What’s Your Baseline?

I spoke at an excellent conference recently and was on a panel there with two big-time economists.  While I was sitting on the dias listening to my “colleagues,” I couldn’t help thinking about this old gem from Sesame Street.

And I was the “thing” that didn’t belong. 

That said, I was a bit surprised that we had so many areas of substantial agreement because our starting points were pretty different.  Economists look at the investment world somewhat differently from the rest of us.  They come at things from a different place.  Plus, neither of them was American, making our outlooks even less inherently consistent.

Doing anything right generally requires that we set a baseline against which to measure our progress, if any. Thus establishing an appropriate benchmark as a baseline is necessary for an effective measurement of investment success (or lack thereof). 

But we also have conceptual baselines or frames of reference. These are the various default settings and starting points — known and unknown, considered and inherent — we use to figure out where we are at any given time. In physics, a frame of reference may refer to a coordinate system used to represent and measure properties of objects such as their position and orientation.  Because the theory of relativity posits that the existence and position of an observer can change the position and movement of that which is being observed, in that context, the concept is often referred to as an observational frame of reference.

I generally use different frames of reference than economists do. That shouldn’t be surprising in that, while I’m reasonably well-educated on the subject for a layperson, I am hardly an economist. I am seeing things from a different vantage point – my observational frames of reference are different.

Differing frames of reference aren’t necessarily bad, of course.  Indeed, it is well established that “diversity unleashes creativity, innovation, and improved group problem solving, which in turn enhances the competitiveness of the organization.”  But differing outlooks also entail differing biases.

Barry Ritholtz’s fine post this morning, What is Your Market Context?, takes a look at how our various frames of reference impact what we see and expect in the markets. More specifically, Barry is critical of our tendency (and desire) to categorize the current market environment as like some earlier market environment — that today’s environment is like another. 

On the one hand, Barry rejects any knee-jerk this time is different claim — since human nature is unchanging, it is never different this time in that respect.  In other words:

You Humans are the same as you have ever been. Your cognitive biases and emotional (over)reactions are no different than they have ever been.

On the other hand:  

…the circumstances in which you make risk/reward decisions, the context of your investing analyses, are vastly different than what we have become accustomed to.

I suspect this change of context may surprise all of us….

I agree. Our frames of reference can be handy mental shortcuts, but they can never provide a complete picture.  Because the world is so complex, such heuristics can be helpful and are often necessary.  But we must remain mindful of their limitations and always check our work to make sure that the outcomes deliver as promised.

Josh Brown interprets Barry as reminding us to ‘[s]top looking at the market through the lens of whatever your first year investing was.”  That is a common frame of reference (and similar to the way so many people think the best music is that which was popular when they were young — Beatles baby).  If you don’t recognize it in yourself, think of parents or grandparents opening a conversation with “When I was your age…”.  The good ol’ days/bad ol’ days frame of reference is in frequent use. But it isn’t the only one.

Watch OutIdeologically based reference points are also quite common. Therefore (to pick an easy example), we shouldn’t be surprised that supporters of the President generally think the economic future is bright (so long as Republicans don’t screw things up) while opponents are anticipating disaster

Another frequent reference point focuses upon self-interest.  There is a wide body of research on what has come to be known as “motivated reasoning” and – more recognizably for those of us in the investment world – its “flip-side,” confirmation bias.   Upton Sinclair offered perhaps its most popular expression:  “It is difficult to get a man to understand something, when his salary depends upon his not understanding it!”  It’s remarkable how often we think the best option (even for others) is also the one that’s best for us.

Every movement, -ism and outlook instills framing mechanisms of various sorts.  I have highlighted only a few.  Plus, it’s a dangerous myth that anyone can be wholly or even largely free of them.  The best we can do is to try to be aware of them and to try to challenge them in ourselves as fully and as often as possible.  Of course, doing so is much easier said than done.

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