Saturday, July 05, 2014

why you invest the way you do

People like to assume they can think objectively. But you and I are just a product of the experiences we've had in life.

In 2006, Ulrike Malmendier of U.C. Berkeley and Stefan Nagel of Stanford University looked at how various cohorts of Americans differed in their views about investing.

Controlling for age, wealth, income, and other social factors, how the economy performed during people's young-adult years had a profound impact on how they invested later in life.

Those who grew up during the Great Depression were half as likely to invest in stocks as adults compared with those raised during the roaring 1960s. Those who grew up during the inflationary 1970s were less likely to invest in bonds later in life than those raised during the stable 1950s. Growing up during the prosperous 1980s made you highly likely to favor stocks during the 1990s. "Our findings suggest that individual investors' willingness to bear financial risk depends on personal history," the authors wrote.

This seems obvious, but there's an important takeaway: One person's view of risk can be completely different than someone else's. And not because one person is smarter or has better insight than another, but simply because they were born in a different year.

Emotional experiences also have a downside: Memories are often distorted, so much so that some of what we remember never actually occurred.

For decades, psychologists have interviewed people who had an emotional experience, sprinkled in some fake prompts, and watched their memories fool them on the spot. In one famous example, Lawrence Patihis of U.C. Irvine discussed 9/11 with a group of research subjects, and found that, when prompted, many could vividly describe seeing video of Flight 93 crash into a field in Pennsylvania (this video, of course, doesn't exist). "It just seemed like something was falling out of the sky," one participant said. "I was just, you know, kind of stunned by watching it go down." They weren't lying. This is a common flaw when recalling emotional experiences, as we try to forget painful memories and replace them with pleasant thoughts.

If someone's view of risk is influenced by what year they were born, and people's memories of emotional events may not even be accurate, there's an obvious lesson: When seeking advice, you should consult a variety of different people of different ages and backgrounds who have experienced different things in life.

This isn't a substitute for skill. But if you get all of your investment advice from 50-year-old white guys, you will get opinions from people whose worldview is colored by similar experiences. And those experiences may be incomplete, not relevant to today's world, and biased in thinking the future will resemble their specific past.

A common trait you'll see among the world's best investors is an open and flexible mind. They are happy to hear diverse opinions from people of all different ages and backgrounds. This isn't because they're nice, but because they understand everyone is biased to their own experiences, and that no group has a monopoly on wisdom. Think about the last five years, when lots of angry old men were hyperventilating about looming hyperinflation and the coming collapse of the dollar, while a bunch of college kids who were "ignorant of history" were busy building billion-dollar tech companies. Not being constrained by past experiences can be incredibly valuable.

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