I wrote a post recently on several lessons investors can learn from BASE jumpers. Full article below.
PDF version here: http://bit.ly/2djuXez
Web article here: http://bit.ly/2d1JxcT
National Geographic recently ran a story – Why Are So Many BASE Jumpers Dying? looking at reasons behind the rise in BASE jumpers fatalities, which I believe can offer investors some important lessons about risk.
The risks that investors encounter is no less different from BASE jumpers. They come in all shapes and sizes, and almost always invisible. As we will see here, a majority of the risks are build up gradually behind the scene before investors actually hit the ‘Buy’ button.
One of the reasons more BASE jumpers are dying is due to proximity flying, i.e flying close to objects like rocks and forests, which offer a richer experience than flying off a plane.
“Flying a wingsuit out of a plane offers little perspective… If the dream was the true and raw perception of flight, then somehow wingsuits needed to be flown closer to objects…one in which the stakes are high, margins are thin, as the rewards are unforgettable and extremely addictive.”
Just as it can be hard for BASE jumpers to quantify how riskier it is to do a proximity flying compare to flying off a plane, investors are constantly pushing themselves into riskier investments that promise high return without knowing what they’re getting themselves into.
“…more people getting into it very quickly without a lot of experience. People are now getting into skydiving only as a way to reach their ultimate goal: wingsuit BASE. Now we have a population who barely knows how to fall or how to fly a canopy [parachute], but they are already skimming rocks in wingsuits.”
Every field has its fundamentals. In this case, it is physics, aerodynamics etc, whereas for investing, it is microeconomics, accounting, psychology etc. Investors tend to rush into the market before having a good handle on basic fundamentals. As the reasoning goes, why worry about fundamentals when you can ride the trend on a rising tide?
“…wingsuit BASE novices are shortcutting every step of the process, a process that might involve tens of thousands of dollars in airplane time, hundreds of jumps at each stage, and ultimately many years of consistent, full-time practice…There’s a lack of education, a lack of awareness of what they’re getting into, a lack of how real the consequences are…”
Risk pervades every stage of the investment process and decision that you choose to take, or not to. In this case, BASE jumpers are shortcutting the entire process instead of taking a methodical approach to practice the sport.
In PC games players have a life meter that indicates their health level. Pretend that as a risk meter, with 0% indicate zero risks and 100% as the maximum. Whenever someone executes a BASE jump or buy a share, the risk meter goes up, otherwise, it stays close to 0% since you won’t lose any money. That’s why during market uncertainty, investors would reduce their risk by selling all their positions and go 100% cash. That’s how things work right? Not really.
The risk meter actually represents the entire process, not only when you are in the market, but every factor that changes your behavior and options. Therefore, if you are shortcutting the process, the meter doesn’t reset itself back to 0% but stays at 20, 30 or 40%. When you’re back in the market, any market risk will add on to that 20-40% baseline. And the problem is all these risks are not obvious.
“Athletes are free to define—and push the limits in—their pursuits however they want. This freedom is a double-edged sword. On one hand, it fosters a creative, artistic approach to these amazing objectives. On the other hand, it has resulted in a culture that constantly needs to take bigger risks, make bolder decisions, and ride narrower margins of safety.”
Investing is similar to this sport in that there’s no limit to how much return one can make. You would’ve heard how someone turn $100k into a few million in a short span of time but what’s unknown is how much risk has been taken to achieve that. That’s why you would see some investors making a truckload of money in a bull market and got decimated overnight when things turn.
“…the fame, attention, and corporate sponsorships that come from pushing the boundaries help eke out a living—often a modest one. Reaching a certain level of significance in most of adventure/extreme sports, however, has gotten exponentially harder, if also more dangerous…I think that as soon as you make being an ‘action-sports athlete’ your profession, there’s a huge risk factor…”
Same as how livelihood can push these athletes to do dangerous things, a full-time investor that relies on investing as an income will have a different risk profile from one that doesn’t need the money for the next 15 years.
When something reduces optionality (i.e. livelihood, leverage, career), it changes behavior. Fund manager doesn’t always do what’s in the best interest of their clients when their career is on the line. A classic example is buying overvalued blue-chip stocks instead of undervalued unknown stocks. Because to the client, it is tolerable if you lose their money on a ‘reputational’ stock but unforgivable if it’s one that they never heard of. As the old saying goes “It is better for reputation to fail conventionally than succeed unconventionally”. Being aware of what can potentially limit your options, which in turn alter your behavior and the risk factor is the key.
