Our minds can deceive us into believing all sorts of things, and all the more so when money is involved.
Did you see this credit crisis coming? And the 20% fall (so far) in house prices? Apparently lots of people did.
According to many commentators, house prices were obviously overvalued, and everyone knew that loose lending criteria would eventually sink the banks. Correct predictions, as it turns out, but not at all obvious at the time. Certainly not obvious to the buyers of houses and bank shares.
I believe what we are seeing at the moment is what psychologists call hindsight bias, the tendency to regard past events as having been more predictable beforehand than they were.
Which is not to say that nobody predicted the crisis. In a world full of forecasts, some will turn out to have been correct, if only by random chance. And in the case of Nouriel Roubini, among others, I believe it was more through skill than luck, but let's not fool ourselves that we all knew this was inevitable.
The fact that the public, the politicians, and the pundits, got it so wrong could be attributed in part to herd behaviour. When the accepted wisdom was that boom and bust cycles had been abolished, that paying rent was dead money, and that banks always make a profit, it can be very difficult to take a contrary view. And it can be even more uncomfortable to express that contrary view, when 'talking down' the market was almost seen as an act of treachery.
So if you made the right call, congratulations. But how do you know if your decision was correct? At one level, if you made a profit or averted a loss, it would appear you made the right decision. Judging the quality of your decision on the basis of the end result, however, can be a bit misleading. This is often referred to as outcome bias.
The 'right' decision is the one that made most sense based on the knowledge you had at the time. Let's say I toss a fair coin -- if it lands heads I pay you £10; tails, you pay me £1. You like those odds, play the game, and lose your pound. Does that mean you made the wrong decision to play the game? If the loss of that pound doesn't cause you considerable distress, I'd say you were right to play. The fact that you lost doesn't change the fact that you were right to take that chance, given the information available to you when taking the bet.
You may choose to beat yourself up over loss-making investments, but if you did your research and believed the odds were in your favour, perhaps you are being too hard on yourself.
Humans evolved in a world without stock markets and mortgages, and evolution hasn't really equipped our brains to deal with these concepts. We can rationally understand the transactions, but how we perceive the markets often has little to do with rationality. Being aware of our natural biases might help us to see the world as it is.
"Why, sometimes I've believed as many as six impossible things before breakfast", the White Queen, in "Through the Looking Glass", by Lewis Carroll.
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