On Magical Thinking And Investing*

February 28, 2012

Margaret Heffernan, author of “Willful Blindness,” provided some additional insights into the behavioral problems surrounding the issue of being wrong. Willful blindness is a legal concept—you can be held responsible even if you weren’t aware, but could and should have known something was wrong and decided not to see it. The claim of not knowing is not a sufficient defense. Heffernan notes: “The law doesn’t care why you remain ignorant, only that you do.” Corporate executives greedy for compensation, politicians who vote for legislation knowing it will never work, and auditors who turn blind eyes to findings because they don’t want to lose their client’s business all make destructive blunders because of willful blindness.

Heffernan observes: “We mostly admit the information that makes us feel great about ourselves, while conveniently filtering whatever unsettles our fragile egos and most vital beliefs.” Her views on the subject are very similar to those of Kathryn Schulz. Heffernan states that while “love is blind, what’s less obvious is just how much evidence it can ignore.” The conclusion she reaches is that fear of change and conflict can blind us to evidence—and so can the power of the almighty dollar.

Schulz believes that perhaps the greatest error of all is the tendency to think that others—not us—make errors because “wrongness” is a vital part of how we learn and change. When discussing the academic evidence on passive investing as the winning strategy, I have frequently observed that no one likes to be told they’ve been doing something wrong all their lives. To address this problem, I point out that I used to be an active investor. However, I did what all smart people do when they learn they are mistaken in their beliefs—they don’t repeat the mistake because that is the behavior of fools.

Another important insight provided by Schulz is that our ability to forget our mistakes is keener than our ability to remember them. During her research, Schulz met many people who said she should interview them as they make mistakes all the time. Yet, when asked to give specific examples of their mistakes, they were hard-pressed to come up with any. If you want to have some fun, try asking your friends to give example of their mistakes. The inability to remember mistakes leads to overconfidence, which in turn leads to other mistakes, especially investment mistakes—such as taking too much risk and failing to diversify—which can be very expensive.

Schulz notes that we think our beliefs are based on facts and reason, and that we are rational. When we reject the beliefs of others, we think we possess good judgment. She calls this the Ignorance Assumption. She notes that at times it holds, but not always. And when the Ignorance Assumption fails, when people stubbornly refuse to agree with us even after we enlighten them, we move on to the Idiocy Assumption—they know the facts but they just don’t have the intelligence to comprehend them. And when that fails, there is always the Evil Assumption—people know the truth but have turned their backs on it.  

Schulz concludes that “mistakes disturb us in part because they call into question not just our confidence in a single belief, but our confidence in the entire act of believing. When we come to see one of our own past beliefs as false, we also glimpse, for a moment, the persistent structural possibility of error: our minds, the world, the gap between them—the whole unsettling shebang.” This is why established institutions such as the Catholic Church fight so hard to suppress ideas that are contrary to doctrine, such as the Earth is the Center of the Universe. People were burnt at the stake for disagreeing. And the famous astronomer Galileo spent the last years of his life under house arrest for stating what the Church’s own scientists already knew to be true. They fight so hard because they know if people learn they are wrong about one thing, perhaps they might get the idea that they are wrong about the whole shebang. This is why Wall Street and much of the financial media fights so hard to suppress and reject the evidence that passive investing is the winning strategy—for them it is economic suicide.


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