Then again, the Association for Psychological Science informs us that parenting any child isn't easy. A recent post, The Myth of Joyful Parenthood, states that "Raising children is hard and any parent who says differently is lying." And that isn't an unsubstantiated opinion, explains John Cloud in a Time Magazine article -- Kid Crazy. "Researchers have known for some time that parents are... more depressed than nonparents..." They're more depressed and stressed, writes author Jay Belsky, PhD, because of "...a fundamental truism about the world we inhabit: The future is uncertain. As a result, no parent...can know for certain what would be best for his or her...child..." Neither can investors know with certainty what is best for their portfolios. So, like parents, "investors hate uncertainty," points out Wall Street Journal columnist Jason Zweig. But certainty, which he defines as "...a state of clarity and predictability... doesn't exist, never has, and never will." However, "Our need for certainty in an endeavor as uncertain as raising children [or, I may add, investing for retirement] makes explicit 'how-to-parent' [or investment] strategies both seductive and dangerous," warns researcher and TED Talk sensation, Dr. Brené Brown.
Therefore, it is hard to resist "...seductive-sounding ideas that will supposedly enable you to beat the market," writes Zweig or be a "perfect" parent, Brown would add. But you must. That's why Brown says you have to "let it go" and Zweig says to "get over it." By doing that, Zweig explains you can then "...try to control the things that are controllable," which is mainly your behavior. So, Brown encourages parents to "Be what you want your kids to be" and Zweig admonishes investors to adhere "...to a set discipline... [to] prevent yourself from making impulsive decisions..."
Investors should heed both pieces of advice and try to emulate the behavior of disciplined role models like Warren Buffett. That means not only knowing what he does but also doing it. "Only when you combine sound intellect with emotional discipline do you get rational behavior," Buffett maintains. For him to nurture such intellect and discipline, he told CNBC, "I do more reading and thinking, and make less impulsive decisions than most people in business." It's something "All of you can do," he points out, "but I guarantee not many of you will do it." And that's the reason why so many investors make the same mistakes over and over.
As humorist Franklin P. Jones observed, "Experience enables you to recognize a mistake when you make it again." Regrettably, there is more truth than humor in that statement. It's true because, "...it turns out that our brains are hardwired to get us into investing trouble," laments Zweig. In other words, nature has cross-wired our brains in such a way that we believe that the world is more predictable and controllable than what logic, observable facts, or past experiences would suggest. Because of that, neither parents nor investors can let go of the belief that perfection (or near perfection) is possible. And that's not very smart, is it? Ya think!
It was one of those innocent inquiries of youth that was so endearing that the illogic was irrelevant. My youngest daughter Hillary, who was about eight at the time, was in a Sedona, Arizona tourist shop when she became interested in a display of dream catchers and wanted to know what they were. Her aunt Brenda told her if she put one over her bed, the netting would catch the nightmares but the holes were big enough to let the good dreams through. Upon hearing this, Hillary had only one question: “Does it work?” Of course not, but since when has logic had anything to do with how we handle our fears?
If you don’t believe me, consider the words of The Economist in its review of Expert Political Judgment, by Phillip Tetlock, “There is a remarkable tendency to trust experts, even when there is little evidence of their forecasting powers.” For financial experts, the evidence is so remote that Eugene Fama, renowned as the father of modern finance, sarcastically declared, “I’d compare stock pickers to astrologers, but I don’t want to bad-mouth astrologers.” So why, contrary to reason, do we trust experts with such terrible track records? Because, Tetlock explains, “…no matter how unequivocal the evidence that experts cannot out-predict chimps… we…are enthralled by experts for the same reasons that our ancestors submitted to shamans and oracles: our uncontrollable need to believe in a controllable world, and our flawed understanding of the laws of chance.”
In other words, we want answers. But the Heisenberg Uncertainty Principle in physics informs us that certain things are fundamentally unknowable. As Tetlock puts it, “Just because we want an answer, even desperately want one, does not mean we have an answerable question.” And what appears to be an answer is often chance. It’s what the mathematician John Allen Paulos referred to as the “Jean Dixon effect;” the tendency to attribute skill to a few correct predictions while ignoring the far more numerous incorrect ones. Although deep down we may know that financial markets are random and unknowable, Tetlock explains, “…we lack the willpower and good sense to resist the snake oil… Who wants to believe, on the big questions, we could do as well tossing a coin as by consulting accredited experts?”
