Resilient Investing: Navigating the Unknowns of a Crisis Environment
/By now, investors have felt the violent market reaction to the COVID-19 pandemic. As with any crisis, the outlook is uncertain as we scramble to latch onto any sense of predictability. But markets, especially in times of crisis, are anything but predictable. Anyone who expects the market to conform to predictable patterns set themselves up for disappointment when the unexpected happens.
Markets are complex environments – full of unknown connections and hidden feedback loops, driving drastic and extreme market moves. Expecting predictable markets is naïve and dangerous. Volatile markets bewilder overconfident investors, as the market moves don’t fit their beliefs of how a market should work.
What does this mean for investors?
One of the biggest challenges is demonstrating clear, decisive, and logical thinking during a crisis. Investors’ emotional responses are usually worse than the crisis itself. At a minimum, reactive emotions exacerbate the negative effects of a crisis. Optimistic, confident investors are quickly transformed into fearful, reactive victims. Impulsivity, uncertainty, and fear is a nasty combination for those managing money.
Most investors, professionals included, are ill-equipped at making decisions under ambiguity and uncertainty. Worse yet, ambiguity and uncertainty drive investors to abandon sound investment principles. Investment astrology replaces rationality as they surrender to so-called experts to divine future market moves.
We’re all dealing with the same level of unpredictability and ambiguity. But what separates those investors who can successfully navigate these markets from those who can’t? Alternatively, how is it that Warren Buffett and other elite investors thrive in the same environments that decimate so many others?
There is help to navigate these markets. One of the most useful frameworks is from Richard Zeckhauser’s 2006 paper, Investing in the Unknown and Unknowable.
Zechhauser’s ideas are a compelling guide to handle uncertain markets. Richard describes the challenges and opportunities of investing in environments that are ambiguous and unpredictable, ranging from stock market crises to pricing earthquake reinsurance. In unknown and unknowable investment situations, very few investors are able to execute appropriately. It’s not because they don’t have the IQ. They’ve just never trained to invest in stressful environments.
According to Zechhauser, unknow and unknowable markets have several commonalities:
· Future probabilities are unknown
· Extreme levels of risk aversion
· Many investors shy away from these markets in search of something more “predictable and steady”
· Investment success in these areas relies more on sound judgement than exceptional IQ
It’s precisely because of these four factors that such high investment returns exist for unknown and unknowable situations.
The following seven ideas from Zeckhauser are helpful to navigate the current crisis.
(All italicized quotes are attributable to Zeckhauser)
Idea #1: Traditional finance theory does not apply in unknown/unknowable situations.
When the probabilities of future states of assets are known, as the efficient markets hypothesis posits, wise investing involves solving a sophisticated optimization problem. Of course, such probabilities are often unknown, banishing us from the world of the capital asset pricing model (CAPM), and thrusting us into the world of uncertainty.
Remember, traditional finance relies on unrealistic assumptions and completely ignores the human element in investing. Rarely do traditional models incorporate the fear and greed many investors exhibit. Rarely do traditional models incorporate other factors affecting investment management:
· fear of being wrong
· fear of losing your job
· fear of being early and looking bad
· fear of client pushback
In addition, traditional finance doesn’t help assess or handicap situations in which probabilities are unknown.
Your investment success will not be dictated by how well you calculate beta or run mean variance analyses. While traditional finance does have some useful applications, they are of limited help in a crisis environment.
Idea #2: Most investors have little training in dealing with the unknowable
…most investors – whose training, if any, fits a world where states and probabilities are assumed known – have little idea of how to deal with the unknowable. [emphasis mine]
We are poorly trained to handle crisis environments. We don’t have the deliberate training to adequately respond to tough environments. Most investors respond by doing what feels natural (which is often the worst choice), rather than what is appropriate (which often feels unnatural).
The failure to learn begins in college and continues through graduate school, the CFA exams, and many other professional-related learning initiatives. The reason is simple – rarely do any of these organizations allocate resources to train investors on how to make decisions under extreme stress. Most investors are left on their own to figure this out, leading to subpar, if not disastrous, results. More data and information are not the answer. Sufficient data already exists. It’s making sure investors properly calibrate and assess the data they have in a disciplined and thoughtful way. In short, data/information/news isn’t the constraining factor.
Investors need to appreciate how a lack of training negates high IQ’s, formal education, and expertise. It doesn’t matter if you have exceptional investment knowledge if you misapply that information during a crisis. Or don’t apply your knowledge because you don’t have conviction and confidence to act on your ideas. Inexperience with adverse markets is the constraining factor when making profitable decisions in stressful market environments.
