Belief in small numbers

Nobel prize winner Daniel Kahneman, and his long-time colleague, Amos Tversky (who would have been awarded the Nobel Prize, too, but sadly was deceased at the time the prize was awarded), wrote an article for the Psychological Bulletin in 1971 titled "Belief in the Law of Small Numbers."

Granted, most of us have heard of the law of large numbers; but the law of small numbers? Basically, they point out how we tend to put more stock in results from limited samples than we should.

A blog post earlier this month raised the question of using less than 36 months for standard deviation, so today's post is, in a way, a continuation of that theme.

We are regularly approached by individuals who want their track record verified. Sometimes their track record is merely a few months' old. Granted, becoming compliant with GIPS(R) (Global Investment Performance Standards) is better done as early in the life of the firm as possible, but what these situations typically show is someone who has had great success for a very limited time. Often, it's with their own money. The real question: will it continue? And, as the saying goes, only time will tell.

My wife and I have become big fans of The Big Bang Theory, and watch it whenever we can (including reruns, since most are new to us). In one episode, Howard Wolowitz proposes to Bernadette Rostenkowski, and she understandably turns him down, pointing out that at the time they had had only three dates. Granted, some folks DO get married after a very short courtship, but most take a while before committing.

The author and speaker Harvey Mackay wrote of requiring prospective employees to be interviewed by many folks in his firm (and on occasion, some of his clients or vendors, too). He would engage individuals in multiple meetings himself, as he felt that just one experience wasn't sufficient.

And so, there is evidence that in some ways we do require more than just a small sample; but too often we are prepared to judge based on a few.

Institutional investors typically want a minimum of five years' performance before considering a manager; the retail world is not as disciplined. And perhaps it's a good thing, because if no one was prepared to give managers money to invest, few would make it to five years.

But guidance is important when presenting a track record, in performance and risk terms, for a short time period. Perhaps additional qualifying language is in order!