By Robert G. Hagstrom
There is a recent trend regarding the importance of liberal arts in people's education, despite the triumph of STEM subjects (Science, Tech, Engineering and Math) in academic circles. "Investing: The Last Liberal Art" does justice to this movement.
Robert Hagstrom, portfolio manager of Legg Mason Capital Management, and a writer who has other books in the subject (Such as "The Warren Buffet Way"), explains fundamental investing principles and ideas in relation to other seemingly non-related liberal arts subjects such as sociology, physics, literature, biology and phsycology.
I'm particularly interested in this topic, since it intrigued me that much the story of Charlie Munger (Warren Buffet partner in Berkshire Hathaway) when he offered a lecture in which he talked about the importance of being a well-rounded investor, and one in which he talked about the similarities between adaptive systems such as ant colonies and the stock market. Hagstrom studied Munger's approach and called this "well-roundness" as "Latticework".
Actually, "Latticework" was going to be the original name of this book.
Amazon Page for details
My Rating: 9/10
Click Here to Read My Notes
There is a recent trend regarding the importance of liberal arts in people's education, despite the triumph of STEM subjects (Science, Tech, Engineering and Math) in academic circles. "Investing: The Last Liberal Art" does justice to this movement.
Robert Hagstrom, portfolio manager of Legg Mason Capital Management, and a writer who has other books in the subject (Such as "The Warren Buffet Way"), explains fundamental investing principles and ideas in relation to other seemingly non-related liberal arts subjects such as sociology, physics, literature, biology and phsycology.
I'm particularly interested in this topic, since it intrigued me that much the story of Charlie Munger (Warren Buffet partner in Berkshire Hathaway) when he offered a lecture in which he talked about the importance of being a well-rounded investor, and one in which he talked about the similarities between adaptive systems such as ant colonies and the stock market. Hagstrom studied Munger's approach and called this "well-roundness" as "Latticework".
Actually, "Latticework" was going to be the original name of this book.
Amazon Page for details
My Rating: 9/10
Click Here to Read My Notes
The lesson Newton took from Kepler is one that has been repeated many times throughout history: Our ability to answer even the most fundamental aspects of human existence depends largely upon measuring instruments available at the time and the ability of scientists to apply rigorous mathematical reasoning to the data.
According to the legend, Newton watched an apple fall from a tree and, in a flash of insight, conceived of the idea of gravitation. Whereas Kepler had defined the three laws of planetary motion and Galileo had confirmed that a falling body accelerates at a uniform rate, Newton, in a stroke of genius, combined Kepler’s laws with Galileo’s observations. Newton reasoned that the force acting upon the apple was the same power holding the moon in orbit around the earth, and the planets around the sun. It was an incredible leap of intuition.
It is impossible to overstate the significance of the shift. It represents nothing less than a complete reversal of the very foundation on which human existence was thought to rest. It meant that scientists no longer relied on divine revelation for understanding. If they could discern natural laws of the universe, they would be able to predict the future based on the present data.
The scientific process used to investigate those natural laws is the legacy of Sir Isaac Newton.
Although colleges soon favored Samuelson’s updated text over Marshall’s classic work, the message of equilibrium remained the same. According to Samuelson, millions of prices and millions of outputs are connected to an interdependent weblike system. Within this system, house holds with preferences for products and services interact with firms that provide those products and services. These firms, each guided by a desire to maximize profits, transform information from households into products sold to households. The logical structure of this exchange, says Samuelson, is a general equilibrium system.
For nearly two hundred years, since the 1776 publication of Adam Smith’s The Wealth of Nations, economists had agreed there is a fundamental value, the “true value,” that underlies the marketplace, and prices tend to bounce above and below this value. Of course, what has haunted economists and investors alike ever since is the debate over what is the true value.
Alfred Marshall tells us competition ultimately determines equilibrium price. If price is oscillating, it is because there is a temporary imbalance between supply and demand, but this is ultimately corrected by the marketplace.
The individual credited with taking Samuelson’s theoretical view of the market to the next level is Eugene Fama. His University of Chicago doctoral dissertation entitled “The Behavior of Stock Price” immediately caught the attention of the investment community. The dissertation was published in its entirety in the Journal of Business and later was excerpted in The Financial Analysts Journal and Institutional Investor. It is the foundation of what has come to be called “modern portfolio theory.”
