By Will Hubbard The market is funny. No matter what your perspective is when you look at it, you can almost always find something to support your opinion. Searching for or favoring data that aligns with your existing beliefs is called “confirmation bias.” It can be found in all disciplines, but the way it shows up in investing is particularly interesting. Everyone from Ray Dalio (founder of hedge-fund giant Bridgewater Associates) to the client who has never opened a brokerage statement seems to have an opinion on the market and economy. But who is right? When opinion and experience are the lenses used to analyze, the answer is, “You’re all right.” Why the bears could be right It’s not hard to take a negative view of the market after 2022. Any one of the following is a reason to be bearish: • Tightening central bank policies. • High inflation. • High commodity prices and shortages. • Record national debts and out-of-control deficits. • The war in Ukraine. • Currency volatility. With all of that going on, it’s easy to see where the bears are coming from. Why the bulls might also be right For the forever bulls, the outlook is still rosy—even though “buying the dip” didn’t work in 2022. And they could be on to something. After all, inflation isn’t as problematic as it was in the 1970s and 1980s, and neither are interest rates, as the following chart of the effective federal funds rate shows. We also aren’t dealing with the meltdown of a global industry like we did in the 2008–2009 financial crisis. Looking at that subset of data, the bulls could make a convincing argument that their view is correct. The downside to “You’re right”—what if you’re not? The problem with confirmation bias is that it can lead to poor investment decision-making. “You’re right” can become a trap you fall into when building your case—like a hole in the ground that provides only a narrow view of your surroundings. By gathering or favoring only the evidence that supports your existing opinion, you may be failing to evaluate the information you need to make a sound decision. Investors who make decisions based solely on first-order thinking can be in danger of confirmation bias. First-order thinking is quick and superficial, and the conclusions drawn are equally so. For the bears, a first-order statement might be, “Inflation is high, so the economy is going to be weak.” For the bulls, it might be, “We’re not experiencing a catastrophe, so stocks should go up.” Second-order thinking is the open-ended response to first-order statements. For the bears, that could be, “Inflation is high, and that could curtail demand. But what are the chances inflation has peaked? What could cause it to increase from here?” For the bulls, it might be, “We’re not experiencing a catastrophe yet, but we have experienced some economic traumas. Have stocks adequately priced these in? What are the chances something could upset my bullish case? Are my positions prepared to handle it?” The solution: dynamic risk management Dynamic risk management is the antidote to first-level thinking. It aims to manage downside potential while positioning for upside opportunity in an ever-changing investment landscape. FPI’s brand of quantitative and dynamic risk management seeks to address those open-ended, second-level questions. It does this within a rules-based framework, resulting in a disciplined approach to handling complex economic environments. It removes the ambiguity of what actions to take and how to manage the different sources of market risk and opportunities for growth that are present in every market environment. It’s a new year and a fresh start, but last year’s losses don’t automatically reset, and risk management is still important. In years when the S&P is down over 20%, the following year can have extremely different outcomes. According to Bespoke Investment Group, if the October 2022 lows don’t hold, we could be in for a painful future—a median downside of 33.6%. But if those lows do hold, we could be looking at a move higher of more than 20%. The following chart shows the first year of returns after a drawdown of more than 20% from all-time highs. Whatever you think of the current economic environment, I’m sure “you’re right.” Because of the massively varied potential outcomes after such a weak calendar year, it would be irresponsible if I didn’t encourage everyone to review their risk-management strategies and make sure their portfolios are positioned to benefit from second-level thinking with a dynamic, rules-based approach.