The Fallacy of Binary Thinking

05.21.2015

I’m often asked my opinion of asset classes, market trends and economic developments. These questions come as no surprise, considering my long career in the financial industry. What surprises me are the responses I get from investors—which tend to be extraordinarily binary.

What do I mean by binary?

A good example is the investor who hears that interest rates are expected to trend higher. Not only does he rule out the possibility of anything other than a straight-line spike in rates—he also expects it in the short term. So he rushes out to replace all bonds in his portfolio with floating-rate securities or cash. Another example is the investor who hears favorable analysis of a company’s earnings performance and rushes into an all-or-nothing decision to bet everything on that stock.

What would make an investor do this? Even after years of exposure to it, I still have to scratch my head. It’s like the person who believes that the world is coming to an end next week. No matter how hard you try to assure them otherwise, they just smile contemptuously because … you just don’t get it.

Why do people invest this way?

The answer lies in the human condition—they invest that way because they think that way. Beliefs are incredibly powerful motivators and are amazingly easy to instill in people, especially if founded in a person’s hopes or fears. From cruel experience, we learn that not all people are honest, not all people play fair and—life is full of disappointments. The flip side of this is that all humans are filled with hopes and dreams, which are just as effective in overriding good judgment as fear and suspicion.

Whether you miss a great opportunity due to distrust of foreign markets or you lose money because of an impulsive decision to invest in a “sure thing,” in both instances, good sense took a back seat to fear or greed. When we give in to human nature, we lose perspective and often make bad decisions.

How, then, do we overcome the influences of human nature? The good news is that it can be done.

The first step is to practice self-awareness and humility. Simply put, acknowledge your limitations and admit that no one can predict the future and no one, no matter how smart they are, can consistently outsmart everyone else.

The second step is to acknowledge that “luck” exists and it should not be confused with “skill.” So often we assume the successful are simply smarter than we are, when in most instances, it comes down to luck. For every winner in Las Vegas, there are far more people who have been hit by lightning—or lost their money doubling down on red at the roulette table. One person’s “luck” is literally another person’s misfortune.

The third step is to adopt a code of financial principles through which you filter all decision-making input. Thankfully, when it comes to investing, these universal truths are fairly well known. Here are several that I believe few would disagree with:

  1. NEVER take an asset class to zero. Diversification is a good thing. Maybe you under- or over-weight an asset class based on your thinking, but recognize that you are just as likely to be wrong.
  2. If someone tells you they know what the future holdsbe very skeptical. There are millions of market opinions–some informed and some not—but all are guesses. Do not make important investment decisions based on these.
  3. Get-rich-quick ideas are nothing more than gambling or speculation. It may be okay for a small portion of your investable assets, but it is not a rational long-term wealth strategy.
  4. Everything in life evolves and changes. Be wary of anyone who says that their way is the only way and that all you have to do is follow a formula for the next 40 years to succeed. This is just another form of soothsaying, even though it may be accompanied by a spreadsheet showing you an impressive past. I can assure you that no one knows what the next 40 years will hold. Never use prior performance as a decision guide for anything.

So, relax and enjoy being a human being. But if you want to learn the discipline of investing, devote the time to learning the basic guidelines that can help you purge human bias from your investment decisions. Remember, almost nothing in life is binary. We live in a complex and ever-changing world, and I am thrilled that is the case.

 

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Frank Muller

As CEO of Provasi Capital Partners, Frank Muller brings nearly 30 years of experience in building and managing multi-channel distribution services. Frank has been a featured contributor in numerous industry publications, bringing his unique insights and perspectives to relevant issues impacting financial advisors and their clients.

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