The Observer Effect and how it messes with investment returns

There is a formal theory called ‘The Observer Effect‘ in science that is to do with how the presence of an observer determines the outcome of a phenomenon. This article is only loosely related, not as deep, and probably more fun.

Think about a time when, on a lazy Sunday mid-morning, a distant out-of-town relative called out of the blue and said they happen to be visiting their son in your city, will be passing close to where you live, and would like to come over, today, in an hour! Please don’t go to any trouble.

Or imagine, at work, that as part of an HR Talent Development initiative with a top Business School, you were assigned an intern to shadow you and learn from “a month in the life of a Director – Strategic Partnerships”. This happens.

You probably scrambled around tidying up, but only your living room while frantically thinking about whether an hour meant you were supposed to offer lunch or just some swiggy’ed samosas and tea would do the job.

For the week with the intern, you probably racked your brain about making sure the impressionable future job applicant walked away with the “right” appreciation for how vital your role was in the goings-on at your organization.

Both of these are low-stakes encounters. You won’t see the distant relative for another decade if at all. And the 24-year old intern is just anxious to make a good impression.

The impending appearance of an observer, any observer, has an impact on our behaviour.

This impact on behaviour is proportional to the perceived importance of the encounter to our future. So, we’re on our most contrived in job interviews. “My biggest weakness is I can be too demanding of myself”. Yeah right.

Let’s switch lanes to investing and say you invested in two mutual funds a year ago. One weekend you decide to see how your portfolio is doing, and you’re not thrilled to find both funds have underperformed the market identically over the last year.

This weekend you’ve decided you will take action. So you open the latest holdings statements of both funds. They are completely different portfolios.

  • Fund A has names you recognize well. An adhesives company, a well-known paints company, the largest private sector lender, the one that makes the high-margin shave gel you use, and so on.
  • Fund B also has names you know, but don’t necessarily like, and others you don’t know. A large infrastructure player, a metals behemoth, a couple of companies you vaguely know are in industrial supplies, and so on.

Your options are take no action, exit both, or exit one. Well, there’s also, allocate more to one or both.

Would you stay invested in both, exit both, exit Fund A and not B, or exit Fund B and not A?

Exit Fund B and retain Fund A. Obviously? At least this is the choice most investors tend to make.

The reasoning goes something like this:

  • Fund B seems to have made some poor sectoral calls and seems to be holding value traps, and some unknown mid-caps.
  • Fund A, on the other hand, has quality companies, albeit expensive, and they’ve already started to turn around going by their recent price movement. It is just a matter of time.

Now, flip hats and become the Fund Manager who is aware of this behavior where investors attribute your competence and therefore decide to allocate less (more) to you based on how they feel about the current companies in your portfolio. Remember, both Funds have done identically poorly over the same time period.

Academics say this makes fund managers take action just before portfolio disclosures are due, to replace recent underperformers with outperformers. They call this “window dressing” because the investor opening the portfolio statement sees a recently added set of companies they will not feel displeased about, irrespective of their portfolio performance.

This might well be true. But I think the overall impact on fund manager behaviour is more insidious.

Returns from equities come for a variety of reasons and businesses. Strong businesses delivering stronger. Mediocre businesses becoming less mediocre. Weak, almost defunct businesses managing to survive. i.e. When business results change trajectory for the better.

But if at any point in time, as per popular perception and recent results, there is consensus over a small number of “superstar” stocks, a few “safe” stocks, and a lot of downright “ugly” stocks, why would a fund manager risk losing credibility (and AUM) by holding anything but the first two categories?

After all, just like no one ever got fired for buying IBM back in the 1970s, no fund manager ever got fired for buying the widely discussed set of “Quality” stocks that everyone seems to know about.

Sure, the “ugly” stocks might have delivered over a longer time-frame, but the Fund’s bills including the Fund Manager’s salary need to be paid yearly.

If you were Fund Manager B, how would this influence your actions in the future?

If you’re the investor, should the underlying portfolio factor in your decision to stay invested or to exit?

No one ever got fired for buying IBM, but maybe they should.

Leave a Reply

Your email address will not be published. Required fields are marked *