The "Seven Sins" of Memory: Why Financial Crises Keep Happening

“Those who don’t know history are destined to repeat it.” -- Edmund Burke

Joachim Klement, the chief investment officer of Zurich’s Wellershoff & Partners Ltd., wondered why similar financial crises continue decade after decade. It’s a question that has long plagued the investment community. Intrigued, Klement decided to do some research on the subject.

His investigation culminated in the working paper “The Flaws of Our Financial Memory.” In it, he attributes the reason for recurring financial calamities to seven “flaws of memory” that contribute to both loss of recall over time and distortion of memory by more recent awareness and attitudes.

Klement calls these memory flaws “the seven sins.” This week, I’ll look at the three sins that relate to how memory changes over time, which in turn makes another financial crisis more likely:

“Transience” is the term Klement applies to the tendency for individuals to forget fiscal crises over time. Initially all memories are likely to be fresh and accurate, but as time wears on they become less clear and therefore imperfect. When a long-term memory is upsetting or unpleasant, there’s a tendency to avoid thinking about it and, therefore, become complacent and forget the pain of earlier crises.

The investment community is also greatly influenced by what’s going on in the here and now, rather than events of the past. For example, by the late 1990s and early 2000s, many financial managers had the forgotten the painful lessons of the 1987 and 1975 financial crises.

“Blocking” refers to instances where individuals tend to remember a disastrous financial event in a more positive light. When this occurs, individuals make decisions today based on inaccurate or subjective memories of what occurred in the past -- another potential contributor to a future financial crisis.

Absent-mindedness is another sin financial managers commit that can contribute to repeat crises, Klement writes. Whether it’s an individual quirk or the inherent stress of the job, a distracted trader in a hectic trading environment could result in orders entered incorrectly. When an error is large enough, it can negatively influence the more general financial markets.

Klement concludes that given the weakness of our memories of unpleasant events, it’s a good idea for financial managers and their clients to continually educate themselves about historic financial calamities -- whether they lived through the events or not. Additionally, attention to detail when making financial decisions is essential. These approaches could largely alleviate the need for the cautionary wisdom of Edmund Burke, “Those who don’t know history are destined to repeat it.”

In my next column, I’ll look at Klement’s remaining four “sins.”

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