The Uncertainty Solution with John Jennings (EP.112)

0:28We all need to make smart decisions with our money. and family office. He is also the author of a great new book called The Uncertainty Solution. And John's going to join the show to explain some of the ideas in his book with how to invest with confidence in what are inherently uncertain and unpredictable markets. So we're definitely going to talk a little bit about how humans react to uncertainty, the difference between the economy and stock market, and the role of skill in luck in investing outcomes. As always, you can access us show notes of everything that we mentioned in the episode at thelongterminvestor.com.

1:03And with that, here is my conversation with Jon Jennings. Jon Jennings, welcome to The Long-Term Investor. I'm excited to be here. Thanks for having me, Peter. Well, I know that you're probably only about a mile away from me. We could have maybe done this in person, but I was so excited to make sure we had the conversation about your new book, The Uncertainty Solution. And let's just dive right in. What are some of the things that we silly humans do when we're facing uncertainty? Yeah. So first, let me describe basically what it means when we're feeling uncertain. And it really means that we're having trouble recognizing a pattern.

1:44So we've evolved to be this pattern-recognizing species. And when we can't recognize a pattern. We feel anxious. We feel worried. And really what we try to do is find a way to resolve the uncertainty. So in fact, the resolution of uncertainty, or you can think of it more, flip it on its head, as the quest for certainty is a primary human motive. So even if you don't realize it, it underpins a ton of our behavior and our decision-making. And some of the things that we do when faced with uncertainty that aren't really helpful or productive and can be counterproductive are things like we search for closure.

2:26So we have what's known as a need for cognitive closure. And the way this works is we want the world to make sense and we want to have explanations. We want to see cause and effect. So what happens is when we feel uncertain is we kind of search around for the first explanation that fits our worldview. And then we say, that's the answer because now we don't feel uncertain anymore. And that's called seizing. And then once we have seized on something, we freeze on it, meaning that we do not want to change our reasoning or our explanation because then that will throw us back into uncertainty. So a great example was during COVID, right?

3:07So when COVID was spreading and we were all feeling incredibly uncertain. Like, what's going to happen? Is this going to become a pandemic? Is this more like the flu or is this more like the Spanish flu that, you know, that occurred back in 1918? We all were looking for explanations and we tended to grasp whatever was fitting our worldview, our social group, and then we wanted to stick with it. Even when the science changed or the virus changed, we didn't want to revisit our explanation for how to view what was happening with COVID. So it's a perfect example. It happens in financial markets and in all areas of life.

3:42So that's just one way that we approach uncertainty that isn't necessarily helpful. And uncertainty is really all around us. The world is uncertain. And I think you talk about when we seek that closure with our brain, it's so uncomfortable to be uncertain, whether it is about our personal life, markets, the weather, whether your flight is going to be on time, how political events turn out, economic events, etc. And social media certainly makes it all the more easy to seize an idea that already fits your worldview. And I think that's really challenging for investors. And they're just constantly looking for these cause and effect links, as you mentioned.

4:22But there are some issues with trying to determine causation, don't you think? Oh, absolutely. There's huge issues trying to determine causation. And again, as a species, we like to see patterns. And so we like to have explanations, which means we like to have causes. So if A happens and then B happens, as human nature, we jump to A cause B. But there's all sorts of different things that could have caused B that wasn't necessarily related to A. And this really gets back to, you know, we all have heard or been taught, if we take in statistics, that correlation isn't the same as causation. And we can all state that.

5:07but it becomes harder to apply in practice. It really does. So there's other things like there's, you know, sometimes A and B are symptoms of the same underlying cause, right? Or it could just be a spurious correlation. So A and B could be happening and it's totally separate. And in my book, I talk about a story that happened and I was at a conference and I ended up talking to someone and Peter, you go to investment conferences, you know how this is. You have like this day of speakers and then you have like this cocktail hour and then like this dinner. So, you know, I'm drinking this like nondescript conference wine.