Fama’s message was clear. Stock prices are unpredictable because the market is too efficient.
Predictions about the future therefore have no place in an efficient market, because share prices fully reflect all available information.
The critical variable that makes a system both complex and adaptive is the idea that agents (neurons, ants, or investors) in the system accumulate experience by interacting with other agents and then change themselves to adapt to a changing environment.
If a complex adaptive system is, by definition, continuously adapting, it is impossible for any such system, including the stock market, ever to reach a state of perfect equilibrium.
The counterview from Santa Fe suggests the opposite: a market that is not rational, is organic rather than mechanistic, and is imperfectly efficient. It assumes the individual agents are, in fact, irrational and hence will misprice securities, creating the possibility for profitable strategies. In later chapters we will consider the underlying psychology that causes people to behave irrationally where money is concerned.
Yet we still hold on to our belief that the law of equilibrium is absolute. We cling to it because the entire Newtonian system, of which equilibrium is one part, has been our model for how to think about the world for three hundred years.
Turning to biology for insight into finance and investing may at first seem a startling move, but just as we did in our study of physics, we focus here on just one core idea from the field of biology: evolution.
Darwin had written the book of the century—perhaps, said the noted evolutionary biologist Richard Dawkins, the book of the millennium. “The Origin changed humanity, and of all life, forever,” Dawkins wrote.4 It also changed our view of other areas of knowledge, including economics, and that is the focus in this chapter.
“The central point of his whole life work is that capitalism can only be understood as an evolutionary process of continuous innovation and creative destruction.”
Innovation, said Schumpeter, is the profitable application of new ideas, including products, production processes, supply sources, new markets, or new ways in which a company could be organized. Whereas standard economic theory believed progress was a series of small incremental steps, Schumpeter’s theory stressed innovative leaps, which in turn caused massive disruptions and discontinuity—an idea captured in Schumpeter’s famous phrase “the perennial gale of creative destruction.”
For some time Marshall had privately chided his colleagues for not recognizing that economic phenomena more closely resembled biological processes than the standard mechanized theory.
I have always wondered why the biological view of economics, conceived over one hundred years ago, has not yet reached the top rung of academic support. It may be, as Marshall wrote, “biological conceptions are more complex than mechanics.”
Fifty years ago, Thomas Kuhn wrote a landmark book titled The Structure of Scientific Revolutions ([1962] 1970). In it, he challenged the conventional view that scientific progress moves in a pedestrian fashion as a series of accepted facts and theories. Kuhn believed there are times when advancement occurs only by revolution. Under “normal science,” he explains, puzzles are solved within the context of the dominant paradigm. As long as there is a general consensus about the paradigm, normal science continues. But what happens when anomalies appear? According to Kuhn, when an observed phenomenon is not adequately explained by the dominant paradigm, a new competing paradigm is born.
But no matter its pace, we must remember there is always change. And this is why we must leave Newton’s world and embrace Darwin’s.
Why are financial strategies so diverse? The answer, Farmer believes, starts with the idea that basic strategies induce patterns of behavior. Agents rush in to exploit these obvious patterns, causing an ultimate side effect. As more agents begin using the same strategy, its profitability drops. The inefficiency becomes apparent, and the original strategy is washed out.
But then new agents enter the picture with new ideas. They form new strategies of which any number may become profitable. Capital shifts and the new strategy explodes, which starts the evolutionary process again.
Will the market ever become efficient? If you accept the idea that evolution plays a role in financial markets the answer would have to be no.
What we are learning is that studying economic and financial systems is very similar to studying biological systems. The central concept for both is the notion of change, what biologists call evolution. The models we use to explain the evolution of financial strategies are mathematically similar to the equations biologists use to study populations of predator-prey systems, competing systems, or symbiotic systems.
The concept of evolution should not be foreign to financial analysts.
If understanding financial markets in terms of evolution seems intimidating to some, I suspect that may be because of the words biologists use to describe the process: Variation. Adaptation. Mutation. Genetic recombination. These are terms not found in the lexicon of an MBA program.
The idea of biological economics should also be easier to embrace now that the theory has graduated from the Santa Fe Institute to mainstream universities and consulting firms that study business and management strategies.
