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Epistemic Limitations

Posted by Jeffrey Baumert on Aug 1, 2016 3:00:00 PM
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epistemic-limitationsThere is a quote by Donald Rumsfeld that says, “There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we know we don't know. But there are also unknown unknowns. There are things we don't know we don't know.” 

Typically, it is not the “known unknowns” that get us into trouble.  When we know we don’t know, we are likely to act prudently.  It is the perceived “known knowns” and the “unknown unknowns” that cause problems.  In other words, we get into trouble because we really don’t know what we think we know or it is incomplete or incorrect or because we don’t know that we don’t know what we don’t know.

The real danger is when we act on things we think we know.  Often, we act on a compelling narrative from someone else or because what we believe to be so is confirmed by someone we consider to be in a position to know.  Often our ideas or opinions are shaped by a narrative promoted by someone we think knows more than we do.  The problem is that those we believe know more may really not know that they don’t know.  We are all easily enticed by simple but compelling narratives.  However, an explanation that we can hear in an elevator or read in a tweet, or even on a blog page - as compelling as it may be - probably lacks the depth of detail necessary to reliably form an accurate and actionable conclusion.

When it comes to investing, this epistemological problem can be broken down into two parts:

  • The first is the limit of our knowledge -- the limitations of what we do know due to the quantity and quality of information and our ability to accurately interpret it.
  • The second concerns the validity of what we think we know or what we think someone else knows because of the effect of certain human behavioral traps.

INTERPRETING DATA

Professional portfolio managers have access to unimaginable amounts of data on the markets and the economy.  Additionally, they are bombarded by reports from very smart and very well-educated professionals who provide analyses and opinions on everything from politics to capital markets to economics.  Yet even with all of this information and the education, training and experience to turn it into actionable knowledge, these portfolio managers still routinely misstep.

Retail investors, too, have access to a good deal of data and are bombarded by a seemingly endless list of “experts” with calls on all things investment-related.  How that information is interpreted is limited by a person’s knowledge, which is founded on their level of education, training and experience.  The challenge is that the information is composed of data that is often not comprehensive and the “experts” are making calls for which they have no accountability.  Then, with a limited ability to accurately interpret that suspect information, an investor may assume they now have a level of knowledge on which to take action.

The thing is, most people, without the second part of the epistemological problem – the behavioral traps, are usually reluctant to make any big financial bets.

However, there are two human characteristics that often prove too strong to ignore.  These behavioral traps are the narrative fallacy and the error of confirmation.  Both of these are addressed by Nassim Taleb in his book The Black Swan and by Daniel Kahnamen in his book Thinking, Fast and Slow.

The Narrative Fallacy

The narrative fallacy relates to our propensity to adopt flawed views of the past.  As Kahnamen says “narrative fallacies arise from our continuous attempt to make sense of the world.”  These views are often simple, compelling, based on shallow information and attribute much to talent or lack thereof.  It is just very hard to seek out and accurately interpret the vast amount of information required to build a comprehensive view, so as humans, we choose the more expedient route and accept that which sounds compelling and concrete.

Nassim Taleb points out that “[o]ur propensity to impose meaning and concepts blocks our awareness of the details making up the concept.”

Kahnamen goes on to say:  “[I]t is easier to construct a coherent story when you know little, when there are fewer pieces to fit into the puzzle.  Our comforting conviction that the world makes sense rests on a secure foundation:  our almost unlimited ability to ignore our ignorance.”

The narrative fallacy has a double impact because not only are we easily subject to it, but so are those we may rely on as “experts” or those who we think should know.  We hear their compelling narrative and, if it supports our own, fall victim to the second behavioral trap, the error of confirmation.

The Error of Confirmation

Taleb describes the error of confirmation as such:  “By the mental mechanism I call naïve empiricism, we have a natural tendency to look for instances that confirm our story and our vision of the world – these instances are easy to find.”

He details the ways in which we unknowingly misinterpret information and sums it up with the notion that “[o]ur inferential machinery, which we use in daily life, is not made for a complicated environment.”  We see confirmation even when confirmation is not there.  This is also where we are duped by “experts” as they often cite a series of facts or observations from which they draw a compelling conclusion.  Talab points out that “a series of corroborative facts is not necessarily evidence.”  He goes on to say that “[i]t is misleading to build a general rule from observed facts.  Contrary to conventional wisdom, our body of knowledge does not increase from a series of confirmatory observations.”  He goes on to suggest that instead of seeking confirmation, we should instead actively seek instances that disprove our position.

Mitigating Traps

People – all people – can fall into these traps as they seek to understand complex issues.  The effect of these behavioral errors is to create a gap between what we think we know and what we actually know.

What we need to do as investors is recognize the challenges that come with the pursuit of knowledge.  We have to accept that there are factors that limit our ability to gain knowledge, and there are behavioral traps that fool us into thinking that we or someone else knows more than is actually the case.

One way to mitigate these traps is to look for certainty.  When you find it, run away!  The reality is that the more you know, the more uncertainty creeps back into the equation.

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So when an investor is confronted with a knowledge-based decision, especially one that is supported by another’s conviction, he should recall his epistemic limitations and perhaps recite the following:

“I know that there is much that I don’t know, and I know that the one who purports to know with certainty probably doesn’t know he doesn’t know.  So I do know that I won’t act on his very compelling but simple narrative because I know that it lacks depth and detail, and there is probably much more that I should know.”

WHAT TO DO WHEN YOU DON'T KNOW

When it comes to what you don’t know about investing, it’s best to consult an expert. An experienced financial advisor has access to significantly more information than the average do-it-yourself investor, and can provide guidance to help prevent investors from falling into behavior traps.

For more information on behavioral investing and ways an advisor can help you avoid these traps, schedule a 20 minute Q&A session with RAA.

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Disclaimer: This blog is intended for informational purposes only and should not be construed as individual investment advice. Actual recommendations are provided by RAA following consultation and are custom-tailored to each investor’s unique needs and circumstances. The information contained herein is from sources believed to be accurate and reliable. However, RAA accepts no legal responsibility for any errors or omissions. Investments in stocks, bonds, and mutual funds may increase or decrease in value. Past performance is no guarantee of future results. Any of the charts and graphs included in this blog are not recommendations for the purchase and sale of any security. 

Topics: Financial Planning