Investor Behavior and the Hot-Hand Fallacy

Investor Behavior and the Hot-Hand Fallacy

By Myra O’Dell

According to Morningstar, the hot-hand fallacy is when an investor perceives trends where none exists and consequently takes action on this faulty observation.  The concept of the hot hand comes from a study done by Gilovich, Vallone and Tversky on the performance of basketball players. The study analyzed the outcomes of players’ shots in hundreds of games. While basketball fans believe that a player’s chances of hitting a basket are greater following a hit than following a miss, the study concluded that the outcomes of both field goal and free throw attempts were largely independent of the outcome of the previous attempt.

Investors often get caught in this hot-hand way of thinking and it can unfortunately cause havoc on long term portfolio performance.  For example, the image below illustrates the difference in total return and investor return for a mutual fund selected from Morningstar’s open-end fund database. The fund’s 10-year total return was 10.6%, but its 10-year investor return was –6.3%. This deviation in return is due to the fact that investors piled into the fund during its run-up, with most inflows occurring near the investment’s peak. Investors then fled as the fund’s returns plummeted, with most outflows occurring near the investment’s bottom. Buying high and selling low is not a worthwhile investment philosophy!

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Similarly, it is impossible to predict which asset class will perform the best or worse in any given year.  The table below shows the random nature of the performance in various asset classes.

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The take away from this information is that although investing in a diversified portfolio may prevent an investor from capturing top-performing returns in any given year, it can protect an investor from experiencing extreme losses. For example, in 2012, a diversified portfolio would have returned 11.3%, which was approximately 6.9% lower than the top asset class that year, small stocks. However, the diversified portfolio would also have performed better than the worst-performing asset class, Treasury bills, by about 11.2% this past year. By investing a portion of a portfolio in a number of different asset classes, portfolio volatility may be reduced which will likely lead to better long-term results.

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