“Glamorization of athletes who have passed creates a positive reinforcement for all of us as spectators in the audience to continue to follow in their path…Whether it’s conscious or not doesn’t even matter. It’s a positive reinforcement mechanism that has dramatic impacts on how we think about things and all the decisions that we make.”
Most risk factors are interconnected, in another word, they create positive reinforcement where one begets another. Just as factors like glamorization, eke out a living etc impact the decisions of these athletes, it changes the temperament of an investor as well. Here’s an example.
When a novice investor takes a plunge into the stock market, a new bull market leg (environment) has just started, and he will find that it’s not that hard to make money. As time passes, he becomes less risk averse and more confident (psychology) as most of his prediction turns out correctly. Assured of his investing skill, he spends less time (resource) studying the stocks he bought (fundamental) and more time checking share prices (fear of missing out FOMO) and finding ways to increase his profit. As his fortune grows, investing replaces his 9 to 5 job as the main source of income. Unfortunately, his living expenses followed the same trajectory, which increases his reliance on investing to maintain his lifestyle (livelihood). As he spends more time stressing about money, a friend suggested margin lending (leverage) to turbocharge his investment return. Well, he thought, since he has been winning all this time, and confident of his skills (hindsight bias), besides those credit card bills are piling up, so why not.
As you can see, all these factors don’t work in isolation but reinforce one another to create a vicious cycle that magnify the whole risk.
“…They’re not dying because they’re pushing the limit. They’re dying because of ignorance and complacency. It’s always easier to screw up on an easy cliff and an easy flight than on the hard one that you’ve trained for…I would say so many experienced wingsuiters are dying because they are trying to execute jumps with very low margin for error.”
Another insider offers his view on why experienced BASE jumpers are dying too. Our brain has a way of taking shortcut (heuristics) when making decisions, which is essential in our daily lives but can have huge consequences when the stakes are high and margin of error is thin.
“The reason so many wingsuit BASE jumpers believe that accidents won’t happen to them is easy to see: that mentality is a prerequisite to taking up the sport. It’s like marriage. No one gets married thinking that it’s going to end, even though the statistics show it might.”
Like BASE jump or marriage, no one is going into an investment thinking that it will end badly, but a fact of life is, the future is never certain. It is critical for investors to take into account as many likely scenarios as possible during their decision-making process.
Another great tool is Premortem. You would have heard of doctors performing a post-mortem to determine the cause of death. Premortem is the opposite that is to determine the cause before something happens. In the context of investing, investors will pretend an investment turn sour, describe how it happens and identify the potential causes of it. Premortem allows investors to test the validity of their initial assumptions and potentially avoid making some heuristic mistakes.
“Ian McCammon, a researcher at University of Utah, identified six “heuristic traps” that identify common errors made in backcountry situations. Interestingly, a lot of these traps could easily be applied to the wingsuit BASE jumping world.”
Heuristic or rule of thumb, is a way for people to make a decision quickly and efficiently to achieve their goals. We do that when we decide what’s for lunch, cash wash or DIY, drive or get an Uber and so forth. It works well when the situation is highly predictable, as it is for most things in our daily lives. But in cases like backcountry, BASE jump or investing, it can lead us down the dangerous path.
Here, Ian McCammon identified six types of heuristic traps in backcountry situations that are applicable to BASE jump. You can read it here and here. And guess what, they’re applicable to investing as well! One of the trap is called Social proof. This heuristic shows that we have a tendency to follow others when we are less sure about something. Sounds familiar? When you have no idea what you are doing, you buy when others are buying, and you sell when others do so. You follow the crowd!
That’s what this article is all about, to learn from the mistakes made by BASE jumpers so we don’t repeat that in investing.
All these lessons might seem a lot to digest so save this up in PDF version and refer back to it from time to time. The key takeaway here is, don’t shortcut the process and know what you are doing. Avoid those traps that trick you into thinking you know what you are doing when in fact you don’t. In short, tame your overconfident. How do you do that? Do premortem, look for differing and contradict opinions. Lastly, be aware of all the risk factors that affect how you make decisions.
Investing is a long-term game. A 10, 20, 30 years game, perhaps even longer. If there’s a 1% risk that will cause you to lose everything, and you’re constantly exposing yourself to it, you don’t need to be a mathematical genius to know you’ll surely meet one.