Remember that in the chapter on physics we postulated that although “equilibrium may indeed be the natural state of the world, and restoring it when it is disturbed may be nature’s goal, it is not the constant condition that Newtonian physics would suggest. At any given moment, both equilibrium and disequilibrium may be found in the market.”
In Lo’s opinion, the market is neither exclusively efficient nor always behavioral—it is both. “Behavior is really the outcome of interactions between our logical faculties and our emotional responses,” he explains. “When logic and emotions are in proper balance, markets operate in a relatively efficient manner.”
Lo’s hypothesis seeks to bridge the gap between market efficiency and behavioral inefficiency by applying the principles of evolution, competition, adaptation, and natural selection to the financial interactions.
Many forward-thinking people, including several we have met in this chapter, believe that the theory of evolution may become the most powerful force in finance.
“after all, financial institutions are uniquely human inventions that provide an adaptive advantage to our species.
Indeed, the movement from the mechanical view of the world to the biological view of the world has been called the “second scientific revolution.”
In the Second Dialogue, Vega lists four basic principles of trading—as relevant today as they were 325 years ago:
Sociology is the study of how people function in society, with the ultimate hope of understanding group behavior. When we stop to consider that all the participants in a market constitute a group, it is obvious that until we understand group behavior, we can never fully understand why markets and economies behave as they do.
The term complexity is derived etymologically from the Latin word plexus, which means interwoven. When we think about complexity we intuitively understand the difficulty of separating the individual from the whole.
One aspect of these systems is the formation process. How do people come together to form complex systems (social units) and then further organize themselves into some sense of order? This question has led to a new hypothesis that may provide a common framework to describe the behavior of all social systems. It is called the theory of self-organization.
Krugman believes that economic cycles are in large part caused by self-reinforcing effects.
Who is right? The answer lies in an outstanding book titled, The Wisdom of Crowds: Why the Many Are Smarter Than the Few and How Collective Wisdom Shapes Business, Economies, Societies, and Nations. Written by James Surowiecki, the business columnist for The New Yorker, it purposefully takes aim at Mackay’s idea of “the madness of crowds” with a simple, powerful thesis: “under the right circumstances [italics mine], groups are remarkably intelligent and are often smarter than the smartest people in them.”
According to Surowiecki, the two critical variables necessary for a collective to make superior decisions are diversity and independence.
Per Bak’s sand pile metaphor is a powerful tool that helps us understand the behavior of many different systems. In both natural and social systems, we can see the dynamic: the systems become a class of interlocking subsystems that organize themselves to the edge of criticality and, in some cases, break apart violently only to reorganize themselves at a later point.
Is the stock market such a system? Absolutely, said Per Bak.
Behavioral finance, which seeks to explain market inefficiencies using psychological theories, was born of the academic work of Kahneman and Tversky.
In essence, Kahneman and Tversky had discovered that people are generally risk averse when making a decision that offers hope of a gain but risk seeking when making a decision that will lead to certain loss.
In my opinion, the single greatest psychological obstacle that prevents investors from doing well in the stock market is myopic loss aversion.
Perhaps it is not surprising that the one individual who has mastered myopic loss aversion is also the world’s greatest investor—Warren Buffett.
have always thought that much of Buffett’s success is a result of his hybrid investment vehicle, Berkshire Hathaway. Because Berkshire owns both common stocks and wholly owned businesses, Buffett has benefited greatly from this unique perspective.
Paraphrasing his teacher and mentor Benjamin Graham, Buffett has claimed he is “a better investor because he is a businessperson and a better businessperson because he is an investor.”
As he often states, “I don’t need a stock price to tell me what I already know about value.”
In an article titled “The Internet and the Investor” (2001), Odean and Barber postulate that the Internet may be doing more harm to investors than good. At first that seems counterintuitive when we think of all the informational benefits. But Odean and Barber suggest that the vast amount of information online enables investors to easily locate evidence that confirms their hunches, which in turn leads them to become overconfident in their ability to pick stocks.
Charlie Munger, who gave us the concept of mental models, has spent much time thinking about how we accumulate bits of knowledge from various fields to achieve worldly wisdom. In investing, he says, obviously we need to understand basic accounting and finance. And as we will see in our chapter on mathematics, it is equally important to understand statistics and probabilities. But he believes one of the most important fields is psychology, especially what he calls the psychology of misjudgment.
