Why investors underestimate acute risks and what they can do about it.
By Samuel Lee | 05-15-13 | 06:00 AM | Email Article

It's a law of nature that bad things happen more often than not. The possible outcomes that humans consider desirable are a sliver of all possible outcomes. It's why genetic mutations usually hurt or kill offspring born with them, why throwing a wrench into a finely turned engine will almost never make it run better, and why stock prices are more prone to sudden collapses than sudden rises.

Samuel Lee is a strategist covering passive strategies on Morningstar's manager research team and editor of Morningstar ETFInvestor, a monthly investment newsletter. Click here for a free issue. Follow Sam on Twitter: @mstarslee.

Consider human history. For all but a fragment of it, about half of all children died before their fifth birthdays. Of the ones who survived, life was nasty, brutish, and short. According to data compiled by economist Angus Maddison, the total world population grew at an annualized rate indistinguishable from zero over the period from A.D. 1 to A.D. 1820. Per capita output grew even slower, if at all. While the data is necessarily sparse and uncertain, the estimates are reasonable. A growth rate of, say, 0.5% annualized over 1,820 years implies growth by a factor of more than 8,750, an implausibly high number. Ergo, past growth rates were likely lower.

Over the millennia, there were pockets of progress, some lasting for centuries. The ones we know of included the Roman Empire in Europe, the Tang and Song dynasties in China, and the Inca, Aztec, and Maya civilizations in the Americas. However, these civilizations, for the most part, did not set growth on a permanently higher trajectory. They usually ended in the sacking of great cities and the burning of books. Humanity didn't convincingly break out of this cycle until a couple of centuries ago. Against the yardstick of written history, this era of growth has been short--only a handful of lifetimes.

Even narrowing our scope to the 20th century, our current prosperity looks surprisingly fragile and uneven, the outcome of a series of contingent events that plausibly could have led to far worse outcomes. The future of democratic capitalism was up for grabs during the Great Depression. World War I and World War II devastated Europe twice over and Asia once. The Cold War risked nuclear apocalypse. If we could reroll the 20th century many times, creating slightly different starting conditions each time, some outcomes surely would have led to regress (the probability of such outcomes is unknowable, of course). If you were born to a random family in the first half of the 20th century, chances are you would have experienced privation or total war. Even today, the majority of humanity lives in poverty by the rich world's standards. Bad things happen more often than not.

I don't write to frighten you but to let you know how good you've had it these past few decades. They were the most peaceful, stable, prosperous period humanity has ever experienced. Unsurprisingly, I've found that many investors have what I believe are implausibly optimistic beliefs about the prospects of economic and societal continuity. For example, I've asked several people, "What is the probability you assign to the U.S. government collapsing or disappearing over the next 100 years?" Responses typically expressed the value as "less than 0.0001%." While patriotic, the estimate implies that if we could reroll the next century as many times as possible with slightly different starting conditions, the average number of years to failure would be 100 million (100 years/0.0001%).

A sound principle of forecasting uses historical data to set a baseline probability and moves away from that baseline depending on the strength of new information. History suggests the average major civilization experiences economic continuity for a few centuries, if that. However, the advent of nuclear weapons has ruled out conventional warfare as a way to wipe out a major civilization. In addition, there haven't been many democratic, capitalist societies, so we're left to make educated guesses. Given how close the U.S. has come to disintegrating over the past couple of centuries, an average life span of 5,000 years seems reasonable. It implies a per-century failure rate of 2%--still uncomfortably high, and far higher than the probability a typical investor would provide without engaging the data.

I believe human nature makes it difficult to accept this argument. Deep down in our bones, we are an overconfident, optimistic bunch. We unjustifiably project the recent past to the far future, and we privilege emotionally vivid experiences above other forms of knowledge. It's why we're so often surprised by the way the future transpires--the future doesn't draw its outcomes from the impoverished imagination of the conventional mind. It's also why so many people find it hard to learn from history.

Learning From History and the Markets Is Hard
We can see how human nature makes learning from the markets an iffy proposition for the typical investor by contrasting it with a typical learning process. Consider learning to drive. (I confess I don't know how to.) If your car swerves, a course correction is a turn of the steering wheel. If your car is moving too slowly, speeding up is a press of the gas pedal. The right thing to do in each case is crystal clear. Moreover, the feedback is near-instantaneous and frequent. Unsurprisingly, almost anyone can learn how to drive.

For the majority of tasks, people figure out what works and what doesn't, and they do it well enough to get by. However, their rate of learning is constrained by two factors:

1) The efficiency with which people integrate new information.

2) The rate at which feedback arrives, and its quality.

In most cases, people are efficient learners because they're dealing with simple cause-and-effect relationships, and the feedback they receive is both high-quality and frequent. It plays to the brain's inherent strengths.

Investing, on the other hand, is an unnatural activity that demands a cold, probabilistic mindset that few people can master. As a result, most investors do not efficiently integrate information from the markets because the brain is hyperactively spinning coherent stories out of all the data presented to it, stories that largely happen to be false. Most investors don't realize this, and believe that they are "learning" from the markets by observing patterns and constructing stories.

The evidence is everywhere, if you know where to look. It's easy to find a lot of very persuasive-sounding people talking about the markets and why they're doing what they're doing. It's not so easy to find people who can actually predict what the market will do. What this tells me is that many investors are fooling themselves or learning the wrong things.

The most corrosive of these "wrong things" is the belief that past performance strongly indicates future performance. Investors make the seemingly logical inference that if they want high returns, they should buy things with high returns and avoid things with low returns. In the short run, their beliefs are validated, as rising prices attract return-chasing investors, causing prices to rise even further, and so on. However, eventually their collective behavior pushes prices far beyond fair value, leading to reversal. The correct inference is that while returns are self-fulfilling over the short run, in the long run, extreme price movements up or down tend to reverse themselves.

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