What It Means to Predict a Crisis
If you play Russian Roulette with 1 bullet and 100 chambers in your pistol, I can’t predict when the crisis will occur. If you play with 10 bullets, I still can’t predict when the crisis will occur but I can say with certainty that the risk has increased by a factor of ten. Analogously, nothing in modern economics makes it theoretically impossible to forecast that greater leverage and higher than normal price to rental rates, to name just two possibilities, increase the probability of crisis. Nor does modern theory make it theoretically impossible to forecast that conditions are such that if a crisis does occur it will be a big one.
Insight: Equities carry too much risk
Usually at bear market troughs, the S&P 500 goes to silly cheap levels. It did not this time round and, six months and 60 per cent later, there is yet again, in 2007 style, tremendous risk in this market. Never before has the stock market surged this far, this fast, between the time of the low and the time the recession (supposedly) ended. What is “normal” is that the rally ahead of the recovery is 20 per cent. This market is now trading as if we were in the second half of a recovery phase, yet it has not even been fully ascertained the downturn is over.
The Evolution of Overconfidence
The puzzle about overconfidence is its ubiquity. Many studies have shown that most people have an exaggerated sense of their own capabilities, an illusion that they have control over uncontrollable events and are invulnerable to risk. Most people, for example, believe they are above-average drivers, a statistical impossibility. We are all overconfident in one way or another.
But how can such a condition have evolved when overconfidence can lead to destruction of communities and catastrophic loss of life?
…All of this sets the stage for the next question: how best to mitigate the worst side-effects of rampant overconfidence in a society with a dramatically exaggerated sense of its own abilities.
{ 6 comments }
Carl,
Insurance. If you have cheap insurance, then taking risk becomes worthwhile. Take Goldman Sachs for example. They can take all the risk they want, knowing they can never goi broke. Sure they can lose. but they cannot lose it all. That's nice insurance.
The rest of us have to do with less.
If you jump out of airplanes, have a backup chute (or two). If you have stock market investments (before or after proper asset allocation), own insurance. The best, least expensive insurance is a collar (buy puts, sell calls when you own equities). The latest study (http://tinyurl.com/ye78jvg) suggests this may even make money in a declining market, but I quibble with their methods. Collars significantly limit limit loses – there should be no profits durings bear markets.
But protect yourself. Disregard that overconfidence and own insurance anyway.
Mark-
Thanks for the comment, your link goes to a typepad log-in page. Can you add
a correct link to the study.
Thanks,
Carl
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Full link to my discussion:
http://blog.mdwoptions.com/options_for_rookies/...
Direct link to the study:
http://www.optionseducation.org/institutional/r...
My view is that the way to deal with overconfidence is to put forward a model for understanding stock investing that puts dealing with overconfidence at its core. I call this model “Rational Investing.” The Rational model is the opposite of the now-dominant Passive Investing model. Passive teaches investors that they do not need to adjust their stock allocations in response to price chages. Rational teaches that they must do so to have any realistic hope of long-term success.
There are a good number who try to speak up about the dangers of overvaluation when we are in a bubble. It's too late then. By the time we are in a bubble, most investors (and most investing “experts” too) have already let their emotions take over their ability to reason. People are not going to listen to the message at that time. They will exhibit the overconfidence that is really bravado, not at all a true confidence.
But if people are taught from the first time that they learn about investing that the biggest danger of stock investing is failing to adjust one's stock allocation in response to price changes (that is, Passive Investing), they get it. I think that the best way to teach this message is through reference to the historical stock-return data, which shows that Passive has never worked and that following Rational strategies consistently over the course of an investment lifetime would permit the average person to retire five years sooner than would otherwise be possible.
The “confidence” that many evidence today is not a real confidence. It is the opposite of confidence, it is a bravado that masks a deep insecurity. The deep insecurity is rooted in the impossible belief that many hold that somehow, someway, this will be the first time in history that Passive works out in the long run. On some level of consciousness, we all know that that cannot be so.
Rob
My view is that the way to deal with overconfidence is to put forward a model for understanding stock investing that puts dealing with overconfidence at its core. I call this model “Rational Investing.” The Rational model is the opposite of the now-dominant Passive Investing model. Passive teaches investors that they do not need to adjust their stock allocations in response to price chages. Rational teaches that they must do so to have any realistic hope of long-term success.
There are a good number who try to speak up about the dangers of overvaluation when we are in a bubble. It's too late then. By the time we are in a bubble, most investors (and most investing “experts” too) have already let their emotions take over their ability to reason. People are not going to listen to the message at that time. They will exhibit the overconfidence that is really bravado, not at all a true confidence.
But if people are taught from the first time that they learn about investing that the biggest danger of stock investing is failing to adjust one's stock allocation in response to price changes (that is, Passive Investing), they get it. I think that the best way to teach this message is through reference to the historical stock-return data, which shows that Passive has never worked and that following Rational strategies consistently over the course of an investment lifetime would permit the average person to retire five years sooner than would otherwise be possible.
The “confidence” that many evidence today is not a real confidence. It is the opposite of confidence, it is a bravado that masks a deep insecurity. The deep insecurity is rooted in the impossible belief that many hold that somehow, someway, this will be the first time in history that Passive works out in the long run. On some level of consciousness, we all know that that cannot be so.
Rob
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