The new White House got into a petty argument during its first week in office over the smaller crowd at President Donald Trump’s inauguration versus Barack Obama’s eight years ago. “We have alternative facts,” said Trump adviser Kellyanne Conway.
In politics, you can get away with this. Voters live in bubbles of their own making — the selective perception and confirmation bias through which they view the world. The penalty for fabricating your own reality, false though it might be, seems to be minimal or nonexistent in politics. Voters live with the consequences of the ballots they cast, though the effects may not be felt for years. Making up alternative facts about childhood vaccines, the unemployment rate, climate change or where your predecessor was born certainly hasn’t hurt Trump — it may even have helped him win the election.
Investors, however, aren’t quite so lucky when their belief systems diverge from reality. Mr. Market seems to take delight in taking money away from those whose capital is deployed based on a set of faulty convictions. This is why I harp on cognitive issues, the importance of understanding your own psychology and, most recently, not mixing politics with investing.
If you doubt that the market punishes those whose subjective reality diverges from objective reality, then consider how a subjective-reality investor engages with the market. It helps to think of this as a three-step process that can be broken down into issues, impact and investment.
Issues: The subjective-reality investor begins with a specific understanding of some big issue: They believe they know what will cause the dollar to swing; how tax reform will affect corporate earnings; how recent inflationary pressures will change Federal Reserve policy and the direction of interest rates; what the odds are for a recession, repatriation of overseas capital, infrastructure stimulus spending or tax cuts. Perhaps they have strong views on U.S. stock valuations, whether they are cheap or expensive. What the specific issue is matters much less than our investor’s belief in the certainty of their opinion.
Impact: This kind of investor imagines they understand these complex issues well enough to envision how these forces and events will affect specific asset classes. They can foretell how any (or all) of these issues will: a) manifest themselves in the broader marketplace; b) believe they can assess how these issues will drive specific risk assets; and c) can express that belief in a market position. There is a high degree of overconfidence associated with this.
Investments: Based on the first two steps, our overconfident subjective-reality investor then puts capital at risk in a trade or investment. Sometimes they get lucky, more often they don’t.