Earlier this year, I was gazing out my window on a calm, drizzling morning, when I was startled by a loud cracking sound. I looked up to see a mature tree tipping and dropping towards the ground, ending up crashing just short of our house...
Earlier this year, I was gazing out my window on a calm, drizzling morning, when I was startled by a loud cracking sound. I looked up to see a mature tree tipping and dropping towards the ground, ending up crashing just short of our house. As I stared, a bit in shock, at the now prone expanse of leaves, I thought of an episode in Jared Diamond’s recent book, The World Until Yesterday.
Diamond recounts one of his first trips to New Guinea. His choice for camp was an idyllic setting beneath a rugged old tree with water nearby. However, when it came time to bed down his indigenous guides refused to sleep at his campsite under the old tree, which although large, straight, and sturdy, had recently died. Diamond recalls thinking: “Their fears were absurdly exaggerated and verged on paranoia.” Diamond slept under the tree, his guides out in the open.
Over the ensuing weeks, Diamond realised that each day he was in the New Guinean wilderness, he did, in fact, hear a tree fall somewhere in the forest. While the chances of any one of these trees hitting a person was small, the cumulative, lifetime risk of death or maiming by falling trees was substantial, and a well-established tragedy for the natives who lived every day of their lives in the forest. Diamond soon adopted the native ways when it came to avoiding large, dead trees.
Diamond’s lesson and the native’s behaviour strike me as a rich example of the way we address risk in our own lives, particularly as investors. Sometimes we are like Diamond, blithely unaware of the real risk hovering over our heads, and sometimes we’re like the natives, hardened to our experiences. But sometimes the instincts that serve humans well in the forest may prove to be the very impulses that lead us astray when it comes to managing the complexities of market decisions.
In a YouTube video, Microsoft founder Bill Gates is seen on a tour of Africa with best-selling young-adult author John Green, whose The Fault in Our Stars became one of 2014’s most successful movies. They’re sitting on a bench in Ethiopia and Gates is calmly explaining why a visibly stressed Green should not be frightened by the prospect of his first, impending helicopter ride.
He calmly explains to Green that the accidents per mile in well-maintained helicopters are extremely low, but does admit: “Its interesting how things we worry about are pretty different than the things that statistically you should worry about.” Perhaps these comments were soothing—Green took the ride.
The key point that Gates makes is the way our attention towards risk is often misdirected. When people estimate the probability of something bad happening, they consistently rate the odds for everyone else worse than the odds that it will occur to them.
One of the ways that we rationalise this optimism is by the illusion of control. Drivers underestimate their risks in a car while airline passengers overestimate the risk of flying because of the control factor.
Research has shown that lottery players are willing to pay more for the privilege of choosing their numbers rather than having them randomly generated, which is clearly an irrational impulse.
While optimism can be a wonderful thing, it can be trouble for an investor who miscalculates the actual risks of an investment or strategy.
In a famous experiment, subjects were set in front of a monitor that showed a completely random wave pattern and told, falsely, that a controller could influence the pattern. In fact, the controller wasn’t even hooked up to anything. Nevertheless, after a period of useless clicking a high percentage of subjects were convinced they were getting better at controlling the random wave. For an investor, this can mean putting too much emphasis on a recent trend that may turn out to be short lived. Or it could result in misidentifying the reasons for previous success, which could be no more than random chance.
In an example of what behavioural economists call confirmation bias, people pay more attention to automobile adverts for the brand they just purchased than while they were shopping. This reflects our ingrained tendency to seek information, which confirms actions or beliefs and in turn, tends to build confidence in those beliefs or decisions as evidence accumulates.
Worse yet, research shows that the more evidence that is gathered, the more confident the resulting decision, even when there is demonstrable lack of correlation between the amount of evidence and accuracy. In other words, if an investor watches four talking heads on TV touting the same speculative stock, he or she will exhibit quite a bit more confidence in making that investment, even if the chances of success are no better than listening to just one of them, or flipping a coin, for that matter.
In another experiment individuals were asked questions with obvious answers. The twist was that they were in a group of experiment collaborators who all answered the question purposely incorrectly. Three out of four people could not resist the urge to go with the pack. In another psychological experiment, subjects were asked to guess the weight of a person by looking at a photograph. The subjects were given a panel of ‘experts’ (actually confederates) to help with the answer. The expert who was loudest and most confident proved to be the champion at exerting influence, even long after it was demonstrated that other panellists were more accurate and reliable.
It can be tough to buck the consensus, whether it be from colleagues, talking heads on TV or the results of a survey. The excess influence of the overly confident is another hazard. We know of this danger in investment bubbles, where there is no shortage of a consensus and always plenty of loud boosters. Or more accurately, we know it to be so, probably painfully, after the bubble bursts.
