Bubbles come and bubbles go, and although the details differ, each time the path remains familiar. So why don’t we learn from our past mistakes?
James Montier led off chapter 12 of "The Little Book of Behavioral Investing: How Not to Be Your Own Worst Enemy" with that question. And, of course, he offered some answers. To start, he blames our X-system, the emotion-driven portion of our brains; instead, what we should use to look at bubbles are our C-systems, which come from the logical portion of our brains.
For support of his position, he turned to John Kenneth Galbraith, a noted economist of the mid-20th century. Galbraith blames the “extreme brevity” of our financial memories:
“In consequence, financial disaster is quickly forgotten. In further consequence, when the same or closely similar circumstances occur again, sometimes in a few years, they are hailed by a new, often youthful, and always supremely self-confident generation as a brilliantly innovative discovery in the financial and larger economic world. There can be few fields of human endeavor in which history counts for so little as in the world of finance.”
Montier also argued that to learn from our mistakes, it is necessary to understand that we made a mistake. This, he said, helps us explore two psychological biases: self-attrition bias and hindsight bias.
Self-attribution bias
This refers to an old, but still true, chestnut: we attribute our successes as investors to our own skill and blame failures on something or somebody else.
To validate this premise, psychologists opened the sports pages of newspapers to examine the attribution biases of athletes. After a win, athletes attributed their success to internal attrition (a form of self-attrition) 75% of the time. When they lost, however,they only referred to internal attrition 55% of the time.
Montier said investors behave the same way, despite the reality being bad analysis. One investor who tries to understand why is David Einhorn (Trades, Portfolio) of Greenlight Capital. Einhorn recommended homebuilder M.D.C. Holdings (MDC, Financial) in 2005. Four years later, after almost everything related to the housing industry had given up much ground, M.D.C. was down 40%. He said, “The loss was not bad luck; it was bad analysis.” Einhorn acknowledged he failed to grasp the scope of the housing and credit bubble.
Countering self-attribution bias
To avoid being stung by this bias, Montier recommended that investors write down what they did and why they did it. Later, that will enable them to diagram their results:
This table forces investors to honestly assess their performance, particularly the self-attribution element: did this success result from good analysis or was it simply good luck?
The investment diary is broader in scope, capturing both investment results and the thinking that drove each decision (this will help separate good analysis from good luck). Writing in “Alchemy of Finance,” George Soros (Trades, Portfolio) said:
“I kept a diary in which I recorded the thoughts that went into my investment decisions on a real-time basis. . . . The experiment was a roaring success in financial terms—my fund never did better. It also produced a surprising result: I came out of the experiment with quite different expectations about the future.”
Montier added:
“Only by cross- referencing our decisions and the reasons for those decisions with the outcomes, can we hope to understand when we are lucky and when we have used genuine skill, and more importantly, where we are making persistent recurrent mistakes.”
Hindsight bias
Montier had another reason for wanting us to keep an investment diary: to avoid the risk of Monday morning quarterbacking, also known as hindsight bias. This bias, like the self-attribution bias, can keep us from learning from our mistakes. He defines hindsight bias as “the idea that once we know the outcome we tend to think we knew it all the time.”
As he noted, investors apparently enjoy an “Orwellian rewriting of history” in the wake of each bubble. It is after-the-fact rationalization that made the bubble seem much more predictable than it was before it happened.
To illustrate this bias, Montier drew upon a psychology experiment in which students were told about the British occupation of India and the resistance of the Gurkas of Nepal. In 1814, the governor-general vowed he would put a permanent end to the Gurka resistance. The campaign went badly for the British and, as Montier put it, “The British learned caution only after several defeats.” The students received more extensive information on this piece of history and were asked to provide the probabilities for each of four different outcomes.
Another group of students were given the same information and later provided with the “true” outcome. Members of the second group, who learned the true outcome, increased the probability they attached to that outcome; indeed, they almost doubled their probabilities compared to the group that did not receive the true outcome information. Montier said:
“This study demonstrates why a real-time investment diary can be a very real benefit to investors because it helps to hold us true to our thoughts at the actual point in time, rather than our reassessed version of events after we know the outcomes.”
Conclusion
Picking up from where he left off in the previous chapter, Montier addressed two new biases in chapter 12 of "The Little Book of Behavioral Investing: How Not to Be Your Own Worst Enemy."
The first is the self-attribution bias, in which we give ourselves too much credit for our successes and too little responsibility for our failures. The problem with this is that we are not learning from our mistakes.
The second bias is called hindsight bias and is described as "the idea that once we know the outcome we tend to think we knew it all the time." Think of it as an "Orwellian rewriting of history." Like the self-attribution bias, it keeps us from learning from our mistakes.
The tool for overcoming both biases, and allowing us to learn from our mistakes, is the investment diary. Simply writing down what decisions we are making—and why we are making them- ensure we do not let ourselves off the honest assessment hook.
About Montier
The author is a member of the asset allocation team at GMO, the firm founded by Jeremy Grantham (Trades, Portfolio) in 1977. According to his Amazon profile, he was previously co-head of global strategy at Société Générale (XPAR:GLE, Financial). The author of three books, he is also a visiting fellow at the University of Durham and a fellow of the Royal Society of Arts. The book we are discussing was published in 2010.
(This article is one in a series of chapter-by-chapter reviews. To read more, and reviews of other important investing books, go to this page.)
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
