“Belief In the Law of Small Numbers”

Season’s greetings – we would like to wish everyone a wonderful, safe and enjoyable festive season. Today, we would like to focus on an investor habit, which has a huge impact on wealth creation – “Belief in the law of small numbers”.

This is a paper written in 1971 (48 years back!) by two great psychologists Amos Tversky and Daniel Kahneman. They were pioneers in the area of behavioral economics and Daniel Kahneman was also awarded a Nobel prize in 2002.

Belief in the Law of Small Numbers

Amos and Daniel carried out experiments in 1969 about how even trained statisticians are quick to draw conclusions. You can read the original paper here. The summary is as follows:

“People rush to make conclusions (often wrong), based on results from a small sample of data, assuming that it holds good for the larger population.”

While this is a behavioral trait, which is applicable to every walk of life, it is particularly relevant for investing.

Does it apply to only individuals? No, it even applies to sophisticated investors like Hedge Funds.  In 2006, the applicability of this to investing was tested by looking at quarterly data of 752 hedge funds. The results are startling – even the most sophisticated investors have a bias towards a momentum strategy and putting money with recent winners. You can read about it here.

In the current context of poor equity returns over the last 2 years, it has made many think that it is going to continue like this.  The reason we, as investors make this mistake, according to behavioral economists, is that humas tend to put too much faith in small amounts of information.  This is also closely linked to recency bias, extrapolating the recent events to continue forever, both on the positive and negative outcomes.

Typical Investor Behavior in current situation

“I invested in Fund X as it had 80% returns in the past two years. It has been two years now, and the fund has given me poor returns. I want to exit as even a FD would have given a better return.”

This is a sure way of not able to grow wealth.

Our behavior has a huge impact on wealth creation.  Before taking any investing decision, it would help us to do the following:

• Stop Extrapolation or snap judgements – We should train ourselves to stop making snap judgements (based on our past history or individual experience) and look at the bigger picture
• Avoid a hot hand bias – Even sophisticated investors have a tendency towards momentum investing (picking recent winners). Looking at larger data sets over periods of time, helps to give us a good perspective
• Look at rolling returns – As a starting point, if you would like to compare returns of products after adjusting for risk, do look at rolling returns instead of point to point returns
• Eliminate recency bias – the recent poor returns from equities shouldn’t cloud your judgement on the asset class

Ignore the noise.  This may be the most difficult thing to do today! Our ability to ignore the noise and reducing our bias is key to wealth creation.  Equity investing is volatile and no doubt about it.  We need to endure the short term pain to create long term wealth.

Happy Dusshera!