The word philosophy is derived from two Greek words, usually translated as “love” and “wisdom.” A philosopher, then, is a person who loves wisdom and is dedicated to the search for meaning.
This study of the beautiful should not be thought of as a superficial inquiry, because how we conceive beauty can affect our judgments of what is good and bad.
we must educate ourselves. The key principles, the truly big ideas, are already written down, waiting for us to discover them and make them our own.
So we are talking about learning to be discriminating readers: to analyze what you read, to evaluate its worth in the larger picture, and to either reject it or incorporate it into your own latticework of mental models.
I suspect much of what you currently read regularly (the material about which you think “but I have to read that”) is about adding facts rather than increasing understanding.
We can all acquire new insights through reading if we perfect the skill of reading thoughtfully. The benefits are profound: Not only will you substantially add to your working knowledge of various fields, you will at the same time sharpen your skill at critical thinking.
In the course of developing this chapter, I talked to several “Johnnies” who after graduation entered the investment world. All of them said that the number one thing they learned in college was how to be a better thinker rather than a better trader, investment banker, financial advisor, or analyst—and that being a better thinker invariably made them better at their jobs.
The mental skill of critical analysis is fundamental to success in investing. Perfecting that skill—developing the mind-set of thoughtful, careful analysis—is intimately connected to the skill of thoughtful, careful reading.
So the very act of reading critically improves your analytical skills.
If you decide to expand your knowledge base by reading in areas outside finance, including some of the other disciplines presented in this book, you are assembling the individual elements to construct your own latticework of mental models.
Or, to put the matter more directly, learning to be a careful reader has two enormous benefits to investors: it makes you smarter in an overall sense, and it makes you see the value of developing a critical mind-set, not necessarily taking information at face value.
“Don’t try to resist the effect that a work of imaginative literature has on you,” says Adler. “Let it do whatever work it wants to do.”
The more practical-minded among you may be wondering what investors can learn from imaginative literature. If it doesn’t add any new insights about investing, why allocate your valuable time to it? My answer is simple: because we learn from experiences—and not only from our own. Just as we learn from our daily experiences how to become better mates, parents, citizens, and investors, so too can we learn from the fictional experiences that fine writers place in our imagination.
“We shouldn’t underestimate the power of literature in a world where most of the business reading consists of corporate profiles, technical manuals and self-help guides,” says Doty.
When I asked Otto who he considered to be the greatest detectives, his answer was concise and unhesitating: Auguste Dupin, Sherlock Holmes, and Father Brown.
Great Detectives, in sum, outwit the criminal not because they work harder, not because they are luckier, not because they can run faster, hit harder, or shoot straighter, but because they think better.
If we carefully study Dupin’s methods, what lessons can we learn? 1. Develop a skeptic’s mindset; don’t automatically accept conventional wisdom. 2. Conduct a thorough investigation.
What lessons can we learn by studying Holmes’s methods? 1. Begin an investigation with an objective and unemotional viewpoint. 2. Pay attention to the tiniest details. 3. Remain open-minded to new, even contrary, information. 4. Apply a process of logical reasoning to all you learn.
What does Father Brown have to teach us? 1. Become a student of psychology. 2. Have faith in your intuition. 3. Seek alternative explanations and redescriptions.
By itself, reading is insufficient. You must put yourself—your own good brain and some of your soul—into the process, by reflecting on what you read. Indeed, the harder you work to understand and absorb the material, the more deeply embedded it becomes.
Listen to Buffett: “The formula we use for evaluating stocks and businesses is identical. Indeed, the formula for valuing all assets that are purchased for financial gain has been unchanged since it was first laid out by a very smart man in about 600 B.C.E. The oracle was Aesop and his enduring, though somewhat incomplete, insight was ‘a bird in the hand is worth two in the bush.’ To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate? If you can answer these three questions, you will know the maximum value of the bush—and the maximum number of birds you now possess that should be offered for it. And, of course, don’t literally think birds. Think dollars.”
Frederick also discovered that people who did well on the Cognitive Reflection Test tended to be more patient in answering questions. System 2 thinking is a relatively slow process. When we are forced to answer quickly, we don’t have enough time to engage the rationality that is at the heart of the reflective process.
