[00:02:16] John Jennings: And in fact, I thought the book I was going to write was going to be completely about uncertainty. So even though the title’s the Uncertainty Solution, and it’s a theme that runs throughout the book, really the book and I’m sure we’ll get into this, more about investment mental models. What’s fascinating is that uncertainty or our quest for certainty, to resolve uncertainty is what’s known as a primary human motive.

[00:02:37] John Jennings: So we may not even understand that a lot of our actions and what we do, really an underpinning is the fact that we don’t like uncertainty and it makes sense from an evolutionary standpoint. So if you think back, if you were a human living in ten or a hundred thousand years ago, your ability to recognize patterns gave you a survival advantage.

[00:02:58] John Jennings: Because if you recognize a pattern and then the pattern persists, it allows you to see into the future, which is a huge survival advantage. So if you can recognize the patterns of, let’s say, migration of prey or, weather patterns or those berries or mushrooms are they nutritious or are they poisonous?

[00:03:16] John Jennings: I mean, all sorts of patterns give you a survival advantage. So the way we’re evolved is that when we can see a pattern, we feel good about things, and when we can’t recognize a pattern, which is really the very definition of uncertainty, we become antsy, we become anxious, we worry, and actually, and in some instances can trigger actually our fight or flight response.

[00:03:36] John Jennings: So there’s things that we do in response to uncertainty that we may not even realize are going on. And then once we resolve uncertainty, everything reverses. Instead of the fight or flight response, our parasympathetic nervous system kicks in. It’s the relaxation response. We calm down, and importantly we get a little dose of dopamine, which is pleasurable.

[00:03:55] John Jennings: It feels good. So really, our relationship with uncertainty is not just straightforward, like, oh, we always dislike uncertainty. We actually like a bit because we love how it feels when we resolve it. So that’s why often we’ll not want to know the insight of a novel or a movie. It’s why some people like to gamble.

[00:04:17] John Jennings: It’s because they crave the, let’s create some non-threatening uncertainty and let’s ride that, kind of wave of adrenaline and stress, and then feel fantastic when it’s resolved.

[00:04:29] Clay Finck: And you tell this sort of a case study where people will turn over rocks and sometimes, they’ll get shocked, sometimes they won’t.

[00:04:36] Clay Finck: And it ties into the idea of humans not liking uncertainty. Where those who experienced the most stress was those who couldn’t recognize that pattern that you’re referencing. And if I were to tie that into my own life, I think about the example of like going to a doctor and going to a dentist. Like if I go to a doctor to get a flu shot, I know that sharp pain is coming in my arm but you know, I’m expecting it.

[00:05:00] Clay Finck: I recognize the pattern, I know it’s coming but if I go to the dentist and it’s like, okay, I don’t know if this is really going to hurt or not, I don’t know which tooth is going to hurt on. And it’s almost like psychologically agonizing, that uncertainty that you mention and you discuss in your book.

[00:05:15] John Jennings: Yeah, absolutely and that study’s pretty interesting and really what it found is, as the study volunteers and how fun to like shock people. So this was a video game they played and if they turned over a virtual rock and there was a virtual snake, they got shocked. So they played around with could they see a pattern to avoid the shocks, could they see no pattern.

[00:05:33] John Jennings: So they got shocked about 50% of the time randomly and then there was a pattern which was they’re just going to be shocked every time. And that was actually a stress situation similar to being able to avoid the shock. So it went like this pattern, no pain, low stress, no pattern, 50% pain, high stress pattern, a 100% pain, low stress.

[00:05:54] John Jennings: So pretty interesting stuff and to your point exactly, if you think about it, like if you knew you were going to be shocked, you will just steal yourself against it. But if you didn’t know, so like my parents have horses and they have like this, like electric fence. So it’s really, just like, it’s just like a wire going around acres.

[00:06:09] John Jennings: And I remember once, like a decade ago, my dad was like, I don’t know if the fence is on, will you touch it and see if it’s on? And again, it would be like a pretty big shock. And I was like, no, there’s absolutely no way I’m going to touch this fence because I don’t know and he kind of goaded me into it and made me feel wimpy.

[00:06:25] John Jennings: So I did and it wasn’t on, but I remember just like, just the adrenaline rush. I can still feel it just thinking about, am I going to get shocked or not. Just the uncertainty was just terrifying.

[00:06:35] Clay Finck: Your book lays out many mental models as you mentioned, which we’re going to be discussing during this episode.

[00:06:40] Clay Finck: Charlie Munger is practically famous for stating that his key to success in investing in life is his ability to develop a lattice work of mental models. To open up this piece of the discussion, maybe we could start by just simply defining what a mental model is and explain why having a lattice work as Munger describes is helpful.

[00:07:01] John Jennings: Yeah, so he talked about this, the first record I could find of it was back in 1994 to a speech to the USC Business School and really what a mental model is it’s just a model we keep in our heads, but it’s how the world really works in particular instances. And in reading about quite a bit and books on mental models, what you come to realize is we all have mental models on our heads.

[00:07:21] John Jennings: But unless you spend time and effort to put correct ones in, you can have things that aren’t true or will jump to things, just emotion and make bad decisions without having the appropriate mental models. And it takes study, right? So it’s not like, oh, I can just read of something once and there it is.

[00:07:38] John Jennings: But you know, one that I love, and this is one that Charlie Munger has mentioned is Hanlan’s Razor. So this is a great example and if you’ve ever sent an email and not gotten a response, you often feel a little irritated or maybe even hurt, maybe even angry. But that’s a great time to apply what’s known as Hanlan’s Razor, which is never attribute malice to that, which can adequately be explained by stupidity or, carelessness, sloth.

[00:08:00] John Jennings: This organization want to have you and the theory behind this is that humans don’t really have for the most part, malice in their hearts towards other people. If you don’t get an email returned or you get ghosted for a lunch meeting or your brother forgets your birthday or cut off in traffic, what have you, I think it’s great to apply this and go, I’m just going to give this person, the benefit of the doubt.

[00:08:20] John Jennings: So that’s an example of a mental model and since I learned of this mental model probably 15 years ago, I use it all the time and it really, saves my own emotions, it saves relationships. I hope people use it with me. I’m not actually that great of an email responder. So that’s an example of a mental model.

[00:08:34] John Jennings: And what I found as I was researching, how to become a better investor, really to help me and my colleagues become better advisors, and then to help our clients be better consumers of investment advice, I found that really what great investors do, Is they have a lattice work of mental models.

[00:08:51] John Jennings: They have these things that they fall back on that are true and they know which ones to pull out when. And I know a few weeks ago on your podcast, you guys had Howard Marks on the show and he, like, he’s an example of someone you know with his memos and his books. And just like, you just hear him and he has these mental models that he falls back on.

[00:09:09] John Jennings: And like for instance, I heard him at a conference back in October of 2022 and people were asking him like, what’s your opinion of the future? And he was like, this is such a great mental model. He’s like, okay, you can’t really predict the future. And those that predict the future don’t do a very good job.

[00:09:23] John Jennings: But that doesn’t mean you can’t have an opinion. It just, it means that when you have an opinion, you should realize with humility that you’re probably not right. And wait that accordingly. He goes. So with that, I’m going to tell you what I think is coming and I realize that there’s probably a less than 50 50 chance I’m correct.

[00:09:40] John Jennings: And at Oak Tree when we invest, we have opinions but we also build in other scenarios and other things that could happen and we don’t go all in and like, wow, that is really a great way to think about it. Like you can have an opinion but don’t go all in.

[00:09:55] Clay Finck: Now, given that we have these issues with uncertainty and we have these mental models, we can apply, what are some of the best ways we can deal with uncertainty when our instincts are maybe at times even almost forcing us to do something that might be really silly.

[00:10:13] John Jennings: Yeah, I think the first step, and probably the most important thing is to learn to recognize when you’re feeling uncertain. And that you are really flailing around looking for certainty because again, it’s something that most people aren’t aware of. And even, whether you’re aware of it or not, this quest for certainty is going to drive so much of your behavior, even if you don’t realize it.

[00:10:38] John Jennings: So if you can just like, turn the light on to the fact that you’re feeling uncertain and then just own it. So, what I say to myself is, so I have this like alternate name, for takeout and just because I didn’t feel like John totally captures my, the essence of who I am. So this alternate name of Keifer.

