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In our last post, we talked about the gambler’s fallacy and how it can fool investors into thinking that since there has been a run of good stock market performance, we must be due for a downturn. Now let’s look at the hot hand fallacy.
 

In sports, the hot-hand fallacy leads one to predict that a player will continue to be hot because his recent performance has been hot; for investors, it is the fallacy that a hot manager or asset class will continue to perform well given recent performance.
 

More generally, the hot-hand fallacy involves predictions of unwarranted continuation when observing processes that are unknown. The belief that streaks have predictive power is an illusion that can cause investors to make poor investment decisions.
 

The chart below shows the 2013 returns for several asset classes. The developed stock markets experienced double digit returns for 2013 but bonds, US REITs and Emerging Markets ranked at the bottom in returns.
 

Are your clients going to buy only last year’s hot asset classes and avoid last year’s cold ones the next time they add money to their account? Or will they remember that just because an asset class performs at the top of the list one year doesn’t mean it won’t be at the bottom of the list the next year?
 

Are they going to be reluctant to sell hot asset classes and buy cold ones when it comes time to rebalance their portfolio?
 

2013 Asset Class Returns
Asset Class US Large Cap Stocks US Value Stocks US Small Cap Stocks US REIT Stocks Int’l Value Stocks Int’l Small Stocks Emerging Markets Stocks Global 1-5 Year Bonds US Gob/Credit 1-3 Year Bonds
Return 32.4% 32.5% 38.8% 1.2% 21.5% 25.6% -2.6% 0.6% 0/7%


Source: Morningstar Direct 2014. Market segment (Index representation) as follows: US Large Cap Stocks (S&P 500 Index), US Value Stocks (Russell 1000 Value Index), US Small Company Stocks (Russell 2000 Index), US REIT Stocks (Dow Jones U.S. Select REIT Index), International Value Stocks (MSCI World Ex USA Value Index (net div.)), International Small Stocks (MSCI World Ex USA Small (net div.)), Emerging Markets Stocks (MSCI Emerging Markets Index (net div)), Global1-5 Year Bonds (Citi WGBI 1-5 Yr Hdg USD), US Gov/Credit 1-3 Year Bonds (BofA ML Corp & Govt 1-3 Yr TR).

 

Past performance does not guarantee future results. Indexes are unmanaged baskets of securities in which investors cannot directly invest; they do not reflect the payment of advisory fees or other expenses associated with specific investments or the management of an actual portfolio.

 

The gambler’s and hot-hand fallacies plague gamblers, sports fans and investors alike, and it is times like these when we have to earn our keep as advisors. Talk to your clients about these mental landmines so they can avoid the mistakes that so many investors make.
 


The risks associated with investing in stocks and overweighting small company and value stocks potentially include increased volatility (up and down movement in the value of your assets) and loss of principal.

 

Real estate securities funds are subject to changes in economic conditions, credit risk and interest rate fluctuations.
 

International and emerging markets involve additional risks, including, but not limited to, currency fluctuation, political instability, foreign taxes, and different methods of accounting and financial reporting. As a result, they may not be suitable investment options for everyone.
 

Fixed income securities are subject to interest rate risk because the prices of fixed income securities tend to move in the opposite direction of interest rates. In general, fixed income securities with longer maturities are more sensitive to these price changes and may experience greater fluctuation in returns.