Dependent On Stupidity

I was reviewing my investment journal and came across this unfinished letter I wrote exactly one year ago today while my family was in the process of evacuating our home due to a forest fire.  I left the letter largely the same and added a few additional facts now that I have the benefit of hindsight and some views on the current market environment.  My current thoughts are italicized.  
 
The Sydney Opera house is one of the most iconic buildings and makes the skyline of Australia instantly recognizable.  At its inception, it was expected to open in 1967 at a cost of $7 million Australian dollars.  If I were to ask you to provide a range of the actual cost with 98% confidence of being correct, what would you guess?  (The answer is at the end of the letter).  The question doesn't matter, I could pose any numerical problem like how many people read these letters or how many licks it takes to get to the center of a Tootsie Pop.  The result is always the same. 
 
This problem was first posed to Harvard business school students and despite asking for a range where the students were confident, they would only be wrong 2% of the time, reality was they were wrong 45% of the time!  Intellectual humility isn't a strength of Harvard students, but amongst the rest of the population the results are similar.  People are wrong 15-30% of the time.  What does that say about us?  We are overconfident about what we think we know and underestimate what we don't know.  
 
Recent news events have had me pondering the intellectual humility of the people we depend on.  I am writing this letter while the wildfires around Lake Tahoe are raging.  My family and I are now driving across the country because the air has become too toxic to breathe.  Out of control fires near your home have a way of holding your attention, and here are a few items I noticed.
 

• The "Dixie Fire" was initially predicted to be 100% contained by August 1st, it went on to burn 963,000 acres of land and was 97% contained on October 30th.  
• The "Tamarack Fire" was initially determined to be no threat and was not given any resources upon its initial discovery because it was expected to burn itself out.  It went on to burn 69,000 acres and forced the evacuation of 22,000 residents in the southern part of Lake Tahoe.  

 
I and the rest of the residents are deeply grateful for the firefighters.  They worked around the clock and did a remarkable job protecting and saving many of the homes and buildings in Lake Tahoe.  But what about the forecasts?  I think it is unfair to ask a firefighter to predict future wind, rain, and humidity.  They are the factors that most impact their ability to contain the fires.  The fires and forecasts were the main topic of conversation this summer and I observed many of the residents believed in them.  What was never provided in the news was the error rate of the person making the forecast. 
 
What about the CIA?  The Taliban overtaking Afghanistan days after the removal of US troops, was headline news for much of the summer.  Instead of taking the CIA's advice at face value when deciding to withdraw the troops from Afghanistan, perhaps the better question should have been, "what is the error rate of the agency's forecasts?"  Would President Biden have made a different decision if he knew the CIA's ability to predict geopolitical outcomes is no better than a coin flip? 
 
It isn't the firefighter or the CIA's fault that we are too dependent on stupidity, we trust our "experts" despite evidence showing expertise isn't possible with moving targets.  It is our fault for listening to these forecasts.  CNBC features numerous predictions daily and many people listen because they are prominently displayed on television as "experts."  Would anyone listen or watch if they posted the pundit's error rate?   I know people are listening to the rubbish on CNBC because I regularly get asked about what they are showing.  When something is active and constantly moving around like the economy, stock market, wildfires, or the political stability of a nation, it is extremely hard to predict the future.  There is no difference between guessing something someone might know, like how many holes it takes to fill the Albert Hall or predict something that hasn't taken place yet.  
 
I started this letter with a little trick, I gave you a piece of information about the predicted opening and cost of the Sydney Opera House.  The more information you give someone, the more concrete the hypotheses formed along the way will become.  This will make people worse off as they interpret random data and mistake it for real information.  Our ideas become sticky and once our mind settles on something, it is difficult to change opinions. When an opinion is developed from weak evidence you will have difficulty processing subsequent information that contradicts your theory, even if the new information is more accurate.  COVID-19 is a wonderful example, at the inception of the pandemic the daily flow of information, some good and some bad, caused people to form ideas that they still hold onto.  Despite changes to what is true from mutations of the virus or just improvement in our understanding from the passage of time.  
 
Update:  Here we are in 2022 now and inflation dominates the news headlines.  The market has rallied significantly since July after Fed Chairman Powell's news conference where people thought he said (but really didn't) that he would pause or end restrictive monetary policy measures in the first half of 2023.  And then in early August it was reported that inflation was +8.5% for the month of July, down from +9.2% in June and again the market took it as a sign the back of inflation has been broken.  The magnitude of the market’s rise over the past two months suggests by my estimation, prices of bonds and stocks are incorporating a view that the Fed will be successful in returning inflation to its target 2% level in the near future.    
 
Just look at the 3% yield on the 10-year US Treasury.  If we assume investors are rational (they aren’t but bear with me), the only way the purchasing power of a dollar is preserved is if the high levels of inflation plummet in the next 18 months to 2%.  If this scenario doesn’t occur, investors have locked in a guaranteed destruction of their savings.  This is occurring while short term bonds yield >3% and don’t require a correct prediction of future inflation.  As for my prediction of inflation, I will place my 98% confidence interval between -50% and +50%; which means I have no idea.  Below is a chart of actual inflation vs. economist projections.  Ask yourself are investors again depending on stupidity?  

Successful investing requires predictions about the future and if the future is difficult to predict, what can we do?  We can borrow ideas from disciplines where expertise is possible, like engineering.  An engineer knows better than to build a bridge capable of holding 2.1 tons and then run a bunch of trucks across that weigh 2 tons.  Engineers build in a margin of safety, it’s better to build a bridge capable of withstanding 10 tons and then run 2-ton trucks across.  We can do the same with investing, but it requires patience and humility, two traits Wall Street isn't exactly known for.  
 
For my partners, I provide quarterly updates on my predictions.  I am aware of my limited ability to forecast the future which is why I go out of my way to show their accuracy.  I have also built a correction mechanism into our portfolios to account for the inaccuracies.  First, we only invest in businesses that are unlikely to change over the coming decades, a much easier starting point.  Then we only invest with a large margin of safety built into the forecast.  When investing in March 2020, I predicted the pandemic would be over in a few months.  Turns out, I was way off.  But my forecast didn't matter because we invested at prices that suggested the businesses would never recover.  When markets aren't enduring manic depressive modes, I am content to own the market indexes and swim with the tide.  
 
With 4% sell-off in stocks last week, it appears investors are waking up to the prospect that the reports on the death of inflation may have been exaggerated.  We don’t need to wait for a full market panic to invest, time in the market is more important than timing the market for building wealth.  Normal volatility will provide plenty of opportunities to purchase equities of great American businesses at sensible prices.  As always, I am here to help if you have any questions.    
 

The Sydney Opera House opened in 1977 at a cost of $102 million Australian dollars and its final version was dramatically smaller in scope than its original plan. 



Cautious Investing, 

To The Front



This commentary is provided for general information purposes only and should not be construed as investment, tax, or legal advice.  Past performance of any market result is no assurance of future performance.  The information contained herein has been obtained from sources deemed reliable but is not guaranteed.