How to choose your investments

In 2018, I lived on Stanford University campus (where my wife was studying) and was intrigued by a French philosopher Rene Girard, a professor there. According to Rene, - human desire tends to be based on other people’s desires. We want things not because of what they are worth, but because people like us want it and we want to imitate them. This is a really powerful thought.

Whether it is the decision to marry or have children or even where we work, everything is determined by what others are doing and what they think. When I was graduating college in 2010 - everybody wanted to work on the trading floor or in the investment banking business of Goldman Sachs.

Ten years hence - it is Google, Amazon, and other tech startups. Our parents chased financial well-being, such as owning a house, a car as the primary pursuit of life. Today it can be the number of followers you have on social media, and tomorrow it may be something else. The fact is that our actions depend a lot on what other people think is cool.

Now, Let’s come to investing. John Bogle (founder of Vanguard) once said, Money flows into most funds after good performance, and goes out when bad performance follows. Why does this happen?

Returns offer ease decision making

With hundreds and thousands of mutual funds out there - high returns become the default filter for choosing investments. Buying a mutual fund is equivalent to trying to decide between 1000 different hair dryers.

It’s hard to predict which hair dryer will work and which won’t. The best decision is to buy a decent one and stick to it for a very long-time -, but investors keep on buying the best hairdryer and selling the worst hairdryer.

Investors don’t understand that juggling hairdryers is more damaging over the long-run. Every hairdryer goes through good and bad performance over a longer time span.

Social proof

If everyone’s investing in it – it must be good. Ratings tend to be high for good performing funds. If returns are the first filter for investors, the next filter tends to be star ratings.

Very rarely will investors see a good fund with a bad rating. Unfortunately, ratings also tend to follow good performance, so investors are back to square one. In fact, in many cases, rating upgrades tend to happen after a period of good performance by the investment.

Mean reversion

A lot of studies show mean reversion in the investment industry as well. By definition, mean reversion is a theory that suggests that asset prices tend to revert to an average level over a long enough point in time.

This theory also suggests that investors following the opposite of return chasing should ideally make more money, i.e., sell good performing investments and buying poor performing investments. In technical terms, this means portfolio rebalancing and yes - it works wonders and forms the basis of intelligent investment management.

Unfortunately, many investors do the opposite of rebalancing - buy more funds that are performing well and sell funds that are not performing well.

Advisors and wealth managers do not advise poor-performing funds. If an advisor sells a good performing fund and it does not perform - it’s technically the funds fault. If he sells a poorly performing fund which then delivers poor returns, that’s the advisor’s fault. To give another example - if someone advises Infosys as a stock recommendation and if Infosys underperforms - something is probably wrong with Infosys.

But if an analyst recommends a small-cap stock - then it’s the analyst’s fault. Investing in under-performing managers and selling strong performers may end up being a good strategy - but comes with significant career risk. That is why you should never expect an advisor to recommend a poor performing fund.

Outcome bias

The investment industry is obsessed with not the process but the outcome of things. Advisors and investors are not judged by the quality of their decisions but by their investment outcomes. A good decision going sour is a sign of poor decision making. A wrong decision with a little bit of luck is a sign of superior decision making.

Good performers talk about their investing prowess, and low performers speak about bad luck. Not many talk about their investing process and frameworks.

FOMO (fear of missing out)

This one is relatively self-explanatory. It’s the reason equity flows tend to be highest at market peaks. Fear of short term loss (FOSTL) is the reason why nobody invests during market bottoms. Overall, FOMO and FOSTL lead to poor long-term investment outcomes.

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