Prudence amidst risk
Managing for Society
Manila Times, June 18, 2013
I wrote about my stock market worries in another daily which came out online in May 29. I said that “in a business boom, prices rise to frothy levels, and it is a certainty that they will come down at some point”. Although I felt that the corporate performance fundamentals did not support the high levels the stock market had soared to, I had no idea that the values would drop so soon. The market index has since lost 15% in value as short-term foreign placements have rushed out of the country in anticipation of higher returns elsewhere, especially the US. I can only hope that those who went in near the peak used money they can afford to part with for a long time. I’m not sure we should expect values to go up to May levels anytime soon.
What I find worrisome is that, for the past several months, I have been cautioning about the market’s unsustainable level to people who make technical recommendations about these matters and have had little success. In fact, the tendency for some was to recommend putting even more money into the market with the belief that values would rise even more. One investment specialist assured me that the investment banks were on top of the situation and knew what they were doing. Needless to say, this wasn’t reassuring given recent memories of large investment bank collapses. Besides, I told this person, investment banks are not always incentivized to be prudent about other people’s money.
Why do people who should know better tend to make bad decisions in the face of risk? In a word, bias. In his book Thinking, Fast and Slow, the cognitive psychologist and Nobel Prize winner Daniel Kahneman, explained why people tend to be biased towards optimism despite contrary information and possible dangers ahead. He labels this as “What You See Is All There Is” or WYSIATI. When people make decisions, they make judgments mainly on what they already know from the past. They tend to ignore new information about the situation and ignore even more the probable events that may happen in the future.
Some investment analysts and decision-makers looking at the impressive rise in the market since the year opened were probably experiencing the WYSIATI bias. Data on corporate earnings and large short-term inflows of foreign funds were given less weight than the high returns which were already on record. Warnings about the unsupportable market level and an imminent drop seemed an abstract future reality. In short: How can you argue with someone backed by a stock index graph that just goes up and up? As I learned, you can’t. Kahneman says that the brain is simply too biased for recent good news.
What can financial decision-makers do to counter the WYSIATI bias and thereby be more prudent when faced by risk? Kahneman proposes adopting a risk policy over the long-term despite the emotions of the moment or a short-term loss. A possible risk policy is the barbell strategy proposed by Nassim Taleb, author of The Black Swan: The Impact of the Highly Improbable. Taleb suggests to design a two-portion (thus, a barbell) investment plan which has zero probability of ruin and the possibility of upward gain. So, one may put the portion one can’t afford to lose in safe, inflation-protected, certificates of deposit and the rest in higher risk but well-selected equities. The point is to stick to this despite the lure of spectacular returns.