5:41I'm talking to this woman and I'm like, you know, what does your firm do? And she was the CEO of an investment firm. And she says, what we do is simple and very effective. We only invest in publicly traded companies that have strong female leadership. Either number of board members, CEOs, president of the company, they're females. Because research has shown that female-led companies outperform non-female-led companies. And I was like, wow, that sounds amazing and really compelling. So I came back to work after the conference and I spent like a few days digging into this when I had time. And yeah, there's all sorts of research that shows that female-led firms outperformed male-led ones.

6:21And there are different indexes of female-led firms and they did better than the S &P. Like over the prior five years when I looked at this, crushed the S &P. I was like, wow, that sounds amazing. And some of the reasons why – in the research why they guessed why female leadership caused firms to outperform is, you know, 70 % of consumers' decisions are made by females. And maybe female leaders are more in touch with their fellow females. Maybe because females are more risk adverse, maybe that's a better management style to take less risks. Maybe your firm doesn't blow up or make bad decisions.

6:56Or maybe because there's this glass ceiling, if you are a female and you've risen to the C-suite or the board of directors of a company, I mean, you've had all these obstacles in front of you. So maybe you are more talented than your male counterparts, right? So there's all these reasons. There was others as well. And I remember I went a few days later and I met with one of my clients who is one of the smartest people I know. He was the CEO and president of and chairman of the board of a Fortune 500 company. And I told him about this and he said, are you sure there's a causal link there? Like what if they're just – they're correlated or maybe they share a common cause.

7:31And I'll tell you, like if it weren't for how much I hold this person in high regard, I probably would have just argued back because I was pretty certain. But I went and did something that was really hard, which was fought my confirmation bias. But just because I so held this person in high regard and I researched the opposite side. And guess what? there is some evidence and some research that says that female leadership is a symptom of a high-performing firm and not a cause. And a researcher from Northwestern who's a female posited this and had some reasons for this. And a psychologist looking at this said, you know, maybe it's that once you're a high-performing firm, then you have the resources to start focusing on things like gender diversity.

8:20And at that point, you say, it's important for us to signal that we think this is important, but you're already high performing. Now, the jury's out. So there needs to be done what's known as longitudinal studies to really tease this out. So I'm not saying that female leadership isn't superior in terms of causing a firm to be high performing. Our CEO, I'm president. Our CEO is a female. We have females on our board. We are 70 % female at firm. I'm a big fan of female leadership, which is, I think, part of the reason I jumped to the conclusion that it caused it. You know, I kind of wanted it to, given our leadership.

8:53But it was really telling when I went and looked at the other side to say, hey, maybe they have a common cause. And the point of me telling the story in response to your question is really to highlight how hard it is to determine causation. Because it does look in a situation like female leadership is causing outperformance. And then there's some explanation for it. And it's like, mic drop, done. But maybe not so much. And I'll tell you, since then, at least as of about a year and a half ago when I last looked at it, over the last three to five years, the female leadership index has actually underperformed.

9:28Again, not dispositive, but just interesting. What a great example of something that seems to be causing another thing. And especially if you're open to that viewpoint, open to that link of cause and effect, it makes it that easier to grasp. And kudos to you for listening to what sounds like a thoughtful gentleman to make you look at the other side. And I know that, and you probably experienced this too, when we're speaking with investors, a really common link that people make that you and I both know just isn't true is the economy and the stock market. Can you talk a little bit about that? Yeah, exactly.

10:06And let me set up kind of this correlation causation and why in my book I talk about the economy versus the stock market and why we started talking about uncertainty. So the premise of my book is that humans dislike uncertainty and we act in some counterproductive ways in the face of uncertainty. And by my book being called The Uncertainty Solution, the solution isn't that I provide certainty. I don't think I'm able to do that. But instead to say that as investors, we're better off focusing on what we can control and what we can know. So in my book, I have 35 what are known as mental models. And I've found that great investors and great decision makers in all areas of life fall back on what's known as mental models, which are just models we keep in our heads of how the world actually works.

