Posted by Robert on July 5, 2010
It sometimes seems as though we aren’t meant to invest. Investing should be easy and can be summed up in two phrases: buy low, sell high. But there are two related problems that prevent us from following this simple strategy. The first is that we can’t know future outcomes. The second is that, because the future remains uncertain, our reflexes cause us to act in ways that run counter to investment success. When markets are falling, we want to sell and when markets are rising, we want to buy.
Two functions of our brain that relate to investing and trading are the tendency to identify patterns and to extrapolate. This heuristic is normal and is one way that our brain reduces and makes sense of the world around us. In many cases, this is helpful. In nature, we can find examples of patterns that help us plan ahead. We know the sun will rise tomorrow as every day it rises in the east and sets in the west. Because it has happened every day of our lives, we know it will happen again tomorrow. The seasons always arrive in the same order: spring, summer, fall, winter. Because we know what season to expect, we can have farms, plan vacations and buy appropriate clothing. Even the acts of counting and reading are based on recognizing patterns and extrapolating missing information.
Patterns are not always obvious and extrapolation can deceive us, especially when data is limited. Some things undergo a fundamental change over time. As an example, a tadpole observed daily will continue to grow larger. However, at some point, it will turn into a frog, something that couldn’t have been guessed by watching it over the first two weeks. Other things change based on their location. A chameleon sitting on a leaf will always appear green, but once it moves onto a branch or a rock, it appears brown or grey. The new appearance could not be predicted based on its original colour. Some phenomena are always unpredictable. The weather cannot be predicted with much accuracy more than five days in advance. So even if the last five days (or two weeks, or three months) have been sunny and warm, tomorrow may have rain.
We cannot know the future, but we need to plan ahead. We cope with this need by finding patterns and extrapolating. Sometimes we are successful, other times this only serves to calm our anxiety until we realize our error. We make our decisions as though outcomes were well defined, usually ignoring most risks. This helps us to remain optimistic, which is important in working toward a better future. How does this relate to financial success? In order to have a better financial future, I need to work, earn an income, use my money to consume, reduce debt and save, invest for future income and insure major losses. What are the risks, all the things that could go wrong with my plan? I could be unable to work due to job loss, disability or death; I could spend too much; my debt could become unbearable due to high interest costs; my savings could be stolen; my investments could lose value; my insurance provider could become insolvent; not to mention other disasters such as divorce, drought, war or an economic collapse. This is where extrapolation keeps us stable. I haven’t witnessed a war in my lifetime, I’ve never been divorced, disabled or bankrupt, the interest rate on my debt has never skyrocketed and I haven’t experienced fraud. Because I haven’t experienced any of these disasters, I feel strongly that they are only remote possibilities which I equate to zero in my mind.
In my mind, planning to “earn, save, invest and retire” is functionally equivalent to planning to “earn, save, invest and retire as long as I don’t experience a personal, national or global tragedy.” I already act as though the outcome is certain, even though I realize that the future is uncertain. What is a better way to account for uncertainty? In nature, we find redundancy. I have two hands, not because I can get twice as much work done, but if I were to lose the use of my right hand, my left hand could compensate. I know a woman who was born with no arms, and compensates by using her feet. In my financial plan, I plan to accumulate adequate dividend income to retire. In order to be safe, I want to have more income than I need to survive, in case of unforeseen changes in investment income. As a backup plan, I want to remain employable in case I need to return to work. In this way, I feel that the probability of my family not having enough resources to survive becomes vanishingly remote.
People crave certainty and hate thinking about all the things that could derail their plans. Because we extrapolate our past experiences into the future, we are ill equipped to respond to changes in our environment or our circumstances. In order to be prepared to deal with risk, it makes sense to over-prepare at the same time as having a backup plan. In this way, the risk of ruin is reduced as much as possible. How do you think about risk? How do you prepare for possible problems in your planning?