On Magical Thinking And Investing*

February 28, 2012

Returning to the beginning of this talk, there is yet a fourth explanation for why more investors aren’t passive. The authors of the wonderful book “Mistakes Were Made (But Not By Me),” social psychologists Carol Tavris and Elliot Aronson provide us with this reason: “Most people, when directly confronted with proof that they are wrong, do not change their point of view or course of action but justify it even more tenaciously. Politicians, of course, offer the most visible, and often tragic, examples of this practice . . . We stay in an unhappy relationship or merely one that is going nowhere because, after all, we invested so much time in making it work.

Tavris and Aronson explain: “Self-justification has costs and benefits. By itself, it’s not necessarily a bad thing. It lets us sleep at night. Without it, we would prolong the awful pangs of embarrassment. We would torture ourselves with regret over the road not taken or over how badly we navigated the road we did take. We would agonize in the aftermath of almost every decision . . . Yet mindless self-justification, like quicksand, can draw us deeper into disaster. It blocks our ability to even see our errors, let alone correct them. It distorts reality, keeping us from getting all the information we need and assessing issues clearly.”

Investors, relying on the past performance of active managers, and rankings like Morningstar’s ratings, hire managers, then eventually fire most of them and repeat the process. They do so without ever asking: “What am I doing differently in the selection process so I don’t repeat the mistake I made last time?” In a triumph of self-justification, they end up doing what Einstein said was the definition of insanity—doing the same thing over again and expecting a different outcome.

Why Do The Experts Get It Wrong?
I would like to move on now to discussing why experts keep failing us, why they keep getting it wrong. As you know, many investors have seen their portfolios devastated despite having followed the advice of experts. They are left to wonder, “What went wrong?” The answer is that the strategy of following the advice of “future tellers” disguised as experts is the wrong strategy. As investment legend Warren Buffett put it: “A prediction about the direction of the stock market tells you nothing about where stocks are headed, but a whole lot about the person doing the predicting.”

David Freedman, in his book, “Wrong,” shows that experts are often the reason we get into big messes, whether the field is medicine, investing, science, psychology, raising children, dieting or business management. With often frightening examples, he exposes the biases and career pressures that often dangerously influence the ways in which experts arrive at their advice. He explains: “Most of us think of scientists as being devoted to uncovering truths, not pumping their career prospects. Less formal experts . . . don’t enjoy that sort of halo.”

Freedman notes that a wide range of economists and even mathematicians, as well as many nonscientist financial experts, have been demonstrating quite clearly for about a century that no matter what technique you use to pick stocks, you’re not likely to beat the market; that “many of us still put our faith in, not to mention bet our life savings based on, the advice of, say, a screaming, bouncing, bell-ringing television personality who claims to have special insight into the movements of stocks, is, I think, a sharp illustration of how some experts can ride straight-out irrationality to great personal success.”

Freedman goes on to add: “The simple fact is that most informal experts can spew out conclusions without much fear of being intercepted by wiser or more careful parties. Who’s filtering the recommendations of investment gurus? . . . in the short run, most informal experts can get away with quite a bit, and do all the time.”


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