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Look forward, not backward, with Warren Buffett

(MoneyWatch) So-called hindsight bias is the inclination to see events that have already occurred as being more predictable than they were before they took place. It leads us to believe that even events that "experts" failed to foresee were obvious or even inevitable.

For example, we know today that Warren Buffett has produced great returns for investors in Berkshire Hathaway (BRK). But was it obvious back in 1965 when he took over the company? In 1989, noted economist Paul Samuelson, who called Buffett a genius, wrote that it was anything but clear that an investment in Berkshire would turn out to be so enormously profitable. He also noted that by that time, even Buffett had acknowledged that with the growing size of his portfolio he doubted he could get the same results going forward.

Most investors rely on past performance when making investment choices. Despite the SEC's standard warning, they believe that past performance is prologue. However, the academic evidence demonstrates that distinguishing skill from luck is very difficult. Consider the following.

Fidelity Magellan had beaten the S&P 500 Index in 11 of the 13 years ending in 1989. However, there was a 99.8 percent chance that a fund manager would beat the market in 11 of those 13 years. Unfortunately, for those believing Magellan's performance was prologue, the fund has gone on to produce poor returns, and investors have fled in droves.

Today, we know that Buffett is a great investor. However, there are many fund managers who invest using the same type of value-oriented strategy espoused by Buffett's mentor, Benjamin Graham. "Confirmation bias," or the tendency to favor information that confirms their beliefs, causes us to ignore information that is contrary to our views of the world. In a 2001 paper, "Buffett in foresight and hindsight," the authors discuss a few other funds that invest the "Buffet way." Among them were the Weitz Value fund (WVALX) and the Legg Mason Focus Fund (now the Legg Mason Capital Management Growth Trust, LMGTX). With the benefit of hindsight, we can now see how investors in those funds fared.

Using Morningstar's data, for the 10-year period ending March 20, 2012, WVALX had underperformed its benchmark by 0.9 percent per year and ranked in the 76th percentile of funds in its category. LMGTX fared no better. The fund underperformed its benchmark by 1 percent a year and ranked in the 71st percentile of funds in its category. And as a demonstration of another risk of investing in actively managed funds, the fund migrated (as the new name indicates) from a value to a growth strategy.

Many other examples could be provided. Of course, there will be some funds that did go on to outperform. For example, another fund that was mentioned in the "Buffett in Foresight and Hindsight" paper was the Sequoia Fund (SEQUX). For the 10 years ending December 2011, the fund earned 5.6 percent and outperformed the comparable passively managed DFA Large Cap Value Portfolio (DFLVX), which returned 4.6 percent. The problem is that without the benefit of hindsight bias we have no way to distinguish the future winners from the future losers. In other words, as economist Eugene Fama and finance professor Kenneth French demonstrated in their 2010 paper, "Luck versus skill in the cross section of mutual fund returns," it's very hard to distinguish between luck and skill.

We know with hindsight that investors in Berkshire who bought in 1965, or even in 1999, outperformed the market. But do we know that with foresight? When it comes to actively managed funds, the evidence demonstrates that the past is not prologue.

The bottom line is that hindsight bias is very dangerous. It causes investors to recall their successes, but not their failures. It also causes investors to believe that investment outcomes are far more predictable than they actually are. Santa Clara University finance professor Meir Statman puts it this way: "Hindsight bias makes it easy to believe not only that the future is preordained, but that anyone with half a brain could have seen it." Hindsight bias promotes both overconfidence and a perception that investing entails far less risk than it actually does.

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