Cognitively Yours 1.24

Raja R, Author

"Skepticism is not believing what you’re told or what “everyone” considers true; it’s one of the most important requirements for successful investing."

The Seduction of Pessimism

With the outbreak of pandemic, March 2020 saw the market tumble to new lows. There were self-styled advisors who predicted further doom and convinced many to exit the market and enter at a much lower level. True, there were saner voices which advised people to maintain composure but were being labelled as those with a “self-serving bias.”. True, there is no denying the fact that it was a crisis never seen before and was destined to cripple the economy. Was the pessimism justifiable? With hindsight, definitely no. But, even without hindsight, we could say that while many extrapolated the crisis, few anticipated what the World will do to combat the unprecedented crisis - economically, politically and medically.

Optimism sounds like a sales pitch. Pessimism sounds like someone trying to help you. “For reasons, I have never understood, people like to hear that the world is going to hell”- Deirdre Mccloskey

Optimism is the best bet for most people because the world stands to get better for most people most of the time. But, pessimism holds a special place in our hearts. Pessimism isn’t just more common than optimism. It also sounds smarter. It is intellectually captivating, and it’s paid more attention than optimism, which is often viewed as being obvious to risk.

What is Optimism?

Everything will be rosy and great is not optimism but complacency. Optimism is a belief that the odds of a good outcome are in your favour over time, even when there will be setbacks along the way. The simple idea that most people wake-up in the morning trying to make things a little better and more productive than wake-up looking to cause trouble and expecting the heavens to fall is the foundation of optimism. It is not guaranteed. It is not complicated but simple. “I am not an optimist. I am a very serious possibilist.”

December 29, 2008, The worst year for the economy in modern history, was about to close and stock markets had collapsed. All indicators of economy showed negative signs. The Wall Street Journal published a story on the front page on the outlook of a Russian professor Igor Panarin. The Journal published: By the end of June 2010, US will break into six pieces. California will be part of China. Texas will go to Mexico. Washington D.C and New York will be part of European Union. Canada will grab a part of Northern States. The Central North American will be a protectorate of Japan or China and Alaska will be subsumed into Russia.”

It is fine to be pessimistic about the economy. It is also in order to be apocalyptic. The interesting thing about the story that appeared in the most prestigious financial newspaper in the world, is that their polar opposite-forecasts of outrageous optimism - are rarely taken as seriously as prophets of doom. Pessimism just sounds smarter and more plausible than optimism.

Tell someone that everything will be great and they’re likely to either shrug you off or offer a skeptical eye. Tell that they’re in danger and peril and you will have their undivided attention. The prediction that a stock will be a multi-bagger will be taken with a pinch of salt as compared to that a company will collapse due to an internal fraud, which will be taken more than at the face value.

Mart Ridley says “A constant drumbeat of pessimism usually drowns out any triumphalist song - If you say the world has been getting better you may get with being called naïve and insensitive. If you say the world is going to go on getting better, you are considered embarrassingly mad. If on the other end, you say catastrophe is imminent, you may expect a McArthur genius award or even the Nobel Prize. In my own adult life time - the fashionable reasons for pessimism changed, but the pessimism was constant.”

Pessimism is not a recent phenomenon. John Stuart Mill wrote in the 1840s – “I have observed that not the man who hopes when others despair, but the man who despairs when others hope, is admired by a large class of persons as a sage.”

