Personal Finance Essentials
Pattern Recognition Bias
The Psychology of Investing > Pattern Recognition Bias
We see things that aren’t there – like staring at clouds and seeing a kitten. Investors often chase such mirages, investing in a fund that has performed better than others over the past few years in the belief that the outperformance will continue. It never does.
No investment manager consistently delivers above-average returns, and funds that are ranked “best” fail to maintain their ranking. This is why investment offerings are required to warn investors that “past performance is no guarantee of future results.”
The Hot Hand Fallacy
Research on basketball players found that athletes are never truly “hot” or “cold” – despite what fans believe. After analyzing hundreds of games, researchers found that performance closely matched random statistical variation, not meaningful streaks. The same pattern holds in investing. In a five-year study of a large universe of equity mutual funds, 52% of the funds that began in the top quartile finished in the bottom two quartiles. In a separate study of Morningstar five-star rated funds, similar deterioration was found. A high past ranking does not predict future outperformance. Chasing it costs investors both time and money.