As human beings, we are remarkably poor at predicting our future selves. We know that our personalities, preferences and values have certainly changed in the past, but, as ConvergEx's Nick Colas explains, we tend to dramatically underestimate what changes might be in store on these fronts in the future. That’s the upshot of a recent bit of research by Harvard psychologist Daniel Gilbert, and it helps explain how we process decisions as varied as whether to get a tattoo or how we invest financial capital. Stasis is our default setting when it comes to considering our futures, and that lack of imagination seems to inform how much we can predict about how other people and systems will change as well. The most important takeaway: no matter how much you think your life will remain the same, you are almost certainly wrong. And the same goes for capital markets.
Via ConvergEx's Nick Colas,
“Human beings are works in progress that mistakenly think they’re finished”. That bit of pithy wisdom comes from Harvard professor of psychology Daniel Gilbert. He recently did a TED lecture (link below) on a 2013 paper he co-authored entitled “The End of History Illusion.” Here is a quick summary of his study and its findings:
Gilbert and his team used online surveys to query thousands of people about their perceptions of their own personalities. The survey questions focused on five traits: conscientiousness, agreeableness, emotional stability, openness to experience, and extroversion.
In a clever twist, the researchers split up the survey group into two components. The first were asked to judge how much they expected their five characteristics to change in the next 10 years. The other group got a different baseline: how much had these features of their personality changed over the last decade?
The research team then lined up the two groups’ responses by their ages. The idea here was to compare how much a 20 year old thought they would change and to how much a 30 year old reported having changed over the prior decade.
The dichotomy between expected change looking forward and reported change from the prior decade is dramatic. At every age, survey respondents underestimated how much they expected their personalities to change versus what someone 10 years older reported as actually having occurred to them. This happens consistently from 18-64, the entire range of the study. We simply never learn that our personalities will change with time.
The title of the paper – “The End of History Illusion” – points to Gilbert and the team’s explanation for this phenomenon. Essentially, people at any stage of life, from college freshman to middle aged office worker to recent retiree all think they are pretty much done evolving as individuals. They think they will like the same music in 10 years, have the same best friend as they do now, and enjoy the same types of foods and vacations. But it rarely works out that way, as the 10-years-older respondents consistently prove.
So how do we get it so wrong? The paper offers two potential explanations. First, most adults think they’re pretty nifty just the way they are and feel they are solidly in touch with their own emotions and needs. So why should we think we need to change? Second, forecasting change is more difficult than just pondering the past. As the paper puts it, “If people find it difficult to imagine the ways in which their traits, values, or preferences will change in the future, they may assume that such changes are unlikely. In short, people may confuse the difficulty of imagining personal change with the unlikelihood of change itself.”
It is in that final point where the link to the investment process makes an entrance. The standard construct of any capital allocation process centers on forecasting. We predict everything from inflation to corporate earnings to risk tolerances to preferences in the market for growth or value or some blend of the two. But if we find it hard to predict the thing we should know best – ourselves- what level of hubris do you need to reach to believe you can forecast the actions of other market participants? Too negative? I get that a lot - sorry. Let’s back off a bit and look for another pathway.
Another lesson for investors from “The End of History Illusion” is that we are hard wired to think that the future will be much like the past. We anchor the self-evaluation of our future selves on the notion that we’ve got a lot of the game of life figured out. And since markets are nothing more than the collected wisdom of humans, you’d expect to see capital markets behave similarly. And right now we have that in spades. A few points here:
If you need any proof that humans still rule the roost when it comes to setting asset prices, and not their co-located high speed algorithmic doppelgangers, just look at the current low volatility, low volume trading environment. The actual 30-day volatility for the S&P 500 (as measured by the SPY SPDR ETF) is 7%, the lowest reading in a year. The equivalent reading for U.S. high yield corporate bonds is 3%, very near its one year low. The highs for actual volatility over the last 12 month for each measure are more than double their current observations: 16% for the S&P and +10% for junk bonds. It’s Groundhog Day, without the piano lessons or Buddhist underpinnings.
While the U.S. Treasury 10 year note now sports a yield back over 2.5% - 2.64%, to be precise – this is still far lower than just at the beginning of the year. Follow in the footsteps of your ancestors on their Grand Tours of Europe and you’ll see that the U.S. is actually lagging France (1.75%), Spain (2.63%), Switzerland (0.74%) and Germany (1.4%) in terms of having to pay investors more for their notionally risk-free returns. The reason? Slack economies don’t tend to generate inflation without a currency crisis. And, like the respondents to Gilbert’s surveys, bond investors don’t expect that part of Europe’s economic personality will change in the next 10 years.
Even commodity prices have a touch of “The End of History Illusion” about them. Over the past 2 days we’ve seen some startling headlines out of Iraq, with al-Qaeda affiliates taking over key northern cities and seemingly on the path to Baghdad. Mosul is in the supposedly safer Kurdish north of the country. And it is an oil producing region in its own right. Iraq as a whole produces 3.6 million barrels of oil/day, so it is not as large a player as Saudi Arabia or Russia. But price happens at the margin, and the recent and largely unforeseen unrest in the country barely moved oil prices today. West Texas Intermediate is only $104.50 and Brent is just below $110. We don’t hear anyone really talking about oil prices yet, but that’s likely a blind spot caused by the “Same as it ever was” wiring of our predicting selves.
The ultimate point here is not to be negative on risk assets like stocks, but rather to provide a fresh construct to understand why we underestimate change until it is right on top of us. As the Gilbert research shows, predicting how we ourselves will change is a very large blind spot in our psychological makeup. Yes, perhaps when we look outside ourselves some of our biases fall away and we can do better. But not a lot better, if current market dynamics are any guide.