One of the greatest books I have come across is The Black Swan by Nassim Taleb, which discusses our attempt to generalize and oversimplify a world that is really chaotic in nature. (The book was originally recommended by Charlie Munger at the Berkshire annual meeting) We can see this everyday in the stock market- as Chris Anderson put it:
Four hundred years ago, Francis Bacon warned that our minds are wired to deceive us. "Beware the fallacies into which undisciplined thinkers most easily fall--they are the real distorting prisms of human nature." Chief among them: "Assuming more order than exists in chaotic nature." Now consider the typical stock market report: "Today investors bid shares down out of concern over Iranian oil production." Sigh. We're still doing it.
Our brains are wired for narrative, not statistical uncertainty. And so we tell ourselves simple stories to explain complex thing we don't--and, most importantly, can't--know. The truth is that we have no idea why stock markets go up or down on any given day, and whatever reason we give is sure to be grossly simplified, if not flat out wrong.
Even more importantly though, is that none of us want to consider the possibility of a truly shaking event, such as a market crash. As the Economist put it:
Betting on a black swan does not offer attractive odds. If a catastrophe only happens 1% of the time, then 99 times out of 100, betting on such an event will lose money. The investor will underperform the benchmark and lose clients.
Staying fully invested, and waiting to get sandbagged by events, makes more business sense. After all, if a catastrophe does happen, the investor has the perfect excuse: nobody saw it coming. The chances are that everybody's portfolios will suffer in tandem.
Needless to say, Warren Buffett would disagree with this type of thinking. In his 2006 Letter to shareholders, Buffett discussed his criteria for a new Chief Investment Officer. He commented:
"But there is far more to successful long term investing than brains and performance that has recently been good. Over time, markets will do extraordinary, even bizarre, things. A single, big mistake could wipe out a long string of successes. We therefore need someone genetically programmed to recognize and avoid serious risks, including those never before encountered. Certain perils that lurk in investment strategies cannot be spotted by use of the models commonly employed today by financial institutions."
How does someone avoid getting blindsighted? Keep your mind open, keep asking questions, and avoid over-generalization.