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When surprises occur in everyday investing

by | Jan 16, 2019 | UpClose

When surprises occur in everyday investing

by | Jan 16, 2019 | UpClose

Nobody knows for sure what market environment will occur next. Isn’t it preferable to have a dynamic, risk-managed investment portfolio that can adapt proactively with rules-based, disciplined decision-making, rather than the “buy-and-hope” portfolios of the past?

When we think of our lives or just talk about what we have been doing lately with a friend, we tend to focus on big events. If we have just taken a trip, the details will be recounted. If a baby has been born or we’ve been to a wedding, the event dominates our conversations. Similarly, in the news, an uprising in Iraq or the World Cup can consume the headlines and color what we think is occurring around us.

But really, life is more often concerned with simple tasks, with everyday activities. We walk to the mailbox. We drive to the store. We eat our meals at predetermined times. We sleep.

Behavioral scientists or psychologists tell us that these actions are controlled by what Nobel laureate Daniel Kahneman calls System 1.

System 1 is our subconscious, automatic response system that takes us pretty smoothly through each day without a lot of conscious thought about how we do it.

Unless you are 6 months to a year old, you don’t give much thought to the mechanics of how you get up on two feet and walk. Unless you are a student in driver’s ed, driving is fairly effortless. And don’t get me started on how easy it is to eat! Now sleeping—it seems the older you get, the more effort it takes, but, generally, if you get tired enough, you just fall asleep.

Buy-and-hold investing has the allure of the System 1 tasks that so dominate our lives. You invest once, you allocate among asset classes to diversify away risk, and—other than an occasional quarterly or annual tweak back to that allocation—that’s it. The markets take care of the rest.

Where ‘System 2’ differs from ‘System 1’

System 1 is very efficient. It handles most tasks … most of the time. But what about reason, logic, and responsiveness? Don’t they come into play? That’s the job, in Kahneman’s view, of the mind’s System 2. It steps in to use those faculties only when System 1 needs its help.

You’re walking along and the sidewalk ends. What do you do? You just can’t continue to follow System 1 and keep automatically walking, can you? You might be lakeside or, worse still, on the edge of a cliff. A decision has to be made.

You’re driving your car when a big, diamond-shaped orange sign appears on your right-hand side: “Detour.” Suddenly, you need more than just an automatic pressure on the accelerator, hands on the steering wheel, and brake at the ready. You need to think about what to do next.

This even happens while eating. You’re automatically eating your salad. Fork to lettuce, fork to mouth, chew, repeat.

Then, soup comes. You prepare to repeat the process—but now with a spoon. You pick up the spoon, dip it in the soup, and bring it to your mouth. All this without a single conscious thought. The soup touches your tongue. You recoil—it’s too hot! Do you really want to keep consuming it right then? You have to think about it.

 

Finally, sleeping seems automatic. What could be more passive? You just have to lie there, right? But that’s an illusion. You have a bad dream. Doesn’t System 2 have to convince you that that’s all it is? A crack of lightning wakes you. A summer storm has sprung up in the middle of the night. “Do I have to close the windows?” There’s a noise downstairs, the dogs start barking. You wake up. Is a trip downstairs to investigate necessary?

These are all simple tasks, and we spend most of our lives automatically carrying them out without even thinking about them … most of the time. But they have one other characteristic: They are all responsive to change.

In every case, these simple tasks still require a contingency plan. They must be ready to respond to the environment around them … especially surprises!

In “Thinking, Fast and Slow,” Kahneman tells us that “the main function of System 1 is to maintain and update a model of your personal world, which represents what is normal in it. The model is constructed by associations that link ideas of circumstances, events, actions, and outcomes. … As these links are formed and strengthened, the pattern of associated ideas comes to represent the structure of events in your life.” Yet, he also tells us that “a capacity for surprise is an essential aspect of our mental life.”

“System 1 is the brain’s fast, automatic, intuitive approach. System 2 refers to the mind’s slower, analytical mode, where reason dominates.”
As I write this article, I’ve been trying to think of an ordinary activity, some simple task we do, that does not require that we also have the capacity to deal with a surprise while we are carrying it out. (Let me know if you think of one. I haven’t.)

Why investors need a ‘System 2’ response: A dynamic, risk-managed investing approach

Most of the investment world seems to be forever trying to convince us that investing is somehow different. The “buy and hold” mantra is chanted on the financial shows and printed repeatedly in both the financial and nonfinancial press.

I guess they would respond, “But investing isn’t a simple task.” And that is true. But does that lead to the conclusion that the way to deal with even a non-simple task is to abandon the use of System 2 when a surprise occurs?

Of course, the buy-and-holders, the advocates of passive investing, would respond that they employ System 2 before they invest. But isn’t that the same as thinking about where you are going and what you are going to wear before you leave on your walk, and then ignoring System 2 completely once you’re dressed?

Couldn’t that lead you to automatically proceed into the lake when the sidewalk unexpectedly ends? Like the buy-and-hold-investing argument, you’re “all wet” as a result.

 

In contrast with passive investing, dynamic, risk-managed investing always has a plan to deal with contingencies. This type of active investing is generally responsive investing. It is designed to deal with routine, day-to-day events but also has the ability to adapt to its surroundings and plans on surprises.

Kahneman said in a 2014 discussion on behavioral science at Harvard Business School, “System 1 is the brain’s fast, automatic, intuitive approach. System 2 refers to the mind’s slower, analytical mode, where reason dominates. But the first often dictates the second.”

What sounds like a more logical and effective investment approach for investors—through inevitable up-and-down market cycles?

Dynamic, risk-managed investing models are designed to generate better long-term performance. They seek to accomplish this by emulating, not rejecting, our everyday experience with life’s simple tasks—letting System 1 carry you along for most of the time. But these models also are built to engage System 2 when surprises inevitably surface.

The opinions expressed in this article are those of the author and do not necessarily represent the views of Proactive Advisor Magazine. These opinions are presented for educational purposes only.
 

Jerry C. Wagner, founder and president of Flexible Plan Investments, Ltd. (FPI), is a leader in the active investment management industry. Since 1981, FPI has focused on preserving and growing capital through a robust active investment approach combined with risk management. FPI was named to the 2015 Financial Times 300 Top Advisers and the 2015 Inc. 5000 List of fastest-growing private U.S. companies. flexibleplan.com

 

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