Reasons for pessimism

1. Part of it, is instinctual and unavoidable

Kahneman says that the asymmetric aversion to loss is an evolutionary shield. When directly compared or weighted against each other, losses loom larger than gains. This asymmetry between the power of positive and negative expectations or experiences has an evolutionary history. Organisms that treat threats as more urgent than opportunities have a better chance to survive and reproduce

2. Biologically, we are designed to be pessimistic

Imagine yourself walking in a garden at dawn when it is still dark. Suddenly you notice a skinny black cylinder on the path ahead. The black shape did not move. Is it a snake? But you will not dare to approach it. You may throw stones at it from the distance. Once the sun comes, you go near and find-out that it is a stick. This is how animals process fearful stimuli. Fear responses travel from the eyes along two separate neural pathways. One passes directly to the amygdala, quicker than thought. The other reaches the amygdala more slowly taking a roundabout route through the cerebral cortex. The quick route allows an animal to respond almost instantaneously to potential danger - a brisk response that favours survival. “It’s better to mistake a stick for a snake than the other way around.”

3. Nature of money

Money is ubiquitous, present everywhere,  so something bad happening tends to affect everyone and captures everyone’s attention. Even though many households do not own stocks directly, the stock market’s gyrations are promoted so heavily in the media that Sensex might be the stock-less household’s most watched economic barometer. Sensex up by 1 per cent is briefly mentioned but a 1% fall will be reported in bold, highlighted as Breaking News in Blood Red. This asymmetry makes investors and even non-investors panic. Narratives about why a decline occurred make them easier to talk about, worry about, and frame a story what you think will happen next and what others will crash.

4. Power of extrapolation of pessimism and narrative around it

Pessimists are experts in extrapolating present trends without accounting for how markets adapt. Progress happens too slowly to notice, but setbacks happen too quickly to ignore. It’s easier to create a narrative around pessimism because the story pieces tend to be fresher and more recent. Optimistic narratives require at a long stretch of history and developments, which people tend to forget and take more effort to stitch and weave  together. It takes years to realise how important a product or company is, and to build the brand, but failures can happen overnight. In careers too, reputation takes a life-time to build and a single email can destroy what has been built over years. The short sting of pessimism prevails while the powerful pull of optimism goes unnoticed.

Pessimism may be helpful too

In 2004 the New York Times interviewed Stephen Hawking, the scientist whose incurable disease left him paralysed at the age of 21. He replied to a question whether he was always this cheerful, “My expectations were reduced to zero when I was 21. Everything since then has been a bonus.” Expecting things to be great means a best case scenario which may fall flat. Pessimism reduces expectations, narrowing the gap between possible outcomes and outcomes you feel great about. Expecting things to be bad is the best way to be pleasantly surprised when they’re not. Ironically, this is something to be optimistic about.

To sum up, should an investor be optimistic or pessimistic - Howard Mark’s prescription in dealing with the future, we must think about two things:

(a) what might happen and

(b) the probability it will happen.

"During the crisis, lots of bad things seemed possible, but that didn’t mean they were going to happen. In times of crisis, people fail to make that distinction. Since we never know much about what the future holds – and in a crisis, with careening causes and consequences, certainly less than ever – we must decide which side of the debate is more likely to be profitable (or less likely to be wrong).

The message of The Black Swan is how important it is to realise that the things everyone rules out can still come to pass. That might be generalised into an understanding of the importance of skepticism. Skepticism is not believing what you’re told or what “everyone” considers true. 

In my opinion, it’s one of the most important requirements for successful investing. If you believe the story everyone else believes, you’ll do what they do. Usually you’ll buy at high prices and sell at lows. You’ll fall for tales of the “silver bullet” capable of delivering high returns without risk. You’ll buy what’s been doing well and sell what’s been doing poorly. And you’ll suffer losses in crashes and miss out when things recover from bottoms. In other words,

→ You’ll be a conformist, not a maverick (an overused word these days)

→ A follower, not a contrarian.

→ Skepticism and pessimism aren’t synonymous.

→ Skepticism calls for pessimism when optimism is excessive. But, it also calls for optimism when pessimism is excessive."

The message of Howard Marks is loud and clear.

References: The Psychology of Money by Morgan Housel, Memo by Howard Marks - “The Limits to Negativism” dated October 15, 2008, The Emotional Revolution by Norman E Rosenthal.

Photo credit: @makyzz - www.freepik.com