[00:10:54] John Jennings: And so what I do is I say to myself, what I’m feeling uncertain. I say, Keifer, you are feeling uncertain. And that’s the first and the key step. Like if you can do that, like you’re most of the way there. And then to recognize here are the things that people usually do when they’re feeling uncertain.

[00:11:14] John Jennings: And then what should I be doing instead?

[00:11:17] Clay Finck: It reminds me of when there’s stock market volatility, people will do something they think is good because it gives them more of a certain outcome. For example, maybe they sell after, a stock market drawdown. They just tired of the uncertainty of what sort of volatility’s going to come in the future.

[00:11:34] Clay Finck: And they just want the certainty of being in cash, no more volatility. And they think it, it feels good to do that. And they think they’re making the right decision, but they’re actually making a poor decision because they’re acting based on their, primal emotions. Exactly.

[00:11:49] John Jennings: That is spot on. Yeah.

[00:11:50] John Jennings: And what we usually do when faced with uncertainty there’s a lot of different things, but there’s four big ones, and the first one is we have this, what’s known as the need for cognitive closure. So when we feel uncertain, what we do is we become hyper-vigilant where we look for answers. And what we want is we want an explanation.

[00:12:09] John Jennings: We want the world to make sense. So we tend to do what’s known as seizing and freezing. So we seize on the first explanation that hits our worldview and then we freeze on it. So we don’t want to, we don’t want to revisit that uncertainty in the future. So we defend it. So you have this situation of you, you have this probably not super well thought out or researched response of seizing an explanation, and then we freeze on it.

[00:12:34] John Jennings: Like, that’s it. And no, I think COVID, the pandemic was this great example of that for so many people, myself included, which is we didn’t know what was happening. So we would seize on explanations for what was happening, and then we would stick with it even if the science had changed or the virus had changed.

[00:12:54] John Jennings: And so we tend to, grasp these explanations and, don’t tend to change our minds or our worldview. So that’s the seizing and then the freezing. Another thing we do is we become information junkies. And I’ve done this in when there’s economic uncertainty. I definitely did this in COVID and when COVID19 was first flying out is we also get a hit of dopamine when we take in information and when things are uncertain.

[00:13:15] John Jennings: And what we want to do is we want to find answers. And especially with the internet and social media and everything it’s more easy than any other time in human history to search for answers, and to search for clues. And that could be great. So if you have something that is unknown, that can become known, searching for more information is great.

[00:13:32] John Jennings: But if you have something that’s just unknowable, flailing around, searching for information and isn’t productive and can actually be counterproductive, you may think that you’ve come up with answers when there’s no real answer. And a great example of this, and another thing we do when we’re faced with uncertainty is we turn to experts for their predictions of the future.

[00:13:52] John Jennings: And experts definitely can predict the future in areas like, engineering and medicine and these other things. But when you have things like the stock market and the economy, or even geopolitics, the ability of experts to predict the future is just really, they have a real poor track record.

[00:14:07] John Jennings: But we find ourselves, in fact I have to resist it, clicking on these articles where some famous guru is telling us what’s going to happen in the future. And again, we feel like we’ve got a dose of certainty when you have somebody that’s a confident expert that tells you what’s going to happen in the future.

[00:14:22] John Jennings: And one of the final things we do is we like to associate with groups that think like we do. And in doing research for this book, I came across this comment by a sociologist, which I think is spot on and is one of the biggest things that has shifted my worldview of how people can have such differing views of what the truth or facts or reality is.

[00:14:41] John Jennings: And that is the truth, is whatever your social group believes it to be. So, whether it’s politics or the economy or religion or all these other things, like whatever your social group thinks the truth is what you think the truth is. It’s like, wow. So when we feel uncertain, that’s not a time period where we want to go and, debate or hear from people.

[00:15:04] John Jennings: All these different points of view from our own, we tend to insulate ourselves in these echo chambers of people that think like we do. So that’s what we tend to do when we are feeling uncertain is, season freeze. We seek more information. We listen to experts, we surround ourselves with people who feel like we do.

[00:15:20] John Jennings: And again, most of those things are either not productive or even counterproductive. Just things that we all should be able to look at for what we’re doing in the face of uncertainty, which really doesn’t bear fruit.

[00:15:31] Clay Finck: The last of the four you mentioned there really hits home for me where people fall into their camp and they fall into the eco chamber.

[00:15:37] Clay Finck: Especially with things like social media and falling prey to listening to just specific experts. One of my biggest insights from tuning into William Green’s episodes here on the Richer, Wiser, Happier show is that he mentions it time and time again, is that the world is fundamentally uncertain.

[00:15:53] Clay Finck: And when people fall into these camps, they can become extremely overconfident in what they believe in. And they just continually to tune in to this one opinion. And I think it’s so empowering to just understand that there is a possibility that we’re wrong and there’s a possibility that maybe the world isn’t the way we believe it to be and we need to position ourselves to account for that uncertainty. And it also ties into that point of Howard Marks earlier that you mentioned.

[00:16:20] John Jennings: Yeah, exactly. And we get to the point where we surround ourselves with people who think the same and we consume the same media and the same social media. And it seems like it’s not possible that other people think something different.

[00:16:33] Clay Finck: That ties into the next question I wanted to ask you, which is related to people quickly coming to conclusions, because they just see this simple piece of data. They’re like, of course then if this happens, then this is going to happen after that. And you caution in your book that correlation does not necessarily equal causation, and that the world is a complex adaptive system with many different variables that really can’t be analyzed in isolation.

[00:16:59] Clay Finck: And you tell this different example in your book of a child’s academic achievement, how that turns out in a number of books that the child’s parents own in the household. And it makes sense that, a child, if they’re surrounded by parents that have a lot of books, then they’re probably more likely to have better academic performance.

[00:17:16] Clay Finck: But that’s not the only variable at play. There are people with more books in their household might just generally read more. They might do other things. They might, push for higher education, things like that. Can you expand on this idea that because humans don’t like uncertainty, we’re prone to quickly jumping to conclusions that are either too simplified or maybe not even true?

[00:17:36] John Jennings: So yeah, I have an entire chapter in my book called Looking for Causes in all the Wrong Places. So it’s all about causation and correlation and full of stories and examples. And the one you mentioned on books and educational attainment looked at, the number of books in a home and educational outcome over 27 different countries.

[00:17:52] John Jennings: And this study was popularized in the book Freakonomics. And it’s really the point of what, the Stephen Lovett and Stephen Dubner said in Freakonomics is they dug into this was really the answer is that there’s this common cause. So if educational success is the result. The books, having the books in the home didn’t cause that.

[00:18:13] John Jennings: It was a symptom of the sort of parents that they were, right? Both their genetics and, their view of learning, the type of person that buys a lot of books was correlated with higher educational outcome. There were children having a higher educational outcome. So it was like this common cause.

[00:18:30] John Jennings: Smart, educated people buy more books. Smart educated people tend to have children that, that go on and achieve a higher educational success. So, that was that example there. And there’s all these other, there’s all these other things with causation and again, it comes back to our dislike of uncertainty.

[00:18:45] John Jennings: Like, we want the world to make sense and we want to have a cause or an explanation. And sometimes it’s difficult. And, another story I tell the book, which was really quite humbling, is I was at this investment conference, years ago probably, it’s probably five years ago.

[00:18:59] John Jennings: And you know how these investment conferences go. Like you, you have all day of like talks and everything, and then you have a cocktail hour and then dinner. So, as I’m sipping my, probably $12 bottle glass of wine. I was talking to this woman who’s the CEO of an investment firm and it was pretty new.

[00:19:13] John Jennings: It was only around for three or four years. And I was like, so what does your firm do? And she said, oh, what we do is very simple. We only invest in companies that have strong female leadership, either female CEO or president or females on the board and it’s because female led companies outperform male dominated ones.

[00:19:30] John Jennings: And I was like, wow, that is amazing. So I instantly was thinking like, that makes total sense, right? Like, and I dug into the research when I got back to work and, there was all this research that supported the fact that female led companies outperform. And it’s things like women are more risk averse, so, their companies won’t maybe have the same propensity to blow up.

[00:19:49] John Jennings: Women consumers make 70% of the buying choices. So maybe either more in tune with their fellow females, more diverse teams outperform. The female leadership style stereotypically is more nurturing and then if you’ve made it to president or CEO or on the board of directors of a company and you’re a female because of the glass ceiling, you’re probably totally a rockstar.

