Stuck in the absolute – How bias affects our decisions?

I have been having a recent email exchange with a Unovestor. I was persuading him to consider more reasonable returns from his investments. His comments:

“If I cannot expect even 15 to 18% returns from equity or mutual funds then what is the point of investing in them.

Even real estate investment held over long periods of time can give 15% returns.”

Now, there are certain issues with this line of thinking.

The behavioural experts have defined a good list of cognitive biases that influence our thought process and this argument was no exception.

In this particular case, there are 2 clear biases that stand out. There is yet another one, that I add. 

1 Recency Bias

Since the past returns of stocks or mutual funds have been in the range of 15% to 18%, there is an assumption that the same will repeat in the future too. This is the most recent information available and the mind falls for it.

The same is true for using the real estate investment returns number.

It is the same bias that millions of new investors flock to the stock markets to make a killing or small investors end up freezing their money in real estate.

Unfortunately, the future is unlikely to be the same as there are several factors (including the unknown ones) that can influence the final outcomes.

So, how should you think about returns? Read more here

2 Survivorship Bias

There is a famous World War 2 story where the analysts were trying to find out reasons that there planes were getting shot and did not return from the battlefield.

To find out the same, they were looking at the planes that had returned to the base. They were looking at the bullet shots on the bodies of the plane and planning to enhance the safety based on that.

Do you think they got it?

Unfortunately no! The big mistake they made was they looked at fighter planes that returned and not that got shot down. They were biased by the survivors.

You can click here to download a detailed note on describing this war story and the Survivorship Bias.

The same story repeats in investing. You and I are prone to look at the winners, those who made it big. However, we completely discount information on what simple mistake could have put their existence in danger. In fact, the mistakes that actually made the losers. We also discount the role of sheer luck in being present at the right place and at the right time.

The story of returns from real estate is similar. Those who lost money never speak about it. Those who made money go tom-tomming about it around the whole town.

Real estate in my view is the arena of those with big pockets such as the institutional players. Given its illiquidity, physicality and maintenance issues, it comes with a very different cost-benefit ratio.

So, it is important to seek out the other stories too, those who did not survive and build that in to your decision making model.

3 Absolute Return Bias

This I just came up with and in some ways is a subset of the Recency bias.

One of the key things to remember about investing is that you don’t just want absolute returns, but better inflation adjusted and risk adjusted returns. You need real returns to grow your wealth.

So, let me invert it for you. What if you get 18% returns but the inflation is at 14%, that is the prices of goods and service that you use are increasing by that rate.

Your real return (Nominal return – inflation) in such a scenario is just 4%. How do you feel?

Here’s what I am telling my dear investor friend. Even if inflation currently averages 8% (more likely to, based on current trends) and you get 12%, you are still good!

So, what’s the more relevant number?