Don't Bet on the Past

Investors can learn much from Wile E. Coyote. Hearing Road Runner’s signature meep meep each time the bird rounds a bend, Wile E., knife and fork in hand, coils and springs on the next meep -- only to be flattened by a bus with a meep-sounding horn.

Wile E.’s instincts are good, but the outcome isn’t. And the instinct that gets him hit by a bus afflicts humans as well. It’s the impulse to act on apparent patterns. Researchers theorize that this way of thinking was hard-wired into our primitive brains, and it made sense back in much simpler times. For example, a Homo erectus who found three nests that contained eggs would have been smart to check out a fourth nest.

Life has grown a bit more complicated, but our penchant for perceiving patterns persists, and even kicks in with random data. A study published in 1985 coined the term hot-hand fallacy to describe this assumption. Researchers found that 91% of basketball fans thought that a player stood a better chance of making a shot after having made two or three baskets in a row. Players and coaches in the NBA likewise shared this belief. In reality, however, a player’s next shot was only as likely to drop as his overall shooting percentage would suggest.

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This compulsion to see a pattern where none exists hurts investors in a number of ways. When it comes to stocks, for example, a landmark study by professors Werner DeBondt, of DePaul University, and Richard Thaler, of the University of Chicago, showed that investors who relied on past information became overly optimistic about stock-market winners and overly pessimistic about losers. But the stock-price patterns didn’t persist. Over time, extreme winners did worse than the market, and extreme losers outperformed.

The hot-hand fallacy also applies to mutual funds. In the case of mutual fund advertising, the warning that “past performance is no indication of future returns” doesn’t seem to sink in with many investors. We see ads for funds with two or three years of good returns and we buy them, even though those results are usually a random phenomenon -- just like three consecutive coin tosses coming up “heads.”

Know the odds. Consider again a basketball player’s hot hand. If he has made two baskets in a row, let’s go ahead and assume that he’ll make another. But what if he’s already sunk eight in a row? Will he sink a ninth?

That twinge of doubt you just felt is a taste of the gambler’s fallacy, which basically says we’re wired to think that no good thing (or no bad thing) lasts forever. So if red comes up on the roulette wheel ten times in a row, we’ll tend to bet black. Film footage recorded at a casino confirmed this tendency -- even though the odds of black or red coming up on any given roll are exactly the same.

At what point does the hot-hand fallacy fade and the gambler’s fallacy kick in? It all depends on “run length” and fear, says Joseph Johnson, a professor at the University of Miami who studies the marketing of financial products. Over short runs -- say, a few coin tosses, a few months of rising stock prices or a few years of solid mutual fund returns -- investors will buy into the hot hand. Eventually, however, fear that the streak will end -- the gambler’s fallacy -- will take over. The point at which that happens will vary depending on the investor and the situation, says Johnson, with cautious investors losing faith in a streak sooner.

So how do you counteract both fallacies? First, look at the long term. With a mutual fund, check its five- and ten-year records to make sure that short-term results are borne out. Consider factors such as fees, fund size and turnover. Likewise, with stocks, a tempting record should be the result of fundamental value rather than investors piling on.

Note to Wile E.: Next time, check the bus schedule.

Kiplinger’s is partnering with Nightly Business Report on the “Your Mind & Your Money” series, funding for which is provided by the FINRA Investor Education Foundation. For companion video reports, tune in to NBR on your local PBS channel Jan. 11 and 25.