Expert’s Choice: Two mistakes in uncertain times

Over the last few weeks, in the face of an unknown outcome, every man and his dog has offered an opinion on markets.

Behavioural economists and psychologists have shown that people, even experts in their field, have poor track records of making proper assessments in times of uncertainty.

There are two ways we quickly assess the probability of an outcome and these are susceptible to flaws. An understanding of these can help investors better assess periods of uncertainty and thus lead to better decisions in uncertain environments.

The lifetime work of psychologists Daniel Kahneman and Amos Tversky was about understanding human behaviour. The work of these two psychologists crossed disciplines, transcending psychology, into military, sports, medicine, politics and economics. In 2002, Kahneman was awarded the Nobel Prize in Economics for his work on decision-making and uncertainty.

Kahneman and Tversky have shown that people, even experienced researchers, make poor decisions when faced with uncertainty. In a research paper, Judgement Under Uncertainty, Kahneman and Tversky highlighted two decision making processes that people use to assess probabilities or make estimations:

1. availability; and
2. adjustment and anchoring.

According to Kahneman and Tversky (1974), “A better understanding of these heuristics and of the biases to which they lead could improve judgments and decisions in situations of uncertainty.”

Availability

Availability is the decision-making process of assigning the likelihood of an outcome by the ease with which instances can be remembered.

According to Kahneman and Tversky, “For example, one may assess the risk of heart attack among middle-aged people by recalling such occurrences among one’s acquaintances.” This leads to biases, often overestimating the likelihood of occurrence.

Recent occurrences too are likely to be more readily remembered and therefore will increase the estimation of occurrence. Furthermore, the impact of an experience will impact decisions. For example, the impact of seeing (or even hearing about) a shark attack will have an impact on your assessment of the probability of a shark attack.

Adjustment and anchoring

The experiment that highlights anchoring and adjustment involves two groups of students. One group is asked to estimate the answer for:

1 x 2 x 3 x 4 x 5 x 6 x 7 x 8

The other estimates the answer for:

8 x 7 x 6 x 5 x 4 x 3 x 2 x 1

Kahneman and Tversky hypothesised that adjustments we make quickly when estimating are typically too low, so the resulting guess will be lower than the real answer. Furthermore, because the result of calculating an estimate is based on a starting point, which is established in the first few steps of making an estimate, estimates will be higher in the descending sequence than the ascending sequence. This is because the descending sequence, anchored by a higher starting point, should give a higher ‘estimate.’ The results of Kahneman and Tversky’s experiment confirmed both predictions. “The median estimate for the ascending sequence was 512, while the median estimate for the descending sequence was 2,250. The correct answer is 40,320.”

Psychologists have found, that because of anchoring we are also bad at estimating probabilities of (i) conjunctive events (for example, drawing a red marble seven times in a row, with replacement, from a bag containing 90% red marbles and 10% white marbles); and (ii) disjunctive events (for example, drawing a red marble seven times in a row, with replacement, from a bag containing 10% red marbles and 9% white marbles).

We tend to overestimate the probability of conjunctive events and underestimate the probability of disjunctive events. This is because our estimation is ‘anchored’ in the simple probability of success at any one stage and our adjustments are insufficient.   

Applying this to the current market

Markets have been responding to every economic release and central bank reaction, or suggestion of reaction since the Fed stated it would “retire” the word ‘transitory’ when describing inflation. Since then, it has been difficult to accurately ‘anchor’ risks. It’s almost impossible to adjust with so much information and misinformation being circulated. It’s also likely we are making decisions based on small samples. The NASDAQ composite peaked in November 2021, since then it has fallen over 20%, which puts it in bear market territory.

Here are some interesting observations about bear markets (most analysts use the US market for analyses because it has a longer history and because it always has been one of the bigger stock exchanges, it has far more data points).

This is the 27th bear market in the S&P 500 since 1928. The average length of the past bear markets was 289 days (9.5 months), with an average decline of about 36%. The longest was in 1973-74, which lasted 630 days.

Now compare these to bull markets. There have been 26 of these since 1928. Bull markets tend to be longer, they average 991 days (33 months). The average rise of the share market during a bull market is 114%. The longest was almost 11 years, from 2009 until the COVID-19 crisis.

It has been well noted that since 1928, overall the share market has been positive, so while bear markets can be painful and can generate headlines, over the long-term the market is positive. There are two reasons for this.

1. Markets are positive most of the time – Bear markets comprise only about 20% of the months since 1928. Bull markets around 80%. Therefore, roughly 80% of the time, share markets are rising and they rise by more than they fall. This leads us to reason two.
2. The asymmetry of returns – You’ll note above, that average bull market return was in excess of 100%. It is impossible, during a bear market to lose that much. There is potential for bull markets to experience higher returns than bull market losses. Put simply, over almost a century, the larger positive returns of bull markets offset the lower negative returns of bull markets.

You may have noticed, the above includes examples availability and anchoring. You may have been surprised that we experience bear markets only 20% of the time. Their impact, and because we are in one, may have meant their frequency is over estimated.

In the above too, to make the length of bull markets seem longer I used 33 months. Reading quickly, your brain may not have been able to quickly estimate that 33 months is just under three years. It just recognised it is much more than the 9.5 months. We are not good at estimating. The media exploits this. Consider these two headlines on the same day from the same publication (9 June 2022).

ASX climbs 0.4pc despite brutal bank sell-off

Falls are presented in billions of dollars, rises in percentage points. While this is not always the case, the estimated or visualised size of the fall, or the estimated or visualised impact of the rise, is anchored by the number reported. 

Hopefully this illustrates it is important to look past the positive and negative commentary and concentrate on your long-term goals. Assess risks, understand the data, act without emotion or haste. We may be ignoring probabilities relevant to our decision or we may have estimated poorly.

Successful long-term investors survive short-term falls by sticking to investment principles that have withstood the tests of time. For portfolios, this may include better diversification. For equities, investing in profitable companies with strong balance sheets and stable earnings has historically given resilience to portfolios.

Kahneman and Tversky’s lifelong passion was to understand why people do not detect the biases and flaws of their own judgements. They proved we are poor decision-makers when faced with uncertainty. Bear markets are not fun, but they should be expected. Given that Australian investors will have their superannuation and pension accounts from, potentially, their teens to well into their happy retirement, they should expect to confront about 15 bear markets over that time, give or take.