There is a cognitive bias that is often undiscussed yet highly relevant to investment management — the illusion of explanatory depth. It is the bias that we think we know more about how things work than we actually do. When asked to explain some process, we are often far from being able to adequately explain a concept. Our confidence drops when we are asked to explain a core concept that requires a degree of explanatory knowledge. Extreme views can be moderated by asking how a system works.
The phrase was coined earlier, but the bias was aptly shown in the experiments by Rebecca Lawson in "The science of cycology: Failures to understand how everyday objects work". When asked to explain how a bicycle works, many were unable to make a simple drawing of its mechanics.
If you ask about how monetary policy works, how the political system works, or how a firm makes money, many may be unable to give good explanations. This will impact confidence, but will ultimately make better decision-makers.
We bring this issue up again because many news stories make assertions about how markets work, yet when you ask how the system works, many explanations become less certain.
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