Release Your Inner Skeptic
As an approach to living, pessimism has a lot to recommend itself. As George Will writes, "the nice part about being a pessimist is that you are constantly being either proven right or pleasantly surprised." Optimism’s not so bad, either. But one without the other can be deadly for your portfolio. more
BFA Media Quotes
Recent media quotes. more
Release Your Inner Skeptic
Take the recent news reports about the price of oil. We're told that rising prices will wreak havoc on the global economy as consumers lose purchasing power and global supply chains grind to a halt. Yet when oil prices drop, suggesting decreased demand, it supposedly portends a global recession. To the pessimist in us, the world looks bleak either way. Oscar Wilde would not be surprised. A pessimist, he wrote, is "one who, when he has the choice of two evils, chooses both."
But our optimistic selves shouldn't gloat too much. They're a sucker for a pretty story, such as this one: over the last twenty-five years, China's economy has grown at a phenomenal 9½ to 10% a year. No country in history has grown this fast over such a sustained period, and at this rate it will be the largest economy in the world in twenty years. For many optimists, when the Chinese stock market suddenly took off in 2006, it was a "no-brainer" that the market would soar, at a minimum, through the Beijing Olympics.
But since last October, the Shanghai Composite is down a spectacular 60%. Moreover, despite an auspicious debut on numerologically favored 08/08/08, the index fell each of the first three days of the Olympics:
With extreme points of view, critical thinking often gets thrown out the window, and our cognitive biases hog the room, chief among them:
As an example of Confirmation Bias, a couple of years ago, a lot of experts pointed to the flattening U.S. government-bond “yield curve” (the relationship between short-term and longer-term Treasury bonds) as evidence that the U.S. was about to enter a recession. But now that the yield curve is back to normal, with longer-term rates higher than shorter ones, the yield-curve is conveniently ignored in recession-watch articles.
Financial experts themselves are often the most guilty of focusing on what they know, rather than exploring what they don't. In fact, this bias looks to be a substantial cause of the recent credit crisis. Risk managers at the banks were focused more on emerging-market debt, since that's where the surprises had happened before (e.g., Russia and Latin America ), rather than on the asset-backed securities such as collateralized debt obligations that no one understood but which the credit-rating agencies had blessed.2
Finally, with each new market disruption – and they come regularly enough that we shouldn't be surprised – investors act as if it's the first time since the Great Depression that things have been thrown off track. Consider these headlines:
They sound much like today's worrisome news. Yet the quotes are from 1974, 1991, and 1998, respectively, as the U.S. made its way through one financial crisis after another.3
How can you avoid the siren call of undue pessimism or naïve optimism, especially when markets are volatile, as now? It helps to be a skeptic when reading news reports about where the economy or markets are going.
When we're skeptical, we routinely ask questions such as "What if they're wrong?" "What didn't they say?" and even "But what could go right?" When we're a skeptic, we remember that what we think at any given moment about the prospects for our long-term investments is neither directly nor inversely proportional to how they'll actually perform.
Most important, we strategically hedge our portfolios by diversifying globally across multiple asset classes. We place part of our bet on bonds and other stable assets because we're skeptical about those risky stocks in any given year. But we keep stocks around because we're skeptical about the long-term inflation-beating properties of bonds.
In other words, as a skeptic, we understand that both our optimistic and pessimistic selves each have something to offer, but only in good measure. After all, as Gil Stern noted, "Both optimists and pessimists contribute to our society. The optimist invents the airplane and the pessimist the parachute."
Recent Media Quotes
BusinessWeek, August 4, 2008
Milo was quoted in Aaron Pressman's article "A Safe Stash For Big Cash" in the August 4th edition of the magazine. The article profiled the Certificate of Deposit Account Registry Service that simplifies purchases of multiple CDs under $100,000 to ensure that all purchases qualify for federal deposit insurance. Unfortunately, as Milo noted, there is a "fatal flaw" with the CDARS network: if the home bank fails, investors' access to CDs at the other banks could be delayed until the FDIC transferred the CDs to a more stable institution – a risk that outweighs purchase convenience. Read the article.
That's it for now. Thank you for reading. Please look for our next newsletter in October.
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