The year that was and making rational investment decisions

Welcome to Finance and Fury, and Happy New year. I hope you are all having a great start to the year.

As it is a new year, a lot of podcasts and even previous episodes that I have done have been looking forward for the coming year, on setting goals or where to invest in the upcoming year – so to not be repetitive, I want to do something different

1. This episode is about perspective – Instead of looking forward about new year new me mantras – we will be looking back on the year that was 2022 – and how to remove one major cognitive bias that impacts our ability to make financial decisions or make rational choices in general
2. No doubt, there were plenty of crazy events that have played out over the last 12 months
   1. Looking just at the political turmoil – this has been across the world and between many nations
      1. In the UK – Queen passed away and they are on their third PM – after two implemented horrible policies
      2. Pakistan is in political a crisis with their PM losing no-confidence votes – seeing instability

• Russia and Ukraine – leading to a massive humanitarian crisis

1. There is major unrest in the middle east – Iranian protests, not to mention the ongoing conflicts between China and India – global tension seem to be on the rise

1. Economically – Inflation has returned after concerns of a deflationary environment for the better part of a decade – we saw some of the largest increases in interest rates in modern history, leading to a revaluation of financial markets, resulting in bond and share markets declining
   1. Crypto assets were by far the biggest sufferers of any pricing over the last 12 months – with event after event that shattered the confidence that what in many cases were no better than JPEGs were going to the moon
2. Every single month saw a new major event spring up – It was a crazy year, right? Lots occurred – but was it really that crazy in the grand scheme of things? Yes – but when viewed in this way, only focusing on bad events occurring and looking at single years in isolation, the world will always be crazy
   1. This isn’t to diminish what you might have gone through as an individual – Everyone is different – you as an individual may have had the worst year of your life – death in the family, bankruptcy, that is a tragedy – what we are looking at here is the macro – a look back in global events
3. Compared to years of the past – If you google the worst year to be alive – a medieval scholar Michael McCormick has nominated 536as “the worst year to be alive” – this is obviously subjective, nobody alive today lived almost 1,500 years ago – but this year has been nominated as the worst year based on extreme weather events probably caused by a volcanic eruption early in the year – leading to average temperatures in Europe and China to decline and resulting in crop failures and famine for well over a year – combined with plague and wars – this would have definitely been one of the worst times to be alive – much crazier time to be alive than in the past few years
   2. Think about this – you wake up one day and there is a mysterious fog that doesn’t break at first sunlight – and it covers Europe, the Middle East, and large parts of Asia and remained for the better part of two years – this created an almost-permanent dimming of the sun where the average global temperatures fell by up to 2.5 degrees Celsius – there was summer frosts/snow and widespread crop failures followed with diseases – widespread famine and major loss of life followed – sounds pretty bad –
   3. But then just a few years later in 541, a bubonic plague outbreak occurs – being one of the deadliest in history with an estimated 100 million people dead across Europe – at a time when between 300m people were alive – Europe took hundreds of years to fully recover
4. Skip forward to 400 years ago – Thirty Years’ War– ranged from 1618 to 1648 – this was a widespread conflict across Europe which saw some of the worst human suffering in recorded history – what brought it about was a combination of monarchical rulers fighting a religious war of supremacy in and out of the HRE in conjunction with famine and abnormal temperatures of the mini-ice age that occurred during this time period
   2. Too much to cover here – but between the religious wars, diseases, and famines caused by this global cooling event, this all resulted in the deaths of around one-thirdof the known global population at the time – can you imagine that 250m people died over a 30-year period, being 1/3^rd of the population in EU at the time? Close to 2.7 billion people dying today
5. These few events were a long time ago – but one that is closer to recent memory is WW2 – too many tragedies to cover – but one of the worst years of the conflict was in 1943 on the eastern front – the Battle of Stalingrad– easily the largest and bloodiest battle in human history in terms of sheer numbers – with over 2 million military and around 400,000 civilians dead by the end of it – where both Soviet and German forces suffered and the population that was besieged was not allowed to leave by their own leaders – for those living through Stalingrad, many resorted to cannibalism just to stay alive

I like to learn as much as I can about history – so the events in recent times don’t seem that bad in comparison – But it is human nature to think that when recent years are worse than the previous ones – Why do we think that more recent years are worst than those of the past

