Reflections 4.17.20


In lieu of a typical commentary on markets and the economy, we thought something a bit different might be helpful. Consequently, we are sharing a few short thoughts on decision making in times of uncertainty.

We all like to think we are rational and that we make rational decisions on a regular basis. Perhaps in our more lucid moments we admit that we are often driven by something other than pure data. Our decisions are based on feelings and emotional responses rather than an impartial review of the facts.  Further, our review of the facts is often skewed by pre-existing biases. Given the barrage of data we are currently experiencing, let us consider a few of these “biases” which may be a challenge for us today.

Along with the cognitive challenge, I also want to highlight two of Bob Farrell’s 10 Rules of Investing because I think they are particularly relevant in light of our current environment. Mentally we utilize short cuts—often referred to as heuristics—to make decisions easier. Heuristics can also be thought of as general rules of thumb. While they can be very helpful, they are often neither perfectly accurate or rational. As one who enjoys snow skiing, I find it a vivid example that several of these decision-making heuristics are often utilized in explaining why humans get caught in avalanches when they should have known better. It is also interesting to note the timing of the recent release of 2013 Nobel Prize winner Robert Schiller’s new book on narrative economics highlighting the way that narratives go viral and can affect economic outcomes (Narrative Economics: How Stories Go Viral and Drive Major Economic Events.) In our current situation, the narrative is very important, and our heuristic response to that narrative is also critical. The two are linked in that our heuristics or cognitive biases often direct our response to a particular narrative.

Some of those heuristics that may be particularly applicable at the present time include: fear instinct, consistency, social facilitation, expert halo, activity bias, and overconfidence.

Fear Instinct: fears that seem to be hardwired into our brains; physical harm is significant in this category.

Consistency: continuing with a plan or staying on message. Consistency is often a good heuristic, but it can also cause challenges like blinding us to new information; think politicians or senior executives who make a bad decision but continue with a series of decisions in order to save face or reputation.

Social Facilitation: being emboldened by the fact you are not alone.

Expert Halo: following a leader simplifies decision making and may be very helpful in a world filled with information, but if we are following simply based upon the perceived qualifications of the individual, bad outcomes can result.

Activity Bias: humans often find it easier to just “do something.” Deciding not to do something is still a decision, but it can be perceived as inaction.

Overconfidence: individuals often tend to be overconfident in their own expertise and knowledge even in the face of overwhelming evidence to the contrary. (Women tend to be better at avoiding this one than men!)

Bob Farrell’s 10 Rules of Investing:

#8. Bear markets have three stages — sharp down, reflexive rebound and a drawn-out fundamental downtrend.

#9. When all the experts and forecasts agree — something else is going to happen.

Perhaps, when one considers these normal heuristic responses to uncertain or dangerous situations and overlays the concept of narrative economics, the challenge of the current situation becomes more clear.  Hypothetically, a disease could trigger a fear instinct (think The Andromeda Strain by Michael Crichton or the movie Contagion); governments could choose a poor response (consistency bias stimulates the response and dictates continuity, and social facilitation ensures it progresses); aggressive action is taken to help demonstrate that governments have a plan and are in control of the situation (activity bias); experts ensure the public accepts the response and willingly follows through with suggested protocols to mitigate their fear instinct and protect the weak (expert halo); the disease is conquered and everyone lives happily ever after (overconfidence).

What about markets and the economy? Enter narrative economics. Perhaps the narrative surrounding our hypothetical situation is extremely positive: there is massive fiscal stimulus, the Fed is fully engaged as both a lender of last resort and a buyer of last resort. Statistically the economic data is terrible, but the narrative states we have avoided something much worse, confidence is restored, the economy rights itself and the markets soar. On the other hand, perhaps the viral containment narrative is positive but the economic narrative is more negative. The virus is contained, but the investors awaken to the plight of the average citizen and realize that the cure is indeed worse than the disease. Economic fear takes hold, savings rates go up, spending goes down, the economy slides into a deflationary spiral and markets sink.

Remember, stories have power! Politicians know this; the media knows this; do we believe this? Are you and I thinking for ourselves or letting others make decisions for us? In her January 2, 2020, article in the New York Times, Heidi Julavits outlines three solutions to heuristic traps: communication, group decision making, and the practice of emotional vulnerability. As we consider what we don’t know in the current situation, this seems like sound advice. When coupled with Bob Farrell’s rules 8 & 9, it becomes an outline for caution and continuous personal review of why we are investing in a particular manner.

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Bryan Taylor