Fix It Friday Ep. 14 - Ambiguity Bias and the Relationship Between Certainty and Return

• Benchmark obsession can distract investors from their main financial goals. There's no statistical evidence to support the consistent outperformance of random benchmarks, such as the S&P 500.
• Successful investing involves establishing clear goals, creating a plan, and choosing investments with historical returns that align with your objectives.
• An investor's plan should be the true benchmark for measuring success, not market indices. Adjustments should be based on life events rather than market fluctuations.
• Frequent portfolio checking can lead to harmful investment decisions driven by overconfidence or loss aversion bias, especially during market volatility.
• Diversification and maintaining a long-term perspective are crucial for capturing market returns and achieving financial success.

Voiceover: [00:00:00] The following podcast by Fusion Family Wealth, LLC Fusion is intended for general information purposes only. No portion of the podcast serves as the receipt of or is a substitute for personalized investment advice from Fusion or any other investment professional of your choosing. Please see additional important disclosure at the end of this podcast.

A copy of Fusion's current written disclosure brochure discussing our advisory [00:00:15] services and fees is available upon request or at www.fusionfamilywealth.com. 

Jonathan Blau: Hello everybody. Welcome to another episode of Fix It Friday. We're recording this one. Uh, just about week and a half or so before the end of summer, and it went by quickly.

But [00:00:30] hopefully you'll enjoy today's episode.

Welcome to The Crazy Wealthy Podcast with your host, Jonathan Blau. Whether you're just starting out or an experienced investor, join [00:00:45] Jonathan as he seeks to illuminate and demystify the complexities of making consistently rational financial decisions under conditions of uncertainty. He'll chat with professionals from the advice world, entrepreneurs, executives, and more [00:01:00] to share fresh perspectives on making sound decisions that maximize your wealth.

And now here's your host. 

Jonathan Blau: Today I want to talk about something called the ambiguity bias. And it's, uh, it's a [00:01:15] bias that drives, uh, our financial decisions in such a way so that because we are seeking, um, investment choices and options that have, uh, more certainty attached to the cash flows that they [00:01:30] provide.

And more certainty, uh, with regard to, uh, the level of fluctuation we can expect from them. Uh, we are attracted to those types of investments. So a good example of that is bonds we're attracted to bonds because in [00:01:45] general, bonds pay interest periodically, usually every six months. And, uh, there's not. Too much ambiguity.

We know at the end of the maturity of the bond, when we get our money paid back, if, if we invest a million dollars in a bond, we loan a company a million at the end of five [00:02:00] years, when the bond, uh, is due, they owe us our million back. We know we can't make more than that million. And we make whatever the interest rate is in between year one and year five at maturity.

And there's a comfort level just knowing that, um, we, we are gonna get that [00:02:15] money. Uh, and, and we, so a lot of people. Will bias their investments toward things like bonds, uh, to be because of the ambiguity bias. So the paradox of wealth management. Is that when it comes to ambiguity [00:02:30] bias, the more we emphasize certainty as it relates to the need for certainty and the cash flows and the returns we get, the more we increase the probability that we'll fail to meet our long-term financial goals.

[00:02:45] So how, how does that happen? Uh, one of the things that, um, that, that we need to do before I talk about how it happens is to define the difference between risk. And ambiguity. So, so risk involves, [00:03:00] um, calcula, calculable odds of events occurring based on their historical record. So, for example, we know that if we invest in the s and p 500 or in stocks broadly, as a general rule, for the last a hundred years, there've been [00:03:15] about, uh, 75% of the single year, 12 month periods have been positive.

And when you go to three year and five year, uh, rolling periods, you have 85% that were positive [00:03:30] for three years and almost 90% for five year periods. So when we look at the risk of investing in stocks once we extend the time horizon past a year, the odds of succeeding, uh, grow. Very close to [00:03:45] 90% in five years and close to, um, 95% in 10 years.

And there's never been a 20 year rolling period where stocks have lost money. So when we look at. The returns that have been available for the last a hundred [00:04:00] years after inflation for investors by investing in the stock, uh, market could be again defined here by the s and p 500. The returns after inflation have been 7% a year investing in, uh, portfolio of [00:04:15] similar companies bonds.

Right to those companies that are in the s and p 500, the after inflation returns for the last a hundred years have been 3%. So 7% after inflation for stocks, 3% after inflation for [00:04:30] bonds. And so we ask ourselves, knowing that long history, why would rational investors choose to have any meaningful portion of the money, uh, that they invest in, in the investment class bonds that earns fully, uh, less than [00:04:45] half.

Of what stocks have earned after inflation. And the answer is, uh, in many cases it has to do with the ambiguity involved with investing in stocks. Um, the 10% a year comes with, uh, a decline of about [00:05:00] 15% every year on average since 1980. And it comes to a, it comes with a decline of about twice that amount, 33%.

Uh, one year in five or six. Uh, but, but we can't know with certainty in the short run when those declines will happen. So for [00:05:15] example, during COV, when the, uh, economy shut down, the market declined 34% from February, 2020 to March of 2020. So in one month we had an unprecedented 34% decline. There's nowhere, uh, [00:05:30] that we can look for guidance to have.

