Saturday, June 25, 2011

How We Know What Isn't So: Chapter 7

Value investors believe the market is not perfectly rational. To understand why, an examination of human behaviour is required. In How We Know What Isn't So, which is recommended by a number of value investors and behavioural economists, Thomas Gilovich explores the fallibility of human reasoning. Only by understanding our flaws can we seek to improve on them, thereby ameliorating our decision-making processes.

This chapter is about how we are heavily influenced by what others think. For example, we think a movie to be worthy if others do.

The thoughts of others can be a terrific source of information. After all, if most people believe something to be true or false, they are usually right. Unfortunately, however, this reliance on others can lead to errors when the crowd is wrong.

Gilovich also argues that we believe others to have the same beliefs we do. This occurs because we lack proper feedback from others. Part of the reason for this is that we associate primarily with people who share our beliefs and values. But even when we do encounter people with different beliefs, we are rarely challenged. This is because people have a general tendency to avoid conflict.

(Interestingly, this applies only to adults. Children are much more brutally honest with each other, so children get a lot of feedback on how they affect others, whereas adults don't. For example, Gilovich argues that an adult is much more likely to return from a social function with broccoli-teeth or an unzipped fly, whereas these mishaps would be pointed out to an offending child at a social gathering for kids.)

Such tendencies can lead to Groupthink, which can have disastrous consequences. When groups of people are put under pressure to produce an action plan, personal reservations are often kept quiet in order to maintain consensus. This can lead to a poor, improperly vetted plan riddled with error.

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