Illusion of Validity and Power of Process

There are only handful of fund managers who have beaten an index for more than 10 years, in India and abroad. There are so many investment management courses and books to teach us how to get better at stock picking; but why is that there are limited number of people who have managed to earn respectable performance?

The answer is an “illusion of validity”.

The term “illusion of validity” was first introduced by Amos Tversky and Daniel Kahneman in a paper published in 1973. It describes the tendency to overrate our ability to make accurate predictions. This bias exists because of confirmation bias – the desire to find information that fits our prediction and the representativeness heuristic – predicting based on what how much this situation resembles other situations. This effect persists even when individuals are conscious of the objective limits in the predictive power of their data. For this reason, simple models are often more effective than expert opinions at accurately predicting outcomes.

Investors and analysts alike have the fallacy of illusion of validity. Based on available data, investors think they are capable to predict outcome of a particular event or future prospects of a company. Managers churn their portfolio several times over in 3 years span based on their short term view on multiple stocks. However, behavioural economists on several occasions have found that simple models/processes can beat the experts at the game. Even an index fund manages to beat their performance because it is based on a simple model.

In investing, it is very difficult to separate skills from luck. Anyone can build a 20 stock portfolio and beat market returns in short term. This is unlike other professions like dentistry or pastry chefs where skills are distinguishable from luck almost immediately. In investing, we will know about one’s skills only after several years of repeated success. Investing with him after 10 years of success can again be unreliable, as till then he/she may have lost the edge. We haven’t found many investors being able to pick winners one after another on consistent basis. One goof up can takeaway several years of stellar performance. In India, no fund has been remained a top performer on more than one occasion.

Luckily, investors today have access to a comprehensive solution. Research houses like Research Affiliates, AQR and O’shaughnessy Management have demonstrated that simple models constructed on certain key metrics like low price to book, low price to sales and price strength tend to beat index returns quite consistently with an occasionally lag. In our opinion, this is more reliable way to invest as we will stick to it because of evidence and risks of occasional underperformance are known in advance. We can diversify across couple of processes and sit tight. Many Indian investment managers are also following one or the other process, we are one of them. Mutual Funds with a process have remained in Top Quartile over any 10 year period; other funds come and go.

At MoneyWorks4me, we follow a process of buying companies that have earned high return on capital for long periods. It is likely that these companies enjoy narrow or wide competitive advantage to continue earning superior returns on capital in the future. We are careful to buy them when they are out of favour so that we can improve our chances to earn good absolute returns. This process was popularised by Warren Buffett, later practiced by Tweedy Browne, Gotham Asset and Sequoia Fund.

As anyone whoever follows a particular process must, we do not second guess what will happen in next year or next quarter. Also, we don’t expect every stock to turns out to be a winner; it will be known only in hindsight. Hence, we recommend holding a basket of them so that few disappointments do not affect portfolio returns. Handpicking companies within that basket based on available knowledge is nothing but fallacy of illusion of validity. We believe, over long term, process is more powerful than expertise. We like them for its repeatability and durability.

One may own all the processes, like we do in our Omega Product. Or one may stick to one process that suits his temperament.