I’m generally a pretty optimistic person. I adhere to the belief that human beings are naturally progressive and most of us wake up in the morning saying “I am going to be better than I was yesterday”. And that mentality, over the long-term, creates a very difficult hurdle for pessimists. If you’ve ever looked at the performance of a short only fund over the course of a decade then you know what I mean. Shorting human progress is a very very difficult way to live your life.
There is a risk, however, in this very optimistic view of the world. And if you’re not aware of it it can be the cause of unnecessary hardship. The following are a few of the risks to this view that you should always be aware of:
- The intertemporal conundrum – If we look at a long enough time horizon (such as the one cited in the link to Barry’s site above) then you can see just how dangerous it can be to short human progress over the long-term. The problem is, no one alive today was alive in 1850 to ride that chart from start to finish. And if you narrow the time horizon down you see a lot more bumps and bruises along the way. I call this the “intertemporal conundrum”. It is the problem of time that we all naturally face. We are thrust into an uncertain world with uncertain timeframes. And our actual risk taking period is MUCH shorter than most of us believe (usually 30 years or so). Someone who was born in 1915 and was becoming a young adult at the height of the Great Depression lived through a dramatically different set of circumstances than someone who was born in 1965 and was becoming a young adult at the trough of one of America’s most prosperous economic booms. This intertemporal conundrum creates a risk in our lives because the short-term future is not nearly as certain as the long-term future.
- The overconfidence effect – It’s tempting to look at the inherent progress of human beings and conclude that the wave of progress is a win-win bet. This sort of mentality tends to become more pervasive after a brief period of economic prosperity and it tends to exacerbate the volatility of the business cycle. So we see people get very bearish in periods like 2008 and then becoming overly bullish in periods like right now. And when that happens we often see people making decisions that are based on overly confident projections. Even worse, we see people using those overly confident projections to embed leverage in their lives that exposes them to even greater near-term risk. And when the intertemporal conundrum and near-term risks emerge the overconfidence leads to bad outcomes.
- Long-term progress is not guaranteed, but near-term regressions are certain. There is no guarantee that humans will always make progress (though it’s likely on a long enough timeframe). But what’s guaranteed is that the volatility of the human world will always exist. Humans are highly irrational and emotional animals who don’t deal well with the stresses of an uncertain world. This creates a certain cyclicality in the near-term as overconfidence leads to booms which leads to busts. Those busts can be devastating even if they appear short in the grand scheme of things. Given our short risk taking time horizons those busts can impose huge hardship on us if we’re unprepared to deal with them.
I’m all for optimism. But be aware of the risks of an overly optimistic view of the world. I always say that we should be pragmatic optimists. Maintain an optimistic bias, but be aware of the potential near-term risks.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.