[00:20:10] John Jennings: So maybe these female led companies have stronger leaders because they’ve had to run this call and it’s like, this is amazing. So, not long after this conference and looking at this research, I was meeting with a client of mine who’s one of the smartest people I know, and he led this Fortune 100 company as CEO and I was telling him about this investment firm.

[00:20:30] John Jennings: I was like, it’s pretty interesting. We’re looking into it as an investment. And he is like, yeah, but is there really a causal link? Like, where is that causal link? Are you sure that there’s not like a common cause or like is this a symptom? So I was like, oh my gosh, maybe he’s right. Like my first reaction was to dig in and defend.

[00:20:46] John Jennings: But like I have so much respect for him. Like I think if most other people would’ve questioned me, I’m like no. I’ve researched this. This is good. But I decided to do something that’s really hard. And battling somebody is known as confirmation biases. I was like, now I’m going to go try to find studies that disprove this.

[00:21:01] John Jennings: And I found ones that took the other side. And really to summarize those, it basically said that when you have a company that’s doing really well, highly successful company, that they have more resources to spend on things like diversity. And there was this psychologist that had dug into this that said, it’s almost like a cynical measure by like companies saying, we’re going to recycle our annual reports, or, we’re going to, buy carbon credits, as almost pr that maybe high performing firms are more likely to hire.

[00:21:34] John Jennings: Female leaders and female board members and the jury’s still out. What hasn’t been done so far, at least as of about two years ago when I last researched this, there haven’t been longitudinal studies between companies to really tease this out. So I’m not saying that strong female leadership isn’t a cause of high performance.

[00:21:51] John Jennings: In fact, our company I’m president of our company but our CEO is a woman who’s incredible. And we have 70% female employees here. So I’m a big fan of female leadership and female-led firms but you know the jury is out. And I had kind of jumped to this causation explanation and my client’s point was a great one.

[00:22:08] John Jennings: Maybe it’s a symptom instead of a cause. And I go through a lot of those things in this. Like that in the chapter, which is really, teasing apart how to look at things and say, is this just merely correlated instead of caused, is it a common cause? Is the observation effect, understanding that there’s often multiple causes.

[00:22:26] John Jennings: It’s hard to pin down, a linear, relationship. Yeah. So I think it’s an interesting area and one that’s absolutely essential to understand as an investor.

[00:22:35] Clay Finck: You tell another story in your book of how you were on vacation in another country and you were out for dinner with your wife and you ran into an old friend at a restaurant thinking that how could this happen?

[00:22:46] Clay Finck: This is just so improbable that it practically felt like a miracle to you. That fate put you at the same restaurant in this different country and this same city of how big the world is. It just seems like it’s totally impossible but then you make the case in your book that highly improbable scenarios are actually to be expected.

[00:23:04] Clay Finck: So I’d love for you to dive into this and talk about how the improbable can seemingly happen all the time.

[00:23:10] John Jennings: Yeah, and it’s kind of like this topic is in some respects kind of a bummer, right? Because like we all love a good coincidence and it’s great to look at a coincidence and think, okay, this shows that there’s like.

[00:23:22] John Jennings: This, that there’s more meaning to the world, right? Like there’s this underlying, ebb and flow that maybe we don’t understand as humans and, life does have meaning or what have you. So when I have given talks on this topic, people have been like, wow, that was really a buzzkill.

[00:23:35] John Jennings: But yeah, so we were in Paris and we get seated at our table and, one table over is this like fraternity brother of mine. I hadn’t seen him in years, and his name’s Dave. And Dave was like, oh my gosh, this is crazy. Like, how improbable is this? And one way to look at it is, and I first thought, oh yeah, like what are the chances.

[00:23:50] John Jennings: Like one in a hundred million, like this is insane. But really the way to look at it is not the way that I initially looked at it or Dave looked at it, which is like, wow, the universe is telling us something. Maybe we should reconnect and become friends again. That fate saying something.

[00:24:04] John Jennings: But really to step back the way to analyze this. Is to say, what are the chances that in all my travels that I would be, see somebody, whether, in a movie theater, on a bus, in a museum, see the next to dinner that I knew from the thousands of people that I’ve known during my life.

[00:24:22] John Jennings: And it’s still a coincidence and it’s still fun, but it’s not one in a hundred million. It’s more like, okay, over the course of decades, it’s almost certain that this sort of thing will happen. And there’s something, a way to think about this, there’s something called Littlewoods Law of Miracles.

[00:24:37] John Jennings: And what this this mathematician did is he said, okay, how often do we experience what you would consider a miracle? Like me being seated next to a fraternity brother, in a restaurant in Paris? And he said let’s define a miracle as a one in a million occurrence. And then he calculated, how many occurrences do we have a day?

[00:24:56] John Jennings: And he came up with about a thousand, I guess, 30,000 things that you observe and see during a day. And so if you do that and you multiply it by the number of days in a month you come up with, you’re going to hit one of these one in a million things about once a month. And even if you say, well, 30,000 a day is too high.

[00:25:13] John Jennings: Maybe it’s, 20,000 or 10,000 or 5,000 a day, you still come up with the fact that, many times a year you’re going to have just absolutely extraordinary coincidences that are just amazing. And Richard Feynman, who is a Nobel Prize winning Physicist and just an all-around entertaining guy and unfortunately, he’s not alive anymore, but he has this book that he wrote.

[00:25:34] John Jennings: This kind of memoir is called, Surely, You’re Joking, Mr. Feynman, which is, I highly recommend, it’s incredibly entertaining. But one thing that he’s known to say is here, I’m going to paraphrase, on the way to dinner tonight, I saw something extraordinary, a car. With the license plate, AEW357.

[00:25:49] John Jennings: Isn’t that amazing? And his point is there’s nothing special about that license plate. It’s just one of the 30,000 things that we see a day. But if it had somehow been my initials and my year of birth or something, it would’ve been just like this extraordinary, like, oh my gosh the universe is talking to me at occurrence.

[00:26:07] John Jennings: So really the mental model here is that the highly improbable happens all the time because there’s this, just huge tens of thousands of things that happen every month. And if that’s the case, we need to train ourselves not to read too much into patterns that we see that really aren’t grounded in anything other than randomness and chance.

[00:26:27] Clay Finck: If I were to tie that into investing, I would say that you want to always account for the improbable scenarios. If you’re ever considering doing something like using leverage or concentrating into one particular asset, you should always account for the fact that no matter how certain you are on this particular strategy, to always, do things like diversify and have excess cash to take into account for those improbable type scenarios.

[00:26:54] John Jennings: Yeah, the improbable scenarios happen all the time, and yet we as humans, and its human nature, we seem surprised almost every time it happened. If it’s something like being seated next to somebody at dinner at a foreign city, yeah, that’s just kind of fun. But to your point, sometimes these improbable things really can have an extreme effect on our actual lives, and yet we end up being surprised by them.

[00:27:17] Clay Finck: I think one oversimplified assumption that people make that you talk about in your book is that if the economy is doing poorly or if people even think the economy is going to do poorly in the future, then their stocks are going to go down, or the stock market isn’t going to perform well. But you make this brilliant point that the stock market is not the economy, which might be obvious to some people and maybe a surprise to others.

[00:27:40] Clay Finck: And you share this great Howard Mark’s quote, that in investing there’s nothing that always works. Since the environment is always changing and investor’s efforts to respond to the environment cause it to change further. So why is it that the stock market is not necessarily directly correlated to what’s happening in the economy?

[00:27:58] John Jennings: Yeah, so I think this is probably from a pure straight up investment standpoint, the most important mental model in the book. And again, let me just touch a bit deeper on the stock markets, not the economy, and then we can maybe hit why that is. But really what this says is that what’s going on in the economy and what’s going on in the stock market are uncorrelated.

[00:28:17] John Jennings: So if you look at current year G D P growth and current year stock market returns, going back to World War ii, the correlation’s 0.03. So basically zero. And what this means is there’s years where the economy is roaring and the stock market is not doing well or even down, and there’s years where there’s recessions and the stock market is up.

[00:28:35] John Jennings: So in fact, looking back to the 1930s of the 19 years where there’s actually been negative GDP growth in a year, in other words during a calendar year 12 of those 19 years, the stock market was up and most of the time more than 18% and so you can look at that and go well that’s bonkers.

