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Thursday, October 25, 2012

The Perception of Risk

Financial Advisors and Planners require a risk profile for all of their prospective and existing clients. The impression of risk has undergone many changes due to the ever-changing economic environment.
The investment climate can no longer rely on the former principles that existed right up until 2008. Since that time the financial arenas have become unrecognizable. Investors have grown skeptical and weary of their losses. The modern portfolio theory can no longer offer the protection once relied upon.
The past was driven through a buy and hold methodology and a Ibbotson model. All one had to do was hold and simply make adjustments to their portfolio based upon the long standing principles of diversification and rebalancing. Nice in theory but the game has changed and with it a new normal.
A large part of this belief system is found in something called the normalcy bias. The normalcy bias, or normality bias, refers to a mental state people enter when facing a disaster. It causes people to underestimate both the possibility of a disaster occurring and its possible effects. This often results in situations where people fail to adequately prepare for a disaster, and on a larger scale, the failure of governments to include the populace in its disaster preparations. The assumption that is made in the case of the normalcy bias is that since a disaster never has occurred then it never will occur. It also results in the inability of people to cope with a disaster once it occurs. People with a normalcy bias have difficulties reacting to something they have not experienced before. People also tend to interpret warnings in the most optimistic way possible, seizing on any ambiguities to infer a less serious situation.
 Late 2007 we saw a financial disaster impact our former comfort zone. Most of the public responded to this by electing a President who promised he was outside the normal politics of the federal government. The public bought this due much in part to the normalcy bias. Most of the populous had never faced a frightening economic climate such as that of the past 4.5 years. The normal response is to interpret these events in the most optimistic way possible and to hold tight to the belief that everything will return to the way it once was. The everything old is new again mindset. Unfortunately, we will never return to the economic circumstances of old.

The sooner the population faces this fact the sooner and better will be the economic recovery. Much of this response can be altered by fresh viewpoint on the principle of risk. If you are not willing to make the necessary change in perception and thought process then we will face a much greater financial disaster. By taking a refreshed strategic process for investing we can successful alter the course of our history.

In the past alternative investments were part of the highest risk level possible, and now if an investor ignores alternatives in their portfolio they will be doomed to no growth and the ongoing liquidation of their asset base.

Tuesday, October 9, 2012

Investing and Unknown Unknowns

In 1999 David Dunning a Professor of Social Psychology at Cornell, produced a study which developed the Dunning-Kruger effect; which basically states that our incompetence masks our ability to recognize our incompetence.

Dunning has long purported that the sign of intelligence is tied to the ability to realize that there are things that you don’t know that you don’t know. Donald Rumsfeld gave a speech on Terrorism in which he was lambasted by the media for the following comments: There are things we know we know about terrorism. There are things we know we don’t know. And there are things that are unknown unknowns. We don’t know that we don’t know.

Being confident about unknown unknowns is one of the core principles behind financial victimization. When investors do not have the ability to recognize their own incompetence in the area of financial decision making they are easy prey for scams and fraud.

No one wants to admit to weakness, we all believe we are better than we truly are. It is a common thread in the trends of human nature. The most prolific danger however exists within the unknown unknowns as this characteristic will ensure our loss consistently.

The blind spot in assuming the unknown leaves one susceptible to manipulation. As an example when I was selling Life Insurance I would often have to work through CPA’s or CFO’s and they would often be a major stumbling block to getting deals done. My method with them was to simply drop a few well designed concepts with their lingo which made them feel that I was their equal when it came to the knowledge of their expertise. This of course was far from the truth but this bluff ALWAYS worked. It worked because these professionals simply knew what they knew and had no awareness that there were things they didn’t know such as being able to have their beliefs manipulated. It is much the same for investors and consumers.

When you gain a small bit of knowledge this is usually extrapolated into your believing you know well more than you truly know. When this happens you are totally blinded to the unknown unknowns because your beliefs are locked into the known. The conman knows how to play the unknowns and also how to manipulate the unknown. Just a few well-placed questions can uncover just what you know and more importantly what you don’t know. Please remember it is always what you don’t know that is most dangerous. Even when investors develop a process for the completion of due diligence they often will miss key issues because they do not know the necessary questions to ask.

Acknowledging that there are unknowns as well as unintended consequences behind every decision will help you develop a better decision making process. Never be afraid to admit there are unknown unknowns which will allow you the open-mindedness to seek the best answers.