We all have a hard time identifying skilled people. Similarly, we all have a hard time identifying smart people. Trust me, I have seen so many people being hired for a job where I would have sworn, they were smart and skilled enough to succeed. And then they turned out to be neither. Most people I know have a hit ratio in hiring people that is only slightly above 50% and I don’t pretend to be any better.
But because it is so difficult to identify skilled people, we often rely on shortcuts that we think give us an indication that this person should be skilled. One of the more famous mental shortcuts is that successful people must be smart. And success is typically measured as wealth in our society, giving rise to the fallacy that rich and successful people must be smart. No offense to the rich people reading this blog, but the correlation between wealth and intelligence is zero.
A similar fallacy is at work, at least according to a new paper by J. B. Heaton and Ginger Pennington, when we pick active fund managers.
Many of us know the classic example of the conjunction fallacy:
Linda is 31 years old, single, outspoken, and very bright. She majored in philosophy. As a student, she was deeply concerned with issues of discrimination and social justice, and also participated in antinuclear demonstrations.
Which is more probable?
1. Linda is a bank teller.
2. Linda is a bank teller and is active in the feminist movement.
Many people will select the second possibility as the more likely one even though that is logically impossible because feminist bank tellers are a subgroup of all bank tellers.
Heaton and Pennington asked a random selection of 1,004 individuals above the age of 30 and with a household income of more than $100,000 a similar question about fund management:
ABC Fund invests in common stocks listed on United States stock exchanges. Which is more likely?
1. ABC Fund will earn a good return this year for its investors.
2. ABC Fund will earn a good return this year for its investors and ABC Fund employs investment analysts who work hard to identify the best stocks for ABC Fund to invest in.
An astonishing 62.5% of respondents selected the second possibility. This is not only logically impossible as in the case of Linda the bank teller, but it shows that investors equate hard work with a higher probability of success in investing.
And this might explain something that is commonplace in fund marketing. Fund managers always point out how many analysts they have working for them and how many years of experience they have. This is obviously done to impress potential investors and show them how many skilled people are looking after their money.
Unfortunately, as I show in chapter 6 of my upcoming book (e-book available here), there is no evidence that having a larger number of analysts and fund managers work in a team leads to better performance. From the point of view of a professional fund selector, choosing the big brand names makes sense because it reduces career risk. As they say in the IT industry: “Nobody ever got fired for buying IBM”. Similarly, if you invest in an actively managed fund from a good brand with many analysts providing analysis for the fund manager, you can’t get fired for that.
But the first five chapters of my book show all the mistakes that professionals make all the time that cost them performance. And picking funds managed by people who make these mistakes is mistake number 6…
But as the research cited above shows, it is an all too common mistake and may be a major reason why good funds run by small boutique firms struggle while poor funds run by large firms succeed. They simply can point to all the work that is done to manage the investments and exploit the conjunction fallacy.