The Independent Market Observer

New Market Highs: Intelligence Vs. Wisdom

Posted by Brad McMillan, CFA®, CFP®

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This entry was posted on Jul 13, 2017 4:09:33 PM

and tagged Commentary

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market highsYesterday saw another new high for the Dow, as well as big bumps in the other indices. The only real news, and what I consider the driving factor for those highs, was that Federal Reserve Chair Janet Yellen appeared a bit more dovish in her Congressional testimony than was expected. Given the low inflation we have seen, she said, the Fed is reserving the right to raise rates more slowly than it has previously indicated. Also, no time frame was given on starting to wind down the balance sheet. The result? Stocks proceeded to rally significantly. Think about that: with no real news about the fundamentals of corporate earnings or economic growth, a hint that the Fed might raise rates a bit more slowly drove stocks up.

It was, in many respects, a rational and even intelligent reaction. Stock prices are largely justified by low rates, with many investors expecting them to remain low indefinitely. Any information that supports that thesis—and Yellen’s comments did—should rationally drive prices up. Buying on that news was, apparently, the intelligent thing to do. The question I find myself wrestling with, though, is whether it was wise.

What’s the difference between intelligence and wisdom?

Although I think most of us know it when we see it, the difference between intelligence and wisdom is tough to define. Here’s one way I think about it: when you face a question you haven’t seen before, intelligence allows you to figure out the right answer; wisdom helps you realize that the question itself is wrong.

It’s in this context that I'm considering yesterday’s market action. Buying the market’s rise on Yellen’s testimony was intelligent if the question is, “How will the market respond to this?” The answer was, “go up.” Was that, however, the right question to be asking?

What we should be asking

As readers know, I expect the economic expansion to continue for a while, probably through the end of the year or longer. But I have growing concerns that we are nearing the end of the cycle. As investors, I think we should be asking, “What does it mean that the Fed has these concerns?” The wise response is to look at the bigger picture.

According to how the economy is generally understood, long expansions and resource shortages should lead to higher inflation. We are not seeing that. In fact, we are seeing the reverse. What this means—and what the real concern should beis that our understanding either of fundamental economic relationships or of what is really happening in the economy right now is somehow flawed. My own thought process is trying to figure out what that flaw is and what it might mean for the future.

Inside versus outside

Another way to think about the difference between intelligence and wisdom is in terms of the difference between the inside view and the outside view. Daniel Kahneman famously proposed that the outside view, which takes into account data beyond the immediate situation, including other similar situations, can yield superior results to the inside view, which focuses only on the immediate. Here, again, the immediate situation (rates lower = buy stocks) is quite possibly discordant with the bigger picture, which would focus on other situations where resource constraints did not lead to higher inflation. Usefully, this gives us an area to try to find the flaws in our thinking.

Short-term results versus longer-term consequences

You could also think of intelligence as focused on the short-term results, while wisdom also keeps an eye on the longer-term consequences. How many of us can look back, especially at our teenage years, and remember decisions that optimized the short-term desires at significant potential risk to longer-term outcomes? I know I can!

In the short term, intelligence is certainly working. But in the longer term? We need to keep asking ourselves if the questions we are answering are the right ones. Asking the right questions is what ultimately leads to investment success, while asking the wrong ones leads to the reverse.

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