“Prediction is very difficult, especially if it’s about the future.”
“Weather forecast for tonight: dark.”
As we saw in “Do You REALLY Know How You Would React if the Stock Market Dropped by 20 Percent,” the personal finance industry loves their risk tolerance questionnaires. They think that you’re going to be able to accurately predict how you’d react if the market dropped by 20%, failing to acknowledge that we have what is called the hot-cold empathy bias, which means that we have no idea how we’d actually react in a stressful situation unless we’ve already experienced such a stressful situation in the past.
But even though Thinking You, what I call our prefrontal cortex – the part of your brain that is responsible for acting like an adult in tempting or stressful situations – can’t predict what happens when Monkey Brain – the limbic system, the part of your brain that wants fun and wants fun now, regardless of future consequences – is in charge, it turns out that Thinking You is also not good at predicting how Thinking You will act in the future when faced with a change.
In other words, if you are faced with a stressful or life-changing event, you probably won’t be able to predict now how you’d feel later after the smoke clears.
Affective Forecasting: Not Just Predicting Rain Tomorrow
Research from the University of Virginia’s Timothy Wilson (go Hoos!) and Harvard’s Daniel Gilbert shows that we overestimate our reactions to future changes to our circumstances. By observing a wide range of outcomes in life, from getting a desirable dorm room to receiving unwanted results on a pregnancy test to not getting tenured professorship at a university to watching your favorite team lose a football game, Wilson and Gilbert’s research showed that, in a relatively short period after the supposedly impactful event, our emotional state and general happiness was pretty unaffected by what happened (see Figure 1 in the cited article for a good example). The respondents expected to be either much happier or unhappier at the outcomes than they actually were. This failure to predict is called affective forecasting, and, in general, we humans stink at it.
I’m living proof of this. Army hasn’t beaten Navy in football since approximately the time that dinosaurs roamed The Plain at West Point; yet, I’m still a pretty happy person.
The reason that we fail to predict how quickly we’ll revert back to a reasonably normal state of affairs in our lives when we face a future shock is that we do not take into account all of the other factors that play into how we feel about life. If your favorite football team loses (which, let’s face it, means that the Atlanta Falcons won’t win the Super Bowl this year), you still have a home, family, friends, hobbies which entertain you, and meaning in life. All of those far outweigh the sports team’s ability to affect your life. However, if you think just about your favorite sports team winning the next game, then that’s all you focus your mental energies on. Because you’re thinking about that event at that moment, you suffer from what is called focalism, and you project out that you’re going to think about that sports team (and its loss or win) for a long time after the event. That’s simply not true. We quickly forget or discount those events and move on.
Even if we have larger events that impact our lives, such as losing a limb or suffering from the loss of a loved one, we adapt more quickly than we think that we will. As we saw in “Get Off Your Hedonic Treadmill,” it’s easy to convince ourselves we need a convertible, then a BMW convertible, then a Ferrari convertible, and then a Ferrari convertible on our own private island. This is called hedonic adaptation – we can get used to luxury and then need more of it to attain the same level of pleasure that we previously had. However, in this case, hedonic adaptation can work in reverse. If we have had a major negative setback, our minds are pliable and we quickly reset our expectations of a “normal” life to include the setback. Our levels of happiness and satisfaction, relatively speaking, rebound quickly and people rarely suffer from long bouts of depression and unhappiness.
The human mind is resilient.
However, in the moment, when we’re faced with a risk tolerance questionnaire and we are asked about how we will react if the stock market drops 20%, we immediately focus on the doom and gloom scenario. “OH NOES!” we think. We expect, and as we have seen in Wilson and Gilbert’s research, wrongly so, that we’ll be miserable and inconsolable, throwing boxes in anger while Monkey Brain throws bananas out of his cage.
Thus, we instruct our financial advisors to put us in inappropriately conservative investments because we fear fear. We fear a fear that will probably not happen, and if it does, it will likely only happen for a little while. We fail to account for all of the other external factors that will keep us from going off of the rails, such as:
We’ll probably still have a job (unless we’re retired).
We’ll still have our family and friends.
The earth will still be spinning on its axis and the sun will come up tomorrow.
You get the point.
As we have seen, because we are both terrible at predicting how long and how intensely we’ll react to future events (our failure at affective forecasting) and because we think Thinking You will be in control when, in reality, Monkey Brain will probably be flying the plane in times of stress (the hot-cold empathy bias), we are much more likely to lead ourselves astray in our investment plans if we let risk tolerance questionnaires guide how we should act and react in the event of market swings.
By the way, in case you didn’t notice, the market swings. It swings a lot. But, in general, it goes up over time, despite the swings.
Therefore, the best way to deal with your own perceptions of the market (and misperceptions about yourself) is to have a quantitatively grounded, steady, and consistent investment plan that does not react or respond to pitters, patters, and emotional shocks.
Leave all of that forecasting to weathermen. It’s what they get paid to do!