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March 25, 2010 5:07 pm

Memory gaps and market disasters

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Is your memory ­playing tricks on you? Whatever your age, the chances are that it is. And that, in turn, could affect your ­investments.

Taken more broadly, systemic problems in the way all humans try to recall information could lead to similarly systemic mispricings in markets. That is a problem for capitalism, which ­prefers markets to price assets and goods ­effi­ciently. But it also creates an ­opportunity that many in the field of behavioural finance are trying to exploit.

Behavioural finance has been around for a while. Its central insight is that the classic axioms of ­economics, ­assuming rational behaviour by all economic agents, need to be adjusted in the light of findings by psychologists on how ­people actually make decisions. ­Rather than being efficient, markets thus fall prey to wide swings of emotion. They are also susceptible to systematic cognitive errors, caused by the mental shortcuts we all use to understand the world.

The literature on the subject is fascinating, and the crisis of the past three years has made it all look more plausible.

The focus lately is on memory. Nobody remembers everything he or she has ever experienced. Our memory banks are selective in ways of which we are unconscious.

That leads to intriguing results when we apply our experiences to investing in markets. Memories, it turns out, are shaped to a great extent by the present. We frame the past using the materials around us.

This implies we are no good at ­learning from the past. And that, in turn, clarifies why markets make the same mistakes in each generation, with ever more elegant arguments to ­explain why overvalued investments such as ­internet shares in 2000, Japanese equities in 1990 or motor stocks in 1929 will not go the same way as Dutch tulip bulbs in the 17th century.

According to a paper by Joachim Klement, chief investment officer at Wellershoff and Partners in Zurich, flaws in memory have driven many of the markets’ problems in recent years.

He points to experimental evidence that bad memories tend to be blocked by good ones. If you have spent a day at the races and bet on the winning horse only once, the chances are you can ­remember the name of your winner – but not those of any of the ­others.

Because we know the high US house prices in 2006 turned out to presage a sharp fall, which led to the credit ­crisis, it is hard not to view the incident through that lens. Many now ­believe they saw it coming – when, at the time, the US housing market generated concern, but also much controversy.

Pure forgetfulness is still a problem, but even here it turns out to be systematic. Klement points out that prolonged exposure to high stress damages long-term memory. As market prices are largely set day to day by people working in the stressful environment of trading rooms, this might help explain how markets collectively manage to forget previous disasters so quickly.

Add these elements together, and it looks like our memory retrieval system has left markets hard-wired for booms and busts.

But can we make any money out of it? Behavioural finance has done a good job of explaining how markets come to be inefficient. It has been much weaker in helping predict those inefficiencies.

Still, it has provided some guidelines. First, a clear emphasis on investment process, rather than outcomes, can help. Stick to a process and ask a series of predetermined questions, and it is harder for your memory to act up.

Klement also suggests keeping an investment diary. If you are confronted with how market events appeared when they happened, it will be harder for your mind to hoodwink you into bad decisions in the future. Faced with evidence that you did not see the last crash coming, you should be more humble in guarding against the next one. You might save yourself some money – and even make some.

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