Injuries Inflicted by the Illusion of Knowing, and what to do about it.
Most of us are poor at assessing our ability to make sound investment judgements. We form judgements about the prospects of an individual stock or the overall market by interpreting available information through the lens of our understanding of how financial markets function. The effectiveness of those judgements depends on our competence, in this case, the breadth of our knowledge base and analytical skill. Although we are constantly updating our understanding of the world and our place in it, we consistently misjudge our competence, not because of ignorance, but because we are ignorant of our ignorance, or we have fallen for the ‘illusion of knowing’: an inclination to overestimate what we know or can do. The more incompetent we are, the greater will be our overestimation of our competence. Rather than correcting our inaccurate self-judgements, we choose to remain deluded, for the simple reason that no one wishes to view themselves as incompetent. Congenial conclusions based on false narratives are preferred over the unsettling truth.
Our minds understand the world through narratives. The disparate information perceived, whether arbitrarily or intentionally, through our senses and stored in memory, doesn’t make much sense to the mind. The mind thus connects this information to form meaningful narratives. However, most of the time, the information provided by senses and memory is insufficient to create a complete narrative. There are always missing pieces in the story. The mind resolves this problem by using its imagination to fill in the gaps and form a cohesive narrative. Ambiguity is eliminated through this mental ingenuity. However, due to its lack of exactitude, such an understanding of the world leads to poor judgments.
We interpret information through beliefs and assumptions derived from our subjective experience, learning, and research. However, most of our investment beliefs are formed in ways that compromise their accuracy. We evaluate an event differently before and after it has occurred. An event that appeared uncertain and unpredictable before it occurred seems more predictable after it has happened. This effect, hindsight bias, is a threat to our investment judgments because most of our beliefs are formed by studying events that have already materialised. Our confidence in our ability to forecast is therefore exaggerated, leading us to assume more risk than is rationally warranted.
Our mind performs various functions: perception, feelings, cognition, and memory. The processing of information received through the senses is essentially a co-mingling of all these functions. The usefulness of the mind’s outcome, therefore, depends on the efficiency of the interaction between the different functions. Sadly, due to human fallibility, the interactions aren’t always up to mark; undue influence from one or two faculties is unavoidable. Past experiences, incomplete information, short-sightedness, cognitive biases, heuristics, and obsolete mental models are among the causes of skewed interactions among the mind’s various functions.
Extreme market events that outrageously shatter our expectations can be emotionally overwhelming. Elevated uncertainty surrounding the event causes extreme asset price volatility and a drying up of market liquidity, a wide deviation from normal market conditions. Our faculties for clear thinking and reasoning are involuntarily suspended on such rare occasions. Similarities are drawn between the current event and an extreme past event, and we instinctively infer a similar outcome. The rational (deliberate) mind, which can exert self-control, slowly process different options, and make better decisions, is overruled by the emotional mind, which quickly perceives the situation and urges impulsive action. Because the rational mind is less powerful than the emotional mind, exerting self-control and waiting until emotional arousal gradually dissipates becomes challenging. Actions by other market participants and regulators to contain the situation or its impact on themselves introduce additional uncertainty.
Decisions made during extreme market events can be impulsive or intuitive. Categorising decisions in those charged moments is strenuous. Impulsive actions are never in our best interests. However, our intuitions can also go terribly wrong. In investing, even highly experienced market professionals lack reliably accurate intuitions. Although their origins may date back a long way, extreme market events unfold rapidly when they do. Short of time, most of us are compelled to rely on our quick, automatic judgments to respond to rapid developments. However, such quick judgments, whether intuitive or impulsive, made without conscious deliberation, are highly error-prone.
While walking through a crowded street, you suddenly notice an old friend from school. The moment brings forth an overwhelming number of thoughts and feelings about your school days into your conscious mind. You immediately approach the person and start talking enthusiastically. However, after a few exchanges of greetings and information, you feel embarrassed when you realise the person is a stranger, not the old friend from school you thought he was. The stranger and your old friend may share physical features, prompting the misintuition that he is an old friend.
We place too much trust in our sensory perceptions and intuitions to the extent that we override conflicting (but more accurate) information or insights from other sources. Recognising the adverse consequences of this inclination, pilots are often taught during training to trust their flight instruments more than their senses and intuition. We may regard an event as similar to a previous event because of a few shared features, leading us to infer that the latest event is familiar and thus predictable. However, the two events may differ in several other respects of which we may be unaware. Our cognitive faculties have misattributed an unfamiliar event as familiar, thereby increasing the likelihood of poor judgments, as we are more likely to trust our sensory perceptions and intuitions in settings that appear familiar.
