The Law of Unintended Consequences: What Investors Need to Know
- Christina McNeal
- May 5
- 6 min read
Perspective Matters
KEY TAKEAWYS
Well-intentioned actions often create unexpected results that can be worse than the original problem they aimed to solve.
Historical examples like "The Cobra Effect" and the 1986 Tax Reform Act demonstrate how policies can trigger chain reactions with costly unintended consequences.
Current global trade tensions illustrate how short-term thinking can overlook the long-term strategic responses of other nations.
China's patient, long-term approach to economic policy provides a contrasting model to Western short-term thinking.
Investors should maintain emergency funds, short-term liquidity, and proper diversification rather than making reactive portfolio changes based on global events.
Professional financial guidance becomes most valuable when navigating complex, unpredictable economic environments.
INTRODUCTION
I've written in the past about the dangers of market timing and shown you statistics on things like missing the best days in the market. I've also noted how often the most volatile up days occur within a couple of weeks of the most vulnerable down days. This month, I want to zoom out and explore how consistently successful forecasting can be extremely difficult when human behavior is involved.
When we try to predict anything involving human decisions, we must consider a long list of variables: what will remain fixed and what will vary across different scenarios? We also need to judge how wide these variations might be and whether some outcomes are more likely than others.
This is where the law of unintended consequences becomes crucial to understand. It refers to situations where an action results in outcomes that were not intended or anticipated. These consequences can sometimes be beneficial but are often negative and can even be contrary to what was originally intended.
HISTORICAL EXAMPLES THAT ILLUSTRATE THE PRINCIPAL
The Cobra Effect: When Solutions Create New Problems
One of the clearest real-world examples is what's now called "The Cobra Effect," which happened during British colonial rule in India.
The British government was concerned about the number of venomous cobras in Delhi. To solve this problem, they offered a bounty for every dead cobra turned in. Initially, this policy worked as intended - people killed cobras and collected rewards.
But then something unexpected happened. Some enterprising individuals began breeding cobras in their homes. They could turn in these captive-bred snakes for rewards, creating a profitable business. The government was essentially paying people to raise the very animals they wanted eliminated!
When officials discovered this scheme, they canceled the bounty program. With no more financial incentive to keep the cobras, breeders released their now-worthless snakes into the streets. The end result? Delhi had an even worse cobra problem than before the program started.
This example shows how:
A solution (bounty system) seemed logical at first glance.
The second-order effect was people seeking profit (expected).
The third-order effect was cobra breeding (unexpected).
The fourth-order effect was cobra release when the program ended (definitely not anticipated).
The fifth-order effect was a worse problem than the original situation.
THE TAX REFORM ACT OF 1986: WELL-INTENTIONED POLICY BACKFIRES
The Tax Reform Act of 1986 provides another excellent example of economic policy with significant unintended consequences. This major overhaul of the U.S. tax code during the Reagan administration aimed to simplify the tax system and encourage economic growth.
One of the most notable unintended consequences came from changes to real estate investment rules. Before the reform, real estate investments offered generous tax shelters through depreciation allowances and other benefits. The 1986 Act significantly reduced these tax advantages.
The unexpected result? The commercial real estate market crashed in the late 1980s. Many investors who had purchased properties primarily for tax benefits suddenly found their investments much less valuable. This contributed to the savings and loan crisis of the late 1980s and early 1990s, as many financial institutions that had loaned money for these properties faced massive defaults.
This example demonstrates how:
The policy was intended to create a fairer, simpler tax system.
Lawmakers didn't fully anticipate how deeply tax incentives had become woven into investment decisions.
The removal of these incentives triggered a chain reaction through real estate markets.
This eventually contributed to a major financial crisis that required a government bailout costing American taxpayers billions of dollars.
PRESENT-DAY IMPLICATIONS FOR INVESTORS
Global Trade Tensions and Their Ripple Effects
The recent actions taken by the Trump Administration on global trade have led to uncertainty both in the U.S. and around the world. The administration's strategy of imposing or threatening tariffs operates on the assumption that the U.S. is such a globally dominant economy that other countries would have no choice but to bend to our will in trade negotiations.
However, this approach overlooks important realities:
The U.S. needs markets for our goods as much as our trading partners need markets for theirs.
We are not the only large market for global trade.
Other nations have more flexibility in their responses than anticipated.
The administration's recent imposition of tariffs exceeding 100% on Chinese goods was expected to force immediate compromise. Instead, China responded by raising tariffs on U.S. goods and canceling orders for American products, including Boeing airplanes and agricultural products like soybeans.
The China Factor: Patience vs. Short-Term Thinking
Western economies tend to be very short-term oriented. We expect businesses to report earnings every three months, and as investors, we expect profits to grow every quarter. If a CEO were to announce that earnings for the next four quarters would be down because the company is making investments to enable future growth, the stock price would likely drop, and the CEO might be fired.
In contrast, China demonstrates patience and a longer-term view. We can see this in their approach to Hong Kong, where changes were implemented gradually over 24 years, and in their Belt and Road Initiative (BRI), which has been making infrastructure investments around the world since 2013 to enhance global connectivity and trade.
Unexpected Consequences in International Relations
The administration's trade policies have changed the dynamics of multiple relationships in ways that may not have been fully contemplated:
European countries have banded together to oppose U.S. trade policy and are actively seeking other markets for European goods.
Canada is exploring alternative markets for its goods, with China being an obvious alternative to the U.S.
China stands to benefit economically by becoming a stronger trading partner with both Canada and Western Europe.
Perhaps most unexpectedly, China's opportunity to deepen its economic relationships globally may actually reduce the risk of military action against Taiwan. Escalating military tensions would jeopardize China's new trade opportunities with Western nations—opportunities that were inadvertently created by U.S. trade policies.
WHAT'S AN INVESTOR TO DO TODAY?
Should these global events and their potential unintended consequences lead you to change your investment strategy? Well, it depends on your specific situation.
You likely don't need to make strategy changes if you have:
An emergency fund covering 3-6 months of expenses.
Enough money set aside in cash and short-term investments with little to no principal risk to cover anything you plan to spend in the next 2-3 years.
A portfolio that is diversified both economically and geographically.
If you can't check all three of these boxes, now might be a good time to consult a Certified Financial Planner™ professional. Our role as CFP® professionals is to help you navigate uncertainty while staying focused on your long-term financial goals. We continuously monitor fundamental investment and planning principles while considering global economic contexts.
CONCLUSION
The law of unintended consequences teaches us that well-intentioned policies can create perverse incentives that lead to results opposite of what was intended. When making investment decisions, we should try to think several steps ahead and consider not just what might happen immediately, but what might happen after that, and after that.
This is precisely why having a well-thought-out investment strategy—one that accounts for uncertainty and unexpected events—is so important. By focusing on your personal financial goals rather than trying to predict short-term market movements, you can avoid becoming a victim of unintended consequences in your own financial life.
If you'd like to discuss your specific situation and concerns, please feel free to schedule a conversation using the link below.
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Neither Prism Planning and Solutions Group nor Insight Advisors provide tax advice, and nothing in this communication should be treated as such. This communication should not be interpreted as a recommendation for a specific investment or tax-planning strategy. We are providing this material for informational purposes only. We have made every attempt to verify that information contained in this communication is accurate as of the date published but make no warranties. Before making any decisions related to your own tax and/or investment situation you should consult the appropriate professionals.
Certified Financial Planner Board of Standards, Inc. (CFP Board) owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, and CFP® (with plaque design) in the United States, which it authorizes use of by individuals who successfully complete CFP Board’s initial and ongoing certification requirements.
