What is... | July 12, 2012

What is the illusion of validity?

But figures dating back hundreds of years show booms and busts in property markets.

American writer Mark Twain famously quipped: “Buy land, they’re not making it anymore." This reflects a general belief that houses rarely lose money. The willingness of many to follow behaviours based on nothing but custom or hearsay demonstrates the “illusion of validity” which can affect many decisions about spending and saving.

The term illusion of validity was coined by psychologist Daniel Kahneman after he found assessment procedures used in the Israeli army were no better at predicting the success of candidates than random guesses. Kahneman talks about this in his 2011 book, Thinking, Fast and Slow, and elsewhere.

Invalid response
Looking at the house price example, there is a belief that an investment in property is “as safe as houses”. But analyses, such as Neil Monnery’s for the book Safe as Houses demonstrate house prices have fallen for sustained periods in many countries. As economist Chris Dillow blogs for eZonomics, it can be argued that people often under estimate the financial risks of buying a home. The beliefs that surround the housing market show illusions can be maintained for a long time – even for generations.

Luck or skill?
A key problem is that it often can be difficult to know if success is down to luck or skill. ING senior economist Ian Bright blogs that in the Euro 2012 football tournament, (good and bad) luck played more of a role than many people might acknowledge. Likewise, while some investors perform better than others, even for several years in succession, it is sometimes not clear whether luck or skill determines that success. Kahneman and others have argued that professional investors may not perform better than the market in general, supporting the case for passive rather than active investing.

Valid to managing money
Since the illusion of validity can lead to costly mistakes, it is worth thinking how to overcome it. It can pay to keep an open mind and look for information that contradicts expectations. Firstly, remember that just because previous generations were successful following certain approaches, replicating their actions may not necessarily be a good idea. An eZonomics poll explains further.

Financial basics (such as budgeting and building a emergency fund) are worth following but blindly buying property in the hope of emulating a past generation’s financial gains may ignore changed economic conditions. Secondly – and crucially – remember that the consequences of decisions being wrong can be more important than the probability of them being correct.

This may sound a little cryptic but the late economic consultant and historian Peter Bernstein explained the idea in Wimps and Consequences. Back in 1999, various commentators and experts circulated statistical models suggesting that share prices could triple due to technological advances. Bernstein challenged the illusion of validity of the statistical models warning that the consequences of putting 100% of wealth into shares and being wrong is crucial. He wrote: “Goodbye wealth!”

When it comes to important financial decisions, don’t just follow the opinions of friends, family or even experts. Consider if they fit your circumstances, and test them by seeking contradictory information. And what would happen if their views proved wrong?

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Phil Thornton
Phil Thornton

Lead consultant at Clariti Economics