Investors Should Use Analogies With Caution

One of the common ways that investors make sense of events charged with chaos, such as the 2011 Middle Eastern crisis and Japanese crisis, is through analogy.  We compare a current event to a past event where we feel that we have a good grasp of the facts that served as causes for that past event.

The problem with this kind of thinking is that we will only understand current chaotic events to the extent that they are similar to past events.  We are in trouble as soon as the new chaotic event throws details at us that fall outside of the bounds of the old event.  Then we are forced to look for another analogy that explains the facts not explained by the old analogy.

Frequently it’s the case that when an analogy is not quite accurate we go out of our way to try and make the current situation adhere as closely as possible to the old situation.  We do this to reduce our feelings of ignorance and anxiety in the face of uncertainty.  Yet, when we do this we are not dealing with the reality of a new situation.  Instead, we are using analyzing phantom information, and likely making mistakes in our analysis.

An example, from Bloomberg’s coverage of the Japanese crisis, will help to make my point clear:

“Others, including Ian Plenderleith, a former executive director at the Bank of England, are more worried…’The world economy was beginning to recuperate,’ Plenderleith, who is now chairman of Brevan Howard’s BH Macro Ltd. hedge fund, told a Bloomberg Link conference in London yesterday. ‘When you’ve got a patient that’s recuperating, it’s quite a good idea to avoid him being exposed to too many shocks, and we’ve had new shocks come at us,’ he said. That ‘makes me nervous about how fast we’re going to recover.’ “

In an article that generally expressed the belief that the crisis in Japan would not affect the global economic recovery – a belief similar to my own – Mr. Plenderleith was one of the few naysayers quoted.  In my Intuitive Assessment of Japanese Disaster I stated, “The affect of the Japanese disaster on the rest of the world is unlikely to result in a double-dip recession.”  Additionally, on 22 March, 2011, no less a light than Warren Buffett himself said that he felt that the Japanese crisis would not affect global gross domestic product (GDP).

At this point it is too early to tell who will be right about the situation.  However, I feel that Mr. Plenderleith (quoted above) has made an error in judgment because of his reliance upon an analogy.  Because he compares global GDP to a recuperating patient any news, positive or negative, will be assessed through the filter of his analogy.  Bad news is threatening to a recuperating patient.  Good news improves the health of a recuperating patient.  The problem is that any event, including the crisis in Japan, has facts absolutely unique to the event.

One of the reasons that I am such a strong advocate of analysis coupled with intuition is that situations like the Japanese crisis, where facts are very scarce and even contradictory, additional sources of information are needed in order to make effective decisions.  Intuition used with discipline is a valid source of information, especially when compared with very flawed analysis tools such as analogy.

Remember this about all analogies:

1. No analogy is perfect.  There is always at least one difference between two things being compared.  If they were identical then there wouldn’t be two things to compare.
2. There is always some similarity between any two objects, no matter how different.

Thus, when you encounter a news story or investment pundit and they are using analogy to assess a current situation remember to increase your caution in respect to this ‘analysis’ because analogies frequently obscure as much as they reveal.

Jason