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Performance sells
Whenever we see financial media run a story covering "Top performers of the last year" among mutual fund schemes, it evokes different emotions among different stakeholders in the business. Fund managers whose funds come out on top of the league tables will understandably be proud of the recognition. Those whose funds didn't make it will take comfort in the SEBI mandated disclosure "Past performance may or may not be sustained in future". Sales teams whose job is to sell the schemes that top the league tables will perhaps rub their hands with glee - they know their job has been made simple, because performance sells. Sales teams who don't have a scheme featuring in the league tables, will probably spend a lot of their time reminding distributors of the past performance related mandatory disclosure sentence. Some distributors will perhaps take a copy of the league tables article to their clients, because performance sells. Other distributors will perhaps groan when they see a league tables article - their clients will perhaps want to know why they have not invested in the top performer and will want to invest in it now - irrespective of whether their distributor is recommending the fund or not. And every mature and wise industry participant will undoubtedly realize that one more publication of a league table means some more investment decisions being taken somewhere in the country, on a shaky premise.
A lot of effort is taken at various levels within the industry to help investors understand the perils of investing by looking at the rear view mirror rather than looking ahead. We all know and fully understand that investing by looking solely at the last 1 year performance is certainly not a smart way to take an investment decision. We also know that recent performance continues to be a powerful magnet that draws investors in, anyway.
The question here is what can we do to reduce the influence of recent performance on investment decisions. Is shouting out the past performance disclosure sentence louder and more often going to be enough? Do we have evidence that suggests that the statutory warning on a cigarette pack has significantly curbed smoking?
To try and meaningfully curb the excessive influence of recent performance on fund selection, we need to first understand why this happens and then find ways to convince investors to take more balanced investment decisions. The why aspect is where we turn to behavioural finance, which is what MasterMind is all about.
Why does performance sell?
Behavioural finance has given a name for this kind of investor behaviour : its called outcome bias. The outcome of investing a year ago in today's league topper was awesome, and that outcome disproportionately influences an investor's decision to invest in that fund today. All of us in this business have seen outcome bias in action - there is really no need to explain more about it. But the important thing for us to understand is what causes outcome bias among investors - among all of us. The brain has an "interpreter" module which performs a very important function. Wikipedia defines the left brain interpreter in this manner :
"In neuropsychology the left brain interpreter refers to the construction of explanations by the left brain in order to make sense of the world by reconciling new information with what was known before.[1] The left brain interpreter attempts to rationalize, reason and generalize new information it receives in order to relate the past to the present"
"Construction of explanations in order to make sense of the world" - that's the key phrase in our context. When we see an effect, the brain rapidly constructs a story about the cause that led to the effect, based on information available to it. This is what we call "understanding". So, when you see an athlete looking overjoyed on the winner's podium, you know he won, although you didn't see the race, because your left brain's interpreter recognizes joy and standing on top of a winner's podium as actions consistent with those of the winner. When you see your neighbour coming towards your house with a huge grin on his face and a box of sweets in his hand, your brain's interpreter races through all the information it has with it. It remembers that your neighbour was very anxious about his son's academic results, then you remember him saying that the results are due today, and you instantly connect all the information and come to the conclusion "Pappu pass ho gaya!", even before he reaches your doorstep and confirms what your brain has already interpreted from his actions and the information it had available to construct a story of the cause.
The brain's interpreter, as the definition suggests, constructs explanations to help us make sense of what is happening around us, to help us understand. The interpreter does a splendid job most of the time, but has one small bug in its software. It is programmed to provide a cause for any effect we see, with whatever information it has available to it. If the information is insufficient, it does not "hang" and not provide a cause for an effect - rather, it provides us with a cause and effect theory anyway, based on whatever information it has. Going back to our neighbour with sweets, if your brain cannot recollect any information about child, academic results etc, it will continue searching for possible causes. It will recollect that last evening when you parked your car, you noticed a brand new looking car parked in your compound. The interpreter latches on to this piece of information and constructs a cause and effect theory rapidly : he's coming with sweets to your house to share the good news of his first car purchase! You greet him at your doorstep with "Sharmaji, congratulations, what a lovely car!" Sharmaji may in fact be coming to you with any other unrelated good news - but your brain has to complete its cause and effect theory rapidly when you watch him approaching your doorstep with the box of sweets.
