VIDEO: Retirement Investing Pitfall #6 – The Clustering Illusion & The Hot Hand Fallacy

 

As we continue through our video series “Retirement Investing Pitfalls”, this video is going to touch on Pitfall #6, and what is referred to as The Clustering Illusion (and The Hot Hand Fallacy). The clustering illusion is the belief that things happen in bunches or clusters and signify something meaningful is happening, vs. the thought that the events are totally random. For instance, while many studies have shown that active mutual fund managers, on average, underperform broad indices such as the S&P 500, investors often still invest in fund managers who’ve beaten the S&P 500 recently on the assumption that they will continue to do so.

Now, while there are certainly fund managers that have the skill to consistently outperform the market, in many cases a fund manager’s success can be attributed to other factors, such as breaking news, market conditions or even luck, rather than the manager’s skill set. Further, as these market conditions change, many of these managers wind up underperforming, WHICH can turn out to be a frustrating experience for investors. Given the challenge in determining whether a particular investment manager has enough skill and performance to make up for the fees being charged, most of our clients choose to use lower-cost ETFs to map out their investment strategy.

The natural tendency to buy funds run by managers with good recent track records, is often referred to as the hot hand fallacy. To illustrate how this works, let’s use a basketball analogy. When players pass the ball to a specific player who has made a number of shots in a row recently, they do so by assuming that player is more likely to make the next shot. This is the hot hand fallacy at play. The fact is, the player being passed the ball is usually no more likely to make that shot…based on what their average shooting percentage says. In my opinion, when building an investment portfolio, I think it’s prudent to look at how a fund manager has performed over a longer period of time, like 10 years for example. This way, you can gauge how they handle markets that more up, down or sideways, and then compare that performance to how the overall market has performed during the same time period. Also, when analyzing performance, be sure to look at the real return, after deducting the funds internal management fees, just to see a truer picture.

Share