What do coronavirus epidemics and consequent market volatility teach us about risk, uncertainty and investment decision making?
Annie Duke and Morgan Hausel explored the question in depth in a conversation at the 73rd CFA Institute’s annual virtual conference last month that provided a three-step rubric to help investors navigate the excitement.
Hausel, a partner in the collaborative fund, summed up the initial hesitation and current environment.
“As an investor, I never thought I would see a time in my life that was 200 more insane than 2008,” he said. “And we are here. By any definition, the last few months have surpassed 2008 in almost every case, and of course, as a student of history, I never thought we would look at an economy that competes with the Great Depression by many metrics.
So what does a thoughtful investor do? How do we predict and plan for the future in the midst of so much uncertainty?
“The best way you can make decisions in this kind of environment,” Duke said, is not to demand certainty, but to seek a broader perspective on what the possible paths are. “
And to do that we need to understand how we make our decisions and what determines their outcome.
According to Duke, this process is driven by two main elements: incomplete information and fate.
We build our models and make (hopefully) our investment decisions based on data. But we should not believe too much in it. The information, by its nature, is flawed.
“It gives you the illusion that you have the truth,” Duke said. “Data is not true. Data is information that we have in the world that has been collected for a specific purpose and then we model the data.
And how the data was collected and who is interpreting it both affect the results models and how we view their results. Given the same dataset, a dozen researchers could come up with a dozen completely different predictions.
Another problem with information: there is a lot more to it.
“When we have so much data around us,” Hausel said, “whatever you want to prove, you can prove it with information, not just information.”
Which means confirmation bias is easily fed.
“More data boosts your confidence, but not necessarily your ability,” he said. There is a great quote from “ [Nassim] Taleb which I like where he says, ‘Big information [brought] Cherry is taking to the industrial stage.
But overconfidence is not the only downside. Data overload can have the opposite and equally detrimental side effects: resentment towards decision making.
“It can cause analytical paralysis,” Duke said. “Because we might think, ‘If only I could go and get more information that would get the answer.’ And then all of a sudden you will find it impossible to make a decision. ”
Draw of Luck
The Duke’s emphasis on the influence of fate in decision-making is exemplary: models are built on probability, but we judge decisions based only on results.
“People don’t think potentially,” Hausel said. “They think black-and-white binary. You are either right or wrong. ”
So if we invest based on being 90% sure about a certain result, by definition, there is a 10% chance that it will not work. But if it doesn’t work, it doesn’t mean it was a bad decision, or similar investments should be avoided in the future.
By the same token, we can bet on 10% result and guess correctly, make bad decision which is good. So what actually was a poor and risky choice looks just the opposite. In both cases there is a complete digestive tract.
The Duke proposed a strategy to avoid such extrapolation.
1. “Clear your forecast”
“When you’re making a decision, try to make your predictions as clear as possible,” he said. “Try to clarify your scenario plan, what the reasons are, what you believe and what events in the world make you believe it’s a good bet, and just record it. Track your knowledge. “
Thus, we extracted a lot of emotion from the equation and took the decision-making process and decision into a more antiseptic, clinical fashion.
We can then look at each of our security and go back and make arguments such as why we bought it in the first place, what our expectations were, where we were in the portfolio building process, and so on. Then, if the stock market starts to disappoint us because of our 60-40 equity-to-bond split, we can revisit the underlying logic and understand the conditions that motivate portfolio building decisions in that particular way. Are they based on our risk tolerance, how close we were to retirement, what market dynamics indicated at the moment?
Duke said, “Once you do that, you can begin to detach yourself from the actual result. It’s much easier to go back and say, ‘It was a perfectly reasonable choice to give what I knew then.’
2. “Claim Broad View”
But our scenario does not clearly explain how we came up with that scenario.
And the prognosis is probably a fool’s work much more today than ever before.
“Very few people predicted an accident in March, and then in April, almost no one saw it coming,” Hausel said. “At what point are we going to say we don’t know what’s going to happen next?”
Our predictions need to acknowledge that uncertainty.
“This is a time when instability is really, really high,” Duke observed. “We are much more aware that there are unknowns. We think about the things we know, the things we don’t know, and then we think about the things we don’t know. And there are those three sections and all those things have been widened at the moment.
He and Hausel cited various Covid-1 epidemic epidemiological models and how they were disseminated to explain the depth of ignorance about our disease, the breadth of possible outcomes, and the number of related variables. The same uncertainty applies to the market.
With coronavirus, predictions were made from Imperial College, Johns Hopkins University, and elsewhere that all presented a broader scenario.
“Colombia had three different models that toggled social distances and each of them had a range,” Duke said. “All of these models are giving you different perspectives on the future, and instead of saying what the answer is, we might better say, ‘Well let’s see them all and see how we can come up with the best plan for any of these possibilities.’
As investors, we need to apply the same lessons, the same philosophy to our forecasts. It is reckless and irresponsible to over-index a future version in this environment and in this degree of uncertainty.
We have to accept that there is no right answer in this market or any other. But some answers are better than others.
“Doing well for a long time is not about finding the right answer, but about making the best decision. It’s about being able to improve within a wide range of outcomes, “Hausel said.” It’s a huge part of surviving as an investor over time as you have a wide range of outcomes that are acceptable to you. “
Because over time when the full benefits of compounding are realized.
3. There is no substitute for modesty in investing.
Finally, we must remember that just because our model performed well does not mean that it was right, that it worked for what we theorized, or that we were “right.”
“Even where you can see growth and valuable investors [the model’s] Right in a certain environment, it may not be right to move forward, “Duke said.” So you have to hold those models very loosely. “
So we have to be humble and assume that what really drives the market is unknown. Our focus should not be to make the most accurate predictions of the future, but to protect ourselves from the unknown.
“Protect yourself against uncertainty,” Duke said. “You’re not trying to be a perfect predictor of what is going up or what is going down. You’re just saying, it can go up and it can go down and that’s how I’m going to deal with it.
To be sure, it may not be as confident as previous stock pickers. But that’s basically the point.
“The more humility you have, the more you’re going to build your portfolio, ‘I don’t know how the world is going,'” Duke said. One kind of says, ‘OK I’m just going to cover my bases.’ “
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All posts are the author’s opinion. As such, they should not be construed as investment advice, or the opinions expressed must not reflect the views of the CFA Institute or the author’s employer.
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