Investing the last liberal Art--Hagstrom

 One of the most useful books I have read, in that it attempts to draw theories into practical uses in the market. 

INVESTING—THE LAST LIBERAL ART—Hagstrom

 

1.     A Latticework of Mental Models

Firstly, you need to acquire significant concepts, ie the models, from many areas of knowledge then, second, learn to recognise patterns of similarity among them. The first is a matter of educating yourself the second, is a matter of learning to think and see differently.

The key is finding the linkages that connect one idea to another….being able to observe similarities in other fields and recognise patterns of ideas.

The human brain transfers knowledge more easily when the new situation and the original situation have similar elements.

It is the ability to recognise complex patterns, classify new information into patterns and draw associations between the new data.

The first step is a basic understanding of each model. –how each model works and the phenomenon it describes. The second step is finding metaphors. Metaphors can translate ideas into models and represent the basis of innovative thinking….a metaphor helps communicate one concept by comparing it to another concept that is widely understood. Using a simple model to describe one idea can help us grasp the complexities of a similar idea. Metaphors, used this way not only express existing ideas they stimulate new ones.  

Many Industries have many examples of existing ideas that were used as a base to invent something with a similar idea but used in a different industry or for a different use.

To explain a complex stock market trend or investment decision you may rely on models of similar occurrences from different models that exist across the spectrum of knowledge.

The lattice work is where the ideas from different fields connect as nodes.

2.     Physics

Equilibrium is defined as a state of balance between opposing forces, powers or influences. In static equilibrium the system is at rest, dynamic equilibrium there are flows in and out but these balance each other out.

After Newton, scholars focused on systems demonstrating equilibrium, believing it is nature's ultimate goal.

Supply and demand reach equilibrium at the clearing price.

Equilibrium in the stock market assumes investors have rational expectations. This equilibrium leads to the EMH, and the ability to generate excess returns then depends on the assumption of greater risk and more volatility.

Opposing this theory is that the stock market is a complex adaptive system being a network of many individual agents all acting in parallel and interacting with one another. The critical variable that makes a system both complex and adaptive is the idea that agents, (investors), in the system accumulate experience by interacting with other agents and then change themselves to adapt to a changing environment.

In an environment of complexity, simple laws are insufficient to explain the entire system.

In my view, equilibrium is more likely the more homogenous the active participants are, the more different they are, for example in various resources, the more likely that disequilibrium will be more common.

3.     Biology

The main reference here is comparing business to Darwin's work on evolution and that constant change is more likely than static equilibrium.

Schumpeter’s theory that capitalism can only be understood as an evolutionary process of continuous innovation and creative destruction. .. the search for equilibrium is an adaptive process. In that process, innovators are the change agents. All change in the economic system starts with innovation. …from this, an entrepreneur, a visionary leader of innovation is required to drive the process of innovative adoption forward…innovation and entrepreneurship require certain environments, chief amongst them are available credit, property rights, stable currencies etc.

Thinking about biology moves the idea from a static equilibrium to a dynamic one. We move from the static world of physics to the dynamic world of biology, where change can be gradual or rapid. Change to a new paradigm can be fast, and then slow to a period of steady but continuous alteration.

Common to the study of complexity is the notion that complex adaptive systems operate with multiple elements, each adapting or reacting to the patterns the system itself creates. Complex adaptive systems are in a constant process of evolving. …An essential element of complex adaptive systems is a feedback loop. Ie, agents predictive models are retained, changed or disappear depending on their success in a dynamic world, that is, continually learn (adapt).

We can observe that over the long term, differing investing styles have dominated their eras. These strategies ultimately get taken over by a new strategy. There is a constant evolution of investment style or approach that dominate. Often these strategies get overwhelmed by the size of flows of money chasing the style and eliminate excess returns.

Will the market ever be efficient? If you accept the idea that evolution plays a role in financial markets the answer would be no. … the market will always maintain some level of diversity and this, as we know, is the principal cause of evolution.

Financial and economic systems are similar to biological systems driven by change. The similarities extend to predator-prey systems, competing systems and symbiotic systems.

BOOKS—Creative destruction: why companies that are built to last underperform the market. –and how to successfully transform them—Foster and Kaplan McKinsey

Christensen—The Innovators Dilemma; when new technologies cause great firms to fail, and The Innovators Solution: creating and sustaining successful growth

The Adaptive Markets Hypothesis: Market Efficiency from an evolutionary perspective (Lo)

Behaviour is the outcome of interactions between our logical faculties and our emotional responses. When logic and emotions are in proper balance, markets operate in a relatively efficient manner.

The dynamism of markets makes predictability a difficult objective. Darwin never claimed predictability (the outcome is uncertain). Progress could take several paths forward, the system is non-linear and unpredictable. In non-linear systems, the individual parts interact and exhibit feedback that may alter behaviour. Complex adaptive systems must be studied as a whole, not in individual parts because the behaviour of the system is greater than the sum of the parts.

