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Whether we want to admit it or not, we are impacted by past performance. The disclosure, “Past performance is not indicative of future results” could be in 72pt font and it still wouldn’t matter. Our future decisions are based on past outcomes; it’s just the way we are hardwired.
The Gambler’s Fallacy
In psychology, there is such a thing known as the “gambler’s fallacy.” It is also known as the “hot hands fallacy.” Whenever our brain detects a “pattern” of past performance, it automatically makes assumptions about the future. I put the word pattern in quotations because it is seldom a real pattern. After all, many random outcomes take the shape of identifiable patters. Regardless of how it may look, the outcomes are still random.
When we see great outperformance, our brains will often come to one of two conclusions. Either the outperformance will continue, or we are due for a change. It doesn’t matter which opinion we have, the problem is that we are making future decisions based on random outcomes. As investors, we should be making outcomes based on a plan. The gambler’s fallacy takes no thought; making decisions on a plan requires discipline and thought. One is easy, one is difficult.
Modern Day Example – ARKK
A technology/innovation exchange-traded fund, ARKK, is a great example of this at play. Investors are chasing performance, and the evidence is strong. Yet the complete story has not been written, so it will be very interesting to see how this plays out.
At the end of 2016, ARKK had just $12M in assets. It 87% return in 2017 was earned by a very small amount of investors. But that return got the attention of investors. Three years later and the assets under management increased to $1.9 billion. But the big surge hadn’t yet happened.
2020 was its big year. It ended the year up 156% (best of all 600 funds in its category) attracting a lot more money. According to Morningstar, between September 2020 and March of 2021, the fund attracted $13 billion in new money. Notice the dates, most of that money came after most of the gain occurred. Again, relatively few investors participated in its awesome gains. But they all participated in losing 23% in 2021 (worst of all funds in category).
So far in 2022 the fund is down an additional 40%, but what is interesting is that investors are still adding money to the fund. Psychology and investor behavior might dictate they would be bailing. What gives?
The Power of Hope
Now we see the power of hope in play. It is one thing to be optimistic about the future, it is another to be hopeful. Investors are likely saying to themselves, “Cathie did it before, she can do it again.” They are not buying ARKK in their attempt to achieve an 8% – 10% return. They are buying ARKK to hit a home run, or a grand slam. They are hoping it comes back with a vengeance.
It will be interesting to see how this plays out. Many of her holdings are beaten up, but just because a stock is down considerably doesn’t mean it will come back – especially those with high valuations to begin with. If performance continues to lag, there may come a time when investors throw in the towel. If that occurs, it will be only after they experience significant losses. We all have some threshold of pain.
From a behavioral perspective, I will be interested to see how investors behave with this fund based on its future performance. No matter what, we know that investors and speculators will be influenced by performance, hope, and maybe even despair.
Related: The Downside of Managing Risk