In his book, Thinking, Fast and Slow, Daniel Kahneman describes a puzzling limitation of our minds: “Our excessive confidence in what we believe we know. And our apparent inability to acknowledge the full extent of our ignorance and the uncertainty of the world we live in. We are prone to overestimate how much we understand about the world and to underestimate the role of chance in events.”
Daniel Kahneman received the Nobel Memorial Prize in Economic Sciences for his groundbreaking work, in applying psychological insights to economic theory, particularly in the areas of judgment and decision-making under uncertainty.
Kahneman has countered some assumptions regarding traditional economic theory (that people make rational choices based on their self-interest) by showing that people frequently fail to fully analyse situations where they need to make complex judgments. Instead, people often make decisions using rules of thumb rather than rational analysis, and they base those decisions on factors economists traditionally do not consider, such as fairness, past events and aversion to loss. As financial advisers, we are often faced with questions such as: What do you think about the current political crises in Europe, or How will the debt problems in the USA impact my retirement portfolio? or With the petrol price heading for R15, what will happen to our share market? What should we tell our clients? Will these events impact our clients’ portfolios? Sure. Do we know how? I don’t think so.
Warren Buffett is revered as possibly the most successful investment guru of our time. He is also often quoted making several different points about investment philosophy and possibly just as often points that he would not agree with. However, I cannot use a better example to prove my point than the case below. During a recent interview with CNBC, I was struck by an interesting repetition in Buffett’s answers. No matter how many times the CNBC presenters attempted to get him to have a definitive view on an economy or political situation, he simply refused to make these complicated matters simple. No fewer than five times, his answer was: “I don’t know,” or “I don’t know all the facts.” Concerning Europe, his conclusion was: “So it’s a really tough problem.”
If Warren Buffett doesn’t know, why is it that the public expects financial advisers to know the answers to these questions? Perhaps we have positioned ourselves as the experts to answer these questions. Even if we steered away from answering these questions ourselves, we might still be aligning ourselves with the gurus, in the asset management teams that we recommend.
Part of our problem is that we feel the need to justify our existence and the fees that we charge. If we cannot have opinions about where the world markets are going or how we should be shifting our clients’ money around, how do we justify our existence?
Kahneman points to decision-making based on rules of thumb and traditional economic theory. When closely examined through statistical analysis, many traditional economic beliefs can be questioned. For example, I was taught in Economics 101 that higher interest rates attract flows into an economy. Today, the analysis shows that the opposite is often true − higher interest rates suppresses economic growth and reduces foreign investment. In fact, many researchers will point to the poor relationship between economic and political factors and market movements.
Daniel Kahneman suggests that we tend to replace difficult questions with simple ones. For example, when faced with buying the shares of a car company, we might ask ourselves whether we like the cars instead of whether the share is good value. We should make sure that we ask the right questions.
I recently carried out a scenario analysis with a couple facing retirement. They were astounded that a lower investment performance didn’t have nearly the same impact as a moderate increase in their spending, on the long-term capital projections. The right question is not: Am I achieving the best performance from year to year? but Can I afford my current spending patterns in different scenarios?
Unfortunately, there are many experts who are willing to give their opinions freely. Answering, I don’t know, does not make for good dinner party conversation or television entertainment. Not unless you are Warren Buffett, it seems. However, we should resist the temptation. Unfortunately, no-one keeps tabs on the easy opinions of experts. They are seldom accountable to real clients.
I’m sure that many seasoned financial advisers can relate to a few embarrassing incidents, where clients from a long time ago remind you of the reckless opinions you had in your youth. The market is a humbling place and if you stick around for a long time, you learn that the best answer is more often than not: I don’t know.
June, 2012 / Sunél Veldtman / INVESTSA