10:55And so the stock market is not the economy is a mental model that when you feel uncertain, that you can fall back on to make better decisions. And I think this is the most important investment-focused mental model in the book. And really what the mental model says is that the stock market and the economy are not correlated. So if you look at what's happening in the economy, so for instance, if you look at GDP growth, which is a measure of how the economy is doing for a calendar year, and then you look at what the stock market does, the correlation since World War II is 0.03. And since my birth in 1970, it's like 0.05.

11:34So it's basically zero. And when something is not correlated, when two things are uncorrelated, it means how one is acting doesn't tell you how the other is going to act. So what that means is what's going on in the economy currently, or what we think is going to happen in the economy in the future, does not tell you what the stock market is going to do. But interestingly, there's research from Credit Suisse. And I'll tell you, like in a few years or decades, people won't know what I mean when I say Credit Suisse. Unfortunately, they were kind of subsumed by UBS, you know, a great storied firm over in Geneva.

12:07But anyway, Credit Suisse looked at it and said, hey, what would happen if we took the prior year stock market returns and compared them then to the following year economic growth? And then the correlation jumped to like 0.6, 0.65, depending on the time period. So what this says is the economy doesn't predict the stock market because they're uncorrelated in real time. But the stock market predicts the economy-ish. Like it's not always right. And again, it's just ish in terms of direction, not in terms of how much it's going to be up or down. But it sort of makes sense. So what's happening is the stock market is anticipating what it thinks the economy is going to be doing, you know, a few quarters, even a year ahead.

12:50And we saw a perfect example of this in 2020. So going into COVID, the stock market high was on February 26. It fell about 34 % between then and March 23. So what was happening on March 23, in the real world, in the economy? So we had about our thousandth reported death. The thousandth death occurred three days later, according to reports. And if we had a crystal ball, so basically, Peter, if you and I were sitting there, we had a crystal ball. And it didn't tell us what the stock market was going to do, but it would tell us what's going to happen in the real world and the economy. And our crystal ball says, hey, guess what?

13:25Next quarter in Q2, GDP is going to decline by 8.9 % in one quarter. Unemployment is going to spike to 14.7%. Unemployment claims are going to go over 3 million. We're going to have over 300 ,000 US COVID deaths by the end of the year and over 6 million globally over the next three years. International travel is going to be canceled. We can't even go to Canada. I mean, holy cow. Entire industries are going to be decimated. Pro sports teams are going to cancel and on and on. And it's not going to go on for weeks. This is going to go on for years. I think we would be like, OK, we should just put everything in, I don't know, gold or under our mattress, right?

14:03But that was the stock market bottom on March 23rd. And the market rallied by 70 % by the end of the year. And that happens over and over. We saw it happen in 08, 09. And people always say, stock market doesn't make any sense. The news is bad, but the stock market's good. The news is good and the stock market's bad. And the reason is, is they're uncorrelated in real time. And the stock market is somewhat predictive of what will happen in the economy, as is, you know, the bond market and how you use this. You could, as an investor go, well, that's useless. That's a useless mental model, Jennings.

14:38I have no way of reading your book. That's dumb. Well, it's actually incredibly useful because what it tells you is that you should be a disciplined investor and you should follow your strategy regardless of what the news is. And the way we use this, I'll tell you, on March 26th, so three days after the bottom, I wrote an article in Forbes called, even though a recession is looming, it does not mean you should sell out of the stock market or something like that. And I made these points on the stock market is not the economy. And the way we advise our clients was let's ignore what's going on in the real world, I mean, in terms of investing.

15:11Let's go ahead and follow the strategy. Let's rebalance. Let's act like the world's not going to end. And it worked out great. And I've been asked, you know, really later that year, people said, oh my gosh, you called the bottom. You wrote an article saying don't sell the stock market basically three days after the bottom. How did you do that? I'm like, no, no, you're missing the point. I didn't say the stock market was going to bottom. I said I had no idea, and nor did anybody else. And that is how we should invest. And we should remember that, that we don't have any idea. And that's really an incredibly important tool.

