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"The world in our heads is not a precise replica of reality; our expectations about the frequency of events are distorted by the prevalence and emotional intensity of the messages to which we are exposed." – Daniel Kahneman, Thinking, Fast and Slow

Thinking, Fast and Slow by Daniel Kahneman might be the most oft-cited book in the financial blogosphere, and for good reason. The text synthesizes decades of psychological research by Kahneman and his long-time research partner, Amos Tversky, who together helped establish the field of behavioral economics.

Specifically, the book focuses on how our brains use two systems to operate: one that is fast, emotional, and instinctive (System 1), and another that is slow, logical, and deliberate (System 2). It also outlines a litany of heuristics, or mental shortcuts, that affect the way we think about and interact with the world. One of these is the availability heuristic. The basic idea is that many of the judgments and decisions we make are based upon evidence and information that comes to mind easily. However, the ease with which things come to mind is not necessarily indicative of their veracity. Thus, we are not particularly adept at guessing the likelihood and severity of certain events because our personal experience colors our perceptions and skews our estimations. Kahneman offers a few examples to illustrate the concept (p. 130):

  • A salient event that attracts your attention will be easily retrieved from memory. Divorces among Hollywood celebrities and sex scandals among politicians attract much attention, and instances will come easily to mind. You are therefore likely to exaggerate the frequency of both Hollywood divorces and political sex scandals.
  • A dramatic event temporarily increases the availability of its category. A plane crash that attracts media coverage will temporarily alter your feelings about the safety of flying. Accidents are on your mind, for a while, after you see a car burning at the side of the road, and the world is for a while a more dangerous place.
  • Personal experiences, pictures, and vivid examples are more available than incidents that happened to others, or mere words, or statistics. A judicial error that affects you will undermine your faith in the justice system more than a similar incident you read about in a newspaper.

Without question, events that are sensational, dramatic, and/or personal tend to impact our impressions of the world more meaningfully than those that are mundane and/or foreign. Moreover, we tend to respond to these kinds of events in predictable ways. For example, citing research by the economist Howard Kunreuther, Kahneman describes how Californians are more likely to take precautionary measures such as buying insurance, tying down their boilers, and maintaining emergency supplies in the immediate aftermath of a significant earthquake. Over time, as the earthquake fades from memory, they become less diligent until the next disaster strikes.

Another tendency is to tie our expectations to the worst disaster we’ve experienced, rather than the worst disaster possible. Consequently, the actions we take to protect ourselves are often inadequate when a novel crisis occurs. Kahneman notes that this habit can even be traced back to ancient Egypt, where preparations for the annual flooding of the Nile were based upon previous high-water marks and failed to account for the possibility of a worse flood.

I believe Kahneman’s research has some important implications as we continue to come to grips with the fallout from COVID-19. Media coverage of the virus has been continuous and sensational over the last two months, and millions of people have experienced personal loss or hardship. Of course, these losses have not been evenly distributed across geographic or socioeconomic lines, so naturally, the levels of concern and complacency vary from place to place, person to person. Still, the overall impacts of the virus on our healthcare system, our economy, our social lives, and our political landscape have been dramatic – precisely the kind of event that leaves a large and lasting impression.

To some extent, these are the unfortunate results of not having sufficiently prepared for a pandemic of this magnitude. Our recent high-water marks (SARS, MERS, etc.) had a more limited scope, and our collective memory of the Spanish Flu faded long ago. As we continue to combat this invisible foe, the mental challenge is neither overreacting nor underreacting, but instead relying more on our System 2 brains than our impulsive, emotional System 1 brains. This is easier said than done when lives and livelihoods are at stake, yet all the more critical because of it.

Likewise, from a financial planning standpoint, it is particularly important to be System 2 thinkers during periods of economic uncertainty and market volatility. Three long months ago, we witnessed the fastest bear market in recorded history – a 35% peak-to-trough decline in the S&P 500 over the course of 25 days. This was swiftly followed by a 35% recovery in the span of 23 days. Big up days and big down days tend to come in bunches when the market waters are choppy, and timing these fluctuations is next to impossible. The ancient Egyptians may not have always accounted for how high the Nile would rise, but at least it flooded predictably in its season. Unfortunately, the stock market has no seasonal pattern. To borrow from Shakespeare, we don’t know when the winter of our discontent will be made glorious summer by a vaccine or some other cure.

Just as the best time to buy earthquake insurance in California is before an earthquake hits, the best time to purchase “portfolio insurance” (e.g. stable investments such as cash or high-quality bonds) is before a severe market decline. You can’t insure a pile of rubble. The thing is, nobody moves to California to stay hunkered down in a basement, obsessing over the security of their boiler. That would be a terrible way to live. Moving to California simply requires some level of risk-taking, including the threat of natural disasters. Likewise, the rewards of investing in the market always have and always will involve risk. The key is having a plan to mitigate that risk so that you don’t have to vacate when the inevitable earthquake comes along, and keeping a level head rather than surrendering to fear or anxiety.

If the 35% decline two months ago was the market’s earthquake, right now, investors are still worried about the aftershocks. The risk is real, and the recovery timeline is uncertain. During this time, I would advise you to focus on what you can control, and whether your plan can handle the stresses of a volatile market. Don’t get swept away by sensationalism; instead, slow your thoughts down and seek to expand your perspective beyond the limited availability of what comes most quickly to mind (i.e. the events and emotions of the last three months). Avoid the extremes of concern and complacency. Finally, if you are feeling overwhelmed - financially, emotionally - by the magnitude of the moment, seek help. The best way to get through any difficult situation is together with someone who cares.

And Now For Something Completely Different...

Last week was "Bike Week" at my son's school. Since they couldn't bring someone in to do tricks in front of the kids this year, they sent a link to this awesome video, which he and I have been watching every day since (3-year-olds have an impressive capacity for repetition).