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The Case for Rational Optimism

January 4, 2011

by Kevin Kroskey, CFP, MBA

(Reprinted from the February 2011 edition of the Bath Country Journal)

Presenting the Case for Rational Optimism

Over the next year, I’ll be writing a monthly column of financial planning related articles for the Bath Country Journal. I have many topics and strategies that I’m looking forward to writing about that can help to plan for retirement, minimize taxes, and provide income in today’s low interest rate environment to mention a few. However, to start things off, I thought we’d take a brief look back over 2010 and then in a much broader context consider the mindset of today’s investor.

 Markets over the past few years have continued to be very volatile, yet substantial positive results were realized in 2010 despite the Greek debt crisis, BP oil spill, record fiscal deficits and other crises du jour. But capturing the market return required plenty of patience: eight months into the year the S&P 500 Index was still down 5.8% and the tepid economic recovery appeared to put a lid on any significant upturn in prices. Nevertheless, stock prices surged over the subsequent five months and the S&P 500 ended the year at 1257.64, recouping all of its losses since the collapse of Lehman Brothers on September 15, 2008.

Today's pessimistic mood and the role of innovation

"The pessimist sees difficulty in every opportunity. The optimist sees opportunity in every difficulty."

--Sir Winston Churchill

Despite the positive market returns of 2009 and 2010 and the continued global economic recovery, a mood of fear and pessimism is seemingly pervasive within investors. Many feel overwhelmed by problems in the United States led by high unemployment, government deficits, and depressed housing prices. Europe has many of the same challenges as well. Yet, it is imperative to remember that throughout history problems of similar and even larger magnitude have routinely been overcome.

Any investor short on optimism would be well served by reading a thought-provoking new book by Matt Ridley, The Rational Optimist: How Prosperity Evolves.  In the book Ridley documents predictions over time by many smart, renowned people, warning of a bleak future. History is filled with examples for Ridley to choose from. Reverend Thomas Malthus, a contemporary of Adam Smith in the late 1700s, wrote that an increasing population would arrest advances in quality of life. In the 1960s, Paul Erlich's best-selling book, The Population Bomb warned of mass starvation that was to come in the 1970s and 1980s. More recently, many will remember the end-of-the-world scenarios around Y2K computer shutdowns.

It's not that these weren't real issues. They were. However, they were also blown out of proportion, overcome or both. As Bill Gates wrote in his review of the book published in the Wall Street Journal, "Despite them, our lives have improved dramatically in terms of lifespan, nutrition, literacy, wealth, and almost any other measure you'd care to name."

The human brain essentially precludes us from seeing non-linear change—from seeing innovation—even though in hindsight history shows us it happens all the time. In his review of Ridley's book Bill Gates remarked, “Pessimism is so often wrong because people assume a world where there is no change or innovation. They simply extrapolate from what is going on today, failing to recognize the new developments and insights that might alter current trends.” In today’s world the impact of the technology only increases the rate of change and innovation.

Emerging markets and the impact on the West

China, India, Brazil, Indonesia and other emerging markets are experiencing rapid growth, increasing levels of wealth and a burgeoning middle class. Thinking back to Winston Churchill's comment about optimists and pessimists, when pessimists read about developing countries, they conclude that they're going to achieve growth at the expense of western countries.  This assumes that the size of the wealth pie we're dividing is fixed. It most certainly is not. Through trade emerging markets are going to dramatically increase the total amount of wealth in the world, making the pie bigger. This is the beauty of capitalism.

The pessimistic view also implicitly assumes that western economies and companies won't adapt to continuing globalization. This too is an erroneous conclusion. The famed Austrian economist Joseph Schumpeter showed that the process of innovation in open markets transforms economies, destroying old business models and jobs while replacing them with new ones. This process has been coined creative destruction and is the essence of how markets work. Granted the process can be painful if your job is being destroyed. However, the world will continue to change, and change must be embraced. Anyone believing otherwise will certainly be quite disappointed.

Implications for investors

It is well documented in behavioral economics that investments work better than investors. This is directly attributable to how the human brain works and that fact that the brain sacrifices accuracy for speed when a perceived threat is before us. Despite whatever crises du jour or perceived threat is upon us, it is imperative investors engage their rational mind—not the reactive one—and change their mindset accordingly. It is irrational to portend persistent societal decline when history shows us the exact opposite to occur. It is rational to be long-term optimistic.

Kevin Kroskey, CFP®, MBA is President of True Wealth Design, an independent investment advisory and financial planning firm that assists individuals and businesses with their overall wealth management, including retirement planning, tax planning and investment management needs. Kevin can be reached at 330-777-0688 or found online at www.TrueWealthDesign.com.

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