John Jennings, author of The Uncertainty Solution joins the show to explain how to invest with confidence in inherently uncertain and unpredictable markets.
Listen now and learn:
- How humans react to uncertainty
- The difference between the economy and the stock market
- The role of skill and luck in investing outcomes
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Show Notes
John Jennings is president and chief strategist of St. Louis Trust & Family Office, a $15 billion wealth management firm. In his book, The Uncertainty Solution, John explains how to invest with confidence in inherently uncertain and unpredictable markets.
John also writes about a wide range of topics on his blog, Interesting Fact of the Day, and wealth management topics on Forbes.
Below are my notes from our conversation.
How Humans React to Uncertainty (1:20)
Humans have evolved to be a pattern-recognizing species. Uncertainty occurs when we’re having trouble finding or recognizing a pattern in a situation. Even if you don’t realize it, a lot of our human behavior in investing and otherwise is driven by a need for cognitive closure.
The quest for certainty is a primary human motive. We want the world to make sense. We want to have explanations. We want there to be clear cause and effect. So when we feel uncertain, our tendency is to search for the first explanation that fits our worldview to resolve the uncertainty—this is called seizing.
Once people have seized on to something, they don’t want to change their reasoning or their explanation because that would throw them back into uncertainty.
A great example was the uncertainty during the pandemic. People were looking for explanations regarding COVID and tended to grasp whatever was fitting of their worldview or social group. Once they found information that was fitting, they wanted to stick with it even if the scientific data said to do otherwise.
People didn’t want to revisit their explanation for how to view what was happening with COVID. It happens in financial markets and in all areas of life. Uncertainty is everywhere with things big and small. Plus, social media certainly makes it far easier to seize an idea that already fits their worldview.
For investors, that’s really challenging.
The Economy Isn’t the Stock Market (3:40)
We’ve established that humans like to see patterns, but they also like to have explanations—that means they want to have causes. If A happens and then B happens, it’s human nature to accredit the effect of B with A as the cause. But, in reality, there are all sorts of different things that could have caused B that wasn’t necessarily related to A.
Correlation isn’t the same as causation.
There are so many great examples of this idea. My favorite has always been that there is an extraordinarily high correlation between butter production in Bangladesh and S&P 500 returns. Obviously, the butter production in Bangladesh doesn’t cause the S&P 500 to go up or down.
But even when there aren’t correlations, people are still drawn to a cause-and-effect narrative that doesn’t always exist. Perhaps the most common misconception is that the current economic environment will drive the stock market’s performance. For example, when unemployment is high or the economy is in the depths of a recession, it’s common for investors to assume that future stock market returns will be poor.
But the correlation between the economy and the stock market is 0.3, which essentially means there is little to no relationship between the two. If anything, the stock market slightly predicts the economy a few quarters to even a year ahead.
John draws from 2020, reminding us that the stock market peak was on February 26 before falling about 34% from that high between then and March 23. By the end of the year, we saw GDP decline by 8.9%, unemployment spiked to 14.7%, and over 300,000 US COVID deaths. And yet, the stock market rallied by 70% between the market bottom and year-end.
Here’s the thing: because the stock market and economy are uncorrelated in real time, stock market returns can be good even when the news is bad. That’s why investors should follow their strategy regardless of what’s going on in the news. Don’t let the noise of the world get you off track.
Investing Through the Lens of a Complex Adaptive System (16:00)
John and I both enjoy thinking of markets as complex adaptive systems.
A complex adaptive system is something with various inputs that interact in a manner such that it results in a system that is unpredictable.
For more details on this topic, see:
Thinking About Markets Like Piles Of Sand (read)
The Market Is Greater Than The Sum Of Its Parts (read)
EP 70: Thinking Of Markets Like Piles Of Sand (listen)
Investors can’t treat the stock market or the economy as a static thing where when A happens, B will always happen. What actually happens is that investors notice that B tends to happen when A happens, and change what they do accordingly, either to profit or avoid loss. That adaptation then destroys the pattern, or at least the ability to profit from it.
A non-investing example John uses is toilet paper hoarding during COVID. When people couldn’t find toilet paper anywhere, it became rational to buy whatever toilet paper they could get their hands on. This adaptive behavior created a system-wide effect of a toilet paper shortage, which created a feedback loop, which caused everybody else to want even more to buy toilet paper. That is a complex adaptive system in action.
Around the same time, investors were exhibiting similar behaviors with meme stocks like GameStop and AMC as well as cryptocurrencies.