15:46And it should be freeing for investors. So you don't have to find an investment advisor that can predict the future, because good luck with that, right? And you don't have to completely keep up and read the Wall Street Journal every day and watch CNBC and have to know exactly what's going on in the economy to invest well. In fact, kind of ignoring all that probably will help you invest better. John, you and I have had the opportunity to speak before. And so I know some of your thoughts on this before I even ask. But one thing that strikes me about people like you and I, who do a lot of reading, who are continuous learners, is that we recognize that investing can be a very complex activity.

16:26And ultimately, as you learn more and more, and even see the market through the eyes of something like a complex adaptive system, the more eloquent a very simple solution to investing can be. And some of your statements of, hey, we can't know where anything is going to go. You need to focus on what you can control are really, in my opinion, driven a lot by the understanding of the concept of complex adaptive systems. Now, this is a slightly more technical concept. So let's try to keep our listeners with us here. Why don't you start us off by describing how you think of the market or just as complex adaptive systems to start with?

17:05Well, I'll tell you a basic problem that economists have trying to predict the economy or investment experts have trying to predict the stock market, is they want it to be like physics. And they have, you know, really economists in particular have what's known as physics envy. So you read these economics papers, and they're full of all these formulas as if there are these immutable laws and rules, kind of like the, you know, Newton's law of gravitation of motion or that are going to happen and occur all through time. And that's just not the case that the economy and the stock market are more like biology, where you have evolution, right?

17:44So there are definitely patterns in the stock market and economy. We do see cycles of boom and bust and growth and decline and crashes and bubbles. Like, we absolutely see that. So there are some patterns. I don't mean to say that everything is completely random. But the amplitude or how high or low things go and when they turn and when they change are things that cannot be consistently predicted. And a key reason why that is, you mentioned complex adaptive systems, and that's what the stock market and economy are. And really what that means is that you have a bunch of different inputs that as they interact can result in system like effects that are unpredictable.

18:26And it especially happens in complex social systems like the stock market or economy or even politics, where you have a bunch of individuals that are intelligent. And what I mean by intelligent is that they learn and they're watching everybody else. So we can't treat the stock market or the economy as some static thing that when A happens, B will always happen because people will notice when A happens, B happens, and then they will change what they do accordingly, either to profit or avoid loss. And then that pattern becomes destroyed, or at least the ability to profit on it. And so an example of this was, again, to use COVID, which has so many different examples, is toilet paper hoarding.

19:09So the chapter you're referring to is called Why the Stock Market is Not the Economy and What Toilet Paper Can Teach Us About Investing. So as you recall, what happened early in the pandemic, you know, in March, is you couldn't find toilet paper anymore. So you had these situations and these, you know, these great pictures where people go to, you know, Costco and Walmart and Target and they'd load up and they'd have these two shopping carts full of toilet paper. And, you know, who knows why toilet paper was what was being hoarded. So like, seriously, like if it was a few years ago, Peter, we were sitting here on this podcast and I said, hey, Peter, if we would happen to have a pandemic, like what would you want to buy to prepare?

19:48Right. And it's interesting. In 2017, I actually wrote, I read a blog and I wrote a blog post in 2017 or 2018 called Pandemic Preparedness 101 and said, guess what? The CDC says at some point we'll have a pandemic and here's what you need to do to prepare. By the way, I did none of them prior to COVID, even though I wrote a blog post on it. But like I didn't list, go buy a bunch of toilet paper. It was things like maybe have some cash, you know, around your house. And I said, have some masks, maybe N95 masks. So I did nail that one, even though I didn't do it. have water, have canned foods like beans.

20:22I didn't say in the blog post, but maybe have some beer or whiskey, right? Or, you know, now that it's legal, maybe have some cannabis or, you know, whatever is going to help you make it through the pandemic. But toilet paper wasn't one of them. So somehow, some way, the spark happened. And I'm not talking about the spark of life that then there's evolution. I'm talking about the spark that caused people to start hoarding toilet paper, Completely irrational or somewhat irrational. But then once it started, it became rational to buy whatever toilet paper you could get your hands on. And I did it too.

