Imagine an alien dispatched to Earth. His job is to keep tabs on our economy.
He circles above New York City, trying to size up the economy and how it changed between 2007 and 2009.
On New Year’s Eve 2007 he hovers over Times Square. He sees tens of thousands of happy partygoers surrounded by bright lights, monstrous billboards, fireworks, and TV cameras.
He comes back to Times Square on New Year’s Eve 2009. He sees tens of thousands of happy partygoers surrounded by bright lights, monstrous billboards, fireworks, and TV cameras.
It looks about the same. He cannot see much difference.
He sees roughly the same number of New Yorkers hustling around the city. Those people are surrounded by the same number of office buildings, which house the same number of desks with the same number of computers, hooked up to the same number of internet connections.
Outside the city he sees the same number of factories and warehouses, connected by the same highways, carrying the same number of trucks.
He gets a little closer to the ground and sees the same universities teaching the same topics and handing out the same degrees to the same number of people.
He sees the same number of patents protecting the same groundbreaking ideas.
He notices that technology has improved. Everyone in 2009 carries smartphones that didn’t exist in 2007. Computers are now faster. Medicine is better. Cars get better gas mileage. Solar and fracking technology has advanced. Social media has grown exponentially.
As he flies around the country he sees the same. Around the globe, more of the same.
The economy is in about the same shape, maybe even better, in 2009 as it was in 2007, he concludes.
Then he looks at the numbers.
He’s shocked that U.S. households are $16 trillion poorer in 2009 than they were in 2007.
He’s dumbfounded that 10 million more Americans are unemployed.
He’s in disbelief when he learns the stock market is worth half of what it was two years before.
He can’t believe that people’s forecast of their economic potential has plunged.
“I don’t get it,” he says. “I’ve seen the cities. I’ve looked at the factories. You guys have the same knowledge, the same tools, the same ideas. Nothing has changed! Why are you poorer? Why are you more pessimistic?”
There was one change the alien couldn’t see between 2007 and 2009: The stories we told ourselves about the economy.
In 2007, we told a story about the stability of housing prices, the prudence of bankers, and the ability of financial markets to accurately price risk.
In 2009 we stopped believing that story.
That’s the only thing that changed. But it made all the difference in the world.
Once the narrative that home prices will keep rising broke, mortgage defaults rose, then banks lost money, then they reduced lending to other businesses, which led to layoffs, which led to less spending, which led to more layoffs, and on and on.
Other than clinging to a new narrative, we had an identical—if not greater—capacity for wealth and growth in 2009 as we did in 2007. Yet the economy suffered its worst hit in 80 years.
This is different from, say, Germany in 1945, whose manufacturing base had been obliterated. Or Japan in the 2000s, whose working-age population was shrinking. That’s tangible economic damage. In 2009 we inflicted narrative damage on ourselves, and it was vicious. It’s one of the most potent economic forces that exists.
When we think about the growth of economies, businesses, investments and careers, we tend to think about tangible things—how much stuff do we have and what are we capable of?
But stories are, by far, the most powerful force in the economy. They are the fuel that can let the tangible parts of the economy work, or the brake that holds our capabilities back.
At the personal level, there are two things to keep in mind about a story-driven world when managing your money.
1. The more you want something to be true, the more likely you are to believe a story that overestimates the odds of it being true.
What was the happiest day of your life?
The documentary How to Live Forever asks that innocent question to a centenarian who offered an amazing response.
“Armistice Day,” she said, referring to the 1918 agreement that ended World War I.
“Why?” the producer asks.
“Because we knew there would be no more wars ever again,” she says.
World War II began 21 years later, killing 75 million people.
There are many things in life that we think are true because we desperately want them to be true.
I call these things “appealing fictions.” They have a big impact on how we think about money—particularly investments and the economy.
An appealing fiction happens when you are smart, you want to find solutions, but face a combination of limited control and high stakes.
They are extremely powerful. They can make you believe just about anything.
Take a short example.
Ali Hajaji’s son was sick. Elders in his Yemeni village proposed a folk remedy: shove the tip of a burning stick through his son’s chest to drain the sickness from his body.
After the procedure, Hajaji told The New York Times: “When you have no money, and your son is sick, you’ll believe anything.”⁶⁴
Medicine predates useful medicine by thousands of years. Before the scientific method and the discovery of germs there was blood-letting, starvation therapy, cutting holes in your body to let the evils out, and other treatments that did nothing but hasten your demise.
It seems crazy. But if you desperately need a solution and a good one isn’t known or readily available to you, the path of least resistance is toward Hajaji’s reasoning: willing to believe anything. Not just try anything, but believe it.
Chronicling the Great Plague of London, Daniel Defoe wrote in 1722:
The people were more addicted to prophecies and astrological conjurations, dreams, and old wives’ tales than ever they were before or since … almanacs frighted them terribly … the posts of houses and corners of streets were plastered over with doctors’ bills and papers of ignorant fellows, quacking and inviting the people to come to them for remedies, which was generally set off with such flourishes as these: ‘Infallible preventive pills against the plague.’ ‘Neverfailing preservatives against the infection.’ ‘Sovereign cordials against the corruption of the air.’
