The research is also compelling that debt-to-GDP ratios in excess of 90 percent are an independent cause of slower real growth due to consumer and investor expectations of higher inflation, higher taxes, or disruptive debt defaults. In effect, consumers save more and businesses invest less, both on a precautionary basis. Governments cannot borrow their way out of a debt problem.
Taking the economic forecasts and economic research together reveals the United States is in for a prolonged period of slow economic growth punctuated by occasional technical recessions. The United States is Japan. The Japanese suffered the infamous “lost decade” from 1990 to 2000, and have suffered almost two additional lost decades since. The United States had its first lost decade from 2007 to 2017, and is now well into its second lost decade. This low-growth pattern will persist absent an inflationary breakout, which the Fed seems powerless to ignite in the short run; a war; or severe depression perhaps caused by a new financial crisis.
Given a baseline scenario of prolonged slow growth, there are three specific strategies investors can pursue both to profit and preserve wealth. The first strategy is to reduce exposure to high-valuation, high-growth stocks in technology, media, and advertising, especially the FAANG basket (Facebook, Apple, Amazon, Netflix, and Google). These stocks may continue to gain in the short run but are overdue for a fall as the reality of another lost decade sinks in. Avoiding these stocks avoids large losses when the inevitable correction commences.
The second strategy is to allocate part of one’s portfolio to sectors that perform well in low-growth and deflationary environments, including utilities, ten-year U.S. Treasury notes, and high-quality municipal bonds. These investments provide steady yields while offering capital gains potential as disinflationary tendencies persist.
The third strategy is to increase your allocation to cash. A cash allocation reduces the overall volatility of your portfolio and offers deflation protection, since the real value of cash goes up in deflation. Importantly, cash offers optionality and an ability to pivot rapidly into other asset classes should war or inflation intrude unexpectedly. Cash also offers the holder the ability to go bargain hunting should another financial panic occur that drives asset values down 50 percent or more, as happened in 2008.
This slow-growth portfolio provides steady yields, hedges deflation, avoids losses on highfliers, and offers a chance to bottom fish in the next recession or crash. The United States took fifty years to dig itself into a nonsustainable den of debt, and will not escape the room quickly. Patient investors can wait out the debt denouement and avoid pitfalls that will ensnare others.
CHAPTER THREE
Find the Cost of Freedom
It is much easier, as well as far more enjoyable, to identify and label the mistakes of others than to recognize our own.1
—Daniel Kahneman, Thinking, Fast and Slow (2011)
Beep, Beep, Beep
I lived for a decade on a 150-acre estate on the Long Island Sound in Connecticut. I didn’t own it; I rented a perfectly nice yet modest house on the estate, with a water view amid more important structures, including a Mediterranean-style mansion, carriage house, and stables from a bygone age. My landlords were descendants of a family who owned the estate for over 120 years, heirs to fortunes in baking powder and tobacco. Some of the buildings are vacant now, although the stables are still active with Thoroughbreds handled by trainers with access to the facilities. I often imagined the Gatsbyesque parties that took place there in the 1920s. Today it is mostly empty and quiet; a great place to write.
The estate has a network of private roads suitable for horse-drawn carriages in the 1890s, yet too narrow for two cars to pass today. There’s little traffic. Still, the few residents and visitors who do drive are courteous when the time comes to yield to another vehicle passing by.
One quirk of living on a large estate is that my house was a half mile from the nearest public road. The few mailboxes on the property are situated on a small roundabout not far from the public road, more accessible to the postal service. This made collecting my mail slightly more effortful than just stepping outside. Typically, I stopped by the mailbox in my car on my way to and from town.
Then the battle began.
If I arrived at night, I aimed my car at the mailboxes, using my headlights for visibility in the dark; left the engine running; and hopped out.
Beeeeeeeeeeeeeeeep.
My car, an Audi A5, would make the most obnoxious high-pitched continuous beeping sound. I don’t exactly know why. It could be because I left the key in the car. It could be because I left the door open with the engine running and the lights on. It could be because my seat belt was unbuckled with the engine running while I was out of the car. It could be all of the above. The noise was unfortunate, because the estate is usually still and silent unless the wind’s up off the Sound, in which case the crashing waves and salt air scent make it even more delightful. The beep ruined the peace.
I would hop back in the car, throw the mail on the front seat, and continue the drive to my house. At this point, I was just a thousand yards from home on private roads with no traffic. I often did not refasten my seat belt for this stretch. There was no objective danger except for leaping deer. After ten years I knew them by name; I’d take my chances. Some German engineer had other ideas.
Ding, ding, ding, ding.
My car was telling me my seat belt was unfastened. I already knew that. I quickly calculated that the seat belt ding alert stops after four dings and does not alert me again for thirty seconds. If I sped up a bit and there were no leaping deer I could make it home before the next round of dings. This strategy usually failed. The ding, ding, ding returned before I made it past the dressage ring.
Now I’d be in front of my house. It’s night, the house is locked, the lights are off. Again, I’d use my car as a 2-ton flashlight pointed at my front door in the dark. I’d hop out of the car with my house keys.
Beeeeeeeeeeeeeeeep.