Kahneman concludes that intuitive skill exists mostly in people who operate in simple, predictable environments and that people in more complex environments are much less likely to develop this skill. Kahneman, who has spent much of his career studying clinicians, stock pickers, and economists, notes that evidence of intuitive skill is largely absent in this group. Put differently, intuition appears to work well in linear systems where cause and effect is easy to identify. But in nonlinear systems, including stock markets and economies, System 1 thinking, the intuitive side of our brain, is much less effectual.
Hedgehogs start with one big idea and follow through—no matter the logical implications of doing so. Foxes stitch together a collection of big ideas. They see and understand the analogies and then create an aggregate hypothesis. I think we can say the fox is the perfect mascot for the College of Liberal Arts Investing.
For many, many people, the financial markets are confusing, and investing has become a hectic search for the right road. But traveling more quickly down well-worn roads is not the answer. Rather, looking down from the calm heights of knowledge gained from wise men’s teaching is.
According to the legend, Newton watched an apple fall from a tree and, in a flash of insight, conceived of the idea of gravitation. Whereas Kepler had defined the three laws of planetary motion and Galileo had confirmed that a falling body accelerates at a uniform rate, Newton, in a stroke of genius, combined Kepler’s laws with Galileo’s observations. Newton reasoned that the force acting upon the apple was the same power holding the moon in orbit around the earth, and the planets around the sun. It was an incredible leap of intuition.
It is impossible to overstate the significance of the shift. It represents nothing less than a complete reversal of the very foundation on which human existence was thought to rest. It meant that scientists no longer relied on divine revelation for understanding. If they could discern natural laws of the universe, they would be able to predict the future based on the present data.
The scientific process used to investigate those natural laws is the legacy of Sir Isaac Newton.
Although colleges soon favored Samuelson’s updated text over Marshall’s classic work, the message of equilibrium remained the same. According to Samuelson, millions of prices and millions of outputs are connected to an interdependent weblike system. Within this system, house holds with preferences for products and services interact with firms that provide those products and services. These firms, each guided by a desire to maximize profits, transform information from households into products sold to households. The logical structure of this exchange, says Samuelson, is a general equilibrium system.
For nearly two hundred years, since the 1776 publication of Adam Smith’s The Wealth of Nations, economists had agreed there is a fundamental value, the “true value,” that underlies the marketplace, and prices tend to bounce above and below this value. Of course, what has haunted economists and investors alike ever since is the debate over what is the true value.
Alfred Marshall tells us competition ultimately determines equilibrium price. If price is oscillating, it is because there is a temporary imbalance between supply and demand, but this is ultimately corrected by the marketplace.
The individual credited with taking Samuelson’s theoretical view of the market to the next level is Eugene Fama. His University of Chicago doctoral dissertation entitled “The Behavior of Stock Price” immediately caught the attention of the investment community. The dissertation was published in its entirety in the Journal of Business and later was excerpted in The Financial Analysts Journal and Institutional Investor. It is the foundation of what has come to be called “modern portfolio theory.”
Fama’s message was clear. Stock prices are unpredictable because the market is too efficient.
Predictions about the future therefore have no place in an efficient market, because share prices fully reflect all available information.
The critical variable that makes a system both complex and adaptive is the idea that agents (neurons, ants, or investors) in the system accumulate experience by interacting with other agents and then change themselves to adapt to a changing environment.
If a complex adaptive system is, by definition, continuously adapting, it is impossible for any such system, including the stock market, ever to reach a state of perfect equilibrium.
The counterview from Santa Fe suggests the opposite: a market that is not rational, is organic rather than mechanistic, and is imperfectly efficient. It assumes the individual agents are, in fact, irrational and hence will misprice securities, creating the possibility for profitable strategies. In later chapters we will consider the underlying psychology that causes people to behave irrationally where money is concerned.
Yet we still hold on to our belief that the law of equilibrium is absolute. We cling to it because the entire Newtonian system, of which equilibrium is one part, has been our model for how to think about the world for three hundred years.
Turning to biology for insight into finance and investing may at first seem a startling move, but just as we did in our study of physics, we focus here on just one core idea from the field of biology: evolution.
