Challenging conventional wisdom

As investors, it's important - if we want to outperform the indices - to think differently. And that means challenging accepted conventional wisdoms, by continually asking questions that reveal underlying assumptions. Also, looking at the quality and quantity of the data before us, can also help us become better investors too.

I enjoy reading articles that consider common investing mistakes, so that I can hopefully minimize these mistakes myself. One recent one I read (by way of Abnormal Returns) was a list of 15 common biases reported at The Kirk Report, from the investor magazine, Trader Monthly. The list is full of good stuff.

But I finally (i.e. years late) suffered some cognitive dissonance when reading item #12 on the list ...

12) Asymmetry of risk tolerance: Investors are risk-averse with regard to gains (preferring to sell "winners" and ensure the gain) but risk-takers when it comes to losses (preferring to hang on to "losers").

Now this isn't the first time or place that I've read this statement, but I finally realized that this is in complete contrast to two other accepted wisdoms I've read multiple times over the years:

a) That investors in mutual funds - in the aggregate - underperform the performance of the mutual fund itself, primarily because they pile into the latest hot fund (whose performance decays thereafter), and

b) That reversion to the mean exists, meaning that stocks and mutual funds that have underperformed for a relative period, generally outperform in the following period.

Something has got to give - all of the above statements cannot be true. While I'm not certain which of the three has to give, I personally think it's the first one. Having seen more than a few investors, I tend to believe that a) is true, and by reasonable extrapolation, also applies to most other investors (i.e. not just those who invest in mutual funds).

I've also seen a fair number of studies showing that underperforming stocks rebound typically have a rebound (because they got priced too cheaply) and outperforming stocks often falter (because they became too expensive ... "priced for perfection). So I tend to think that b) is also true.

So, I'm going to say that I think bias #12 is probably false - and I think in fact it might be the opposite - investors holding "winners" for too long, and dumping "losers" too early.

But what do you think?


JW

The Confused Capitalist