The modern world of instant-everything means a 24-hour, never-ending barrage of polarizing news headlines and alerts. One hour, it is the China trade negotiations. Another hour, it is impeachment hearings or presidential election jockeying. A few hours later, you get news alerts about Ukrainian phone calls, Turkey’s military offensive in Syria, and escalating riots in Hong Kong. You open your Twitter feed or your blog subscriptions and read about the inverted yield curve, slowing economic growth, and the Federal Reserve’s latest actions. Hello 21st century news cycle.
Several years ago, I hosted a monthly conference call for advisors who subscribed to get a monthly update on the markets, economy, tax policy updates, etc. After I finished summarizing the current landscape each month, one advisor (always the same one) inevitably remarked about how “there seems to be a lot of uncertainty and elevated risk right now” – or some variation of that sentiment. Nearly every single month. It eventually became something that we both could joke about.
The reality that I tried to politely convey each month is that there has never been a shortage of risks or reasons for caution. Never. Ever. Point to any month or any day in history and, while it might seem in hindsight as if that was a period of calm, there were substantial risks at that time. Lots of them. We easily forget about grave risks of yesterday like the spreading contagion of Detroit’s bankruptcy or the Ebola scare or oil prices at $110/barrel or the fiscal cliff and sequestration or Russia invading Crimea or Iran’s nuclear capability advancements. There’s an enormous list that could keep us here awhile longer.
We forget about these risks as just a little time passes but in the here and now, they’re of momentous concern because we are overly influenced by recent events, the latest economic data, or today’s attention-grabbing political headlines.
Not only do we get bombarded daily with risks but we then dramatically overestimate the probability of them escalating into something really bad. Our brains are molded by more than 200,000 years of adaptation to survival optimization. That is, our ancestors evolved to instinctively reduce uncertainty by reacting to a rustle in the weeds and retreating to safety. Even if 99 times out of 100, the rustle was merely caused by a wind gust, our ancestors survived by treating all 100 occurrences as if a saber-toothed tiger was approaching. Great for survival. Not good for investing.
A real-life example occurred in the months following the tragic events of September 11th, 2001. Americans reacted to the recency of the disaster and altered their behavior – avoiding air travel in favor of the roads. Passenger miles in the US increased by 12-20% during the final months of 2001 although highway driving was and still is roughly 100x more deadly than flying per mile travelled. Researchers suggest that an additional 1,595 Americans died in car accidents during the final quarter of 2001 from this change in behavior and the reliance on a much riskier means of transportation.
So, we are overly influenced by the most recent events rather than by centuries of data, we overestimate the probability of these events having a material impact, and then we act as if we are above average in our ability to interpret and respond to the risks. That is, we are overconfident in our abilities.
Consider an individual investor who reads about the recent yield curve inversion, the slowdown in GDP growth, the weaker manufacturing data, and the uncertain impact of next year’s Presidential election. He then interprets that these risks are likely to be bad for the stock market and reduces his stock exposure. The reality is that none of this news is proprietary or just available to him. Moreover, there is a better than 90% probability that the buyer on the other side of the trade is an institutional investor – a professional trader with far more information, experience, and analytical resources than our retail investor. So when our naïve investor is selling stock because he interprets the data to be bad for stocks, the likely buyer is a large pension fund or hedge fund with overwhelmingly more data, resources, skill, and experience.
What can we do about our tendencies that help us survive but not invest well? The keys are self-awareness and humility. To be successful investors, we must recognize the tendency of our brains to make stupid investment decisions. We must accept our predisposed risk tolerance and not try to stretch it. We should turn off the financial pornography – all the business news channels business news channels that saturate us with the noise of today and then pretend to know what’s going to happen tomorrow. We should be humble in our abilities and appreciate that we likely know much less than the institution on the other side of the trade. And we should differentiate the forest from the trees such that we avoid getting lost in the irrelevant details of today’s headlines.