“We tolerate complexity by failing to understand it. That’s the illusion of understanding.” Steven Sloman and Philip Fernbach, The Knowledge Illusion, 2017.
“But today we have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand. The result is that our possibilities of wealth may run to waste for a time, perhaps for a long time.” John Maynard Keynes, The Great Slump of 1930, 1930.
If you’ve ever tried to explain something to a small child, then you’re familiar with their constant response of “Why?” to whatever answer you provide. As adults, we seem to believe that this is because children enjoy annoying adults. But maybe it’s because children see the world as a complex place and simple answers just won’t suffice. Eventually we all (or at least almost all of us) succumb to the realization that we are never going to be able to understand this complexity and we learn to rely on mental shortcuts, or heuristics, to give us “good enough” explanations for what’s going on in the world.
For the most part, these heuristics work well enough. But when we try to understand complex systems, like markets, monetary systems, or broad economies, these heuristics often break down. To make matters even worse, our reliance on heuristics to understand causality in complex systems leads us to seek the easy answer, not the complex answer, and feeds into an overconfidence that we understand that which is quite often not understandable.
Performance in the financial markets in the third quarter was a bit of a jumbled mess. The S&P 500 ended the quarter up 1.70% and is up 20.55% for the year. But there was a four-week period running from late July to late August when the S&P 500 lost 5.9% before recovering over the last month of the quarter. Other equity markets, such as U.S. small-cap stocks (Russell 2000), foreign developed markets (MSCI-EAFE), and emerging markets (MSIC EM), were all down for the quarter.
Fixed income markets were no less volatile, with the bellwether 10-year U.S. Treasury yield dropping from 2.00% at the beginning of the quarter to an intra-quarter low of 1.47% on September 3 before rates backed up. The 10-year Treasury ended the quarter at a yield of 1.68%. The falling rate environment was a strong tailwind for bond returns with the Bloomberg Barclays U.S. Aggregate Index up 2.27% for the quarter and up 8.52% for the year.
What led to this intra-quarter volatility? Those seeking the quick answer had a plethora of choices from which to choose – trade wars, slowing economies, tweets, election uncertainty, falling earnings growth, more tweets, and on, and on. It’s tempting to latch on to one or two of these explanations, especially if they conform to our view of the world as we try to seek order in chaos. But the very real danger is that oversimplified explanations can imbue us with a false sense of confidence. Believing that we understand the causal relationships in these complex systems, we in turn are in danger of poor decision making based on our overconfidence. To avoid this trap when we manage portfolios, we try to develop a sound, long-term investment plan, we engage in thoughtful and deliberate decision-making processes, and we seek to build portfolios in such a way as to diversify our risk exposures and our opportunities for return.