One Beam at a Time

                                                                                                                                                   Art source:  Street Art Utopia

In Word and Object, Quine made Neurath’s boat analogy famous. It compares the holistic nature of language and consequently scientific verification with the construction of a boat which is already at sea.

“We are like sailors who on the open sea must reconstruct their ship but are never able to start afresh from the bottom. Where a beam is taken away a new one must at once be put there, and for this the rest of the ship is used as support. In this way, by using the old beams and driftwood the ship can be shaped entirely anew, but only by gradual reconstruction.”

This powerful analogy applies in most areas of life, I think, investing included. 

The world we live in is profoundly complex and is much more difficult for us to navigate than we usually think or assume.  As Dan Kahneman put it, “We systematically underestimate the amount of uncertainty to which we’re exposed, and we are wired to underestimate the amount of uncertainty to which we are exposed.” Accordingly, “we create an illusion of the world that is much more orderly than it actually is.”

Our ability to forecast the future, much less control the future, is extremely limited and is far more limited than we want to believe.  We simply misapprehend (or ignore) the data.  Instead, we concoct stories — often wonderful stories — to provide an interpretive framework for our forecasts, expectations and decisions.  These stories are much more compelling than the actual data, which is discouraging at best.  Stories sell better.

We are in a season of stories.  In the investment world, these stories will come in the form of year-end letters (often designed to justify performance that wasn’t quite up-to-snuff), projections, forecasts, “best of” lists and expectations.  The data (such as it is) will be handled with great care — comparisons to measures that can be beaten (or nearly so), for example — with thoughtfully wrought stories as explanation (such as “we were right, but too early”).    

Kahneman again:  “we can expect people to be way overconfident, because they have that ability to tell good stories, and because the quality of the stories is what determines their confidence. The extent of that overconfidence is actually quite remarkable.”

Remarkable indeed.

Those of us who are honest with ourselves and others will be left trying to muddle through, building portfolios and managing money like Neurath’s boat — making adjustments on the fly while trying to keep the whole thing afloat, keeping our promises and expectations grounded in the limiting reality of the data.  It isn’t a good recipe for sales success.  But it helps me sleep at night.

We would all like progress and thus real success to come more quickly, more cheaply and more comprehensively than reality allows. And if success comes, we desperately tell ourselves it’s because we’re really good and not because we’re really lucky. 

We are always tempted and too often swayed by the shiny new object — the next “silver bullet” — that will make things right.  Sadly, life doesn’t seem to work that way very often. No matter what our stories say.

Here’s to a New Year of muddling through but doing so with integrity, one beam at a time.


The Planning Fallacy

In his terrific new book, Thinking, Fast and Slow, Nobel laureate Dan Kahneman outlines what he calls the “planning fallacy.” It’s a corollary to optimism bias (think Lake Wobegon – where all the children are above average) and self-serving bias (where the good stuff is my doing and the bad stuff is always someone else’s fault). Most of us overrate our own capacities and exaggerate our abilities to shape the future.  The planning fallacy is our tendency to underestimate the time, costs, and risks of future actions and at the same time overestimate the benefits thereof.  It’s at least partly why we underestimate bad results. It’s why we think it won’t take us as long to accomplish something as it does. It’s why projects tend to cost more than we expect.  It’s why the results we achieve aren’t as good as we expect.  Clients and financial professionals are both (all!) susceptible.

In a financial context, it has several particular applications, including the following.

  1. Because we underestimate risk generally and discount future risk too much, we ought to be particularly skeptical about our various estimates of results and outcomes and ought to consider more carefully the consequences if (when!) things don’t turn out as well as we planned.
  2. We should value the benefits of guarantees (when available) more than the benefits of potential.  Accordingly, we should typically be concerned more about the costs of failure than about opportunity costs.  A bird in the hand is worth two in the bush.
  3. We should think about tail risk more.  For example, is a “safe withdrawal rate” that assumes a 5 percent portfolio failure rate over a 30-year time span (longevity risk anyone?) anything like “safe” when the consequences of failure are so high and our willingness to undervalue such risks is so clear?

Another reason why this problem is so acute for advisors is the so-called “authorization imperative.”  Our plans and proposals must be approved by our clients and we have a stake in getting that approval. This dynamic leads to our tendency to understate risk and overstate potential.  Perhaps we see it as easier to get forgiveness than permission or perhaps it’s just a sales pitch.  Or maybe we have convinced ourselves that we’ve got everything covered (confirmation bias!). Either way, despite its strategic benefits, we run the risk of serious misrepresentation. 

Similarly, nearly every advisor works with individuals who say they are risk averse to varying degrees, but typically more risk averse than the advisor would like them to be.  The tendency is then to try to convey to or convince the client that not being aggressive enough is a risk too – the risk of not meeting one’s goals.  The planning fallacy is another reason not to push that approach too far.