage teenagers had in my 1970’s youth while drinking and driving at elevated speeds. It did not always end badly, but when it did… Might a portfolio that may face a high probability negative event benefit from diversification [i.e. wearing a seatbelt], even if it reduces performance?

Outcome bias drives investors to chase performance because they fail to grasp that choosing the high probability outcome does not ensure the outcome the odds predict. Instead, investors draw false conclusions that fly in the face of data. And while this may work in the short term, luck, over a long period of time, does not a sound investment strategy make.

Outcome bias arises when a decision is based on the outcome of previous events, without regard to how the past events developed. Outcome bias does not involve analysis of factors that lead to a previous event, and instead de-emphasizes the events preceding the outcomes and overemphasizes the outcome.

Annie Duke, the author of Thinking In Bets, refers to outcome bias as “resulting.” Perhaps the most accessible example that outlines the danger of resulting occurred in Super Bowl XLIX when the New England Patriots improbably thwarted the Seattle Seahawks imminent touchdown by intercepting the most maligned pass in the history of the Super Bowl and went on to win their 5th Super Bowl title. But what if the data showed that Seattle Seahawks head coach, Pete Carroll, made the correct choice based on the data? We know the result, but the data argue strongly that Pete Carroll made the correct play call. Don’t believe me? Have a listen to Annie Duke discuss the data that led Coach Carroll to make the correct call that resulted in an inauspicious result: Thinking in Bets with Poker Star Annie Duke.

Clearly, Seahawks ownership agreed with Pete’s call as he continues coaching the team today despite making the “worst,” read ‘outcome bias,’ play call in Super Bowl history. If you diversified your portfolio in the face of a high probability negative event that ultimately did not occur, and the diversifying elements negatively affected performance, will you succumb to outcome bias?

One final example should drive the intended point home. In March 2009, no one, and I mean no one, wanted to own stocks, but had you invested in the S&P 500 Index on March 1, 2009, you would have received an annual return of 16.029% through August 2019.¹ A similar investment for the same time frame in 10-year U.S. Treasury Notes returned an annual return of +3.259%.² Let’s compare that to your investment return in the S&P 500 Index on July 1, 2000 through February 2009 of -5.137%¹ and that of 10-year Treasury Notes for the same time frame of +6.516%.²

With 31+ years of investment advisory and management experience, I remember quite well that in the summer of 2000, clients sold the diversifying, risk reducing fixed income part of their portfolios for the high growth, “can’t miss” stocks of that day. Most abandoned stocks by the fall of 2002 when the stock markets bottomed. They returned to risk assets just in time for the Great Financial Recession. These same investors, again, abandoned stocks in 2008-2009 for the safety and diversifying characteristics of bonds as stocks began their new bull phase. You see, in the spring of 2000 and the winter of 2008, markets flashed nearly the identical warning signs they flash today. And clients argued against diversification, as they do today.

Today, we see four serious storm clouds that inform our cautious stance in portfolios and explain our desire to own seemingly performance killing diversifying investments:

1. Persistently Inverted Federal Funds to 10-year Treasury Note Yield Curve [March 28, 2019 to date]
2. A Decelerating Profits Cycle [3Q 2019 forecasted to show negative year over year growth]
3. Exuberant Risk Taking [private equity assets under management at all-time highs and valuations greater than those of the Russell 2000 Small Capitalization Index]
4. Uncertain Regulatory and Policy Landscape [tariffs, interest rates, etc.]

These troublesome data points raise the probability of a significant market correction. These data do not guarantee a significant market correction, but the odds favor that outcome. Ask yourself if you heed the sage wisdom of the Oracle of Omaha because most investors do not clamor to invest in stocks at the beginning of new bull markets. Investors do not question the benefits of the safe assets at market bottoms they shunned at market tops. By definition, a diversifying asset should not perform well when your risk assets perform well. If the alarming data does not lead to a bear market, and this time, truly, it is different, will you react based on outcome bias?

You hired LRG Wealth Advisors to prudently invest your treasure with probity and our clear-headed, assessment of the risks and rewards open to you in a risk appropriate fashion. Doing that well will sometimes result in short term under performance so that one reaps the long term rewards the investment markets provide. Listen to Warren Buffett; avoid the long-term performance destroying nature of outcome bias; and most importantly, remember that it’s not the money, but what the money will do for your family and you. Thank you for your attention and confidence.

 1. https://dqydj.com/sp-500-historical-return-calculator/

2 https://dqydj.com/treasury-return-calculator/