The Central Intelligence Agency knows a thing or two about gathering information. That’s why a CIA publication titled The Psychology of Intelligence Analysis is, in my opinion, a valuable resource for investors. Of particular note is a section titled “Do You Really Need More Information?” which offers this counterintuitive finding: To make sound judgments, some amount of information is necessary. But beyond a certain point, gathering more data doesn’t always lead to better decisions. In fact, it can lead to worse results. That’s because more information can “lead the analyst to become more confident…to the point of overconfidence.” The lesson for investors: It’s important for financial decisions to have a quantitative basis. But it’s also important to avoid going too far with any analysis.
Many investors, for example, worry about investing in the stock market during uncertain times. Consider today’s headlines: Inflation has moderated but is still not totally under control. Meanwhile, mortgage rates are at all-time highs, and the Federal Reserve has said it won’t hesitate to push rates up further. There’s also the continuing war in Europe. Against that backdrop, investors might conclude that the market, which has gained nearly 20% this year, is skating on thin ice. And for that reason, some are opting to stay on the sidelines, holding excess funds in cash rather than taking any risk in the stock market.
But as the CIA document notes—and as investors have observed over the past three years in particular—it’s impossible to know where the market is headed next. For better or worse, in the absence of a crystal ball, no amount of further analysis will get us closer to an answer. Further analysis, however, may have the unintended consequence of making us feel more confident in an outlook that is, by definition, imperfect. That’s why I recommend a different approach entirely: If you structure your portfolio so it will meet your needs whether the market is up or it’s down, you don’t have to worry about making forecasts.
If you have a sum of cash to invest, does that mean you should invest it all immediately? Here’s where you can again apply the CIA’s principle. When making financial moves, always look for ways to make that move incrementally. Among the benefits of moving slowly is that it will allow you to gather more information—not because you’ll spend that time doing more research, but because as time goes on, more information will simply become available. A year from now, we’ll have answers to things that, today, are unknown. Two years from now, we’ll know even more, and so forth. Investors can then use that information to fine tune decisions rather than needlessly belaboring decisions today.
In the past, I’ve talked about splitting the difference as a decision-making strategy. Though it may not seem, on the surface, like a rigorous way to make decisions, I see a number of virtues in this approach. The CIA’s principle illustrates another reason why splitting the difference on decisions can make sense. Suppose, for example, your company offers a Roth 401(k) option. Should you go for it, or should you stick with the traditional tax-deferred option? To answer this question, you might start by comparing your current tax rate to a projection of where you think your rate might be down the road. That’s a good start, but at the end of the day, there are things about the future we simply can’t know. Today, for example, the top marginal tax rate in the U.S. is 37%. But 40 years ago, it was 70%, and at times it’s been over 90%. We can’t, in other words, simply extrapolate today’s tax rates into the future. And because we don’t know what the future will look like, it wouldn’t be unreasonable to split the difference on a decision like this. Then, over time, as more information became available, you could adjust. Importantly, though, there would be no real benefit to perseverating on the question in the meantime.
In his new book, Decisions about Decisions, Harvard Law School professor Cass Sunstein offers a related recommendation: Don’t focus on the likelihood of being right or wrong on any given decision. That’s too difficult to know. And in any case, there’s almost always a non-zero chance that something might or might not happen. For that reason, Sunstein suggests never going out on a limb in forecasting the likelihood of an event. Instead, he suggests weighing the cost of being wrong versus the benefit of being right, both of which are easier to estimate without having to forecast the future.
Last year, author Mike Piper employed this principle in helping investors think about risk in the bond market. The question was: In light of potential rate increases, should an investor shift away from longer-term bonds? Piper’s recommendation was as follows: It’s impossible to know where rates are headed, but if an investor did choose to make a move like this, the cost of being wrong would be very modest. “He just misses out on the slightly-higher returns that he could have gotten by holding longer-term bonds.” For that reason, Piper concluded that this would be a fine decision. This same logic can be applied to a number of decisions in personal finance.
Sunstein’s Decisions about Decisions offers a further recommendation that can help investors make decisions without belaboring the unknowable. He recommends understanding the difference between picking and choosing. These might sound synonymous, but Sunstein explains the difference: When we use data to analyze a decision, that’s choosing. Picking, on the other hand, is random. It involves no data, like picking a number out of a hat.
Picking might not sound like a rational way to make financial decisions, but it’s another way to employ the CIA principle. Consider, for example, some of the frequently-debated questions on asset allocation. Should you include in your portfolio a small allocation to value stocks or to small-caps or to real estate? Since past performance does not guarantee future results, there’s no way to know whether any of these will add or subtract from future performance. But if it’s a small allocation, then the cost of being wrong will likely be low. In those situations, where no amount of additional analysis will help you divine the future, it wouldn’t be illogical to make a decision by simply picking. And again, you can adjust over time, if and when more information becomes available.
A final thought: Recently, I was speaking with a fellow who was planning to attend a tennis match for the first time. He was struggling with the question of which seats to choose. Research online indicated that one side of the stadium offered more sunlight. On a cool day, that might be welcome, but on a hot day, it could be unpleasant. The other side, meanwhile, offered a direct line of sight to the umpire. Which would be the better choice?
I had never been to a tennis match, so I suggested he poll others. At the same time, I mentioned another of Sunstein’s decision-making rubrics: Regardless of how a decision turns out, we can almost always learn something when we spend the time to look into a question. That in itself can be valuable and can help us the next time a similar question comes up. In the world of investing, there is no end of opportunity for regret. But these principles, I hope, can help individual investors in making decisions with the facts available.