We also selectively perceive data, hoping to find something that confirms our prior views. We ignore data that contradicts those prior views. We even reinterpret old evidence so it is more in sync with our perspective. Then, we only selectively remember those things that support our case. Last, we overuse Heuristics, which is defined as simple, efficient rules of thumb that have been proposed to explain how people make decisions, come to judgments and solve problems, typically when facing complex problems or incomplete information (call them mental short cuts). These short cuts often generate "systematic errors" or blind spots in our analytical reasoning. And that's only a partial list of analytical imperfections you have inherited. The good news: These defects can be overcome. We can develop an awareness of these specific defects, and we can learn to employ strategies that attempt to overcome these inherent analytical shortcomings.
What Have You Learned in the Past 2 Seconds?
Let's place these defects into a historical framework within the context of the capital markets. My favorite illustration as to why humans simply aren't hard-wired to undertake risk/reward analysis in capital markets comes from Michael Mauboussin, Legg Mason Funds' chief investment strategist. Mauboussin takes our evolutionary argument -- the mind is better suited for hunting and gathering than it is for understanding Bayesian analysis -- and places it into a chronological context. In an article titled What Have You Learned in the Past 2 Seconds?", he creates a timeline of human history scaled to equal one day. He starts at the beginning: Homosapiens came into existence 2 million years ago. Next, Mitochondrial Eve, the common female ancestor among all living humans, lived less than 200,000 years ago. Last, he notes that modern finance theory, the framework to which investors are supposed to adhere, was formalized about 40 years ago. If all of human history were a day long, then investing is only about two seconds old. Is it any surprise that most humans do it so poorly? The vast majority of human history has been spent learning to survive, not analyze P/E ratios. Learning to fight nature won't be easy. To outperform, you sometimes must go against the crowd, despite the appeal and seeming safety in numbers. You must be humble and willing to admit error; meaning you'll have to overcome your ego's predisposition to avoid embarrassment, so as to maintain status amongst your tribe (and thereby enhance survival probabilities).