A growing amount of attention is being devoted to the behavioral biases that affect the actions of all investors. Thanks to the research of Kahneman, Tversky, Shiller, Thaler and others, we can now identify areas of vulnerability that few if any knew about a generation ago. Taking nothing away from the value or importance of those insights, consider: An excessive focus in one area means that something else is being overlooked.
Experienced investors understand that the actual risks or opportunities in the financial markets do not necessarily correlate with the attention they receive. While it may already be a distant memory, for a few months in late 2012 the only thing on investors’ minds—the headline of headlines for months on end—was the Fiscal Cliff and all the bad stuff that would happen if we went over it.
In fact we did go over the cliff and the market rose 30%. While investors were obsessing over the fiscal cliff they failed to notice that the actual health of the economy was both decent and improving.
Behavioral biases are nothing new—but our focus on them is. As a result, other basic threats to investment success are being ignored. One particularly pernicious threat that is receiving little to no attention is investors’ continuing struggle to learn anything useful from history.
Like behavioral biases, responding to perceived threats without any historical context leads investors to make terrible choices. But unlike behavioral biases (which are extremely difficult, if not impossible to recognize in real time) learning from history is a much easier problem to resolve—we just need to reframe things a bit.
When I was growing up, excepting Hebrew School (which was completely off the scale), history led my list of truly hated subjects. Ugh! Did I CARE who was the 12th vice president of the United States, or why Napoleon invaded Russia, or what the Supreme Court decided in Plessy v Ferguson? History was boring and irrelevant.
It wasn't until decades after my formal education ended that I finally understood that the value of lessons I was learning from my own personal history were an infinitesimal fraction of the genuine treasure trove of wisdom available to me from the world-at-large. Yet in order for me to mine its valuable insights I had to rethink, reframe and ultimately reject most of what I had been taught about the subject.
Admittedly, history is a bunch of facts. Our challenge is what do we do with them? How do we sift through the mountain of data to find the important and meaningful stuff? And even if we can find the important and meaningful stuff, how do we know we can exploit it for our benefit?
Physicist Thomas Kuhn explained in his classic book The Structure of Scientific Revolutions that data by itself are meaningless. Only within the context of a paradigm (a mental model of the world that helps us distinguish between what's important and what's unimportant) can one understand what the facts mean.
While Kuhn was writing specifically about the history of science, he really opened up the entire enterprise of historical scholarship for examination. What is history? Why should we study it? How do we know what is important and what is not? Is one approach better than another? If so, who makes that determination?
We are today the beneficiaries of the accumulated knowledge of history. In almost every aspect of life we are healthier, wealthier, more informed and more sophisticated than those that came before us. Yet despite this wealth of information, investors are uniquely handicapped because there is virtually no consensus, academic or professional, on how to interpret the data.
As a result investors struggle to identify the most fundamental aspects of risk and opportunity. That explains why it is a totally normal occurrence to find the following investment comments written on the same day:
“A substantial number of independent metrics imply that the stock market is in a very high risk mode now.”
“Investor enthusiasm about the outlook for U.S. equities, which is evident when the market is at such high levels, has reflected what we believe to be compelling opportunity.”
Imagine if medicine was like the investment world: You are examined by two eminent doctors. The first one tells you that you’re so healthy you’ll live to be 100, and the second one advises you to put your affairs in order because you have two weeks to live. Medicine is obviously imperfect—but we are confident that it is the rule, not the exception, for doctors to know the difference between a healthy patient and one about to die. Not so the world of investing.
With no consensus, it is up to each of us to come to our own understanding of history, and how it can be used to inform us what is important and what is not. This challenge is not as daunting as it may seem—and I offer up a few observations that will allow you to identify and use the lessons of history more productively.
The simplest way to approach this subject is to look inward, at our own personal history: Who we are, what we think and how we interact with the world are hugely influenced by a lifetime of experiences. The most important, valuable and meaningful historical experiences are our inevitable mistakes—they are golden opportunities for learning and growth. But our own mistakes, while valuable, are not varied enough to teach us all that we need to know, and we don't have the time (or the money) to make them all.
That dilemma is easily solved. For every mistake we have made personally we can observe hundreds of examples made by other investors, not to mention the almost unending list of mistakes that we haven't yet made. This is the gift of history: While we can still learn from our own painful experiences, we can gain even more wisdom and insight learning from the pain of others.
You might be wondering why I’m suggesting focusing only on mistakes. Wouldn't it be better to review our own personal insights that led to success and then search through history to identify the brilliant insights of others—sort of a personal version of “In Search of Excellence” or “Good to Great?” Isn't that a more positive and productive use of history? Maybe … but it's a long shot.
Investing is the art of increasing the odds in our favor that we will have a good outcome. As investors make many more mistakes than come up with brilliant insights, the laws of probability dictate that we will be identifying and avoiding dozens of mistakes well before we even have the possibility of coming across some rare but brilliant investment insight. And the more mistakes we can eliminate, the more likely that our path to success won't be derailed by those avoidable self-inflicted mistakes.
It's a well-worn phrase, but it's worth remembering: “If you watch the downside, the upside will take care of itself.”
If you go by the news or most investment commentary, you would think the downside is a function of big picture risks: the economy, the level or direction of the stock market, Washington, the Federal Reserve, foreign affairs, interest rates, etc.
History (both our own and that of others) teaches us that investment risk exists almost exclusively within our own behavior. Putting this lesson into practice means that when the rest of the world is focused exclusively on external threats and other big picture issues, our attention will be focused on actually watching the downside. If we are careful and do our job well, our reward is the second half of that well-worn phrase.