Darwin had written the book of the century—perhaps, said the noted evolutionary biologist Richard Dawkins, the book of the millennium. “The Origin changed humanity, and of all life, forever,” Dawkins wrote.4 It also changed our view of other areas of knowledge, including economics, and that is the focus in this chapter.
“The central point of his whole life work is that capitalism can only be understood as an evolutionary process of continuous innovation and creative destruction.”
Innovation, said Schumpeter, is the profitable application of new ideas, including products, production processes, supply sources, new markets, or new ways in which a company could be organized. Whereas standard economic theory believed progress was a series of small incremental steps, Schumpeter’s theory stressed innovative leaps, which in turn caused massive disruptions and discontinuity—an idea captured in Schumpeter’s famous phrase “the perennial gale of creative destruction.”
For some time Marshall had privately chided his colleagues for not recognizing that economic phenomena more closely resembled biological processes than the standard mechanized theory.
I have always wondered why the biological view of economics, conceived over one hundred years ago, has not yet reached the top rung of academic support. It may be, as Marshall wrote, “biological conceptions are more complex than mechanics.”
Fifty years ago, Thomas Kuhn wrote a landmark book titled The Structure of Scientific Revolutions ([1962] 1970). In it, he challenged the conventional view that scientific progress moves in a pedestrian fashion as a series of accepted facts and theories. Kuhn believed there are times when advancement occurs only by revolution. Under “normal science,” he explains, puzzles are solved within the context of the dominant paradigm. As long as there is a general consensus about the paradigm, normal science continues. But what happens when anomalies appear? According to Kuhn, when an observed phenomenon is not adequately explained by the dominant paradigm, a new competing paradigm is born.
But no matter its pace, we must remember there is always change. And this is why we must leave Newton’s world and embrace Darwin’s.
Why are financial strategies so diverse? The answer, Farmer believes, starts with the idea that basic strategies induce patterns of behavior. Agents rush in to exploit these obvious patterns, causing an ultimate side effect. As more agents begin using the same strategy, its profitability drops. The inefficiency becomes apparent, and the original strategy is washed out.
But then new agents enter the picture with new ideas. They form new strategies of which any number may become profitable. Capital shifts and the new strategy explodes, which starts the evolutionary process again.
Will the market ever become efficient? If you accept the idea that evolution plays a role in financial markets the answer would have to be no.
What we are learning is that studying economic and financial systems is very similar to studying biological systems. The central concept for both is the notion of change, what biologists call evolution. The models we use to explain the evolution of financial strategies are mathematically similar to the equations biologists use to study populations of predator-prey systems, competing systems, or symbiotic systems.
The concept of evolution should not be foreign to financial analysts.
If understanding financial markets in terms of evolution seems intimidating to some, I suspect that may be because of the words biologists use to describe the process: Variation. Adaptation. Mutation. Genetic recombination. These are terms not found in the lexicon of an MBA program.
The idea of biological economics should also be easier to embrace now that the theory has graduated from the Santa Fe Institute to mainstream universities and consulting firms that study business and management strategies.
Remember that in the chapter on physics we postulated that although “equilibrium may indeed be the natural state of the world, and restoring it when it is disturbed may be nature’s goal, it is not the constant condition that Newtonian physics would suggest. At any given moment, both equilibrium and disequilibrium may be found in the market.”
In Lo’s opinion, the market is neither exclusively efficient nor always behavioral—it is both. “Behavior is really the outcome of interactions between our logical faculties and our emotional responses,” he explains. “When logic and emotions are in proper balance, markets operate in a relatively efficient manner.”
Lo’s hypothesis seeks to bridge the gap between market efficiency and behavioral inefficiency by applying the principles of evolution, competition, adaptation, and natural selection to the financial interactions.
Many forward-thinking people, including several we have met in this chapter, believe that the theory of evolution may become the most powerful force in finance.
“after all, financial institutions are uniquely human inventions that provide an adaptive advantage to our species.
Indeed, the movement from the mechanical view of the world to the biological view of the world has been called the “second scientific revolution.”
In the Second Dialogue, Vega lists four basic principles of trading—as relevant today as they were 325 years ago:
- The first principle: Never advise anyone to buy or sell shares. Where perspicacity is weakened, the most benevolent piece of advice can turn out badly.
- The second principle: Take every gain without showing remorse about missed profits.
- The third principle: Profits on the exchange are the treasures of goblins.
