These days, Sensex is at new high and investors are still bullish on pharma and FMCG sectors.

Just because in last 5 years these two sectors performed well does not mean they will continue to do well in future too.Such thinking is absurd.

Most investors fall victim to this behaviour of analysing past outcomes while taking future investment decisions.

                                                         This is known as “Outcome Bias.

Outcome bias is a human behaviour in general and can be applied to several non financial situations as well. Take for instance the area of medical science. Let’s say Mr Dumb has a job of evaluating the performance of three heart surgeons. To do this, he asks them each to carry out a difficult operation on five patients each. Over the years, the probability of dying from this kind of operation has been standardized at 20% (i.e. Probability of 1 in 5 patients dying from this procedure).

The results of this experiment turn out to be as under:-

  • With surgeon A, no one dies.
  • With surgeon B, one patient dies.
  • With surgeon C, two die.

Now, how will he rate the performance of A, B and C?

If he thinks like most people then he would rate A the best, B the second best, and C the worst.

If he does so we can very well tell that he has fallen prey to “Outcome Bias”.

This is because “5” is too small a sample for arriving at a conclusion. He should rather evaluate the surgeons based on their preparation and execution processes for the operation.

Let us now look at the mutual fund industry. Here, most investors take decisions on investing in a particular scheme based on its past performance. One must understand that performance is a function of both the companies’ performance as well as the performance of the economy. Both these factors are dynamic and not repetitive in nature.

Hence, future performance can only depend on the future and would have little bearing on the past. Therefore it would be better to take a long term view on performance based on fundamentals of the economy and quality of the asset management companies.  A good asset management company with long track record and good processes is much better lens to view future performance.

The message that “Thinking Man” bring is to resist the temptation of forecasting the future based on the past outcomes. Instead take an advice of experts who can help you navigate the future.