[00:28:51] John Jennings: Like how is it that you have. A contracting economy and a stock market that’s up. But what’s fascinating, and this came out of, research I read that came from Credit Sui, so I’ll just say that name because that name is going away, as we all know, as they’re being subsumed by subs, I think here in the next few months.

[00:29:07] John Jennings: But really, if you look at the prior year stock market returns and the current year GDP, then the correlation jumps to, kind of a 0.6 and above meaning that the stock market predicts what the economy’s going to do. Not perfectly kind of an ish, right but the economy doesn’t predict what the stock market’s going to do.

[00:29:24] John Jennings: And as an investor, you’d love to have it reversed, you’d love to say, because it’s easier to kind of figure out, I mean, not. Ish what’s going on in the economy and say, okay, I’m going to use that to inform my investing. So you could say, oh, I think inflation is a problem and interest rates FED raising interest rates going to slow the economy and therefore, we may not tip into recession, but we’re definitely going to have slower growth here for a while.

[00:29:45] John Jennings: And then if you could take that and say, now I’m going to use that to kind of time my investments. That would be amazing. But that’s not how it works. So the stock market moves in advance of the economy, typically up and down and tells you what the economy’s going to do, which is a, has some usefulness but as an investor it’s just not very useful.

[00:30:06] John Jennings: And so what that means is pretty much every economic indicator out there doesn’t tell you what’s going to happen in the stock market. And I’m I’ve been on a number of like charitable investment committees over, over the years and even chair of, some endowments. And we’ll have these investment managers or these consultants come in and they’ll give us their economic update and they’ll talk about all these things going on in the economy, their views of, the path of interest rates and inflation and unemployment claims and GDP growth and corporate earnings and all these things.

[00:30:32] John Jennings: And then based on that, they’ll talk about how they would tweak the portfolio and what they’re missing out there. And I’ll talk to some of them and I’ll say, do you do realize that all those things you just listed out don’t tell you what’s going to happen with stock market returns? And some of them are surprised by this.

[00:30:49] John Jennings: The more erudite ones go, well, we know. And I’m like, well then why did you spend, half hour talking about them? But it means that all these economic indicators don’t tell you what the stock market’s going to do, which is, again, it’s it may seem like depressing and like, oh, well that’s telling us there’s no Santa Claus.

[00:31:04] John Jennings: But knowing that is so important. So like during COVID, when things were getting really bad, we didn’t go to our clients and say, let’s take some risk off the table and move out of the market. In fact, if anything, we rebalanced into stocks not thinking that we knew when the bottom was.

[00:31:19] John Jennings: We just knew that all the bad news in the real world and in the economy, wasn’t going to tell us when the stock market was going to bottom or what the stock market was going to do. So, the, it was, kind of this incredibly short bear market that was very steep and then this great rebound. And I think people that looked at all the bad news, they missed it.

[00:31:36] John Jennings: They didn’t invest their money or they pulled money out. And the bottom was March 23rd of March. And on that day, or like three days later, they announced the thousandth COVID death in America. I mean, imagine like if somebody says think about this Clay. If somebody said, hey, guess what? I have a crystal ball and here’s what I’m going to tell you.

[00:31:51] John Jennings: Okay, we just hit a thousand deaths. We’re going to have nearly, 350,000 in the US By the end of the year, it’s going to hit a million or 2 million worldwide. International travel’s going to shut down and sport pro sports leagues are going to stop. And all these restaurants are going to fail. Entire industries are going to be decimated, GDP growth.

[00:32:08] John Jennings: This quarter is going to be a negative 14 something percent. Unemployment’s going to spike to nearly 15% here in a week or two. We’re going to have 3 million weekly unemployment claims. Like if we knew all that. And oh by the way, this is going to go on for years. Like, if we knew all that, like we would be like, okay, we’re taking our money out of the market.

[00:32:25] John Jennings: But if you use the stock market as not the economy, you know that you can’t use what’s going on, or even if you knew what was going on in the economy, you can’t use that to inform what’s going on in the stock market. In fact, I wrote an article in Forbes on March 26th, three days after the bottom that said, even with a recession looming, which doesn’t mean you should sell the stock market.

[00:32:46] John Jennings: And I went through a lot of these things and I had people say, wow, how did you know? How did you call the bottom? And they’re missing the point. Like, I didn’t call the bottom. I had no idea. The point of the article is, we have no idea. Could it have gotten worse? Absolutely. Why was that? The bottom? Don’t know.

[00:33:03] John Jennings: Exactly. So I think that’s what’s important to know about this middle model, the stock market’s, not the economy. And if we moved it, like why is that the case? And that’s where we get into this concept of complex adaptive systems. And this really comes from engineering, but it is applicable to complex social interactions.

[00:33:22] John Jennings: So this is true of politics, it’s true of the economy, it’s true of the stock market. And the idea here is that in the economy, and in the stock market, you have actors that are intelligence called agents. So these are all the people and all the companies that buy and sell stocks, so they’re intelligent.

[00:33:39] John Jennings: So they don’t operate on rules of physics, like Newtonian physics or even the theory of relativity, right? It’s everybody watching each other, watch everybody else. So we’re all trying to decide what everybody’s doing. And if you think about investing, The true value of a company is what the market says it is, which means everybody else.

[00:33:57] John Jennings: And we learn from patterns. So we have these feedback loops, we have external information, so you can use, like, for example, let’s use like GameStop. So, going back to the meme stock, from early 2021. And really there was no underlying sound fundamental like economic reason why GameStop would do well.

[00:34:16] John Jennings: Really it was, this chat group on Reddit that started driving it up. And so people bought. Shares a GameStop because they thought other people would buy shares a GameStop and it was AMC as well and Bed, Bath and Beyond, which just declared bankruptcy unfortunately. But then what this did is this caused real world effects.

[00:34:35] John Jennings: So like what AMC did, which was brilliant, is they said, hey, like if these Reddit people are going to push up the value of our stock, we’re going to issue more stock. We’re going to gain all this like financial, extra-financial footing. So they started issuing shares of stock, which in turn, gave the company more money to ride out, the problems with movie theaters and everything.

[00:34:54] John Jennings: So it created these real world effects, which in turn made people go, oh, well maybe we should buy AMC. It was fascinating that this sort of thing happened, but what it means is with a complex adaptive system, is you can’t take the inputs. And know what the outputs are going to be. It’s like toilet paper hoarding in the pandemic, like going into the pandemic like, Clay. If I was like, what do you think if people are going to hoard some stuff, what’s it going to be like if you’re like me, I would probably would’ve said, jugs of water or cans of beans, or, I don’t know, something useful to survival, not toilet paper, but once it happened, Individual rational actions, which is if you see some toilet paper, buy it.

[00:35:30] John Jennings: Like don’t let that package of toilet paper pass you by cause you don’t know how long this is going to go on. But that further created this action, this irrational outcome system-wide, which is a toilet paper shortage, which was bonkers. And I was part of this in April 2020, I was in Walgreens picking up a prescription and I saw, this mostly empty shelf of toilet paper and there was one package there and I bought it even though we didn’t need it.

[00:35:52] John Jennings: And I was telling the checkout clerk, I’m so sorry I’m buying this, we have plenty of toilet paper. I’m being part of the problem, not part of the solution. And she was looking at me like, just, I have no idea what you’re talking about. Just checkout. So that’s really how the stock marketing economy work is, all these individual actors that are intelligent in learning and reacting to patterns.

[00:36:09] John Jennings: And that’s why it’s so hard to predict. What’s going to happen in the stock market or in the economy. And this is why experts get it wrong over and over again because it’s just not something that can be modeled well. And it’s why, patterns that have persisted in the stock market in the past won’t necessarily work in the future.

[00:36:24] John Jennings: It’s because, we’ve learned from the prior patterns and once a prior pattern patterns known, then everybody knows it. And you have to have a buyer for every seller and a seller for every buyer, right? So anyway, I’ve probably been just getting too excited about these two mental models.

