Psychology

Hi,

I've just been reading a lot about psychology, especially in the context of the markets.

http://www.newyorker.com/reporting/2009/07/27/090727fa_fact_gladwell?currentPage=all

The above article by Malcolm Gladwell, talks about how the older and more experienced we get, we overate the accuracy of our judgments. Specifically, he focused on Jimmy Cayne and how he was overly confident and led to the downfall of Bear Stearns.

I've also been reading Contrarian Investment Strategies by David Dreman. There he talks about how analysts tend to psychologically be unable to handle configural/ interactive processing of information. Configural processing of information is processing information with multiple variables which are interdependent and have unknown and unstable relationships with each other. Thus they have a really difficult time coming up with accurate earnings forecasts. Also, how analysts are overly confident with regards to their forecasts, even though statistics show how inaccurate they are. They keep insisting that this time will be different. Or how they didn't have enough information or made some mistake along the way. Dreman suggests that it's not that we don't have enough information. It's the opposite, we have too much. Humans just aren't able to process all that data and come up with an accurate prediction.

Next comes The Psychology of Human Misjudgement by Charlie Munger. It's a paper that Mr Munger writes about human cognitive biases and how they affect our ability to assess different situations.

Finally, Margin of Safety by Seth Klarman, where he talks about humans continually insisting on assessing risks of securities by their past rates of returns/ default rates. We just somehow don't understand the concept that "Past performance is no guarantee of future returns". This line is constantly written in every single prospectus out there but we just don't get it that the past is no guarantee for the future. The future is dynamic and constantly changing.

The most curious thing I found in Margin of Safety was when Mr Klarman talks about CBOs (Collateralized Bond Obligations) and how they were able to convince the rating agencies to give Triple A ratings to 75% of the structure. Basically, CBOs are securitized junk bonds. Doesn't this seem familiar? Doesn't it remind you of the Collateralized Mortgage Obligations (CMOs) and the Collateralized Debt Obligations (CDOs) from our recent past? They spun the same trick of getting the ratings agency to rate most of the structure as triple A as well. The question is how did we manage to fall for the same trick over again? Come on, they barely changed the name! We really don't learn, do we?!

My main worry is this how can I overcome the problems with my cognition?! It's part of me. I can't change it. Worst of all, I don't know where my limits lie. Or when my brain is failing me or it's just simply I didn't do enough homework on the investment. I guess there is no answer as to where our limits lie and how much we should trust our judgment in any given situation. The flip side of the coin is analysis paralysis. We just have to admit that there are some situations where we simply don't/ can't know about - the Unknown Unknowns - as Mr Rumsfeld so eloquently puts it. Guess this makes the game all the more interesting eh?