1. No one cause – one obvious one is a lack of knowledge beyond own personal experience – if you have only lived in times where things are good, one slightly bad time can seem much worse
2. but even with your own experiences, Heuristics occur – such as availability bias – this is a mental shortcut that relies on immediate examples that come to a given person’s mind when evaluating a specific topic, concept, method, or decision.
   1. The availability heuristic explains why it can seem as if the world is falling apart when share or bonds are down
   2. availability heuristic comes from Behavioural economics is a field of study bringing together knowledge from psychology and economics to reveal how people behave in the real world. Contrast to traditional economic with the view of Homo economicus – i.e. the economic man who acts rationally in their own best interest in all scenarios
   3. Quick heuristics enable us to make rapid decisions without taking the time and mental energy to think through all the details – this is great in our day to day lives – helps to avoid decision fatigue in many cases – but it comes at the cost of sitting down and taking our time to make the optimal choice, such as homo economicus would
   4. But the majority of times, using heuristics lead to a satisfactory outcome
   5. But this bias can lead to some irrational thinking, and irrational choices – this is due to not realising that we are using heuristics
   6. Tversky and Kahneman did many publications on this topic – based on their findings, we tend to judge the likelihood and significance of things based on how easily they come to mind – in other words, the more available a piece of information is to us, the more important it seems and the greater weight we give to this information
   7. We also give greater weight to information that is shocking or unusual – like a shark attack or plane crash – these are out of the norm and hence, overreported on so we overestimate the odds of dying in this manner when compared to what is much more likely – such as a car accidents or drowning
3. Narratives are more memorable than disjointed facts, but personal experience can also make information more noticeable
   1. If you’ve recently purchased a certain type of car, you are more likely to notice more of this type of car that you would have otherwise – The base rate hasn’t changed – but due to availability of this car being in your minds eye, due to now owning one, you notice them more often
4. Anything that makes something easier to remember increases its impact on us – this is where repetition also plays a major role – associative bonds are strengthened by repetition – if you are trying to remember something, what do you do? Normally repeat it over and over – The availability heuristic exploits this – it uses strength of association as a basis for which you judge the probability of a certain event playing out
   1. In thinking fast and slow – Kahneman states that our capacity to retrieve pieces of information from memory is largely determined by the extent of coverage in the media – the more a story is covered, the more we are likely to remember it
5. How this can mislead up – We sometimes avoid one thing in favour of something objectively riskier to us in the long term
   1. Think about holding cash versus investing excess savings over a 10 to 20 year period
   2. In times where the share market is massively up – the availability heuristic kicks in and can bias you to invest after the rise – you have likely heard through the media, friends or other forms of communications about how the market is up 20% year on year over the last 3 years – this makes you want to invest, to not miss out on the gains
   3. Or if you hear that the market is down 30%, this is a story that will be covered day in day out by the corporate media – so you might want to avoid investing – as this short-term information which is often repeated, as fear sells, is at the front of your mind – but a year such as where the market drops significantly, by 30% or more is less likely, and rarer than years where markets are in a positive position –
      1. Remember that we overestimate the likelihood of unlikely events – such as large market declines – and we underestimate the likelihood of likely events – such as markets being down by a small amount, or up by a similar margin, say 10% – it isn’t a rare event for markets to be down by 10% in a short period of time, or is it rate for them to be up by this margin – markets declining by 10% or more are actually relatively common – doesn’t mean the market ends the year in this position though
   4. Market declines of 30% or 40% are very possible – but are rare – we may be in for a major collapse in 2023 – there is no way to tell in reality
   5. Overestimating the risk of unlikely events leads us to waste enormous amounts of time and opportunity costs through trying to mitigate things that have lower probabilities of occurring
   6. Ignoring the risk or benefits of likely events leads us to fail to prepare for predictable problems and occurrences – such as average returns of asset classes over a decade plus period
   7. All of this is not to say that you shouldn’t prepare for the worst – but don’t let it run your life

What to do – Knowing about a cognitive bias isn’t usually enough to overcome it.

1. First step is to remember that everyone struggles with the same irrational patterns – But being aware of the availability heuristic is helpful – allows you to take a step back to make sure it isn’t distorting your view – but there are additional processes
   1. Remember that every outcome has a base rate – The base rate of any occurrence is normally the average based around the probability of an event unfolding – if you invest in the ASX share market today, on average you will be in a positive position 79% of the time based around 120 years of data – but this also means that there is just above 20% chance you will experience a negative return – this is why investing is a long-term game
   2. Look at the long term – in statistics – the concept of a regression to the mean teaches us that extreme events tend to be followed by more moderate ones – for shares, periods of extreme volatility both in the positive of negative are also followed by their inverse – i.e. after a negative 40% year there can be a positive 40% year that follows – but once markets normalise, annualised returns start to kick in – so whenever possible, base your judgments on long term trends and be focused on returns in 10 years’ time, not the next month
   3. Don’t rely on your memory – look at the data – we are more likely to make investment decisions based on the most recent events, this is simply due to our memory and our availability heuristic – always look at the data over long periods of time – even if you have the best memory in the world, going back to look at historical patterns and data can help to remind us of the truth that growth assets on aggregate increase in value over the long term
   4. Take the time to think before making a judgment. The whole point of heuristics is that they save the time and effort needed to parse a ton of information and make a judgment – this is helpful for many daily decisions – but financial decisions are something that should justify taking some additional time to think about – there are no initial shortcuts when it comes to initial financial decisions – but once you build heuristics around investments, that are rational, things can become easier

Summary –

2. Remember we always have availability heuristics – Affects our every day decisions and how we respond to events
3. But don’t let recent events that are over repeated or shocking events skew the real probability for them playing out – use long term judgements and make decisions around these
4. Taking a long term view really helps – make decisions around where you want to be in the future – not what you think is going to happen over the next 12 months – base decisions around your long term goals