We have models for everything around us.
We have weather pattern models that help us predict tomorrow’s forecast. We have climatological models that project the path of global warming. We have child development models that help us determine proper interventions for correcting misbehaviors. We have economic models that suggest how people will behave given different economic stimuli.
My 11-year-old daughter, Annie, interacts with a basic model every day when she asks, “Echo, what is the weather today in Berkeley, CA?” If Echo says she should expect rain based on the forecast recorded, then Annie knows to wear her raincoat or bring an umbrella to school.
Using data on current and past weather conditions, a meteorologist makes a number of assumptions and attempts to approximate what the weather will be in the near future. But if you’ve ever been caught in an unexpected rainstorm without an umbrella, then you know the weather report isn’t always right.
Every model out there is based on an imperfect set of assumptions about how the world works, and all models have limitations that people are often unaware of. (Annie learns about the limitations of the weather reports on a regular basis.)
How We Use Investment Models
In our office, we have investment models that help us put risk and return within a historical context. These models help us set our expectations about the future and communicate those expectations to our clients. They’re used to gain insights that can help inform investment decisions.
Financial researchers frequently look for new models to help answer questions like, “What drives returns?” or “What causes recession?” These models are often touted as ‘sophisticated’ and the modelers frequently debate whose model is best.
The reality of markets, just like the weather, is that it cannot be fully explained by any model. Investors should be wary of any approach that requires a high degree of trust in a particular model.
The Limitations Of Investment Models
Instead of things like barometric pressure or wind conditions, investment models look at variables like inflation, productivity, employment, valuation, volatility, or expected return. Based on these inputs, one investment model may recommend an “optimal” mix of securities based on how these characteristics are expected to interact with one another. Another model might recommend a different mix.
However, a model’s output can only be as good as its inputs and assumptions.
Overconfidence in poor assumptions can lead to poor recommendations. Even with sound assumptions, a user who places too much faith in inherently imprecise inputs can be exposed to extreme outcomes.
The Power Of Choosing Mindfulness Over Models
Given these constraints, we believe bringing financial research to life requires mindful awareness of the limitations on what we can know.
No model is a perfect representation of reality. We don’t ask, “Is this model true or false?” Instead, we ask, “How does this model help us better understand the world?” and, more importantly, “How might this model be wrong?”
So, what do we do with the limited applicability of “models?” Do we throw models out? Do we distrust everything?
We recognize that the future is unpredictable and even the most valiant attempts at modeling it will ultimately fall short. Investors should look to understand how advisors use their models and ask how to evaluate the effectiveness of their implementation.
To me, this sounds a lot like humility.
The Bottom Line
In the end, there is a difference between blindly following a model and using it to thoughtfully guide your decisions. You can have a model that works very well over time… but that isn’t working right now. When something isn’t working you have to remember this.
You want to have a process that works overtime, not one that requires a series of correct decisions every time. You introduce unnecessary stress and anxiety when you have to be “right” in order for your investment scenario to work. This type of pressure leads to emotional misjudgments and bad decisions.
As investors, we have to cut through the noise around recent market turbulence and the newest investment products. We have to identify a process that employs sound judgment and thoughtful implementation over time. By doing so, we increase the probability of having a positive investment experience, and we have a more enjoyable life.
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