By Hannah Busick, CFA, Vice President, Investment Manager, and
Amir Mossanen, Managing Director, Wealth Advisor
We’ve all seen that part in the movie where the weary desert wanderer has been walking for hours and is dying of thirst. Then he happens upon a vast body of water on the horizon. He runs towards the water, it grows closer and closer, until he springs himself into the air only to land back down in the sand and no water in sight. You might think the traveler was hallucinating, but rather it was a mirage, a naturally occurring optical illusion. Illusions and mirages don’t only occur in the desert, but they also appear in times of extreme stress and enhance our cognitive biases. With the heightened level of uncertainty created by the coronavirus, those biases cause us to gravitate towards believing in something unproven if it provides hope that will carry us through to ‘the other side.’ While we would hate to be the ones to take hope away from others, misplaced beliefs are dangerous, not only to individuals but to society as a whole and our survival. To the extent possible, we would like to make you aware of potential mirages to allow for more informed decisions.
Mirage No.1 – Fortune Telling (overconfidence bias)
There’s evidence mankind has been in search of fortune tellers as far back as 4,000 years BC. While few of us would admit to placing any great value to those who portray themselves as fortune tellers, we innately have a strong desire to feel as though we have some kind of control. We may not refer to our sources as fortune tellers, but we use overconfidence bias, which is the illusion of a person having superior information or ability to interpret and predict the future. I’m sure many of you have heard from friends or others that it was the time to get out of the market, and then because they proved to have been right, they have now earned themselves the status of being some kind of ‘savant.’ During the great recession, one such example was John Paulson who was able to short the housing market, and that elevated him to celebrity status. Before long, investors were clamoring to get an allocation to Paulson & CO. funds with the belief he had an exception ability to predict the future and hit home runs. Unfortunately, what followed was disappointing returns. This doesn’t mean there aren’t exceptionally talented people who are able to produce exceptional results. But they do this by becoming experts at managing risk and assess probabilities as opposed to pretending they can predict the future. In the absence of information, there’s nothing wrong with making educated guesses, and often that’s the best we can do. It becomes dangerous, however, when we pretend that guesses are facts.
Mirage No.2 – Rain Dancing (confirmation bias)
Rain dancing existed as a practice for hundreds of years and was practiced all over the world. Today the practice has nearly disappeared as humans evolved and learned that there’s no correlation between dancing and atmospheric conditions. One reason why it survived for so long was because of confirmation bias, which seeks data points to support beliefs while discounting contradictory facts. So when the Pueblos performed their rain dance, and it would subsequently rain, it acted as evidence that it worked. On the other hand, if they danced and there was no precipitation, then they figured they must have done something wrong to upset the gods. They would not question the belief, but instead create an alternative explanation. Confirmation bias isn’t specific to societies of years ago; rather, it’s all around us in modern society as well. For example, many people believe their home is their best investment. However, if one were to compare the Case-Shiller housing price index to that of the S&P 500 one would see that stocks have done much better. Thanks to confirmation bias, people will ignore this evidence and point to the absolute increase in their home value, or its outperformance verses cash. Everyone who was hesitant to invest in general, is now giving themselves a good pat on the back as the most recent history has confirmed the fact that they should not trust the stock market. They disregard the fact that for roughly 11 years, we had not seen a bear market.
Mirage No.3 – Pattern Observation (recency bias)
Despite all the sophistication in artificial intelligence, there are many aspects of pattern recognition humans understand that supercomputers do not. The amount of computing power it takes to distinguish a dog from a hyena is great, and yet, small children would be able to do it with relative ease. However, our overactive pattern recognition system gives us a lot of false positives and overestimates our own ability. On March 20, many people believed it was evident the stock market would continue to plummet. They made claims like ‘it is clear’, or ‘it is obvious’ because they believed what was most recent and impactful to our memory was going to continue. However, what followed was the greatest bounce back we have witnessed in 80 years. Recency bias is one reason why bubbles form, examples being the housing crisis in ‘07, the 2000 tech bubble, or the tulip craze in 1637. One area of concern we’re observing are attitudes towards bonds. As interest rates have plummeted to the lowest levels in history, bonds have experienced uncharacteristic appreciation as shown by last year being the best year for them in 18 years. While current yields are at historical lows, the expectations of total returns have not followed and recency bias is leading many to believe they will continue to provide returns similar to years prior. Perhaps this is because of recency bias or confirmation bias. Perhaps it’s because of our need and desire to believe in something, even if it’s not true. Most likely it’s the combination of all the above. We will gladly acknowledge there’s a role for quality fixed income in most portfolios to reduce volatility but to believe bonds will continue to have returns similar to the past is an extremely unlikely scenario.
So, what good is an advisor if he or she cannot predict the future, cannot spot patterns, and cannot give us false hope?
Perhaps one of the greatest values of an advisor is to protect us against all the biases we have that can cause us harm. Perhaps it’s to get us to do what’s in our best interest even when we don’t feel like it. Perhaps it’s to bring discipline and process to our decision-making in an otherwise chaotic world. Perhaps it’s to help us plan for a future that is distinct from our past. Perhaps the greatest advisors are the ones who are able to do all of the above with the utmost of personal care, sensitivity, empathy, and professionalism while not leading you to mirages that ultimately end in disappointment.