This December I picked up The Uncertainty Solution by John Jennings. I found the book interesting as it promoted the idea of building mental models as tools for decision making. It was a good read and I definitely learned some interesting concepts.
Correlation is not causation
If two events are correlated, it does not mean one caused the other. This is caused mainly due to our brain’s need to see patterns and certainty of why things happen.
Eg: Sitting on the left side of your couch seems to make your team win. This is merely a coincidence but our pattern seeking brains interpret that as causation i.e. because I sit on the left side, my team wins.
Eg: When the FED increased interest rates, the stock market crashed. In reality, stock markets generally act in anticipation, ahead of a major event like FED policy meeting.
Most events are either:
- Random – too many variables acting in random order to make the event happen. The three body problem.
- Multiple causes – a series of events (causes) happening in a particular order make the final event happen.
However, people like simple explanations and so assign a single direct cause to an event.
Hawthorne Effect
People change their behavior when they know they are being observed. Everyone usually puts up their best game when they know they are being seen.
Regression to the mean
After an outstanding performance, a stock is bound to give lower performance. Be prepared to experience prospect theory.
The stock market is not the economy
The economy and the stock market are related but they don’t work in perfect sync.
Stock market reacts before the econonmy. This is because the stock market is forward looking and reacts in anticipation the economic growth or decline in the future.
There is no correlation between the current year’s GDP growth rate and the stock market returns. However the correlation become strong when we compare current year’s stock market returns to next year’s GDP growth rate. This is because the stock market predicts what the GDP will do next year and reacts accordingly now.
When economic news is bad, know that the stock market has already absorbed it and priced it in. Surprises move markets, not expected news. This is the reason why recovery usually starts right in the middle of a catastrophic event like COVID-19 while it is still undergoing.
The stock market often drops when the economy is healthy and recovers when the economic news is dire.
FOMO = when markets are going up
FUD = when markets are crashing
Complex Adaptive Systems
It’s a dynamic system made up of many individual components that learn and adapt based on their interactions with other parts. The outcome of such systems cannot be predicted because the individual parts are in a state of constant adaptation mode. I see you, you see me, I see you, you see me.
Eg: The three body problem.
Eg: The stock market is a big complex adaptive system and so it cannot be predicted because there are multitudes of individual investors who are observing each other and constantly adapting.
Similar concept: Chaotic Systems
Level 1: These systems do not react or adapt to their predictions.
Eg: weather. If we predict that tomorrow it will then this prediction will not impact the outcome of whether it will rain or not tomorrow.
Level 2: These systems react and adapt to their predictions.
If we predict that the stock market will rise tomorrow then traders will rush to but today and instead of rising tomorrow, the markets will end up rising today and tomorrow will remain uncertain.
Skill & Luck Continuum
Stock market has a big component of luck.
How to distinguish between a game of skill vs a game of luck? It’s really simple. Just ask two questions:
- Can you lose by choice?
- Can a novice beat a pro?
If the answer is yes to both the questions, then it’s a game of luck. In stock market, a novice (or even a monkey) can beat the returns of a professional investor. However, in a game of chess a novice cannot beat a professional player.
Sit in discomfort
Uncertainty gives us discomfort stress & anxiety. This in turn makes us take bad decisions.
Sit in your discomfort
- Face: acknowledge that you’re facing discomfort from uncertainty, fear, boredom, anger
- Accept: that the situation cannot be immediately resolved
- Float: let your thoughts, emotions and feelings float by like clouds
- Let time pass: be patient and let things play out
Observe, don’t act. Doing nothing is the hardest thing to do.
Illusion of knowledge
We think we know a lot about everything until we’re asked to deep dive into the topic. It stems from overconfidence bias.
Eg: we think we know how a toaster works until asked to explain how does the pull down lever stays down only when connected to power?
Eg: we think we know how a helicopter flies until asked to explain how does it shift from hovering to moving forward
Other Ideas
Fractals are everywhere in life.
Stories are far more powerful than facts.
Simple algorithms are more effective and reliable in decision making than expert judgment.
