I’m often asked what I think is going to happen. It’s part of my job. My preferred answer in these situations is to say that I don’t know and nor does anyone else because the future is unknowable. It is not really what people, especially investors, want to hear.
They don’t want to hear it for the simple bio-chemical reason that thinking about ambiguity fires up the part of our brain associated with fear. At the same time it smothers activity in another bit of the brain that helps us feel the pleasure of being in control of a situation and which is closely associated with feelings of trust.
This is why parts of the financial services industry are so keen on forecasts, predictions, expert analysis and all sorts of other spurious mumbo jumbo. As Jason Zweig puts it in “Your Money and Your Brain”, his brilliant book on behavioural psychology, “not knowing the odds not only inflames our fears, but also strips us of the feeling that we are in charge.”
There’s a great experiment which shows how this works. People are told they will win money if they pick a red ball from one of two boxes containing both red and black balls. In one box they are told there are equal numbers of the two colours; in the other, the ratio is unknown.
People tend to go for the box where the odds are known, which is maybe not surprising. More interesting is the fact that if they are immediately offered a prize for picking a black ball from the same boxes they will still go for the first box with the 50:50 colour split. Now if they thought they were more likely to get a red ball from that box a minute ago it is, of course, totally irrational for them to now think the odds favour getting a black one.
The fact is that they are not really thinking about the probabilities involved. Rather, they are acting in response to how they feel about the situation. The basic premise of behavioural finance is that there is a huge difference between thinking and feeling and it is the latter that ultimately determines how we act.
Donald Rumsfeld, secretary of state under George W. Bush, understood this well when he made his ridiculed but actually profound remarks about uncertainty. He knew there was an important difference between known knowns (the first box) and known unknowns (the second box) and he introduced a further concept which is extremely important for investors, unknown unknowns (the things that we don’t even know we don’t know).
I was reminded of Rumsfeld’s comments when I recently looked back at my outlook for 2014 and compared it with how things have actually panned out in the first few months of the year.
So, for example, at the beginning of the year there was one important known known. The tapering of monetary stimulus in the US had just begun. With unemployment in America on a steady downward path this was predictable and so too was one of its consequences, pressure on emerging markets that had grown dependent on money that was now looking to return to havens in the developed world.
At the turn of the year one known unknown sat on the horizon in the form of Japan’s proposed sales tax hike. We knew it was coming in April but we didn’t know what the consequences would be. We had a template from the late 1990s that didn’t augur well but there were plausible arguments that things were different this time around. In the event the market’s brain has responded in time-honoured fashion when faced with ambiguity and assumed the worst.
Another known unknown has been the Indian election. Again we knew it was coming. What we didn’t know was that investors would make an assumption about the likely winner, the BJP’s Narendra Modi, and draw positive conclusions about his likely impact on the Indian economy and stock market.
Finally, of course, Vladimir Putin provided the unknown unknown, the event that wasn’t predictable and which has had any number of unexpected consequences. For example, I could argue that the market’s new-found aversion to highly-rated technology stocks can be traced directly to the souring of sentiment caused by Russia’s sabre-rattling in Ukraine.
Uncertainty is perhaps the only certainty in investment, so the best we can do is work out strategies for coping with it and, if possible, use our experience to capitalise on the predictable behavioural biases it creates. But that is a topic for another day.
