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April 28, 2014 at 08:00 PM
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?
Paradigm Shift
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?