The experts definitely don’t want to believe their advice is useless so they “…talk themselves into believing they can do things that they manifestly cannot,” says Tetlock. They congratulate themselves for their shrewdness when they get things right and they attribute failures to unusual circumstances or bad luck. Combine this delusion of experts with client fears and you get, warns Tetlock, “… a symbiotic embrace between self-confident suppliers of dubious products and their cling-on customers.”
The products investors are embracing are dubious because the underlying strategies are based on chance which, according to the “Jean Dixon effect,” means there is no way of knowing in advance which ones will work. Instead of relying on chance, which is uncontrollable, Tetlock and The Economist recommend focusing on what is controllable. That’s why they suggest buying low cost index funds and only paying for advice that steers you away from “fraudulent funds” and makes you “aware of the benefits of diversification and of the effect on your portfolio of taxes rules and regulations.”
While trusting dream catchers may be endearingly innocent, trusting forecasts of financial experts is irrationally ignorant. That’s why any rational discussion of forecast-based financial products and strategies would logically lead to a negative response to the question, "Does it work?"
“The older I get, the better I was.” A while back my kids gave me a T-shirt with those words printed on it. As you no doubt can gather from my newsletters, I like to tell stories. Over the years, my kids have heard many of them and have questioned the veracity of some of my claims. I think they have a hard time imagining their dud of a dad could have been a stud at one time. As I like to remind them, “Children think there are three genders: male, female, and parents.” But my children’s perceptions aren’t the only reasons to doubt the veracity of my stories: my memories of past experiences may not be accurate.
In his book, Thinking, Fast and Slow, Daniel Kahneman says we have two selves, “the experiencing self and the remembering self.” And, since “memories are all we get to keep from our experience of living, the only perspective that we can adopt as we think about our lives is therefore that of the remembering self... the experiencing self does not have a voice.” So, the life narratives we tell ourselves are not based on experiences, but on our memories of those experiences… and our memories could be wrong.
The reason memories can be so wrong, says Jason Zweig in Your Money and Your Brain, is that they are “...not just recollections. They are also reconstructions.” We revise the past in order to feel better about ourselves. Nassim Taleb explains in the Black Swan, “Memory is more of a self-serving dynamic revision machine: you remember the last time you remembered the event and, without realizing it, change the story at every subsequent remembrance...to make what we think of as logical sense after the fact.”
Since memories are convenient cognitive deviations from reality, “...it makes it difficult to learn from experience,” writes Philip Tetlock in Expert Political Judgment. This is true, not only because our memories deviate from reality, but also because the constant rewriting of events to make logical sense makes us feel like we knew what was coming all along. He reports that this knew-it-all-along effect, known as hindsight bias, “...forecloses the possibility of surprises, and surprises — because they are hard to forget — play a critical role in learning when and where our beliefs failed us.”
Interestingly, one of the most common mistaken beliefs perpetuated by hindsight bias is that the future is predictable. As Kahneman explains, “The illusion that one has understood the past feeds the further illusion that one can predict and control the future.” A perfect example of this is the adoration investors have for Morningstar ratings, which ranks mutual funds from five stars (top) to one star (bottom) based on past performance. And, while Morningstar prominently displays its “past performance is not a guarantee of future results” disclaimer, Jane Bryant Quinn says, in a CBS Money Watch article (May 6, 2010), that “Money pours into the four and five star funds…[However,] Morningstar’s own research shows how little its stars are worth as investment guides.” That’s because experience shows that mutual fund returns are random and unknowable. Four and five star funds inevitably fall back to the pack, while the lower rated ones routinely rise toward the top.
But, investors stubbornly hold to their misguided belief in the usefulness of Morningstar ratings, like I cling to the veracity of my stories. We do so because our brains ignore the voice of experience in favor of the self-serving revisionist voice of remembrance. It’s not that we are stupid, just flawed. Without realizing it, we construct plausible sounding memories that are wrong. This causes investors to believe Morningstar ratings are more predictive than they are, and me to believe I was better than I was.
I have always been known as a numbers guy. So, when my pastor said that there were “…things too wonderful for words,” I leaned over to my wife and whispered, “That’s why God invented numbers.”
The “numbers guy” was a nickname I picked up in the late 90s when I was writing software for required distributions from retirement accounts. At the time, there was a small group of attorneys and CPAs who were specializing in the field and a few of them used me to double check the numbers for their speeches and writings. Through their acknowledgement of my contributions, I built-up a little bit of a national reputation for my skill with retirement distribution numbers. My software programing not only enhanced my reputation but also improved my mathematical abilities. I learned how to calculate annuity factors using interest rates and mortality tables, but to do so I needed the help of a highly respected actuary.