20:53In April, I went to pick up a prescription at Walgreens and there was one package of toilet paper. I couldn't believe it. I bought it. And I was checking out. I tell the clerk, I'm so sorry I'm buying this because we have plenty of toilet paper at home. I'm being part of the problem, not part of the solution. And that's not how I see myself. But I'm going to buy it anyway. And she like looked at me kind of like, why don't you take your possible COVID breath and move on, right? But like I bought it. So I think it was completely rational to buy a package of toilet paper when one existed, but it caused this irrational system-wide effect.

21:23And so what you had is you had everybody watching everybody else. I only bought toilet paper because everybody else was buying it. And then my action and everybody else's rolled up to cause this adaptive behavior, created this system-wide effect of there being a toilet paper shortage, which created a feedback loop, which caused everybody else to even more want to buy toilet paper, right? And that is a complex adaptive system in action. And that's what happens in the stock market. I mean, we saw it with like GameStop and AMC, probably most cryptocurrencies at this point. Who knows? I mean, who knows?

21:59I mean, Dogecoin, I mean, the thing was started as a joke and Elon Musk tweaks about it and it spikes in value. And it's because people think other people will think it's worth something. That's a complex adaptive system. And it happens even in real stocks as well. Like you look and you think, oh, people think this is valuable. So other people will think it's valuable as well or on the way down, et cetera, et cetera. So it's pretty fascinating. But what it tells you and the main takeaway from a complex adaptive system is that it's really hard or even impossible to predict system-wide effects because it's too complex to model all the millions or billions of actors that are intelligent, that are reacting to stimuli, watching each other, watching each other, and reacting to feedback loops, which means that you should be pretty skeptical of predictions of what are going to happen in complex adaptive systems.

22:52I love the toilet paper story. I remember reading it when you first published it on your blog, then obviously again in the book. And the thing about complex adaptive systems that people really fall victim to with those predictions is that they place so much emphasis on just a few specific data points that allow for a narrative to closely link cause and effect. And complex adaptive systems, when you take all those inputs, they suddenly take on these additional characteristics that can't be accounted for by simply weighing the individual parts. And I think that's what a lot of people when you really start to appreciate the market as a complex adaptive system, that's a really big piece.

23:32And then you can ignore predictions and you can assume that chaos will eventually occur. So it's important to have a plan in place. You can't really worry about when or why it's going to occur. I was first introduced to this concept by Michael Mobison. You make reference to what is also one of my favorite investment books, The Success equation in your book. And another important idea that Michael Mobison talks about is the skill luck continuum. So by the way, he also writes a ton about complex adaptive systems. For people listening to the show on any podcast platform, I actually have a couple episodes, I believe episode 70.

24:08And if you're watching on YouTube, you can go to the longterminvestor.com. But as we transition into another great big idea, the skill luck continuum, there's really two questions that can help people sort of untangle how much skill and how much luck is contributing to outcomes. Could you talk a little bit about that? Yeah. And I'll tell you, again, this is all Michael Mobison. So like I quote him heavily, not just that one book, but some of his other books, you know, he's an amazing thinker that a number of his concepts have really had a big impact on how I view the world. And I think beneficially in the skill luck continuum says on one side are things that the outcome is determined purely by luck.

24:48So think roulette or the lottery or slot machines. And at the other end, there are things that are determined entirely by skill, like chess or close to all skill would be a running race. Somebody that's faster will beat somebody that's slower, swimming, things like that. And then towards the skill side is more sports and towards the luck side is investing. And there's definitely skill in investing, no doubt. But there's a huge luck component, much more than there are in sports. And think about how much the luck there is in sports. Like I'm a huge St. Louis Blues fan. And there's nights that we lose by one, but we hit the post three times.

25:24Or you watch football and the game-winning field goal doinks off the uprights because there's a gust of wind, right? So there's definitely luck in the results of all these things. But there's two questions he asked that I think are so great to tell whether something's mostly skill or mostly luck. And the first is, can an amateur beat a pro? So if you think about it, like I don't play chess. So if I learned chess and then played against my nephew, who's an expert chess player, like he'd beat me every time. Absolutely. Whereas like I'm also an amateur slot machine player because I don't play slot machines.