Today I want to discuss the curious nature of surprises. Astonishment, shock, alarm, disbelief, wonder, amazement — pick any synonym you want, we seem to be genuinely surprised by what can only be described as ordinary events. At least, that is how things look when emotions are no longer running high and in the cool light of hindsight.
This tendency to be surprised isn’t a very surprising trait among investors, or people in general. Our mission today is to understand why.
Why are investors so often surprised? There are many reasons that help explain unfolding events in ways that are rather curiously described as “unexpected.”
As investors we:
- have an incomplete understanding of the world around us
- assume we know the drivers of complex systems such as markets and economies
- underestimate the potential for significant random events to occur
- believe in numerous myths, false ideas and incorrect “facts”
- misunderstand the degree of complexity that exists
- think we are apart from — yet understand — crowd psychology
- ignore the tendency for investment styles to go in and out of favor
Let’s put this into the broadest possible terms. Your mental model of the world around you is, at best, incomplete and often is inaccurate. To paraphrase the statistician George E. P. Box, all models are wrong, but some are useful. The simple truth is that the 360-degree vision of the world about you, that model of the universe in your head, works just well enough to allow you to perform basic functions. You can cross the street, prepare dinner, drive a car. Your depiction of the world may be imperfect, but it is good enough to allow you to do many things with varying degrees of success. It is wrong, but useful.
So too, do most investors carry in their heads an imperfect model of markets. It allows them to function most of the time (though just barely). However, there are times when the flaws in investors’ understanding become apparent, and chaos seems to reign. Laments of “uncertainty” are the pundit’s response. It is nothing of the sort.
A brief digression: “Uncertain” and “unknown” are two very different things. Roll a pair of dice, and the results are unknown in advance, but are hardly uncertain. The set of possible outcomes is well understood (1, 1; 1, 2; 1, 3; and so on). Uncertainty is when the possible outcomes are wholly unknown and unknowable. War is a classic example of uncertainty. More recently, when the New Horizon’s space probe did its flyby of the Pluto system, what we would find was truly uncertain. Actual surprises occurred.
The word uncertainty, when spoken by befuddled pundits, usually means they are coming to grips with their own imperfect mental models. Most of the time, they have fooled themselves into believing they understand what’s going on. But they don’t. This is when they are forced to admit to themselves — however briefly — that they haven’t the slightest idea what is happening. They shrug it off as uncertainty, instead of admitting the truth.
Survival and reproduction never required you to develop a perfect model of the world, hence, your ancestors never did. “Good enough” was enough to allow them to pass their genes along to their progeny, including you. This is why you can still accomplish so many amazing things, despite your highly imperfect model of the world.
This is very significant in the capital markets, where good enough is a (surprisingly) high bar, indeed.
Consider a professional baseball batter’s internal physics engine; that is his model of the world. He doesn’t need to know the spin of every electron around him; he merely needs to correctly understand the speed, direction and aerodynamic action of a thrown ball good enough and often enough to make contact. If he does that more often than other batters, we call him a good hitter; if he does this a lot more,he becomes an all-star. But he doesn’t need to have a perfect model in his head, just one good enough to understand where the ball will be as he brings his bat around.
Similarly, investors don’t need to perfectly understand the universe to be successful. They need only understand enough so that they can achieve whatever specific goal they set for themselves.
Here’s the problem: Good enough for a specific task — batting, driving, investing — requires only a narrow understanding of a relatively small subset of factors to achieve success. One doesn’t need to know everything about, well, everything, to be reasonably successful at these tasks.
But there are times when investors’ good-enough models do a poor job of explaining events. So far, 2016 seems to be one of those periods. It isn’t all that surprising.
Originally published here: Why Investors Are So Surprised by Surprises