Cognitive Investing

The skills required for successful investing are difficult to learn.  In the next few essays, I discuss four obstacles that thwart the education process.  They are:

1. The feedback loop is extremely long.
2. It is difficult to distinguish the contributions of skill vs. luck.
3. It is difficult to maintain objectivity when making judgments about your own investing skill.
4. The process sometimes requires substantive amounts of unlearning.

1. The feedback loop is extremely long.

Imagine you are in school and you take a test to determine your proficiency in a subject.  The results from this test are important to determine which areas you have mastered and which areas you need to study further.  How effective would the learning process be if years elapsed between when you took the test and when you received your results?  By the time you received your results, you would likely have forgotten all about taking the test and what the test results were supposed to help you to learn.

This protracted feedback loop is frequently encountered in the investing world.  Jack invests his 401(k) in an actively managed stock fund and Jill invests hers in a passively managed stock index fund.  It will typically be years before it becomes evident that Jill made a better decision than Jack.  Jack and Jill might be tempted to reach a conclusion in a shorter time frame, but the chance of drawing an erroneous conclusion increases as the measured time period decreases.

By the time you receive feedback on the quality of your investing decisions, it is likely that you have forgotten the process or reasoning that led to the initial decision.  Without prompt and accurate feedback, it is difficult to learn enough to avoid making similar mistakes in the future.

Contrast this feedback situation with other disciplines, in which learning from one’s mistakes is necessary in order to progress.  If you hit a wrong note while learning to play a musical instrument, you know it right away.  You can take corrective action.  If you try to shoot a basketball into the basket and it does not go into the hoop, you know you need to make some sort of adjustment.  If you take a quiz, the feedback is most meaningful if you get it shortly after taking the quiz, when the topic is fresh in your mind.

With extremely long feedback loops, it is quite possible that you will learn the wrong lessons.  For example, if I bought XYZ stock based on the opinion of one of my coworkers and two years later the stock had declined by 75%, I might be tempted to draw the conclusion that I should not pay attention to my coworker’s opinions about which stocks should do well.  Although this conclusion is correct, it does not go far enough.  One lesson that I should have learned instead is to not buy a stock based on anyone’s recommendation.  In spite of all the potential sources of investment recommendations, there is no one source or magic formula that will lead to above-average results.  It might also be the case that I might need to learn that I should not be buying individual stocks at all.

Unless you are a day trader (not recommended!), the measurement period for judging investment success is on the order of years.  The last several stock market cycles have lasted for about seven years, so making conclusive judgments about decisions with shorter time frames could easily lead one astray.  Decisions that work well in advancing markets may work horribly in declining markets as many Wall Street professionals discovered several years ago.  Decisions that appear smart in a declining market may look foolish in a rising market.  After a complete market cycle, one can begin to make some informed judgments by measuring the success of all the decisions made during the entire time period and comparing them to a simple alternative, such as a broad-based index fund.  This process will always be somewhat incomplete, but revealing patterns should emerge after a while, if you are attuned to the nature of the feedback loop.

Unfortunately, the learning difficulties continue.  Even after patterns have been identified, it can be difficult to determine how much should be attributed to skill and how much to attribute to luck.  That is the topic of the next essay in this series.