[00:36:39] Clay Finck: I wanted to tap more into the great financial crisis. I didn’t personally experience the.com bust or the great financial crisis as an investor myself. So it’s always interesting to draw from the experience of others who actually lived through it. And I took this piece from your book that the market bottomed on March 9th, 2009, after a 57% drop. And the troph of the recession in economic growth didn’t come until four months later in June and it just ties directly into, since the economy is not the stock market, just because the economy is going down, the stock market actually rebounded four months before the economy rebounded. And I’d love for you to tell the story of the hedge fund manager you chatted with during that time and you chatted with him and he was just screaming more pain to come and you actually decided not to make any changes to your client’s portfolio. So I’d love for you to tell this story.

[00:37:34] John Jennings: So, first of all, let me say that like, the great financial crisis, the Great Recession, wow. Like, it’s one of the really seminal things, experiences I’ve had in my life. It was so stressful. Like I felt all this responsibility. For our clients’ assets. And I really, I hadn’t developed all these mental models and I didn’t know what to do.

[00:37:52] John Jennings: And I was this big consumer of financial information. Like I, my amount of knowledge about what’s going on in the economy and the markets was greater than it is now. But I, what I was lacking is, the Charlie Munger wisdom and mental models to make good decisions. And so it was really the great financial crisis.

[00:38:07] John Jennings: That was the impetus for me writing this book is all that I’ve learned. Cause I realized after that experience that I wanted to find, what did great investors do? What do they know? That I could learn that really spurred me on the financial crisis, and what I was doing is trying to find more information about, like, I couldn’t see how we were going to get out of this.

[00:38:25] John Jennings: And I know that the entire global financial system almost collapsed, and I don’t even know what that means. I just know it was really bad. And I was reading all these economists and investment managers that were just saying, there’s no way out and everything’s going to get worse. And so I’d gone to a conference.

[00:38:40] John Jennings: The prior year where I had met this hedge fund manager that had given a talk and he was so impressive and their returns were great. And kind of back in the s hedge funds were kind of the darling investment and money was flowing into him. And this guy was so impressive and had all these pedigrees and everything and I’d ended up, having a, an adult beverage with him in the cocktail hour of the investment conference.

[00:38:59] John Jennings: And we had exchange cards. So I’ll call him Tom as I do in the book. It’s not his real name, but I ended up emailing him and setting up a time to talk. And again, it was on the phone, back in oh nine, we didn’t like, zoom and Skype. And I asked him, I was like, you know what do you see happening?

[00:39:12] John Jennings: What’s our way out of this? And he said, oh, what we’ve experienced so far is just an appetizer to like this much bigger meal of misery that we’re going to, we’re going to have. And he says they had moved their hedge fund mostly to cash and gold and, it’s like a 3 billion hedge fund. They’d moved it almost out and, they were pretty sure that the stock market, which was at this point down, nearly 50% in February of ’09 was going to be down another 50%. The way that math would work, I guess I’d mean like 75, over 75% down from the high and he was at the time just so incredibly dower. And he had all these great reasons and there were things that I’d read before, but to read someone that had actually said, okay, we’re, really selling our clients out.

[00:39:50] John Jennings: And he said he had even bought farmland in New Jersey because he lived in New York City and he had like this stockpile of gold coins to buy passage out of New York City, if, which he thought was a decent chance if the, the economy collapsed. He was like, it’s going to be like, escape from New York stuff.

[00:40:09] John Jennings: If you know the old movie, by the way, which was filmed in St. Louis, go figure, but you know, the old movie escaped from New York. He was just like, I’m going to be able to get bypass out of New York City. And, maybe gold has always been a store of value for most of civilization. And, that he had like guns and generators and seeds and everything, and he was going to like, live off the land in like rural New Jersey.

[00:40:28] John Jennings: And I was like, oh my gosh. Like, I am so upset, and I remember talking to a few of my coworkers and fortunately, they kind of talked me off the ledge, and I did like breathing exercises and meditated, and they’re just like, okay, it’s just one opinion. I’m like, yeah, but there’s a lot of people with similar opinions.

[00:40:44] John Jennings: But I think cooler heads prevailed because it really freaked me out, and, but I look back on that. And in addition to being an entertaining story in retrospect, and by the way what he predicted could have happened. Like it could have happened, it just didn’t. And later in my book, I talk about something called invisible histories, which are things that could have happened but didn’t.

[00:41:02] John Jennings: So I look back, not just to be like, and I say something that’s funny in my book. Like, whenever I look, think back on this story I think about Tom sitting in a cell in New Jersey, like with a shotgun across his lap, eating a can of peaches, right? Or something, but which I thought was kind of funny, but I really have more sympathy for this, and you’re, and if you’re a hedge fund manager, maybe you’re all about making big calls and he could have been correct.

[00:41:23] John Jennings: But I use this as a mental model to remember that, even if you have all the possible information you can have, you’re this highly pedigreed, hedge fund manager with all this staff and this analyst analysis and research, it doesn’t mean that you’re going to be any better than anybody else from calling What’s going to happen in the stock market?

[00:41:41] John Jennings: And about a month later is when the market bottomed and his hedge fund and I haven’t gone back and checked it out, but they may well have gone out of business because they had moved everybody to cash and gold and missed the, from March 9th, 2009 the end of 2022. Even with 2020 twos down period, stock market has been up over 600%.

[00:41:58] John Jennings: So yeah, that was a costly mistake and just it reminds you that, even though he could have been right, this idea that you need to know what’s going to happen in the future and that you should follow expert predictions to invest. It’s just a great example of why none of us should invest based on our own or others’ predictions of the future.

[00:42:17] Clay Finck: I think this ties well into a point you make from your favorite investment book, which is the Success Equation by Michael Mauboussin who has been on the show back in 2021. I believe in it. He has what he calls the skill luck continuum, where certain activities fall somewhere on the spectrum of primarily being skill-based or primarily being luck based.

[00:42:40] Clay Finck: Based on your research and writing this book, where do you think investing falls on this spectrum?

[00:42:46] John Jennings: Yeah, and of his books the Success Equation, it’s really my favorite investment book cause it had this outsize maybe the biggest impact on how I view the investment world and really opened my eyes to a lot of things.

[00:42:57] John Jennings: And yeah, his skill luck continuum is pretty fun. Cause it’s not just investing, he, on one end of the pure luck is, like roulette and slot machines and you can put the lottery there, just complete luck and at the other end, things that are a hundred percent skill, like chess is a hundred percent skill and things that are pretty close to full skill, which are like races.

[00:43:15] John Jennings: So like a running race, like the hundred meter race, running race, or in swimming. So if you think about it like Michael Phelps, he’s going to beat. A less skilled competitor. Pretty much every time there’s very little luck involved. I guess you could like, slip a little bit coming off the block or have a, something happens, but really, I guess, that even that falls within skill.

[00:43:33] John Jennings: But then you look at a lot of sports and, they vary and how much, luck is involved. I love hockey and all the time, you’ll watch your team and your team will hit the goalpost a few times and you’ll lose, or the vice versa happens or you’re watching football in the game-winning field goal hit doings off the upright. So there’s all sorts of things that happen that, that you can see where, luck comes into play. But really, and he did all this, the study and research and analysis and what he found is investing falls way down towards the luck into the continuum, skill matters.

[00:44:05] John Jennings: But it’s way, it’s definitely much more towards gambling and some gambling, like poker, has a lot of skill, but it’s much more down towards, the roulette than it is up towards, chess or swim races. And he asked a few great questions that we all can ask to tell where an activity falls in the continuum. And the first is, can an amateur beat a pro? And the answer on skill-based things is no. Like I don’t play chess. So if I played my nephew who is this incredible chess player, like I’d have zero chance of beating him. And I swam and if I swam against Michael Phelps, like it would be laughable.

[00:44:41] John Jennings: Like, or ran a running race against like a college, or even high school, track person. They would just, they would cream me and, same thing if I played one-on-one basketball or horse against like a college basketball player. Like all those things, like an amateur cannot beat the pro.

[00:44:54] John Jennings: Whereas if you think about roulette, Like, can an amateur roulette player beat a pro roulette player? Yeah, of course. Like it’s random, right? And or slot machine. Like, can an amateur slot machine player win? And if you think about investing, an amateur can beat a pro all the time. And I tell the story in my book of, in 2020, our highest performing portfolio in 2020 was out of a middle schooler.

[00:45:14] John Jennings: We had helped her set up an account at Schwab and, educating her on stocks and like, oh, what stocks would you like to buy? I think she had like a thousand bucks for her grandparents then, she picked like Netflix and Tesla, it was like some of the highest performing stocks of 2020.

