Thursday, November 2, 2023

The illusion of explanatory depth - an investment problem

 


There is the illusion of explanatory depth, the perception that we think we know about how things work better than we actually do. A classic study done around 2006 gave people an image of bike and asked the test-takers to fill-in the rest of the frame, the chain, and petals. 40% of the test-takers could not properly place these items on the bike. You can just image how a test of the illusion of explanatory depth may fare when asked about what drives the stock or bond market. If we are asked a set of repeated "why?" about an investment it is not clear what kind of answers we will get.

We have greater confident in our understanding of how things work versus our ability to explain how things work. When asked to explain even simple gadgets, many will fail. We also give ourselves more credit for understanding complex tasks just by watching other undertake the task. after watching some hit a baseball, we will usually conclude that it is relatively easy, and we can do it. Guess again. Our powers of observation concerning even repeatable task is poor. It is no wonder that many asset managers cannot explain their investment process or what may drive markets. 

Learning is not easy nor is understanding any activity. Accept that all investors suffer from the illusion of explanatory depth and a key part of making better investments is stripping away this illusion and focusing on creating clear simple stories for what the is relation of cause and effect, and accepting that sometimes, perhaps many times, there is no good explanation for why things happen. 

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