How to make decisions in the face of uncertainty and why deciding to sell stocks should be based on feelings of regret rather than gut feelings about what we think will happen with financial markets and the economy.
In this episode you’ll learn:
- What are the heuristics or rules of thumbs we use to make predictions.
- What is the availability heuristic.
- What is hindsight bias.
- How we make investment decisions based on regret and risk aversion.
- Do economic expansions die of age.
Should you sell your stocks before Trump takes office?
I received several emails recently from listeners of my show who are exceedingly concerned about the incoming Trump Administration and its potential negative impact on the economy and financial markets.
One listener, who is a psychiatrist and worries about the instability of Trump, is considering “pulling out of the stock market as much as possible,” although he acknowledges he can’t predict the future. He writes, “I keep telling myself ‘we will see’ but that probably represents an unconscious bias.”
The other listener has about half of his portfolio in cash and much of the rest in real estate. He writes, “I am smart enough to know that I can’t time the market, but this is a case where my gut is telling me the axe is about to fall and I am extremely uncomfortable.”
Three professors of psychiatry from Harvard Medical School and the University of California recently addressed a letter to President Barack Obama which read, “Professional standards do not permit us to venture a diagnosis for a public figure whom we have not evaluated personally…Nevertheless, his widely reported symptoms of mental instability — including grandiosity, impulsivity, hypersensitivity to slights or criticism, and an apparent inability to distinguish between fantasy and reality — lead us to question his fitness for the immense responsibilities of the office.”
Meanwhile, the U.S. stock market has gained 7% since the presidential election.
Should we reduce our investment risk by selling stocks given the uncertainty regarding the incoming Trump administration or should we stay put?
Michael Lewis in his excellent book the “Undoing Project” in which he profiles Nobel Prize winning psychologists Daniel Khaneman and Amos Tversky writes, “A prediction is a judgment that involves uncertainty.”
Khaneman and Tversky, whose groundbreaking research focused on how humans make decisions, wrote, “In making predictions and judgments under uncertainty, [people] rely on a limited number of heuristics which sometimes yield reasonable judgments and sometimes lead to severe and systematic error.”
Khaneman and Tversky’s research showed individuals assess the likelihood of an event occurring by comparing whatever we are judging to some model in our mind. Are current circumstances representative of the mental model? Do they fit an existing pattern?
We do this subconsciously, and when we find a match we feel in our gut that something is likely to happen or play out in a certain way.
Although this approach comes naturally to us as humans, there are several flaws.
The Availability Heuristic
First, we suffer from what Khaneman and Tversky called the availability heuristic. The mental models we conjure up for comparison are often based on something we recently experienced rather than being more reflective of a broader sample set.
For example, after suffering through the severe bear market and Great Recession of 2008, it was not uncommon in subsequent years for investors and pundits to be convinced in their guts that incoming financial and economic data indicated a recession or bear market was imminent.
Khaneman and Tversky wrote, “Images of the future are shaped by experiences of the past.”
Michael Lewis explains, “The more easily people can call some scenario to mind—the more available it is to them—the more probable they find it to be. Our minds recalculate the odds in light of some recent or memorable experience.”
When we have made up our minds that something is likely to happen it is often difficult to unhinge that determination.
“Once we have adopted a particular hypothesis or interpretation, we grossly exaggerate the likelihood of that hypothesis, and find it difficult to see things any other way,” wrote Khaneman and Tversky.
Of course, sometimes when we conduct mental comparisons our minds don’t find a good match.
“We often decide that an outcome is extremely unlikely or impossible, because we are unable to imagine any chain of events that could cause it to occur. The defect, often, is in our imagination,” wrote Khaneman and Tversky.
At other times, we too readily find mental matches and determine the likelihood of an event when we shouldn’t because current circumstances are unique and/or completely random.
Khaneman and Tversky wrote, “Each occurrence of an economic recession, a successful medical operation or a divorce is essentially unique, and its probability cannot be evaluated by a simple tally of instances.”
Finally, when it comes to decision making we suffer from hindsight bias. Lewis writes, “once something happens, we assign much higher probabilities that it was going to happen, not even remembering the low odds we assigned prior.”
How do these heuristics apply to the foreboding many feel about president-elect Trump?
Trump will be the 44th person to serve as U.S. president. Few of us remember more than eight or nine U.S. presidents in our lifetimes.
Consequently, the sample size in our mental model of world leaders is too small to determine in our gut how good or bad Trump will be as president or what his impact will be on the economy and financial markets.
The reality is Trump is unique and the period of time in which he will lead is unique so we don’t really have a mental model to compare him against. No one knows what Trump will do as president so making investment decisions to buy or sell stocks based on what we think might happen is futile.
Instead, we should make investment decisions based on another criteria that Khaneman and Tversky researched: regret.
How much regret will we feel if markets fall significantly in response to some presidential action and we didn’t make changes to our investment portfolios to reduce risk?
Or how much pain will we experience if we sell our stocks and markets soar in response to some presidential action?
The listeners of my show I described earlier admit they can’t predict the future or time the stock market. Consequently, what they are struggling with is determining the level of regret they are willing to experience and what price they are willing to pay to avoid that regret.
Risk aversion is a fee that people willingly pay to avoid regret: a regret premium is how Lewis describes it.
Determining our risk tolerance is a process of deciding how much of a premium in terms of performance give-up and the associated regret of missing out are we willing to pay in order to avoid the pain of losses.
If you believe a potential 60% loss in stocks would be too painful or disrupt your financial plans, then you should consider lowering your stock exposure, recognizing the stock market could continue to reach new highs after Trump takes office. No one knows.