The Illusion of Understanding

Over the years, I have observed that there are many people who like to fabricate stories in order to make sense of what is happening in the world. Philosopher Nassim Taleb also introduced this notion called “narrative fallacy”. He said that we humans like to fool ourselves by constructing flimsy accounts of the past and believing that it was true. However, our interpretation of what has happened is lacking and it is more likely that what actually occurred was much more random and unplanned. We want to believe that there is a good explanation, and that it was predictable, when it really was not. We all have a need for the encouraging message that actions have appropriate consequences, and also to know the determinants of success and failure.

Similarly to what is happening in the markets, I see people linking share price movements to events such as news or earnings release. From there, they will make certain assumptions to predict and forecast the market. This illusion that one has understood the past feeds the further illusion that one can predict and control the future. The fact is that no matter much you study markets, and how much you think you know, there will always be unknowns that you have to deal with.

I had narrowly escaped from a catastrophe a few years ago. I was in the railway industry and I assumed that I know everything about it from the construction outlook to supply chain and material sourcing. Hence I invested in a company called Midas Holdings Limited. It looked like a pretty decent growth company at that time, with them announcing positive profit guidance quarter after quarter and winning “Most Transparent Company Award” at the Singapore Corporate Awards from 2012-2016.

Due to my complacency and over confidence in this company, I failed to do my due diligence before investing. After investing in them for a couple of years (they have been under performing in my portfolio), I felt something was not right about this company. Slowly I began to pore through their financial statements and realized that their numbers looked fishy, especially their cash flow statement. Free cash flow is negligible even when they are announcing huge increase in profits.

Soon I made the decision to accept the loss and divested all my holdings in Midas. 2 months later, stock price rose substantially and the local investment community were raving about this stock, some saying that their future is bright and fundamentally solid. Many had made handsome profits and those having FOMO issues also followed them and boarded the boat.

A while later, the unthinkable happened when they were suspended until further notice as they had uncovered “several litigation cases, enforcement orders and court documents involving firms within the group”. Everyone was surprised that this company, which had won “Most Transparent Company” for years, had severe lapse in their internal process and controls, and suffered losses from their trades. How lucky I was, to have escaped from this event.

That’s when the blame game started. They blamed everyone for their losses, from those traders who highly recommended this stock to SGX for failing to spot the lapse and even the DBS analyst who covered the stock (well, the research house did gave a pretty high Target Price for this stock).

In Daniel Kahneman’s book titled Thinking Fast and Slow, he touched on the topic of the social cost of hindsight. 

Hindsight bias has negative effects on evaluations of decision makers.  Leads observers to assess quality of a decision not by whether the process was sound but by whether its outcome was good or bad.”

This is especially unkind to decision makers who act as agents for others, eg. doctors, financial analyst, CEOs, etc etc. They always prone to be blamed for bad outcomes. This also brings undeserved reward to irresponsible risk seekers – where they are celebrated for taking crazy risks and winning. We like to identify clear causes for success or failure and tend to ignore the power of luck. 

To avoid this, we have to understand that predictions and forecasts are not foolproof. No matter how in depth we study the markets, there will always be unknowns, and also unknowns unknowns. Meaning that we dont even know what we dont know. The market is a complex system and there are bound to be many of these lurking around, waiting to strike when we least expect it. Also knowing the importance of luck, learn to be suspicious when identifying patterns. In the presence of randomness, regular patterns can only be mirages. Dont look for the precise and local, dont be narrow minded, dont try to predict, always remember to factor in a margin of safety in your analysis to mitigate the risk of the unexpected. When the “impossible” happens, you will not be caught with your pants down.

Till then, cheers!

Links to books mentioned:

Thinking Fast and Slow by Daniel Kahneman

The Black Swan by Nassim Taleb

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