An Investor's Guide To Confidence Ft. Professor Peter Atwater

When big events happen in the markets, analysts and economists try to discover what led to those events. But accurate forecasting is a far harder skill to master, and Professor Peter Atwater, behavioral economics pioneer, suggests that what we see so easily in hindsight could be easier to see in the present if only we looked through the right lens.

TRANSCRIPT

Oscar Pulido: Welcome to The Bid, where we break down what's happening in the markets and explore the forces changing the economy and finance. I'm your host, Oscar Pulido.

When big events happen in the markets, or even in history, analysts, economists and journalists set out to discover what led to those events, often working backwards, organizing a chain of events into a logical timeline. But on the flip side, accurate forecasting is a far harder skill to master, and our guest today suggests that the same deciding factors we see so easily in hindsight could in fact be easier to see in the present if only we looked through the right lens.

Peter Atwater is a behavioral economics pioneer and professor of confidence driven decision making at William and Mary and the University of Delaware. His latest book, the Confidence Map examines the hidden role of confidence in the choices we make and why events described as being unprecedented are often entirely predictable.

Peter, welcome to The Bid.

Peter Atwater: Thanks so much, Oscar. Glad to be here.

Oscar Pulido: So, Peter, congratulations on publishing your book, the Confidence Map. It's your second book, if I'm not mistaken. So, in this book you mentioned control and certainty as these two variables and you describe a visual graph of four different sectors, so can you walk us through what that graph is and what it's intended to show?

Peter Atwater: As I was trying to write this book on confidence, I discovered that to most people they know what confidence looks like when they see it, but they have a hard time explaining it, and it becomes this random word cloud.

And as I did more research, what I found was that the feelings of certainty and control that we have are really what drive our behavior. That confidence is how we see ourselves faring in the future, we need there to be a sense of predictability and certainty to what's ahead, and we need to have a feeling that we're prepared for it, that we have a sense of control. What I did was to develop a relatively simple framework, it's a two-by-two box chart, a quadrant that looks at the different, magnitudes of certainty and control that we experience. So, the four boxes, there's the comfort zone where we have both certainty and control and the stress center where we lack both of them. And those are what we think of when we think about confidence.

The other boxes are hybrid environments. you'd be familiar with what I call the passenger seat, where we have certainty, but no control. Anytime we're on an airplane or in a cab that's the environment that we're in. And then the fourth environment is what I call the launchpad. Where we have control, but the outcome's unclear to us and in the world of financial services, every decision that we make, whether it's to lend, to borrow, to invest, are all made in that environment where we have to imagine what's ahead as we're making the choice today to enter into a transaction.

Oscar Pulido: Well, I'm taking an airplane later this week so I, I will definitely be in that passenger seat part of the quadrant. But maybe as you describe those four quadrants, how do people make decisions when they're in each one of those quadrants? You described it well but take us through the decision-making process for individuals in those four boxes.

Peter Atwater: So, no matter what box we're in, we have to recognize that we're making decisions where we're imagining the future and that imagination becomes critical. It involves the stories we tell and then the outcomes that we imagine based on the choices that we're making.

When we're in the stress center though, where we have a sense of vulnerability, and we don't think of it this way, but vulnerability is the opposite of confidence. We crave familiarity, we need things to be certain. When we feel vulnerable, something's wrong.

And so, what happens in that lower left box where we are in the stress center, is that our decision making takes a very narrow focus. I focus on myself. I focus on right here, and I focus on right now. I don't care about the future, I don't care about others, and I don't care about the places that are distant from me. If there's turbulence on your airplane flight later this week, the only person you're going to care about is you in that moment.

And this has a big bearing then on the choices we make, we see this in the investment world where people out of nowhere suddenly decide they want to hoard cash. They're craving that certainty. We saw the same thing during the early days of Covid where people were hoarding water and wipes and the things that we needed to address the, the vulnerability that we were experiencing. And so that focus alters what we want and in turn what we do.

At the other end of the spectrum, we're a very different person. There we tend to be focused on, what I say is 'us, everywhere, forever'. Where we're generous, we're cooperative, we explore, we're interested in the future, and we're planning for the future. And you can see this in the investment world with the kinds of things that we invest in when confidence is really high, they’re oozing with abstraction. We saw this in 2021 with the whole focus on eVs, space and, NFTs and crypto.

And today I think we're seeing a similar phenomenon with AI where we're so interested in opportunity and that's the antithesis of what we think about in terms of possibility versus familiarity.

Oscar Pulido: That stress zone you described certainly sounds like not a great place to be in, at least not for an extended period of time. But I can't help but think that if you're in that upper right quadrant, that high confidence, high certainty, it sounds really compelling, but could you be overconfident? Isn't there something healthy about, maybe a little bit of uncertainty that keeps you somewhat cynical, keeps you asking questions, keeps you intensely curious. How do you think about that upper right quadrant not becoming also a hindrance to the decision maker?

