Tuesday, July 10, 2012

It's Not All Bad ... Hang In There but Beware of the "Planning Fallacy"

The Euro Crisis In Ourselves is a timely read. It's also contains solid advice for us when listening to the daily drumbeat of bad news coming from Europe.

Along those lines, a wise man told me once to always remember two things: (1) when it's great, it's not that great; and (2) when it's bad, it's not that bad. He was right on both counts.

And so it is with the economy, markets, politics and other sordid bad news items making the rounds these days. Here's what the article says about hanging in there:

"Here's just one gauge of how uncertain business is about the risk posed by Europe's slouch toward the abyss:

For months, companies . . . have been moving excess cash out of continental Europe. That isn't a great show of faith in the euro zone. But who wants to face angry shareholders if the worst actually happens—if Greece breaks away and devalues, the banks fail or the currency collapses.

Measuring this kind of mega-uncertainty, and making rational decisions, is tricky for business. Research shows that, for better or worse, we still deal with risk chiefly through gut instinct. And what the gut is likely telling business in this instance is both time tested and not exactly inspiring: Suck it up and muddle through.

Our "intuitive feelings are still the predominant method by which human beings evaluate risk," two psychologists, Paul Slovic and Ellen Peters, wrote in 2006. "Most risk analysis in daily life is handled quickly and automatically by feelings arising from what is known as the 'experiential' mode of thinking."

"What are the robust principles that apply here? . . . One is that people typically do the natural thing, either what they've done in the past or what other people are doing."

How will we react when history presents us with uncertainty and risk? A sign on a Stalin bust in Prague in 1989 reads 'Nothing Lasts Forever.'

Business has weathered similar crises abroad with the same sorts of incremental moves companies are using in Europe today—moving cash home, keeping inventories lean, trimming costs, bracing for slow sales. If Europe slides into a prolonged downturn, those steps will multiply.

That's how business coped with smaller financial crises in Russia in 1998, Asia in 1997, and Latin America over several decades. Add to that tally the collapse of the Soviet Union in 1991, China's convulsions in 1989, and the global oil shock in the 1970s, among other calamities.

Few businesses can turn away from so large and developed a market as Europe. Its politics are adding risk. But its special attractions reduce uncertainty. The rule of law is at the top of that list.

Add cultural affinity with the U.S., strong institutions committed to stability, and companies deeply integrated with U.S. business and the global economy. There's a lot of overlapping self-interest.
"The likelihood of the euro zone falling apart is near nil," says Ian Bremmer, president of Eurasia Group, a political risk research firm. "The countries we're talking about in the euro crisis are fundamentally stable countries."

Beware of Planning Fallacy

How might the business mind nonetheless trip up in euroland? Researchers offer plenty of ways:
The psychologist Daniel Kahneman writes that humans naturally "tend to exaggerate our ability to forecast the future, which fosters optimistic overconfidence," something he terms the "planning fallacy."

"In terms of its consequences for decisions, the optimistic bias may well be the most significant of the cognitive biases," he notes. "When forecasting the outcomes of risky projects, executives too easily fall victim to the planning fallacy."

We may just be too overconfident about handling the dangers in Europe.

Mr. Fischhoff says a herd mentality in reacting to the crisis and "unrecognized assumptions" are possible trip wires. . . .

Some say the ejection of Greece wouldn't endanger the euro. Is that an unrecognized assumption?
Then there's the physiological. John Coates and Joe Herbert measured the levels of cortisol—a hormone released during stress—in traders at a London options desk. Cortisol levels jumped when the brain sensed uncertainty.

Messrs. Coates and Herbert note that if cortisol stays elevated for extended periods, it can inhibit rational decision making and "produce a tendency to find threat and risk where none exists."

These days, volatility in Europe is bathing the brains of business people in cortisol.

Yet during particularly fearful moments humans can also overestimate the likelihood of the worst happening. The legal scholar Cass Sunstein, who currently heads the White House's Office of Information and Regulatory Affairs, studied this in regard to instances of terrorism. His findings could also be applied to the worst expectations about the Europe crisis.

In the Journal of Risk and Uncertainty, he writes that humans are prone to "probability neglect, especially when their emotions are intensely engaged.... When probability neglect is at work, people's attention is focused on the bad outcome itself, and they are inattentive to the fact that it is unlikely to occur."

A cataclysmic economic collapse in Europe is unlikely to occur, though intense anxiety levels in some circles would suggest otherwise. This may just be an instance of probability neglect.
Maybe things aren't as bad as people think."

Summing Up

While nobody knows the future, and while Europe is a mess, this too shall pass.

Same with the U.S. situation. It's self inflicted as well.

That which we've done to ourselves can be undone.

Even the free lunch, big government knows best and entitlement debt ridden mentality and way of life.

So keep the faith. And by all means, hang in there!

That's very much my plan.

Thanks. Bob.

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