The plague killed a quarter of Londoners in 18 months. You’ll believe just about anything when the stakes are that high.
Now think about how the same set of limited information and high stakes impact our financial decisions.
Why do people listen to TV investment commentary that has little track record of success? Partly because the stakes are so high in investing. Get a few stock picks right and you can become rich without much effort. If there’s a 1% chance that someone’s prediction will come true, and it coming true will change your life, it’s not crazy to pay attention—just in case.
And there are so many financial opinions that once you pick a strategy or side, you become invested in them both financially and mentally. If you want a certain stock to rise 10-fold, that’s your tribe. If you think a certain economic policy will spark hyperinflation, that’s your side.
These may be low-probability bets. The problem is that viewers can’t, or don’t, calibrate low odds, like a 1% chance. Many default to a firm belief that what they want to be true is unequivocally true. But they’re only doing that because the possibility of a huge outcome exists.
Investing is one of the only fields that offers daily opportunities for extreme rewards. People believe in financial quackery in a way they never would for, say, weather quackery because the rewards for correctly predicting what the stock market will do next week are in a different universe than the rewards for predicting whether it will be sunny or rainy next week.
Consider that 85% of active mutual funds underperformed their benchmark over the 10 years ending 2018.⁶⁵ That figure has been fairly stable for generations. You would think an industry with such poor performance would be a niche service and have a hard time staying in business. But there’s almost five trillion dollars invested in these funds.⁶⁶ Give someone the chance of investing alongside “the next Warren Buffett” and they’ll believe with such faith that millions of people will put their life savings behind it.
Or take Bernie Madoff. In hindsight his Ponzi scheme should have been obvious. He reported returns that never varied, they were audited by a relatively unknown accounting firm, and he refused to release much information on how the returns were achieved. Yet Madoff raised billions of dollars from some of the most sophisticated investors in the world. He told a good story, and people wanted to believe it.
This is a big part of why room for error, flexibility, and financial independence—important themes discussed in previous chapters—are indispensable.
The bigger the gap between what you want to be true and what you need to be true to have an acceptable outcome, the more you are protecting yourself from falling victim to an appealing financial fiction.
When thinking about room for error in a forecast it is tempting to think that potential outcomes range from you being just right enough to you being very, very right. But the biggest risk is that you want something to be true so badly that the range of your forecast isn’t even in the same ballpark as reality.
In its last 2007 meeting the Federal Reserve predicted what economic growth would be in 2008 and 2009.⁶⁷ Already weary of a weakening economy, it was not optimistic. It predicted a range of potential growth—1.6% growth on the low end, 2.8% on the high end. That was its margin of safety, its room for error. In reality the economy contracted by more than 2%, meaning the Fed’s low-end estimate was off by almost threefold.
It’s hard for a policymaker to predict an outright recession, because a recession will make their careers complicated. So even worst-case projections rarely expect anything worse than just “slow-ish” growth. It’s an appealing fiction, and it’s easy to believe because expecting anything worse is too painful to consider.
Policymakers are easy targets for criticism, but all of us do this to some extent. And we do it in both directions. If you think a recession is coming and you cash out your stocks in anticipation, your view of the economy is suddenly going to be warped by what you want to happen. Every blip, every anecdote, will look like a sign that doom has arrived—maybe not because it has, but because you want it to.
Incentives are a powerful motivator, and we should always remember how they influence our own financial goals and outlooks. It can’t be overstated: there is no greater force in finance than room for error, and the higher the stakes, the wider it should be.
2. Everyone has an incomplete view of the world. But we form a complete narrative to fill in the gaps.
My daughter is about a year old as I write this. She’s curious about everything and learns so fast.
But sometimes I think about all the stuff she can’t comprehend.
She has no idea why her dad goes to work every morning.
The concept of bills, budgets, careers, promotions, and saving for retirement are completely foreign to her.
Imagine trying to explain the Federal Reserve, credit derivatives, or NAFTA to her. Impossible.
But her world isn’t dark. She does not wander around in confusion.
Even at a year old, she’s written her own internal narrative of how everything works. Blankets keep you warm, mom snuggles keep you safe, and dates taste good.
Everything she comes across fits into one of a few dozen mental models she’s learned. When I go to work she doesn’t stop in confusion, wondering what salary and bills are. She has a crystal clear explanation of the situation: Dad isn’t playing with me, and I wanted him to play with me, so I’m sad.
Even though she knows little, she doesn’t realize it, because she tells herself a coherent story about what’s going on based on the little she does know.
All of us, no matter our age, do the same thing.
Just like my daughter, I don’t know what I don’t know. So I am just as susceptible to explaining the world through the limited set of mental models I have at my disposal.
Like her, I look for the most understandable causes in everything I come across. And, like her, I’m wrong about a lot of them, because I know a lot less about how the world works than I think I do.
This is true for the most fact-based of subjects.
