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Are we deluding ourselves?

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Are we deluding ourselves?

Humans are fascinating, complex creatures, capable of amazing achievements.  At the same time, as psychology researchers like Daniel Kahneman and Amos Tversky have pushed forward our understanding of the human mind, it has become increasingly clear that we are indeed strange.  Far from being the rational decision makers that behavioural theory once assumed, we find that our cognitive processes can be deeply flawed, leading to poor decision making and sub-optimal outcomes.

As investors, it is helpful to have a working knowledge of some of the more prominent threats to orderly investment thinking.  Indeed, many of the opportunities that exist in investment markets arise out of being able to exploit the poor decision-making of others.

One of my (least) favourite cognitive biases is hindsight bias: the tendency to view events after they have happened as much more predictable than they actually were before the event.  When we become aware of an outcome of something – say an investment decision – we all have a tendency to reconstruct our memory with the benefit of the new knowledge (the outcome), such that we believe we knew – or perhaps should have known – all along what the outcome would be. The knowledge of the outcome can lead to the creation of new memories that are completely false, but very believable.

The concept of hindsight bias first emerged in the psychological research in the 1970s, and since then we have learned a few things about it, including:

  • It is more likely to occur when the outcome of an event is negative. That stock call that you or your advisor got wrong – it turns out that that was especially easy to spot.  Like a mile off;
  • It is surprisingly resilient. Even people who are aware of it, and consciously trying to avoid it, suffer from it. Attempts to counter it have generally not been very successful;
  • It is a particular problem for people who suffer from schizophrenia, and is associated with delusional belief, typically found in patients suffering from schizophrenia. However, this ability to delude ourselves is something we all share to some extent.

So, in answer to the question above, yes, we are all deluding ourselves, at least some of the time. Sometimes we have accomplices – the investment industry for example is replete with commentators who can explain (after the event) why said event was the inevitable consequence of what came before it.

For those that would be free of this particular bias, one method that has shown some promise is to take the time to explicitly think about the counterfactuals.  If you actively think about the other things that could have happened but didn’t, you become less attached to the one thing that did happen.

Give it a try the next time you find yourself regretting an investment call that didn’t work out. Learn from your mistakes, by all means, but learn from the real ones, not the imaginary ones.

 

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Tim joined Montgomery as Head of Research and Portfolio Manager of The Montgomery Fund in July 2012. Prior to this, Tim was an Executive Director in the corporate advisory division of Gresham Partners, where he worked for 17 years. Before joining Gresham Partners, Tim worked for McKinsey & Company for four years, where he was involved in strategic consulting in both Australia and Denmark.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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Comments

  1. I always think it is interesting judging who the ‘experts’ are. After the GFC people in hindsight judge ‘experts’ like Steve Keen and Roubini as just happening to be right. The idea is that some contrarians will eventually be right. Yet if, one was closely following these people prior to the event and followed their reasoning as to why the crash was going to occur and their escalating alarm even weeks and days before the crash occurred one realises they did have solid insights.

    The point I am making is that valid hindsight requires the evaluation of one’s foresight and that requires one being close to the phenomenon that is unfolding rather than having a vague conception of it.

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