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Thursday, 26 July 2012

Things Investors Should Hate 4/5: Observation

No human being can resist trying to draw general conclusions from personal observation.  It’s not purely a matter of wilful ignorance, but is an in-built evolutionary trait necessary for our ancestors' survival. After all, on the primeval savannah if you didn’t learn rapidly from experience you were likely to end up as a lion's dinner.

Unfortunately, in our globalized, modern investment world personal observation is about as useful a survival trait as poking a sleeping cobra with your bare foot.  It’s just that the poison is a lot slower acting.

Quite clearly learning from personal observation is an incredibly important behavioral feature for humans.  If we didn’t quickly figure out that the cars drive on the wrong side of the road in Hong Kong, or that Scandinavian women tend to stand surprisingly close to people they're talking to without having the slightest personal interest in them, we’d rapidly find ourselves in a great deal of trouble.  However, these observations tend to be located close together in terms of time and space, and they’re not always generally applicable.

For example, in the late Middle Ages, in Sweden, the rulers developed a local belief that they were a great nation.  This was largely based on their residence in the capital city, which was indeed busy.  However, when they carried out the first-ever population census it turned out their actual population was a factor of ten lower than they thought.  Thus evidentially armed, Sweden stopped invading other countries and concentrated on developing a new line in knitted pullovers.  Thus making the world a safer, and warmer, place.

The concentration on personal observation as a primary learning mechanism is particularly true in investments where a personal experience can lead to people developing abiding aversions for specific corporations or types of stock which override any attempt at logic.  Moreover, people develop powerful beliefs about their ability to predict the future which transcend any evidence whatsoever.

Indeed the research strongly suggests that most people have no ability whatsoever to predict the future, and that most of their beliefs are based on a mistaken understanding of their own true natures.  It’s not just that personal observation biases people but that their beliefs about their personal observations do as well.  You will think I’m biased, but you’ll have a hard job believing that you are. This is true even when there’s powerful, peer-reviewed and statistical evidence that contradicts the arguments being put forward.  

Sadly, if you resort to such evidence most people will ignore you or come up with yet more personal “evidence”.  In the main we would prefer to believe our own faulty, localised observations than that of carefully constructed studies that aim to tease out the real nature of life.  So beware the investor who starts with the phrase “I /believe/think/expect …”.  We all have opinions.  What counts is why we have them.  

Further reading:

Our problems with extrapolating personal observations to general principles were discussed in Puke: Don't Invest In The Familiar, Investor Decisions, Experience is Not Enough and Google Charts You Can Trust. The historical problem of observation bias was covered in Laplace's Hammer: The End of Economics.  Our fundamental unwillingness to accept that our personal theories are wrong is examined in Backfiring Investment Theories, Disconfirm, Disconfirm, DisconfirmBamboozled by Your Blind Spot Bias and James Randi and the Seer-sucker Illusion.

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  1. Great blog. While actual Swedish demographics data trumps perception in a decision to conquer other nations, in investing, it is often the perception of data, rather than objective reality of the data, that is most important, as markets move by perception and emotions of the players. So in investing, understanding the perception of key players is most important. --Bruno

  2. But who's biased ?
    As a student i read every day a lot of contradictory topics on EVERY subject, sometimes with very similar data you can interpret differently etc... Its quite exhausting and maybe the "economics curse" so I'd disagree with you on this point.
    Personal observation and experience is probably the most important because there's no such thing as 'statistical evidence' in investment