- The fourth principle: Whoever wishes to win in this game must have patience and money, since values are so little constant and the rumors so little founded on truth.
Sociology is the study of how people function in society, with the ultimate hope of understanding group behavior. When we stop to consider that all the participants in a market constitute a group, it is obvious that until we understand group behavior, we can never fully understand why markets and economies behave as they do.
The term complexity is derived etymologically from the Latin word plexus, which means interwoven. When we think about complexity we intuitively understand the difficulty of separating the individual from the whole.
One aspect of these systems is the formation process. How do people come together to form complex systems (social units) and then further organize themselves into some sense of order? This question has led to a new hypothesis that may provide a common framework to describe the behavior of all social systems. It is called the theory of self-organization.
Krugman believes that economic cycles are in large part caused by self-reinforcing effects.
Who is right? The answer lies in an outstanding book titled, The Wisdom of Crowds: Why the Many Are Smarter Than the Few and How Collective Wisdom Shapes Business, Economies, Societies, and Nations. Written by James Surowiecki, the business columnist for The New Yorker, it purposefully takes aim at Mackay’s idea of “the madness of crowds” with a simple, powerful thesis: “under the right circumstances [italics mine], groups are remarkably intelligent and are often smarter than the smartest people in them.”
According to Surowiecki, the two critical variables necessary for a collective to make superior decisions are diversity and independence.
Per Bak’s sand pile metaphor is a powerful tool that helps us understand the behavior of many different systems. In both natural and social systems, we can see the dynamic: the systems become a class of interlocking subsystems that organize themselves to the edge of criticality and, in some cases, break apart violently only to reorganize themselves at a later point.
Is the stock market such a system? Absolutely, said Per Bak.
Behavioral finance, which seeks to explain market inefficiencies using psychological theories, was born of the academic work of Kahneman and Tversky.
In essence, Kahneman and Tversky had discovered that people are generally risk averse when making a decision that offers hope of a gain but risk seeking when making a decision that will lead to certain loss.
In my opinion, the single greatest psychological obstacle that prevents investors from doing well in the stock market is myopic loss aversion.
Perhaps it is not surprising that the one individual who has mastered myopic loss aversion is also the world’s greatest investor—Warren Buffett.
have always thought that much of Buffett’s success is a result of his hybrid investment vehicle, Berkshire Hathaway. Because Berkshire owns both common stocks and wholly owned businesses, Buffett has benefited greatly from this unique perspective.
Paraphrasing his teacher and mentor Benjamin Graham, Buffett has claimed he is “a better investor because he is a businessperson and a better businessperson because he is an investor.”
As he often states, “I don’t need a stock price to tell me what I already know about value.”
In an article titled “The Internet and the Investor” (2001), Odean and Barber postulate that the Internet may be doing more harm to investors than good. At first that seems counterintuitive when we think of all the informational benefits. But Odean and Barber suggest that the vast amount of information online enables investors to easily locate evidence that confirms their hunches, which in turn leads them to become overconfident in their ability to pick stocks.
Charlie Munger, who gave us the concept of mental models, has spent much time thinking about how we accumulate bits of knowledge from various fields to achieve worldly wisdom. In investing, he says, obviously we need to understand basic accounting and finance. And as we will see in our chapter on mathematics, it is equally important to understand statistics and probabilities. But he believes one of the most important fields is psychology, especially what he calls the psychology of misjudgment.
The word philosophy is derived from two Greek words, usually translated as “love” and “wisdom.” A philosopher, then, is a person who loves wisdom and is dedicated to the search for meaning.
This study of the beautiful should not be thought of as a superficial inquiry, because how we conceive beauty can affect our judgments of what is good and bad.
we must educate ourselves. The key principles, the truly big ideas, are already written down, waiting for us to discover them and make them our own.
So we are talking about learning to be discriminating readers: to analyze what you read, to evaluate its worth in the larger picture, and to either reject it or incorporate it into your own latticework of mental models.
I suspect much of what you currently read regularly (the material about which you think “but I have to read that”) is about adding facts rather than increasing understanding.
We can all acquire new insights through reading if we perfect the skill of reading thoughtfully. The benefits are profound: Not only will you substantially add to your working knowledge of various fields, you will at the same time sharpen your skill at critical thinking.
