If it is true that you can improve your performance by learning from the past, then the weak link in this process is our memory, the findings of recent neuroscientific research assert. Investors should heed these research findings before going on to repeat past mistakes.
A bad memory will distort our recollection of our past financial decisions and outcomes, making it likely we will not be able to learn the proper lessons from them.
Neuroscience experiments have identified two memory flaws. First, we often do not properly store information. Second, the stored information is often distorted by common cognitive biases when it is recalled.
Too much information
Research has shown that our brains simply do not have the capacity to hold in long-term memory every detail of every event we have experienced.
Much detail can be held in short term memory, but after a while only a general outline—including perhaps a few specific details—of events and facts remain in our memory.
Then, when we recall those memories, our brains reconstruct them based on what it has stored. But it also fills them in with information from our current set of beliefs and knowledge, a process that often distorts the memory of the actual event.
Transience, a memory phenomenon where information is lost the longer it is stored in memory, may explain why stock market participants who have experienced long periods of calm markets are shocked when a crisis period ensues: the vividness of their memories of previous crisis periods has faded. They may panic and sell their investments because they don’t fully remember how quickly markets recovered after past crises.
Absent mindedness can also affect your memory: you may hear a long-detailed recommendation about an investment, but miss the warnings of potential risks.
Blocking the bad
Researchers also say we often block salient information with other information, making it difficult or impossible to retrieve. For instance, it is more common to remember pleasant experiences than unpleasant ones. For investors, that can mean recalling our winners but not fully remembering our losing decisions.
However, highly traumatic memories seem to persist in our memory more than others. The Depression generation, for instance, never got over the stressful memories they had of the 1930s and were generally more risk averse when investing than were subsequent generations.
Overcome your limits
Investors can overcome these memory flaws by using written investment policies.
An investment policy documents your goals, risks, and rules and limits for investing. Frequent consultation with it can prevent you from making short-term investment decisions that conflict with your long-term goals.
This article was written by an independent writer for Brewster Financial Planning LLC and is not intended as individualized legal or investment advice.