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Retirement Planning: Embracing Zero-Risk Bias February 23, 2009

Posted by retirementwithaplan in retirement.
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Embracing Zero Risk Bias

We have seen a lot over the last year. And it looks as if the unfolding crisis has yet to spread itself out completely over the whole globe. While it may have started here in the United States, gradually it has found itself into all of the major economic contributors and is now exposing its toxic self in countries many of us would not have 022309_bi_zer_rik1considered as much more than secondary players.

Countries such as Portugal, Ireland, Germany and Spain all face the possibility of default, largely in part because their banking systems are at a critical point. Many of these aforementioned countries have financial institutions that are larger than the host countries and because of that, may be too big to save. This is the polar opposite of the old saying: “to big to let fail”. Rather than asking how could this have happened, we should be asking when could this have happened.

We tend to be believers in history when it suits our natures. If we have been investors for less than ten-years, we believe that every five years or so, the markets will crash. But if we were to look at the markets from the beginning of the Greenspan years, you will find little if any indication that the there is any trouble in the near future. Nick Silver from FiveThirtyEight.com calls this the recency bias. In fact, Mr. Silver has concluded that, should you fail to delve far enough into the past, using only recent history as a guide, there would have been no indication that the turmoil the markets are currently experiencing would even be possible.

Why do we look no further than the historical nose on our faces when we make determinations about risk? Our bias comes as second nature to us. We allow them to influence our process of estimation and in doing so, using the inclusion of only the most basic facts, often the most recent available. John Grable, writing for THE JOURNAL OF INVESTING in 2006 suggested that risk could change based on something as tenuous as a market’s closing price. What happens when the conclusion reached by numerous economists and market analysts offer an unbiased opinion based on studies they have made that were, on the surface seemingly rigorous but were all making the same mistake?

It would seem that understanding the possibility of bias exists is not enough. You must estimate the risk of bias as well. The risk that bias will enter into the equation makes investing for the present and in many cases, for the future more difficult. We enjoy the immediacy of upward moving trends and run from the reverse.

When we open our 401(k) or brokerage statements, we might experience a sunk cost, an effect that forces us to believe that these times cannot be reversed and the money we lost, is forever lost. Another bias that rears its ugly self is the impact bias, which some will understand as the anti-optimism. Not pessimism but the feeling that this will be an endless spiral downward, or sideways and will continue unabated ad infinitum.

How can we rationalize these losses? No amount of risk was too much. Aggressiveness reaped rewards that made you feel as though you possessed some special skill. You were the master of the markets (and your fund managers and brokers all performed feats of financial skill). You were lucky to have had such good experiences. You were lucky, nothing more. And now that those fortunes have shifted somewhat, so has you feeling for risk.

It seems that we have now fully embraced a zero-risk bias. We hug it as if it will yield the answer to a good night’s sleep, shine a light on the path to the future, and keep the hard-earned money that we had once invested and lost in our possession.

This kind of bias is often used when we speak of pharmacological cocktails that may have some good for the greater number of patients but the minority when they used these drugs, experienced ill effects. The result of such bias results in the removal of the drug because the risk that the few might get harmed takes precedent over those that might benefit.

Many newcomers to the markets – those that use the recency bias as their investment history, are now using a zero-risk bias to control how and where they invest their money. This is having a profound effect on the stock markets, which is having a ripple effect on the rest of the world. (Corporate debt, it should be noted is having a great 2009 but, overall, folks are finding the risk in such a security still too high).

Zero-risk assumes that no risk is better than some. Those that lost money over the last year fall into three basic categories: the “shocked into paralysis” which has ironically turned out to be the new buy and hold investor, the “run for the hills and sell” and in the process, leaving a trail of losses in their wake, and the zero-risk investor. While each group provides a glimpse at the new age for risk, it is this last one that is most troubling.

With this type of bias, these investors believe that the markets will repeat this event again and possibly even soon. Although nothing in the past prepared anyone for the present and the unknown is just that, zero-risk bias prevents us from looking at risk as the single most important component in the investment model.

This presents a real problem, bigger than banking and possibly more profound than the housing crisis. Evaluating risk used to involve some simplistic tools. Past performance is no longer worth considering. Year over year, quarter over quarter comparisons will yield little. Tenure, experience and style will not offer a distinct measure of how a money manager will perform. But what if these are the only tools we have.

Then we should use them. If everyone fails, singling out members of the herd will not provide any insight. Instead, those past performance numbers, throwing out the high and the low, the manner in which the funds or brokers performed in the years leading up to this debacle and looking for instances where recoveries where long and drawn out, will give us enough evidence that things will and can get better. Until we release ourselves from the comforting embrace of zero-risk, we can expect this market ennui to continue much longer than it should.

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