The Uncertainty Solution: How to Invest with Confidence in the Face of the Unknown

By John M. Jennings

A better approach to investing

​This is not a typical investment book. It is an experiential guide on cultivating the mindset and behavior necessary to weather inherently uncertain and unpredictable markets. It doesn’t just tell you how to invest but how to think better about investing. Referencing studies on psychology, decision making, and investment behavior, Jennings provides a no-nonsense analysis of the financial markets and a road map to navigating its inevitable twists and turns.

Jennings uses mental models to create a latticework of wisdom that will help you evaluate investment advice and learn better behavior in the face of uncertainty. To name a few: ignore expert predictions, be wary of stories, and try to invest like a dead person.

An engaging dive into investing psychology and best practices, The Uncertainty Solution is an authoritative, accessible guide for both lay investors and professionals inundated with financial news and data. Read this book to improve your thinking about investing, practice better investment behavior, and ultimately, have more money.

• Language: English
• Publisher: Greenleaf Book Group
• Release date: May 2, 2023
• ISBN: 9798886450330

Book preview

PREFACE

You can think of your life in two parts. Or, more accurately, as a continual before and after. You’re moving through your life, then something happens, and you step through a door into another reality—physically, emotionally, mentally, or spiritually. After that, everything changes. We tend to think of ourselves as the same person, but when we move into the after, who we are fundamentally shifts. A new normal, if you will.

Having a baby creates such a door, and after the baby, everything changes. Before, you weren’t a parent; after, you are. The immense responsibility of caring for and raising another human is suddenly, irrevocably yours. Entering the workforce is another before-and-after moment. You spend two-plus decades going to school and preparing to do something. Then, you do it. You enter the working world, and there’s no going back (no more naps!).

Then there’s the Financial Crisis of 2008—a watershed event that sliced my life into two parts and changed who I am professionally and intellectually. It exposed massive cracks in my understanding of how the financial world works and forced me to face the uncertainty inherent in investing and stop searching in vain for certainty where it doesn’t exist.

I was inspired to write this book after my view shifted on how to help my clients after the Financial Crisis. Instead of delivering the false certainty of expert predictions and bell curve–based projections or drowning them in torrents of financial statistics and data, I’ve learned that it’s best to tell clients the truth. That means conveying the investment world as it really is—full of uncertainty and wild randomness, where luck plays a sizable role, rendering the future inherently unpredictable. This truth is hard to accept (cue Jack Nicholson screaming, you can’t handle the truth in the movie A Few Good Men), but ignorance of reality won’t make you a better investor.

Yet, investors aren’t powerless in the face of uncertainty. There are things we can know and things over which we do have control. We’re better investors when we shut out the noise of the unknowable and uncontrollable swirling around us and instead focus on what matters. I wrote this book to help you do this. Give me five hours of reading time, and I’ll show you how to improve your thinking about investing, practice better investment behavior, and ultimately, have more money.

INTRODUCTION

DRINKING FROM THE INFORMATION FIRE HOSE

Before the financial crisis, I thought that to be an effective advisor I had to know as much as possible about everything happening in the financial markets. I drank from the fire hose of information. I read the Wall Street Journal, Investor’s Business Daily, the Financial Times, BusinessWeek, Barron’s, and The Economist. I subscribed to numerous investment research services and devoured their reports. I consumed quarterly commentaries from our multitude of investment managers and research consultants. And I attended conferences and webinars where I learned about the hot investment trends of the moment.

I always knew the price-to-earnings ratios of the major stock markets, how value stocks were faring relative to growth stocks, what the shape of the yield curve was (and was predicted to be), how global shipping costs were trending (via the Baltic Dry Index), the level of Volatility Index (the VIX), and on and on. In short, I was a walking, talking encyclopedia of economic indicators and investment news.

It was exhausting, exhilarating, stressful, and hectic. I loved it, and sometimes I hated it. But my vast store of knowledge always made me feel like I had a good handle on the economy and the stock market. I thought I generally knew what was coming in the financial markets.

But it turns out I was kidding myself.

The global economy and markets were rocked by the Financial Crisis that began in late 2007. The S&P 500 fell 57 percent from its peak to its trough, and the world’s financial system teetered on the brink. And I hadn’t seen it coming. All the information I’d consumed hadn’t helped me foresee or prepare for the meltdown. I had no idea what to do. I became frantic. So, I ratcheted up my reading about the economy and markets, met with economists and investment consultants, and attended conference calls hosted by investment managers. Everyone I spoke to in the investment world was in a lather, just like me. I couldn’t see how things could end well—there was just too much bad news. I was paralyzed with fear and didn’t know how we should be advising our clients.