Eventually I’d unload the car, not forgetting the mail, move the car to its parking place, make it inside, and settle in for some peace and quiet. Maybe I’d do some writing in my studio. No more beeps and dings.
Wrong.
Once I turned my computer on, the horrific host of prompts, reminders, dings, and alerts start up again. At least I know how to disable or mute most of those. I dread that if I ever tried to reprogram the German-engineered prompts on my A5, the result would be disastrous, possibly including arrest by some car safety SWAT team of whose existence I was unaware.
For one who’s thinking I could easily make these annoyances disappear by turning off my car engine at the mailbox, fastening my seat belt in the final stretch, and closing the car door behind me in the driveway, my answer is, “Yes, you’re right, I can make the prompts go away. All I have to do is obey.”
Life isn’t more quotidian than picking up the mail and opening my front door. That’s the point. If one can’t get through the most routine tasks without a constant stream of audible, digital, visual beeps, dings, and bells, consider the sensory cognitive bombardment one undergoes in making fateful decisions regarding a 401(k), life insurance, health-care plans, and credit cards. Your employer’s 401(k) election form is designed to make it more likely you will join the plan than other less manipulative designs. Insurance applications are designed to steer you into long-term plans with savings features rather than toward simpler, less expensive coverage. Credit card applications are adorned with scenes of exotic getaways and expensive meals without highlighting 20 percent interest rates on unpaid balances and thirty-five-dollar “late fees” that apply within days of the bill being issued. These prompts go beyond mere advertising into a dark corner of behavioral psychology called “choice architecture,” where financial forms are engineered by scientists who look out for the best interests of plan sponsors, not you.
It wasn’t always this way. People have made important decisions on health, safety and income security for over a centu
ry, since the passing of a more self-reliant age. But they weren’t always bullied about it. That’s relatively new.
We know exactly whom to thank for this constant compulsion in our lives—Richard H. Thaler and Cass R. Sunstein, two intellectuals who find the temptation to tell others what to do simply irresistible. Thaler and Sunstein are the best-known, but far from only, practitioners of a branch of social science called behavioral economics. Their most influential contribution to the field is their book Nudge (2008), a handbook by big brains who want to push you around.2 Their full pedigrees are more pernicious.
Richard H. Thaler is professor of Behavioral Science and Economics at the University of Chicago, former president of the American Economic Association, and recipient of the 2017 Nobel Prize in Economics. He is the author of numerous books in his field and a prominent public intellectual.
Thaler’s interest in the economics of behavior and personal choices was present from the start of his career, as shown in his Ph.D. thesis, “The Value of Saving a Life: Evidence from the Labor Market,” published as an article by the National Bureau of Economic Research in 1976.3 In this thesis, Thaler creates a model of what a worker’s life is worth to the worker and the employer by using pay differentials in various risky occupations, such as fishing and mining. I’m not sure how many deep-sea fishermen Thaler ever met; I’ve met quite a few. They assume the risks of fishing without regard to pay differentials for a love of the sea, camaraderie aboard their vessel, and fresh seafood from the ship’s cook while under way.
When it comes to risky occupations, high-altitude mountain guides may take the prize. I’ve met many mountaineers. Guides work in one of the most deadly and least well-paid occupations. I’ve had the opportunity to discuss their professional motivations while on expedition. We all know the risks of death. Money is the least important consideration in climbing. Mountain guides do what they do because they love the view. Thaler’s first model leaves little room for spectacular vistas.
Cass R. Sunstein is a Harvard professor and director of the Program on Behavioral Economics and Public Policy at Harvard Law School. He is a prolific writer—author, coauthor, or editor of almost fifty books and hundreds of articles in both academic and popular publications. His most important role outside of academia was administrator of the White House Office of Information and Regulatory Affairs (OIRA) during the first term of the Obama administration. The White House website describes the role of the OIRA as “the United States Government’s central authority for the review of Executive Branch regulations [and] approval of Government information collections.” If your goal is to control the behavior of others using behavioral psychology and unseen influence, there is no more powerful seat in government than head of OIRA. Obama and Sunstein were well acquainted from their days together teaching at the University of Chicago Law School in the mid-to late 1990s.
Thaler and Sunstein’s book Nudge is by far their most influential and well-known effort at social control. It was a New York Times bestseller with over 750,000 copies in print in many languages. Most of the book is a straightforward account of insights on human behavior gained over the past fifty years from the work of behavioral psychologists. These insights begin with Stanley Milgram’s seminal work on powerful yet controversial experiments on obedience in the 1960s.
Milgram’s most famous experiment involved a subject (who didn’t know he was the subject), under the direction of the experimenter, who was asked to assist in a program on learning and memory. Another participant, supposedly the learner, but really a collaborator in the experiment, is seen strapped to a chair. The real subject’s role is to administer electric shocks to the learner under the experimenter’s supervision. Soon the learner appears to suffer acute pain from the shocks and demands to be released from the chair. The experimenter insists that the method is safe and the subject should continue to administer shocks to the learner. In repeated experiments, the subject most frequently continues to administer electric shocks to the learner up to the highest settings on the apparatus.
