Behavioral Finance: Knowledge vs Wisdom

"There is no truth; just perception." ~ Friedrich Nietzsche

Are the messages you see and hear accurately reflecting reality? What are your sources of information? Are your decisions being formed by opinion, belief, or confirmation bias? What do you know and how do you know it? With so much uncertainty in the markets, now is a good time for investors to self-reflect and to learn a few good lessons in behavioral finance.

What Is Behavioral Finance?

Behavioral finance, a sub-category of behavioral economics, teaches that the collective psychology of consumers, businesses, governments, and the investor herd can significantly impact the economy and capital markets.  A proponent of behavioral finance may argue that the stock market is more driven by biases and emotion than by prevailing economic fundamentals.

On an individual level, investors can use behavioral finance to gain self-awareness and to make better decisions as a result of this reflection. Since this blog is The Financial Philosopher, and not The Financial Psychologist, we'll use philosophy as a supplement here.

Psychology vs Philosophy: Knowledge vs Wisdom

In the short term, the messages your brain receives from various information sources are mostly just noise. And when the noise is heard, your brain will attempt to process it, make sense of it, and store it as knowledge to make decisions today or in the future. The problem here is that it's difficult to know, with exception of hindsight, whether your decision is the correct one or not.

Wisdom acknowledges the possibility that you don't really know anything for certain and that all sources of information are to be questioned. But we live in a time where the combination of confirmation bias and unprecedented access to information blurs the lines between opinion, belief, knowledge and truth. 

• When knowledge isn't knowledge: One of the primary questions that philosophy asks is, "What do you know and how do you know it?" When you say that you know something, it's quite possible that you don't really know because the source didn't know, either. In this case, it's not knowledge that you possess: you have information, or perhaps you have just an opinion masked as facts. In today's world, this may be referred to as misinformation or disinformation. 
• Information, knowledge and wisdom are not the same things: Knowledge, and especially the lack thereof, is the root of fear, which is often the foundation of bad decisions. Hearing a loud noise does not mean something bad is happening. But your emotions in the moment may tell you otherwise. A sudden headache is likely a temporary annoyance. But a Google search yields information telling you it's a symptom of brain cancer. 
• Ignorance is bliss: You can't erase your knowledge and you can't undo your past life experiences. But you can control how you react to a large portion of the information you receive on a daily basis. You can even avoid the media noise altogether! This is conscious ignorance and it can be more beneficial to you than knowledge. 

Media Produces Noise, Not Useful Information

Gone are the days that the news media exists for the purpose of providing useful information to a wide range of information consumers. The media likes to paint things with a broad brush and they like to provoke emotion, which helps them to accomplish their primary goal -- to sell advertising and/or subscriptions. How do they do this? Attract as many eyes, ears, and clicks as possible. How do they do this? Sensationalism, click bait, and search engine optimization, or SEO, which is just a method of giving you what you ask for, not necessarily what you need. 

Be Aware of Confirmation Bias

Since marketing is more efficient, and is thus is more profitable, with defined demographics, dividing the consumer base into segments works well for the media. And consumers don't mind this at all. In fact, people prefer to seek out information that confirms their own biases, rather than information that may challenge their worldviews. This is why opinion-based news is more prominent (and thus, more dangerous) today than ever.

The media and its audience members are simply feeding each other's desires. The same goes for politics: the politicians and the political-driven media has no interest in uniting the country; they get the best results with the divide-and-conquer strategy and the general voting public sub-consciously prefers it that way. 

Now back to the theme of investing. If you're bearish, and you're thinking that the market will crash any day, you'll find information to confirm this bias. If you're bullish, and you believe that pent-up demand and a massive, post-Covid reopening will fuel the next leg up, you'll find that information. Thus, you have the power to paint your own subjective reality by seeking and finding narratives that fit your biases. 

How Today's Market Narritives Could Be Wrong 

It's important to seek out alternative views to the information you consume. Here are some current market narratives out there today and some counterpoints to consider:

Narrative: Inflation and rising rates will crush stock prices.

Counterpoint: Yes rising inflation and rising rates can push stock prices down. But to be a real threat to stocks and bonds, they need to be high and sustained, not just "rising." Furthermore, at present, inflation and rising rates are already priced into stocks.

For the market to see a significant correction (decline in aggregate stock prices of at least 10% or more), there would need to be a rise in inflation, and a rise in the 10-year Treasury bond yield, that is higher than the investor herd is currently expecting (AND sustained for more than a few months).

The herd expectation is probably above 2.5% inflation and above 2.0% for the 10-year Treasury. The herd also expects inflation to jump as high as 5.0% in the short term before it resumes its "normal" level. The 10-year Treasury touched 1.75% in March 2021 but fell to under 1.30% by July.

Narrative: Higher corporate taxes will kill the bull market.

Counterpoint: There's plenty of media noise surrounding Biden's plan for raising the corporate tax rate from 21% to 28%. But based on history, this increase would be far from a problem for the stock market. In fact, during the last five corporate tax increases in 1950, 1951, 1952, 1968, and 1993, the S&P 500 posted an average gain of 12.9%.

Or think of the opposite scenario and compare this to the dismal 4.9% average gain during the nine periods where corporate taxes were decreased. Remember the last big corporate tax break in 2018? The market was down -4.5% that year.

As for an individual tax increase, Biden's plan would only tax those with incomes above $400,000. This represents 1.8% of taxpayers and about 25% of the nation's income. Furthermore, it would be a marginal tax hike, meaning that taxpayers earning between $400,000 and $700,000 would see just a 1% tax increase. Is this worthy of concern? Probably not.

