The outside view
The classic 2002 book ”When Genius Failed” tells the true story of a hedge fund, run by a supremely confident Wall Street bond dealer who with the help of two Nobel laureate economists thought he had cracked the code to make millions in the markets.
For a while, Long Term Capital Management (LTCM) was seen as invincible. But when emerging markets crashed in 1998, the leveraged bets it had made threatened to bring down the entire financial system. Only coordinated central bank action saved the day.
The failure of LTCM and the sullied record of its highly credentialed founders bring to mind a famous quote from the American writer Mark Twain: “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”
It’s a reminder that human beings, even the very smartest ones, are naturally inclined to view the world through the prism of their own circumstances, beliefs and experiences. All of us, no matter how high our individual IQs, have our blind spots.
In the case of LTCM, mathematical assumptions about the volatility of its investments turned out be wrong, with literally catastrophic consequences.
Seeking another opinion
The lesson of this episode for we mere mortals is that if even Nobel laureates suffer delusions about the wisdom of their investments, we all could improve our positions by seeking another opinion before making big financial decisions.
In her book, “How to Decide: Simple Tools for Making Better Choices”, author and former professional poker player Annie Duke says that all of us are trapped in our “inside view” and can improve our decision-making by seeking another perspective.
“Part of why it’s easier to see other people more objectively than you can see yourself is that you are motivated to protect your beliefs when it comes to reasoning about your own situation. Your beliefs form the fabric of your identify,” Duke writes.
“Discovering that you’re wrong about something, questioning your beliefs, or admitting that some bad outcome was because of a bad decision you made and not just bad luck – these all have the potential to tear that fabric.”
This is the likely psychological explanation for the LTCM disaster. The deeper these masters of the universe sank, the more resistant their egos were to admit their errors.
In fact, Annie Duke says being smarter can make people’s adherence to their inside view even harder to shake because they tend to succumb to “motivated reasoning”, which is another way of saying they tend to seek out the data to fit their theories.
This is why it is so important to seek an outside view. An objective view can help you uncover your assumptions or blind spots. It can anchor your beliefs and help you to be better prepared in case things don’t turn out the way that you expect.
“Marrying the outside and inside view gives you a clearer view of yourself, how you ended up where you are, and what the future might hold for you,” Duke says. “That can improve the quality of what you learn from the past and the quality of the decisions you make going forward.”
The value of independent advice
In the world of investment, this may be the best argument for having an independent financial adviser helping you make decisions. No matter how much you think you know, there will always be things you haven’t considered or have simply overlooked.
That other person can help you clarify risks, but also opportunities. They can help you make decisions from a broader perspective, simply because they are outside your situation and don’t have the emotional investment that you do.
A good adviser may challenge your preconceptions and help you uncover the motivations underlying your expressed goal. That can also build a practical bridge connecting your non-material aspirations and values with your concrete goals.
At the very least, the outside view teaches you about what you can change and what is beyond your control. Even geniuses could do with that reminder once in a while.