We don’t know what we know: this comes from the subconscious or ‘instinct’ and includes ‘genetic’ and ‘social’ ‘volatility’ learning. It also includes cultural learning, like our being Indian makes us uniquely distinguishable from, say, a German. As far as investing is concerned, it includes all the many ‘evolutionary rules’ that we apply instinctively to economic situations, without knowing why we do what we do.
Declaimer: This article written was originally in January 2013, and some of the data points may be outdated.
How we deal with money
For example, the brain has no ‘equipment’ to deal with money, simply because such a thing has not had time to evolve. Money was invented just 10,000 years back, too small a period for the brain to evolve something to deal with it. It is the reward center in the brain, the amygdala, that was developed to deal with food (satiation) and sex (drive), that deals with money. This is the cause of much trouble in the markets. One of the big ones is that we confuse Volatility with Risk; volatility is merely the waxing and waning of liquidity, while risk is the possibility that something will fundamentally go wrong. Hence, volatility in wealth is misunderstood by us as a Risk to our wealth, leading to very irrational behaviors.
The Sense of ‘Self’
Another one is the belief in our uniqueness. This comes from the id, which is where our self-awareness sits. It helps us to recognize ourselves in the mirror, unlike the swordfish which is prone to fight with its mirror image; it has no recognition of self. Somewhere in the same place, is our instinct of self-preservation. This id leads us to believe that what we are thinking is unique and prevents us from checking whether others have come to the same belief. This is particularly dangerous when we are prone to herd belief, an instinct that is seated in our cerebellum medulla; when you are thinking the same thoughts as the herd, but make the mistaken assumption that you are unique in your thoughts, it can lead you to slap bang into the middle of a bubble, from which your Net Worth may never recover.
We know what we know: this is the quadrant most of us (consciously) live in. Depending on our ego state, this quadrant can be artificially expanded to include what we don’t know, or even what is unknowable. It is the source of millions of investing mistakes…all bad investors live mostly in this quadrant.
The ‘Self’ confused with ‘Identity’
Left-brain thinkers (like Chartered Accountants, MBAs, and sundry ‘qualified’ people) who have got educated in a particular ‘domain’ are very prone to identify themselves with the degree they got from 3 years of college. They confuse literacy with education, jargon with know-how, and data with insight. All of the latter resides in the right brain, and CANNOT be taught by explicit teaching; it can only be learned internalized, with attitude and experience. This is what distinguishes IQ from Emotional Intelligence, a.k.a. EQ. As in many other areas of life, this leads to a lot of damage in the markets too.
It’s not what you DON’T know that ever hurts you in markets, it’s what you think you know, but ain’t, that will hurt you…..if you know your limitations, you will not get hurt. It’s when you jump off the 28th floor, thinking you have a parachute, but discover too late that what you were carrying was an umbrella…well, that is when you will hurt yourself.
Ego to arrogance to ignorance
Consciousness (and control) of your id, which is the seat of your ego, is perhaps the greatest source of Emotional Intelligence, which is now known by Behavioural Economists to be the single most important factor in investing success. It is also perhaps the most important factor for success in business, organizations, or even relationships, but I will limit myself to the subject of investing…
Ego leads to arrogance, which leads to ignorance. Ego-driven ignorance is worse than raw ignorance because it precludes you from learning from your mistakes; in fact, you start to rationalize them. This why Chartered Accountants are the single biggest failures in the markets, and the more ‘educated’ and successful you are in your work, the more likely you will fail in the marketplace. The spectacular failures of scientists like Albert Einstein and Isaac Newton bear this out.
The Learning Quadrant
We know what we don’t know: the learning/ enquiring/ exploring state. All good investors live mostly in this quadrant. Soros once said that “all good investors are good drivers, but all good drivers are not investors”. His likening of the investing paradigm to driving is very interesting, and for students of this subject, it contributes almost a lexicon that helps communicate some core concepts:
o Most (85%) drivers believe that they are good (drivers), and yet almost nobody has accident-free records.
o The whole idea of “road rage” comes from blaming somebody else for your hindrances, instead of trying to anticipate the mistakes of others. The acceptance of this (that others will not drive as per your requirements) would eliminate this. Sounds familiar?
o Nowhere else in our daily lives do so many people handle uncertainty (and consequent risk) together. The only other place we do the same is in markets: whether equity or commodity/ forex. Nowhere else do we jostle through crowds, create gridlock, and even face sudden panic.
o In driving, as in investing, we confuse left-brain talk of accelerator/ brake/ etc with right-brain talk of traffic rules. Everybody knows how to operate the left-brain stuff, but very few people know how to handle traffic. In the same way, in investing, every neophyte knows the jargon of Finance, but almost nobody has the emotional maturity needed to navigate markets.
o Lastly, we trust our cars to any idiot who walks in with a Driving Licence, without even checking whether he is a rapist, murderer, or saint….not that these things impact his driving, but we forget that we are also trusting our own (and our children’s) lives to him. In the same manner, we hand over our own money to anybody who puts an ad in the newspaper, not realizing that we trust him with our future.
The Complexity Quadrant
We don’t know what we don’t know: the biggest quadrant by far, and many of us are least aware of this. The spirit of inquiry that I have alluded to above, is an assumption that you do not know enough to be sure of anything. It is all over the place: in business, Andrew Grove, the iconic boss of Intel wrote a book with the title: “Only the Paranoid Survive”.
Just how the fluttering wings of a butterfly can alter the path of a tornado is not fully understood, nor also the (Monte Carlo) path of security, which can start with different initial conditions. Nassim Taleb pointed out these unexpected outcomes, saying that the only way to survive such conditions is to “expect the unexpected”. In various succeeding books, he has dwelt on various aspects of this state of existence, but that journey is for a different day.
Complex (human) systems, especially markets, are inherently unstable, just like a mound of snow that launches an avalanche. Physicists have studied such “fingers of instability” to try and figure out the rules to predict such avalanches. While they will one day be able to build complex computer-based models that mimic the actual process, there is no hope of similar success with human systems.
“Complexity” of Investing
The good news is that in the world of investing, we just need to stay out of trouble, not predict it. And if we follow some simple rules of sensible diversification, we are likely to get more than one attempt at getting it right.
The reason this is not a natural state for most humans is that it is “anti-ego”, i.e. humble, a state of existence that is anthropologically alien to us. This mental state has to be developed/internalized with training; and since even limited success in markets brings in money, it sows the seeds of its destruction….money creates arrogance, which inflates your ego, ipso facto setting you up for failure. This is why those legends about Warren Buffet’s humility gain significance; if you think you are a “Master of the Universe”, then this lesson is not for you.
