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Friday, 20 July 2012

Mindless Money 5/5: Avoid Overspecification

The paradox of investing is that the best investors have a system, but that this system, mindlessly applied, exposes them to the very risks that they’re trying to avoid.  Markets go through phases, and systems and concepts developed during one phase may not be suitable for others.

The problem of overspecification – developing methods which are so tightly specified that they can’t respond to novel situations is one met in many walks of life.  Simply following a recipe ensures you can always make your favorite cake; but what happens when no one wants to eat it any more?

Of course, everyone tells the individual investor that they need to develop a system for investing because if you “fail to plan you plan to fail”.  However, if your plan is so prescriptive it eliminates all possibility of novel interactions then you face the issue of how you develop a mechanism that is good for all time, when time itself  can change.

A mindful system is, by definition, a fluid one.  It cannot be entirely prescriptive because it will always be coming up against events for which it was not designed.  The inevitable temptation is to try to fit new data to the model, a problem otherwise known as confirmation bias, when the appropriate response is to change the model.  But if you have a system which you think deals with all your possible investment needs then you potentially have a problem.  This is the Titanic Effect: if you don’t think you need to avoid icebergs you’ll take less care to do so: but why do think it’s safe to hit an iceberg in the first place?

A similar problem happened to many institutions in 2008, who found themselves holding worthless sub-prime paper because the credit rating agencies had rated it triple-A.  The institutions had no idea what this meant (neither did the credit rating agencies), and hence had no ability to deal with the problem when it occurred.  Similarly with people who kept on holding bank stocks, right into the abyss of government bailouts.

Markets throw large and unexpected wobbly fits far more often than the standard models predict.  This is not in question: what is, is how you’ll cope with it when it happens.  How will you deal with a 50% drawdown in your capital value, something Charlie Munger reckons will happen to an investor two or three times in their investing lifetime?

The critical underlying issue is that if you simply plan for the surprises you can anticipate you will both expose yourself to risk aversion – when exactly is the Eurozone going to implode and when will that big investing opportunity arise – and fail to plan adequately for the surprise you can’t anticipate.  This is overspecifiying your responses.  But, generally, waiting until a problem occurs in order to develop a plan to deal with it is going to be a losing proposition. 

This is perhaps the major problem that investors face. Everyone needs to decide how, and when, they're prepared to modify their mental models.  Eventually everything changes, figuring out how to deal with this is our greatest challenge.  Most of us can't, which is why most of us aren't great investors.  But if the facts change, so should our minds. Don't be lucky, be mindful.

Further reading:

We look at different modes of investing in Buy and Hold, the Least Worst Option? and Investing With A Time Machine, while Confirmation Bias, the Investor's Curse is the subject of ... confirmation bias. The Titanic Effect is addressed in Trading on the Titanic Effect and the failures of the credit rating agencies in Credit Rating Agencies: A Market Failure? The likelihood of scary drawndowns is nauseatingly outlined in No Need For A Drawdown Drama.

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