[00:45:28] John Jennings: So it was like three or four stocks. And we went back and looked at like, yeah, what can we learn about the high versus low performing portfolios? And yeah, so this middle schooler was the top performing. And so it just shows you that an amateur can beat a pro in investing. And it happens all the time, especially over shorter periods.

[00:45:43] John Jennings: And then on the other question he asked, which is so good, is can you lose on purpose? So if it’s a, if the outcome is mainly based on skill, you can lose on purpose. So like I could, my nephew and chess could choose to lose to me on purpose. He could intentionally make poor moves. Or if I was swimming against somebody that was a better swimmer, they could choose to swim slower and I would win.

[00:46:03] John Jennings: Or I race my now six year old nephew and like I’m still faster than he is. So I could choose as I usually do to lose. Every once in a while, I choose to win, but mostly I choose to lose. And the same things in investing true of stocks. Like can you lose on purpose? And when I ask this question to people that they often say, oh well yeah, the answer is though, not really.

[00:46:24] John Jennings: Because if you could pick stocks in advance that weren’t going to do well, you could make a ton of money as a short biased, stock picker. You could short stocks. And there were basically, like no famous short. Managers because it is so hard to do that in general, stocks go up to, so pick the ones that go down or even to pick the ones that are relatively don’t do as well as others is incredibly hard to do because, long short hedge funds, their history and their performance hasn’t been great.

[00:46:52] John Jennings: So it just really shows you that, investing, skill does matter, but there’s a huge component of luck. And what this means is when you see an investment manager or a middle schooler that does really well, you know, it, it behooves us not to read too much into their performance or if they do really poorly, we can’t read too much in their performance.

[00:47:11] John Jennings: I mean, if picking a star investment manager that was going to outperform in the future was merely as simple as how do they perform into the past and let’s pile into the ones that have done well, that would be easy. But you know, what studies of public stock managers have shown is there’s basically no persistence from year to year.

[00:47:27] John Jennings: And very few investment managers over long periods of time show that they have skill and they deliver outperformance beyond their fees. So there’s a lot that have skill, but just not in excess of their fees or especially, the taxes that might be generated. So what it means is picking a manager, someone that’s going to buy stocks for you, that’s going to outperform. Picking a manager like that is really hard because there’s so much luck involved and it’s so hard to tease out skill.

[00:47:54] Clay Finck: I think a key part of that last point with the difficulty of success and investing over long periods of time is that times are continually changing. An investor might have a really good decade, but if they apply that same exact strategy the next decade, then odds are they aren’t going to do as well because just times change and the environment changes.

[00:48:15] John Jennings: Yeah, that is so true. It’s really hard and what happens is, as an investment manager, there’s ways to invest that you have a high likelihood that you’re going to beat the market. But the problem with them is that it takes a lot of time for you to be correct and there’ll be a lot of time where you look horrible.

[00:48:33] John Jennings: And in fact, Vanguard did a study of investment managers that had over 15 year period that both survived and then beat the market. And of the over 1500 funds, they looked at, only 18% actually beat the market over the 15 year period. And that’s pretty consistent with other studies by S&P and others that have looked at, the success of active managers.

[00:48:54] John Jennings: But what was fascinating of the 18%, two thirds had five or more years of underperformance. So five years out of 15 years, if I do my math correctly, is one third. And a lot of them had 6, 7, 8 years of underperformance. And also the majority of them, had at least three years of consecutive underperformance.

[00:49:17] John Jennings: And so what that means in the real world is if you’re an investment manager and you’re like, okay, I’m going to outperform, but I know that I’m going to look like crap. Like a lot of the time, the problem is your investors likely won’t be sticky. And that after three years of consecutive underperformance, or four or five even, or I’m underperforming five or six or seven out of 15 years, you’ll have people fire you and you’ll go out of business.

[00:49:42] John Jennings: So what the investment managers do is they change their strategy so they don’t get fired, or they invest in a way that is very similar to what the market is, and they just tweak it a bit so they don’t look too different. And it’s really a business decision. And it’s really based on, it’s really based on the investor.

[00:49:59] John Jennings: It’s really the investors, and there’s this idea that if you could invest maybe with a manager that has a lockup, so I manage it. If you invested with an investment manager that said, I’m going to buy. Publicly traded stocks, but you can’t get out for 10 years or you could invest in a publicly traded manager that you could get out every day.

[00:50:17] John Jennings: I’ll tell you that the one that you can’t get out of for 10 years, likely with a high degree of likelihood, will beat the one that you can get out of every day. cause the one that’s investing for 10 years is going to invest with a long-term view and not be worried about whether their investors are going to pull out and it won’t change their strategy.

[00:50:34] John Jennings: And they’ll stay with something that has, been shown to, likely over long periods of time beat the market.

[00:50:40] Clay Finck: You also touch on some behavioral biases in your book that are, again, hardwired into us, which essentially means we’re all susceptible to these to some degree. And two very common behavioral biases are loss aversion and overconfidence.

[00:50:55] Clay Finck: And part of me feels like this kind of go at odds with each other. If you’re loss averse, then you might not take enough risk. If you’re overconfident, you might take too much risk. So I’m curious if you believe that most people are susceptible to both of these to some degree, or do people sort of lean one way or the other that they should be aware of?

[00:51:14] John Jennings: Yeah, I don’t really think that they’re actually at odds. I think there are things that each of us applies at different times. And I’ll give you an example. So if you’re overconfident, so it means that you think you know more than you do, you’re better than you are, you’re better looking than you really are.

[00:51:28] John Jennings: You’re a better driver than you are, better spouse, parent, on down the line. But in terms of investing, again, it means that we think. That we know more than we do or that other people do, that we make better decisions. And then we have this loss aversion, which, at its core states that losses feel more painful than gains feel good.

[00:51:48] John Jennings: And so there’s these different things that we do when we’re faced with decisions with loss aversion. The first is we make decisions to avoid losses. But then importantly, once we’re at a loss, we tend to double down. Like we don’t want to keep, we don’t want to lock in the loss. And I think overconfidence there goes hand in hand because I, you know when you’re down and you decide, okay, I’m going to double down, or I’m going to engage in risk seeking behavior cause I don’t want to lock in a loss. It just shows right there that you’re being overconfident in terms of your abilities and really you should step back and go, okay, this invest, this investment that I have is down.

[00:52:23] John Jennings: It’s at a loss. What should that teach me about my ability to make investment decisions? If it’s just the rest of the market’s down, fine. But if it’s down, more. If it’s an individual stock or other type of investment, maybe you should say to yourself, I don’t really know what I’m doing and I’m going to cut my losses instead of, engage in risk seeking behavior.

[00:52:43] John Jennings: But I do, to your point at the beginning of the question, I do think that these are two of the, the biggest behavioral biases to be aware of as investors. And I hit five of them in that chapter. And there’s entire books and great ones written about behavioral biases. And I think a key takeaway is, and my business partner Spencer Burke, who also my mentor, what he has said over the decades is, you read these books about behavioral biases and a few things happens.

[00:53:07] John Jennings: First of all, its human nature cause we’re overconfident that we think about like, oh, other people do these, like, oh, these other silly people that, are doing risk seeking behavior when they’re at a loss. Or these silly people that have hindsight bias or succumb to confirmation bias, et cetera, et cetera.

[00:53:24] John Jennings: So we first of all think that we’re not as bad as everybody else. And so we needed to be like, no, we’re, we are as bad, like I’m human just like everybody else. But then the other thing that’s sort of insidious is once you read about these biases, you think that now that you know them, that you’re going to be better at them.

[00:53:41] John Jennings: And what I’ve found is, so, like I had this professional certificate where a lot of studying research, it wasn’t actually, like a multi-year sort of thing. So maybe it sounds more impressive than it is, but, in prep for that. But also over the years I’ve probably read, I don’t know, 15 books on behavioral biases and behavioral aspects of investing in and the like.

[00:53:58] John Jennings: And every time I read about it, I think, oh, okay, I got this. I got this right. I’m going to be, I’m going to be better. And I’ll tell you, I think I’ve gotten a bit better just because I’ve done so much study over the years. But this, I think this idea that you can read, like, like one book or one paper or like my book one chapter and like, okay, you’ve got this, you’re going to make this big improvement.