8 Behavioral Tips for Investing
- Choose inactivity over activity – observe, don’t act
- Prefer simplicity over complexity – occam’s razor
- Focus on the long term – savor the journey
- Don’t look at your portfolio – low saliency
- Have a play account – to satisfy your cravings
- Find the right advisor – your acountability coach
- Create a investment policy statement – your playbook
- Have a margin on safety – hold cash for emergency
Mental Models
| Model | Description |
|---|---|
| 1. The Wisdom Hierarchy | Think of information in four categories: data, information, knowledge, and wisdom. Turn off the noise of data and information. Focus on knowledge or, better yet, wisdom. |
| 2. Uncertainty | We dislike uncertainty. It makes us stressed and triggers our fight-or-flight response. When we resolve uncertainty, we feel pleasure. So we seek certainty. Recognize when you feel the discomfort of uncertainty. Resist seeking closure, becoming an information junkie, listening to expert predictions, or associating with groups who think just like you do. Instead, sit in your discomfort and focus on what you can control. |
| 3. Correlation is not causation | Just because two things are strongly correlated doesn’t mean that one causes the other. Remember that unrelated variables can be highly correlated – like Bangladeshi butter production and the stock market. |
| 4. Causation is tough to determine | It’s risky to think that one thing has caused another. Coincidence can lead us to assume causation. Multiple factors often combine to create outcomes, so it’s usually impossible to pinpoint a single cause. |
| 5. Regression to the mean | Regression to the mean describes the phenomenon whereby extreme events are usually followed by ones closer to the average. Regression occurs whenever two variables are less than perfectly correlated, like child and parent heights. Regression to the mean explains why it may make sense to invest in underperforming funds and why outstanding performance is often followed by stumbles. |
| 6. Law of large numbers | Beware of drawing conclusions based on small sample sizes. As sample sizes get smaller, variation from the mean increases exponentially. Ignorance of this statistical law has led to a lot of wasted time and money. Asking “what’s the sample size?” is critical whenever causation is asserted. In short, as sample size increases the variation gets smaller and the outcome tends to the average. |
| 7. The highly improbable happens all the time | The highly improbable happens all the time. It’s just that we aren’t actively looking for it in our daily lives. Coincidences are not supernatural miracles; they’re just math. Being surprised by unlikely occurrences can leave us unprepared both in our portfolios and in our lives. |
| 8. The stock market is not the economy | Economic growth and stock market performance are not correlated. The stock market reacts before the economy does. Stock market works on anticipation of the future. The stock market often rebounds when economic news is bad and declines when it is good. |
| 9. The stock market is a complex adaptive system | Millions of intelligent agents are all watching each other, learning, drawing their own conclusions, and creating feedback loops, which makes predicting the stock market movements nearly impossible. |
| 10. Economic indicators don’t predict the stock market | Because the stock market is a complex adaptive system, economic indicators and market signals don’t predict market performance. The market changes and evolves, and investors learn. Indicators that might be predictive of market returns will be destroyed once they are widely known by those millions of agents. |
| 11. Markets move in cycles but defy prediction | Boom followed by bust followed by boom. Cycles vary in duration as well as the height of their peaks and the depth of their valleys, but there are no permanent plateaus. Knowing where you are in the market cycle can help you practice good investment behavior by not getting caught up in the greed of market tops or the panic that accompanies market bottoms. |
| 12. Stability creates instability | Minsky’s financial instability hypothesis holds that it is stability that creates the behavior that leads to bubbles and crashes. Thus, times of apparent stability are the riskiest; the best opportunities often occur when everyone else is going cuckoo. |
| 13. Market timing doesn’t work | Trying to time the markets doesn’t work. A primary reason is because the market is a complex adaptive system. Plus, in order for market timing to work you have to be right twice—once at the top and then again at the bottom. |
| 14. It’s okay to invest in advance of a bear market | Waiting to invest until the coast is clear is not a sound strategy. Even if you invest just a few years in advance of a bear mar-ket, your portfolio will do fine if you don’t panic and follow a disciplined strategy. |
| 15. The skill-luck continuum | Luck plays a big role in investing, so we shouldn’t read too much into good or bad results over short periods. Randomly selected stocks, middle-schoolers, and monkeys can score outstanding returns; grizzled investment veterans have dismal results. And vice versa. |
| 16. Most investment managers underperform the market | Most active managers underperform after fees. And sticking with those who outperform can be a bumpy ride. This doesn’t mean you should never invest with an active manager-but you should consider the odds before you do so. |
| 17. Most stocks underperform the market | Buying an individual stock is like flipping a weighted coin where you lose the majority of the time. It’s essential to understand the odds before you decide to pick an individual stock. |
| 18. Monkey portfolios outperform | Beating the market requires investing differently than the market, which requires great heart and discipline. If you choose to break off from the herd, it’s essential to stick with your strategy through the inevitable ups and downs. |
| 19. Private Investments | It is easier to outperform in private investing, primarily due to information asymmetries that don’t exist in public mar-kets. If you have the financial resources, adding private investments to a portfolio with skilled investment managers is the way to go. |
| 20. Creating vs preserving wealth | Great wealth is generated by owning a concentrated position in a single company in which you invest your own blood, sweat, and tears. Investing in the stock market isn’t likely to lead to great wealth but can nicely grow wealth generated elsewhere. |
| 21. It is difficult to spot a trend early | It’s hard to spot trends early, partially due to the challenges of comprehending the nature of exponential growth. Remember Oak versus Acorn. |
| 22. Trends don’t always turn out as imagined | Established trends can change course rapidly as new competitors and technologies upend trends. Remember the “Malthusean catastrophe.” |
| 23. It’s Difficult to Find a Successful Needle in a Haystack of Competitors | It’s hard to pick winners. As new technologies create new industries, many companies enter, and most fail. Early pioneers usually aren’t the long-term winners. Instead, fast followers often are the most successful. Remember that Google was the twenty-first search engine. |
| 24. Storytelling bias | We’ve evolved to pay attention to and communicate through stories. As such, stories make an outsized impact in our decision making. When we invest, we evaluate stories. Realize that stories will sway your investment decisions, and step back and ask, “what’s the base rate?” |
| 25. Overconfidence bias | We think we know more than we do. This is the mother of all biases and an ingrained human trait. Overconfidence is a primary ingredient in bad decisions. Recognizing our (and others’) overconfidence is an essential mental model. Also, realize that we are drawn to overconfident experts, yet confidence and predictive ability are negatively correlated |
| 26. Choose inactivity over activity | Don’t tinker with your portfolio. Don’t try to time the markets. When fear or greed makes you want to change things up, take a deep breath. Then take another. If you’re a man, tell yourself to invest like a woman. If you’re a woman, try to invest like a dead person. |
| 27. Prefer simplicity over complexity | Start with simplicity as your default. Only add complexity if there is a good reason to do so. Complexity makes good behavior harder, adds fees, and generates more taxes. |