8th April 2010
Is your memory playing tricks on you and damaging your investment decisions?
Odds are it is, according to John Authers in the Financial Times. In ‘Memory Gaps and Market disasters' he reveals how systemic problems in the way humans recall information can, and do, lead to systemic mispricing of securities.
And that, he rightly points out, is something of a problem for capitalism and markets that prefer efficient pricing of goods and assets.
But hang on, isn't the whole point that you learn from your mistakes? If only that were true, but according to Authers it would seem that we humans are simply no good at learning from the past.
In fact, we're more likely to gloss over past mistakes, preferring to remember the good decisions and forget the bad.
Investment can be a little like backing a horse on Derby day. Everyone remembers their winners. I had a brilliantly successful day at the races when I bet on jockeys wearing red. That this strategy has never worked again has not deterred me.
Investors are prone to ascribing skill to their wins and bad luck to their losses.
There was a notable fund manager in the late 1990s who had a brief, but glorious moment at the top of the performance tables.
His performance was largely down to one large technology stock, but he was too attached, didn't sell in time and spent the next couple of years languishing at the bottom of the performance tables before disappearing from the retail investment world altogether.
That there is room for a second Wall Street film some 20 years after the first certainly suggests that investment markets change little from one generation to the next.
The tools may become more sophisticated and the consequences of failure more profound, but the same emotions that governed investor behaviour in 1987 are still driving markets in 2010.
This can also lead people to ascribe patterns where there are none. Memory is flawed, as is a reliance on past performance. Financial experts rely on over-complex analysis and modelling, predicting the future, based on extrapolation from the past.
It often doesn't work and, as the past two years have shown, sometimes it fails spectacularly.
For those with an awareness of behavioural finance, this does create opportunities though.
Plenty of investment managers would like to suggest that markets are rational places, governed by balance sheet analysis or profit and loss expectations.
In the long-term, that may be true, but as John Maynard Keynes suggested, the market can stay irrational longer than investors can stay solvent.
Take Tony Dye, the notoriously bearish chief investment officer at Philips & Drew, his problem was not so much that he was wrong – markets did prove to be over-exuberant in the 1990s – but that he failed to understand that irrational behaviour can persist and lost a lot of money before his prediction came right.