September 06, 2019
In the spring of 2012, Warren Buffett wrote in the Berkshire Hathaway annual letter:
“I ask the managers of our subsidiaries to unendingly focus on moat-widening opportunities, and they find many that make economic sense. But sometimes our managers misfire. The usual cause of failure is that they start with the answer they want and then work backwards to find a supporting rationale. Of course, the process is subconscious; that’s what makes it so dangerous.”
As the scientists, psychiatrists, and many others on this list know, this problem is not unique to corporate management. The average parent could write a tome on it before lunch.
One of the difficulties in investing is that it's easy to do this. It's easy to come up with a hypothesis, find some evidence that supports it, and then make a decision based on that. Your mind wants to ignore the counter-evidence, wants to cling to a partial slice of friendly data. Once you begin to feel ownership of an idea's trajectory, this process snowballs.
However well-intended, on average this decision-making process is not working out well for Americans. Dalbar Research publishes a large, 30 year study of investor returns. Jeff Sommer wrote about it in the NY Times (1):
The Dalbar results for 2018 are especially painful to contemplate. The inflation rate was 1.93 percent, so investors would have had to earn that just to tread water. Instead, the average stock fund investor lost 9.42 percent, for a gap of more than 11 percentage points.
Performance was so bad that Dalbar titled their press release "Average Investor Blown Away by Market Turmoil in 2018" with a subtitle "Average Equity Fund Investor Lost Twice the Money of the S&P in 2018." (2)
And over 30 years?
"they underperformed by 5.88 percentage points, annualized, over 30 years." (1)
This statement from Sommer is more powerful than it seems, regarding his own underperformance:
"I had accepted the imperfect choices and high fees imposed by so-called active mutual funds, and I had compounded those liabilities by buying and selling at the wrong times."
The compounding effect is key. It's not just the error in the mutual fund, it's the error of investors buying and selling at the wrong time. That error blossoms as investors try to find supporting rationale to an argument they have already crowned a victor in their minds.
The discipline needed for great returns succumbs to a pre-conceived answer that seems real, vivid, and confident.