Sunday, April 11, 2021

Thinking too much or too little

We think that there's a dichotomy between thinking too much and too little in the financial freedom-sphere. One could call it oversimplification versus overthinking. 

Clearly overthinking.
(Ny Carlsberg Glyptotek, Copenhagen, 2019)

Here's an Einstein-ism: one should, generally, simplify as much as one can, but not further. 

In other words: it's better to aim for the sweet spot instead of finding oneself in the extremes.

Oversimplification

There's a popular advice in investment that goes something like this. Keep investments simple - really, really simple. Just put your money in one broad index fund and leave it there and don't think more about it. 

Then keep the savings rate high, and if it's really high (50-80%) one will hit financial independence soon enough.

It's admirable, and it's absolutely true that investments are easier than one might think, and if one does the above and sticks to it, one is probably well off in 10-20 years.

But is the advice good

The answer perhaps lies in that word 'probably'. There are several layers behind what the word 'probably' hides.  

We would like to point out three things with the seemingly simple advice above. 

Oversimplification 1. Difficulty of keeping calm.

The above assumes, and this is a BIG assumption, that the investor really can stay calm during a credit crunch and stock market setback. Many, many new investors can't do that. 

And many seasoned investors neither, even if they think so. 

When one jumps in and out of the market, driven by fear, one might very well destroy a large part of one life's savings. Then one might have a really hard time to get back, or perhaps get so scared that one never gets back to investing. 

Oversimplification 2. The risk is higher than the oversimplifier thinks

Risks don't just disappears because one doesn't want to think about them. 

One aspect of this is the effects of start date sensitivity. A new investor is likely to jump in after seeing others earn from the stock market. The stock market is, after our new investor has been standing by the sidelines, more likely to be close to the top of a bubble/burst-cycle.  The sudden fall might come as a big surprise, and there might be a long, long time until a beginner is back where she started, with the emotional toll that follows.

The adage is that there's just so many decades in a life and one probably only get one shot at early financial independence.

Another challenge is that the highest mountain we've seen is probably not the highest mountain there is. What does that mean? It means that during the last 100 years there have been several crises that set an investor back with 10+ years, and the worst with 25+ years. But that's the last 100. Going back to the 1870, it's even worse in many countries. 

A lifetime can prove to be long, so one should probably think a little about the possibilities for the future, and bear in mind that the highest mountain we've seen, well, as said, is probably not the highest there is.

This is a game where our freedom is at stake, and chances to play the right game are few. Probably we will only get one shot at truly early retirement. 

We only get one roll of the barrel for our gamble, so it might be wise to consider the odds. Or, in other words, we only get one shot at the target, so one should mind the precision of the weapon. How many empty chambers in that revolver do we need to be ok with, to play russian roulette? When the counterpart is unreliable and not quite revealing the whole truth to us? 9 to 10? Or 99 to 100? Or 999 to 1000?

Oversimplification 3. One doesn't get a fair compensation for risk. 

The risk, however we measure that, is related to what we pay to get something in return; in investing that's some kind of expected return - average return for the oversimplifying investor, baseline-return at 15% of the worsts cases for the more thoughtful investor perhaps. 

But what do we pay? However we measure, the quota between risk and reward is not particularly good for the oversimplifying investor. 

This is not just an academic problem. Let's not just consider the average case. Is it ok to have a bad case that prolongs the time to financial independence 8 years into the future? Or 15 years? Or 20 years? Where is one's ruin, one's breaking point?

For a total stock market investment, beginning some time into one's career, the bad case might not be acceptable, corresponding to that ill-fated chamber in the revolver.

And furthermore, and more importantly when getting closer to independence, volatility is BAD for the safe withdrawal rate. Really bad. 

Just some very easy tweaks with the investment strategy can significantly improve the safe withdrawal rate (e.g. 4%-rule). This can turn into additional budget to spend in the freedom phase, or extra safety margin, or an earlier retirement.

This is why we think one should think twice before giving the above overly simplified advice to oneself or anyone else. 

It might be worthwhile to stop and think, at least a little more then a few hours or reading one single author or blog post, before putting one's life's savings are the table.

Overthinking 

The first effect of overthinking is, of course, paralysis by analysis. Instead of thinking for too long, one should select a reasonably conservative approach, go for it, and learn as one goes. We have never really learned something from the armchair beyond the initial reflections.

It's by trying, repeating and refining that we make a sufficient emotional investment to really think hard, observe and learn.

So sitting still and overthinking will not help much more beyond some thorough initial investigations. Then it's time to act.

Ego & overconfidence

But when one acts, one shouldn't trust that logical-ego-complex-voice in one's brain, with its alluring whispers that everything is square, well-behaved and understood.

The consciousness is a late and secondary addition to the brain, as Joseph Campbell observed, and is never to be fully trusted. Our consciousness thinks it's in the driver's seat but, as it seems, the consciousness is better at making up a story why it's in control than truly run the show.

We don't understand what we don't understand. And if one is too prone to the ludic-fallacy - the fallacy that we mistake the world for being a casino with understandable risks; then it's about at that point that we get run over by a train that showed up from a totally unexpected direction.

Hence, for instance, for us we never pick single stocks and call that investments. Actually we never pick single stocks. 

Don't think soo much that you fool yourself that you can outsmart the market. Then we are overthinking. 

It's always much easier to fool oneself than the market.

What do you live for?

Even worse in the overthinker's corner is when one gets really interested by investments. The inner nerd takes over, and uses the stock market or other speculations to cover for another need: a feeling of emptiness, a hope of recognition, a want to feel alive, a complex of inferiority or superiority.

Needless to say, such games are not a good foundation for decisions regarding one's life's savings.

For a retail investor, like us, the stock market shouldn't be the meaning-creating part of life, or an emotional thrill.

There are much better things to spend one's time with.

Conclusion:

It's our life savings we are talking about. Think of all the long years it took to come where we are now.

It's worth to spend some time, perhaps even weeks, to dig into the subject and do research.

A checklist for those weeks of study could be:

  • Do we know at at least three different portfolio strategies, and at least one that uses other assets than stocks and bonds? (so, at least, one knows what one is saying no to when selecting one's own strategy)
  • What are the longest drawdown periods during the last 50 years for those portfolios? 
  • How would the longest drawdown feel if that happened to us? If it was 20 percent worse?
  • What is the difference between some kind of baseline return and average return, and why is that important?
  • How long was the longest time and baseline time to financial independence for the portfolios of our choice, for our circumstances, during the last 50 years? 
  • How would the longest time to financial independence feel for us?
  • What is the safe and perpetual withdrawal rate and how does that compare for the portfolios?
  • What can be meant with start date sensitivity, and in what way can the time-stability of portfolio returns be important both for starting with investments, and also after one has been in an investment for 5 or 10 years?
When those questions are at least partly understood, then there is probably not that much more to gain from spending years trying to understand an art that still at its core is both random and beyond the grasp of the ego--narration-complex-fellow in our monkey brains. If one tries, one needs to be prepared, as said, that one is more likely to fool oneself and not the market.

In the choice between overthinking and oversimplification; don't let the pendulum swing too much in either direction.

Farewell,

//antinous&lucilius


Where to go now?

Read more about our articles about portfolios here.

Or read more about volatility here.

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