Each and every person has certain beliefs that he stands by and follows. However, it is not necessary that all beliefs are correct and true to the standards. Beliefs are always evolving and must keep evolving. They need to be tested against the reality tests from time to time and removed, added or altered.
This process is not just significant in day-to-day life, but also in the field of investment. In fact, beliefs and evolution of them plays a significant role in the process of investing. If an investor keeps sticking to his beliefs forever, he puts an end to his growth and evolution. For a person to grow, especially for an investor to grow, he must keel challenging his beliefs and testing them. Thus, it is rightly said that beliefs are hypotheses that must be tested, instead of treasures that need to be protected.
The process is well-depicted by Michael J. Mauboussinn, Dan Callahan and Darius Majd of Credit Suisse, in their 21-page letter, "Reflections on the Ten Attributes of Great Investors". Of the ten great attributes, one is to keep updating the beliefs and not remain adamantly stuck to them. The letter explains,
“Most people prefer to maintain consistent beliefs over time, even when the facts reveal their beliefs to be wrong. Further, we commonly expect others to be consistent. For example, politicians who change their views are derisively called “flip-floppers.” The need for consistency tends to grow with age. The idea that many older people are set in their ways is grounded in truth.
It is good to be consistent, but it is also necessary to be flexible and adaptable. If an investor remains adamant and is not willing to challenge and modify his beliefs and theories, he will not be called consistent, but outdated.
We all walk around with views of the world that we believe are correct. You are compelled to change your mind only when you confront reality that disconfirms your beliefs. The easiest way to avoid the sensation of being wrong is to fall for the confirmation bias. With confirmation bias, you seek information that confirms your view and interpret ambiguous information in a way that is favorable to your belief. Consistency allows you to stop thinking about an issue and to avoid change as a consequence of reason.
But great investors do two things that most of us do not. They seek information or views that are different than their own and they update their beliefs when the evidence suggests they should. Neither task is easy.
The trait of seeking alternative views is called being “actively open-minded,” a term coined by a professor of psychology at the University of Pennsylvania named Jonathan Baron. Actively open-minded is defined as “the willingness to search actively for evidence against one’s favored beliefs, plans or goals and to weigh such evidence fairly when it is available.”23 Research shows that actively open-minded people perform well in forecasting tasks that demand collecting information. The trait of being actively-open minded can offset confirmation bias.
We may remind ourselves of the concept of second-level thinking here. Second-level thinking also involves challenging the first-level thinking or the commonly accepted beliefs and traditions, and modifying them to suit the current requirements. Thus, just the way second-level thinking gives extraordinary results, so does testing and questioning the beliefs.
Great investors also update their views as new information arrives. The idea is that you can represent your degree of belief about something by a probability. When new information arrives, you update that probability. The formal way to do this is to use Bayes’s Theorem, which tells you the probability that a theory or belief is true conditional on some event happening.
See, there is also a non-biased method of doing so. The method prevents the bias of emotions and feeling of protection towards our beliefs. Once the probability is updated, it is clear in front of the investor that his beliefs were tested out to be weak according to the new circumstances and need to be updated.
The practical challenges are to avoid overreacting to information that appears to explain causality on the surface but in fact does not, as well as to detect information that does matter but that does not appear to be causal. In addition, while it is often clear to shift your degree of belief up or down, the magnitude of the shift is also important.
The best investors among us recognize that the world changes constantly and that all of the views that we hold are tenuous. They actively seek varied points of view and update their beliefs as new information dictates. The consequence of updated views can be action: changing a portfolio stance or weightings within a portfolio. Others, including your clients, may view this mental flexibility as unsettling. But good thinking requires maintaining as accurate a view of the world as possible.”
As a bottom line, as important as second-level thinking is to extraordinary growth and development of the thought process and investing process, challenging the beliefs is equally important. The investors must keep the beliefs as hypotheses and keep testing them from time to time. They must be retained if they still hold true and discarded if they do not fit the current scenarios.