According to Al Seibert, author of The Resiliency Advantage, “Optimism and pessimism both tend to be self-fulfilling prophecies.”1
Therefore, if you train and believe you can perform under stress, you will. If you believe you’ll be a victim to stress, you’ll do exactly that.
Idea #3: Unknowable situations are associated with powerful investment returns
The major fortunes in finance, I would speculate, have been made by people who are effective in dealing with the unknown and unknowable.
Exceptional investors capitalize on these opportunities. Panicked investors drive prices down to a point where exceptional investment returns are available for investors who calmly assess these mispricing. Most investors are stressed out and worried. But it doesn’t have to be that way. Make a shift in your mindset: start viewing crises as opportunities to capitalize on rather than a threat to be feared. It’s your call how you want to view them.
Idea #4: Extreme market environments are unpredictable - we need to prepare before they arise
Similarly, the more difficult a field is to investigate, the greater will be the unknown and unknowables associated with it, and the greater the expected profits to those who deal sensibly with them.
There’s a saying in the military: you don’t rise to the occasion; you fall to the level of your training. Don’t expect to capture exceptional opportunities if you haven’t done the work. If you wait until a crisis to figure out what to do, you’re too late. You need to have the fundamental knowledge and conviction to accurately assess a range of investment value under different scenarios. Too many investors wait until the crisis hits and then scramble to figure out what they should do. It’s the same reason firefighters, fighter pilots, and surgeons go through rigorous training before operating in live situations. You can’t catch up and learn it all during the crisis. By then, you’re either ready or not.
Idea #5: Poor decision making is amplified during market crises.
Individuals who are overconfident of their knowledge will fall prey to poor investments in the UU (Unknown and Unknowable) world.
A faulty decision-making process is an annoyance in a normal environment but catastrophic in a crisis. Because of the intense pressure during a crisis, we tend to make more mistakes with bigger consequences. Investors often exhibit catastrophic thinking (for example, that the market’s going down and never coming back). These investors dump risk assets at the exact time they are most attractive. Because the stakes seem so high, we tend to go to extreme measures to counteract the stressors we feel.
The best way to negotiate stress is through repeated, realistic training.2 According to Hendrie Weisinger, author of Performing Under Pressure, “A finding that continually intrigues us is that most of the thousands of individuals who’ve participated in our research take a haphazard approach to managing pressure in their lives. Very few think about how to handle pressure moments better—until it’s too late.”3
Idea #6: Ambiguity aversion – the more ambiguous the environment, the greater the aversion.
Similarly, the more difficult a field is to investigate, the greater will be the unknown and unknowables associated with it, and the greater the expected profits to those who deal sensibly with them. Unknownables can’t be transmuted into sensible guesses -- but one can take one’s positions and array one’s claims so that unknowns and unknowables are mostly allies, not nemeses. And one can train to avoid one’s own behavioral decision tendencies, and to capitalize on those of others.
This is a simple idea. The more pain in a given market, the greater the chance of mispriced opportunities. By opportunistically building a diversified portfolio within blown-out markets, investors can capture significant risk premiums while mitigating the risk of individual mistakes at the security level. As Zeckhauser states, “Some losses will occur. Understand you will have bad outcomes even though you have a strong process.”
Idea #7: In an unknown/unknowable situation, computer models won’t help you. They project false precision.
In the passage below, Zeckhauser describes how Warren Buffet assesses the odds of a payout:
It is also instructive to consider Buffett’s approach to assessing the probabilities in this UU situation, as revealed in the same annual report: So what are the true odds of our having to make a payout during the policy's term? We don't know - nor do we think computer models will help us, since we believe the precision they project is a chimera. In fact, such models can lull decision-makers into a false sense of security and thereby increase their chances of making a really huge mistake. We've already seen such debacles in both insurance and investments.
I’m not advocating the avoidance of computer models. They are valuable tools. The problem arises when there is too much reliance on over-precise model output. You shouldn’t need a model to tell you what investments have spectacular forward looking returns. With equities, you’re not trying to buy a company that normally trades at 20x earnings at 19.8x earnings. You’re trying to buy that same company at under 10x or 12x or 14x earnings. In this case, it doesn’t matter if the true value is 15x, 20x, or 25x. The odds are so stacked in your favor that a diversified portfolio of these opportunities sets you up for a wonderful future.
What will set you apart in these environments is having the mental resilience to understand you will be early and won’t get every investment right. Calmly navigating difficult markets provide exceptional returns over time to those who have prepared for them.
Notes:
1 The Resiliency Advantage, Al Seibert
2 The Unthinkable, Who Survives Disaster and Why, Amanda Ripley
3 Performing Under Pressure, Hendrie Weisinger and J. P. Pawliw-Fry