In Part II of a two-part series, The Money MD focuses on the remaining four of the "seven sins" of memory that Joachim Klement, CIO at Zurich's Wellershoff & Partners, says are to blame for recurring financial calamities.
In Part II of a two-part series, The Money MD looks at the remaining four of the “seven sins” of memory that Joachim Klement, the chief investment officer of Zurich’s Wellershoff & Partners Ltd., says are to blame for recurring financial calamities. (Read Part I here.)
Financial analysts and meteorologists have a lot in common. They both make predictions with confidence. But when faced with a mistake, only one of the two groups is likely to wave a white flag and admit an error -- the weather people. Meteorologists allow that a weather event either couldn’t be forecast or they simply made a mistake. Consequently, meteorologists are able to learn from past misjudgments.
Financial analysts don’t do so as easily. Why?
In Joachim Klement’s working paper, “The Flaws of Our Financial Memory,” he attributes the reason for recurring financial calamities to seven memory flaws that contribute to both loss of recall over time and distortion of memory by more recent awareness and attitudes.
Understanding and working with these mind flaws in a constructive way can benefit not only financial analysts and mangers, but anyone who self directs his or her own investments. It is also a message of hope that someone in the financial industry is researching and trying to lessen the chance of financial catastrophes in the future.
The first three of Klement’s sins were covered in last week’s column. The last four follow here:
“Misattribution” is the fourth sin. Klement describes misattribution as a fact that’s remembered, though the source is not. For example, an investor recalls hearing that a company is going to report higher earnings than expected, but can’t recollect where he heard it. If a friend unrelated to the business tells him, the information is likely idle gossip. If someone in the operation itself informed him, the information may be meaningful (though it could also be construed as insider information). Nevertheless, without recalling where the information came from, it is less useful and could be detrimental if the investor uses the information to make an investment, but the source was wrong.
“Suggestibility” is another sin. Suggestibility occurs when an incomplete or incorrect picture is conjured up in someone’s mind, either because little information is offered or because the information is wrong. This leads to incorrect assumptions. The consequence is that a product is thought to be better than it actually is. Suggestibility happens frequently in the investment industry. For example, when a broker or financial advisor presents only the advantages of an investment and not the downside, an unsophisticated investor may unwittingly think he or she is buying something that is not what it is portrayed to be.
“Bias” is the sixth sin. We know that past memories are influenced by present circumstances. This includes knowledge gained since the memory was placed, our current feelings, and our overall mental state. As an example, say a real estate agent tells a friend that residential property values will continue to decline in New York City. Then, when values suddenly rise, the agent denies ever saying it.
The last sin is unique. It is “Persistence.” Persistence arises when we would rather forget a memory, but can’t. It is related to a traumatic experience that makes it imprinted indelibly on our brains. If financial distress occurs, especially during formative years, it’s likely to influence the sufferers’ outlook going forward, often in a dramatic way. Consider a child growing up during the Great Depression. Exposure to such a devastating event may forever adversely influence that investor’s choices, making him or her excessively risk averse.
Hope for the Future It is a given that categorizing the sins of memory is easier than recognizing them in ourselves and doing something about them. Nevertheless, not only can financial analysts and managers become better at their job by paying attention to them. Private investors can as well.
To this end, Klement offers two main suggestions: 1.) Create an investment policy statement; and 2.) keep an investment diary. The policy statement should outline long-term guidelines, along with restrictions. It is meant to be reviewed often to assure that flaws of financial memory are less likely to occur. The investment diary provides day-to-day reasoning for decisions and offers a way to learn about the root of investment mistakes.
Financial crises such as Long-Term Capital Management crisis in 1998, or the mortgage debacle of 2008, plus others that caused unimaginable monetary loss -- not to mention the emotional pain and suffering of millions of people -- leave investors vulnerable to commit one or more Klement’s seven sins. Attention to Klement’s work may lessen the chance this will happen in the future.
What is most exciting about his paper, however, is that Klement is one of the few in the financial industry to give serious consideration to emotional tendencies that could help his organization make better investment decisions going forward. This can do nothing but benefit the client, too.
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