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Misplaced Confidence - Investment Strategy Committee Monthly Blog
Famed economist and financial engineer Dr. Andrew Lo of MIT once wrote a paper entitled “Warning: Physics Envy May be Hazardous to Your Wealth.” Lo warns that, while we have come up with many “important breakthroughs in economics, physics envy has also created a false sense of mathematical precision in some cases.”
Though it’s been more than a decade since that paper, the concept and idea have stuck with me as it relates to economics, markets, various investment strategies, managing for risk and return, and using new information in old models.
We need to remind ourselves that economics and markets cannot be predicted with precision or consistency. They are not like the laws for gravity, inertia, velocity, mass, or thermodynamics.
Many have seen the studies showing that, even with the best research and models:
- Active equity managers underperform the S&P 500, over long periods.
- Economists and strategists are more often wrong than right.
Yet, we still sometimes see many trying to connect the dots, show a correlation chart giving “proof” that they’re right, or worse, telling us that the economy will collapse or that we’ll all run out of food. And it’s not just limited to economics and markets. Politicians have been known to use statistics and data to suit their narrative, often in less than truthful ways. We sometimes fall for these narratives, whether they are economic, political, or market related. Sometimes, we fall for them en masse.
Our confidence too often is misplaced in things or in people that do not offer precise models. Sometimes the predictions aren’t even close.
I’m guilty as the next person, however, for both analyzing various pieces of imprecise data as well as putting out my own imprecise forecasts. If I know it’s not precise, why do I do it and why does everyone else?
Because that’s all we have to work with. It’s not that dealing with imprecision is bad. It’s when we put too much weight or too much confidence in our views or when we think we are more precise than we actually are that it can become problematic.
Our evolved brains no longer need to worry about the predator hunting us, but we wish to be as certain as we possibly can in our decisions and in our beliefs. And we are right often enough to give us the confidence that we might be right again. The confidence isn’t bad either, it’s just having too much of it and in large doses that can hurt us.
When things are going smoothly, we might become subtlety overconfident about the precision of our decisions. Over time, we can confuse luck with skill. When we are overconfident, we tend to narrow our confidence intervals, because we feel higher conviction, perhaps due to our past successes.
We may be tempted to put too much weight on “normal” statistics, even though markets are often not normal. Or worse, to throw diversification out the window or fire our financial advisor, because of a few lucky bets we made that were overwhelmingly successful.
But the markets and the economy have a way of reminding us and humbling us when we mistake luck for skill and when we have gotten too loose with our discipline, throwing caution to the wind. Whether it be neglecting diversification, risk management, or abandoning information that doesn’t confirm with our views, there’s always a price to be paid for being overconfident.
Fast forward to yesterday and the market meltdown for several technology and energy stocks on the news of DeepSeek. We had heard experts tell us one thing, that we needed to spend hundreds of billions of dollars on AI investments for a number of years. There was apparently no way around it.
And over the weekend, we saw a totally different narrative come out of the blue, that DeepSeek was able to accomplish what huge companies were able to accomplish, but on a shoe-string budget with limited chips and in just two months. Marc Andreesen even called it “AI’s Sputnik moment.”
The news sent shockwaves through the equity market. Several stocks, including Nvidia, dropped by 15% or more yesterday. Today, the markets appear to be digesting the news in stride, with Nvidia up roughly 9% as of market close on 1/28/25. Did the assumptions completely change? Not entirely. We will still need large amounts of capital spending in technology. Will there likely be things that improve how efficient we can be at it? For sure. Will another innovation disrupt the current innovations? Likely.
This was a good example of a widely held assumption being challenged.
Some may have thought it was game over for Nvidia. Throw in how we communicate over social media and those feelings may have translated into some investors pressing the “sell” button in their investment accounts at precisely the wrong time. Had investors been grossly overconfident in their positioning, it could have been even worse.
In an imprecise economic world that is not governed by the laws of physics and one where human behavior, sometimes even crowd behavior, dictates directionality and amplitude, things can move very fast, often irrationally and without much thought as to reason.
This is why financial advisors and financial coaches can be critically important to clients, especially when emotions such as fear and greed come into play. Those emotions can come into play quickly and they almost always come into play during periods of uncertainty or volatility.
While yesterday was different than every other pullback we’ve seen in the markets, there is one similarity shared with other market events that is worth paying attention to – new information challenging one or more pre-existing assumptions or the appearance of such. This could be related to an earnings report, a currency collapse, or fears of a recession or higher inflation.
When this condition is present, it can be easy to switch off our brain and let the emotions take over and get caught up in it. But if we are prepared in advance with proper portfolio positioning and we are investing for the right reason and at the right risk tolerance level, we can tell ourselves that “this too shall pass.”
If we are conditioned to remember that economics and markets are not predictable like gravity, we can avoid the unnecessary angst and stress over markets and economies that will almost always occur. If we can better understand why these things occur, we might even take advantage of the volatility and add to our investments, following the admonition of Warren Buffett, “be fearful when others are greedy, and be greedy when others are fearful.”
Securities offered through LPL Financial, Member FINRA/SIPC. Investment advice offered through WCG Wealth Advisors, a registered investment advisor. WCG Wealth Advisors and The Wealth Consulting Group are separate entities from LPL Financial. LPL Approval: 689305
All data as of 09/19/24