Things I’m Pretty Sure About
A few things I’ve been thinking about lately …
Market behaviors feed on themselves. Daniel Kahneman once said:
There is one class of problems with groups and the wisdom of crowds where averaging really works: When the errors that people make are completely uncorrelated. So when different people are prone to make very different errors, then the errors will tend to cancel them out and the law of large numbers will work and so on, so you get an advantage there.
But when you have problems where the biases are shared, then actually groups could be worse than individuals because people finding that others agree with them become even more overconfident.
We all see the same market price and read the same commentary, the latter of which is like gasoline on the flames of herd behavior. So investing misbehaviors can snowball. The consequence is that markets rarely sit at “average” valuations; they spend far more time in areas that look historically cheap or historically crazy.
We will probably look back at the record-low volatility during Trump’s first year in office as a remarkable event. Investors have talked about the risk of political uncertainty for years. Then as the lead-in to an era where constitutional rivets seem to be popping off, markets took a nap. This is less about politics and more about the lag between big events and coming to terms with big events. Same thing happened in 2007, when the financial crisis began sparking in the summer of 2007 and markets rolled on to new all-time highs.
It is hard to be a good investor and a good investment salesman, because good investing is usually either accepting painful volatility, or avoiding it through dampening diversification. Neither appeals to the emotional part of the brain that marketing targets. What works in marketing – promising something above average and soon – are the two things market gods walk around with sledgehammers trying to destroy. Jason Zweig: “The advice that sounds the best in the short run is always the most dangerous in the long run.”
What if we’re currently in a recession? I don’t know if we are. No one does. But recessions are often only known in hindsight, after economic data is revised to show that a period of slow growth was actually negative growth. This happened during the last recession, which started at the end of 2007, despite headlines like “Economy holding up” and “What economic slowdown?” I look around today – housing slowing, trade wars brewing, shutdowns stewing – and wonder if it’s the kind of stuff we’ll look back at a year from now and say, “Why wasn’t this more obvious?” What I’m sure of is that if recessions are best viewed in hindsight, recoveries are too. Warren Buffett on buying stocks in 2008: “If you wait for the robins, spring will be over.” The lag between what you see and what you should do about what you see is why actively navigating recessions is so hard.
There’s more to learn from people who endured risk than those who seemingly conquered it, because the kind of skills you need to endure risk are more likely repeatable and relevant to tomorrow’s risks. I’m more impressed with someone who has outperformed by a little bit over multiple cycles than someone who has outperformed by a lot over one. This is true for managers, marriages, countries, products, and businesses – compounding favors endurance over sprints and tolerance over avoidance.
Part of the reason pessimism is more seductive than optimism is because, despite an awareness of how powerfully things have changed in the past, it’s easy to underestimate our ability to change in the future. Psychologists call this the end of history illusion. In people it’s a tendency to underestimate how much your tastes and preferences will change in the future. When you combine this quirk with markets’ propensity to be in wild states of unsustainable highs and lows, pessimism reigns because it’s easy to underestimate how those crazy states will ever adapt or revert to the mean. If you extrapolate college tuition growing at 10% a year for another 20 years, it looks insane and you’ll be pessimistic. Extrapolate current government deficits as far as you can see and we’re in trouble. Extrapolate negative growth during a recession and you’ll want to build a bunker. But the whole history of economics is a story about things adapting and reverting. Newton’s third law applies to economics: For every reaction – rising price, falling price, higher margin, lower interest rate, whatever – there is an equal and opposite reaction. Somewhere. To someone, who will eventually have enough sway to move things in the other direction or figure out a more palatable option. Underestimating adaptation and reversion to the mean is the greatest cause of pessimism. If you can stick around long enough to stomach the adaptations, optimism should virtually always the default assumption.