Season Investments


The Greatest Fault

Posted on March 17, 2015

“The greatest of faults, I should say, is to be conscious of none.” -Thomas Carlyle

2015-03-17_cognitive.jpgLast week we came across an op-ed by famed hedge fund manager Ray Dalio. As some of our long-time readers may already know, we have an immense amount of respect for Mr. Dalio and have written about him in the past. The op-ed was entitled Unconventional Wisdom in which Ray made an argument for why his firm has embraced a culture of what he calls “radical openness,” even though this level of honesty can be very difficult and uncomfortable at times. The conclusion he comes to is that this type of culture allows his investment team to achieve a higher level of understanding for each investment since they rigorously stress test their opinions. Quoting from the op-ed, radical openness…

demands that you get over your ego-driven desire to have whatever answer you happen to have in your head be right. Instead, you need to actively question all of your opinions and seek out the reasoning behind alternative points of view.

2015-03-17_Ray-Dalio-Quote.jpgThis statement and the op-ed as a whole got us thinking about how difficult it can be to maintain an open mind and admit when we are wrong. In our search to learn more about this human trait, we came across the research of Carol Tavris and Elliot Aronson from their book Mistakes Were Made (But Not by Me) via the self-help blog The Art of Manliness.

Whenever we as humans are confronted with ideas or behaviors that challenge our ideals, we experience something called cognitive dissonance. Cognitive dissonance is a state of mental discomfort where the brain is trying to decipher truth from conflicting information. Our brains crave continuity and clarity, so they figure out ways to resolve conflict. A good example is someone who smokes. Pretty much every smoker alive has been told that smoking is a bad for their health, yet over a billion people around the world smoke. At some point along the way, people that smoke have rationalized their decision (life is short, my grandfather smoked and he lived to be 90, etc.) in order to reduce the mental tension associated with making the daily decision to light up a cigarette at the long-term cost of their health.

Cognitive dissonance also shows up when we make mistakes. Most people think of themselves as fairly decent people. Sure everyone has their faults but at least we are always trying to do our best. A person’s worldview and self-image is shaped by their life experiences and even though billions of people on this earth go through billions of different experiences, we all believe our view of the world around us is realistic and rational. When we make a mistake we experience cognitive dissonance as our brain searches to reconcile the apparent conflict between our questionable behavior and our elevated self-image. At this crossroad, the dissonance is alleviated by either admitting the mistake and revaluating our self-image in light of it or by justifying the behavior and assigning blame elsewhere in order to defend our self-image. The former is a much harder path to take than the latter because of two cognitive biases that every human must address: the confirmation bias and sunk cost fallacy.

Everyone, even Ray Dalio, at some point in their life has fallen prey to what psychologists call our confirmation bias, which filters information in a way to further solidify our beliefs while rejecting beliefs that run in contradiction to our own. This is why two people with differing beliefs can be presented with the same information and one finds it to be brilliant while the other immediately dismisses it as nonsense. When we are presented with information that challenges our beliefs, researchers have shown that the reasoning parts of our brain actually shut down. Focus is instead turned to finding any sort of inaccuracy or fallacy in the conflicting information so that it can be wholeheartedly dismissed in order to restore harmony, which engages the happiness centers in our brain. This odd defense mechanism is a way for our ego to “circle up the wagons” in defense of our self-image and is one reason why conflicting information can end up further solidifying previously held beliefs rather than challenging them. The confirmation bias is one reason why it is so difficult for people to see their own errors and admit when they are wrong.

In addition to confirmation bias, psychologists have identified the sunk cost fallacy as another cognitive bias which hampers people’s ability to see the error in their ways. The sunk cost fallacy is simply the idea that we justify a seemingly bad decision because we have put a significant amount of time or money into it and don’t want that investment to be wasted on a mistake. To combat this, we come up with sensible sounding arguments to defend our previous and ongoing actions in order to justify the “mistake.”

blackboard.jpgOur culture here in the US makes it especially difficult to admit mistakes because we are a results driven culture. Making a mistake is an indication of failure and is construed as a lack of intelligence. In contrast, the Japanese culture is much more process driven and values effort over results, viewing mistakes as simply part of the learning process. Back in the 1970s a group of American researchers were observing a Japanese classroom in which a student labored over a problem on the chalkboard for 45 minutes in front of the entire class. The researchers were amazed by how calm and comfortable the student was during this seemingly embarrassing moment. What they came to realize was that Americans internalize mistakes as a personal failure, whereas the Japanese simply see them as part of the learning process and evidence that improvement can be made.

In the short history of our firm, we have made plenty of mistakes. Perhaps the largest example was our belief that loose monetary policy and quantitative easing would be extremely bullish for gold (see Three Fundamental Tailwinds for Gold, A Golden Life Raft, & Will Gold Glitter Again?) only to see it see sell-off off by close to 40% from its 2011 peak to its recent low. In light of this, we could have chosen to make excuses for our misplaced belief, but rather we chose to retool our investment process by taking the same sector rotation/trend following concepts we employ in our stock model (MarketVANE Equities) and applying them to hard assets, which we classified as diversified commodities, gold, and publicly traded real estate investment trusts (REITs). At the time, this decision was a difficult one as it meant throwing in the towel on a high conviction, underwater gold position in favor for a more agnostic approach which relies on trends in the market to dictate investment. In hindsight, the shift has been beneficial as gold continues to trade in a range bound, sideways pattern while REITs have done fairly well in this low interest rate investment environment.*

As the opening quote from prominent 19th century philosopher Thomas Carlyle states, “the greatest of faults…is to be conscious of none.” Perhaps Ray Dalio’s concept of “radical openness” is too extreme for most people that prefer to maintain a sense of social normality, but the idea of suppressing our ego’s defense mechanisms when we are faced with information that is in conflict with our beliefs and self-image is paramount not only to investing but also to the pursuit of living a well-balanced life in general. Those that don’t pursue this goal run the risk of becoming like Chevy Chase’s character Elmer Fudd Gantry in the hilarious movie Fletch Lives (“It takes a big man to admit when he is wrong. I am not a big man!”). We need to shift our thinking so as to not view mistakes as personal failures but rather see them as an inevitable part of life that provides an opportunity for growth and change.

*MarketVANE Hard Assets recently moved to an all cash signal as both gold and diversified commodities have yet to establish an uptrend and price movements in publicly traded REITs have triggered the “volatility override.”

elliott_headshot_bw.jpgAuthor Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.

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Transparency is one of the defining characteristics of our firm. As such, it is our goal to communicate with our clients frequently and in a straightforward way about what we are doing in their portfolios and why. This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. It represents only the opinions of Season Investments. Any views expressed are provided for informational purposes only and should not be construed as an offer, an endorsement, or inducement to invest.