The effectiveness of our intuitions depends on our state of mind. A calm mind and a good mood enable sound, intuitive judgements. Meanwhile, intuitions formed during emotional arousal should never be trusted. However, certain urgent situations may require immediate decisions or responses without time to assess and manage emotions. In such moments, even when entering the situation with relative calm, the immediacy and urgency may trigger emotional arousal. Detaching our cognitive faculties from emotional influence is onerous.
The outcomes of our intuitions and rational analyses arise from the processing of information by two distinct cognitive systems. The seat of intuition is in the automatic mind, which is fast and immediate, processing information from senses and memory in the blink of an eye. It is always running in the background, scanning our surroundings for possible danger. The ability to reason and rational analysis resides with our deliberate mind, which is slow and, as the name suggests, must be activated intentionally.
Intuition is a sudden insight accompanied by intense feeling, the cause and purpose of which are unclear at the time, and whose significance can be understood only through later reflection. The seat of intuition resides in our automatic mind. But so does that of our instincts and impulses. Strong feelings always accompany all three. The advantage of our automatic mind is its ability to generate quick responses in urgent and serious situations. Those time-constrained occasions don’t allow us to deliberate on whether we are having an intuitive insight, an instinctual response, or an impulsive desire. Even when there is ample time to respond, deliberately distinguishing intuition from instinct and impulse is challenging, as all three arise from the automatic mind and are accompanied by strong feelings.
Instinctual responses are innate reactions to external stimuli that evolution endowed us with to protect and survive. We still have them, despite most having become irrelevant due to changes in social and living environments. Impulsive desires are sudden, strong urges to act in response to emotional arousal or for immediate gratification. Meanwhile, intuition is a learned skill, acquired through years of learning and experience in a specific field. It is an immediate, productive combination of unconscious information in response to sensory cues; an intense feeling accompanies the resulting insight.
When I think about intuition, four incidents come to mind, drawn from my reading of the literature on intuition. The first incident involves a group of firefighters attempting to extinguish a fire in a house’s kitchen from the living room. Their captain enters the scene in the midst of the action, senses danger intuitively, and orders his subordinates to leave the house immediately. Within minutes of them leaving, the living room floor collapses, revealing a much bigger fire underneath the fallen floor in the basement. The captain’s quick insight saved his team members’ lives.
Another incident concerns a group of firefighters airdropped to combat a forest wildfire. While fighting a fire on the ground, the firefighters suddenly realise a blaze is rapidly approaching them. They decide to run up the nearby hill and seek safety on the rocks at the hilltop, essentially acting in accordance with their training. While heading up, four of them realise they couldn’t outrun the fire and reach the rocks in time. However, one of them, suddenly, dropped all his gears, burned the grass around him, poured water over the grass-burned area, covered his face with a wet towel, and lay face down on the damp ground, covering himself with a fire-retardant blanket. The fire ran up the hill, bypassing the grass-burned, wet area. He had asked his co-workers to emulate him, but they didn’t; instead, they chose to run up the hill. His ingenious just-in-time manoeuvre saved him while his three co-workers perished in the fire.
The third incident concerns a mountaineer with experience climbing more than 100 peaks. The day before he was supposed to make his first climb of Mount Everest, while in the base camp, he had a strange, bad gut feeling. There were seven people in the base camp, including him. On the day of the climb, one person stayed behind due to extreme fatigue. The gut feeling persisted even when the other six embarked on the climb. A few distances into the climb, the mountaineer with the bad gut feeling decided to abandon the climb and return to the base camp. Three co-climbers followed him, while the other two continued their climb. A few minutes later, the returning climbers had to tragically witness the two climbers who decided to continue their climb fall off the mountain into their deaths. The wind unexpectedly turned harsh at a higher altitude, causing the fall.
There is another instance of a fighter pilot making a quick turn during a flight in time to save his plane from crashing; the life-saving move was made even before his flight instruments gave out danger signals. Pilots of fighter planes who flew alongside and made the turn after receiving danger signals from the flight instruments didn’t survive the flight. The four incidents have common features: 1) in each, the intuitive actions that saved the situation were rapid responses to sudden, unexpected, and dangerous developments in their immediate environments. 2) An intense negative feeling motivated all reactions. 3) The people who had the intuition had extensive experience in the respective fields. In other words, they were masters of their craft.
Intuitions are more accurate when the person having them has sufficient expertise in the specific field. However, long experience doesn’t fully ensure expertise. Rather than quantity, the quality of the experience determines a person’s expertise. One measure of quality is the ratio of negative to positive surprises. We are surprised when our expectations are violated; these surprises can be positive or negative. These two forms of surprise differ in their contribution to unconscious learning, with negative surprises imparting much greater learning than positive surprises. Therefore, the more negative surprises we have had, the more our unconscious has learned, and thereby the more expertise we are likely to have in the field. Once we no longer encounter negative surprises or do so infrequently in the course of our work, this could be construed as a sign of expertise in the particular field.
