Normalcy Bias and a bit of Impact Bias

Yaaawwnn.  The stock markets in the last few weeks have been rather boring and uneventful.  The US-market (measured by the S&P 500) has even entered an unusually long period of volatility contraction.  The daily market moves up a bit and then down a bit.  All in minuscule steps.  We recently have gone through the least volatile period in almost 23 years.

This market action can lull one to sleep.

But don’t let your guard down.

It is a good time to revisit two of our psychological quirks we are saddled with as part of our evolutionary baggage.

The Normalcy Bias

Everything that has ever happened in history was “unprecedented” at one time.  The Great Depression.  The crash of 1987.  Enron.  Wall Street bailouts.  All of these events had never happened… until they did.  “Black Swan Events” (or google it) do happen and often their impact is harder than expected.  So be aware that the next financial crisis might be bigger than the last!

normalcy_is_overrated

Example 1: The backbones of our economies – the banks – are still highly leveraged.  A Black Swan Event could create havoc for them and you.

The 2005 bankruptcy reform legislation in the USA elevates— derivatives—above all other asset classes in a bankruptcy.  This puts the banks (holders of 99% of all derivatives) above any other asset holder.  The “small prints” of the T&Cs states that any brokerage-held asset can be used legally to pay off exploded derivatives.  They can legally post client funds to pay off their own debts or use them as collateral.  So far, this has not happened (or at least it was not widely published), but it might happen in the near future => Get over your normalcy bias … get your above-emergency-fund-level-deposits out now and more diversified!

Example 2: Investors have notoriously short memories.

Interest rates have been falling for 30 years.  The prospect of rising interest rates is really daunting.  Even some of the most grizzled, seasoned bond managers haven’t experienced a sustained rise in interest rates.  From now onwards, they can literally only go up.  Or continue further down south into deeper negative territory. Either way, be prepared that the normalcy of the last 30 years is coming to an end (negative interest rates are certainly not normal according to historic standards).

Are you worried about your money yet?

Don’t overdo it, and start living by the motto: Worrying works! 

In my case at least 95% of the things I worried about never happened.

So our blindness to the Normalcy Bias is not a failure to see the new fact; it’s a failure to see that the facts in our minds have the potential to be out-of-date at all.

Be concerned about that and act upon it by stocking up on broad-based ETFs, on SWANs – “sleep well at night” stocks, or combine that with some Put Options.  Put Options near market tops and in low volatility are “cheaper”.

And neither get disheartened by any future violent move to the downside.  Being human brings with it the common tendency to overestimate the intensity and duration of our emotional reactions to future negative events.  We see tragedies in our minds.

The Impact Bias

So why do we mispredict our reactions to tragedies? Impact Bias - we see tragedies for the future

Our mental image captures one moment of a single event.  But one’s happiness – say – a year after the event is influenced by much more than the event itself.  A lot happens in a year—there are birthday parties, promotions, love-making, dental appointments, Shibuya toasts, and so on.  These things aren’t nearly as important as the tragedy, of course, but they are real, there are a lot of them, and together they have an impact that we tend not to consider.

When we’re trying to predict how happy we will be in a future that contains Event X, we tend to focus on Event X and forget about all the other events that also populate that future—events that tend to dilute the pleasurable impact of Event X.

In a sense, we are slaves to the focus of our own attention.

It’s good to be aware of that.  Take note of it and then move on with your happy life.

“There is nothing either good or bad, but thinking makes it so” – William Shakespeare

 

In case you want to read more about your skills in forecasting the future: Do you want to predict the future?

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