We live in a world that is increasingly complex. Academic and scientific researchers have responded by tightening their focus into even more specialized areas of inquiry. But narrowing our attention too far, while continuing the growth of knowledge, can inhibit our understanding of it. The perceptual cobwebs can be cleared out only by someone who can see things differently.
The Nobel Prize for Economics was awarded in 2002 to Daniel Kahneman, a psychologist. Along with his colleague (the late Amos Tversky), Kahneman's outside perspective laid the foundation for an entirely new field of study: behavioral economics. That is why we now understand that the biggest obstacle to achieving clarity and success is ourselves.
The great 19th century psychologist William James was referring to a baby's first experience with the world when he called it “one great blooming buzzing confusion.” But he might as well have been talking about the world in general and our continuing struggle to make sense of it.
Consider the following: there are approximately 7.4 billion people living in the world who communicate in over 6,500 languages, are spread out among 196 countries, and create $75 trillion dollars of economic value each year, either individually or in hundreds of millions of mostly tiny enterprises.
Worldwide there are more than 45,000 listed stocks and $82 trillion worth of bonds. For those who don't feel capable or willing to winnow those choices, there is an equally daunting number of third parties who will do it for you: approximately 3,500 ETFs, 7,500 mutual funds, 11,000 hedge funds, and 70,000 private investment managers, including myself.
The thought has crossed my mind that you have to be just slightly delusional to think that it is possible to sift through the world's available data (assuming it's even accurate) and come up with valid reasons to feel confident that your choices are sound. How exactly do we separate fact from fiction, risk from opportunity and order from chaos? In other words, how do we make sense of James's “blooming buzzing confusion”?
There is considerable research in how we process what goes on around us. In his book “Mindware,” Richard Nisbett writes: “[O]ur understanding of the world is always a matter of construal — of inference and interpretation. Our judgments about people and situations, and even our perceptions of the physical world, rely on stored knowledge and hidden mental processes and are never a direct readout of reality.”
What we think of as reality is actually inference, based on a mental model known as a schema. Schemas are enormously useful frameworks for organizing, categorizing and finding relationships between things in a world that, without them, would be complete confusion. So schemas have enormous utility — but they are not reality.
For centuries, illusionists have exploited (to their benefit and our entertainment) the simple belief that what we see with our eyes is real. That issue has been a subject of ongoing interest within psychology; a brief video demonstrates the McGurk Effect, a simple but powerful reminder how easy it is to separate perception from reality. (To find the video, enter the words “McGurk Effect BBC Horizon” in any search engine or directly in YouTube.)
Why is this so important? Because investing occurs at the intersection of perception and behavior: how we see the world and how we respond to it. The obstacles to achieving clear perception and sensible behavior are robust and plentiful, external and internal, learned and instinctive. Overcoming them is not easy.
One of the paradoxes of investing is that our goals are long term, but we live our lives day-to-day, and it is hard to separate what feels risky from what is risky. The Internet compounds that challenge by offering up unlimited amounts of easily accessible information into the increasingly limited space of our attention. All too often, the winners of that attentional contest are the most extreme, most controversial or sensational. Our attention needs to be recalibrated so it resonates on a different wavelength.
Over the last few months the momentum in the financial markets changed, volatility increased, and risk became more palpable. Instead of digging deeper into the same informational pit for guidance, I thought it would be more helpful to take a few steps back and reframe things more broadly — to give us a fresh look at a recurring problem with a different perspective on how to respond to it.
For 20 years, author John McPhee immersed himself in the lives of a half dozen geologists and the world of deep time they must inhabit in order to do their work. He writes, “On the geologic time scale, a human lifetime is reduced to a brevity that is too inhibiting to think about.” In order to understand what they see, geologists have to consider time frames and facts that exceed their sensory capacities. Human history — even all of human existence, relative to the 4.5 billion years that our planet has been around — doesn't even show up within a measuring unit of change.
The Appalachians have risen and eroded down no less than three times over the last 250 million years. Over the next 10 million years, 10,000 of what we in California fear as the Big One will cause Los Angeles to slowly slide by San Francisco as the Pacific Plate moves north against the North American Plate. To a geologist, the gnashing of teeth over when the next earthquake might strike is not as important as knowing that this is the nature of how the world slowly rearranges itself.
While predicting earthquakes is still a work in progress, strong building codes and emergency preparedness are incredibly effective in surviving them — the death toll in Tokyo from the 9.0 earthquake in 2011 was just seven people. Similarly, while we fear market declines and the very real damage they can inflict on our lives, sensible portfolio diversification and appropriate risk management offer investors far better survival odds than prediction.
The efficient markets hypothesis, while perhaps not as perfect in practice as in theory, is still one of the most important insights in all of finance. Markets are enormously efficient pricing mechanisms — the most famous example of what we now know as a smart crowd.
Yet, if markets are anything they are reflective of the aggregate behavior of their participants. And psychologists know that the best predictor of future behavior is past behavior. Investors will always overshoot optimism or pessimism and become either too complacent or too fearful. The cycles are not necessarily predictable, but the behavior is easy to spot and even easier to exploit for profit. Benjamin Graham explained how this can be done with his simple but brilliant metaphor of a periodically manic-depressive fellow named “Mr. Market.”
Taking advantage of Mr. Market seems like an attractive proposition. The biggest challenge is that most of the time Mr. Market acts pretty normally — leaving us with a lot of time on our hands to sit around and wait. Like McPhee's geologists we need to change our frame of reference so we can resonate with the wavelength of Mr. Market's behavior. Then what used to feel like a financial earthquake is now perceived as an inconvenient but normal part of the landscape — obviously to be respected and survived, but otherwise inconsequential.
Kahneman's great lesson to us is that investing is a behavior — and like all behaviors it is influenced and biased by a myriad of things that have nothing to do with investing. That may be why all of the investors I have admired most in my lifetime shared a broad interest in things that (seemingly) had nothing to do with investing, yet gave them considerable wisdom and insight they could apply to their choices, investment or otherwise.