Maps and Models
The emotions of fear and greed are apparently more powerful than memory. Perhaps this is why most investors tend to forget the pain of investments gone bad. Perhaps it is because people are wired to believe in systems and models, something bigger than ourselves, to make sense of the chaos of the world, and of the financial market.
Kahneman told a story that illuminates those conditions. Once, a Hungarian army officer sent a troop of men into the Alps on a patrol. They were caught in a snowstorm. Three days passed. The officer thought they were dead. On the fourth day, the troop returned to base. The officer asked what happened. The soldiers said they had given up hope and were preparing to die when one of the men found a map in his pocket. The map rallied their spirits. They used it to discover where they were, and make their way back to base. The officer asked to look at the map. “This is a map of the Pyrenees,” he said, “not the Alps!”
Kahneman says the story shows that people need things that contribute to their sense of well-being, and their confidence, and their ability to go on. It can be a useless number, or even a map of mountains in an entirely different country. It is important to be confident—but only up until a point in investing, lest one learn too late that all of the money one has spent has been predicated on an erroneous assumption based on a faulty map.
Few people have thought more about financial models than Emanuel Derman. He is one of the world’s ...