It’s a Small World (of Illusion) After All!

I just returned from a family vacation in Disneyworld.

As you might imagine, returning from a fantasy land filled with amazement, consumption, blissful illusion, and other happiness-stretching experiences, I received more than the usual number of greetings from friends, family and colleagues at home – the same kind of welcome home greeting you’ve probably heard before: “Well I guess it’s back to reality for you now, isn’t it?”

I smiled and politely nodded my head in agreement while thinking to myself that I am not returning to reality – I’m simply returning to a different form of illusion!

“Art has a double face, of expression and illusion, just like science has a double face: the reality of error and the phantom of truth.” ~ Publilius Syrus

When Barry invited me to contribute a blog post this week, I thought it might be fun to think of the many forms of illusion we all frequently experience in our broad world of finance and economics. I’ll contribute a few of my own observations and perhaps you could add some of your own.

Financial Plans: This may be unexpected coming from a CFP but financial plans, in general, are highly illusory in nature. The conventional planner gives the client exactly what the client (or what the client’s brain) wants – a neat and attractive package containing graphical displays and supporting data that illustrate the quickest monetary movement from point A to point B – in other words, unrealistic shortcuts. Most financial planning software still have default annualized returns of higher than 10%, which is simply an irresponsible assumption to make, to put it lightly.

The shortest distance between two points is not a straight line (except in geometry and the human brain)! As you might have guessed, I do not use financial planning software!

Heuristics: On the subject of illusions and brains, your brain is wired for pattern recognition, which is why the vast majority of investors are fooled by randomness. A common example here is the Gambler’s Fallacy: If a coin is tossed 5 times and lands on heads on each toss, the gambler will most likely bet on heads for the next toss, even though the odds remain 50 percent that it will land on tails and the results of the next toss are completely unrelated to that of the previous one.

In my humble opinion, the fundamental cause of this financial crisis is heuristics. The core deadly assumption, based upon pattern recognition, made on all sides of finance preceding the crisis included the assumption that home values and personal income would continue rising in perpetuity. This heuristic illusion enabled federal deregulation, irresponsible lending practices, the purchase of exotic home mortgages, the repackaging of questionable loans into investments, and the rise of Credit Default Swaps.  You know the rest of the story…

Confirmation Bias: This brings illusion back to the individual (you), which is often the source of the illusion. Yes, you even trick yourself! Confirmation bias occurs when you primarily seek out and select only the information that reinforces your existing attitudes. These biases are largely based upon pre-conceived notions. This behavior is irrational because the careful comparison of data that disagrees with a given bias is rarely if ever sought, making for a poor data set for forming a hypothesis. For example, if you believe stock prices are due for a large correction, you will seek out information that agrees with (or confirms) this notion and you will ignore all other information.

The media: Most readers here do not need to be made aware of the illusion that the media presents.

Mainstream media, especially, is simply in the business of selling advertising – they are not in the business of providing useful information. To sell advertising, headlines are created to steal attention and push readers’ emotional buttons. This relates to confirmation bias (above). Have you ever cited a mainstream media source to confirm your own bias? This might combine for layer upon layer of illusion.

Wealth: The current financial crisis has certainly pulled the curtain down on much of this illusion. Even if a person has a negative net worth or is even a breath away from bankruptcy, they can still appear wealthy. Ironically, this diminishes the value of material wealth. Driving a Lexus, wearing designer clothes and living in a large home does not, by default, correlate with positive financial wealth.

“Truly it is an evil to be full of faults; but it is a still greater evil to be full of them and to be unwilling to recognize them, since that is to add the further fault of a voluntary illusion.” ~ Blaise Pascal

In summary, illusion is not just visual or optical in nature – it may be considered a distortion of reality, including the understanding (or misunderstanding) of any form of information received by the brain. Because the information available to the brain is rarely complete, it simply fills in the missing spaces, which opens the door to much opportunity for the illusionist to manipulate reality (and the potential peril for those lacking in self-knowledge and mindfulness). Without this awareness, we actually enable the illusion.

Where else have you found illusion? Is everything illusory to some degree? Certainly a prudent-minded person would not walk around with paranoid delusions of being tricked everywhere they turn; but is it not responsible to at least be mindful of the tactics and biases of every source of information that we consume?

I’m already wishing I was back in Disneyworld where at least the illusions are honest!

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Kent Thune is blog author of The Financial Philosopher

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