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I have written frequently about the futility of trying to predict the direction of financial markets. And, of course, I am not alone in issuing these warnings.
Now I know why most people ignore my warnings.
Our surprising brains
The brain is a small but powerful prediction machine. We literally can’t stop ourselves from making predictions. If we didn’t make predictions, we couldn’t perceive the world as we do. Making predictions is hard wired into our circuitry and is essential to our survival.
The mechanisms at work are described in eye-opening detail in How Emotions Are Made by Lisa Feldman Barrett, Ph.D. Barrett is a noted psychologist and neuroscientist who has studied the inner workings of the brain for years.
She says the classic view of how brains work is wrong. Most of us think that we take input from our five senses, create a picture of reality from that information and then react to it. In other words, we make rational decisions after reviewing the data presented to us.
Not so.
Instead, our brain constantly makes predictions about our surroundings and the future we will encounter. We manufacture our version of expected reality and compare it to the information provided through our senses, making any needed adjustments along the way.
As another brain researcher, Anil Seth, put it, “The brain doesn’t hear sound or see light. What we perceive is its best guess of what’s out there in the world.” He suggests that our perceptions are just predictions or simulations – what he calls “controlled hallucinations.”
According to Barrett, there are a couple of reasons our brains operate this way. They don’t have enough capacity to take in all the raw material our senses provide and make sense of it in real time. It’s a far more efficient use of the brain’s limited resources to anticipate future reality and selectively make corrections based on the input our senses provide.
Second, by anticipating the future, the brain can prepare the body for what is to come so it can respond appropriately. It can release the chemicals necessary to run or stand and fight. It can devise plans to evade danger or capitalize on opportunities. In short, it can maximize its chances for survival in an often-hostile world by properly regulating its internal workings.
Our predictions are based on our experiences and our understanding of how the world works. Babies have almost no experience and thus their prediction machines are poor ones. As we grow and have more experiences, our prediction machine becomes more refined. Our predictions have a greater chance of matching up to the reality we encounter.
But this means our expected reality is a very personal one. I have one set of experiences that produce my reality, while my neighbor has a very different set of experiences that will produce different expectations about what the future holds. These predictions are a very powerful part of our perceptions. We interpret “facts” through our personal reality lens.
When we encounter situations that are new or unfamiliar, our brains have a harder time constructing a model of our expected reality. How should it prepare the internal organs in the body it rules over for what that body is about to encounter? What actions should it take to keep that body safe and alive? This uncertainty creates stress, anxiety, and even fear.
Our brains crave the positive feeling associated with “knowing” and seek to avoid the negative feelings associated with not knowing or uncertainty. And so, our prediction machines run non-stop. If we can’t create a model of the future based on our own experiences, we will look to others who may be able to fill in the blanks and create a sense of clarity – a sense of certainty.
Not everyone has the same intolerance for uncertainty. Some tolerate it well while others are “allergic to uncertainty,” according to Professor Michael Dugas. Dugas, a psychology professor at the University of Quebec, is one of the architects of the intolerance of uncertainty scale (IUS), which was developed to measure the differences in individual tolerances for uncertainty.
He described those who demonstrate a higher level of intolerance for uncertainty as having a “cognitive vulnerability.” This vulnerability can cause them to engage in “certainty-seeking behavior.” They may try to impose a level of order and predictability on a situation or a set of facts that is not justified.
What it means for advisors
This research has many implications for financial advisors.
It explains why our profession is replete with pundits presenting their visions of the future, despite their poor track records for accuracy. Professor Philip Tetlock and others have documented their failures and found their prognostications to be no better than those of “dart-throwing moneys.” But they have brains in their skulls, so they can’t help themselves.
It also helps explain why there is such an appetite among advisors and clients for punditry. It helps reduce the negative feelings associated with uncertainty. Even predictions of a dire future give us the sense of knowing and that allows us to plan and take action.
This research also helps explain why many clients become anxious and even fearful during turbulent markets. Most don’t have enough experience regarding investing and markets to form a picture of the future that feels either safe or reliable. “When will the markets recover?” “Will they ever recover?” “Have I just lost what I worked so hard to accumulate?”
It helps explain why presenting clients with what you see as compelling data may have little impact. Their experiences may be, and probably are, very different than yours. Thus, their perceptions of reality will be very different than yours. They may interpret the data you present differently than you do, or they may be unable to interpret it at all.
It also has implications for how to present your advice most effectively. Presenting a series of choices with associated probabilities of success may be overwhelming and even frightening to someone who does not have enough experience to sort through them.
It puts a premium on listening and learning about how each client sees the world. It will not be the same way you see it. Only after you understand their goals, experiences, preferences, misconceptions, and fears can you expect to fashion a plan they can live with.
And you may find that you need to spend a fair amount of time educating and preparing your clients for the experience of investing. Don’t sugar coat it. Investing is hard and can be scary for those who don’t have the experience to put turbulent markets into perspective.
No one can reliably and consistently predict the future course of the financial markets. Like Tetlock’s dart-throwing moneys, those who try may hit a bull’s eye but not because they know what the future holds. But we can’t keep ourselves from trying. Our brains won’t let us.
You cannot turn off your prediction machine. But, when it comes to predictions about the financial markets, you can recognize that your brain is manufacturing controlled hallucinations and refuse to act on them.
You can also use your newfound knowledge about what happens in the dark recesses of your skull to screen out the noise coming from other prognosticators and better understand and serve your clients.
Scott MacKillop is CEO of First Ascent Asset Management, the first TAMP to provide investment management services to financial advisors and their clients on a flat-fee basis. He is an ambassador for the Institute for the Fiduciary Standard and a 45-year veteran of the financial services industry. He can be reached at [email protected].
Read more articles by Scott MacKillop
Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
