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The Curse of Complacency

I've been thinking about complacency a lot lately. We're approaching the 10-year anniversary of the collapse of Lehman Brothers, but with markets buoyant, it's hard to believe we might return to those perilous times. Allowing complacency to seep into markets generally doesn't end well, though. I also recently finished 'The Siege' by Cathy Scott-Clark and Adrian Levy, which details the 2008 terror attacks on Mumbai. A major theme through the book is that government authorities and administrators at the Taj Hotel, the scene of the worst casualties, failed to deal with mounting threats and visible loopholes, which were promptly exploited by terrorists. Complacency, quite literally, was a killer.

The Oxford Dictionary defines complacency as "a feeling of smug or uncritical satisfaction with oneself or one's achievements." I actually see at least six overlapping varieties of complacency:

1) "I'm so good or lucky that nothing bad could ever happen to me." This kind of complacency is essentially hubris. You see it most often in young people, who have yet to encounter misfortune, but it's equally apparent in a certain type of self-assured individual (mainly men).

2) "Things have been good for so long. They're not going to change." Types 1 and 2 are both kinds of extrapolation errors, but they're a little different. I distinguish them in that the first centres on one's own perceived personal excellence, whereas type 2 is more about faith in the general environment. Type 1 is a hedge fund manager who thinks he can't make a mistake; type 2 is a retail investor who believes that stocks will go up, not because of his own refulgent intellect, but because, well, stocks just go up, don't they? This can further be broken down into a passive complacency and active complacency. Passive complacency is best described by Nassim Taleb's description of a turkey that assumes life is going great until Thanksgiving comes. There's also active complacency, where people deliberately take more risk because things have been fine for a while. In the financial system, for example, Hyman Minsky warned that stability breeds instability.

3) "Things have been good for a while. I know they could change, but it's hard to imagine how bad things might be when they do." In some ways, this is a failure of imagination. The legendary macro trader Bruce Kovner said, "I have the ability to imagine configurations of the world different from today and really believe it can happen." Most people find that a much harder task. It's also hard to imagine how truly bad things will be if those bad scenarios materialize. For example, most people seem to accept that man-made climate change is occurring, but it's really tough to imagine what kind of non-linear phenomena may occur with a seemingly small change in global temperatures.

4) "Things have been good for a while. I know they could change, but it's hard to remember how bad they were the last time something went wrong." Some forgetting is healthy - when we are scarred permanently by a bad outcome, it sometimes prevents us from acting rationally in the future. As Mark Twain said, "We should be careful to get out of an experience only the wisdom that is in it and stop there lest we be like the cat that sits down on a hot stove lid. She will never sit down on a hot stove lid again but also she will never sit down on a cold lid anymore." But it's fairly remarkable that some people seem to forget just how gut-wrenching it feels when, to cite a relatively trivial example, your portfolio declines by 30-40%.

5) "Things have been good for a while. I know they could change, and that it's going to suck when they do, but I'm too relaxed and/or lazy to prepare for trouble." Most people have some sense of historical perspective, or at least pay lip service to the possibility of bad outcomes. But they don't believe those outcomes are very likely, or other priorities intervene in preparing for those outcomes. When things are going well, who has the time to focus on the negative?

6) "I know deep down that things are changing, but change is scary, so I'm going to resist it as long as I can, and maybe things will work out ok." This is ostrich-like, head-in-the-sand stuff. I'm not sure it's technically complacency, but I think Tyler Cowen might use a similar definition in his book 'The Complacent Class', which details the decline of American dynamism.

Which of one these are you most susceptible to? I rarely fall prey to Types 1 and 6, but am often guilty of Types 2-5. That's a bit embarrassing for someone whose blog is named for George Soros's line: "I consider myself an insecurity analyst... I realize that I may be wrong. This makes me insecure. My sense of insecurity keeps me alert, always ready to correct my errors." I'm usually sufficiently insecure about the correctness of my opinions, but not always diligent enough to act on them.

A caveat: it's worth noting that not all bad outcomes are the result of complacency. Sometimes future outcomes are really unforeseeable, even though we think they're obvious in hindsight. My go-to in this regard is the 2008 financial crisis, which received wisdom today sees as inevitable given excesses in the system. My preferred theory is that while some kind of crisis was highly likely, its depth was exacerbated by monetary policy errors stemming from the zero lower bound of interest rates and concerns about high oil prices. A far more colourful example: Morgan Housel tells the remarkable story of how German tanks outside Stalingrad were rendered inoperable by field mice which had eaten away the tanks' electrical insulation. That one was really hard to predict!

Sometimes, it may also be too costly to take action. It's easy to feel outraged at the inaction of government officials when terrorist attacks occur, but it's hard to know what the trade-offs were. Do you spend $100 million on defense, or do you spend it on education? Another kind of cost is when the world really is getting better. I'm quite firmly in the Steven Pinker camp: by many metrics, the world is radically better than it used to be, and so we should update our priors accordingly. If we overweight the odds of a negative outcome, we may overpay for insurance (in all senses of the word).

Still, we need to make an effort to reduce harmful complacency. Here are some steps that I try to incorporate in my own life to varying degrees of success:

a) Read history. When you read history, you see alternative worlds that could have played out, and how improbable sequences of events occur. The aim is not to fight the last battle; it's to realize that the last battle was different from the one before it.

b) Keep a diary/decision journal. This helps remind ourselves of just how bad certain things can be, so we don't fall into the same trap again.

c) Rigorously, relentlessly consider your preconceived notions, and formulate alternative scenarios. Back to Bruce Kovner again: "One of the jobs of a good trader is to imagine alternative scenarios. I try to form many different mental pictures of what the world should be like and wait for one of them to be confirmed. You keep trying them on one at a time. Inevitably, most of these pictures will turn out to be wrong - that is, only a few elements of the picture may prove correct. But then, all of a sudden, you will find that in one picture, nine out of ten elements click. That scenario then becomes your image of world reality." I've found this motif recurring in Asian philosophy. In Zen, Manjusri uses his sword to cut away old opinions, habits and patterns. Zhuangzi wants us to break the shackles we place on our own understanding. And modern science is catching up. Michael Pollan's fascinating new book suggests that certain states help us break out of these mental ruts (I'm not quite ready to jump on board with psychedelic drugs, but Pollan talks about other possibilities).

d) Understand statistics; pay attention to fat tails. The world we know is just one of many possible "draws" from a variety of worlds, so it helps to think probabilistically. But most of us aren't very good at that. Learning more about probability and statistics is helpful - not to focus on a solitary measure of expected value, but to develop a deep appreciation for variability and fat tails.

e) Surround yourself with good risk managers. This isn't the same as surrounding yourself with worriers. As I said earlier, there are emotional costs to worrying and trade-offs implicit in every course of action. People who constantly worry also run the risk of becoming the boy who cried wolf - it reduces the impact when they warn of genuine threats. But I believe that we can train ourselves to be better risk managers, so don't just dismiss people as worriers - try to help them understand why you feel differently (and recognize that you're going to be oblivious to your own errors).

f) Identify the "little bets" of complacency. Some kinds of action are costly, but many aren't, and some of these have very asymmetric payoffs (or avoided costs). A good recent example: my wife pointed out that my phone charger was fraying, with exposed wires. I'd just been too lazy to replace it (Type 5 - ugh) but she pointed out that that kind of thing can lead to your phone getting damaged, or even worse, an electrical fire. A replacement charger cost £2 - I bought one the next day.

Inevitably, I'm going to get complacent about my complacency. But maybe, just maybe, I'll remember these the next time I know in my heart of hearts I should be doing something different.

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