I read an interesting reflection by artist and producer Brian Eno. He was the record producer for U2, Coldplay and Talking Heads. He said:

“[Here] is a question that [Ludwig] Wittgenstein used to pose to his students. It goes like this: You have a ribbon, which you want to tie around the center of the Earth (let’s assume Earth to be a perfect sphere). Unfortunately, you’ve tied the ribbon a bit too loose; it’s a meter too long. The question is this: If you could distribute the resulting slack—the extra meter—evenly around the planet so the ribbon hovered just above the surface, how far above the surface would it be?

Most people’s intuitions lead them to an answer in the region of a minute fraction of a millimeter. The actual answer is almost 16 centimeters."

Here’s another question: if you’re flipping a coin and have gotten 10 heads in a row, what’s the probability that you’ll get heads the 11th time? Most readers of this blog know the answer is 50%. When flipping a coin, past outcomes have absolutely no influence on future outcomes. Every flip of the coin is an independent event, so the chance of getting a head on the 11th flip is still 50%.

The importance of these two stories cannot be overstated when advising clients: as professionals, we understand that the human mind has built-in vulnerabilities that make intuition a terrible way to assess probabilities and mathematical relationships. Most clients don’t think and work within a refined, mathematical and probabilistic discipline every day. They are much more likely to “feel” their way to decisions.

This is why casinos have big signs next to roulette wheels that show the outcomes of the past several spins of the wheel. They know that gamblers are likely to adjust their bets on the basis of what has happened in the past even though those past events have no impact whatsoever on the next spin of the wheel! As advisors, we work in a disciplined world of risk management and probabilities, while our clients rely on feelings and “gut” decisions all day long.

The Challenge of Advising

We shouldn’t take our discipline for granted. We need to remember the vulnerabilities that lurk in the hard-wiring of the human central nervous system. In his book, The Signal and the Noise: Why So Many Predictions Fail—but Some Don’t, Nate Silver penetrates the “noise” to find us the signal that matters for our work. Referencing Eugene Fama’s famous PhD dissertation, Silver points out: “Studying the returns of dozens of mutual funds in a ten-year period from 1950 to 1960, Fama found that funds that performed well in one year were no more likely to beat their competition the next time around.”

Silver wanted to confirm the insight. He looked at two mutual funds that had beaten the market by almost 10 percent annually from 2002 to 2006: “When I looked at how these mutual funds performed from 2002 through 2006, and compared it with how they performed over the next five years from 2007 through 2011, there was literally no correlation between them.…In the stock market, the data on the performance of individual traders [are] noisy enough that it’s very hard to tell whether they are any good at all. ‘Past performance is not indicative of future results’ appears in mutual-fund brochures for a reason."

If this is the case, why do we promote asset management based on one-, three-, five- and 10-year performance? Because it appeals to the pattern-recognition software hard-wired into our clients’ brains. Whether or not it actually helps investors make a good decision about an investment, showing past results has helped advisors convince investors to take action.

Is There Reason to Be Concerned?

Unfortunately, frequent experience has shown that it is rarely a good time to buy into a fund when it is riding high—after three or five years of outperformance or when everyone is talking about it. But our intuition about patterns can be very seductive, and this tendency to succumb to the seduction of outperformance isn’t limited to finance; it’s everywhere in business. Charles Wheelan (another mathematician) reminds us about this vulnerability in his book Naked Statistics: Stripping the Dread from the Data:

“Perhaps you’ve heard of the Sports Illustrated jinx, whereby individual athletes or teams featured on the cover of Sports Illustrated subsequently see their performance fall off.…[The] statistically sound explanation is that teams and athletes appear on its cover after some anomalously good stretch…and that their subsequent performance merely reverts back to what is normal, or the mean.…As a curious side note, researchers have also documented a Businessweek phenomenon. When CEOs receive high-profile awards, including being named one of Businessweek’s ‘Best Managers,’ their companies subsequently underperform over the next three years.”

What’s an Advisor to Do?

Advisors are caught between a psychological rock and a neurological hard place. Our clients’ intuition and even our own gut instincts cause the outperforming fund manager to “feel” like a better choice over the fund that has struggled. Of course, past underperformance can be indicative of a weaker fund manager or poor research, and we must use some rationale to select the managers with whom we want to work. Looking at historical performance and the stability of a management team is a starting point, but there are two additional, practice management disciplines to consider.

Invest Time and Effort in Client Education

Pointing out our normal, behavioral finance vulnerabilities and showing how intuition and gut instincts fail can be the first step in teaching clients how to make more rational investment decisions. The annual client review and seminars or conference calls provide opportunities to discuss these topics. Take some time in each meeting to explain some of the ways effective decisions can be foiled by our intuition.

It is also helpful to suggest books to clients. Even more powerful, send books as gifts, and then talk about them as important shared understandings in the relationship. I recommend Nassim Taleb’s book Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets, but there are many highly approachable commentaries on probability and the human mind’s challenges in “getting it.”

Explain the Mechanisms

Human beings are attracted to simple and familiar solutions to complicated problems. This is a big part of the appeal of the Morningstar Rating™ system. By looking at past performance, the system appeals to our (faulty) intuition and pattern-recognition habits. It is also amazingly effective in sorting out and simplifying a manager selection process. As such, it is both seductive and highly useful, provided it’s used correctly as part of a larger decision-making process. Morningstar itself provides this guidance:

“The Morningstar Rating™ is a quantitative assessment of a fund’s past performance—both return and risk—as measured from one to five stars. It uses focused comparison groups to better measure fund manager skill. As always, the Morningstar Rating™ is intended for use as the first step in the fund evaluation process. A high rating alone is not a sufficient basis for investment decisions."

As Morningstar clearly states, this one rating is not enough. Beyond appealing to our clients’ affinity for past experiences, we need to add layers of exploration to the selection process. One option is to help clients understand how a particular manager creates value for investors. This type of education can help a client assess not only what a manager has done in the past but the specific mechanisms he or she has used to achieve those results.

Understanding how the results were achieved is important for two reasons. First, it forces the client to use rational thought processes and move beyond simple and familiar intuitions about investments. The more the advisor models a thoughtful, information-rich approach to investing, the more he or she inoculates clients from indulging their “gut.” Second and more importantly, on those occasions when an investment disappoints, the advisor and client have a common vocabulary and experience from which to assess the decision about the investment. Rather than “You should have known better than to buy that fund,” the client is invited to reflect on the quality of the rational decision. Just because an investment disappoints doesn’t mean that it was a bad choice.

The two takeaways are this: First, investing in client education is the key.Helpclients get involved in the process of thinking it through rather than using their emotions as a way to “feel” that a decision is the right thing to do. Second, educate clients about how you pick managers on the basis of the mechanisms they are using and not merely by those simple and familiar performance track records.

Do you have a thoughtful process for educating clients about their behavioral finance vulnerabilities? Have you developed an effective way of educating clients about how you choose the managers you work with? I’d like to hear.

Ken Haman is the Managing Director at the AllianceBernstein Advisor Institute, visit http://ria.alliancebernstein.com.

Register or login for access to this item and much more

All On Wall Street content is archived after seven days.

Community members receive:
  • All recent and archived articles
  • Conference offers and updates
  • A full menu of enewsletter options
  • Web seminars, white papers, ebooks

Don't have an account? Register for Free Unlimited Access