Holly Black: Welcome to the Morningstar Series, 'How to be a Better Investor.' I'm Holly Black, with me is Dan Kemp from Morningstar Investment Management. Hello.
Dan Kemp: Hello, Holly.
Black: So, we've been talking about the fact that whether you've been investing for a couple of weeks or a couple of decades, there are probably a few things you could be doing better. Sorry to be the bearer of bad news, no one is perfect. And this is an area that you're particularly interested in, isn't it?
Kemp: That's absolutely right. So, one of my roles at Morningstar is to think about how we make investment decisions, and how we can improve the investment decisions we make for the investors that we look after.
And what we find is that, as you say, we all make mistakes, whether you've just started investing, whether you've been investing as long as I have, we all make mistakes. And those mistakes aren't random. So, a great psychologist Dan Ariely calls us predictably irrational. We make the same mistakes over and over again. And so, one thing is that we need to think about is where those mistakes are and how we overcome them.
Black: And this is rubbish because we're supposed to be going through life learning from our mistakes. So, not only are we getting it wrong over and over, we're all doing the same things wrong?
Kemp: That's exactly right.
Black: So, what are some of the most common mistakes that we make?
Kemp: Well, there is lots of common mistakes. But one of the ones that I think about the most is called the hot hand fallacy. And this comes from a term in basketball, it was put together in the States, as you'd expect, given the sport it's based on and the work was done by an amazing psychologist called Amos Tversky. And his idea was that people tend to see streaks in performance. So, sometimes in basketball, you'll have a player who will score number of baskets in quick succession, and he'll be described as having a hot hand. So, having this streak of good performance, and the work that Tversky did was to investigate whether these streaks really happen, and how we should respond to them. And what he found was that actually we see streaks more often than they really happen, and we tend to assume that they'll carry on.
Now, if we put that in investment context rather than the basketball context, we look at fund managers. And we look at the ones that do really well, and we assume that that streak will continue, whereas in reality, it often doesn't. And that's one of the danger of looking at past performance.
Black: The past performance is one of the easiest things to look at when you are starting out assessing which funds to invest in. So, how do we avoid falling prey to the hot hand fallacy?
Kemp: Well, it's very difficult because there is also an opposite, which is that we sometimes assume that data will revert to normal far too quickly. So, we also need to be aware that these streaks can continue. So, we're not just caught by assuming they'll continue for too long we are also caught by assuming that things will revert to normal too quickly. So, it's even more difficult to overcome than one must…
Black: No wonder we're getting it wrong.
Kemp: Exactly right. That's why we find it so difficult. And the key is to understand that it's very, very difficult to see genuine patterns that are predictable. And so, stop looking for them. As creatures we are great at pattern recognition, it's one of our really strong things as human beings. And so, our minds want to see patterns. But that can really get in the way of decision-making. And so, we would encourage investors to look at past performance last, and only look at it as a way of confirming the investment thesis, the investment process of the manager of the fund that you're looking at.
So, for example, if you're looking at a fund that claims to be quite a core fund, let's say, a tracker fund, and it's following some sort of stock market index, then at the end of that process, you might want to check whether it has actually mirrored that index. That's a way of using performance for confirmation. But never, never start with recent past performance and assume that that will either come to an end very quickly, that there'll be sudden reversal, or that it will continue long into the future. That's normally a mistake.
Black: So, instead, we need to focus on the actual facts, which are the investment process, what the managers investing in, and the team around him that's helping him do that?
Kemp: That's exactly right. Whereas a lot of people, as we know, start by just screening on past performance, let's look at who has done well in the past, or let's exclude people who have done badly, but that's the last thing you should do. You're right. Start with the investment area that you want to consider, focus on cost. We know that's really important. And then look at things like the managers process and experience and things of that kind.
Black: Thank you so much for your time.
Kemp: Thank you. It's been a pleasure.
Black: And thanks for joining us.
