Quarterly Commentary

We are wasting our time listening to or reading commentary from so-called “Wall Street Experts.” Sad but true, rats are smarter than us and we should spend more time learning from them, rather than learning from the “brilliant experts” trotted out by the media.
The 1999 Nobel Prize for economics was awarded to Professors Vernon Smith and Daniel Kahneman for their groundbreaking work on “Behavioral Finance.” In short, they showed we don’t make decisions about our money based on information, we make decisions based on the order that information is presented to us.
For seven consecutive years they asked the incoming freshman students at Princeton University and the University of Chicago two questions:
The first question asked to Group “A” was, “Are you happy?” The second question was, “How many dates have you gone on in the last 12 months?” With that group they found almost no correlation between dating and happiness.
The first question asked to group “B” was, “How many dates have you gone on in the last 12 months?” The second question asked to that group was, “Are you happy?” Kahneman and Smith found the correlation between happiness and dating in this group was nearly 90%.
If you didn’t catch the subtle difference, Kahneman and Smith switched the order of the questions. When someone wasn’t first thinking about how much they dated, dating wasn’t a factor in their happiness. But, when they were led to think about dating first, dating suddenly became the paramount variable for happiness. This showed that knowledge and outcomes are not the dominant decision-making variable for humans. The dominant variable is the order in which we receive that knowledge.
When the order of one’s decision making is first to watch a “financial expert” on TV telling you some-thing positive or negative and then make an investment decision, we tend to make poor decisions. The pragmatist in me has always found it better to define my investment process first, and then listen to “experts” for a second opinion.
What does this have to do with you as my client? A lot! As I recall, in 1999 the average return I generated for my clients was north of 50%. Clients first looked at those results, and then called me asking to take a more aggressive investment posture, just as we were at the beginning of a multiple year decline. The weeks following September 11, 2001 saw a col-lapse in stock prices, which resulted in my being inundated with calls to move to low yielding, safe/risk free investments. In other words, rather than structuring their portfolio based on their goals and particular circumstances, clients first looked at re-turns and secondly made their investment decision.
This brings us to another experiment conducted by Kahneman and Smith. I don’t remember some of the experiment’s specific details, but I do remember the gist of it. Their hypothesis for the second experiment was essentially that human brains hate chaos and so create the illusion of order where there is none—or more simply, humans see patterns where no patterns exist. Here is what the professors did:
Humans See Patterns Where No Patterns Exist
One at a time they placed 100 humans in a room. At the opposite side was a red light and a white light. The lights blinked 1,000 times, and each human was asked to predict which color light would light up next. After approximately 50 blinks, each human thought they uncovered a pattern and began guessing. What the humans didn’t know was that a computer was programmed to blink the lights red 80% of the time and white 20% of the time, but in a totally random sequence. In other words, there was no pattern. Each time a human picked red they had an 80% chance of being right, and each time they picked white they had a 20% chance of being right. What is interesting is that humans picked red 80% of the time and white 20%, so while human brains incorrectly saw a pattern, somehow humans got the weighting correct. The result was that humans were right in their prediction 68% of the time. Here is how that math worked:
Blinked Red 800 x 80% probability = 640 correct predictions
Blinked White 200 x 20% probability = 40 correct predictions
Total correct predictions out of 1,000 680 equals 68% correct
The same experiment was performed with a group of rats, but with some minor changes. If the rats predicted correctly they were given a reward (food or something, I can’t recall), but if they chose incorrectly they received an electric shock (don’t get mad at me animal rights people, I’m just the messenger). Interestingly enough, just as humans made a decision to begin forecasting after 50 blinks, after 50 blinks the rats also made a decision. But their decision was not to forecast which light would blink. Rather, they just chose red every time and thus were right 80% of the time. By see-ing patterns where no patterns exist, humans reduce their probability of being right. Whereas rats, not concerned about chaos just chose the option that was going to be right more often, and subsequently maximized their outcome (note, I don’t think they used “colored lights” for the rats).
Kahneman and Smith chose 80% because historically the stock market goes up 80% of the days and goes down 20% of the days. When we gather information to make a decision to buy or sell stocks, we need to be aware of the sequence in which we gathered that information. We need to remember that every time we make a decision to sell we are making a decision that has an 80% probability of being wrong (selling because we need money is a different decision). Certainly there are times and reasons when I will be a bit more aggressive and times I will be a bit more conservative. This is something we in the financial industry call “times to play hard and times to play soft.” But wholesale selling or buying is putting client assets at greater risk, not less risk (as taught to us by the rats).
Making major investment alterations after a year like 2022 is very risky. It’s easy to repeat the discouragement experienced by the college students who we referenced at the beginning of this commentary. We say to ourselves, “Wow, 2022 hurt, so I need to be a more conservative investor and sell.” This is the same as when a year ago clients were ask-ing me if we should be more aggressive going into 2022, because 2021 was such good year.
Markets go down much faster than they go up. Depending on which index you want to reference, in 2022 those market declines were in the 20% to 30% range. However, remember that according to Kahneman and Smith, markets go up four times longer than they go down. I believe after more than a year of market declines, we are much closer to the end of this bear market than we are to the beginning. In fact in my last commentary, I said I believe September was the bot-tom. Therefore, I have begun to start the process of “playing hard.” But not so much as to give those rats a big ad-vantage.
Dr. Joe Monaco
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