Confirmation bias and the perma-whatevers

The stock market climbs a wall of worry. It is a bit of a cliche because it has some truth to it. In my book I wrote this:

So most of the time and for most assets, there exists a wall of worry. It takes a lot to convince the general public to achieve a level of willful disbelief that the risk in any asset has been eliminated. For any market, or stock, to achieve this level of risk blindness, something else needs to occur. A market needs to eliminate the proverbial wall of worry before it can seem like it is bulletproof to investors. Ironically those markets that have performed the best, that have supplanted whatever worries existed and now seem invulnerable, are actually the riskiest. This perception of invulnerability sows the seeds of the market’s eventual and inevitable decline.

Today’s equity markets are undergoing this very process. Since 2009 all manner of worries have been leveled against the US market including the implosion of the Euro. To be sure there are still some legitimate concerns with today’s market including high valuations and much higher than normal corporate profit margins.

However the biggest and most persistent worry is that the Federal Reserve, and by extension all of the world’s central banks, are simply propping up the equity markets via cheap money. As worries goes this one is a pretty big, existential one that should be addressed. Barry Ritholtz at the Big Picture talks about the Fed’s effect on the markets in a post today:

There is no doubt that the Fed is a large factor in our economy; the impact on both bond yields and risk assets is very significant. But to claim that markets are purely Fed driven is to misunderstand the basics of how equities function.

So investors who have shunned stocks for fear of the Fed pulling out the rug from underneath them have missed out. Over the very long run investors should have some confidence the equity market generally reflects the real economy. A recent report from McKinsey & Co. makes this very point. They note that despite some big and obvious deviations from fair value the US equity market does a pretty good job of it. The authors write:

Unlike the market for fine art or exotic cars, where value is determined by changing investor tastes and fads, the stock market is underpinned by companies that generate real profits and cash flows. Most of the time, its performance can be explained by those profits, cash flows, and the behavior of inflation and interest rates. Deviations from those linkages, as in the tech bubble in 1999–2000 or the panic in 2009, tend to be short-lived.

This rally will, as all rallies, get overbought and correct. However those investors that ignored the potential for a rally, or rallies, post-financial crisis have greatly damaged their performance over time. The worst case has been for those who were aggressively invested going into 2008 and subsequently bailed out without the benefit of the market’s rebound.

Josh Brown at the Reformed Broker last week noted how there is little upside in trying to be a permabear. In short, even when you win, the world loses. History has been kind to those investors who have been able to put into context the bad times in light of better potential times down the road. Brown writes:

Pessimism is intellectually seductive and the arguments always sound smarter, especially when they dovetail with our own worries. You think this period is more frightening than the sixteen month recession between July 1981 and November 1982 only because you weren’t there and you haven’t studied history.

Josh talks about optimism being a better ‘default setting’ than pessimism. That being said investors should always be willing and able to look all sides of the issue. The biggest problem the perma-whatevers have is that they are highly prone to confirmation bias. Combating confirmation bias is no easy feat, but as Warren Buffett has shown, taking on the opposite case is a useful exercise no matter what the outcome.

That is why having a well-thought asset allocation strategy in place is so important. It provides a framework around which an investor can make substantive statements about the market without going headlong into the world of market timing. For most investors without a view on the markets a static, well-diversified asset allocation will serve them best. One can see how this approach would have been in part the beneficiary of the rally we have experienced since 2009.

The markets end up fooling us on a regular basis. Investors who come to the markets with a hardened worldview are likely to be fooled most often.

Items mentioned:

Abnormal Returns: Winning Strategies from the Frontlines of the Investment Blogosphere.  (Amazon)

Josh Brown – Are bears more seductive?  (Institutional Imperative)

Warren Buffett, Jeremy Grantham and John Hussman on profit, GDP and competition.  (Greenbackd)

Revisiting reflexivity: Contextualizing cause and effect.  (Big Picture)

Wither the US equity market?  (McKinsey & Co. via MoneyBeat)

Optimism as a default setting.  (The Reformed Broker)

On the dangers of micromanaging your asset allocation.  (Abnormal Returns)

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The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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  • Tadas ViskantaAbnormal Returns has over its seven-year life become a fixture in the financial blogosphere. Over thousands of posts we have striven to bring the best of the financial blogosphere to readers. In that time the idea of a “forecast-free investment blog” remains as useful as it did six years ago. More »

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