Milgram’s work was influenced by his desire to understand the behavior of Nazis and their collaborators in the Holocaust. His electric shock experiments were devised and conducted in the aftermath of the 1961 trial of Adolf Eichmann, the SS -Obersturmbannfüher responsible for logistics and operations in the murder of 6 million Jews. Eichmann never denied his role; his defense relied on the claim that he was just following orders.
Milgram’s conclusion from his experiments is that at some point the subject relinquished his independence or agency to the experimenter based on a mélange of beliefs that the experiment was for the good of science and the experimenter was a benign figure. Once the subject surrenders agency to the experimenter, he is just following orders. With Milgram’s work as a foundation, behaviorists went on to explore diverse aspects of human behavior at odds with common assumptions about rationality and good intentions.
Behavioral psychology made its greatest strides, including those most closely associated with economics, in the 1970s, through the experimental work of Daniel Kahneman and Amos Tversky. These landmark experiments were described and analyzed in two books, Judgment Under Uncertainty: Heuristics and Biases (1982) by Kahneman, Tversky, and their collaborator, Paul Slovic; and Choices, Values, and Frames (2000) by Kahneman and Tversky.4 These books laid the foundation for what is called prospect theory in contrast to the longstanding economic paradigm of utility theory.
In brief, utility theory claims that humans are rational decision makers with a clear view of the future and a strong sense of those choices that maximize happiness expressed as material well-being. When aggregated across a society and expressed through markets for the exchange of goods and services, utility theory forms the basis for a classical liberal, free-market economy that produces the greatest good for the greatest number, as espoused by nineteenth-century utilitarian philosopher Jeremy Bentham.
Prospect theory claims the opposite. Humans are riddled with cognitive biases that lead them to decisions not at all rational from a wealth-maximizing perspective. Not only are these biases irrational on their own terms, they contradict each other in ways that make behavior difficult to predict in individual situations and volatile in the aggregate.
In one famous experimental setup, subjects are offered a choice between $4.00 with an 80 percent certainty of receiving the reward, and $3.00 with 100 percent certainty of receiving it. A simple bit of math shows that the first choice has a higher expected return. An 80 percent probability of receiving $4.00 has an expected return of $3.20 (0.80 × $4.00 = $3.20). The second choice has an expected return of $3.00 (1.00 × $3.00 = $3.00). As $3.20 is greater than $3.00, a rational wealth-maximizing individual would take the first choice. From the mid-nineteenth to the late twentieth century, a facile belief that individuals would make the rational choice was the basis of free-market economics. Since 1947, the same belief forms the bedrock of modern finance.
Kahneman and Tversky demolished these and like assumptions about rational behavior through ingeniously designed experiments involving real humans. The experiments show that in the choice between an expectation of $3.20 versus $3.00, subjects overwhelmingly chose $3.00. The reason is that they value the certainty of some reward independently of the mathematical expected value. Individuals are highly averse to coming away empty-handed. If subjects chose the $4.00 offer, there’s a 20 percent chance of getting nothing. Simple fear of losing outweighs the chance of making more in the minds of the subjects, despite the math.
This particular bias is called risk aversion. Based on experimental results, one might conclude humans shy away from risk in almost all life encounters. Yet that’s not true. Other experiments show that humans underestimate risk and inflate their chances of success in diverse situations. This bias is called the overconfidence effect. The contrast between risk aversion and overconfidence shows individuals both avoid risk and embrace it depending on specific circumstances.
In uncertain situat
ions, people overestimate their capacity to perform tasks and rank their competence more highly than others, even in the face of objective evidence to the contrary. This bias manifests itself both in excessive optimism while confronting adversity and wishful thinking in the face of a looming reversal of fortune. Overconfidence can be dangerous when applied to critical tasks in law, finance, or engineering. As Kahneman wrote, “In general, … you should not take assertive and confident people at their own evaluation unless you have independent reason to believe that they know what they are talking about.5 Unfortunately, this advice is difficult to follow: overconfident professionals sincerely believe they have expertise, act as experts and look like experts. You will have to struggle to remind yourself that they may be in the grip of an illusion.”
So, are humans risk averse slugs or overconfident pretenders? The answer is both, depending on past circumstances and current conditions at a point of decision. This behavioral contradiction, one of many, illustrates why it is so difficult to make sense of human behavior in markets.
Other contradictions in the cognitive bias litany include anchoring (the tendency to make judgments based on past events rooted in the subject’s mind), and recency bias (the tendency to make judgments based on the most recent experience or information received). So, is human judgment influenced by the distant past or the latest news? Again, the answer is both, depending on the setting.
Experiments in behavioral psychology have identified over 180 specific cognitive biases. New biases are added to the taxonomy all the time, based on new experiments. These biases present contradictions of the kind just noted and make the practice of behavioral psychology highly demanding. The science is compelling, yet application is complex.
Although Kahneman is a behavioral psychologist, he was awarded the Nobel Prize in Economics in 2002 for his insights into how cognitive biases affect market behavior. His collaborator, Amos Tversky, died in 1996 and did not receive the Nobel Prize because it is not awarded posthumously. Had he lived, Tversky would no doubt have been a corecipient that year.
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