3 Riddles, 1 Answer

The Sports Illustrated Cover Jinx

Several of my college roommates and I were huge sports fans. Since some of us had been subscribing to Sports Illustrated for many years we came up with what we considered a brilliant idea to decorate our apartment. We gathered up all our old copies of Sports Illustrated, removed the covers, and wallpapered our entire apartment with them. We probably wouldn’t have won any interior decorating contests but we loved it. Our apartment was unique if nothing else.  Below is a picture of my mother, Alice Esplin, taken in our apartment in 1985, only a few months before her unexpected death from a heart attack.    Surrounded constantly by sports greatness we couldn’t help but notice something interesting. Many of the faces staring out from our walls had never again regained the prominence that caused Sports Illustrated to immortalize them on its famed cover. Most of them suffered a decrease in the level of their performance not long after appearing on the cover and more than a few suffered injuries that kept them from performing at all, at least temporarily. We weren’t the only ones to notice this interesting phenomenon which came to be known as the Sports Illustrated cover jinx. There was no doubt this was happening, but why? At the time I would have been hard pressed to come up with an explanation.

Top Gun Training

Famed Israeli psychologist and Nobel Prize winner Daniel Kahneman served many years in the Israeli military. One of his assignments was to observe the training of fighter pilots and recommend ways to improve it. After watching the flight instructors repeatedly hurl obscenities at trainees who made mistakes Kahneman taught them an important principle. He told the flight instructors that research indicated that when teaching skills “rewards for improved performance works better than punishment of mistakes.” The flight instructors weren’t buying it. One of them, speaking for the group, responded “On many occasions I have praised flight cadets for clean execution of some aerobatic maneuver. The next time they try the same maneuver they usually do worse. On the other hand, I have often screamed into a cadet’s earphone for bad execution, and in general he does better on his next try. So please don’t tell us that reward works and punishment does not, because the opposite is the case.” Who is right? How could the flight instructor’s experience differ so much from the scientific research Kahneman was relying on?

Falling Stars

“Past performance does not guarantee future results.” This is perhaps the most frequently repeated warning given to investors. It is also the most frequently ignored advice, as we have a hard time believing that a fund manager who achieves superior results one year will not be able to replicate those results going forward. It just seems to make sense that the best way to pick mutual funds is to go with the funds that did the best in the recent past.   To test this theory the Wall Street Journal did a study of all 5-Star rated mutual funds going back to 1929. Of the 248 funds given a 5-Star rating during that period only 4 still had that lofty rating a decade later.   Many of the top-rated funds had a hard time maintaining superior performance for even one additional year, as illustrated by Carl “Sketch Guy” Richards in one of his brilliant drawings: This persistent believe, in spite of evidence to the contrary, that past performance does predict future results leads to what Larry Swedroe terms “The Investor’s Lament,” which is: “I own last year’s top performing funds. Unfortunately, I bought them this year.” Why does the evidence so clearly contradict our intuition that past results are the best way to predict future mutual fund performance?   

Solving the Riddles

Interestingly these seemingly unrelated riddles, one from sports, one from pilot training, and one from investing, all have the same answer. In statistical terms the explanation is called reversion to the mean, which, according to Robert G. Hagstrom, is “the tendency of unusually high or unusually low values to eventually drift back toward the middle.” While you might not be familiar with the term reversion to the mean you are undoubtedly familiar with several proverbs that express the same concept. These include:

• “What goes up, must come down.”
• “Pride goeth before the fall.” and
• “What goes around, comes around.”

Let’s see how the principle of reversion to the mean solves each of our riddles.

The Jinx

The Sports Illustrated cover jinx is not a jinx at all. It is simply reversion to the mean in action. To get your picture on the cover of Sports Illustrated you have to do something extraordinary, and it is difficult to be consistently extraordinary. Indeed, to be featured on a Sports Illustrated cover you need not only incredible skill, but also a dose of good luck, and both incredible skill and good luck are likely to deteriorate over time. For most people the only direction to go after being featured on the cover of Sports Illustrated is down, and unsurprisingly that’s what most of them do. What superstitious players and sports fans see as a jinx statisticians see as practically inevitable.

Reward & Punishment

Daniel Kahneman didn’t doubt the flight instructor’s observation that praise was usually followed by a disappointing performance while punishment was usually followed by improvement, but he did disagree with the conclusion that the feedback of the flight instructor was the cause. In the words of Kahneman, “The instructor was right – but he was also completely wrong!” Kahneman continued: “Naturally, he praised only a cadet whose performance was far better than average. But the cadet was probably just lucky on that particular attempt and therefore likely to deteriorate regardless of whether or not he was praised. Similarly, the instructor would shout into a cadet’s earphones only when the cadet’s performance was unusually bad and therefore likely to improve regardless of what the instructor did.” Kahneman concluded, “Consequently, the human condition is such that, by chance alone, one is most often rewarded by punishing others and most often punished by rewarding others.” Bobby Knight’s behavior is explained at last!

5-Star Mutual Funds

5-Star mutual funds can be thought of the same way as SI cover subjects. Both achieved their success based on some combination of skill and luck and both are a reward for success at a single moment in time. If a 5-Star mutual fund rating says anything about future investing performance it is that, as with the SI cover “jinx,” it will be extremely difficult to maintain the great results going forward.     This persistent pattern of today’s hot mutual funds being replaced by a new batch of hot funds in the not-to-distant future lead Vanguard founder John Bogle to define reversion to the mean as, “…the law of gravity in the financial markets that causes funds that are up to go down, and funds that are down to go up.” Under such conditions the only logical thing to do is to follow Bogle’s advice and stop trying to pick winning funds at all. Instead stick to low-cost index funds. In Bogle’s always memorable words, “Don’t look for the needle – buy the haystack.”

Lessons Learned

• Most jinxes and superstitions can be easily explained if you just look a little deeper.
• Praise doesn’t cause poor performance and punishment doesn’t cause improved performance.
• It’s alright to generously compliment great performance and behavior while being merciful towards mistakes. Kindness and praise work.  
• Stop trying to pick winning mutual funds and stick with low-cost index funds. By doing so you are likely, over time, to beat most of today’s “hot” funds without even trying.

There you have it.   Three riddles with a single answer – reversion to the mean. It is hard to believe that this simple concept can explain so much. While I don’t want to overstate my case I believe that learning and applying these lessons can make all of us better spouses, parents, teachers, coaches, friends – and perhaps least important, better investors. I would love to hear your thoughts.