How we make sense of the world might hinder our ability to navigate it effectively.
Real Knowledge is to know the extent of one’s ignorance – Confucius
Evolution has instilled within us an innate yearning to make sense of the world, perhaps, to ensure our species’ survival. The world perspective we construct towards this end by interpreting our experience and that of others determines how effectively we navigate this world. Similarly, an accurate market perspective enables us to navigate equity markets effectively and achieve superior investment returns. The ideas and beliefs that form the market perspective must be coherent to make sense; we can only utilise what makes sense to us. Unfortunately, due to human fallibility, our pursuit of a cohesive market perspective results in a perspective that appears logical and instils confidence but is largely imprecise or flawed.
We sift through the vast amount of information generated daily by the economy and financial markets to form our market perspective. However, the data to be sifted and processed is so large that the task often far exceeds our brain’s processing capacity. We solve this problem by choosing information selectively. However, the information is not selected based on its relevance or importance, but on its ability to provide a coherent perspective that makes sense. Any information that doesn’t fit into the perspective is disregarded. Unfortunately, the discrepancy between such a limited perspective and reality is dangerously wide. Market judgments and future expectations based on such flawed perspectives only lead to poor decision-making, adversely impacting our investment performance.
This detrimental tendency towards flawed perspectives originates from our brain’s intolerance of randomness, incoherence, and uncertainty. Although truth and revelations steer us to the right path, they are often discomforting and sometimes excruciating. We all prefer comfort over truth, whether we agree with it or not. It is a mistaken notion that our brain can make complete sense of the world. Therefore, instead of relying on faulty perspectives that only promise but never deliver the expected results, accepting that the world is more uncertain, random, and incoherent than we think is more likely to help us effectively navigate this complex world and make effective decisions.
When an event produces a desirable (positive) outcome, we usually search for its causes in the past under the impression that deciphering the causes would make such events predictable. This behaviour is driven by the belief that events can be predicted, and their causes can be determined by a study of their past. However, what we see when we look at the past before and after an event’s outcome is known is widely different. After the event, we only notice information that has a causal relationship with the event’s outcome and fits into a coherent narrative, where those causes convincingly lead to the transpired outcome. In short, an event appears more predictable once it has materialised.
Suppose a stock tripled or quadrupled in three years, and we search for its causes in the past under the impression that knowing them would help us identify more such opportunities later. We noticed that, three years ago, the stock was cheaply valued, had high profit margins, a robust balance sheet, and an expanding capital expenditure; additionally, over the three years, its earnings and profitability grew considerably. These factors are enough to create a coherent narrative that convincingly explains the stock’s superior return over the past three years. Now the stock’s superior return makes good sense to us, and we have also decoded the criteria that future investment opportunities should meet to deliver similar high returns. However, this is more likely to be an illusion of understanding.
Firstly, we formed the narrative by considering only stocks that produced a desirable outcome. By examining stocks that have not yielded desirable outcomes over the past three years, we may discover that some of them met the same criteria as stocks that have produced desirable outcomes. We never knew that because we never looked for them. Secondly, the stock that delivered superior returns over the past three years might have had deteriorating working capital conditions and weak cash flows three years ago. However, when searching for the causes for the superior return, such unfavourable factors never gain our attention because they don’t fit into the narrative that seeks to explain the stock’s superior return.
Events appear more predictable in hindsight, and we believe that the narrative we construct to explain the event would provide us with foresight. However, a narrative formed after an event (whose outcome is already known) is more likely to be flawed than accurate, and thus, misleading. The utility of a narrative explanation is determined not by how convincing it is, but by how capable it is in predicting the event in advance. The more compelling a narrative seems, the more sceptical you should be.
We evaluate a stock’s merits (or demerits) by analysing its past and present performance, but future investment return depends on future financial performance. How useful are past and present information in predicting a stock’s future financial performance? Narratives are formed with selected past and present information. They might seem to make perfect sense of an event, but are more likely to be deceiving than predictive. Narratives are formed after the event, with the outcome known. There is only one outcome once the event has transpired. However, before the event, we have thousands of possible outcomes that could be favourable or unfavourable.
Successful investing involves selecting opportunities that are more likely to result in favourable outcomes. This could only be delivered by an effective decision-making process, not by meeting specific criteria derived from a flawed narrative constructed to explain an event that has transpired and whose outcome is already known.
An effective decision-making process begins with accepting uncertainty, recognising the extent of our ignorance, and acknowledging the significant influence of luck on many of our decision outcomes. Our brain is inclined to seek certainty and order in everything, and the formation of flawed perspectives and narratives we saw earlier is an offspring of this inclination. Seeking certainty in an uncertain world is a futile exercise. Instead, we must accept and become comfortable with the fact that the world is uncertain, which implies that even the best decisions might sometimes result in unfavourable outcomes. The most positive behavioural change that accepting uncertainty brings is ‘thinking in probabilities’ rather than delusively relishing certainties.
‘Certain thinking’ assumes that events have definite causes and outcomes, with outcomes nicely predictable from the causes. ‘Probabilistic thinking’ considers that an event could have many possible outcomes, and all we can do is get the odds in our favour. It also involves accepting that unfavourable outcomes might ensue despite our best efforts. In other words, good decisions might have bad outcomes, and evaluating decisions based solely on their outcomes is unproductive. Problems arise if our investment portfolio is constructed without sufficient leeway for this possibility.
This does not make outcomes irrelevant to decision-making: outcomes are how we keep score, and they provide valuable feedback. Refining our investment decision-making process using input received from outcome analysis is essential for making quality decisions. It is just that the decision outcome should be analysed in conjunction with the decision process, alongside the acceptance of luck’s influence on it.
We make sense of a situation or event by interpreting the available information. A common error we make in interpretation is assuming that the available information is all there is to know about the situation or event. This tendency, often termed WYSIATI (What You See Is All There Is), is prevalent in decision-making, primarily because the brain is reluctant and uncomfortable with acknowledging that our ignorance far surpasses our knowledge; moreover, acknowledging ignorance can be hurtful to our ego. So, we conveniently ignore our ignorance and comfortably relish the pseudo-confidence that comes with it.
We don’t need to be an all-knowing polymath to make effective decisions. Instead, we must embrace the extent of our ignorance, which is possible only with a sufficient degree of humility. Embracing ignorance allows us to take risks prudently, significantly improving our investment outcomes. Awareness of ignorance is equally important as knowledge and insight to make effective decisions.
We all desire to feel good about ourselves. This desire causes us to attribute skill to our good decision outcomes and luck to our bad decision outcomes. However, while evaluating other people’s decision quality, we do the opposite: we attribute luck to good outcomes and (lack of) skill to bad outcomes. For an inexperienced person, a good outcome is more likely to be caused by luck than skill; however, they are more likely to attribute their success to their own skill. Similarly, he will attribute his bad outcomes to bad luck. This is a misguided inference because both skill and luck contribute to our decision outcome, but the extent of their contribution is ambiguous.
As we gain more experience and learn from them, the role of skill in decision outcome might increase, and that of luck might diminish (but it never ceases). Just as accepting our ignorance enhances decision quality, acknowledging luck’s role in decision outcomes could have a similar effect. Sometimes the best decisions might produce bad outcomes just because of sheer bad luck, and there is nothing we can do about it. Moreover, besides improving the quality of our decisions, accepting luck’s role in decision outcomes makes us more compassionate towards others and ourselves.
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