Investors, future is unpredictable and ‘tail-end consequences’ can devastate

Mr. Kim is the Chief Operation Officer and Chief Compliance Officer for Kirr
Marbach & Co. LLC, an investment adviser based in Columbus IN. Please visit
www.kirrmar.com.

We humans hate uncertainty. In dangerous times, we crave assurance if we do
X and Y, then Z will occur and all will be good again. To feed the media
beast, there is never a shortage of pundits bellowing predictions with great
authority and confidence. Unfortunately, the harsh truth is no one knows
what’s going to happen.

As economist John Kenneth Galbraith famously said, “There
are two kinds of forecasters: those who don’t know and those who don’t know
they don’t know.”

Howard Marks, Co-Chairman of Oaktree Capital, recently wrote
two terrific pieces on the importance of understanding the future is
unpredictable, “Uncertainty
<www.oaktreecapital.com/docs/default-source/default-document-library
/uncertainty.pdf?sfvrsn=0> ” and “Uncertainty II
<www.oaktreecapital.com/docs/default-source/memos/uncertainty-ii.pdf
> .” According to Marks, we should be leery of some dangerous tendencies
regarding expertise:

* to confuse general intelligence with knowledge of the facts relative
to a given field,
* to confuse factual knowledge with superior insight,
* to conflate expertise and insight with the ability to predict the
future,
* to treat experts in one field as if they’re knowledgeable about all
others, and
* to credit rich and successful people with all of the above.

The field of economics is not a “real” science with hard and
fast rules like chemistry, where combining A with B results in C, every
time. In economics/investing, there are only historical patterns that tend
to repeat, but they’re still only tendencies. Additionally, we all carry
the baggage of our own behavioral biases, which color our view of the
future.

Hindsight bias refers to our ability to misremember past decisions in ways
that make us look smarter. Attribution bias means when things turn out
well, we attribute the outcome to our skills. When they turn out poorly, we
blame outside forces beyond our control. Confirmation bias is our tendency
to give too much weight to information that supports our existing beliefs
and discounting the rest.

Our most insidious bias is overconfidence, our tendency to overrate our
abilities, knowledge and skill, leading to a false sense of security. As
Mark Twain said, “It ain’t what you don’t know that gets you in trouble.
It’s what you know for sure that just ain’t so.”

Humility is underrated. Dr. Anthony Fauci has been America’s top expert on
infectious diseases for 36 years, but stated in testimony before the U.S.
Senate, “But I am very careful and hopefully humble in knowing that I don’t
know everything about this disease and that’s why I’m very reserved about
making broad predictions. “

In probabilistic terms, a “thousand-year” flood may be a “tail-end” (i.e.
extraordinarily low probability) event, but that doesn’t mean it can’t
happen tomorrow. In addition, as the recent catastrophic failures of the
Edenville and Sanford Dams in Michigan proved, the “tail-end consequences”
can be devastating.

In fact, Warren Buffett said in Berkshire-Hathaway’s 2014 shareholder
letter, “We will always be prepared for the thousand-year flood; in fact, if
it occurs we will be selling life jackets to the unprepared.” During the
Great Financial Crisis a decade ago, corporate titans including Goldman
Sachs and General Electric were forced to turn to Buffett for financial life
jackets.

Because Buffett understands low probability events can and do happen, he
avoids debt, even as corporate America has been bingeing on nearly “free”
money to juice returns for a decade. “Unquestionably, some people have
become very rich through the use of borrowed money,” he said. “However,
that’s also been a way to get very poor. When leverage works, it magnifies
your gains. Your spouse thinks you’re clever and your neighbors get
envious. But leverage is addictive. Once having profited from its wonders,
very few people retreat to more conservative practices. And as we all
learned in third grade-and some relearned in 2008-any series of positive
numbers, however impressive the numbers may be, evaporates when multiplied
by a single zero.”

The pandemic didn’t cause the bankruptcies of Hertz, Diamond Offshore
Drilling, J. Crew, Neiman Marcus, J.C. Penney and others, but their high
debt loads left them vulnerable to this devastating tail-end consequence.
Unfortunately, there will be many more.

Using auto racing as an analogy, Buffett said, “to finish first, you must
first finish.” “Though practically all days are relatively uneventful,
tomorrow is always uncertain. (I felt no special apprehension on December
6, 1941 or September 10, 2001). And if you can’t predict what tomorrow will
bring, you must be prepared for whatever it does.” Finally, “in our view,
it is madness to risk losing what you need in pursuing what you simply
desire.”

The opinions expressed in these articles are those of the author as of the
date the article was published. These opinions have not been updated or
supplemented and may not reflect the author’s views today. The information
provided in these articles does not provide information reasonably
sufficient upon which to base an investment decision and should not be
considered a recommendation to purchase or sell any particular stock or
other investment.