What are the odds that you’ll win the lottery, be in an automobile accident, make market beating investments, or get a divorce? We’re all capable of making educated guesses regarding the probability of these events, but how likely would we be to update our predictions if presented with the actual base rate odds? According to an interesting 2011 study, it depends.
The study shows that we are far more likely to update estimates when presented with better than expected information. The opposite also holds true: we’re extremely unlikely to update estimates when presented with worse than expected information. For example, if we predicted that the likelihood of getting divorced was 60%, but the average likelihood was actually 45%, we might adjust our estimate to 50%. If the information was worse than expected – for example, if we had estimated 25% – we tend to adjust our estimates much less, if at all. In fact, we’ll even go as far as trying to avoid situations where our beliefs are expected to be challenged. To summarize the study, most of us are predisposed towards optimism, welcoming of confirming information, and dismissive of information that suggests we might be wrong.
Optimism is obviously not always bad, but the distinction between realistic optimism and unrealistic optimism is an important one. Relating specifically to investing, unrealistic optimism needs to be avoided at all costs.
When investing, we’re all naturally drawn to the positive aspects of different strategies: why does it work, how much has it historically outperformed by, what’s the best way to implement it, and who’s had success with it in the past. It’s very rare that anybody asks what the negatives are. When we aren’t searching for the downside of an investment strategy, we’re flirting with unrealistic optimism by willfully ignoring reality.
In theory, we should all want to know accurate facts for and against our viewpoints, so we can reach rational conclusions. In practice, it’s clear we definitely do not do this. Bloomberg’s Joe Weisenthal and Tracy Alloway recently had Professor Jay Van Bavel on their Odd Lots podcast to discuss just that. Professor Van Bavel is an Associate Professor of Psychology and Neural Science at NYU. Joe, Tracy, and Professional Van Bavel discussed a new paper he recently co-authored called, “The Partisan Brain”. While his paper relates to politics, Joe and Tracy asked him to provide some tips for investors who recognize their biases and are looking to make more sound decisions. Two of Professor Van Bavel’s recommendations were: have a system to check yourself and find trusted skeptics to interact with.
In an attempt to heed Professor Van Bavel’s advice, how should investors approach selecting different strategies for their portfolios?
In order to avoid unrealistic optimism, it might make sense for a system to include inverting the way we normally vet investment strategies. Instead of seeking the reasons why a given approach is good, maybe we should be focusing on its drawbacks. Good questions to ask might include: when has this historically underperformed, how long did that underperformance last for and how dramatic was it, could this approach stop working in the future and how will I know if it does, why is this opportunity available to me, and who are the harshest critics of this approach. Reconciling these realities with our often rose-tinted views will be helpful in assessing whether or not a given strategy truly is a fit.
As Professor Van Bavel also recommended, it can be helpful to have a trusted skeptic pose these questions to you. Healthy debate and pushback from a valued resource can go a long way towards rounding out the decision making process.
To me, our inherent aversion to disconfirming evidence is a sign that we need to embrace it and dig deeper. We all know that no investment approach is perfect, but can we specifically name its flaws? If you can’t name what stinks about a given investment strategy, you likely just don’t understand it well enough yet.