Investors should learn from these examples that instincts and ‘gut calls’ are often wrong for reasons that can be demonstrated. In order to avoid the common behavioural, psychological and innate forces that create misperceptions of risk, individual investors need to be aware of the many impulses that can result in bad decisions. At Madison Scottsdale, we have a long-standing process for our buying and selling disciplines, and we find that enforcing these standards helps moderate the emotions that can colour decisions.
We actively address the subject of possible biases in our decisions. We recognise that avoiding the common pitfalls requires an ongoing openness to evidence that contradicts an established opinion. It requires the willingness to be a contrarian to both consensus opinion as well as one’s own optimistic instincts. As Warren Buffett puts it, a successful investment manager has to have “the temperament to control the urges that get other people into trouble”. Behavioural economics has been a tremendous boon in helping us understand and potentially circumvent these urges.
That is the $64,000 dollar question, or perhaps we should be speaking in terms trillions when one considers the total global value of stimulus by the Federal Reserve, the European Central Bank, the Bank of China, and the Bank of Japan. For the moment, let’s just think domestically.
Interest rates
While the fluctuation of interest rates may seem far afield from everyday life for many people except when financing the purchase of a home, the effects on insurance companies are substantial and ever-present. When rates rise, the impact on insurers is likely to be much more substantial and at the forefront of management’s mind.
Shifting rates have a direct and predictable effect on the value of bonds. When rates drop, higher-yielding, existing bonds look more attractive than the newly issued bonds, and their value increases. But when rates rise, bonds are issued at higher interest rates than existing bonds, which makes lower-yielding bonds less attractive in comparison and results in their values declining.
Interest rate movements do not affect all bonds alike however. In general, the longer the bond (the further away the date of the bond’s maturity), the more the bond is likely to move in response to interest rates.
At Madison Scottsdale, we practice active duration management for the majority of our clients. What this means is rather than stick with a predetermined mix of bonds likely tied to besting a benchmark, we will shift towards shorter maturity bonds when it appears the risk of rising rates is high. Conversely, we will shift to longer bonds when the market appears to be entering a period of falling rates.
In the US, the Federal Reserve is the country’s central banking system and has enormous influence over the state of interest rates. The Federal Reserve is charged with two main objectives: maximum employment and stable prices (control of inflation). Since the financial crisis of 2008 and 2009, the Federal Reserve has been doing all it can to stimulate the economy to improve employment. The Federal Reserve’s primary tool is the Federal Fund Rate, a short-term interest rate for inter-bank lending. This rate, in turn, influences the rates of mortgages and the yields of certificates of deposits and money markets.
By keeping this rate close to zero since late 2008, the Federal Reserve has been using the full power of the rate for economic stimulus. For the past six years we’ve been living with the lowest fed funds rate in US history.
The Federal Reserve also began massive quantitative easing (QE) programmes in December of 2008. An article in The Economist on 9 March 2014, entitled ‘What is quantitative easing?’, effectively summed up the practice by saying: “Central banks create money by buying securities, such as government bonds, from banks, with electronic cash that did not exist before.” By October of 2014, the Federal Reserve had had purchased more than $3.5 trillion in bonds, or roughly about $11 million for every single person in the US. Personally, we wish they had simply written us a cheque for our share.
Now the rest of the world is doing the same thing. Everyone is ‘printing money’ in an attempt to stimulate their economies, devalue their currencies and increase their prospects for exports. Well, not Greece, but that is another story, entirely.
Does quantitative easing work? There is no universal agreement on that point. Again, according to the article: “Studies suggest that [quantitative easing] did raise economic activity a bit. But, some worry that the flood of cash has encouraged reckless financial behaviour and directed a fire hose of money to emerging economies that cannot manage the cash. Others fear that when central banks sell the assets they have accumulated, interest rates will soar, choking off the recovery.”
Given that the federal funds rate is virtually zero, the Federal Reserve’s next move is likely to be an increase in rates. The question is when this will happen and what might be the result. We anticipate continued economic growth over the next year, which we believe will create an environment where the Federal Reserve will begin to raise rates later this year, or perhaps early in 2016, although no one knows the exact timing or extent of such increases. As a result, we remain cautious with the overall maturity of bonds in our portfolios, since rising rates can produce a loss in bond values, especially longer maturity bonds. It is our goal to moderate bond losses should rates begin to spike upwards, with the plan of rotating to higher-yielding bonds in the future.
Risk is a given. Perceiving it rationally and planning to manage it is what active money management is all about.