The main takeaway from thinking about markets as complex adaptive systems is that it’s impossible for prediction to be a profitable strategy for investing. There’s simply no way to predict or model all the millions or even billions of actors that are intelligent and react to stimuli from each other and then react to the resulting feedback loops from their reactions.
John and I see this all the time. Investors making (or following) a prediction place far too much emphasis on a few specific data points that allow for a narrative to closely link cause and effect. That’s why it’s important to ignore predictions of all kinds and have a plan in place that doesn’t require you to worry about when or why any type of volatility occurs.
You can find out more about this in my post on Why Expert Predictions Are BS.
Outcomes Driven by Skill vs Luck (24:00)
John and I discuss the skill-luck continuum, an idea that we both first came across in Michael Mauboussin’s wonderful book, The Success Equation.
On the skill-luck continuum, on one side are outcomes determined purely by luck such as roulette, the lottery, or slot machines. On the other end, outcomes are determined entirely by skill such as chess or running a race.
Most things, however, fall somewhere between the extremes on the skill-luck continuum. For example, sports lean towards the skill side, but have an element of luck involved. Meanwhile, there’s skill in investing, but there’s also a large element of luck.
Mauboussin poses two questions to help determine the amount of skill vs luck involved in a given activity:
1. Can an amateur beat a pro?
If you were to sit down for a game of chess against a Grand Master, there is almost no chance you would win. But if you played slot machines against a grizzled slot machine player, you could potentially win because of the lack of skill required in the activity.
With investing, amateurs can absolutely beat the pros.
2. Can you lose on purpose?
Going back to chess, it is possible to lose on purpose. Losing on purpose with slot machines or roulette, however, is a bit more difficult.
With investing, people can’t lose on purpose. If they could, then they could easily sell short that stock and make a killing. Remember, picking a stock that can go down is as valuable as picking one that will go up. There are no famous short sellers who made a long career of profiting from losing stocks.
Investing is a lot closer to the luck side of the continuum. There is skill involved, but you need decades of data points to untangle an investor’s skill from luck. On the other side of the continuum, you can tell instantly whether a tennis player, swimmer, or chess player is good.
Because so many Wall Street “experts” and money managers are incredibly intelligent, they become victims of the paradox of skill. As everyone increases in skill with an activity, the difference between the best and worst participants narrows, which in turn results in luck playing a larger role in outcomes than skill.
This is a point that nearly everyone that talks to me about a “brilliant manager” misses. I have no doubt that the manager of any given fund is brilliant, but so is everyone else. There are great examples of this in baseball and poker, but investing might just be the best example of all.
To achieve better investment outcomes based on skill, you need to either have better information or be better at interpreting information than everyone else (collectively) in the world. And, perhaps most importantly, you have to have better behavior.
It’s Hard to Earn the Market Return (30:30)
It’s so hard to earn the market return. That’s why it makes sense to simplify your investments. The more investments you have, the harder it is to have good behavior and manage all the moving parts. Both John and I agree that the more complicated your portfolio, the harder it is to even capture the market return.
John believes a big role of an advisor is getting people into not just the right type of investment, but investments that promote good behavior.
An advisor’s job shouldn’t be to outsmart the market. They should be intelligently designing a well-diversified portfolio that meets the client’s needs and then coach the client through behaviorally challenging moments in time.
Resources:
- John Jenning’s website
- The Uncertainty Solution by John Jennings explains how to invest with confidence in inherently uncertain and unpredictable markets
- John’s blog Interesting Fact of the Day
- John Jennings on Forbes
- Thinking About Markets Like Piles Of Sand (read)
- The Market Is Greater Than The Sum Of Its Parts (read)
- EP 70: Thinking Of Markets Like Piles Of Sand (listen)
- Why Expert Predictions Are BS (read)
- The Success Equation by Michael Mauboussin
- The Paradox Of Skill (research paper published by Credit Suisse)
- Market Prediction Is Harder Than You Think (read)
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Long-term investing made simple. Most people enter the markets without understanding how to grow their wealth over the long term or clearly hit their financial goals. The Long Term Investor shows you how to proactively minimize taxes, hedge against rising inflation, and ride the waves of volatility with confidence.
Hosted by the advisor, Chief Investment Officer of Plancorp, and author of “Making Money Simple,” Peter Lazaroff shares practical advice on how to make smart investment decisions your future self with thank you for. A go-to source for top media outlets like CNBC, the Wall Street Journal, and CNN Money, Peter unpacks the clear, strategic, and calculated approach he uses to decisively manage over 5.5 billion in investments for clients at Plancorp.
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