Sunday, October 02, 2022

Devil's Advocates are Investors' Best Friends

If those on the opposite side of the trade are viewed as threats rather than friends, it's time to revise the analysis.

Of the many self-generated dangers investors face, few are more dangerous than confirmation bias, the comfort we experience seeking out views that confirm our own positions and our resistance to studying opposing views.

Confirmation bias is both self-evident and complex. We all understand the psychologically soothing feeling when others heartily agree with us, and the frustration, anxiety and sense of being threatened we experience when our core positions are challenged.

But there's more to it than just that. Taking a position with conviction empowers us, for by publicly espousing a forecast, prediction or position, we're implicitly saying, "When events show I'm right, that will show I'm smarter than the average bear."

If we push our position and conviction to an extreme and shout it out loudly enough, we'll attract those seeking to confirm their own biases. Confirmation bias thus generates a self-reinforcing feedback loop, as those shouting the loudest attract those who agree with them, rewarding their conviction with "likes."

We all know the danger of marrying your position, that is, taking not just a financial stake but also an emotional stake that eventually becomes entwined with our identity. What may have started out as a calculated risk morphs into an all-or-nothing reflection of our identity. Any challenge becomes a threat to our selfhood.

Conviction is good, but a hedge and a Plan B are even better. Hedges and Plan Bs arise from a simple question: what if I'm wrong?

If we want to avoid the dangers of confirmation bias and marrying our positions, Devil's Advocates become our best friends. Devil's Advocates delight in probing the consensus or popular view for weaknesses, and exploring how and why the consensus or popular view might be riskier than advertised, or even completely, catastrophically wrong.

The grizzled investor who's ridden conviction trades all the way to zero suppresses the desire to confirm biases in favor of seeking out informed Devil's Advocates, skeptics and proponents of the opposite side of the trade.

This is especially important in unstable, volatile eras like the present. Since every forecast and prediction (and thus every investment position) is based on previous analogs playing out, what happens when none of those analogs map to the present? Very simply, nobody knows what's going to happen, and the appropriate level of confidence in any prediction or forecast is near-zero.

If we cannot justify a conviction trade, then it becomes appropriate to pair every position with a hedge (to protect the position if we're wrong) or a Plan B (escape with most of our capital intact, limit our risk in any one position or sector, stay in cash until the weather clears, etc.).

If we listen with some detachment to informed Devil's Advocates, we might even change our minds (gasp). No crystal ball is unclouded, but being flexible enough to change our minds when presented with evidence is a positive trait.

In other words, the most fervent Bulls would be well-served by seeking out the most fervent Bears--and vice versa. There's a spectrum of Devil's Advocates, of course; some delight in puncturing everyone's balloons, others are probing their own conviction trade for potentially fatal weaknesses, and so on.

If those on the opposite side of the trade are viewed as threats rather than friends, it's time to revise the analysis. It's never comfortable to be told "you're wrong," but the possibility of being wrong should be uppermost in every investor's mind, as that possibility informs calculated risk: yes, we understand this position is risky, but we're taking it anyway because we judge the potential upside to be worth the risk.

Anyone who helps me re-think a position and hedge risk is a friend, not a threat.

What are some current Devil's Advocates' provocations? Here are a few guaranteed to make blood boil in many veins: (Remember, the key question is: what if I'm wrong?)

1. The US dollar will only continue strengthening, crushing the euro to .80, the yen to 250, the yuan to the depths of Heck, etc. It will not crash or die, not now and not in five years or ten years.

2. The 10-year yield is heading toward 5% and TLT toward 85. Rates are not going back to zero.

3. Not all fiat currencies will die.

4. Not all markets will crash.

5. Liquidity isn't all that matters.

6. Burning all the deadwood (non-performing debt, phantom wealth, etc.) is necessary to re-seed the forest.

7. Every prediction and forecast will be wrong because the past doesn't map the present. Correct forecasts will be so rare that they will be statistically insignificant.

8. Take control of your life, take ownership of everything you generate. Everything else--opinions, forecasts, predictions-- is signal noise.



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