Outcome bias. A ‘hot’ trade idea may be just a bubble about to burst.
Outcome bias is a cognitive bias where decisions are based on outcomes rather than underlying factors. Investors often make this mistake and buy risky stocks. To counteract this bias, research investments thoroughly, seek professional advice, and consider factors like diversification and risk exposure. Discover whether you are prone to an outcome bias and the extent to which it affects your investment decisions with PRAAMS BehaviouRisk.
Behavioural science. What is outcome bias?
This is a behavioural pattern whereby a person makes decisions based on the outcomes of events rather than the underlying factors that led to such events. For example, concluding that it is worth investing in a stock because it has been going up for the past three years. Three consecutive years of growth is an outcome, but nothing was said about the factors behind this growth. The stock may be up because of pure luck or because the market has been soaring over the past three years. Before making an investment decision, one has a single set of information. Once the decision is made and the outcome is known, you have more information, and the quality of the decision is clear. The trick is that it is easier to judge the value of the decision once one knows the outcome.
Outcome bias is a cognitive bias, i.e., a mistake in decision-making. These biases can be effectively corrected with education.
What are the consequences and portfolio risks?
Investors often choose investments based purely on past performance (i.e., the end result) and do not consider what contributed to this outcome. For example, the recent returns of a particular bond may look better than others, and they may create the temptation to invest. However, the bond’s higher risk may easily explain the performance. By investing based on past performance alone, one may end up accepting a level of risk beyond one’s investment risk tolerance and risk comfort zone. Similarly, consider investing in an asset that is performing exceptionally well. It may mean investment in an overvalued asset. Even worse, a dramatic increase in an asset’s price may mean that it is just a bubble about to burst. Gamestop and other ‘meme’ stocks are perfect examples. Another mistake associated with outcome bias is not investing in specific asset allocation strategies simply because their past results were poor. The respective strategy may be more profitable in the future because it relied on a sound investment approach, and its past performance was simply bad luck.
What can I do to make my portfolio optimal?
Our first recommendation is to recognise your potential inclination to this bias. The next piece of almost universal advice for a sound risk management framework is to do more research on any investment, especially if it has a history of demonstrating above-average results. It is often the case that an above-average performance is explained by above-average risk exposure. More information and understanding of how the returns have been generated is critical. Regarding your research and risk analysis, good areas to explore are diversification, risk exposure, correlation with the benchmark, tracking errors, and standards of performance disclosure. If you deal with complex instruments like structured notes with embedded option baskets, estimating all the risks may be challenging. In such cases, it makes sense to ask for the help of a professional risk manager. We reiterate that external advice must be independent to avoid conflict of interest.
