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Friday, 3 July 2015

Lost In Your Own Memories: Age And The Room Effect

Remember ...

Old people, you may have noticed, have a much better recollection of past events than they have of current ones. Memory is a very odd thing; what we remember and what we don’t isn’t always entirely rational, and the lessons we learn from our memories aren’t always the ones we ought to.

For investors, who all too often rely on their unsupported memories for insight into what they should be doing, this opens up a world of potential dangers. Although, as it turns out, simply wandering from one room to another can be enough to ruin your portfolio.

Physical Reframing 

The method of loci is a memory technique with a very long tradition – it can be traced back to the Rhetorica ad Herennium, dating from around 80 BC – but is perhaps more frequently associated with the Roman philosopher, orator and politician Cicero. It's commonly known as the memory palace technique. You associate an architectural layout – the palace – with the things you want to remember and as you wander in and out of the rooms – the loci – you recall the objects or ideas you’ve placed in them.

As it turns out that this method works is deeply ironic, because in real life moving from room to room has exactly the opposite effect. In an odd case of physical reframing, changing your context resets your brain.

The Room Effect

In a paper entitled Across The Event Horizon the author, Gabriel Radvansky, has discovered that walking through doorways causes us to forget things – like why we walked through the doorway. In fact this isn’t just a real-world phenomena – it happens when we’re reading and the action shifts from one location to another; our reading speed slows as these transition events are detected.

Some of this research is truly bizarre:
Moreover, that study also showed that if people travelled through two doorways, they were more likely to forget than if they had travelled through only one. So, memory is disrupted by the number of event boundaries, not just a simple change in context.
What seems to be happening is that each physical change of location causes a new, location specific memory model to be created – and the transition phase sees both models being simultaneously activated, causing interference, slowing down processing speeds and increasing error rates.  The information that we’re carrying across the event boundary – like the fact we entered the kitchen to make a cup of coffee – is liable to get lost.

The Method of Loci

Yet the event boundary effect can also improve memory if the information to be remembered is kept discrete to specific rooms. So two lists of items are remembered with less interference if they’re learned in two different rooms than if they’re learned in the same room – which explains why the method of loci works even though the room effect is unquestionably real.

What this points to is the mutability and context sensitivity of memory. It’s a constant source of amazement to me how highly most people regard their memories, taking them as some kind of permanent record of the past. The reality is that we all misremember things – we misremember what we think we predicted in the past (hindsight bias) and we overweight recent experience (recency) and overweight memorable events (salience). You can trust nothing and no-one, and especially not yourself.

Context is Everything

The idea is that memory is context sensitive – and that's something we see in investing rather a lot. People try to fit their new experiences into the context of their old ones, so memories of a horrific investment experience will trigger when a similar situation presents itself – the only problem being that history rarely repeats itself, exactly.

The room effect also hints at what happens when we run into new or conflicting situations: if you have multiple memories being simultaneously triggered – perhaps because we’re on the cusp of a change of market momentum or, more usually, are about to leave one room for another – then this event boundary can lead to cognitive dissonance, and a lot of procrastination.

Given that we can see that memory context switches merely because we move from one room to another we shouldn’t be surprised if investors suffer from similar memory related issues. Of course, there’s a general theory that age improves our investing performance – basically the more experience we have the better our investing performance. Of course, this is true – up to a point.

Age Shall Not Whither Us ...

With greater age comes greater experience, a greater store of memories upon which to draw upon, and therefore we might expect to become better investors. Well, George Korniotis and Alok Kumar analyzed the age effect in Do Older Investors Make Better Investment Decisions? The answer starts out quite positively:
Our evidence indicates that older and more experienced investors hold less risky portfolios, exhibit stronger preference for diversification, trade less frequently, exhibit greater propensity for year-end tax-loss selling, and exhibit weaker behavioral biases such as the disposition effect and familiarity bias. Thus, their choices reflect greater knowledge about investing.
We’ve examined these benefits before in Investor Decisions –Experience Is Not Enough and its snappily named sequel - Investor Decisions –Experience Is Still Not Enough (But It Helps A Bit).  Basically if there’s straightforward causality involved – i.e. making a specific decision leads to a specific outcome – then people learn effectively. If the path of causation doesn’t run quite so smoothly then they don’t.

... Until It Does

So that’s all good there for us older investors, eh? Well, sadly, it all goes wrong rather quickly:
But consistent with the cognitive aging hypothesis, we also find that older investors have worse investment skill, where the skill deteriorates sharply around the age of 70.
Basically there comes a point where the advantages of our greater knowledge and experience of events are cancelled out by the deterioration of our mental faculties. Remembering in intimate detail your exact response to the great flash crash of 1987 probably isn’t going to help you very much when it comes to deciding whether to buy the latest bio-neural social network stock or space mining corporation in 2030.

Roughly, long term memory can be divided into conscious and unconscious, and conscious memory into episodic and semantic. Episodic memory is our recollection of past events, semantic our knowledge of how to do stuff. Age impacts both, but in particular our semantic decision making capabilities suffer. The Korniotis and Kumar paper suggests aged investors earn between 3% and 5% less than younger counterparties, when adjusted for risk.

Methods Not Memories

The way that memory interplays with experience, and the fact that memory retrieval is context dependent and fails with age ought to be enough evidence, if more were needed, that relying on unsupported beliefs about our investing abilities isn’t safe.  What is needed is a method rather than a belief system, a set of techniques to assist the investing process.

For most people simply keeping an investment diary and revisiting it occasionally would be sufficient to improve their investing methods. You could even use the method of loci to remember the steps you need to take to assess your next trade. Just don’t leave the room while you’re doing so, you may end up buying a stock you didn’t mean to.

The Room Effect added to the Big List of Behavioral Biases

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