Interpretation based on incomplete data
Whenever an effect has an element of randomness or chance or luck, the interpreter's interpretation of cause and effect sometimes goes haywire. So, when an investor sees Fund X as the topper in a performance league tables chart put out by media, his brain's interpreter swings into action to figure out a cause for the effect - a reason why Fund X did better than all others over the last one year. The investor's brain does not have access to data like attribution analysis of every fund and other sophisticated analysis of what caused Fund X to outperform others. But, the interpreter has a job to complete anyway. So, the cause it assigns is "Fund X is the best, therefore it did better than others". If Fund X is the best, which investor would not want to invest in the best fund?
When the brain understands clearly that there is an element of randomness or luck or chance, it will attribute the cause to chance. So, when you see a neighbour winning a lottery, you instantly call him lucky, you don't praise him for his lottery ticket picking skills. Its events that you are not familiar with, that the brain's interpreter sometimes falters with, in assigning causes for the effects its sees.
How can we help investors look beyond only recent performance in fund selection?
The key for us to understand here is that investors come to incorrect conclusions in picking funds solely based on league tables, due to lack of familiarity and lack of adequate information. The solution is therefore not to write the "Past performance may or may not be sustained in future" sentence in larger font and in more places and hope that investors will become better informed and wise. The solution lies in us providing investors with the information that helps them construct well informed cause and effect relationships in their minds, and thus take wise investment decisions.
How can we do this? Here are some suggestions, for you to consider:
For starters, it would be great if you can help your clients understand how we as human beings sometimes make erroneous decisions due to the little bug in the software of our mind's interpreter. Taking your clients through non-financial situations where we come to wrong conclusions based on incomplete data will help reinforce the point. You can then take them through how this impacts investment decisions. Next, you can look at how you are going to provide quality data that can help your clients make rational and well informed decisions. So, when your client finds Fund X at the top of a league table printed in this morning's financial daily, if you have been tracking funds, you should have known this already. And, if you knew this, you should anyway have done your homework on what actually helped this fund reach the top. Merely because a fund is a top performer for the last 1 year, does not either make it a buy or a fund to avoid. The key is for you to see consistency of performance over time and showcase that to clients. You can, for example, use the Performance Consistency Report in the Fund Trackers section of the Wealth Forum website for 3, 5 and 10 year periods to get an idea of consistent performers (Click Here) If you are not already doing it, please consider engaging with your AMC RMs on attribution analysis for their top performing funds to understand what actually drove outperformance. Was it just a single stock that the fund manager rode successfully? Or was it due to good calls across several stocks and sectors, thus leading you to believe that he didn't just get lucky with one? WF Saturday School discusses more about attribution analysis - click here if you'd like to know more. Its important for you, as the advisor, to actually establish the correct cause and effect relationship that helps explain outperformance of the league table toppers. Its important for you to take an independent and well reasoned call whether you think a fund on top of the league tables should or should not be in your recommendation list, and for what sound reason. Once you have done this, do share your insights with your clients the next time they come to you with a copy of a performance chart, asking you to invest their money in the no.1 performer. You will be surprised, if you have done your homework well, and if you share quality data with them, how they come to pretty much the same conclusions that you want them to come to. We just need to ensure that the brain's interpreter is provided with all relevant data - then you can trust our lovely brain to make the right connection and take great investment decisions.
All content in MasterMind is created by Wealth Forum and should not be construed as an opinion of Sundaram Mutual Fund.
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MasterMind is a joint initiative between Sundaram Mutual and Wealth Forum, in which we offer insights into how you can become a more effective advisor to your clients, by understanding them better, understanding how they think, understanding how they take financial decisions. This gateway into your clients' minds we believe will help you relate better to them, communicate more effectively with them and thus serve them better. Mastering your client's mind is your gateway to becoming a more successful advisor. Its not for nothing that they say, "Its all in the mind!"