During one of the darkest periods of the crisis—February 2009—I attended a client meeting with Liz, one of my colleagues and a fellow founding member of my firm. While I spent hours reading and keeping up with what was happening in the markets daily, Liz took a different tact. She had more of a big picture approach and merely kept lightly abreast of the happenings in the financial markets. At the meeting, I was struck by Liz’s calm demeanor as she counseled our client to take a longterm perspective. She said the market would be back up; we just couldn’t say when. Liz reminded our client that, in her portfolio, she had plenty of cash and bonds and was well-positioned to ride out further market declines. She told the client not to look at her portfolio because it would cause her needless anxiety. Liz said we were worrying about her investments, so she didn’t have to. It was great advice, and our client followed it. And when the market began its historic rebound a month later, the client enjoyed strong returns.

After that meeting, I thought about how, while I was more knowledgeable than Liz about the economy and financial markets, she was more focused on what mattered. While I was cataloging trees, Liz was looking at the forest. For me, this was an epiphany. I realized I needed to change my focus and that I’d been wasting my time by concentrating on irrelevant noise.

So, I changed. I stopped spending hours every day reading investment news and analysis and stepped through the door to the after of my wealth management career. I embarked on a quest for investment wisdom.

THE WISDOM HIERARCHY

So, what is wisdom? I think it’s best captured by a concept known as the Wisdom Hierarchy, first developed by organizational theorist Russell Ackoff in 1989. In this model, Ackoff divides the types of things we hear and learn every day into four categories: data, information, knowledge, and wisdom. Then he ranks them in order of usefulness and availability: wisdom is rare and most useful, while data is plentiful and not terribly helpful.

A key to making sound investment decisions is to base more of your choices on wisdom rather than on knowledge, information, or data. But to do that, you must first understand the differences between them:

▪Data is raw facts, events, experiences, and observations; stuff like housing starts, stock prices, weekly unemployment claims, and interest rates.

▪Information is data with context. For example, housing data becomes information when organized by region and price because it indicates which market segments are doing better than others.

▪Knowledge is data or information coupled with experience, understanding, and expertise. For example, an economist armed with housing starts, unemployment, and GDP data can tease out insights about the overall state of the economy.

▪Wisdom is knowledge applied with judgment earned through experience. For example, suppose experts—using data, information, and knowledge—conclude that the stock market is becoming overheated. In that case, wise investors will understand that the market tops are nearly impossible to time and, consequently, they will take a long-term view.

Wisdom is a rarer commodity that often sounds simple but isn’t easy to implement because it runs counter to our instincts and emotional reactions. When you view the investment industry through the lens of the wisdom hierarchy, it becomes apparent that most of the expert opinions we read in the news or hear on TV aren’t wisdom but mere knowledge or information. Before the Financial Crisis, I spent way too much time and effort in the data, information, and knowledge realms.

My pursuit of investment wisdom meant scaling the Wisdom Hierarchy Pyramid. I began by limiting my financial information and news consumption to just fifteen minutes a day. It felt great to turn off all that noise—like coming up for air after being underwater. Instead of my previously frenetic information intake, I read books—stacks and stacks of them—about investing and other relevant areas like mathematics, statistics, physics, economics, complex adaptive systems, and psychology. I supplemented the books with academic research on investing, uncertainty, brain physiology, behavioral biases, and evolutionary psychology. The common thread was to step back and try to understand how humans interact with each other in financial markets.

A few years into my investment wisdom journey, I discovered the concept of mental models, which make nuggets of investment wisdom and knowledge useful to investors of all experience levels and sophistication.

THE WISDOM OF INVESTMENT MENTAL MODELS

How often have you sent an email and not gotten a response? All the time, right? It’s off-putting, and it’s common to think, Do they think I’m not important? or Are they blowing me off or sending me a message? All seemingly reasonable thoughts, which can lead to anger or hurt feelings.

But there’s a more productive way to think about not getting a response to an email. It’s called Hanlon’s razor. In philosophical terms, a razor is a guiding principle or mental model that allows us to shed unlikely explanations. The most famous razor is Occam’s, which posits that simpler explanations are more likely to be correct than complex ones. Hanlon’s razor is similarly straightforward. It states:

Never attribute malice to that which can be adequately explained by stupidity (or carelessness, disorganization, forgetfulness, etc.).

So, when someone doesn’t return an email or text, it’s best to assume they just messed up and didn’t mean to slight you. When your friend keeps you waiting at a restaurant, chalk it up to her disorganization. When someone cuts you off in traffic, he probably hasn’t targeted you; he’s just a crummy driver. Your brother forgot your birthday? Maybe something is going on in his life you don’t know about. Hanlon’s razor is an important concept that can save us a lot of wasted negative emotion. It’s an excellent example of what is known as a mental model.

