Stop chasing hot stocks and star fund managers. Learn Daniel Kahneman’s concept of “regression to the mean” and why S&P 500 index funds are the only rational choice.
Introduction
Welcome back to the Investing Library. In this series, we are exploring the behavioral economics of Nobel laureate Daniel Kahneman to understand why our brains are naturally wired to lose money in the stock market.
In our previous posts, we learned how “Mental Accounting” makes you sell your winning stocks too early, and how the “Anchoring Effect” traps you into holding losing stocks just because you want to “break even.”
Today, let’s talk about how you choose your investments. Have you ever watched a YouTube finance expert recommend a “hot” mutual fund that went up 50% last year, and decided to invest your hard-earned money into it? If so, you probably noticed that almost immediately after you bought it, the fund’s performance crashed.
Why does this happen every single time? Are the Wall Street gods playing a cruel joke on you? No. You are simply a victim of a mathematical law called “Regression to the Mean.”
The Illusion of the Flight Instructors
In his book Thinking, Fast and Slow, Daniel Kahneman tells a fascinating story about his time teaching psychology to flight instructors in the Israeli Air Force.
Kahneman explained to the instructors that rewarding good behavior works much better than punishing bad behavior. However, an experienced flight instructor disagreed. He said, “Whenever I praise a cadet for a perfectly executed flight maneuver, the next time he flies, he does worse. But when a cadet performs terribly and I scream at him, the next time he flies, he almost always does better. So, punishment works, and praise doesn’t!”
Kahneman realized the instructor was completely wrong. The instructor was observing a statistical phenomenon, not a psychological one. When a cadet executed a “perfect” maneuver, he was likely having an unusually lucky day. It is mathematically probable that his next flight would be less perfect, regardless of whether he was praised or not. Conversely, a terrible flight meant the cadet was having an unusually unlucky day, so his next flight was bound to be better, even if the instructor didn’t scream at him.
The instructor mistakenly interpreted a random fluctuation in performance as a cause-and-effect relationship. This statistical law is called “regression to the mean,” meaning extreme outcomes are usually followed by more normal, average outcomes.
The Formula for Extreme Success
How does this apply to the stock market? Let us look at Kahneman’s simple formula for success:
- Success = Skill + Luck
- Extreme Success = A little more skill + A lot of luck
When a mutual fund manager or a specific stock becomes the #1 performer of the year, bringing in massive returns, investors immediately assume the manager is a genius. But according to Kahneman’s formula, extreme success requires a massive amount of luck.
We see this exact same phenomenon in corporate promotions. As an HR manager, I have observed countless executives. In large Korean conglomerates, the promotion rate to the executive level is less than 1%. Does this mean the other 99% are incompetent? Not at all.
When you look at the final 10 candidates for an executive spot, they are all incredibly smart, possess excellent interpersonal skills, and are highly skilled in their respective fields. If we could score their abilities, their total points would be almost identical. So, what makes that final 1% cross the finish line?
A CEO once joked to me, “Becoming an executive is 70% luck and 30% fortune.” At first, I thought he was just making a mathematical joke to be humble. But watching the corporate world up close, I realized it is the absolute truth. Even when a company is going through a massive crisis, there is always someone who luckily benefits from that specific situation and gets promoted.
Just like climbing the corporate ladder, becoming the #1 mutual fund manager in any given year is largely a roll of the dice, not sustainable skill. The problem is that luck is fickle. You cannot predict luck, and it does not last forever.
The problem is that luck is fickle. You cannot predict luck, and it does not last forever. If a fund manager had an extraordinarily lucky year, statistical probability tells us that next year, their luck will “regress to the mean” (return to average).
Decades of research prove this. When researchers look at the rankings of mutual fund managers year over year, the correlation is almost zero. A fund that is ranked #1 this year is just as likely to be ranked at the bottom next year. Their short-term success is largely a roll of the dice, not sustainable skill.
Stop Driving Using the Rear-View Mirror
Despite this mathematical truth, amateur investors constantly pour their money into last year’s top-performing funds. They look at a star fund manager’s recent extreme success and believe it is pure skill.
When you buy a fund after it has already gone up 50%, you are paying a premium price at the exact moment the manager’s luck is about to run out. As the legendary value investor Seth Klarman noted, investors who follow simplistic, backward-looking formulas are essentially driving by looking only in the rear-view mirror. They buy what was hot yesterday, only to suffer the inevitable regression to the mean tomorrow.
Conclusion: The Power of Index Funds
Do not pay a 2% annual management fee to a Wall Street expert just because they were lucky last year. When you chase extreme performance, you are almost guaranteed to catch the downward regression.
The only logical investment methodology for a FIRE investor is to accept that nobody can consistently predict the future or rely on luck. Instead of searching for a needle in a haystack, just buy the entire haystack. By investing a fixed amount of money every month into a low-cost S&P 500 ETF, you completely avoid the trap of chasing star managers. You harness the average growth of the entire economy, letting the magic of compounding build your wealth safely and quietly.
In our next and final post of the Investing Library behavioral series, we will uncover why checking financial news every day is practically guaranteed to melt your portfolio. Stay tuned!