Don’t look now
We live in a world where rapid developments in technology have altered almost every aspect of our personal and professional lives. It can be a wonderful thing – bringing us closer, making us more effective and providing an almost endless supply of entertainment. In the horrific state we currently find ourselves, there may finally even be some broad social utility in the cute kitten videos that pervade the internet.
But as we all know, technology also has a dark side. Beyond some of the obviously bad things, many are inadvertent flipsides of the positives. Let’s take rapid access to news. Having access to bad news quickly can sometimes be good. For example, many of us have sighed with relief as real-time traffic data has moved us off a motorway before we get stuck in gridlock.
However, watching non-stop rolling coverage of disasters such as Coronavirus, seamlessly, across all our devices, provides us with very little actionable information, but has the potential to skew our perspectives and impact our emotional equilibrium. And now is a time that everyone across the investment decision-making chain sorely needs to be calm and clear-headed when making important choices.
The double-edged sword of timely data
We now have second-by-second market data on our phones. Many institutional investors and individuals can now track the aggregate performance of their assets and liabilities daily. In the current environment, it’s entirely natural to feel drawn to frequently checking our portfolios. Whilst this level of accessibility has some benefits, it brings its own set of problems.
These were highlighted nearly twenty years ago by Nassim Taleb in ‘Fooled by Randomness’. For me, this was a ‘worldquake’ book – as a non-mathematician, it made me see and understand the world differently. It’s full of interesting thought experiments – the one below is incredibly relevant today.
Imagine an investor…
Taleb asks us to imagine an investor who can generate an annual return of 15% with 10% volatility (or uncertainty) each year. That number perhaps reflects early noughties optimism, but in reality, it’s the ratio of return to risk that matters. That ratio is exceptional – if you could find that, you’d be very happy indeed. However, even that exceptional investor will not always generate a positive return. If we assume a normal distribution of returns, over an annual period, we’d expect to see a 93% probability of making money in any given year.
The question for you is, over the shorter time periods that are blanked out, what is the probability of the exceptional investor making money? Using a tool called a Monte Carlo simulator, it’s possible to robustly answer that question, which Taleb does.
Now when we look at the probability of making money over a second, it’s essentially a coin toss. But what about the other periods? What does your gut tell you about the chances of making money over a month? Make a guess before looking at the data.
The key point is that over shorter periods, the data will be noisy. Even if your manager is exceptional, it may not look like it. And when we look at data that shows gains or losses, it will provoke an emotional response.
Our emotional reactions to gains and losses
Researchers have spent considerable time thinking about how we assess losses and gains. Loss aversion theories suggest that most of us react to them differently. This is neatly summarised in the graph below:
A loss of £10 will result in a more negative emotional response than the comparable positive emotions caused by a gain of £10. When we frequently look at short-term data, whether that’s markets or our portfolios, we risk a lot of pain from short-term volatility that in a longer-term investment context could be random noise. This has two important impacts:
Emotional burn out: Just like watching Coronavirus rolling news, we risk burning ourselves out emotionally. This will not help us make well-reasoned choices over the short-term.
Future risk taking: Leading behavioural researchers, such as Richard Thaler, have researched the impact of losses and desire to take risk in the future. Thaler notes, ‘The more often people look at their portfolios, the less willing they will be to take on risk, because if you look more often, you will see more losses.’
What can we do about it?
We don’t want or need to roll back the clock on technology. We just need to be aware of its risks and manage them effectively:
- Education. If you’re on a board, make sure everyone is aware of this issue. Try getting your colleagues to estimate the probability of an exceptional investor making money over different time periods – I suspect most will be surprised at how much noise there is in the data.
- Is the data ‘actionable’? Data is at the heart of many investment decisions. The key question is whether the data that you are looking at will help you make a good choice. Watching the minute-by-minute fluctuations between red and green on a market price feed can be hypnotic. But can or will you actually do anything with the information? If not, looking at it regularly is likely to lead to emotional fatigue that will cloud your decision-making. Turn it off. To be clear, I’m not advocating a ‘head in the sand’ mentality. I’m suggesting that it’s important to understand what the relevant metrics are for your situation and to monitor them at appropriate time intervals.
- Let your advisers do the heavy lifting. A good adviser should be monitoring all the important metrics on your behalf and ensuring that you are being kept abreast of what’s relevant. If you feel nervous about what’s happening at the moment, ask them to explain what they’re doing for you. You’ll hopefully be reassured about how much is going on behind the scenes. Once you understand that, you may feel that you can turn your attention to big-picture strategic issues.
A final thought from Taleb
Now best known for his writing, Taleb was first and foremost an investor who sought to make money from the behavioural mistakes of others. In the context of technology’s impact, he made the following point back in 2001:
‘When I see an investor monitoring his portfolio with live prices on his cellular telephone or his PalmPilot, I smile and smile.’
In 2020, Taleb will probably be the only person walking around New York with a beatific grin on his face. But when Taleb is smiling at our behaviour, we should probably stop doing it. He would wholeheartedly endorse us switching from checking our portfolios to checking out the soft, distracting and comforting world of kittens.
As always, both the science and practice of real-life decision-making is more complex than a blog post allows. If you’re a pension fund trustee or other institutional investor and would like more information, feel free to get in touch.
If you missed them, you can view posts #1 and #2 here:
Coronavirus: Beat the Behavioural Gremlins #1 – Gains and Losses
Coronavirus: Beat the Behavioural Gremlins #2 – Managing the Truman problem
