Last Updated Nov 22, 2010 9:59 AM EST
A simple attention test
Play the video below and follow the instructions. I'll give you a little help by letting you know the instructions will simply be watching 25 seconds of people passing a basketball to each other. During this short period of time, your only task is to count how many times the players in white pass the ball to each other.
Let's make this task very important to you. Imagine that you will be financially set for life if you can correctly count the number of passes watching this video once. If you count them incorrectly, however, you'll be working for the rest of your life, never achieving financial independence. Remember only to count passes from the team wearing white.
Play the video before you read on. Are you ready? Good luck!
So how did you do? Did you get the answer right? If you didn't, take comfort in the fact that most people who watch it don't either, but that's not actually the point of this exercise. If you played the whole video, you may or may not have noticed that standing smack dab in the middle of all the ball-passing was a gorilla. As with the miscounting of how often the ball was passed, most people, including yours truly, missed the gorilla entirely.
The point of this exercise lies in the realization that when you are looking for one thing in financial markets, you may tune out many other things that are, in hindsight, very obvious. Now that you've seen the video, it would be virtually impossible for you to watch it again and miss the gorilla.
If we look at investing over the past dozen years or so, we now know that it was obvious that paradigms like "cash no longer matters" in the internet bubble, or "real estate prices can never decline" in the more recent bubble, were downright idiotic. Yet, in the heat of our quest to strike it rich, we missed the gorilla staring us in the face and beating his chest.
Don't be so sure of yourself
I'll admit that I set you up to make you concentrate on one task in order to make it more likely that you'd fail in another. But in this instance the ends justified the means since it didn't really cost you your retirement.
So I guess this wasn't actually an IQ test, it was more a test of human bias to tune out any information we don't view as important. And unlike this exercise, our propensity to tune out critical information can end up costing us dearly.
Brilliant investors, like Legg Mason's Bill Miller, missed the severity of the financial crisis. Miller then went on television and implied that this was a once in a lifetime mistake, only to have his fund (LMVTX) badly underperform yet again.
A good dose of humility, along with an acceptance that the market is smarter than we are, is the key to investing success. Only after a market plunge or raging bull will we actually see the proverbial gorilla that is so obvious in hindsight. Asset allocation and rebalancing, using low cost index funds, really is the ticket.