One of the best things to do when confronted by a major surprise is to see what there is to be learned from the experience. I always try to identify what sorts of lessons can be gleaned from nonmarket events. You would be surprised at how often there are rules and insights to be had about investing.
In the past, I have found some investing wisdom in March Madness, the 2012 elections, Super Bowls and $8 million janitors.
The surprise win by Donald Trump, which rattled markets worldwide, should be no different. Please bear with me while I repeat myself:
Forecasters are terrible – I have written this too many times, but it bears repeating: Forecasters aren’t very good at predicting the future. We have learned this about economists, market strategists and now political pollsters.
We can tease out potential outcomes on a probabilistic basis, but even these expectations are frequently dashed.
Confirmation bias – Everyone reads what confirms their prior beliefs. Everyone. Not just read, but specifically seek it out, retain it and ignore everything else. This is why the internet is so balkanized and why fact-checking hardly matters. Confirmation bias is hard to shake and often impervious to reality.
Models are not perfect – Let’s start with the classic George E.P. Box quote: “Essentially, all models are wrong, but some are useful.” Now we can add a corollary: “Any model that figures out what is going on will soon be bypassed by events.” Everyone was so impressed with the various models like FiveThiryEight’s that they expected them to perform flawlessly.
They didn’t. This is true of models for trading, generating econometric analyses or determining who is going to win the World Cup. Everything is always changing. The best models stay right for months, or even years, but not forever. That we seem to always be surprised is part of our flawed wetware.
Optimism bias – We all suffer from the same belief that most of us are, despite the obvious mathematical odds, above average. We believe we possess special insight, that we can determine what comes next, that we have an ability to do better than everyone else. That may be true for some people at some times, but those who can are a single-digit percentage of those who believe they can. Most can’t.
Random factors and luck – We underestimate the impact of luck while confusing random chance with skill. How different might the outcome have been but for a lucky bounce or a slip? Consider what the results might have been had Republican primary candidates done solid opposition research on Trump; had FBI Director James Comey not dropped his October surprise; had 9 percent of voters ages 18 to 29 not voted for third parties, or 8 percent of voters ages 30 to 44.
Hindsight bias – After the fact, many of us seem to believe that we knew it all along. Of course, Hillary Clinton was a terrible candidate – she lost to Barack Obama in 2008 when she should have won; she almost lost to Bernie Sanders when it was another slam dunk. But that’s how we recall it after the fact. We need to learn to say “I don’t know” about the future more often.
The Narrative – We create a story line – also after the fact – to try to make sense of what we didn’t expect and can’t explain. It’s a global populist uprising, or white angst, or voter rage, or a rejection of the powers that be. Or not. Pundits get this wrong all the time.
After you hear all of the convenient story lines, try to factor this into your latest narrative: Trump won with fewer votes than Mitt Romney received in 2012, and it looks as if Trump lost the popular vote.
Nobody knows anything – Another favorite truism from my big bag-o-quotes. We know much less than we imagine. Our perceived expertise is wildly overstated and overrated. Our optimism bias lulls us into believing we have abilities that history and experience make clear we do not possess.
There are lessons we all should learn from this big surprise. But it’s doubtful that many of us will pay attention to them.
Barry Ritholtz, a Bloomberg View columnist, is the founder of Ritholtz Wealth Management. He is a consultant at and former chief executive officer for FusionIQ, a quantitative research firm. firstname.lastname@example.org, www.ritholtz.com/blog.