Near the top of investor mistakes is the stubborn adherence to something that has been proven wrong. The error might be a strategy, an economic viewpoint, a market opinion, or the choice of favorite pundits. You need to step back and reevaluate when there is important new information.
Here are two key examples:
- The failure of Lehman. Many thought that the big investment banks were too big to fail. It turned out not to be true. While some still think that the government should have acted, those in power felt they lacked authority to act. In the aftermath we all learned what would happen to the economy if there was no confidence in any financial institution. What we call "normal and sensible lending" came to an end. Most mainstream economists adjusted their forecasts to account for the extreme reaction of corporate leaders.
- Massive government intervention. Many thought that the government would be powerless or ineffective. This turned out not to be true. While some still think that the government actions were wrong, those in power saw a responsibility to act very aggressively. In the aftermath we all learned what would happen when there is aggressive action and intervention by the federal government. Most mainstream economists adjusted their forecasts to account for the extreme reaction of government leaders.
Ironically, many observers who were accurate on one of these key points missed the other. In a further touch of irony, economists who adjusted forecasts in both cases (notably those in the mainstream) are now frequently criticized for "missing" the first move. The implication is that their current forecasts will be wrong.
The Three Doors Problem
We anticipated this situation in June when we asked the following question:
You get the chance to be on a game show. The host lets you pick one of three doors for a prize. One door has a great prize and the others have trivial rewards. You make your pick. The host (who knows where the real prize is) reveals one of the two alternatives and offers you the chance to switch your choice. Should you do so?
Top traders with whom we have been associated use this question as a screening test for new recruits. Getting it right on the first pass (easy for bridge players, who are experts at probability) is excellent. Since most people fail on the first pass, the question is how long it takes them to accept the answer. Some of the most intelligent people in our universe could not accept the solution. That is a bad trait for a trader!
The problem is a simple probability question, but the answer is counter-intuitive. The best simple explanation comes from Leonard Mlodinow, whose book, The Drunkard's Walk, we recently recommended. The explanation comes from an excellent quiz presented by The Numbers Guy, Carl Bialik.
Answer: Yes. When you initially chose door No. 1, you had a one in three chance of picking the car. The other scenario, in which the car is behind one of the other two doors and so only one of those two doors hides a cow, has a probability of two-thirds. Let’s focus on that scenario, and assume — since we don’t have any information to the contrary — that the host always opens a door that reveals a cow. In that case, the door he didn’t open and that you didn’t choose always contains the car. So if you switch, there’s a two-thirds chance that you’ll win the car. If you don’t, you’re stuck with a one-third chance.
Bialik goes on to note the recent featuring of this problem in the poker movie, 21, which we recently saw on Netflix. We might have chosen a different problem, since many readers now seem "clued in" to this specific answer while missing the concept. Readers who want more such questions should look at his original quiz, especially #3, which has a similar theme (also a layup for bridge players).
The issue of stubbornness is highlighted in the reaction to Marilyn vos Savant, who presented the question in her popular Parade Magazine column. Many "experts" disputed her answer.
We see many economists and pundits who stubbornly adhere to a viewpoint that "called the crash" or had some method of market valuation that seemed, in retrospect, to be accurate.
Forecasts must change with facts and new data. There is no substitute for keeping current on the best indicators. We try to balance our fundamental analysis with market indicators from our disciplined trading system. It is a reality check. Many of the most popular financial websites have an ongoing commitment to finding the worst possible interpretation of any reported data. There is a need for balance.