The internal model of the world generated by the human brain helps us to navigate through three-dimensional space, understand complex ideas and adapt to the world around us.
It also is a self-fabricated fiction, but it allows most of us to get through each day without any sort of existential crisis. This is critical for investors to keep in mind because our internal thought processes are so filled with potential for bias and error that unless we are vigilant, we are easily fooled by our own narratives.
I was reminded of this last week when I saw a chart at CNN Money. It may not be fake news, based on the definition used by the president, but it is one of those things that gets passed around despite being deeply flawed. The chart encapsulates the conventional story that markets are rallying on expectations for tax cuts, infrastructure spending and deregulation — in other words, adoption of the Trump legislative agenda.
It is a tale that doesn’t stand up to scrutiny, as we have discussed before. First there is the tendency of markets to ignore the dysfunction in Washington — as they have for most of the past decade. If markets are really rallying on expectations of good things from the government, then the inability to get anything done in the past few years should have thrown them into reverse.
Folks have difficulty with this. If their internal models tells them the U.S. president is important (he is) to the economy (somewhat less so) and the stock market (even less so), then the goings-on inside the beltway must be significant (they mostly are not).
Special investigations, congressional incompetence and endlessly fevered news cycles simply doesn’t add up to record highs for markets. Our mental models struggle to make sense of it, and so we latch onto any explanation that seems even remotely plausible. Hence, the reason that the deregulation/tax cuts/infrastructure spending/repatriation of overseas profits story easily fits so readily into our flawed models.
Too bad it’s wrong.
The latest explanation is that the so-called Trump rally doesn’t need Donald Trump to succeed. Some analysts are coming around to recognizing that markets can do well despite an economic recovery, full employment and rising corporate profits. (I am only saying that partly in jest). Even after the Federal Reserve’s recent interest-rate increases, borrowing costs are historically low. Emerging markets are doing better as the dollar weakens, and Europe’s corporate earnings are strengthening.
We really shouldn’t be so surprised at the disconnect between the tales we tell ourselves about the Trump bump and reality. We saw the same sort of phenomenon during the Obama and Bush presidencies as well. I recall hearing from left-leaning hedge-fund buddies how terrible the Jobs and Growth Tax Relief Reconciliation Act of 2003 (better known as the Bush tax cuts) was going be. Those who embraced that position missed a stock market that almost doubled during the next few years. Chalk up another bad investment decision to political bias. Similar talk was rampant in March 2009, after America elected as president a Kenyan-born, Marxist Muslim bent on destroying capitalism and the U.S. economy. That was almost 300 percent ago for the stock market.
Good memes die hard. It isn’t a coincidence that we see the same mistakes made over and over again.
Why? The way the brain builds its internal models of the world has a lot to do with it. We have come to rely upon these models because they have been so good at keeping us alive. We invest so much biological energy and sense of self in these models that we have difficulty comprehending information that is at odds with them. This is why mere facts alone will never convince people that they are wrong about any deeply held belief, whether it’s about religion, partisan affiliation, global warming, vaccinations and so on; facts don’t really matter because if they challenge the mental model, the brain works to downgrade it.
This is a feature, not a bug. It has helped humans survive, create a functional society, adapt and thrive, besting all other hominids for control of the surface of the Earth and beyond.
Novelist and journalist Will Storr, in his book “The Unpersuadables: Adventures with the Enemies of Science,” speaks with what he calls “heretics” — the alien abductees, homeopaths, young-earth devotees, Holocaust deniers and others who hold fringe beliefs. The results are fascinating.
What is so intriguing about these individuals isn’t that they are crazy — rather, the exact opposite. They are perfectly rational, lucid individuals who happen to hold outlier beliefs at odds with not only accepted wisdom, but demonstrable factual evidence. Somehow, their models of the world are off-kilter. But the rest of their mental faculties are perfectly fine.
Think of this in the context of mental model creation — the internal depiction of the world around you, and it is easy to see how it could lead to expensive investing mistakes. It is chilling to hear the subjects in Storr’s book rationalize their own belief systems, and not recognize our own errors when it comes to markets and investing. Even worse, these decisions are for the most part unconscious, often built upon a flawed foundation we are wholly unaware of.
We may believe we are rational, but the reality is often something terribly different.