Peter Atwater: So, when we're in that upper right-hand box, we forget that scrutiny and confidence are inversely related. The more confident we are, the less we pay attention because we don't think we have to. And so, our cognitive processes are inherently lazy, and that laziness is a disservice to us when we're really confident because we're not paying the kind of attention that we should be. The result is that we take too much risk in too great a size while at the same time paying the least amount of attention. And as you imagine, those three things together often are what precipitate a crisis that then follows.

Oscar Pulido: So how does somebody then, who finds themself in a certain quadrant, what changes do they need to make in their decision making to migrate from one box to the next or what have been your observations of how people adeptly move across these four quadrants?

Peter Atwater: The first thing is to recognize that confidence isn't a one and done experience. The self-help world would like you to believe that once you have confidence, you're going to always have it. And so, we're constantly moving around, and I think it's always helpful for us to pause before we're making a decision to step back and say, so where am I?

Am I feeling certain and in control, am I feeling vulnerable? Because that's then going to give me clues in terms of what things I should do better. For example, in the stress center, we're as likely to be under confident there as we are overconfident in the comfort zone, and so we need to be careful and to take more risk rather than less risk when we are feeling vulnerable.

And that's very counterintuitive, that really fights against our gut, particularly in the finance world. But panic tends to be an experience that should lead us to be more optimistic than we are. Panic tends to be a behavior that reflects that the worst is behind us, not ahead of us like we imagine it to be. So that's one of the things we need to do.

In the launchpad, we need to be careful about our imagination of the future because if I have control, but no uncertainty, I'm likely to make a choice based on what I imagine. And particularly in the finance world, we need to be open to both sides of the potential outcome that's ahead.

And if you are certain of an outcome, that's God's way of telling you, you're either being too pessimistic or too optimistic about what's ahead.

Oscar Pulido: When you think about like high performing individuals or some of the people that you've come across, do they rotate across all four of these quadrants and that's okay. or do like high performing individuals, people in leadership positions, whether that's in the public or private sector, do they typically operate in only one or two of these?

Peter Atwater: No, so what I find is people who are resilient recognize that all four of these boxes are going to happen. So, it's not about avoiding a box, it's more about recognizing that I'm going to be in the stress center, I'm going to be in the passenger seat, I'm going to be in the launchpad. That those are a natural part of a business cycle of a life experience.

And so, their focus isn't on avoiding those, but getting comfortable in those boxes. And to appreciate that they're not going to be there forever. I think one of the mistakes a lot of inexperienced leaders make is that they get themselves in the stress center and they become paralyzed, they feel like it's never going to end.

Somebody who's resilient recognizes as oh no, this is today. and what I'm going to do when I'm in that box, and this is where the high performers, I think really differentiate themselves is that they pause to say, what can I do, what must I do to regain certainty and control? Both of those are very actionable and interestingly, one of the best things people can do is to ask for help. Asking for help isn't weakness, it's actually taking control of the situation.

Oscar Pulido: Right, and that leader who finds themselves in the stress center and knows how to cope with it, it's almost going back to an earlier question, right? The leader who's in the comfort zone, perhaps the really good leader recognizes that now is a good time to ask questions of what could go wrong or what am I missing, and to not develop overconfidence, but to be almost like a healthy paranoia, I think is how I'm picturing somebody who knows how to properly, navigate being in that box.

Peter Atwater: Yeah, they're never complacent, they're always anticipating something that could go wrong and they're not of it. They're not being doomsday about it it's a much greater awareness of the fact that conditions change.

I think about at the other end of the spectrum, some of the most interesting conversations I've had have been with, emergency room doctors. The stress center is their day, and they spend their day going back and forth and back and forth, and their behavior in the stress center is so different from what particularly in corporate leadership. If you listen to emergency room teams, they're talking candidly about what's wrong. they're sharing information. They're not focused on what happened as much as what is, so there's never a concern about blame or shame.

It's like, look, this is where we are, and all of the energy is focused on resolving not only the problem, but the vulnerability arising from the problem. In the medical world, the difference between curing a patient and healing a patient is the restoration of confidence, the elimination of the vulnerability that patients feel. And I think sometimes leaders get themselves so focused on the problem, what's broken, what's crashed, what's burned, and they forget that what makes something a crisis isn't the problem, but the feelings that arise from the problem and that as much attention needs to be given to those feelings as to the situation itself - because the crisis won't be done until those feelings are restored.

Oscar Pulido: And an emergency room doctor, certainly emotions run high in a hospital or any sort of medical setting. Maybe bringing it back to markets because emotions can run high with markets as well, and you talked about Covid and some of the behaviors that we saw during the Covid era, or you talked about hoarding cash, especially in stressful periods for markets where investors, don't want to lose money. When you think, about some of the recent market shifts in history, how do you apply this frame, these four boxes, to how investors react?

