Guesstimating your future self

Thoughts on forecasts, emotional intelligence, overconfidence, fat tails and bailouts

A crisis we see from a mile away

The corona crisis took me by surprise. Today, however, a lot of intelligent people including business leaders and politicians are telling me that they know exactly what is about to hit us: the toughest challenge since WWII, it will get worse than the 2008 global finance crisis, etc...

This feels serious.

Strangely though, what the future is holding for us feels very knowable at this point. We are shutting down life and the economy for a defined period of time, something like 4 - 8 weeks, and it will hit businesses and the economy heavily in Q2 and probably also Q3 as the world slowly emerges from its shutdown and goes back to normal. Virologists and mathematicians calibrate how many people will be infected and how many will die in a variety of scenarios depending on how well mankind responds to the corona outbreak. We can put that into a mental compartment and write it off as an exogenous shock. It’s not like the GFC where our whole financial system collapsed because its design was flawed. The corona crisis is going to be a rough ride, but the economy is going to recover in either a V, U or W shape. We need to look through this and think long-term. We can see the severity of the crisis ahead, but it’s temporary and we are mentally prepared. In the stock market, experts tell us, we should be buying as prices come down and it doesn’t matter whether we time the bottom perfectly because we are investing for the long-term and at some point, prices will recover. Alright, let’s do this!

*confidence has entered the chat*

What do you know?

I wanted to list a few of the most pertinent cognitive biases for this situation until I noticed the list was getting ridiculously long. So, let's opt for laziness. Check out the following chart and assume that almost all of these are currently working against you: Cognitive Bias Codex

Three curious things at the moment:

(1) Our confidence in our ability to operate within the context of a crisis. We are assuming that we will act rationally and do the right thing when the house is on fire because we have made a plan. BUT, operating within a burning house (a crisis) is challenging. There is friction, pressure, fear and chaos. In general, people are not trained for such environments. Furthermore, one could deem the act of imagining your own psychological framework in a future crisis scenario as a high form of self-reflection. Mixing the complexity and randomness of emotions with the abstract nature of a future crisis is one hell of a self-awareness challenge. Can somebody please craft this into a viral Instagram/youtube challenge?

(2) Our confidence in forecasts. While there certainly is dispersion about the length and gravity of the recession/crisis and which letter of the alphabet the recovery will be dressed in, there seems to be agreement on the fact that mankind will emerge from this situation and normalize at some point. The return to normality is a heavy mental anchor for economists, politicians and the broader society - just like a stock that dipped from 60€ to 20€ is perceived to be a pretty safe bet to make 3x money if you catch it at the bottom. I want to stress that I don’t think people are overly confident in their ability to call the bottom, However, people seem very confident in their ability to say that there will be a structural bottom at some point and that we will somehow recover after that. The art of forecasting has been researched heavily by social scientist Philip E. Tetlock. One of his findings has been that very specific, confident, expert forecasters might be a lot worse than we think. 

(3) Our confidence in the “map”. The “map” is the framework and boundaries within which we are making our forecasts and along which we are designing our plans, investment behavior or crisis response. We’ll leave it to Ray Dalio to explain. On January 28th, he wrote to his clients: “What we don't know is much greater than what we do know.” Ray gets powerful support from Howard Marks. In chapter 14 of his book “The Most Important Thing”, Marks classifies investors into the “school of I know” and the “school of I don’t know”. He considers himself part of the latter. This is important because the future we are currently imagining is a very curated set of scenarios. This is most ironically and metaphorically displayed by the shapes of economic recoveries that have been presented to us. V, U or W and no one is even talking about L’s anymore by the way. But what if it’s an X, Q, R, Z or I? You get the point. One of the most universal characteristics of “mental maps” is their incompleteness. Anything that is not within the mainstream scenarios (rump of the bell curve) basically gets treated as if it were non-existent. In his studies, Tetlock also found out that experts often rated certain scenarios - which actually turned out to happen later on - with a 0% probability, The human brain’s strategy for dealing with big fat tail risks is to ignore them. We spend little to no time imagining what might happen and how we should behave when we are actually presented with one. I’d like to give a general shoutout to Nassim Taleb on anything fat-tail related.