In the course of developing this chapter, I talked to several “Johnnies” who after graduation entered the investment world. All of them said that the number one thing they learned in college was how to be a better thinker rather than a better trader, investment banker, financial advisor, or analyst—and that being a better thinker invariably made them better at their jobs.
The mental skill of critical analysis is fundamental to success in investing. Perfecting that skill—developing the mind-set of thoughtful, careful analysis—is intimately connected to the skill of thoughtful, careful reading.
So the very act of reading critically improves your analytical skills.
If you decide to expand your knowledge base by reading in areas outside finance, including some of the other disciplines presented in this book, you are assembling the individual elements to construct your own latticework of mental models.
Or, to put the matter more directly, learning to be a careful reader has two enormous benefits to investors: it makes you smarter in an overall sense, and it makes you see the value of developing a critical mind-set, not necessarily taking information at face value.
“Don’t try to resist the effect that a work of imaginative literature has on you,” says Adler. “Let it do whatever work it wants to do.”
The more practical-minded among you may be wondering what investors can learn from imaginative literature. If it doesn’t add any new insights about investing, why allocate your valuable time to it? My answer is simple: because we learn from experiences—and not only from our own. Just as we learn from our daily experiences how to become better mates, parents, citizens, and investors, so too can we learn from the fictional experiences that fine writers place in our imagination.
“We shouldn’t underestimate the power of literature in a world where most of the business reading consists of corporate profiles, technical manuals and self-help guides,” says Doty.
When I asked Otto who he considered to be the greatest detectives, his answer was concise and unhesitating: Auguste Dupin, Sherlock Holmes, and Father Brown.
Great Detectives, in sum, outwit the criminal not because they work harder, not because they are luckier, not because they can run faster, hit harder, or shoot straighter, but because they think better.
If we carefully study Dupin’s methods, what lessons can we learn? 1. Develop a skeptic’s mindset; don’t automatically accept conventional wisdom. 2. Conduct a thorough investigation.
What lessons can we learn by studying Holmes’s methods? 1. Begin an investigation with an objective and unemotional viewpoint. 2. Pay attention to the tiniest details. 3. Remain open-minded to new, even contrary, information. 4. Apply a process of logical reasoning to all you learn.
What does Father Brown have to teach us? 1. Become a student of psychology. 2. Have faith in your intuition. 3. Seek alternative explanations and redescriptions.
By itself, reading is insufficient. You must put yourself—your own good brain and some of your soul—into the process, by reflecting on what you read. Indeed, the harder you work to understand and absorb the material, the more deeply embedded it becomes.
Listen to Buffett: “The formula we use for evaluating stocks and businesses is identical. Indeed, the formula for valuing all assets that are purchased for financial gain has been unchanged since it was first laid out by a very smart man in about 600 B.C.E. The oracle was Aesop and his enduring, though somewhat incomplete, insight was ‘a bird in the hand is worth two in the bush.’ To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate? If you can answer these three questions, you will know the maximum value of the bush—and the maximum number of birds you now possess that should be offered for it. And, of course, don’t literally think birds. Think dollars.”
Frederick also discovered that people who did well on the Cognitive Reflection Test tended to be more patient in answering questions. System 2 thinking is a relatively slow process. When we are forced to answer quickly, we don’t have enough time to engage the rationality that is at the heart of the reflective process.
Kahneman concludes that intuitive skill exists mostly in people who operate in simple, predictable environments and that people in more complex environments are much less likely to develop this skill. Kahneman, who has spent much of his career studying clinicians, stock pickers, and economists, notes that evidence of intuitive skill is largely absent in this group. Put differently, intuition appears to work well in linear systems where cause and effect is easy to identify. But in nonlinear systems, including stock markets and economies, System 1 thinking, the intuitive side of our brain, is much less effectual.
Hedgehogs start with one big idea and follow through—no matter the logical implications of doing so. Foxes stitch together a collection of big ideas. They see and understand the analogies and then create an aggregate hypothesis. I think we can say the fox is the perfect mascot for the College of Liberal Arts Investing.
For many, many people, the financial markets are confusing, and investing has become a hectic search for the right road. But traveling more quickly down well-worn roads is not the answer. Rather, looking down from the calm heights of knowledge gained from wise men’s teaching is.