Making Love to Short Term Performance

Location Date: 
February 14, 2014

Special Valentine's Day Guest Blog Post by: Sean Wynn

Hi all,

In case you ever needed confirmation that Jim McGovern is both smart and crafty, today he asked (I’m going with coerced) me to write a Guest Blog for his site. Why smart and crafty you ask? Well today’s topic will try to tie a formula about marital stability, involving frequency of lovemaking and frequency of quarrelling to how we make our investment decisions. Presently, both Jim and I are married, and on my side this may be directly related to my wife not having read this blog yet. Smart and crafty...

If you know Jim you’ll probably know he is a big fan of 1982 Nobel Laureate Dr. Daniel Kahneman, author of the bestselling book “Thinking, Fast & Slow.”1. In fact, he recommended this book to me, and I very recently skimmed it, while doing so I stumbled onto a section that I found riveting for several reasons.

The section discussed an article “The Robust Beauty of Improper Linear Models in Decision Making” 2 co-written by the late Robin M. Dawes, a University professor and a pioneer in the field of behavioural research. At a very high level it discusses how you “properly” weight different parts of formulas... are some factors more important than others. Historically, it was assumed certain factors in each formula should be weighed more heavily than others for a multitude of reasons.

Dawes challenged this notion and developed a formula that has proved far better than the average marriage counselor at predicting whether a marriage will last. The (linear and equally weighted) Dawes Formula is remarkably simple: Marital stability is very predictable by taking the frequency of love-making minus the frequency of quarrels. A positive difference predicts marital happiness (stability), a negative one unhappiness (instability)

I found this formula both funny (but to be clear, not THAT funny Sweetheart) but also seemingly obvious and intuitive? As a side note: It was suggested I post some of my own personal marital stability formula numbers here, but after dialogue with Arrow’s legal team we have decided this may not be totally prudent.

Really though, this got me to thinking about how the individuals I interact with on a daily basis make some of their Investment decisions and the resulting stability or instability of those decisions? I think there are a seemingly endless number of factors that Investors use to make their decisions: Manager pedigree, long term performance, short term performance, fund size, firm size, volatility of returns, Beta, Alpha, Sharpe Rations, skewness and Kurtosis (who really even knows what these last two are?) etc... ad nauseum. 

However, I think the factor that is most often over-weighted is short term performance. Alfred Rappaport has written a piece that focuses on this error, called "The Economics of Short-Term Performance Obsession"3Click here to read this article. 

This short term performance obsession also ties back to another principal from Kahneman called the WYSIATI principle – “What You See Is All There Is”1. Hence, if the Managers performance has been stellar for the last 6 months, it follows that it must always be stellar? Clearly, this fails to reflect reversion to the mean and also our favourite disclaimer on any investment business marketing piece: “Past Performance is not indicative of future returns”.

So where am I going with all of this? There are all kinds of ways that we make decision making easier in our daily lives. But by being aware of our natural biases we can hopefully avoid placing too much value on (overweighting) certain factors at the cost of underweighting others? This should prove to be helpful to investors and allow them to make decisions that are more stable for the long term.

And really, on Valentine’s Day, shouldn’t we all make love a little more frequently and quarrel just a little bit less?

For the first and possibly last time.

The currently married Sean Wynn

1. Thinking, Fast & Slow, Daniel Kahneman, 2011 
2. The Robust Beauty of Improper Linear Models in Decision Making, Robin M. Dawes
3. The Economics of Short-Term Performance Obsession, Alfred Rappaport