The Quest for Certainty
By Tim Egart, CFP®, AIF®
In any given day, Google manages about 8.5 billion web searches – an astounding number. With over 3 trillion searches per year, technology has allowed us to have an answer to basic and complex questions. In 2023, the most asked question thus far is “how many ounces in a cup?” Feel free to google the answer… But among top searches are more existential questions like, “what’s the meaning of life?”, “who am I?”, or “is there a God?” While we can debate whether Google is an appropriate avenue for such questions, the magnitude of our annual search points to a challenge for modern day society – we want to know the answer to everything. We desire certainty.
When investing, the main challenge we deal with is uncertainty. For investors, the focus is managing a risk-return trade off. The higher the uncertainty, the greater the expected return (and also the greater the potential loss). And vice versa; the lower the uncertainty, the lower the expected return. The challenge is balancing exposure to life’s myriad risks with our innate desire for certainty.
To help explain our need for surety, we can turn to Prospect Theory[1]. Developed by Amos Tversky and Daniel Kahneman, it suggests humans tend to prefer certainty over probabilities. Given the choice between receiving a guaranteed $10,000 and a 50% chance of winning $20,000, most would opt for the sure $10,000, even though the expected value of both outcomes is the same.
Shown below is the commonly referenced “Cycle of Investor Emotions”, which illustrates the various feelings that investors experience at different phases in market performance. When markets are great, we’re euphoric. When markets are challenged, we can become despondent.
What’s perhaps more relevant is the impact that this has on the returns an average investor earns. Reacting to headlines, economic trends, and talking heads, the average investor is more prone to tactical moves. They grant their feelings – thrill, euphoria, fear, or despondency – authority over their long-term investment decisions. When that happens, we can materially unwind years of thoughtful and disciplined wealth creation. This alone is a compelling reason to slow down when panic or euphoria set in.
In the current landscape, the 10-year US Treasury Note (currently yielding 4.55% as of 11/15/23) is offering the strongest yields we’ve seen in ~15 years. Why would one not simply move more assets towards this security? Despite the certainty offered, a 75% chance of achieving a ~6.06% return from equities over that timeframe provides an equal expected return. Historically speaking, those aren’t bad odds – we just need to expose ourselves to uncertainty. Nevertheless, the fear of losses could cause limited, but more secure gain to seem far more attractive. And even more so in volatile market environments.
The world may feel like a tinder box right now, but we’d remind you this isn’t the first time that markets (or people) have faced volatility. Below is a logarithmic chart of the S&P 500’s performance through time overlaid against various crises the world has endured. It’s instructive to note that worldwide equity markets rely on uncertainty.
Between COVID, the war in Eastern Europe, and the horrendous situation in the Middle East, it seems the last 3 years have proven that certainty is more fragile than we’d like to think. Carefully thought-out plans shouldn’t be dropped in reaction to temporary circumstances. Our team is ready for these conversations and happy to evaluate the investment lineup that makes sense for each situation. But let us also aim to ensure that we understand our human biases and make decisions based on fact. Stay off the rollercoaster of investor emotions. We’re here to help smooth the ride.
*For more reading on human biases, we strongly recommend Daniel Kahneman’s book, Thinking Fast and Slow. In that book, he demonstrates that humans often distinguish between “system 1” (quick and automatic) and “system 2” (careful and logical) thinking. Our tendency is to default to system 1 and we must slow down intentionally to draw our minds into system 2 decision making. The goal is to mitigate reactionary decisions while not getting delayed in over-analysis.
[1] Source: https://www.nngroup.com/articles/prospect-theory/