Why do investors sometimes succumb to fraudulent schemes that promise great returns but in hindsight are just too good to be true? Why did so many savvy, sophisticated and well-educated bankers ignore the risks inherent in the mortgage and credit markets? Why were our elected politicians unwilling to appropriately regulate the mortgage and banking industry that appears to have been so greedy? Why did so many individuals accept mortgage terms they could not afford to repay?
As time marches on, economic historians will help us understand the facts and circumstances that have reduced asset values and embroiled the world's banking and credit systems in a crisis not seen since the Great Depression. Hindsight will likely show us the flaws in our assumptions and that many decisions made by investors, bankers, politicians and homeowners were just plain wrong.
This period has been one of the most challenging financial times for all of us. Most of us are less wealthy today than we were a year ago and feel uncertain about our future. Over the last 18 months, it appears that one of the basic principles of investment planning (e.g.,asset allocation) didn't work very well at all. Diversification across a broad spectrum of asset classes did not help reduce volatility since almost all asset classes lost significant value during this bear market. Nevertheless, we should not discard an important strategy because it wasn't successful over a relatively short period of time. But what should clients and financial advisors learn from this crisis and should we make any adjustments to the way we make financial decisions?
How could so many seemingly rational people make so many irrational decisions that were against their own best interests? Traditional economics assumes that people make logical, rational and self-interested decisions. In reality, men and woman do not always make rational decisions and our decision making is far more complicated and inconsistent. Since the 1970's, there has been a sub-field of economics called behavioral economics that attempts to combine psychology and economics in order to better understand human economic decision making.
Was it rational for investors (hedge funds, investment banks, etc.) to buy pools of mortgages from banks that issued mortgages to homeowners that wouldn't be able to repay their mortgage? Why didn't they consider the risk of higher defaults rates and lower home values? Maybe behavioral economics can help explain this financial decision making.
Behavioral economic tendencies may affect our decision making. For example, we have a tendency for "self-serving bias." We tend to attribute successes to internal or personal factors (intelligence, hard-work, etc.), but we attribute failures to factors beyond our control (the economy, a bad boss, etc.). Self-serving bias can lead to overconfidence and arrogance in financial decision making. During a bull market, many investors tend to congratulate themselves on the great stocks or funds they have chosen, but do not have a process or strategy for selling or rebalancing their portfolio. They watch their stocks or funds increase in value during a bull market, but do not want to sell or rebalance the portfolio. When the bull market ends and the bear market begins, these same clients often suffer greater volatility because they are overly concentrated in the stocks or funds they have chosen.
"Anchoring" is the tendency to rely too heavily on one trait or piece of information when making decision making. "Confirmation bias" compounds the problem of anchoring. We tend to look for and treat kindly information that confirms our initial impression or preference. Said another way, we tend to avoid asking questions that challenge our preconceptions. These biases might explain why so many sophisticated and smart bankers and investors did not ask more questions and insist on transparency when it came to investing in sub-prime mortgages.
Not many people predicted the economic crisis that started in late 2007 and even fewer guessed that it would have such an effect on the world economic system. In 2007, Nassim Nicholas Taleb wrote a fascinating book called The Black Swan - The Impact of the Highly Improbable. Prior to the European discovery of Australia, it was accepted as fact in Europe that all swans were white. Since it was not part of the European experience, it came as a shock that swans were actually not all white. Taleb defines a "Black Swan" as an event with the following three attributes:
“… it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility. Second, it carries an extreme impact. Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable….
Black Swan logic makes what you don’t know far more relevant than what you do know. Consider that many Black Swans can be caused and exacerbated by their being unexpected.”
Examples of Black Swan events include the terrorist events of September 11, 2001, the market crash of 1987, the demise of the Soviet Bloc, the spread of the internet, the devastation of Hurricane Katrina, the sub-prime crisis and subsequent recession and bear market of 2007 through today. Black Swan events remind us that we can not rely on the "facts" as we know them to predict the future. Unfortunately, people tend to excessively focus on what they know and don't consider the unknown. The human brain tends to string together facts, make order out of chaos and then reach conclusions. Next time we hear an "expert" predicting the future, please remember that unpredicted "outlier" events often occur and can change the course of history.
For the Raskin Planning Group, recent Black Swan events have crystalized some of our financial planning core beliefs. During the planning process, we use assumptions that help us project what might happen in the future. Our assumptions must include "outlier" events, like terrible bear markets, that can dramatically change our client's planning. We must also consider other Black Swans, like unemployment or illness, that can affect any family. On an ongoing basis our assumptions need to be tested, remodeled and challenged to avoid anchoring and confirmation and self-serving bias.
People do have a tendency to become overconfident, greedy and irrational, but behavioral economics and Taleb's The Black Swan don't completely explain investor fraud, the banking crisis, recession or bear market. Our belief that comprehensive financialplanning can make the decision-making process rational and thoughtful has been reinforced. Planning does not attempt to predict the future, but it helps us prepare and lessen the impact of circumstances beyond our control. It is never-ending, challenging work that will hopefully lead to a satisfying and inspiring future.
While the recession, fraud and market declines have taken their emotional toll, it is only natural to have diminished confidence in the markets. Nevertheless, we have confidence that a personal financial recovery plan will help you weather the storm.
This letter represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This letter may include forward looking statements that are subject to certain risks and uncertainties. Actual results, performance or achievements may differ materially from those expressed or implied in the forward-looking statements. Risks or uncertainties that could cause or contribute to such material differences include, but are not limited to, general economic conditions, interest rate environment, competitive conditions in the financial services industry, changes in law, governmental policies and regulation, and rapidly changing technology affecting financial services. Market conditions are subject to change, and past performance is not a guarantee of future results. This letter does not constitute a recommendation to buy or sell any specific security.
By Peter A. Raskin