Expertise can be acquired more quickly in some fields than in others, depending on the field’s feedback mechanism. Learning is accelerated and more accurate when feedback is immediate, thereby making the cause-and-effect relationship more transparent and direct. However, some fields have delayed feedback mechanisms, such as investing, in which we may have to wait two to three years to determine whether we made the right decision. The cause-and-effect relationship is ambiguous, as many developments during the wait period may or may not have influenced the outcome. Surely, intuition should never be the default mode of decision-making for equity investors. The ambiguous and delayed feedback mechanism isn’t the only reason.
Intuitions aren’t effective in situations with probabilistic outcomes. Our brains aren’t very good at numbers, and this difficulty worsens as the number of numbers increases. Our brain overcomes its difficulty in making sense of situations that involve large numbers through heuristics – mental shortcuts formed through subjective experience. Although heuristics smooth and ease the navigation of everyday decisions, for larger problems whose outcomes are governed by probability, heuristic answers are more likely to be distorted and misleading. Our minds assign greater significance to familiar, easily recallable, emotionally salient events, thereby implying a greater likelihood of their occurrence than indicated by a larger sample of objective data. The solution lies in moving beyond our heads and basing our decisions on a broader, more inclusive body of objective information. Successful investing requires probabilistic thinking. The outcomes of our investment decisions depend on an uncertain future, and the best way to address uncertainty is by processing broader objective information using statistical tools and probability theory.
Another caveat of intuition is that it is effective only in an environment or context that is the same as, or similar to, the one in which the unconscious learning occurred. A change in environment necessitates extensive unlearning and relearning before we can apply our intuition to our problems or situations. In a fast-changing world, the environment can change again before our intuitive system can adapt, rendering the new learning irrelevant. However, these challenges don’t render intuition irrelevant in today’s world. We have too much going on in this fast-paced world; delegating every decision to our slow and deliberate system is unfeasible. We need our intuitive system more than ever, and its productivity will be decisive to our effectiveness in navigating this fast-paced, ever-changing modern world. What is required is an intuitive system that is malleable and adaptive to a changing environment.
Perhaps, we may have accurate intuitions about the investment prospects of a specific stock we have previously analysed and have known for the past two or three years. Regular calibration enabled this intuitive accuracy. We calibrate our outlook each time we review the stock’s prospects in light of new information and the surprises its performance produces, thereby gradually approaching accuracy. However, for new ideas, the slow, deliberate system should be employed to analyse, form judgements, and make decisions. We should be wary of intense feelings that may seem intuitive towards new investment ideas. Most importantly, we should be aware of changes in the investment environment, because familiarity with the stock doesn’t count for much if the investment environment has changed significantly in the meantime.
The world experienced a rising-interest-rate investment environment for almost 40 years, from the end of World War II in 1945 to the early 1980s, during which global interest rates rose from near zero to nearly 18%. However, the following 40 years were marked by declining interest rates, with rates falling from the highs of the early 1980s to near zero by 2008 and remaining near zero until 2021. Rates have now risen to more normal levels since 2022, which has put us in a very challenging situation because our intuitive system has been trained in the declining-interest-rate environment that prevailed from the early 1980s to 2021. A rigorous unlearning and relearning of the intuitive system has become imperative by the pivotal shift from a declining-interest-rate to a rising-interest-rate environment. A progressive step in this regard would be to expose ourselves to the literature that explores the economy and the financial markets from post-World War II to the early 1980s.
Our mind craves instant gratification, but the whole essence of successful investing is the ability to delay gratification, the power for which lies in our slow and deliberate mind. However, the deliberate mind’s default mode is hibernation and therefore must be intentionally activated. Meanwhile, as the deliberate mind’s functioning is effortful, we are inclined towards the effortless and quick judgments of our automatic mind, which, although fast, is highly error-prone.
Mark Twain has conveyed correctly in a single sentence what we are trying to discuss here: “It ain’t what you don’t know that gets you into trouble, rather it is what you think you know, but ain’t so.” Poor judgments happen when we overestimate our competence. Poor judgments happen when we have a limited, incomplete, or distorted understanding of the world. Poor judgments happen when our natural inclinations aren’t the suitable response in a situation.
A little insight into how the human mind operates can help us neutralise or avoid some of the causes of poor judgment. That’s a start, but not enough. Most importantly, we should understand our own idiosyncrasies: how our individual minds operate – how we think, feel, and behave in various situations. Cultivating self-awareness and self-control can help us avoid many of the pitfalls of decision-making. Clearly identify our inclinations; restrain instinctual and impulsive reactions; use intuition only in situations where it is likely to be accurate; and, wherever possible, use the deliberate mind to validate intuitions. Our deliberate mind should serve as the linchpin of our decision-making process; the gatekeeper, controlling what enters and exits our mind, moderating our instincts and impulses, and honing our intuitions.
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