2 Blind Spots We All Have—And How To Profit Off Them

The "Illusory Correlation" Bias

September 21, 2024

Read Time: 4-minutes

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Today, we're going to look at 2 blind spots we all have and how we can actually profit off of them.

“Above all, never fool yourself, and remember that you are the easiest person to fool.”

— Charlie Munger

While we all like to think that we never make mistakes or have blind spots, it's probably unrealistic to assume that will be the case…

After all, if even the best investors in the world, like Munger, first prioritize studying how not to make poor decisions, then we'd probably be wise to do the same.

So, I curated a few passages I recently came across to explore how to help avoid sub-optimal decisions.

Let’s dive in.

The Lucretius Problem

The first passage comes from the New York Times bestselling book "Antifragile"1 by Nassim Nicholas Taleb:

"Indeed, our bodies discover probabilities in a very sophisticated manner and assess risks much better than our intellects do…

To take one example, risk management professionals look in the past for information on the so-called worst-case scenario and use it to estimate future risks – this method is called “stress testing.” They take the worst historical recession, the worst war, the worst historical move in interest rates, or the worst point in unemployment as an exact estimate for the worst future outcome​.

But they never notice the following inconsistency: this so-called worst-case event, when it happened, exceeded the worst [known] case at the time.

I have called this mental defect the Lucretius problem, after the Latin poetic philosopher who wrote that the fool believes that the tallest mountain in the world will be equal to the tallest one he has observed.

We consider the biggest object of any kind that we have seen in our lives or hear about as the largest item that can possibly exist. And we have been doing this for millennia.

…

Likewise, the former chairman of the Federal Reserve, Fragilista Doctor Alan Greenspan, in his apology to Congress offered the classic “It never happened before.” Well, nature, unlike Fragilista Greenspan, prepares for what has not happened before, assuming worse harm is possible.”

— Nassim Nicholas Taleb

As bad as it's been, it can always be worse…

But it's not all doom and gloom.

In fact, as long we acknowledge this bias, we can turn it into an asset.

How does Taleb recommend overcoming this tendency to believe the worst we've seen will be the worst we see?

By applying a margin of safety. A degree of conservatism to our investing. There are a couple of ways we can do this.

First, by holding a large cash pile. While many try to portray maintaining a margin of safety, or extra cushion, as defensive or passive, it's actually a "leading indicator" of aggression. Taleb:

"…it can be extremely aggressive. For instance, if you have extra inventory of, say, fertilizers in the warehouse, just to be safe, and there happens to be a shortage because of disruptions in China, you can sell the excess inventory at a huge premium. Or if you have extra oil reserves, you may sell them at a large profit during a squeeze."

— Nassim Nicholas Taleb

Similarly, while folks wonder why Buffett's cash pile is so big, it's likely so he can be aggressive the next time the market experiences a crisis and his "phone rings on a Sunday." Buffett explains:

"During the Long-Term Capital Management crisis, we were getting calls on Sunday from people. By the way, you can make a lot of money on calls on Sunday – that shows you things are really getting out of hand."

— Warren Buffett

The second way to apply a margin of safety is to use conservative estimates. As humans, we have a tendency to extrapolate past results into the future.

But by understanding The Lucretius Problem, we know businesses may experience challenges worse than they've ever seen…

So building in conservative projections adds a layer of protection to our process. Charlie Munger touches on this:

"Conservative investing with steady savings without expecting miracles is the way to go."

— Charlie Munger

The Illusory Correlation Bias

Another bias we can be aware of is the "Illusory Correlation" bias. James Clear explains:

An illusory correlation happens when we mistakenly over-emphasize one outcome and ignore the others. For example, let’s say you visit New York City and someone cuts you off as you’re boarding the subway train. Then, you go to a restaurant and the waiter is rude to you. Finally, you ask someone on the street for directions and they blow you off.

When you think back on your trip to New York it is easy to remember these experiences and conclude that “people from New York are rude” or “people in big cities are rude.”

However, you are forgetting about all of the meals you ate when the waiter acted perfectly normal or the hundreds of people you passed on the Subway platform who didn’t cut you off. These were literally non-events because nothing notable happened. As a result, it is easier to remember the times someone acted rudely toward you than the times when you dined happily or took the subway in peace.

Here’s where the brain science comes into play:

Hundreds of psychology studies have proven that we tend to overestimate the importance of events we can easily recall and underestimate the importance of events we have trouble recalling. The easier it is to remember, the more likely we are to create a strong relationship between two things that are weakly related or not related at all.

— James Clear

As investors, we can be susceptible to this dynamic—particularly in large bull market runups.

When "meme stocks" are flying, cryptocurrencies are going "to the moon," and every stock we purchase seems to almost immediately go up, it's easy to start attributing all of our performance to skill—rather than partially to exuberant, irrational market participants…

As Munger put it:

The antidote?

Developing a sound investment process. With valuation as a central focus, and, once again, requiring a margin of safety.

Plus, we can profit off this tendency…

We can let other investors grow overconfident.

And when the bubble they create inevitably pops, the market will swing the other way…

Then, we can be confident in our skills to use our large cash reserves to pick up bargains.

Takeaways

While it would be nice not to have any blind spots or biases, it’s probably pretty unrealistic to assume we will operate that way.

So, we looked at two biases that can impact our decision-making:

  1. The Lucretius Problem: the tendency to assume history’s worst outcomes will be the worst we’ll see in the future

  2. The Illusory Correlation Bias: mistakenly mis-assuming facts about a situation due to how easy they are to recall

The key is to acknowledge these issues, take action to avoid them, and even profit from them when they affect other market participants. Three actionable ways to do this include:

  1. Holding a large cash pile (to take advantage of future market crises)

  2. Being conservative in our investment projections (in case the business environment gets worse than we’ve ever seen it)

  3. Not misattributing outstanding performance entirely to skill during frothy markets (to avoid overconfidence)

Well, that's it for this week.

I hope you found it valuable.

See you next Saturday.

Two resources I think you might like:

Book Summaries: One of the most important lessons from Charlie Munger is to strive to become a little bit wiser each day. To accelerate my learning on everything from investing & decision-making to negotiating & habit-building, I use Blinkist (Thank you to the Blinkist team and their affiliate program for helping keep this newsletter free to the reader). Blinkist offers easily readable book summaries to help you get the most valuable ideas from the most popular books. You can check out Blinkist here.

Mental Exercises: To paraphrase Morgan Housel, the common factor among elite investors is they have complete control over the space in between their ears. Financial news networks and social media can create a lot of "noise" for investors. To stay focused and calm, I like to use Headspace (I don't receive any compensation from Headspace currently). Headspace offers mindset and breathing exercises to help you keep control over the space between your ears. You can check out Headspace here.

Footnotes:

1 — I do not receive any compensation on purchases made through Amazon.com

Disclaimers

This material is not investment advice. No responsibility for loss occasioned to any person or corporate body acting or refraining to act as a result of reading this material can be accepted by the publisher. Additional disclaimers here.

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