Uncertainty And Pessimism Bias

Popular blogger and lawyer Barry Ritholtz has a great piece on uncertainty at the Bloomberg.

Mr. Ritholtz writes, (bold highlights mine)

Wall Street has a sweet tooth for such investing maxims. They infect the trading community like influenza in December. Repeat mindless dictums ad nauseam, and they soon become the accepted wisdom.

The problem with these supposed truisms is they are no more accurate than the flip of a coin. A closer look at this uncertainty meme reveals it to be a false-ism -- one of those emotionally appealing phrases that ping around trading desks. The lack of evidence supporting their premise seems to matter very little.

To recognize how meaningless these statements are, consider the opposite: Could markets function without uncertainty? It takes only a little thought to realize that markets actually thrive on doubt, imperfect information and a lack of consensus.

Uncertainty drives the market’s price-discovery mechanism. Investing requires there to be differences of opinion. When there is broad agreement as to an asset’s fair value, trading volume falls. Without any uncertainty, who would take the opposite side of your trade?

History teaches that whenever the opposite occurs -- when certainty overwhelms uncertainty -- the herd tends to be wrong. In rare instances, when there is a near-total lack of uncertainty in the market, the outcome is usually a spectacular disaster.

Should the prospects of uncertainty prompt us to hide in our proverbial shells?

The answer is NO. What matters is the understanding of the risk-reward tradeoff.

Here is Mr. Ritholtz again,

When we discuss uncertainty, what we are really discussing is risk. All unknown outcomes contain risk, and therein lies the possibility of loss. Risk is inherent in the concept of uncertainty. However, anyone looking for performance must embrace risk, for without it, there can be no reward...

And what to do with people who always preach ‘uncertainty’?

Once more Mr. Ritholtz,

The future, by definition, is unknowable. Investing involves making our best guesses about the value of an asset at some point after this moment in time. There will always be an element of uncertainty involved. We can discount various outcomes, engage in probabilistic analysis, but no one knows for certain what tomorrow will bring.

Those who claim to know fail to understand the most basic workings of markets. We need only consider the track record of Wall Street’s prognosticators to know the truth in this statement. As much as the future is uncertain, the most likely outcomes are well understood.

Exactly. Many who preach doom and gloom hardly managed to predict the markets accurately, yet they stubbornly insist that the world is headed for the gutters.

Uncertainty is NOT a valid reason to be maintain a bias on pessimism. A bias that largely emanates from:

-resistance to accepting critical changes, e.g. industrial age to information age

-undue fixation on several variables as harbinger for gloom or to quote Professor Bryan Caplan,

a tendency to overestimate the severity of economic problems and underestimate the (recent) past, present, and future performance of the economy.

-and finally, a bias which is predisposed at the attainment of a desired political and or economic outcome.

Again the brilliant Professor Caplan,

a general-interest prop to political demagoguery of all kinds. It creates a presumption that matters, left uncontrolled, are spiraling to destruction, and that something has to be done, no matter how costly or ultimately counterproductive to wealth or freedom. This mind-set plays a role in almost every modern political controversy, from downsizing to immigration to global warming.

Like Mr. Ritholtz, the implications of misunderstanding uncertainty imbued as a bias often leads to misdiagnosis of the risk-reward tradeoffs that leads to wrong conclusions and subsequently a poor or dismal track record in investment decisions.