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(Bloomberg View) – Why are investors so often surprised?

Astonishment, shock, alarm, disbelief, wonder, amazement – pick any synonym you want, we seem to be genuinely surprised by what can only be described as ordinary events. At least, that is how things look when emotions are no longer running high and in the cool light of hindsight. There are in fact many reasons that help explain unfolding events in ways that are rather curiously described as "unexpected."

As investors we have an incomplete understanding of the world around us, assume we know the drivers of complex systems such as markets and economies, and underestimate the potential for significant random events to occur. We investors also think we are apart from – yet understand – crowd psychology.

Let's put this into the broadest possible terms. Your mental model of the world around you is, at best, incomplete and often is inaccurate. To paraphrase the statistician George E. P. Box, all models are wrong, but some are useful.

Most investors carry in their heads an imperfect model of markets. It allows them to function most of the time (though just barely). However, there are times when the flaws in investors' understanding become apparent, and chaos seems to reign. Laments of "uncertainty" are the pundit's response. It is nothing of the sort.
The word uncertainty, when spoken by befuddled pundits, usually means they are coming to grips with their own imperfect mental models. Most of the time, they have fooled themselves into believing they understand what's going on. But they don't. This is when they are forced to admit to themselves – however briefly – that they haven't the slightest idea what is happening. They shrug it off as uncertainty, instead of admitting the truth.

Survival and reproduction never required you to develop a perfect model of the world, hence, your ancestors never did. "Good enough" was enough to allow them to pass their genes along to their progeny, including you. This is why you can still accomplish so many amazing things, despite your highly imperfect model of the world.

This is very significant in the capital markets, where good enough is a (surprisingly) high bar, indeed.

Consider a professional baseball batter's internal physics engine; that is his model of the world. He doesn't need to know the spin of every electron around him; he merely needs to correctly understand the speed, direction and aerodynamic action of a thrown ball good enough and often enough to make contact. If he does that more often than other batters, we call him a good hitter; if he does this a lot more, he becomes an all-star. But he doesn't need to have a perfect model in his head, just one good enough to understand where the ball will be as he brings his bat around.

Similarly, investors don't need to perfectly understand the universe to be successful. They need only understand enough so that they can achieve whatever specific goal they set for themselves.

Here's the problem: Good enough for a specific task – batting, driving, investing – requires only a narrow understanding of a relatively small subset of factors to achieve success. One doesn't need to know everything about, well, everything, to be reasonably successful at these tasks.

But there are times when investors' good-enough models do a poor job of explaining events. So far, 2016 seems to be one of those periods. It isn't all that surprising.

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