[00:54:19] John Jennings: To realize that these are hardwired into us. And a thing I hit in my book is some of the reasons why that is. And I think, behavioral economics or behavioral finance or whatever you want to call it, tend to talk about these biases. And then heuristics, which means, this shortcut that you make, these shortcuts you make in decision making.

[00:54:35] John Jennings: They talk about them like in this way. Like, aren’t we flawed? Most of the books. But really if you dig into like evolutionary psychology, there’s really good reasons why we have these biases and it’s because having these biases helped in terms of our survival. So we’ve evolved to have them.

[00:54:53] John Jennings: But the situation we are in now is that like we have these ancient brains that evolved to be in this time period of, thousands or hundreds of thousands of years ago. But we live in modern times where, we’re not being stalked by prey and we have all this abundance. And, we feel these, these biases come into play on our decision making when so many of them just aren’t as applicable anymore.

[00:55:20] John Jennings: And that’s really our struggle because if you think about like loss aversion, those ancestors of ours that took action not to lose are the ones that were more likely to survive. Because, back in the day, we’ll call it like the caveman days, a mistake could easily lead to your death or at least your inability to reproduce and, pass your genes down.

[00:55:42] John Jennings: And it was the ones that were more risk-adverse in an incredibly treacherous world that survived and passed on their genes. And we are their descendants, right? So there’s a very good reason for us to be loss adverse. But again, as an investor, for most people, it just doesn’t make sense to give outsized focus and emotion to losses as compared to gains in this world of abundance that we live in.

[00:56:07] Clay Finck: And another behavioral bias that I really enjoyed learning more about was how we’re just naturally drawn to a really good story. And with a lot of investments, people have almost perfected the art of telling a good story around it to almost pitch it. So what should we know about storytelling to help prevent us from being persuaded into a potentially poor investment?

[00:56:32] John Jennings: So this is something that isn’t talked about a whole lot when it comes to investment behavioral biases, and it a bit falls under the, what’s more commonly known as like base rate neglect. I just think calling it storytelling bias adds a different, spin to it that is first of all sounds more interesting than base rate neglect, but it also, flips it and highlights why we neglect base rates.

[00:56:53] John Jennings: And so storytelling bias. It’s interesting I read this book called, tell Me a Story by this AI pioneer named Roger Schank, and he wrote a book, this book, tell me a story in 1995. So if you think back to 1995 and compared to what’s going on with AI today, like in 1995 we had, I think the, definitely the first, maybe the second Terminator movie in some science fiction, but you know, really hadn’t done much in the way of artificial intelligence.

[00:57:16] John Jennings: But what he says in this book, which is fascinating, is one of the big challenges. With AI and AI passing, what’s known as the Turing test. And the Turing test is, was something formulated by Alan Turing. So, he was famous in the forties as one of the big code breakers in Britain and the enigma machine and is arguably the creator conceptually of modern day computers.

[00:57:38] John Jennings: But he had created this test of, will there be a time period someday, how can a computer trick a human to think that they’re interacting with another human? So that’s passing the Turing test and there’s like movies like, like Ex-Machina, which is just a great movie about this sort of thing.

[00:57:52] John Jennings: So, Roger Schank was writing. One of the big challenges, or maybe the big challenge with AI passing the Turing test is that the way that humans interact is we tell each other’s story. So I’ll tell you a story of something that’s happened. And you’ll tell me one back and your story back will typically be relevant to my story.

[00:58:09] John Jennings: And what that story will do will convey to me that you’ve heard me and you understand. And then I’ll tell you one back and we’ll go back and forth. And in fact, we judge each other’s intelligence by the quality of stories that we tell. So like, if you go out and you meet a person, or if you’re somebody that’s dating and you go on a date and then afterwards someone says, oh, you know how intelligent was Carl?

[00:58:27] John Jennings: You won’t realize it, but the way that you will evaluate Carl’s intelligence is what quality of stories did Carl tell me? How relevant were they to mine, et cetera. And the reason we evolved to be storytellers, it’s cause again, it comes back to a survival advantage, everything else, evolutionary.

[00:58:44] John Jennings: And there are other mammals or animals that work in small groups, but humans are the only species that works in a large scale group. So, there’s something called Dunbar’s number that you can really only know. 150 people or know, know them by name and by parents and know something about them.

[00:59:03] John Jennings: But if you think about it, we have all these groups that are much bigger. You can work for a company. I used to work for Arthur Anderson. We had 88,000 employees and I identified as an Arthur Anderson employee. And there were certain stories about how we served clients and what we did, or nations like, there’s certain narratives and stories around, being an American or, being a Brit, a Canadian, et cetera, et cetera.

[00:59:23] John Jennings: And religions as well. There are certain stories that different religions have, about creation and what the religion stands for and et cetera, et cetera. So we can believe as a species, all these things. And what that allows us to do is it allows us to work in bigger groups and to have shared myths and shared experiences.

[00:59:40] John Jennings: And so because of all this, we pay outsize attention to stories. And what this means from an investment perspective and just making decisions on our in everyday life is that we rarely stop to consider the base rate of, what’s happening. So, I’ll give you an example.

[00:59:56] Clay Finck: Yeah, go ahead. Could you just briefly define what a base rate is?

[01:00:00] Clay Finck: I feel like this is a topic that isn’t discussed too often. I first learned it from Buffett and I think it’s just an incredible insight. So please define what a base rate really is.

[01:00:10] John Jennings: Really it comes down to statistics, like what is the probability of something happened in a given situation. So for instance, we needed to send my daughter’s passport to her.

[01:00:24] John Jennings: So she’s my younger daughter’s off at school and is applying to study abroad. And we were discussing, should we wait till she came home for spring break or should we like U P s or FedEx at tour? And it was interesting, my wife made a good point. She said, I read the story that popped up on, social media of somebody that was FedExing.

[01:00:43] John Jennings: Something really important. I forget now what it was. And how it got lost. And like, it was something that was basically irreplaceable. And so I don’t think we should FedEx the passport if it got lost, this would be horrible. And I ended up agreeing with her. I said, yeah, the risk is too high.

[01:00:57] John Jennings: Like if the passport gets lost, like she may not be able to get a replacement in time and to get a visa and to study abroad. So we, we decided to wait till she came home a few weeks later, which had a negative effect on the timeline. But really another way of thinking about it is we could have researched what’s the base rate.

[01:01:11] John Jennings: Like how many FedEx envelopes go missing? And we could have weighed this one story that we heard of this person on social media that had something irreplaceable lost by FedEx. We could have weighed that against the, the 0.0001%. I haven’t looked it up, so I don’t know what it is. Chances it would’ve been lost.

[01:01:29] John Jennings: But neither of us did that. It was only later, that I was actually thinking about, oh, we didn’t apply. The base rate and other base rates are things like the vast majority of startup businesses fail. Like, less than 30% of it make it to their 10th anniversary, or the majority of stocks, publicly traded stocks underperform the market.

[01:01:49] John Jennings: So, over a, any given year, any given 10 or 20 year time period, two-thirds, three-fourths, even an 80% of stocks underperform the market. So like you would use that base rate. To inform should I be buying a single individual stock or even five, knowing that the chances are that most, if not all the stocks I will pick will underperform the market over the next, 10 or 20 years.

[01:02:10] John Jennings: So it behooves us as investors to think of the base rate. But the problem we run into is because we’re primed to pay attention to stories, we, first of all, we hear stories of other investors making outsized returns. Our friends typically talk to us if they’re going to talk about investments, about their investment victories, et cetera, et cetera.

[01:02:28] John Jennings: But also, we’re being sold stories. We’re being told stories. Even if you’re just looking at investing in a single stock, the company has a story to tell. It’s part of their marketing. It. They may not necessarily be trying to sway investors, but you know, they’re putting forth like, just think about like Facebook, which is now, meta platforms kind of based on the whole metaverse concept.

[01:02:46] John Jennings: Like they’re putting out the story of what they see the future being and how they’re going to take advantage of that. And so if you said, I’m going to spend any time at all reading about whether I should buy meta stock, you’re going to get the story about the future that they’re going to be selling you. And we hit this as investors all the time.

[01:03:06] John Jennings: And in my book, I think the most fascinating study on this that I’ve read was one of medical decision making where basically they told these volunteers, you have a fictitious disease and there’s two different drugs. One has a 50% effectiveness rate, and then the other one they would vary. And the other one, let’s say it has a 90% effectiveness rate.

