Dr. Daniel Crosby, a psychologist specializing in behavioral finance, wrote an article titled Into the unknown.

« Uncertainty, which requires us to prepare for every contingency, is metabolically burdensome and psychologically uncomfortable. Unwilling to sit with such discomfort, the human tendency is to paper over uncertainty with a thin veneer of false certainty. But there’s a different and better way for behavioral investors who want to approach the world in a more honest way that involves two principles: simplification and diversification. »

« Haldane argues that the more complex a problem, the more simple the solution must be to avoid what statisticians call “overfitting.” »

Simplicity

« “Among detectives locating serial criminals, simple locational rules trump complex psychological profiling… and among shopkeepers understanding repeat purchase data out-predict complex models.” Complex problems yield noisy results that can only be understood using big-picture, simplifying frameworks. »

« Haldane contrasts rules for governing known risks versus operating in a situation fraught with uncertainty, like investing in the stock market. He says, “Under risk, policy should respond to every raindrop; it is fine-tuned. Under uncertainty, that logic is reversed. Complex environments often instead call for simple decision rules. That is because these rules are more robust to ignorance. »

Diversification

« Take, for example, the “Lost Decade” of the early aughts, thusly named because investors in large-capitalization US stocks (e.g., the S&P 500 Index) would have realized losses of 1% per annum over those 10 years. Ouch. However, those who took the “I don’t know” approach and were evenly diversified across five asset classes (US stocks, foreign stocks, commodities, real estate, and bonds), however, didn’t experience a lost decade at all, realizing a respectable annualized gain of 7.2% per year. »

« The simple fact is that no one knows which asset classes will do well at any given time and diversification is the only logical response to the uncertainty currently facing investors. For instance, stocks and bonds have only been down in the same year three times since 1928 (1931, 1941, and 1969) »

« Take, for example, the case of European, Pacific, and US stocks cited in Ben Carlson’s A Wealth of Common Sense… Each market had good years and bad years and automatic rebalancing has the effect of selling winners and buying losers. Buying low and selling high – sound familiar? By entering when stocks were cheap and exiting when they became more expensive, the synergistic effects of diversification are realized. Turns out, not having a clue isn’t so bad after all. »

Crosby is the author of The Behavioral Investor and The Laws of Wealth.

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