Take history. It’s just the recounting of stuff that already happened. It should be clear and objective. But as B. H. Liddell Hart writes in the book Why Don’t We Learn From History?:
[History] cannot be interpreted without the aid of imagination and intuition. The sheer quantity of evidence is so overwhelming that selection is inevitable. Where there is selection there is art. Those who read history tend to look for what proves them right and confirms their personal opinions. They defend loyalties. They read with a purpose to affirm or to attack. They resist inconvenient truth since everyone wants to be on the side of the angels. Just as we start wars to end all wars.
Daniel Kahneman once told me about the stories people tell themselves to make sense of the past. He said:
Hindsight, the ability to explain the past, gives us the illusion that the world is understandable. It gives us the illusion that the world makes sense, even when it doesn’t make sense. That’s a big deal in producing mistakes in many fields.
Most people, when confronted with something they don’t understand, do not realize they don’t understand it because they’re able to come up with an explanation that makes sense based on their own unique perspective and experiences in the world, however limited those experiences are. We all want the complicated world we live in to make sense. So we tell ourselves stories to fill in the gaps of what are effectively blind spots.
What these stories do to us financially can be both fascinating and terrifying.
When I’m blind to parts of how the world works I might completely misunderstand why the stock market is behaving like it is, in a way that gives me too much confidence in my ability to know what it might do next. Part of the reason forecasting the stock market and the economy is so hard is because you are the only person in the world who thinks the world operates the way you do. When you make decisions for reasons that I can’t even comprehend, I might follow you blindly into a decision that’s right for you and disastrous to me. This, as we saw in chapter 16, is how bubbles form.
Coming to terms with how much you don’t know means coming to terms with how much of what happens in the world is out of your control. And that can be hard to accept.
Think about market forecasts. We’re very, very bad at them. I once calculated that if you just assume that the market goes up every year by its historic average, your accuracy is better than if you follow the average annual forecasts of the top 20 market strategists from large Wall Street banks. Our ability to predict recessions isn’t much better. And since big events come out of nowhere, forecasts may do more harm than good, giving the illusion of predictability in a world where unforeseen events control most outcomes. Carl Richards writes: “Risk is what’s left over when you think you’ve thought of everything.”
People know this. I have not met an investor who genuinely thinks market forecasts as a whole are accurate or useful. But there’s still tremendous demand for forecasts, in both the media and from financial advisors.
Why?
Psychologist Philip Tetlock once wrote: “We need to believe we live in a predictable, controllable world, so we turn to authoritative-sounding people who promise to satisfy that need.”
Satisfying that need is a great way to put it. Wanting to believe we are in control is an emotional itch that needs to be scratched, rather than an analytical problem to be calculated and solved. The illusion of control is more persuasive than the reality of uncertainty. So we cling to stories about outcomes being in our control.
Part of this has to do with confusing fields of precision with fields of uncertainty.
NASA’s New Horizons spacecraft passed by Pluto two years ago. It was a three-billion mile trip that took nine and a half years. According to NASA, the trip “took about one minute less than predicted when the craft was launched in January 2006.”⁶⁸
Think about that. In an untested, decade-long journey, NASA’s forecast was 99.99998% accurate. That’s like forecasting a trip from New York to Boston and being accurate to within four millionths of a second.
But astrophysics is a field of precession. It isn’t impacted by the vagaries of human behavior and emotions, like finance is. Business, economics, and investing, are fields of uncertainty, overwhelmingly driven by decisions that can’t easily be explained with clean formulas, like a trip to Pluto can. But we desperately want it to be like a trip to Pluto, because the idea of a NASA engineer being in 99.99998% control of an outcome is beautiful and comforting. It’s so comforting that we’re tempted to tell ourselves stories about how much control we have in other parts of our life, like money.
Kahneman once laid out the path these stories take:
When planning we focus on what we want to do and can do, neglecting the plans and skills of others whose decisions might affect our outcomes.
Both in explaining the past and in predicting the future, we focus on the causal role of skill and neglect the role of luck.
We focus on what we know and neglect what we do not know, which makes us overly confident in our beliefs.
He described how this impacts businesses:
I have had several occasions to ask founders and participants in innovative start-ups a question: To what extent will the outcome of your effort depend on what you do in your firm? This is evidently an easy question; the answer comes quickly and it has never been less than 80%. Even when they are not sure they will succeed, these bold people think their fate is almost entirely in their own hands. They are surely wrong: the outcome of a start-up depends as much on the achievements of its competitors and on changes in the market as on its own efforts. However, entrepreneurs naturally focus on what they know best—their plans and actions and the most immediate threats and opportunities, such as the availability of funding. They know less about their competitors and therefore find it natural to imagine a future in which the competition plays little part.
We all do this to some extent.
And like my daughter, it doesn’t bother us a bit.
We don’t wander around blind and confused. We have to think the world we operate in makes sense based on what we happen to know. It’d be too hard to get out of bed in the morning if you felt otherwise.
But the alien circling over Earth?
The one who’s confident he knows what’s happening based on what he sees but turns out to be completely wrong because he can’t know the stories going on inside everyone else’s head?
He’s all of us.