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.

Graphic: 7 (+1) Ingredients That Led To Today's Financial Crisis

Interesting graphic on the anatomy of today's crisis [hat tip: Barry Ritholtz/wallstats.com]

I'd like to add an 8th variable; policies and regulations that has skewed the public's incentives towards the bubble.

As Tyler Cowen wrote in the New York Times, ``And legislation that has been on the books for years — like the Home Mortgage Disclosure Act and the Community Reinvestment Act — helped to encourage the proliferation of high-risk mortgage loans. Perhaps the biggest long-term distortion in the housing market came from the tax code: the longstanding deduction for mortgage interest, which encouraged overinvestment in real estate.

``In short, there was plenty of regulation — yet much of it made the problem worse. These laws and institutions should have reined in bank risk while encouraging financial transparency, but did not. This deficiency — not a conscientious laissez-faire policy — is where the Bush administration went wrong."

To add, this from Arnold Kling of Econlib, ``Our high corporate tax rate, along with the deductibility of interest for corporations, encourages corporations to look for ways to minimize equity financing. For individuals, government-subsidized mortgages and the tax deductibility of mortgage interest help to encourage over-leveraging."

Barry Ritholtz: How to Fix Financial Television

Prolific blogger Barry Ritholtz in one of his latest post "How to Fix Financial Television" submits a wish list of how media should conduct their TV programs when discussing financial affairs (some of this seem applicable to the Philippine equivalent).

Except for number 3, all bold highlights mine. We quote Mr. Ritholz...

1. Stop Yelling. Stop interrupting. Stop Talking Over Each Other: This is not Jerry Springer, its serious business. People’s retirement and investments are at stake. Please treat it that way.

2. Bring us People We Don’t Have Access to. What various FinTV channels do really well is when they bring us long, thoughtful interviews with the likes of Warren Buffett, WIlliam Ackman, David Einhorn, and others. People we wouldn’t ordinarily have access to. Example: This morning, CNBC had on James Rickard. More of this please.

3. S - L - O - W D - O - W - N

4. Risk: All traders must appreciate the potential downside of trades. So too, must FinTV. Explain stop losses. Understand Risk/Reward. Recognize there are periods when Buy & Hold is a jumbo loser.

5. Lose the Octobox. Fire whoever came up with the Decabox. ‘Nuff said.

6. Separate the Signal from the Noise. Understand that most of the day-to-day action is simply noise. Look at a long term chart, you can barely see 9187 or 9/11. If those major events get lost in the long term trend, what does the intraday jags, kinks and reversals mean? Very little. Recognize that not every data release, slice of news, or rumor is at all significant. Stop treating them as if they were.

7. Fact Check: An awful lot of things on air get stated with authority and confidence. Much of them are little more than junk or pop myths. Why is it that the more dubious a proposition is, the greater the confidence the speaker seems to muster? Consider fact checking as much of the statements that are made on air as possible, and making frequent corrections.

8. Accountability is important: I am astounded at some of the money losing hacks that are various shows again and again. These are the “articulate incompetants” to use Bennett Goodspeed’’s phrase. Why not keep track of the records of guests — and let the viewers know how their past few calls have been. Are they Perma-bulls or bears? Are their stock picks awful? Are they reliable money makers? If not, let us know. (Of course, the better question is, if not, why even have them on?)

9. Bring Back Louis Rukeyser: Not the man, but rather, his style. Wall $treet Week — Rukeyser hosted it from 1970 to 2005 — was plain-spoken, thoughtful and accessible. Quiet, contemplative, discussions, with intelligent market participants, revealing helpful information. The investing public would appreciateagain. something of that sort —

10. Sound FX: What is with all the bizarre sound effects every time a screen changes? Its financial news, not a video game. Kill ‘em.

11. Embed your video (on your own website or YouTube) instead of using WMP. At long last, thank you.

12. Investigative Pieces: David Faber seems to have a monopoly on deep, long thoughtful analyses. Be they on Wal-Mart, the credit crisis, whatever, his long format work is a highlight of CNBC. More of these, please.

13. Most stock picks are losers. That’s normal, but the audience does not realize this. A big part of the challenge is informing the viewer that finding the biog winners is a low probability, high outcome event. As in a baseball, a 350 hitter is a star. Explain this to your audience.

14. Stop the Bull/Bear Debate: This is a vast over-simplification of the market, and often does not serve the audience well. There are nuances and variables that get lost when you reduce everything to black and white.

15. Partisanship: Leave your personal politics at home. Viewers don’t care what most of you think.

16. Respect the Audience: We are adults. Treat us that way.

Great stuff, Barry.

I'd like to add, for the Philippine setup -stop projecting markets as some sort of a "game" similar to horse racing. It is one reason why locals have a poor understanding of the markets.