Thanks For The Memories

ESSAY

Behavioral Matters: Insights from the application of Behavioral Finance | Issue 18

Written by Michael A. Ervolini

8 min read

Thanks For The Memories

"Memory itself is an internal rumour."

- George Santayana, Philosopher

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INTRODUCTION

The bedrocks of professional investing — experience, judgment, intuition and deliberation — rely heavily on the use of memory. Though it is fundamental to learning and making effective choices, memory is also highly imperfect. While memories are sometimes cherished, they can push you toward investing misadventures. This essay examines how experts look at memory and its potential for generating investing shortfalls.

MOTIVATED MEMORY

Memory is the result of how information is captured, stored and retrieved. Most of what we remember after an experience (visual, auditory, etc.), happens automatically and pretty much involuntarily. Supporting this process the brain chooses to capture information it finds interesting, useful or that stimulates strong feelings. It encodes this information into long-term memory that sits in the unconscious brain. Unavailable for conscious or deliberate probing and review, memories are accessed and reconstructed upon demand, through either willful intent or involuntarily. Emotions affect both the encoding and retrieval of memories. Excitement about a series of great buys or pain from liquidation of deep losers can change how information is perceived, making it more vivid and stickier. Incorrect learning results from the deep encoding of such emotionally charged impressions. If such incorrect learning transforms into a strongly held belief, it can lead to repeated ineffective decisions.

Market turmoil and position volatility can cause stress and a high emotional state. When these emotions are present during the retrieval of memories they can limit the brain's searching for information or answers, often pushing it toward simple and emotionally soothing solutions, rather than analyzing a more complete set of options.

MAKE MY MEMORY

False memories may help explain why ineffective tendencies creep into otherwise sound investment processes. Researcher Brian Gonsalves studied the formation of false memories using Functional Magnetic Resonance Imaging (FMRI) technology. Participants were shown images of certain objects and accompanying words, with some words matching the objects shown and other words being unrelated. The participants were asked to visualize the image represented by the words not the objects. What they remembered is fascinating. When asked what objects they were shown they tended to remember seeing objects related to the words they visualized, even if a picture of that object was never presented. What happened According to Gonsalves: "Many of the visual images that the subjects were asked to imagine were later misremembered as actually having been seen." He points out: "A vividly imagined event can leave a memory trace in the brain that's very similar to that of an experienced event." Gonsalves and team were able to accurately predict when an imagined image would be remembered as having been seen because highly vivid imaginings stimulate the same part of the brain as do real experiences.

Memories can also be suggested, even impossible ones. Professor Elizabeth Loftus asked adults if they had met Mickey Mouse when they were children. Some were first shown a video of people having fun at Disney World. Recollection of this experience was significantly higher among those who saw the video. Loftus believes that when in a positive emotional state the participants’ old and fragile autobiographical memories were unconsciously rewritten to include a personal experience with Mickey that never happened. To confirm this phenomenon, another group was asked about whether they ever met Bugs Bunny instead of Mickey while at Disney Land. Among those shown the same Disney video, 16% recollected shaking hands with Bugs at Disney land, even though he is not a Disney character, but a Warner Brothers creation. They recalled an event that was not simply unlikely but impossible.

Interestingly, participants in both studies that viewed the video overwhelmingly denied it affected their recollections. Suggesting that not only is memory malleable but internal defenses refuse to accept this proven quality. Loftus concludes: "These studies show that with suggestion and imagination, a significant minority of people can be led to believe that they had experiences that were manufactured, and many of them elaborated upon those false experiences with idiosyncratically produced details."

THESIS, PROCESS AND DISCIPLINE REMEMBERED

Despite its known flaws, memory remains a primary tool used by managers for learning about their strengths and shortcomings. Other conventional sources of portfolio information like return and attribution help some, but using them to improve is like a golfer playing at night using only the total score for feedback. Whether hitting above or below par, the golfer can't see where performance is strongest or where it needs refinement.

Over relying on their memories, managers have no choice but to imagine where their alpha comes from. They commonly misidentify which skills are strongest and which need improvement or precisely how to improve. And this leads to missed opportunities regardless of the quintile they are in. Studies of actual portfolios conducted by Cabot show that:

Some strong buyers can and do consistently sell winners prematurely — giving away alpha in the process.
Managers that pick great names often do not feed them sufficiently — reluctant to pay up for a stock on the run.
Selling winners tends to be difficult — they are often held well past their ability to generate excess returns and drag down performance.

Ineffective decisions such as these can start with a faulty memory. These memories then go on to produce flawed beliefs and rules-of-thumb, which then are used to make investment decisions. In addition, critical analysis of skills and process is hampered as recollections reflect motivations as well as facts. You see only what your memories allow and your decisions integrate half-truths as if they were rigorously constructed data.

CONCLUSION

Memory defines who you are and what you think. It is, however, imperfect, fragile and quite capable of making falsehoods seem like facts. Memory recall can range from consistent and complete, to partial and irregular.

As reliable as memories may seem, their flaws can hurt portfolio performance. This can be the result of false memories that tilt decisions toward ineffective choices. Faulty Memories may be the product of weak encoding, retrieval or both. Comparing your treasured recollections to verifiable information is one straightforward antidote to ineffective memories. The alternative may position you as a prisoner of a past that never really happened.

REFERENCES

Brian Gonsalves, Paul J. Reber Darren R. Gitelman Todd B. Parrish Marsel Mesulam and Ken A. Paller, "Neural Evidence That Vivid Imagining Can Lead To False Remembering", Psychological Science, October2004.
Elizabeth F. Loftus, Kathryn A. Braun and Rhiannon Ellis, "Make My Memory: How Advertising Can Change Our Memories of the Past", Psychology & Marketing, John Wiley & Sons, Inc, 2002.
Tim R. Holcomb, R. Duane Ireland, R. Michael Holmes, Jr. and Michael A. Hitt, "Architecture of entrepreneurial learning: exploring the link among heuristics, knowledge, and action", Entrepreneurship: Theory and Practice, Jan, 2009.
"Motivated Reasoning", A Behavioral Matters essay, April 15, 2009, available at http://www.cabotresearch.com.

MICHAEL A. ERVOLINI, AUTHOR

The ideas expressed on this website are developed and/or curated by Michael Ervolini. Mike has spent his entire 35 year + career leading efforts to improve and strengthen active management.

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