Setting the Context
In this week’s article, we explore a plethora of topics, from “End of History Illusion” to “Pluralist Ignorance Effect”, concept of “Alternative Histories” and other such fluff from interdisciplinary domains, pivotal for investors to be cognisant about in the world of Finance. This particular read is tilted towards Behavioural Economics, Human Psychology, Philosophy and a lot more. So, let’s jump right to it!
History is not the Future. A simple, easily understandable statement, ain’t it? But when it comes to investing and our personal lives, we don’t seem to innately imbibe this very notion.
Heard about the End of History Illusion? It’s when we are cognisant of how much we’ve changed in the past but grossly underestimate how much our personalities, goals and aspirations might change in the future. In a way, we believe we’re different from our past selves now and we’re likely not going to change much hence forth. When it comes to investing, we tend to overly rely on past data to extrapolate the likely future forecasts and subsequent outcomes.
We humans, tend to give ourselves a little too much credit for having the ability to make sense of past events. Why did the Tulip Mania take place? Why did the Dot-Com Bubble burst? Why did we undergo the Great Financial Crisis? Things might seem pretty obvious now and we might have perfectly logically narratives constructed for each of these events, but we must humbly accept the percolation of Hindsight-Bias (aka I-knew-it-all along) in all such stories. Thing is, we’re pretty bad forecasters and pretty good story-tellers. We can rationalise to ourselves of what’s happening around the world, even though we had no prescience of the same, because that’s what the human brain is designed to do, to make sense of whatever small fraction of reality we can perceive and try generating a narrative out of it in order to survive.
Well, as Yuval Noah Harari says, “There is no higher authority than human emotions.”
Emotions move in Herds, but does the adage “There’s Wisdom in the Crowds” hold true?
Well, the short answer is both yes and no. There’s this observation by Charles Darwin’s cousin Francis Galton in 1907. Galton pointed out that the average of all the entries in a ‘guess the weight of the ox’ competition at a country fair was amazingly accurate – beating not only most of the individual guesses but also those of alleged cattle experts. This is the essence of the wisdom of crowds: their average judgement converges on the right solution.
Let’s also consider the famous “audience poll” lifeline given to contestants on the show “Who wants to be a millionaire?”, that again, is a potent example of the participant trusting the wisdom of the crowd.
But is this always the case?
I mean think about all the instances when the judgement of crowds was horribly wrong. The very genesis of the Great Financial Crisis of ’08 was because the most popular consensus amidst “experts” was that “people just don’t default on mortgages”, we all know how that panned out.
So when do we decide that the crowd has lost it’s wisdom tooth and when do we determine that it’s got it’s wisdom hat on?
Well, according to research studies conducted by Yale School of Management and University of Michigan, the average judgement of crowds subsumes a misplaced bias when the decisions of the individuals in the crowd are socially influenced by one another. It’s when the crowd contains, independent and more importantly diverse thinkers does the judgement of the herd converge near accuracy for topics involving an objective answer, that is. Things, well, get more complicated when it’s subjective and there’s uncertainty involved. For this you need to understand the Pluralist Ignorance Effect.
Pluralist Ignorance Effect
It’s when the group’s majority privately believes one thing and mistakenly assumes that most others believe the opposite.
For instance, say you’re sitting in a classroom, the lecture is on “Fat Tailed Distributions”, the mathematics of which is pretty abstruse and the professor asks, “Any questions?”, let’s assume the following equation was etched on the blackboard.
You look-around and nobody has any questions. Which means it’s obviously supposed to be something easily digestible and you’re the sole idiot who didn’t get it and you don’t raise your hand to clarify your query. See here, chances are that every other student in the class, was looking around and conforming to the social average, they assumed everybody around knew this stuff and asking questions would simply make them look like an idiot, when the objective reality was in fact, nobody understood what was going on in the classroom.
This, my dear readers, is a consequence of the Pluralist Ignorance Effect. We assume people know stuff and we conform to their behaviour which we perceive to be the “correct, acceptable norm”. When in fact, nobody know’s their stuff and are just as confused as you are!
When people are uncertain, they look to the actions of others to guide their own actions. We are social evidence seeking monkeys.
So, how does this tie into us super-extrapolating past events into the future?
At the end of the day, we need to acknowledge the deep-seated reality that the history that took place was just one random realised path out of the infinite possible branches of this crazy decision-tree called life. And that studying the past won’t increase our odds of being prescient of the future with regard to significant events which have an actual impact on the course of our lives. To appreciate this notion further, let me (or rather Taleb) explain the concept of Alternative Histories.
“The concept of alternative histories is particularly interesting. If you were to relive a set of events 1000 times, what would the range of outcomes be? If there is very little variance in your alternative histories (i.e. You chose to become a dentist and you will probably make more or less the same amount of money and live a similar lifestyle all 1000 times), then you are in a relatively non- random situation. Meanwhile, if there is a very wide range of normal results when considering 1,000 variations (entrepreneurs, traders, etc.), then it is a very random situation.” – derived from Fooled by Randomness, Nassim Nicholas Taleb
Basically, we couldn’t estimate the past’s past and we won’t be able to draw conclusions of the future based on the recent past (think about the Dot-com bubble, the Tulip Mania, the oil prices dipping below zero, the Arab Spring and now COVID-19). Things always seem more obvious in hindsight (ex-post) than they are ex-ante. But, let’s all humbly acknowledge the premise that:
History is not the future.
So, when nothing is predictable, how do we brace ourselves for the future and in a more dramatic sense, how does one survive in this random, chaotic world?
As the Greek Philosopher Epictetus beautifully quoted:
“The chief task in life is simply this: to identify and separate matters so that I can say clearly to myself which are externals not under my control, and which have to do with the choices I actually control. Where then do I look for good and evil? Not to uncontrollable externals, but within myself to the choices that are my own . . .”
The way this stoic principle can be juxtaposed into investment decision making hygiene is by allowing for what Charlie Munger calls the “Margin of Safety”, in a world full of uncertainties, it is the Room for Error which becomes our safety haven. Here are the two investment gurus themselves expatiating the concept with respect to making investment decisions:
So to drive the concept of Margin of Safety home, think about it like this, the WHO safety regulations dictate we maintain a minimum of 6-feet distance apart from each other in public places to minimise the possible transmission of the Corona Virus. Margin of Safety is when we decide to stay home to minimise the possibility of contraction as a whole. It’s a “just-in-case things go wrong” safety measure.
Here’s an extract from the book Psychology of Money which is a good compendium of the key takeaway from the plethora of topics discussed above: “Many bets fail not because they were wrong, but because they were mostly right in a situation that required things to be exactly right. Room for Error- often called Margin of Safety- is one of the most under appreciated forces in Finance. It comes in many forms: A frugal budget, flexible thinking and a loose timeline- anything that lets you live happily with a range of outcomes.”
So, remember, History is not the Future, let’s give some Room for Error.
That’s it for this week.
Coffee Time Finance.