*confidence has left the chat*

Let’s get more specific.

Thinking of fat tails

Ask yourself how much time you have spent thinking about what happens to a share price after a company has announced it will be filing for insolvency. Then ask yourself how much time you have spent thinking about what happens to a share price after a company has announced that it will be bailed out by the government. You are probably not alone if the specificity of your response to these two questions is limited to “kind of down” in the former case and “kind of up” in the latter case.

Here is the share price chart of a company for which the government bailout was announced at the beginning of 2009. A nation-state bought 25% of the equity in that company. If we get lucky and pick the bottom correctly, or start averaging into the position with the bailout announcement it looks like we could make 2-4x money as the share price dipped to just over 20€ in March 2009 and recovered to a stable level of €60 a year later.

That was perfect execution, because we were prepared and had a long-term mind set. Let’s expand that chart from 16 months to roughly 11 years because, hey, we are long-term!

That share price turned out to stabilize over the long term as well, although not around €60, but much rather at €5. Now, ask yourself whether you would have had the patience, financial firepower or confidence to keep “dollar-cost-averaging” into that position once the price really started collapsing just over two years after the bailout?

The stock you are looking at is Commerzbank AG.

A hypothetical conversation between the schools of “I know” and “I don’t know”

School of I know (IK): “Come on, who would have bought a bank in the midst of the GFC! That’s a no brainer! The system was flawed! Don’t touch it!”

School of I don’t know (IDK): “Going into and during the GFC, how much did you know about global contagion risks stemming from synthetic securitization processes and principal-agent problems between credit-rating agencies and investment banks?”

IK: “But the corona shock is different and it’s exogenous. I bought Boeing shares at $90, but they’re going to be bailed out for sure! The US government is going to save this symbol of national pride! Look, I already made almost 2x, the shares bounced back to $180! Totally nailed it! It’ll go back to normal, there is no systematic flaw like we had in the financial industry. And I’ll do the same thing with Lufthansa! They are going to consolidate the entire European airline industry! Heinz-Hermann Thiele already sees it coming, that’s why he invested!”

IDK: “What if air travel doesn’t just bounce back to normal? How do we know that a system that rewards frequent air-travel is not flawed? After all, look at what has been happening to our environment. An objective outside observer could justifiably say that we have a few design flaws in our means of travel and how we use our planet’s resources.”

A non-rump scenario

On Friday, March 27th, CNBC published an article on the US government airline aid package: “Airlines warn government aid ‘not a cure’ for coronavirus travel plunge”.

A few highlights:

• “Airlines expect the demand slump to last months, if not years, pointing to a slow economic recovery from coronavirus.”
• United Airlines CEO and president wrote in a message to employees: “That means being honest, fair and upfront with you: if the recovery is as slow as we fear, it means our airline and our workforce will have to be smaller than it is today.”

With business travel on pause, companies forced to sell their products without trade fairs and many unnecessary in-person meetings being replaced by video conferences, all while the air quality in large, densely populated cities is becoming notably better, I can’t help but think there is a chance that we don’t simply go “back to normal”.

Being optimistic or pessimistic in this environment is a choice. But maybe we should accept the fact that we don’t know anything about anything. It seems as if a lot of weird stuff can happen once we step on a fat tail (Tiger King anyone?). Fat tails comprise chains of cause and effect that we rarely think about in the first place, and that might be even more random than those in our “normal” world.

If after reading this, you are still very confident about your forecasts on how the future will play out that’s good news because you can help me out. I have been thinking about the following issues and couldn’t get a clear answer:

(1) The productivity of a factory that is shut down is 0%. Compared to normalized level, what’s the relative productivity of someone in the service industry that has been forced into home office? 80%, 50%, 30%? Is the productivity loss of an employee of a large corporate equivalent to that of a startup employee?

(2) How well can people follow a conference call while trying to prevent their kids from smashing every single window in their house during their living room soccer match because that’s what kids do when they are off school for 4 weeks?

(3) What happens to the market power of previously oligopolistic producers of respirators when a government publicly announces a reward for alternative models? Will the market dominance and pricing power of the incumbents be the same afterwards?

Meanwhile, I recommend moving slow, staying flexible and preparing for the worst.