[01:03:22] John Jennings: So it’d be like this Clay, you have a disease, it will kill you. Left untreated drug A has a 50% effective rate. Drug B has a 90% effective rate. But then they tell you two stories about the 50% drug. They would tell you a neutral story. Chris has taken the drug, we don’t know if it’s going to work. The second drug, pat has taken the drug, it’s not working.

[01:03:39] John Jennings: She’s blind and can no longer walk, and her death is imminent. All right, so based on that, most people in this situation picked the 50% effective drug instead of the 90% effective. Like the 90% effective drug is, based on clinical trials and FDA approval and all this, blah, blah, blah, blah. But one story swayed most people to pick the less effective drug because there was a negative story attached.

[01:04:02] John Jennings: And when they said this drug B is 30% effective and told a positive story, like 80% of people still pick the less effective drug. Because the positive story was attached. So it’s not even just an investment concept. And what I think is fascinating, and as I’ve dug into, the storytelling bias is pay attention.

[01:04:18] John Jennings: I say this to all the listeners, pay attention to how when you interact with people, you tell each other’s stories. And then when you go to make a decision, how you’re almost certain to pull out a single story that you heard, a news story, something you heard on social media, something you heard from a friend to inform your decision.

[01:04:33] John Jennings: And you probably won’t go research what the base rate is, which is, how often what really happens in the real world and how that should affect your decision. And I’ll tell you like I do it too. I’ve become expert on the storytelling bias. And I laugh at myself how often I succumb to it like I did with the, the FedEx story that I just told.

[01:04:52] John Jennings: So again, like I feel good with our decision because we couldn’t take the risk of not FedExing the passport but I didn’t stop to consider the base rate. I jumped into the story and was like, oh, I don’t want that to happen. Great story, honey.

[01:05:04] Clay Finck: It’s really hard. Yeah, I mean, I think the case of the IPOs is a perfect example where an IPO might have a great story and it might make a ton of sense to you, but if you invest, you should keep in mind that the base rate is really low for the success of IPOs.

[01:05:19] Clay Finck: And then there’s all these incentives for, the investment managers trying to pitch it and the company wanting to get a lot of attention. But I don’t want to hold you too long, and I wanted to ask you a couple questions. Since you’re in the wealth management industry, we’ve had a number of guests on the show that have claimed what I’ll call the death of the 60/40 portfolio.

[01:05:38] Clay Finck: Now that inflation is here just today, and there’s all these reasons for why it structurally may be around for the years to come. I just wanted to ask if you have adjusted your portfolio or your client’s portfolios to account for a potential inflationary environment or regime, if at all.

[01:05:57] John Jennings: Yeah. So again, a little bit about our company.

[01:05:59] John Jennings: So we’re a multi-family office. We oversee help our clients with about 15 billion of wealth and about, again, about 63 client families we work with. So that’s a bit about what we do and we don’t really have, here’s our exact model portfolio we should do our clients. It’s pretty custom and based on what they need in terms of cash flow and things.

[01:06:17] John Jennings: But that being said, we don’t have many portfolios that are 60 40. We tend to be the kind of eight, we’re more like the 80 20 or 70 30, sometimes 90 10 sometimes 95 5. It just really depends on the client. But as we’ve dug into inflation, which we’ve done, numerous times over our 21 year history, there’s a few interesting things about inflation.

[01:06:34] John Jennings: First of all, economists still debate what causes inflation exactly. And what to do about it. So it’s pretty interesting. And what is the big driver of inflation? Also tells you what asset classes. Might do better versus not. So it’s kind of tough. You can look back into the seventies where you really had this cost push inflation.

[01:06:54] John Jennings: A lot of it was driven by the oil crisis and, you had these high labor costs. You had a lot of labor unions in the seventies that, a much high percentage of workers were in labor unions. So it was really hard when there was, low economic growth or declining profitability, you couldn’t really cut wages and things.

[01:07:08] John Jennings: So that was like one situation. And we’ve had different situations that have been more driven by monetary policy. So, the fed, being too loose for too long. And then you have times like we have now that are probably a combination of a bunch of different things is, part, partly driven by monetary policy, but definitely fiscal spending and the rescue that was done out of COVID, but then combined with all these supply chain issues and in each era you can’t just say, this is the investment asset that’s going to work.

[01:07:33] John Jennings: I mean, you look at, tips, treasury, inflation, protected securities, and those haven’t done well. Over this inflationary time period because its inflation adjustment has been overwhelmed by, the rise of interest rates and there wasn’t a, a buffer. So it’s tough to say exactly what you should be in as an inflation hedge.

[01:07:48] John Jennings: I’ll tell you, during all these time periods, if you look long term, the best performer relative to inflation has just been equities. So whether public equities are private equities, so we’ve pretty much have stuck to our original, asset allocations with clients. We know that there are time periods is not going to look as good and others that it’s going to look better.

[01:08:08] John Jennings: I’ll tell you like for the history of our firm, we’ve had an allocation to non-US stocks and that was great in the aughts, but since the financial crisis until 2022 and so far this year, it’s been a huge drag while clients going, oh my gosh. Like, will the pain never end? We’re like, let’s continue to rebalance and buy more international stocks and it’ll cycle back.

[01:08:28] John Jennings: And that’s really how we view, these asset allocations. And for instance, if we had a client that’s 60 40. We would say the best investment behavior you can have is not outguess it and to continue to rebalance back to 60 40. Yeah, it’s been, it was 2022 was brutal for a bond investor, but you know, bonds are looking more attractive now.

[01:08:47] John Jennings: They’re going to look, better and worse over time. So we’re really about behavior, what’s, what gives you the best behavior and we find for investors it’s having more of a static asset allocation and trying not to outguess. And we’ve done a lot of paying attention to what other firms do in terms of their tactical allocations.

[01:09:03] John Jennings: And they’re right sometimes, but they’re wrong a lot. And the, a lot of times they don’t work out. And I think an issue is investors feel like they should be doing something when most of the time the better thing to do is not to do anything. So, I think, people worried about inflation and interest rates and the allocation of their portfolio are better just to back up and think more in like 20 and 40 and 50 year timeframes and just realize, an important mental model is you’re not going.

[01:09:29] John Jennings: To you’re going to be wrong as much or more than you’re going to be. Probably. And again, not have overconfidence and realize that there’s all these other people that are in the market, and the price of everything is established by buyers and sellers. And, people tend to think, oh, well I know more than these other people.

[01:09:45] John Jennings: Do you know when I’m selling a stock? Woo-hoo. And look at those dumb buyers or, vice versa and have a little bit more humility and say there’s all these other people, all these other firms, and realize that they have a reason for what they’re doing. And that’s part of the thing that’s setting, that’s it’s setting the path of interest rates and it’s setting what’s happening in the stock market and realizing that maybe, you don’t know more than they do.

[01:10:07] John Jennings: And maybe even if you did, would that really help you? So I think it’s just a big healthy dose of humility.

[01:10:13] Clay Finck: Well, John, thank you so much for coming on the show. This was absolutely wonderful. If the audience enjoyed this episode, I’d encourage you to go check out John’s new book, the Uncertainty Solution.

[01:10:24] Clay Finck: John, before I let you go, how about you give the handoff to learn more about you and learn more about your book and whatever other resources you’d like to send them to?

[01:10:33] John Jennings: Yeah, so I have a website that is johnmjennings.com, J-O-H-N-M as in Michael, jennings.com and on it has a little bit about my book, but importantly in the menu there’s a tab that says IFOD, which is stands for Interesting Fact of the Day, and that is my blog that about twice a week. I write on things that have usually nothing to do with investing.

[01:10:54] John Jennings: They’re just things that people might find interesting. So it’s very wide ranging. Some of my most popular ones have been what happens to a bullet shot straight up in the air. Why do females generally have neater handwriting than males? Why do competitors often put stores to close to each other?

[01:11:11] John Jennings: Like, why do you see a CVS and Walgreens on the same block, or a Lowe’s and Home Depot? Why does that happen? So, yeah, it’s just various interesting things like that. Would love to always to have more subscribers to my blog.

[01:11:23] Clay Finck: Awesome. Well, thanks again, John. Really appreciate it.

[01:11:25] John Jennings: Yeah, thanks Clay. Enjoyed it.

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