I Have a Doubt

Will Casey |

“We’re generally overconfident in our opinions and our impressions and judgements” – Daniel Kahneman

 

The title of this quarter’s newsletter was inspired by a line from one of my favorite movies, The Fifth Element. It was uttered by President Lindberg in deciding whether to engage a menacing planet that was rapidly approaching the earth. One of his military advisors, General Staedert, overconfidently stated “my philosophy, Mr. President, is to shoot first and ask questions later”. With each missile fired from the general’s ship, however, the sphere only grew larger, and once out of ammunition his defenseless ship was engulfed by the orb which represented ultimate evil (Mr. Shadow).

Overconfidence is all around us – politicians, scientists, celebrities, media, your neighbor (about lawncare and stock tips).  How is it that two people can look at the same data and come to dramatically different conclusions?  What causes this, and why is it important to recognize and understand it?

The quotation above is from a fascinating book Thinking, Fast and Slow, written by Dr. Kahneman, an Israeli Psychologist, PhD holder, and Nobel prize winner for his work in Economic Sciences.  In the book he describes two “systems” as it relates to brain function.  System One is the intuitive system. This system is characterized by “cognitive ease”, and is impulsive, emotional, and optimistic. This system is effortless and automatic and operates as the dominant system for most people. It is responsible for stopping us from stepping into traffic, and gives us the ability to ride a bike, or recognize by facial expression when someone is sad.

System Two is the effortful deliberate system. It is characterized by “cognitive strain” and is the thoughtful system employed when doing complicated computations.  It is the reasoning mind that is used to solve problems that we have not encountered before.

Here’s an example of the two systems through an old riddle: A bat and a ball cost $1.10 together. The bat costs $1.00 more than the ball. How much does the ball cost? If your immediate response was $.10 you were probably using System One. The correct answer is $.05 ($1.05 for the bat and $.05 for the ball).

System One creates a model of the world for each of us based on past experiences.  These experiences shape our reaction to a stimulus.  It has been shown through psychological studies that when a difficult judgement is required, and a related judgement comes easily to the mind, the easy judgement is used instead (see your answer to the above riddle).

So, what does this have to do with financial matters?  A lot.

Another great book, The Black Swan, written by Nassim Taleb, focuses on the extreme impact of rare and unpredictable outlier events, and the human tendency to find simplistic explanations for these events retrospectively (System One).  He contends that just because you’ve never seen a black swan in your life it doesn’t mean that they don’t exist; and if you’ve built your “world” on the existence of only white swans, the world you created is threatened by the discovery of a black one.

Recognizing that System One is pervasive in our every day lives is important, not only in the decisions we make, but in who we trust.

It has been shown that confidence is not a good factor in judging when to trust yourself, or someone else.  There is little evidence that confident people are any more likely to give the right answer than those less confident.  In fact, those with less confidence may be more likely to do the hard work (System Two) to come up with the correct answer.

In many cases trust comes down to accountability.  Think of the heart surgeon that has to make decisions during a surgery that can mean life or death for a patient.  Contrast this with a financial pundit, who prattles on about the next boom or bust, or the next hot stock tip.  In the first case, the surgeon gets immediate feedback and accountability from his or her decisions.  The latter will either be long gone before the consequences play out, or will move onto the next “crisis” du jour, never being held to account for a bad recommendation.

I’m as guilty as anyone when it comes to cognitive biases. They can be quite helpful.  Our individual worlds are constructed from past events (don’t grab that hot pan with bare hands, or that yellow light is long enough for me to make it across).  It is important, though, to challenge some of our long-held assumptions from time to time.

A significant assumption we are currently challenging is that the economic conditions that we have grown accustomed to over the past 40 years, low inflation alongside solid economic growth, may not exist for the next 40.  The matrix below describes four potential economic outcomes, and investments that perform in each.

We have been solidly in the “green” quadrant of economic conditions for the past 40 years.  That is an economy characterized by solid growth coupled with low levels of inflation.  It is commonly referred as the “Goldilocks” economy.  In this environment traditional stock and bond portfolios perform well.  If, however, economic conditions shift from this to a “gold” economy (Boom) of strong growth and high inflation, emerging market investments and traditional commodities typically perform well (we are clearly in this quadrant for the moment).  A “pink” economy (Stagflation) takes my mind back to the early 70’s where we experienced a shrinking economy coupled with high inflation, and favors investments like gold and silver.  Finally, a “blue” economy (Recession) characterized by a shrinking economy along with deflation favors US Treasuries and Treasury Inflation Protected Securities (TIPS).  True diversification requires thinking outside the (green) box.

Our job requires us to engage in System Two thinking.  To challenge the status quo and protect your assets as prudently as we know how.  To ask questions before we shoot.