Mental models are conceptual structures that help us understand how the world works. They are bits of knowledge or wisdom we file away in our heads to help us make decisions. Warren Buffett’s business partner Charlie Munger is the pioneer of the concept. Here’s how he described mental models in a 1994 speech at USC’s business school:

What is elementary, worldly wisdom? Well, the first rule is that you can’t really know anything if you just remember isolated facts and try to bang ’em back. If the facts don’t hang together on a latticework of theory, you don’t have them in a usable form. You’ve got to have models in your head . . . You’ve got to have multiple models—because if you just have one or two that you’re using, the nature of human psychology is such that you’ll torture reality so that it fits your models, or at least you’ll think it does . . . 80 or 90 important models will carry about 90 percent of the freight in making you a world-wise person.¹

In his talk, Munger was referring to mental models that help us make business and personal decisions, but the concept of mental models is equally applicable to investing. In my decade-plus-long quest for investment wisdom, I discovered that great investors create a latticework of mental models.

An example of an investment mental model is Warren Buffett’s simple and straightforward advice that successful investing requires being fearful when others are greedy, and greedy when others are fearful.² This is a model to apply when you feel investment FOMO (fear of missing out) when the stock market is soaring and investors are euphoric. It also reminds you that the best time to invest is when the market is down, and everyone is panicking.

Investment mental models serve as guideposts to help you make the best possible decisions in the face of uncertainty. Here’s an example: in March 2020, as the dimensions of the COVID-19 pandemic were becoming clear, the stock market was in free-fall, dropping nearly 35 percent in a month. The outlook was dire; the United States and the rest of the world were entering a recession, and sickness and death inevitably would sweep the globe.

During the Financial Crisis, I didn’t know how to advise our clients. But I knew what to tell them as the COVID-19 crisis unfolded. I used the mental model that the stock market is not the economy. We’ll look at this in-depth in Chapter 3, but for now, I’ll summarize it: You cannot use what is happening in the economy to predict what will happen in the stock market. Using the stock market is not the economy model (and others) as a guide, we advised our clients not to panic and, if it helped them maintain their asset allocation strategy, to sell bonds (which had held their value) and buy stocks (which were down). Our clients navigated the brief bear market with flying colors and enjoyed the strong stock market recovery.

HOW TO THINK BETTER ABOUT INVESTING

The purpose of this book is to provide individual investors with mental models that will help them make better investment decisions, practice better investment behavior, and be better consumers of investment advice—to build a latticework of wisdom. This book is not about how to invest but rather how to think about investing. It is the culmination of my thirteen-year quest for investment wisdom. In the following chapters, I share the essential wisdom for creating a latticework of mental models for investing; they are vital tools for investors to make better decisions when faced with uncertainty and the unknown.

This book is not about how to invest because there isn’t a single right way to do it. For some investors, public securities are best; for others, private assets like private equity and venture capital are the way to go. For most investors, being in index funds is the surest road to success. For others, active management is better. Additionally, this investment book is G-rated—suitable for all levels of experience and sophistication.

Two years ago, as I was working with my editor outlining this book, she noted that learning about investment mental models laid out in this book is like finding out there’s no Santa Claus. I get it. The mental models in this book describe the investment world as full of uncertainty, wild randomness, unpredictability, and pitfalls. There’s no easy path. But mental models that embrace reality—that take the world as it is, not how we think it is or want it to be—will make you a better investor and a better consumer of investment advice.

Now let’s dig in.

CHAPTER 1

THE QUEST FOR CERTAINTY

What men really want is not knowledge but certainty.

—BERTRAND RUSSELL

Would you rather know for sure that you’ll receive a painful electric shock or have the possibility that you might? A study performed at University College London answered this question by having volunteers play a strange, painful video game while their stress levels were measured.¹

The game required the volunteers to turn over rocks that, at times, had snakes underneath them. If they turned over a rock with a snake, they received a painful shock on their wrist. At first, there was a pattern and the players quickly learned which rocks harbored snakes, and they could avoid shocks. Then the snakes were distributed randomly, and the players received shocks about half the time.

Then the game changed again. Now there were snakes under all the rocks, and the players were shocked every time. In other words, the game progressed. In the first version, the participants had a zero percent chance of being shocked. Then they had about a 50 percent chance. Finally, they were shocked every time, a 100 percent certainty.