Narrative: Cryptocurrency is the place to be now.

Counterpoint: If there were a poster child for the popular acronym, FOMO (fear of missing out), cryptocurrency like Bitcoin (BTC-USD) or Ethereum (ETH-USD) would be it. Yes, Bitcoin doubled in price in the first three months of 2021, but then dropped 50% in the three months to follow. Betting on digital currency can win big money. But just like the casino floors in Vegas, you can also lose big. Each of the last three crashes for Bitcoin over the previous five years have seen price drops of up to 80%.

Narrative: If the market crashes, that would be bad.

Counterpoint: Major market corrections or only bad for short-term investors who are caught in overly-optimistic long positions (or for those who choose to see them as bad). But for long-term investors, market corrections are simply opportunities to average your cost lower on stock investments.

The name of the game for long-term investors is share accumulation. Lower prices translate to the accumulation of more shares. Whether you have a DCA approach with your 401(k) plan or you have cash available to buy more shares, a market correction is just another natural aspect of the long-term market trajectory. 

Narrative: Pent-up demand will drive stock prices higher.

Counterpoint: If you believe the stock market is going higher in the short term, you can find information that supports your bullish bias: Consumers are ready to go out and spend their stimulus money and their record high savings on cars, clothes, home improvement, restaurants, hotels, casinos, rock concerts, and weddings. But isn't this so-called pent-up demand already priced into stocks? If so, stock prices don't have any room to run up. If not, and expectations for post-Covid recovery are more robust than expected, the stock market can continue to climb. But then, the Delta variant could be a spoiler for the global economy later in 2021.

Narrative: Falling yields on the 10-Year Treasury bond point to a weaker economy ahead. 

Counterpoint: The worry over rising yields that clouded the market a few months ago is now being replaced with a worry over falling yieds? That's a big stretch and it points to how the investor herd really doesn't know where the market is headed. Sure, the Delta variant could pose a problem for economic growth later this year, but it could also help to solve some of the problems of runaway inflation and high yields the herd was worried about just weeks ago.

Opinion is Not Fact 

Perhaps the most important point to make here is that knowledge is by definition true. But opinion can be true or false. Understanding the difference is the skill that one must possess to be successful in any endeavor, not just investing. Almost everything you read in the modern media is opinion, although it is presented as fact. Ultimately, we live in a world where you can choose your own reality and there is no end to the supply of information that can support your beliefs. 

Perception is Everything

Now that we've made the point that things are never quite as bad (or as good) as they seem, our observations don't really matter much in the short term. This is because we're making rational observations about something that is not best viewed through a rational lens. The short-term movement of stock prices is not often founded in reality. The market moves on perception. Thus, perception IS reality and the irrational herd is "right," in the short term.

Thus, we are back to square one: What do we do about it? The short answer is to try your best not to make long-term decisions based upon short-term conditions. If a storm is expected to come next week, we don't change our travel plans for next year. Likewise, if the market appears to be headed off a cliff sometime in the next few weeks or months, it's not wise to change your long-term investment strategy.

To put everything into perspective: If you invested a lump sum into an S&P 500 index fund 15 years ago (July 2006, as of this writing) and didn't even look at your returns since then, you'd have enjoyed a 10.7% annualized return. This time frame and above-average return includes three significant market corrections: (2007-2009 down 59%, Q3 2019 down 19%, and Feb-Mar 2020 down 33.8%). 

So, What's the Answer?

Whether you are deciding where to invest, trying to choose a healthy world view, or just wanting to live a satisfying life in reality, it's wise to practice the greatest of virtues, such as humility, simplicity, frugality, and contentment. With regard to media noise, it's wise to see it as just that -- noise. Or perhaps you can simply see it as entertainment. Either way, the media is not in the business of reflecting reality. So, choose your sources (and your perspectives) wisely!

The bottom line is that humans are naturally naive scientists. We all want to describe, explain, predict and control what's going on in our environment. But this doesn't often work well for us (hence the naive descriptor). What does work well is conscious ignorance - being aware of what you don't know and ignorinig the unhealthy noise.

In the end, philosophy beats science. Be willing to not know everything. And if you still want to know, just don't predict because you'll probably be wrong. 

Kent Thune is a philosopher who happens to be a wealth manager and a Certified Financial Planner (TM). Serving clients all around the U.S., Kent is owner of Atlantic Capital Investments, LLC, a registered investment advisory firm located in Hilton Head Island, SC. Kent is also a professional writer and his works have been published on multiple investing websites, including MarketWatch, Yahoo Finance, Kiplinger.com, InvestorPlace.com, and The Motley Fool. Kent currently writes educational content for Seeking Alpha.

Comments

[J.D. Roth]

Kent, I don't have anything constructive to add here (so feel free to delete this comment). I just want to say how happy it makes me to see an article from you. You were always one of my favorite money bloggers and I thought you'd gone away. :)

[Kent Thune, TFP Author]

Hey J.D., it's great to hear from you, as well. And likewise, Get Rich Slowly has long been among my favorite blogs. I've been distracted with life (mostly good things) but I never really went away. I even plan to finally publish a book in the near future! Please stay in touch and thanks for reading.

[Franklin]

Hey Kent. I thoroughly enjoyed reading this common sense and simple framework to explain gas prices. It helped me look at the issue with a more knowledgable point of view. I too use Victor Frankl's teachings to help people reframe their obstacles about eating habits. Looking forward to reading your book.

[Kent Thune, TFP Author]

Hello Franklin. I appreciate the comment! I'm a big fan of Viktor Frankl and he is a featured philosopher in my book, which will hopefully be published later this year.