In the wilderness one quickly learns that the mind often plays tricks and is not to be relied upon, especially if other, ‘harder’ indicators are available. How often have I been convinced that the destination was one way when the compass pointed another. Along the same lines, it’s only too easy to underestimate the time it takes to hike uphill compared to hiking on the flat, unless one knows the rule of thumb that it takes approximately three times as long. Similarly, optimism springs eternal in the wilderness and it’s an experienced guide who heavily discounts the euphoria of a macho group of climbers setting out on a beautiful cloudless day to summit.
What the wilderness teaches us with respect to the limitations of the mind has been rediscovered and developed, albeit more rigorously, into the new discipline of behavioral economics. The bottom line, scientists tell us, is that the mind is riven with cognitive biases. These biases evolved at a time when they no doubt had utility, but although they have now outlived their usefulness, we are doomed to carry them around inside our heads like the cursed sailor carrying an albatross around his neck in the Rime of the Ancient Mariner.
According to cognitive scientists we are lazy and tend to favor information that confirms our beliefs. We tend to ‘anchor’ on irrelevant numbers, so while the asking price of a house should have nothing to do with its value, it does seem to affect the price we are willing to pay. Events in the recent past influence us more than events from long ago. We tend to overestimate the likelihood of visible risks such as a terrorist attack and ignore risks of which we are unaware. We tend to rate ourselves as better than the median. Losses cause us pain out of proportion to the pleasure of winning. We have a tendency to dwell on bad news rather than embrace good news. We are biased towards inertia and so fail to get around to taking action, even on things we want or have agreed to. Finally we tend to make choices based in large part on how the questions are framed.
These biases explain why investment success is as much about behavior as it is about investment performance. The recent price action in gold illustrates this principle and the importance of using a ‘compass’, a ‘handrail’, or some type of objective measure not subject to our cognition, to determine when to sell an investment. Objectively the fundamentals have created an almost perfect backdrop for investing in gold. Unprecedented global money printing to support asset prices and stimulate debt burdened economies, global currency wars as countries compete to stimulate exports, a growing list of possible political and/or economic black swan events, and most importantly, the unique advantage that gold presents of owning an asset with no counter-party risk in a world increasingly aware of such risk. However, despite this glowing backdrop the price of gold has dropped from a high of $1,921 on September 6, 2011 to $1,232 today, a 35 percent fall. It was crystal clear from the gold price chart when gold needed to be sold. After an 18 month period of moving sideways gold was either in the process of consolidating for another push skywards or it was making a huge top. The collapse of gold in April through key support around $1,520, was a decisive message that, for whatever reason (deflation anyone?), gold had actually topped back in 2011.
If you were still holding gold after the drop in April and you started to think that the Fed was manipulating the gold price lower to disguise inflation, or that the big players such as JP Morgan, wanted you to sell so that they could buy back gold cheaply, or that you were going to keep your gold, come what may, because it was the only true source of value in a fiat world, then you were letting your mind play tricks on you. The charts may be wrong but, unlike your mind they don’t deliberately deceive.
(Please note that posts will be somewhat sporadic during the summer as travel plans interfere with writing schedules.)
“Lying to ourselves is more deeply ingrained than lying to others.” Fyodor Dostoevsky