Mistakes are a part of life. Yet, somehow, we don’t learn from our mistakes — we tend to make much the same mistakes over and over again.
Take mergers and acquisitions (M&As) — they continue to be a huge business every year, even though they hardly ever work. As Michael J Mauboussin, chief investment strategist at Legg Mason Capital Management, writes in his new book Think Twice – Harnessing the Power of Counterintuition, “Corporate mergers and acquisitions are a multi-trillion dollar global business year in and year out. Corporations spend vast sums identifying, acquiring and integrating companies in order to gain a strategic edge…The problem is that most deals don’t create value for the shareholders of the acquiring company (shareholders of the companies that are bought do fine on an average). In fact, researchers estimate that when one company buys another, the acquiring company’s stock goes down roughly two-thirds of the time.”
Despite this lack of success, M&As remain a popular way of expanding business.
People who invest in mutual funds that actively manage money, instead of just investing in an index fund, are making the same mistake as well. As the author writes, “Researchers have shown that in aggregate, money managers who actively build portfolios deliver lower returns than the market indexes over time, a finding that every investment firm acknowledges. The reason is pretty straightforward: markets are highly competitive, and money managers charge fees that diminishes returns. Markets also have a good dose of randomness, assuring that all investors see good and poor results from time to time. Despite the evidence, active money managers behave as if they can defy the odds and deliver market-beating returns.”
So the bigger question is — why do we make these mistakes despite knowing the background. “Most people see their future brighter than that of others. For example, researchers asked college students to estimate their chances of having various good and bad experiences during their lives. The students judged themselves far more likely to have good experiences than their peers, and far less likely to have bad experiences,” writes Mauboussin.
This level of optimism is also followed by an illusion of control, where “people behave as chance events are subject to their control.” “For instance, people rolling dice throw softy when they want to roll low numbers and hard for high numbers,” writes Mauboussin.
Over and above the feeling that we can influence the results of chance events, human beings also mix up skill and luck. As the author points out, “We have difficulty sorting skill and luck in many fields, including business and investing.” This leads to a situation where we feel that a winning streak will continue and we fail to appreciate the concept of “reversion to the mean.”
So what is reversion to the mean? “The idea is that for many types of systems, an outcome that is not average will be followed by an outcome that has an expected value closer to the average,” explains Mauboussin. But even though people seem to understand this concept, they don’t incorporate it in the decisions they make. This leads to a situation wherein we give grave importance to short-term performance while making decisions.
Take the case of this piece of research carried out by Professors Amit Goyal and Sunil Wahal, who analysed “How thirty-four hundred retirement plans, endowments, and foundations hired and fired firms that manage investment funds over a ten-year period.” And what did they find? “The researchers found that plan sponsors tended to hire managers who had performed well in the recent past. And the number one reason to fire a manager was poor performance. Consistent with reversion to the mean, the researchers noted that in subsequent years, many of the managers who were fired went onto outperform the managers who were hired.”
Retail investors also tend to behave in a similar way. As Mauboussin writes, “Individuals earn returns that are generally 50% to 75% of the S&P Index precisely because they pour money into hot markets and yank it out after a drop. They buy high and sell slow.”
This happens primarily because they ignore “reversion to mean” and “forgo substantial investment returns on their hard-earned money.” The moral of the story is, “When a large number of people participate in an activity that is influenced by chance, some of them will succeed by sheer luck. So you have to scrutinise even long successful track records in fields with lots of participants. Investment track records are a good example.”
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