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.

The Pleasure of Partial Vindication, Personal Tips

``Reading is a means of thinking with another person’s mind; it forces you to stretch your own.” - Charles Scribner Jr.

It feels soooo good to be vindicated, even if it is just a partial vindication, especially coming from an onslaught of skepticism. Partial because I can be temporarily right today but risks from an adversarial outcome especially from a shock may overwhelm us again. But so far, so good.

Yes, the most difficult part from a contrarian perspective is to be unpopular. Since our insights deal with independent systemic based analysis than from outright simplification of the causality variables as espoused by almost a majority in our field, our ideas tend to be ignored. People like to be told stories that are easy to comprehend or easy to visualize or tales that attached to present prominent events or if we quote Bill Bonner of the Agora Publishing fame, ``People come to believe what they must believe when they must believe it.”

Since we don’t sell anything to anybody, my goal has always been to be as objective as possible, even if it comes at a cost of non-patronage. Sometimes in soliciting our advice, some may have probably felt offended when we dealt them the glacial realities from the functionalities of marketplace, but overtime I hope they come to realize that what we told was for their own good. Sorry it is not my role to confirm your biases.

As a student of the market we try to learn from the deeds of those whom have succeeded in the field and so attempted to assimilate the same traits tailored in accordance to one’s personality.

And as an example of such traits, we learned that independent thinking is crucial to long term investment success, so in adherence to Mr. Warren Buffett’s words of wisdom, ``You can't do well in investments unless you think independently. And the truth is, you're neither right nor wrong because people agree with you. You're right because your facts and your reasoning are right. In the end, that's all that counts. And there wasn't any question about the facts or reasoning being correct.”

Nevertheless, we don’t pretend to know everything, nor do we pretend to pinpoint the exactitudes of peaks and troughs of markets. In the years of learning, it has been a painful realization that trying to engage in market timing is almost like playing a game of vanity. Yes, at times, it comes with accompanying thrills alright; insider treats, forum whispers, support-resistance trade and gossip mongering does add up to the adrenalin. And when the tide turns in our favor we feel infallible or overconfident, never realizing that the rising tide allowed us to benefit than from what we assumed as our inherent “skills”.

But once the tide has turned against us, the pain of losses is almost always greater than the short term successes. We tend to get consumed by regrets, and worst, pass the blame on others instead of admitting and learning from our mistakes.

Besides, in contrast to the simplistic notion that financial market investments is a no-risk, no-failure model is likewise delusional. Some people think that success in the marketplace requires a magic wand. Some people think that the function of analyst is to be a soothsayer or astrologer. This is a no-no or a disconnect from reality.

Exposure in the capital markets always entail risk taking. The truth is we can’t grow trees from the sky. Maybe if you are in the government, but not in the markets. Since we can’t exactly predict tomorrow, we will have to learn how to face the hard facts and correspondingly deal with the risks with appropriate action when conditions so require.

Thus, from the understanding of the cyclicality of the markets we can use our best guessestimates on the whereabouts of the phases of the cycle. Since we lack the market sophistication tools for hedging, from here we can work with what we have by balancing our portfolio in accordance to the risk environment and to one’s risk profile. In short, we get ourselves exposed to the market in the degree where we can have a good night sleep regardless of the daily fluctuations.

Remember, we can’t get married to the market too. We will have to understand that market returns always reflect a tradeoff between risk and returns. The mainstream or my counterparts rarely touches on these aspects. That’s why horse racing sells, you are trained to look at gains and ignore losses. In other words, we learned that investment success has the golden rule-to know your risk. So before putting money in the any endeavor always know how much risk you can afford to take and position accordingly.

We will have to always keep ourselves open to the diversity in opinion or perspectives since it is one way to extract or collapse built in complacencies or biases. Since the market is a channel of exchange thus it is always about diversity-that’s how transactions get consummated. Buyers need sellers in as much as sellers need buyers. That’s the beauty of the market, satisfaction is usually attained by virtue of exchanges.

Finally, understanding the thought process is also another very important factor for us. That is why it has been an obsession for us to study the behavioral framework in terms of finance or economics. From Bernard Baruch (1870-1965), Financer, Speculator Statesman and Presidential Adviser, ``“Only as you do know yourself can your brain serve you as a sharp and efficient tool. Know your own failings, passions and prejudices so you can separate them from what you see.”