Why does pessimism sound so smart?

October 31, 2022 | Field Guide

Today, we want to let you in on a secret. It’s a simple secret, but one we believe has the ability to make you a better investor overnight.

Here’s Zak to tell you all about it:

Note: This video was originally published in our monthly client e-newsletter, Guidepost.

The thing about pessimism

I want to confess something to you.

Over the past few months, I’ve had multiple conversations and email exchanges with clients about what’s going on in the economy and markets, and these exchanges have left me feeling….well…

Stupid.

Okay, I get it. That’s not too big of a confession. We all feel stupid sometimes. Let me explain what I mean, though, because I think it will help you be a better investor—especially in times like this.

You see, each time the market goes on one of these downward swings, people usually start doing two things:

They try to figure out what is going on.
They try to figure out what will happen in the future.

Let’s take these in order.

First: What is going on?

“What’s going on with the market!?” It’s certainly a valid question right now.

Let’s think about the economy like a tire. When the whole world shut down due to the COVID-19 pandemic, the tire—the economy—went flat. Central banks and governments tried to pump the tire back up. And it worked! The tire filled back up with air. We avoided runaway long-term unemployment and the bread lines of the Great Depression.

Yet you’ll also recall how the COVID-19 pandemic brought about widespread supply chain issues, a massive shortage of basic supplies like toilet paper, cargo ships stuck sitting off the coast of California, China shutting down, and worker shortages across major industries. Lumber prices went through the roof. Used cars cost more than new ones! Add to all of this, Russia invaded Ukraine which left us with an energy squeeze.

What happened, then, was that there became too much demand for too few goods which overinflated the tire, leading to…wait for it…

inflation.

So, the central banks (the folks with the “air pump”) now need to deflate the tire a bit. They let “air” out of the economy by raising interest rates to slow demand. This can be a painful process with far-reaching consequences. Yet, to paraphrase what the Chair of the Federal Reserve, Jerome Powell, stated in his latest FOMC press conference: this pain is better than the alternative of run-away inflation. And I would tend to agree with him.

There has also been some encouraging news. Recent rate hikes seem to be slowly getting some traction as job openings have fallen by 10%. Meanwhile, corporate earnings have continued to hold up reasonably well. US households have also remained resilient, as they still hold over $1 trillion dollars of excess savings in hand (link for reference).

Second: What will happen in the future?

Once we’ve figured out what’s going on, we often try to predict what will happen in the future.

This is where things get hard and where investors can get into trouble.

So, I want to let you in on a secret and give you an inside tip to help you understand why some market predictions seem so smart while others seem naive.

The way I view predictions changed ever since I heard this tip, and it will for you too:

“Pessimism always sounds smart.”

It’s just that simple. Pessimistic predictions sound smart! They feel urgent and attention-grabbing. And the opposite is true as well. Predictions that seem optimistic tend to sound naive.

Back in 2016, we shared an article from the Motley Fool titled “Why does pessimism sound so smart?” In the article, author Morgan Housel states:

“If you say the world has been getting better you may get away with being called naïve and insensitive. If you say the world is going to go on getting better, you are considered embarrassingly mad… In investing, a bull sounds like a reckless cheerleader, while a bear sounds like a sharp mind who has dug past the headlines.”

Morgan’s article goes into detail as to why this is. She says,

Optimism appears oblivious to risks, so by default pessimism looks more intelligent.
Pessimism shows that not everything is moving in the right direction.
Pessimism requires action, whereas optimism means staying the course; We all feel better when we are taking action about a concern.
Optimism sounds like a sales pitch, while pessimism sounds like someone trying to help you.

Think about it next time you hear the market pundit on TV, get a doom and gloom email, or your friend starts talking about how “rising rates are going to cause all kinds of havoc on the housing market,” or the “upcoming elections are going to lead to the decline of the economy.”

Doesn’t it all sound smart and worthy of your full attention?

And on the flip side, if seemingly everyone is sounding alarms, wouldn’t a headline reading “Everything is going to work out” feel completely naive?

