Outcome Bias

This week we are going to examine what is known as Outcome Bias.

According to Michael M. Pompian, author of Behavioral Finance and Wealth Management, “Outcome bias refers to the tendency of individuals to decide to do something—such as make an investment in a mutual fund—based on the outcome of past events (such as returns of the past five years) rather than by observing the process by which the outcome came about (the investment process used by the mutual fund manager over the past five years). An investor might think, “This manager had a fantastic five years, I am going to invest with her,” rather than understanding how such great returns were generated or why the returns generated by other managers might not have had good results over the past five years.

Implications for Investors irrationally attributing successes and failures can impair investors in two primary ways. First, people who aren't able to perceive the mistakes that they have made are, consequently, unable to learn from those mistakes. Secondly, investors who disproportionately credit themselves when desirable outcomes do arise can become detrimentally overconfident in their own market savvy. The following points describe the pitfalls of self-serving behavior that can often lead to financial losses:

1. Investors may invest in funds that they should not because they are focused on the outcome of a prior action, such as the performance record of the manager, rather than on the process by which the manager achieved the results. This may cause investors to subject themselves to excessive risk if the source of the performance was a risky strategy.
2. Investors may avoid investing in funds that they should not because they are focused on the outcome of a prior action, such as the performance record of the manager, rather than on the process by which the manager achieved the results. Investors may avoid a manager based on a bad outcome while ignoring the potentially sound process by which the manager made the decision.
3. Investors may invest in overvalued asset classes based on recent outcomes, such as strong performance in gold or housing prices, and not pay heed to valuations or past price history of the asset class in question, thereby exposing them to the risk that the asset class may be peaking, which can be hazardous to one's wealth.”

Let us help you eliminate this bias. Professional advisors with disciplined systems of investing tailored specifically to your investment goals will allow you to overcome many of the obstacles inherent in our very nature. At DWAM, we can help.