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Wednesday, 18 July 2012

Mindless Money 3/5: Hold the Big Picture

The key phrase here is situational awareness.  It’s about having the big picture as well as the focused analysis.  The world, even that part of it tracked by stockmarkets, is a complex adaptive system made up of many working parts.  Ditto corporations.  No one can keep track of everything all the time.

So maintaining a big picture of the world around us, and how it impinges on our investments, is an important factor for the able investor.  It’s about paying attention, and knowing what to pay attention to; it’s about identifying the warning signs which should cause us to revisit our beliefs and expectations.

Investment markets, and individual corporations, are complicated machines made up of many moving parts including people, equipment, processes, suppliers and so on.  No one – including CEO’s and investment analysts – can possibly know all of the things going on at any one time.  And there are a myriad ways in which things can go wrong all of the time.

The sensitive investor will hold a mental model – a cognitive map – of the important factors that they use to manage their investments.  Some people do this more easily than others, but it’s a quality known as situational awareness.  Situational awareness, the ability to almost naturally become aware of unusual factors, is a powerful weapon against mindlessness, the investor’s enemy.

This may sound exceptionally and unnecessarily complicated, but overly complex models don’t aid our analysis.  Too much information leads not to clarity of thought but to information overload, and a tendency to overreact to short-term information.  No, what we need to be constantly on the look out for are corporate or economic events that may require us to adjust our models.

Understanding the critical issues in individual investments, how these integrate together to form an investment portfolio and what this means for your risk management processes are the important aspects of this process.  Situational awareness is about continual risk management and assessment. 

So, in particular, what we should be looking for are things that don’t fit in with our expectations.  It’s all too easy to ignore minor discrepancies; an odd director resignation, a surprisingly accurate earnings announcement, a strange acquisition, but these are things that should cause us to focus our attention: anything that’s a discrepancy needs to be understood and integrated into our cognitive map.

Of course, oft-times peculiar factors can be explained and many don’t require us to change our models or our opinions.  But sometimes they can’t, and when we adjust our models we may find results that we don’t necessarily like.  Nonetheless, this process of adjustment and extrapolation is exactly what we need to be doing all the time – it’s a key sign of mindfulness in investors and an important way of combating confirmation bias.

Intense and detailed analysis of every cough and snivel in our investments isn’t required, but a genuinely situationally aware investor will be continually integrating new information and comparing it with the baseline.  It’s surprising how often data that doesn’t fit is a sign that something, somewhere, has changed.

Further reading:

Complex adaptive systems are a constant theme: see Contrarianism, Complexity in Financial Systems and Perpetual Novelty, Santa Fe Style. What a lack of attention does to investors was analysed in Zombies in the City of London. The problems of information overload were examined in The Curse of Seven, and the peculiar case of the overprecise earnings forecasts in Whither Forecasting, The Butterfly Stirs. Confirmation bias is considered in Confirmation Bias, The Investor's Curse and Disconfirm, Disconfirm, Disconfirm.

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