Expected that might happen in history. Uh, it it's just part of ambiguity, right? We, we just couldn't forecast. Okay. Well, a good way to look at ambiguity. Ambiguity is what's involved with the short run decisions, right? [00:05:45] W what's gonna happen in the next month, year, year and a half? Anything can happen. Um, but risk and, and, and analysis of, of, of risk, and the history of risk is what we look at over long term.

And we're investing, we're investing for the long term. So. [00:06:00] What does one to do to fight, uh, the, the, um, the ambiguity bias that we have, uh, and prevent it from causing us to make very poor, long-term financial decisions. Uh, so what we really need to do is look at, uh, look at our needs, look at the [00:06:15] risk and return expectations involved as opposed to.

Looking at whether or not an investment outcome is more or less ambiguous, right? Because that doesn't help us in the long run. We need to make sure that we fight inflation and that [00:06:30] we have enough spending 10 years, 20 years, 30 years down the road. And we need to choose the investments that are more ambiguous than less ambiguous.

So let's take a look at a real life example. A lot of, uh, retirees. Uh, who, who are revisiting their investment plan, [00:06:45] like to make sure that the stocks that they own have higher dividends than lower dividends, because there's less ambiguity involved. If you're starting off with a stock, let's say, with a 4% dividend cash flow, then with a stock with a 1% dividend cash flow, [00:07:00] in your mind you're saying, well, I'm getting four times the cash flow.

That's really nice. I don't, I, I like that. Perceived certainty. But when you now unpack the baggage, let's take a look at it. If you look at the fact that total returns include dividends [00:07:15] plus growth, and you recognize that, why does uh, one company pay a much higher dividend, let's say, than the average company in the s and p 500?

And the reason is, is generally because that company who's paying the higher dividend. Is not [00:07:30] growing their company or their business as fast as the other companies. So the CEOs of that company, the people in charge of making sure they maximize shareholder value, uh, say, gee, I'm, I'm just gonna pay out more of my cashflow in the form of [00:07:45] dividends.

Because my business isn't growing fast enough to warrant investing more money in it. And, and so why would one want to own a business that's not growing fast enough so that the appreciation of the asset, the stock won't be there. Uh, and, and the reason is [00:08:00] they feel more secure that they know there's more cash flow in that higher dividend.

But when you think about it realistically, you actually wanna own the companies that are growing fast enough. To warrant investing and reinvesting the money in the company's growth because that growth is gonna be so [00:08:15] far superior to the company who isn't growing. That the total return, the, the lower dividend plus the higher growth, is gonna lead to a higher financial and a better financial outcome.

So, so that's just a real life example that we see. And the other [00:08:30] example, of course, is the basic one where people will prefer. To have more bonds than they need in the portfolio, than stocks, uh, just simply because of the, uh, the need that they feel to reduce ambiguity. So one of the things I like to tell people is it's, it's [00:08:45] very difficult to invest, to satisfy our emotional wants, the need to not have a lot of movement or volatility in our portfolio.

Uh, versus investing for our financial needs, the needs to maximize our ability to have the, uh, income we need in [00:09:00] retirement and leave the legacy, uh, behind. So we need to decide on which end of our financial life we are willing to have more uncertainty so that we may have more certainty on the other end.

And so those who, [00:09:15] who, who are not willing to put up with ambiguity, uh, in their earlier years. Or even when someone's 70 and have God willing another 20 years to live off of their money. If they're not willing to put up with the ambiguity in, in, in, in the first [00:09:30] part of that 20 year period, or if you're retiring the first part of the 30 year retirement period, then you have to put up with the uncertainty later on that you may have to reduce your lifestyle or run out of money.

And, and that's the trade off for choosing less ambiguous [00:09:45] investments that are also likely lower returning investments, uh, in, in, in the short run. And so, uh, just be aware of the ambiguity bias. Focus more on risk and return where there are probabilities. Recognize that, [00:10:00] uh, as a long-term investor. You can calculate the probabilities and determine whether or not that's appropriate for you.

Uh, meaning that if stocks return 7% a year over long periods of time after inflation and bonds return three. And if stocks for one year [00:10:15] periods go up 75% of the time historically, and, uh, for, for five year periods, almost 90% of the time say, gee, I, I can live with that. I don't mind the short term ambiguity and I certainly don't want to trade in choosing.

Less ambiguous investments that will, [00:10:30] that will lead to a, a, a very low probability of me hitting the financial goals that are so important to me and my family. I hope you, you enjoyed this episode of, uh, fix It Friday and that, uh, learning how to identify and [00:10:45] not succumb to the ambiguity bias will help everybody make better investment decisions.

Uh, you can catch us on your favorite. Podcast channels, and you can always get us on, uh, fusion family wealth.com and crazy wealthy podcast.com. [00:11:00] Uh, wishing everybody a uh, happy fall. See you next time.

Thank you for tuning into another episode of The Crazy Wealthy Podcast. For more insights, resources, and to sign up for our [00:11:15] newsletter, visit crazy wealthy podcast.com. Until then, stay crazy wealthy.

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