Peter Atwater: So, if we look at what happened with the regional banks earlier this year, you could see that sense of panic people moving rapidly into the stress center. And I think one of the things Oscar, that's so unique about today is the speed and scale at which groups can mobilize and translate changes in sentiment into action. Between social media and online trading, what we're seeing is these microbursts of energy and I think that in investors today need to appreciate that the speed at which markets are moving up and down, arguably meme stocks represent the behavior at the other extreme, is that we're seeing this highly impulsive, highly emotional behavior at both ends of the spectrum. and to not fall victim to it. As I've said, panic is a sign that we're approaching the lows in confidence. It's not a time to be afraid, but a time to be preparing for a turn that's likely to happen imminently, and the same things with manias. Don't become seduced by the siren song.

Oscar Pulido: And it makes sense and I think about Warren Buffett and be fearful when others are greedy and be greedy when others are fearful. It's kind of what, you're touching on, being sometimes a contrarian, you know, Hopefully the emergency room analogy that person is a well-trained, professional who knows how to control their emotions. But it seems like in markets people have trouble controlling those or have you witnessed something differently?

Peter Atwater: So, what I found is that individuals may have a hard time controlling their own emotions. It's very helpful for them to use the framework that I have to identify where is the crowd today, where are others? And it's remarkable to me how quickly we can spot where the crowd is on this quadrant. And just being able to objectively say the crowd is panicking allows you to take what would otherwise be a highly subjective and emotional phenomenon and look at it almost clinically. And that then allows you to make decisions in a much more really decisive and definitive way that allows you to have distance between, your own emotion and actions.

Oscar Pulido: And that then speaks to how investors can use those insights, knowing where the crowd is in those four quadrants is what allows you to make that, forward looking decision in your portfolio. That is what sets you apart from the crowd. And if you do that, that's usually where you generate better performance.

Peter Atwater: Yeah, and there are three dimensions that are easy to identify because at all locations. Our confidence, those feelings of certainty and control, our actions and our stories exist in equilibrium. So, I can look at where the crowd is in three different ways. What are the headlines that we're seeing in financial television and or, what are the actions that we're seeing people buy? As an economist, we talk a lot about elasticity. I think we overlook something called confidence elasticity, which is to say, how does confidence drive the choices we're making? And there's a high confidence elasticity for cash, for example, when confidence is low, that's when we demand it most.

And just knowing that the range of investments that we're going to buy is a function of our level of confidence allows me at all times to spot where the crowd is. Because what's hot in the minds of investors is revealing their level of confidence. Are they stampeding into cryptocurrencies or are they stampeding into cash? Those are things that I see at the two ends of the confidence spectrum.

Oscar Pulido: Peter, when I think about investors, I'm thinking about mom and pop and the individual investor, but have you worked with what I'll call professional investors, portfolio managers, people who do this for a living, who wake up every day and are thinking about what stocks or bonds to buy, and if you've worked with those folks, how do they think about this confidence map, the four quadrants, and what do you observe in these individuals?

Peter Atwater: So, most of my clients are institutional investors, and in the same way that they're looking at economic data, they're looking at, industry data. They're using sentiment as another overlay. And so, what they're interested in is that the indicators of sentiment that I identify as being representative of things that might be important to them in their portfolios.

So, for example, looking at the behavior in luxury today and the excesses that we're seeing there and how is that different maybe from what we saw a year or two years ago? Because, cultural trends, from the music we listened to, to the TV shows that we watch have a bearing on our behavior and they reflect how we feel. The media is an enormous mirror of our mood.

Oscar Pulido: And Peter, just taking a step back, maybe I should have asked you this at the beginning, but why is this topic of confidence something that you have dedicated So, much time to? Just curious as to what is it that got you interested in either this particular topic or maybe even just behavioral economics, in the first place?

Peter Atwater: As somebody who spent the first part of his career in financial services, I had never really considered the role that emotions play in the choices that investors make. I sort of missed the forest for the trees. During the financial crisis, it became clear to me that we made a series of choices to borrow, to lend to buy homes that were in characteristics completely different in 2007 from 2009. And so, what I wanted to do was to understand why did we make those decisions? Were there characteristics that were universal? That while the means may change, what are we doing differently and consistently from crisis to crisis, from euphoria to euphoria. Twain says, history rhymes and I wanted to know why. And what I found was that the behaviors that we exhibit all act in a very consistent way based on our level of confidence, and this is something that exists not just in the markets, but outside of the markets. The trends in fashion, repeat the trends in architecture, repeat the trends in politics, repeat. There's so many different ways that confidence sets up what we're doing outside of the markets that then become useful to investors in the markets.

Oscar Pulido: So, some of that you had real world experience, working in financial services and now when you stepped out into academia, you had an opportunity to just see the role that emotion plays in markets. And I think for certain, anybody who's watched the markets this year, or even over a longer period of time, could attest to the fact that it is an emotional, exercise investing and those who can control it probably do a better job in the long term. Peter, we appreciate you joining us and sharing with us your framework. congratulations again on your second book, the Confidence Map. And thank you for joining us on The Bid.

Peter Atwater: Thank you so much, Oscar.

Oscar Pulido: Thanks for listening to this episode of the Bid.

This post originally appeared on the iShares Market Insights

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.