Given the amount of volatility in the markets this year, as well as changing economic conditions like inflation and interest rates, it’s easy to look for patterns and draw parallels with similar past economic events to draw conclusions about the potential future of the economy and financial markets. While there may be value in this analysis for investors and the general public, there is also pitfalls and distractions that may arise by forcing trends and patterns to explain the uncertainty that lies ahead in order to better prepare oneself for the future.
As the 2022 year wraps up, the time comes for another year end review, but this time without our friend Norbert. Instead, we will focus more on some of the magic and fairy dust commonly sprinkled in the investing world, and how to look through this cloud of ambiguity and confusion.
First, let’s start with attributing chance and coincidences to explainable and justifiable causes and reason. We all do this in every day life, whether it’s trying to explain a phenomenon in financial markets or trying to explain why something happened, random or non random. This type of thinking where we make up causes for chance events forces us to try and find reasons for all kinds of events. Michael Shermer states in his publication of Skeptic,
“Humans are pattern seeking, story telling animals. We look for and find patterns in our world and in our lives, then weave narratives around those patterns to bring them to life and give them meaning.”
If you look hard enough at enough clouds in the sky, you’ll eventually see one that looks like a face, or a bird, or some other recognizable person place or thing. Scale matters, and when the sample size is large enough, unlikely things will happen (think of the tails of a normal distribution). Flip a coin 5 times in a row. Repeat this over and over and eventually you will get a sequence where a head shows up on all 5 coins at the same time. It is always possible to find patterns if you actively seek out a recognizable pattern or meaning, and then selectively pick anything that fits this recognizable pattern and ignore everything else that doesn’t. For example, someone who has a superstitious ritual before each soccer game they play may attribute their goal or their team winning to them having performed that ritual prior to the game. But what about all of the times where that player performed their superstitious ritual and didn’t score a goal that game, or when their team actually lost? We selectively pick events that fit a pattern and ignore the other events that don’t. This tends to be how “miracles” are explained.
Many behavioral economic pitfalls are built around this narrative of justifying chances and coincidences. For example, as discussed in Lesson 34, the hot hand fallacy states that if someone has been successful for x number of attempts in a row, whether it be shooting a basketball into a hoop or winning at the roulette table, then the next attempt will also be successful. The same can be applied to analysing successful money managers. The top performing money manager in year X is not an indication of whether that same money manager will be successful, or the top performing, in the following year. You see this same ill applied logic when it comes to “gurus” or “experts” who correctly predicted some event, like a financial market crash, or a black swan event. So the next time this same person makes a future prediction about something else, their word is taken as gospel. In reality, there is no indication that this person will again correctly predict a future event, random or not. Past performance is no indication of future performance. Now this doesn’t mean expertise doesn’t play a role in correctly and accurately predicting outcomes. Expertise plays a large role in any industry. Someone who studies financial markets is going to be a lot more likely to properly manage money and predict future economic outcomes than someone who doesn’t work in finance. Someone who works at a Central Bank probably knows a lot more details around what is driving inflation than a random viewer tuning into BNN. Behavioral economic fallacies can highlight the binary and emotional nature of people when it comes to investment decision making, and show that we often overlook outcome probabilities to make a decision
Financial news outlets often have guests making predictions about future economic or financial events, or selecting the hottest stock for the following 12 months. If a prediction is made far enough into the future, the person who made the prediction never has to face the consequences when it’s wrong. Fortune tellers do this all the time, and provide very general forecasts that can be applicable to almost anyone in such a way where it can’t be proven wrong. This is also seen in the finance and investing world. A talking head on a media outlet can make some far out prediction about the economy or stock markets, and it’s difficult to actually prove that statement wrong over time. If someone predicts a recession is coming, they’re technically always going to be right since business cycles happen all the time due to continuous and repetitive supply and demand imbalances. However, applying a time frame around this prediction, or attaching some other specific detail such as GDP growth or inflation, will make it much easier to measure whether the prediction has merit in the future. As Peter Bevelin states in Seeking Wisdom,
“Some things can’t be proven false. The fact that there is no evidence against ghosts isn’t the same as confirming evidence that there are ghosts. What is true depends on the amount of evidence supporting it, not by the lack of evidence against it.”
The world and society changes over time. In other words, conditions and environments and circumstances are always changing, which makes decision making difficult, even if the issue at hand has been solved in the past. As Warren Buffet has quoted,
“People like to look for systems that have worked over the past 20 years or so. If you could make money based on what has worked the past 20 years, all of the richest people would be librarians.”
This isn’t to say that certain investing philosophies and strategies can’t consistently work over time, but the parameters in which one is working within may change and cause one to alter how they go about executing a particular strategy.
When analysing an investing decision, whether it’s reading the prospectus on a company or fund, reading market advice, or analysing economic conditions, keep the following prompts in mind:
How has my financial state changed since the last time I was faced with a similar decision?
What assumptions or inputs need to be updated to reflect the current economic environment and my current financial state?
Have I consulted other sources of expertise or inputs for my decision?
Are there multiple sources of expertise that are telling the same narrative or suggesting the same decision path?
What are the possible outcomes of my decision, how likely is each outcome, and what is the consequence (good and bad) of each outcome?
Applying these prompts will help avoid the magic and fairy dust that is so commonly found in the investing world that can mislead investors to make the wrong decision, or have unrealistic expectations of future outcomes.
Let’s continue our investing journey into 2023 and let’s keep making sense of making cents!