The Difference Between Life Insurance and Credit Default Swaps

Every day, shortly before nine o’clock, a man with a red hat stands in a square and begins to wave his cap around wildly. After five minutes, he disappears. One day, a policeman comes up to him and asks: “What are you doing?” “I’m keeping the giraffes away.” “But there aren’t any giraffes here.” “Well, I must be doing a good job, then.”

This little story comes from  Rolf Dobelli’s wonderful The Art of Thinking Clearly. The man in the red hat clearly suffers from a bad case of the illusion of control, a behavior that honest investors are all too familiar with.

Why do we constantly check our account balance? Or buy and sell dozens of stocks a year? Or hire a new large-cap growth manager every other year? Each time we engage in one of these activities, we fool ourselves into thinking that it will have some sort of positive impact on our wealth.

Dobelli provides a wonderful example of why the 10,000 hour rule does not always apply to investing:

Central bankers and government officials employ placebo buttons masterfully. Take, for instance, the federal funds rate, which is an extreme short-term rate– an overnight rate, to be precise. While this rate doesn’t affect long-term interest rates (which are a function of supply and demand, and which are an important factor in investment decisions), the stock market, nevertheless, reacts frenetically to its every change. Nobody understands why overnight interest rates can have such an effect on the market, but everybody thinks they do, and so they do. The same goes for the Federal Reserve; markets move, even though these statements inject little of tangible value into the real economy. They are merely sound waves. And still we allows economic heads to continue to play with the illusory dials. It would be a real wake-up call if all involved realized the truth–that the world economy is a fundamentally uncontrollable system.

Think about the average mutual fund manager- Imagine this person is 40 years old and has been in the industry for 15 years. At eight hours a day and 300 days a year, he or she would have 36,000 hours under their belt. But if it were just a matter of putting in the time, 91.91% of large cap managers would not have lagged their benchmark over the last five years. I can already hear the eyes rolling so let me clarify- I absolutely believe, in fact I know that there are incredibly skilled investors out there, and they all have put in their 10,000 hours. What I’m saying is that you can put 10,000 hours into investing and still come away empty-handed.

Here is Dobelli again, on risk and uncertainty:

There are billions of humans on earth. Our bodies do not differ dramatically. We all reach a similar height and a similar age. Most of us have two eyes, four heart valves, thirty-two teeth…For this reason, there are many similar diseases and it makes sense to say, for example: “There is a 30 percent risk you will die of cancer.” On the other hand, the following assertion is meaningless: “There is a 30 percent chance the euro will collapse in the next five years.” Why? There are not billions of comparable currencies from whose history we can derive probabilities. The difference between risk and uncertainty also illustrates the difference between life insurance and credit default swaps…In the first case, we are in the calculable domain of risk; in the second, we are dealing with uncertainty. 

The best way to combat the illusion of control is to deeply understand the limitations of your strategy. For example, I’ve built myself a low cost, global equity portfolio. Yea there are some different factors in there, but at the end of the day, when the market gets crushed, I’m going down with the ship. I’ve already accepted this because I know I don’t possess the ability to pick stocks or time the market. I’d much rather read books than balance sheets and I take pride in the fact that I practice what I preach. Hopefully I’m not being overconfident that I can handle a monstrous drawdown, but that’s another topic for another post 🙂

Source:

The Art of Thinking Clearly

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