Studying human psychology, market history, and my own investment mistakes, I have increasingly come to believe that “Apparent Coherence” is a source of large investment mistakes. Stories that are so apparently coherent that they lead us to nod instinctively in agreement — that is often how large investment mistakes are born. It is not that coherent investment ideas are necessarily bad, but in fact, the logic goes the other way around. It appears to me that apparent coherence usually drives large investment mistakes. Below is a diagram I drew to illustrate what I mean.

There are two aspects to this logic that are worth some expanded discussions. One, the reasons why apparent coherence is behind large investment mistakes (with the emphasis on “large”). Two, the reasons why apparent coherence can cause large investment mistakes (with the emphasis on the causal relationship).

First, let’s talk about why apparent coherence is behind many “large” investment mistakes. Large investment mistakes usually grow out of large bets. If a story lacks coherence to start with, an investor typically would not bet at all, or only bet a small amount — so, there is little room for “large” investment mistakes to develop. For a reasonable person to make a large bet, a highly coherent story is needed in order to convince the investor herself and/or convince the investment committee she serves. Therefore, logically speaking, behind large investment mistakes are large bets, and behind large bets is apparent coherence. And therefore, apparent coherence is behind “large” investment mistakes.

Next, why can apparent coherence give rise to large investment mistakes — i.e., that causal relationship?

From what I understand by studying psychology, in particular the works of psychologist Daniel Kahneman, human brains first evaluate the coherence of a story so as to arrive at the subjective confidence that we feel about that story. In short, coherence leads to confidence. In investing, when we encounter an investment pitch that is coherent and fluent to our mind, that story then “makes a lot of sense” to us and we feel a high degree of subjective confidence, which can lead us to make corresponding investment decisions.

However, here lies a major problem: The coherence of a story does not always have much to do with the quality and the quantity of the information that is behind that apparently coherent story. Quite often, the less information we have, the easier it is for us to form a coherent narrative in our head. Think about the well-known “first impression” bias — we form quick and sticky judgements about others based on extremely limited information. The same thing exists in investing, I think. The less information an investor has, the more coherent the story will be, and the more confident the investor will feel when making investment decisions — therefore, the investor makes large bets, which easily result in large mistakes. That is why apparent coherence can lead to large investment mistakes.

Kahneman once said, “We believe in arguments, because we believe their conclusions. The beliefs and the opinions come first, and then we believe in arguments that are psychologically coherent or cohesive with the conclusions we believe in… The belief in the conclusion governs the beliefs in the arguments. So, this seems to be the key. There is a critical lesson from this, that people generally reason backwards.” Coherence leads to confidence — confidence in some sort of conclusions, in taking some kind of big actions. Conclusion, front and center. Argument, take a back seat. Facts, analyses, and truth play a limited role. Naturally, large investment mistakes follow.

Then, what does it all mean for investors who want to pursue successful investing? My answer is the following: What matters is not that whether or not there is the presence of coherence, but that whether or not an investor has done high-quality truth-seeking homework. The best investment ideas are those that look apparently coherent to investors who have done high-quality truth-seeking homework but laughably ridiculously incoherent to everyone else. The worst investment ideas are those that look apparently coherent to most people but littered with factual errors to investors who have done high-quality truth-seeking homework. And, because the market is sufficiently efficient, what is apparently coherent upon first look, even if the story is true, its returns are probably already arbitraged away — because the story is so apparently coherent to everyone that everyone has already taken actions, leaving behind no meaningful returns. These are probably why we have adages such as “the biggest market consensus is often wrong” and “what’s obvious is often not true.” Moreover, given the investing game is hyper-competitive, perhaps the most productive way to play the game is to focus on those apparently incoherent stories and try to seek the truth behind those laughable ideas — perhaps, in today’s markets, apparent incoherence is where investors have a better chance to generate outsized returns.

It is relatively well known that over-confidence leads us to make big mistakes. Now, as I lay out my arguments in this article, I think apparent coherence does the same to us as well. For investors, apparent coherence is a source of large investment mistakes. Therefore, investors should be on high alert when encountering an apparently coherent investment idea, especially when investors themselves haven’t done high-quality truth-seeking homework yet. So, mind “Apparent Coherence”!

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