What's Past is Not Prologue
5 Pages Posted: 8 Aug 2018
Date Written: April 1, 2017
In this note we present several thought experiments involving coin-flipping to illustrate the common tendency to over-weight past data in forecasting the future, particularly in the context of investment returns. We start by describing a survey we conducted of about 700 respondents involving the identification of a biased coin. From there, we connect a simple coin-flipping thought experiment to the challenge of picking good investments based on past returns. We then develop a more realistic model (moving on from coin-flipping) that shows the difficulty in discerning attractive investments from within a pool of mostly unattractive ones. We conclude with some observations on other practical challenges in using past returns to identify exceptional investment opportunities.
Keywords: Decision Making under Uncertainty, Risk, Utility, Risk Aversion, Coin Flip, Heuristics, Rules of Thumb, Market Timing, Gambling, Betting, Manager Selection, Sharpe Ratio, Mutual Funds, Data Mining
JEL Classification: B12, B16, B20, C00, C10, C11, C50, C57, C73, D03, D81, D83, E00, G00, G02, G11, G12, G14, G17, G23
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