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THE CENTRAL Intelligence Agency knows a thing or two about gathering information. That’s why a CIA publication titled The Psychology of Intelligence Analysis is, in my opinion, a valuable resource for investors.
Of particular note is a section titled, “Do You Really Need More Information?” It offers this counterintuitive finding: To make sound judgments, some amount of information is necessary. But beyond a certain point, gathering more data doesn’t always lead to better decisions. In fact, it can lead to worse results. That’s because more information can “lead the analyst to become more confident… to the point of overconfidence.” The lesson for investors: It’s important for financial decisions to have a quantitative basis. But it’s also important to avoid going too far with any analysis.
Many investors, for example, worry about investing in the stock market during uncertain times. Consider today’s headlines: Inflation has moderated but is still not totally under control. Meanwhile, mortgage rates are at lofty levels, and the Federal Reserve has said it won’t hesitate to push rates up further. There’s also the continuing war in Ukraine. Against that backdrop, investors might conclude that the stock market, which has gained nearly 20% this year, is skating on thin ice. That’s prompted some folks to stay on the sidelines, holding cash rather than taking any risk in the stock market.
But as the CIA document notes—and as investors have seen again and again—it’s impossible to know where the market is headed next. For better or worse, in the absence of a crystal ball, no amount of further analysis will get us closer to an answer. Further analysis, however, may have the unintended consequence of making us feel more confident in an outlook that is, by definition, imperfect. That’s why I recommend a different approach: If you structure your portfolio so it will meet your needs whether the market is up or down, you don’t have to worry about making forecasts.
If you have cash to invest, does that mean you should invest it all immediately? Here’s where you can again apply the CIA’s principle. When making financial moves, always look for ways to make that move incrementally. Among the benefits of moving slowly is that it’ll allow you to gather more information, not because you’ll spend that time doing more research, but because—as time goes on—more information will become available. A year from now, we’ll have answers to things that today are unknown. Two years from now, we’ll know even more, and so forth. Investors can then use that information to finetune decisions rather than needlessly belaboring decisions today.
In the past, I’ve talked about splitting the difference as a decision-making strategy. That may not seem like a rigorous way to make decisions, but I see a number of virtues. The CIA’s principle illustrates another reason splitting the difference on decisions can make sense.
Let’s say your company offers a Roth 401(k) option. Should you go for it or should you stick with the traditional tax-deductible option? To answer this question, you might start by comparing your current tax rate to a projection of what your rate might be down the road. That’s a good start. But at the end of the day, there are things about the future we simply can’t know.
For example, today’s top marginal tax rate in the U.S. is 37%. But four decades ago, it was 70% and, at times, it’s been over 90%. We can’t, in other words, simply extrapolate today’s tax rates into the future. Because we don’t know what the future will look like, it wouldn’t be unreasonable to split the difference on a decision like this. Then, over time, as more information became available, we could adjust. Importantly, though, there would be no real benefit to fretting further over the question in the meantime.
In his new book, Decisions About Decisions, Harvard Law School professor Cass Sunstein offers a related recommendation: Don’t focus on the likelihood of being right or wrong on any given decision. That’s too difficult to know. In any case, there’s almost always a non-zero chance that something might or might not happen. For that reason, Sunstein suggests never going out on a limb in forecasting the likelihood of an event. Instead, he suggests weighing the cost of being wrong versus the benefit of being right, both of which are easier to estimate without having to forecast the future.
Last year, author Mike Piper employed this principle in helping investors think about risk in the bond market. The question: In light of potential rate increases, should an investor shift away from longer-term bonds? Piper’s recommendation was as follows: It’s impossible to know where rates are headed, but if an investor did choose to make a move like this, the cost of being wrong would be modest. “He just misses out on the slightly higher returns that he could have gotten by holding longer-term bonds.” For that reason, Piper concluded that shifting away from longer-term bonds would be a fine decision.
Sunstein’s Decisions About Decisions offers a further recommendation that can help investors make decisions without belaboring the unknowable. He recommends understanding the difference between picking and choosing. These might sound synonymous, but Sunstein explains the difference: When we use data to analyze a decision, that’s choosing. Picking, on the other hand, is random. It involves no data, like picking a number out of a hat.
Picking might not sound like a rational way to make financial decisions, but it’s another way to employ the CIA principle. Consider some of the frequently debated questions on asset allocation. Should your portfolio include a small allocation to value stocks or small-caps or real estate? Since past performance doesn’t guarantee future results, there’s no way to know whether any of these will add or subtract from future performance. But if it’s a small allocation, the cost of being wrong will likely be low. In those situations, where no amount of additional analysis will help you divine the future, it wouldn’t be illogical to make a decision by simply picking.
A final thought: Recently, I was speaking with a fellow who was planning to attend a tennis match for the first time. He was struggling with which seats to choose. Research online indicated that one side of the stadium offered more sunlight. On a cool day, that might be welcome, but on a hot day, it could be unpleasant. The other side, meanwhile, offered a direct line of sight to the umpire. Which would be the better choice?
I had never been to a tennis match, so I suggested he poll others. At the same time, I mentioned another of Sunstein’s decision-making rubrics: Regardless of how a decision turns out, we can almost always learn something when we spend time looking into a question. That in itself can be valuable, and it could help us the next time a similar question comes up.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on Twitter @AdamMGrossman and check out his earlier articles.
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Your articles always make me think, and sometimes think again. While we all know, in principle anyway, that no one can predict the future, some try hard to determine the probabilities of various outcomes. Pascal’s wager reminds us to also consider the impact costs of seemingly low probability adverse outcomes, which explains JP Morgan’s advice to sell down (our stock allocation) to the point where we can sleep. As you have said in the past, “being approximately right” and “splitting the difference” are sensible strategies to follow when investing and will likely leave us in a reasonably good position when the unpredictable future arrives.
If you are not familiar, Adam Grant is an organizational psychologist who has 2 incredibly insightful and entertaining podcasts. He has also written several books focusing on the concept and benefits of re-thinking and thinking again. You might enjoy his work.
Investing, like so much of our lives, involves making difficult decisions about projecting future events with incomplete information. The thing is, though, I’ve known people who think they have the luxury of postponing important decisions indefinitely, when doing nothing eventually becomes the choice they make. Take asset allocation, for example; an indecisive investor with a pile of cash can’t decide how much to put in stocks and how much to allocate to bonds. Instead of, say, splitting the difference, and *for now* making a 50/50 allocation, for example, they just stall and leave their assets in cash. Will this make much difference next week, next month, or next year? Probably, not a lot. But if that no-decision isn’t addressed, at some point it becomes the de facto decision, and over the long haul it’s likely to lead to about the worst outcome possible. So yes, I really like the suggestion of “splitting the difference”, and re-visiting that periodically to fine-tune and re-affirm that we’re on the right track. It may not lead to the absolute optimum outcome, but a good plan put into play now beats a perfect plan left on the drawing board every time! Great article.
How do you produce such consistently interesting pieces, Adam? Love to know your process.
Adam, thanks for a very interesting article. I may have to read Sunstein’s book. I like this advice:
“Don’t focus on the likelihood of being right or wrong on any given decision. That’s too difficult to know…”
“Instead, he suggests weighing the cost of being wrong versus the benefit of being right, both of which are easier to estimate without having to forecast the future.“