Can we understand the illusion of cause and effect in investing
18-Jul-2023 •Dhirendra Kumar
Several decades back, a particular incident sparked Daniel Kahneman's journey toward ground-breaking discoveries, ultimately leading to the birth of behavioural economics as a widely accepted field. Despite being a psychologist, Kahneman was honoured with a Nobel Prize in Economics for his pioneering contributions. However, for us investors, this story sheds light on how we can be misled into believing we are correct, even when we're off the mark.
In the 1960s, Kahneman was a junior psychology professor at the Hebrew University of Jerusalem while having a part-time assignment of giving psychology lectures to the Israeli Air Force flight instructors. One of his recommendations was to advise instructors to praise trainee pilots for their achievements but to abstain from criticism when they erred. This approach was rooted in his psychological education and understanding.
However, the flight instructors argued that their real-life experiences taught a different lesson. They had seen that trainees often underperformed after receiving praise and improved after being reprimanded. Although Kahneman was confident in his ideas, he didn't outright dismiss the instructors' assertions, given their substantial real-world experience. He kept thinking it over. And then, he had the insight that set him on the path to behavioural economics.
Kahneman realised that good performance after a scolding was not a result of the scolding itself. Each pilot had a certain skill level, which gradually improved with training. Naturally, each trainee had some good days and some bad ones. These were distributed around an average that represented that trainee's skill level. A good day in the aircraft had a higher likelihood of being followed by a bad day, and vice versa. However, because the instructors followed each day with either praise or criticism, it looked as if the feedback had a contrary impact. An almost random set of events created a powerful impression of cause and effect, which was utterly believable.
Isn't it obvious how this has a great similarity to how we all make decisions about investments and how we come to conclusions about the impact of our decisions? The brain is an extremely powerful and persistent pattern-recognition system, to the extent that it will create believable patterns where none exist. After a few years of investing, whether in equities or equity mutual funds, all of our brains are likely to be as clouded with false conclusions and misleading rules of thumb as those flight instructors. The worst part is that, exactly like the flight instructors, we all have 'evidence' that our rules work. When we make bad investments, we explain them away by making more spurious connections that are, in effect, even more rules. Curiously, I find many more people who have made these little rules about timing the markets rather than identifying good investments. Everyone seems to have these signals they follow about when to buy stocks, when not to buy, and when and how to sell. Sometimes, purely due to chance, the rules appear to work, reinforcing our beliefs.
The way I have described this phenomenon, there is no solution. However, there is, and a very simple one. One word: automate. I don't mean in the technology sense but in the sense of rule-based investing. A perfect example is investing through a SIP in an equity mutual fund. That subjects you to an automated, rule-based system that is not amenable to the ad hoc timing you may be tempted by. For equity investing, do the equivalent. For stocks on your buy list, keep putting in a fixed amount of money at a regular period. That's exactly the strategy we recommend in our Value Research Stock Advisor service.
Remember, the pattern recognition that serves you so well in many other aspects of life can be your biggest enemy as an investor.