Have you ever forgotten where you left your keys or the name of someone you just met at a cocktail party? We all do, of course. These experiences are caused by fundamental flaws in memory. At the 64th CFA Institute Annual Conference, Joachim Klement, CFA, chief investment officer for Wellershoff & Partners, says that these flaws lead to predictable investment behavior.
Klement conducted several experiments with the audience to illustrate common memory flaws. For example, he asked attendees to remember a list of seven colors. Most people can recite five to nine colors fairly well, but the number attendees could remember decreased substantially once Klement increased the list to ten colors. The “information overload” of the longer list inhibited recall.
This experiment produces a common result, but some memory flaws trigger different manifestations in each of us. Birth years, for example, can influence investment behavior. Many of us know that “depression babies” are less likely to participate in the stock market than investors reared in more halcyon times. But in a less commonly known trend, young portfolio managers tended to outperform the market by a wide margin leading up to the burst of the tech bubble in 2000. During the ensuing market correction, they dramatically underperformed. More “mature” portfolio managers, by contrast, reversed this sequence but did so with far less flourish: They slightly underperformed beforehand and moderately outperformed during the correction.
How might we overcome these flaws? Klement provides several suggestions, including the familiar advice of drafting and periodically reviewing an investment policy statement, which helps control our impulse to overreact to experiences in our recent past. He also suggests a less well-known solution: keeping a financial diary that documents the motivation and possible risks for each investment decision and comparing it to the outcome of the decision. This practice, however, is “not for those with low self-esteem” because it removes our hindsight bias for things that have gone wrong and our attribution bias for things that have gone right, revealing the naked truth about investment performance and attribution.
Whether or not we can improve our memories, we can put controls in place to help prevent us from making decisions that are likely to lead to our biggest mistakes.