What were the players’ stress levels in each scenario? Predictably, the stress was low after they learned how to avoid shocks. When they were faced with randomly distributed snakes and uncertain shocks, their stress skyrocketed. But what happened when the shocks were 100 percent certain was surprising. Their stress level was about the same as when they had a zero percent chance of being shocked. Knowing that they were going to be shocked was less stressful than being randomly shocked; the participants preferred inevitable pain to an uncertain chance of pain. If you stop and think about how you’d feel if you played the game, you can probably imagine how anxious you’d be to turn over a rock, not knowing if you’d be shocked. And you’d feel less stress if you knew a shock was coming, and you could steel yourself against it.

This conclusion—that we prefer certainty to uncertainty, even if the certainty is bad—is consistent with numerous other studies, including the following:

▪We’d rather have a boss who is always unfair compared to one who is sporadically unfair; variability results in more significant psychological stress than both consistently fair and consistently unfair treatment. ²

▪When given a countdown to a possible electric shock, a group informed that their chance of a shock was 5 percent experienced greater anxiety than a group told that their chance was 95 percent. ³

▪Even our immune systems don’t like uncertainty. A 1995 study found that the immune systems of a group of volunteers who were subjected to unpredictable exposure to cold experienced more stress than when the exposure was predictable. The researchers found that predictability buffered the effect of the [cold] stressor on immune function. ⁴

Bottom line? Humans hate uncertainty. We prefer certainty, even if it comes with pain.

OUR PATTERN-SEEKING BRAINS

Our brains are pattern-recognizing machines. For eamxlpe, it deson’t mttaer in waht oredr the ltteers in a wrod aepapr, the olny iprmoatnt tihng is taht the frist and lsat ltteer are in the rghit pcale. The rset can be a toatl mses and you can sitll read it wouthit pobelrm. S1M1L4RLY, Y0UR M1ND 15 R34D1NG 7H15 4U70M471C4LLY W17H0U7 3V3N 7H1NK1NG 4B0U7 17.

Our mind’s ability to recognize patterns is an inherited trait, a survival advantage. Imagine you lived in a small tribe of hunter-gatherers 100,000 years ago. Your ability to survive as a hairless, relatively weak, and slow mammal depended on your ability to recognize patterns that signaled threats. Was that rustling in the bushes a predator? Did those clouds predict a storm that would require you to find shelter? Were those red berries nourishing or poisonous? This was all critical to your survival. And if you were good at it, your chances of living long enough to breed and pass on your pattern-recognition ability to your children increased. As a result, our minds are superbly attuned to finding patterns. And when we can’t detect a pattern, we get antsy.

The physiology is fascinating. When you feel uncertain or threatened, your brain enters a vigilant state as it seeks information and searches for patterns to resolve the uncertainty. Your brain triggers the sympathetic nervous system, which unleashes the fight-or-flight response, and you become hyper-alert. Your respiration and heart rate quicken, and glucose is released into the bloodstream for a quick shot of energy. You’re primed for action. You’re ready for anything. This all happens in a flash, and you usually don’t even realize it. You just know you feel keyed up and stressed.

When we resolve uncertainty, the opposite happens. The parasympathetic nervous system kicks in and calms us down; our brain releases dopamine, creating a sense of pleasure, and our stress and anxiety melt away. Nice.

OUR MINDS ARE SUPERBLY ATTUNED TO FINDING PATTERNS. AND WHEN WE CAN’T DETECT A PATTERN, WE GET ANTSY.

These opposing sensations of feeling anxious during uncertainty and pleasure when we resolve it create a complex relationship with uncertainty. We like a bit of it—especially when it’s nonthreatening—because we enjoy the dopamine that comes with its resolution. That’s why we like suspense novels and horror movies and why some people like to gamble. But too much uncertainty creates anxiety, and our brains seek ways to resolve it.

HOW WE REACT TO UNCERTAINTY

The combination of feeling stress when we experience uncertainty and pleasure when it’s resolved makes our need for certainty a primary human motive that drives large swaths of our behavior.⁵ Most of the time, we’re unaware of it. We don’t realize that our drive to seek certainty is underpinning our behavior. It all happens subconsciously, which has the advantage of speeding up the process.

You didn’t think when the bush rustled; you ran, giving you a head start on that fast predator. That made a lot of sense. But in our modern world, many of those subconscious reactions are neither rational nor helpful. Today, there are rarely tigers hiding in our hedges, but we still react as if there are because our brains don’t distinguish between real tigers and imaginary ones. Consequently, today our fight-or-flight response is triggered by work deadlines, our daily commute, political discussions, perceived social snubs, or the stock market’s ups and downs. When the stock market becomes volatile, we can feel the same way we would if a saber-toothed tiger were chasing us, even though we’re in no physical danger. That’s because the world has changed a lot faster