Friday, August 7, 2009

Know Your Biases: Outcome Bias

When something's obvious in retrospect, it's hard to remember what things were like at the time. It's obvious that the market bottomed on March 9th, but that day was one of several plunges that took market-watchers by surprise. Back then, no-one knew what today's market would be trading at. What they did know was that the supposed November end to the bear market had turned into another vicious short-term growler - an unexpected one - as of February 9th. When Commerce Secretary Geithner made that announcement of his, the market participants were getting used to the idea that the worst was over and the new Administration had things well in hand. Because he had unveiled no specifics of any bank-rescue plan, that confidence vanished and the market dove in a hurry. It was to be that way, barring a few relief rallies, for the next month...a 28-day stretch when the S&P lost more than 22%. A full-fledged mini-bear market in the space of a month.

There was no way to tell whether or not the March rally was a sucker's rally. Given near-term experience as of then, there was no reason to doubt that March 10th, 11th and 12th was setting up another bear trap. We can look back and see that it was the start of a mini-bull market that ended on May 8th, pushing the S&P 500 up 28.5% in the meantime, but no-one saw it at the time.

For value investors, March 9th was like being tugged in two directions at once. Bargains were aplenty, but all signs pointed to those same bargains becoming more plentiful and cheaper. Dollars may have been selling for fifty cents, but it wasn't that long ago that they were selling for seventy cents. They may have been snagged at forty cents had March been akin to February. A larger cash position made sense given that dynamic. Cash didn't fall, and even bargains have to be marked down to market. Many value funds - most notably, Legg Mason's - were riding huge losses. A large cash cushion cushioned the mark-to-market bite, and also freed up the manager from having to sell more stocks later in order to snap up new bargains. Given a crushing February, holding a cash reserve made sense. JP Morgan may have gone down to $16, but who then would rule out it not going to $13 or even $10? It was more than $27 as of Feb. 6th.

According to Wikipedia, "outcome bias is an error made in evaluating the quality of a decision when the outcome of that decision is already known." It's easy in hindsight to see that March 9th was the day to buy with both hands, and it's just as easy to see that many bears should have reversed course in mid-March. The trouble with that hindsight, though, is that we are now habituated to a completely different market than March's. You didn't have to be a market timer to be affected, either. From a value investor's perspective, March 9th to May 10th was the season of the elusive bargain. Undervalued stocks were taking off at a pace that made a market order look like overpaying. Ballyhooed rallies exposed as sucker rallies were fresh in memory. Given this situation, who would risk looking like a fool by buying in to a rocketing market? Except for the foolhardy?

The above dynamic was what kept so many fund managers holding cash in the bag until it turned into holding the bag. It's easy to conclude that they were just stubborn, or bureaucratic, but they didn't know then what we know now. More to the point, we don't know now what they knew then. (We don't even know how many limit orders expired unfilled in those two months.) The above only sketches it out.

Outcome bias is hard to avoid because we naturally factor in present information when evaluating a past decision. We can only adjust for it by using our memories as best we can, and reminding ourselves that what goes around comes around. Perhaps, the most that can be realistically hoped for is to not inflame the bias.

When you think about it, there are a lot of trading systems and E-Z Investment books whose sole source of credibility is their appeal to outcome bias...


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