One of my hobbies is playing board games. I am an avid player of Settlers of Catan, Carcassonne, Ticket to Ride, and Lords of Waterdeep, and classics like Risk and Trivial Pursuit. While playing Dungeons & Dragons with a group of friends, I recalled an important investing lesson.
For those who don’t know, Dungeons & Dragons is a co-operative game in which players each role-play a character, adventuring through a story of the players’ own choosing. Most of the actual gameplay is decided by rolling dice – usually special 20-sided dice. A player in my group, “Elton”, has had a great streak of dice rolling over our past few sessions. He has consistently rolled numbers in the high teens, including several “natural 20s” (a perfect roll which guarantees success) and his in-game performance has helped the group overcome many difficult challenges.
As Elton continued to have great dice rolls in our games, I realized I had come to expect him to roll the dice well. I was surprised when he rolled low numbers, and saw several high rolls in a row as ordinary. But of course, it doesn’t require a degree in statistics to realize that dice rolling is random. No person, with fair dice, will ever roll consistently better or worse than anyone else in the long run, and someone who rolls well – or poorly – should see their results regress to the mean over time, with approximately equal proportions of high and low rolls.
How does this relate to investing? The goal of investing is simple: “buy low and sell high”. Actually doing so is much more difficult. It is more difficult especially when investors fall victim to the representative heuristic, a behavioural economic theory proposed by Amos Tversky and Daniel Kahneman. (A heuristic is a thinking shortcut or an easy way to make a decision). A common way that the representative heuristic manifests is when our brains extrapolate data from a small set of samples. If we watch a coin land on heads six times in a row, we are quick to assume that either the coin is biased, or that it is now “due” to land on tails, since it should regress to the mean. In reality, of course, the chance of the next flip being heads or tails remains 50/50.
Investing in stocks is very similar – though it’s much more difficult than rolling dice. It’s very easy for investors to fall in love with their good performers and assume that they will continue to perform well forever. A company which enjoys a meteoric rise after purchase would be seen as “doing great” and a must-own, while the keen investor would re-assess his or her valuation of the company, selling (or buying more) should the market price be removed from the investor’s valuation estimate. Conversely, investors can find it difficult to imagine that a poor-performing stock will turn it around, since the representative heuristic creates the expectation that the recent pattern of poor performance will continue, in spite of the knowledge that most companies do regress to the mean eventually.
And that’s where we as professional investment managers come along. When we manage a client account, we constantly monitor its holdings, continuously assessing the valuation of each holding and comparing it to our estimate of its value. We still like it when stocks go up – who doesn’t? – but in part by doing our best to avoid the representative heuristic, we can hope to achieve strong investment results for our clients.
And perhaps we can lead our clients to victory in their own investment adventure.
June 21, 2017