Why pessimism isn’t that smart

Morgan’s last point reveals why pessimism really isn’t as smart as it seems. She says, “Pessimists extrapolate present trends without accounting for how reliably markets adapt.”

You see, it seems smart to highlight the continuation of a known problem. It feels naïve to say things will adapt to come up with the solution.

But if you look back over history, it’s been smart to have confidence in the market’s ability to adapt.

Consider the fact that the S&P 500 has risen 18,000-fold over the last century. Think about how much turmoil the market has weathered in the last century—how many wars, market collapses, crises, and political power changes have taken place.

The market’s ability to reliably adapt over the long term has long been the smart, prudent viewpoint after all.

Let me give you a near-term, real-life example.

What if we could peer into a crystal ball?

Let’s say you were in our office when we first shared Morgan’s article on our blog in February 2016. We were all in our sweaters sitting around the conference room table talking about all the pessimistic predictions at the time and trying to figure out how to invest. But what if, instead of just predictions, I had a crystal ball and was able to tell you with certainty what was going to happen in the coming years

I would have told you how:

In just a few months, the world was going to be shaken by the Brexit vote.
We were going to have major trade tensions and tariffs with China.
Political parties were going to change several times.
There was going to be a global pandemic that would literally shut the world down.
We were going to have trouble buying basic goods like toilet paper and baby formula.
The federal deficit was going to balloon.
A session of Congress was going to be attacked by US citizens.
Russia was going to invade Ukraine and cause an energy crisis.
Rumors of nuclear instability would abound.
Inflation was going to hit a four-decade high.

I could go on and on and on.

Now, what if I finished our discussion by telling you, “You need to get out of the market now while you still can. This is not going to turn out well.” I would have sounded smart and measured, right? Of course I would!

Yet, what if I looked you right in the eyes and said, “You know, the coming years won’t be easy. Yet, despite everything, it’s smart to stay invested. Despite how it sounds, things are going to somehow adapt and work out.” Wouldn’t I have sounded completely naïve, even stupid? Of course I would!

However, consider what actually happened with US stocks. Despite the rocky year we have had so far, the total return of the S&P 500 since that time has been a whopping 116%! (Feb 16, 2016 — Oct 20, 2022; Yahoo Finance ^SP500TR).

Has there been some short-term market pain along the way? Absolutely. Has it continued to, despite everything, work out over the past 6.5 years? You bet. And we could look at many more similar examples throughout history.

(Disclaimer: We know that past performance does not guarantee future results, but history does provide helpful context and perspective.)

So, what now?

I want to be clear; we are not saying challenging things aren’t going to happen (they will) or that we don’t need to plan for them (we do). We also aren’t saying you need to suddenly embrace a mindset of undying optimism.

The main point is this:

When we try to figure out what is going to happen in the markets, we have to counteract our innate human tendency to be overly swayed by pessimistic predictions as well as our tendency to discredit predictions that focus on the market’s ability to adapt, and continue to march forward over the long term.

We as your advisors must resist trying to “sound smart” by being overly pessimistic. Rather, we must risk sounding stupid and naïve by continuing to highlight how reliably resilient markets have shown themselves to be.

So, the next time you hear a prediction that sounds smart, ask yourself, “Is this a pessimistic prediction? Is that why it sounds smart?” And the next time you hear a prediction that sounds naïve, ask yourself “Is this, in fact, an optimistic prediction? Is that why it sounds naïve?”

Remember, we’re here for you! If you’re a LifeGuide client, we plan for difficult markets like we have experienced this year. It is why we plan for our clients’ cash flow needs, stress test retirement income plans, allocate money to “buckets one and two,” and diversify portfolios. We also do a lot for our clients because of how reliably markets adapt, like encouraging them to stick to their investment plan, allocating money to “bucket three,” rebalancing their portfolio, and implementing our BDP strategy.

From all of us here at LifeGuide, we appreciate being your guides on this journey to greater financial peace, freedom, and eternal impact.

Zak Lutz, CFP^®, RLP^®, CKA^®
LifeGuide Chief Investment Officer