Over the years, I have stayed in touch with this actuary, a real “Numbers Guy.” Recently, he sent me the following email in response to a speech I had given called, “We Hate Uncertainty.”
‘I am an actuary – OF COURSE I hate uncertainty. So much so that in the process of admitting that I cannot peg the future with certainty in absolute terms, I pretend that I can peg it as a “statistical certainty” using interest rates and mortality tables – all the while assuming interest rates and future mortality must of necessity fall into patterns like past interest rates and mortality. But there is no necessity to that whatsoever. I can think up any of ten simple changes in culture, government, or science that would probably invalidate those past rates as even “corridor” predictors of future rates. So while I make everyone more comfortable with my expert analysis of the past to constrain the projections of the future, the future keeps coming along in its own way completely unaware that it is supposed to fit a certain model.’
Using differential equations (calculus), my friend can calculate how to fund a retirement plan, an annuity, or even social security. However, like Isaac Newton the inventor of calculus, he is aware of its limitations. Newton lamented, “I can calculate the motions of heavenly bodies, but not the madness of men.” Predicting planetary movements is precise because the parameters describing the position, size, and shape of their orbits are all known. Madness enters the picture when we believe economic projections can be calculated with equal accuracy. They can’t, according to Nobel laureate Friedrich August von Hayek, because, “Unlike…the physical sciences, in economics… the aspects of the events…which will determine the outcome of a process…will hardly ever be fully known or measurable.” That’s why Jason Zweig in a 2011 Wall Street Journal article observed “…people with years of experience, massive expertise and mountains of data…so often get the future wrong…The future is the realm of surprises; no one, no matter how expert, can reliably foresee what will happen and how people will react to it.”
As a “numbers guy,” I cringed recently when I heard a CNN pundit refer to Congressional Budget Office (CBO) numbers as “indisputable facts.” At best they are only educated guesses. Regrettably, the newscaster’s comment represents a public perception that certainty and predictability exist where they don’t. Isaac Newton called this “madness”, Zweig the “prediction addiction,” and von Hayek The Pretense of Knowledge. Whatever you call it, the reality is that economic and financial forecasts aren’t reliable. So while numbers maybe more wonderful than words, they aren’t prophetic. We live in a world that is far less knowable, measurable, and predictable than we want to admit. And that’s why God also invented hope.
“Tom Delonge gave me his guitar!” From the level of excitement in her voice, I knew that my daughter considered this gift a very big deal, but I had no clue why. Looking at her Facebook page after our conversation, I started to see why she was so excited: “Hillary had the BEST weekend EVER with my hubby[…] we went to a Blink 182 concert and I left with Tom Delonge's guitar. You may be wondering how that happened?!? Well, HE HANDED IT TO ME FROM ON STAGE!!!!!!” From the magic of YouTube, I was able to relive that serendipitous moment when my daughter’s rock star hero pointed her out in the crowd, motioned her forward, and handed over his signature Gibson guitar in front of 22,000 screaming fans.”
Life is full of all kinds of twists and turns, and my daughter had no inkling of what lay around one of those corners when she and her new husband blew their honeymoon stash on tickets for their dream concert, with just enough cash left over to rent the honeymoon suite at Motel 6 and dine on a gourmet dinner at In-and-Out Burger. For this financially struggling couple, life handed them a totally unexpected treat.
While there is no question that getting the guitar was pure chance, this story brings up an important question that is the great debate in investing. Is investing a matter of chance, with price fluctuations that are random and unknowable or is investing a matter of choice, with price variations that have discernible patterns that are predictable? How you answer that question will determine your investment style and market strategies. I think because our investment style is known as “passive investing,” too often people take that to mean we don’t do anything. But passive investing doesn’t mean not making choices; it means making choices that have a realistic chance of success and avoiding those that don’t. Therefore, we make prudent choices, not speculative or emotional ones.
Of all the people who have gone to Blink 182 concerts, only one in over a million fans has been given a guitar by Tom Delonge - not very good odds. As investment advisors, we always try to put the odds in our clients’ favor. We do that by making prudent choices and by not blinking when things don’t work out as planned. Because we know investing isn’t a question of choice or chance, it is a question of consistently making choices that increase our clients’ chances.