Rational Advisor

Philosopher George Santayana said “Those who cannot learn from history are doomed to repeat it.” I think George Bush needs to hear that - Vietnam, Iraq War part 1, and now Iraq War part 2.

What I’ve noticed is that there is currently some added fear in the air with regards to the stock markets and finances in general. Will it get worse? is it going to zero? IS the market going to crash? Will Oil go to $100 and gold to $1000. Will my investments disappear? Will they fulfill my financial objectives?

TIME Magazine published an interesting article, in the December 4, 2006, edition titled, “Why We Worry About Things We Shouldn’t … and Ignore The Things We Should.”

The gist of the story is how we routinely mismanage risk. An excerpt from the article sums it up this way:

We pride ourselves on being the only species that understands the concept of risk, yet we have a confounding habit of worrying about mere possibilities while ignoring probabilities, building barricades against perceived dangers while leaving ourselves exposed to real ones.

Among the many examples cited:

Shadowed by peril as we are, you would think we’d get pretty good at distinguishing the risks likeliest to do us in from the ones that are statistical long shots. But you would be wrong. We agonize over avian flu, which to date has killed precisely no one in the U.S., but have to be cajoled into getting vaccinated for the common flu, which contributes to the deaths of 36,000 Americans each year. We wring our hands over the mad cow pathogen that might be (but almost certainly isn’t) in our hamburger and worry far less about the cholesterol that contributes to the heart disease that kills 700,000 of us annually.

While this article does not talk about our mis-management of financial risk, the same principles apply. Our calculation of risk is rarely done by the logical part of our brain. More often than not, it is the hyper-sensitive emotional part of our brain that evaluates risk.

This evaluation takes in several factors, none of which are very helpful. For example, we over-emphasize the risk of things we dread. Risks that occur quickly with minimal agonizing discomfort are given less weight than those that terrify us, even if the more tolerable risk is far more likely to occur.

Perhaps more importantly, we focus on the short term and ignore risks that might occur farther out in the future. This explains why we have gone to extreme lengths to protect ourselves against terrorism but do nothing about the fact the baby boomer generation doesn’t have enough money to retire.

We also habituate risk. In other words, unfamiliar risks are scarier than familiar ones. Eventually, our familiarity causes us to under-react, rather than over-react.

A sense of control, even if it is illusory, also dampens our sense of risk. Do-it-yourself investors may feel more comfortable because they believe they can react quickly in the event something bad happens - like say another terrorist attack. The truth of the matter is, once it has happened, it is too late. The way to manage that risk is not through control but by proper planning up front.

Finally, there is it-won’t-happen-to-me bias. We all believe risks apply to other people and not us. This allows us to ignore inconvenient facts, for example, stock markets do go down and they do recover. They go down approximately once every three years. If this weren’t true, why would people continue to smoke, overeat or drive without seatbelts? And yet people continue to believe it won’t happen to them. “They’re smarter than the average bear” – Yogi Bear (Hanna Barbara)

Classical economics assumes we are perfectly rational beings. But clearly we are not. Our emotional biases cause us to do things that are obviously detrimental, like buying an investment at the wrong time, its peaks, and selling, at the wrong time, the valleys.

Our natural state is pessimism. When I tell this to people they look at me like I had two heads. Yep, most of us are pessimistic about almost everything, it’s going to rain, the terrorists are going to take over, the aliens are amongst us (okay, I agree but that’s only the US president!), blah blah blah…

In fact, you’re not just pessimistic, but serially pessimistic if one apocalypse du jour doesn’t pan out for you, you’re on to the next one. Okay so we weren’t attacked by the terrorists again, but we will have a shortage of Oil, and the ice caps will melt because of global warming so we’ll all drown!

Whatever happens, Never, Never buy into this pessimism, Never (did I say never enough times!), and here’s why, just read about the two economists that I have the greatest belief in Adam Smith (the Father of economics) and Hyman Minsky (the father of financial instability hypothesis).

Why do I like these guys - because they are rational

Adam Smith, believed in the “Invisible Hand” in that when things look like they are going wrong, like say Oil going up, inflation increasing, or War, each individual independently tries to do better for himself, and in doing so there is a global impact of everyone trying to do well independently, and that reduces the global problem. Think of it like a invisible hand that rises from the heavens to solve the problem du jour. A good example was Y2K, individually companies began to resolve their own issues so that finally it was not a global panic. Another good example was WWI, WWII.

Hyman Minsky, Minsky, advanced the idea that financial systems are inherently susceptible to periods of speculation that, if they last long enough, end in crises. At a time when many economists were coming to believe in the efficiency of markets, Mr. Minsky was considered somewhat of a radical for his stress on their tendency toward excess and upheaval(greed and fear).

At its core, the Minsky view was straightforward: When times are good, investors take on risk; the longer times stay good, the more risk they take on, until they’ve taken on too much. Eventually, they reach a point where the cash generated by their assets no longer is sufficient to pay off the mountains of debt they took on to acquire them. Losses on such speculative assets prompt lenders to call in their loans. This is likely to lead to a collapse of asset values.

Time and again we see this, fortunately Adam Smith’s invisible Hand works to correct Minsky’s greed and fear. This can be seem buy looking at eh ever rising chart of the stock market over the long term.

In the long run pessimism is always wrong. Beyond that it’s counterintuitive. To believe that economic life can end in ruin, and that values of good investments can be permanently extinguished, is to believe in something that’s never happened.

Optimism is the only available long term realism. It’s the only worldview that squares with the historical record.

So the investment world is really a combination of Adam Smith and Minsky.

So how do we combat our poor risk management capabilities? I do believe the answer for investors is to create systems when we are logical and sane that take into account the probabilities of various risks, weigh them in a logical way, and then follow those systems even when our emotions tell us we are crazy. Our emotions make us do crazy things. One of the keys to being a good investor is removing emotion from process.

Thanks

Rational

“The uniform, constant and uninterrupted effort of every man to better his condition, the principle from which public and national, as well as private opulence is originally derived, is frequently powerful enough to maintain the natural progress of things toward improvement, in spite both of the extravagance of government, and of the greatest errors of administration. Like the unknown principle of animal life, it frequently restores health and vigor to the constitution, in spite, not only of the disease, but of the absurd prescriptions of the doctor.”

- Adam Smith The Wealth of Nations, Book II Chapter III, written in 1776 (read that again, this was written in 1776!, and it is still true today)

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