Disaster Myopia – History repeats?
The disaster myopia hypothesis is a theoretical argument that may explain why crises are a recurrent event. Under very optimistic circumstances, investors disregard any relevant information concerning the increasing degree of risk. Agents’ propensity to underestimate the probability of adverse outcomes from the distant past increases the longer the period since that event occurred and at some point the subjective probability attached to this event reaches zero. This risky behaviour may contribute to the formation of a bubble that bursts into a crisis.
This is basically the tendency of humans to forget the past disasters once they are long gone.
The tendency of people to greatly underestimate the chance of catastrophic events.
We tend to forget the past disasters after a long time which leads us to make decisions that lead to newer disasters.
Disaster Myopia examples
1. Any natural disaster when it occurs the authorities get on high alert and does all that is necessary to save people and assets. People plan and take all necessary precautions related to the threat to survive one such disaster in future. Once the disaster fades off from everyone’s memory and long gone people are again laid back.
2. Once a disaster strikes people start taking all types of related insurances and after years pass by, the insurance policies may not get renewed or more people may not take new insurances.
3. When we drive on a highway and notice a drastic accident, we go in high alert mode and start driving slowly for next few days or even months. After a year or so, our old driving habits come back.
4. If you are a smoker, and you hear some of your close friend gets cancer because of smoking, you will reduce the number of smokes a day or even quit for a few weeks, then after few months, you may start smoking again
5. All Financial bubbles and crises are formed, ballooned and burst because of this. All past history of financial bubbles like Tulip mania, South Sea crisis, 1929 crisis etc., were forgotten and hence we landed up in 2008 financial fiasco. This time it is different?
6. A person who is not satisfied with his job might quit before getting another job, and have had a tough time finding another job. He/She may repeat this even in future once the past tough times fades out – or may be thinking this time it is different?
Overcoming Disaster Myopia
1. Remembering the history of events is the most effective way before making key decisions in life
2. Making cautious and rational decisions can be brought in as a way of living and making decisions
3. In financial products, proper analysis, understanding biases, and purchasing with margin of safety
4. Discussing with your well-wishers before making key decisions will also help
My experience with Disaster Myopia
Even after reading and knowing my friends who lost heavily during the Tech bubble in 2000-01, I invested heavily during 2006-07 in infrastructure stocks. Starting Jan 2008, everything seems to break loose and started falling. Hence, I had to cut my losses earlier and get out with around 40% loss on few stocks. I think I was fortunate enough because those stocks went down further.