“How do you think Trump’s trade war with China is going to affect my investments?” “Are we heading for a recession?” What do you think is going to happen with the stock market?” “Do you think interest rates are going up or down?”
These are the types of questions we hear from clients every day. Among our most important roles as financial advisors is to help guide clients through questions like these. As much as one might hope, there is no “crystal ball” to predict what’s coming next.
While we don’t have a crystal ball, we do have a philosophy and thought process that helps us embrace the unknown, allowing us make better decisions in times of uncertainty and stress.
Knowing what you don’t know
Our philosophy begins with an understanding that we don’t know what’s going to happen, and neither does anyone else. Financial professionals are particularly susceptible to the “know it all syndrome”, or as social psychologists call it, “illusory superiority”, which is a cognitive bias where a person overestimates their own abilities. A study performed in 1981 illustrated this overconfidence by finding that 93% of U.S. drivers surveyed felt their driving skills and safety put themselves in the top 50%. Have you ever overestimated your abilities? Well, most financial advisors overestimate their predictive powers; feeling they are in the top echelons as well. Mark Twain once said, “it ain’t what you know that gets you into trouble. It’s what you know for sure that just ain’t so.” So true.
Ok, so we know there is no crystal ball, but decisions still need to be made regardless of the environment. So how do we do that? We think it starts with the quality of questions being asked.
Understand first- and second-level thinking
We believe that if you ask good questions, you will arrive at the right answer more times than not. One of my favorite authors, Howard Marks, who wrote “The Most Important Thing: Uncommon Sense for the Thoughtful Investor” talks about what he calls “first- and second-level thinking.”
First-level thinking looks like this: I think the stock market will be higher by the end of the year because the Federal Reserve will be lowering interest rates.
Second-level thinking dives much deeper by asking additional questions, starting with; why do you think the Federal Reserve will be lowering interest rates? If I’m wrong, what could cause the opposite to occur? What are other possible outcomes? What are the probabilities that I see, and how does this differ from the consensus viewpoint? What am I missing or not thinking of?
In other words, you embrace uncertainty by getting past the surface-level view and examining the likelihood of alternate outcomes.
Embrace uncertainty in portfolio management
So how do you apply these concepts of embracing uncertainty and applying first- and second-level thinking when it comes to managing investments? Here’s RS Crum’s approach:
- Start with diversification. Simply put, diversification works. You want diversification across markets, securities, asset types, etc. If you are adequately diversified, then there will always be one investment that you are not happy with.
- Move slowly. It’s important to avoid big mistakes by making quick and abrupt changes. Even if you apply responsible second-level thinking, you can still be 100% wrong even if arrived at the right conclusions. Markets are fluid and incredibly complicated. We choose to make measured moves because being 100% right means you could also be 100% wrong.
- Employ trading efficiency. Although our goal is to buy low and sell high, you can never be certain whether a security will keep going up or down. We take the emotion out of trading by utilizing a state-of- the- art trading software to help us make smart and efficient trading decisions without being subjected to the emotions of the moment.
- Keep an eye on the large cycles. We may from time to time apply a cycle positioning strategy whereby we strategically overweight or underweight investments based on their relative value and position in the larger business cycle. Do we believe that stocks are undervalued, fairly valued or overvalued? And of course, beyond our gut-level responses to these questions (i.e. the “first-level thinking”), what are the probabilities, implications, and other possible outcomes?
When I was younger and less experienced, I really thought I knew a lot. Over the years I have come to understand that the best investors in the world start from a place of knowing what they don’t know. They also know how to keep their emotions and biases in check, by building repeatable processes to support their efforts. However, we must not forget that the most important thing of all is to have quality people asking quality questions.