My Take: No doubt markets evolve and as investors, we should evolve with them. Evolving is very difficult. The ability to alter a process that has worked well in the past is difficult. The changes that are likely to be made will be evolutionary not revolutionary but still evolving. The changes are likely to be judged over years not weeks or days. How many great fund managers have found that their edge or style has become redundant, and that process that worked well in the past no longer works? A possible successful case study is Buffet, he has had to evolve and probably has done the best at it, despite much criticism. The GOAT evolves and constantly learns, the ability to judge the usefulness of an existing process, adapt it to new environments and thrive is a challenge and goal of every investor.

 

4.     Sociology

Sociology in this regard is the study of attempting to understand group behaviour.

By definition, the investigation involves the subjective and unpredictable behaviour of human beings, in the social services the process is less precise the in the natural sciences.

The theory of emergence refers to the way individual units combine to create something greater than the sum of the parts. Adam Smith's invisible hand is an example. Emergent behaviour.

Decision-making appears to be more robust if the group contains a broad diverse mix of agents. They must also be independent, that is, not influenced by the stronger members of the group. This is quite counterintuitive as select experts are usually expected to do better and crowd behaviour has been identified as making terrible errors. Crowds prove remarkedly intelligent under the right circumstances. Those critical variables are independence and diversity.

BOOK – The Wisdom of Crowds: Why the Many are smarter than the few and how collective wisdom shapes business, economics, societies and nations. –Surowiecki

The Difference: How the Power of Diversity Creates Better Groups, Firms, Schools and Societies. -Page

Regarding the influence on the stock market what we need to understand is the market’s level of diversity and the independence of its participants. If the market agents are adequately diversified and more importantly, if the decisions of the participants have been reached independently, then the market is efficient. If the diversity of opinions breakdown then sub-optimal outcomes can occur, ie inefficient.

BOOKS—Mauboussin—More than You Know: Finding Financial Wisdom in Unconventional Places, Think Twice; Harnessing the Power of Counterintuition

Information cascades and that can lead to diversity breakdowns, ie when people make decisions based on the actions of others rather than on their self-generated private information. Cascades can help explain booms, fads, fashions, and crashes.

Self-organised criticality identifies the dynamic that the systems become a class of interlocking subsystems that organise themselves to the edge of criticality and, in some cases, break apart violently only to reorganise themselves at a later point. The stock market could be such a system where crowd-induced inefficiencies bring the system to a violent collapse and then ultimately a recovery.

Bak explains in his paper, “Price Variations in a Stock Market with Many Agents” that there is a battle between fundamentalists and trend followers. When they are equally balanced the market is efficient, but when the mix of fundamentals and trend followers becomes unbalanced, we are heading towards a diversity breakdown. Note this theory is unable to identify individual breakdowns but is a general concept.

That self-organising systems tend to be dominated by unstable fluctuations and that instability has become an unavoidable property of economic systems.

To help understand these influences on the market we should be considering the belief structures underlying various mental concepts and not the specifics of the choices, Another is to acknowledge that if mutual knowledge fails, the problem may centre on how knowledge is transferred in the system.

My Take: The market in most cases is relatively efficient, given the uncertainties apparent at the market and the individual stock level. There are rare circumstances when the market is certainly taken to irrational extremes, individual stocks as well, when there is a high probability of instability. Recognising the likelihood of these occurring is well worth the effort.

The other take is that passive and momentum strategies now likely outnumber the valuation-style strategies in the market (probably by a fair way). The upshot of that is more volatility and inefficiency are likely to occur. Good for stock pickers.

5.     Psychology

Behavioural finance seeks to explain market inefficiencies using psychological theories. I have covered the world of biases in detail in a separate post.

Thaler “Myopic Loss Aversion” and the Equity Risk Premium Puzzle 1995

Loss Aversion or Prospect theory is illogical and prevents investors from seeing long-term.

The equity risk premium is high (generating excess returns for long-term holders of equities) and persistent because of loss aversion and mental accounting. Mental accounting is coding financial outcomes. Taking this to the stock market, the longer an asset is held the more attractive it becomes and secondly, but only if the asset is not evaluated frequently. Put differently, the two factors contributing to an investor's unwillingness to bear the risks of holding stocks are loss aversion and a frequent evaluation period. (myopic loss aversion).

Using a loss aversion factor of two, the indifference between holding bonds (stable) and stocks (volatile) is a holding period of one year. Loss aversion is difficult to remove, but frequent evaluation can be adjusted and your returns should be measured once a year to avoid the angst of volatile returns. The impact of frequently looking at stock prices puts undue psychological pressure and increases errors.

Over-trading is identified as a source of value destruction. Trading could be linked to loss aversion.

The vast amount of information on the internet possibly also adds to investors easily locating evidence that confirms their hunches, which in turn leads them to become overconfident in their ability to pick stocks. –the illusion of knowledge.

Another problem is investors gravitating from boldness to fear of the market. Comfort with risk, we found, is connected with two demographic factors, age and gender. Older people are more cautious than younger people, and women are more cautious than men. Personal wealth does not seem to be a factor (it should! ed). Two personality traits are also important, personal control orientation (where the investor believes they are in control of the outcome) and achievement motivation (investors that are goal-focused). Both take on more risk. People choose higher-risk strategies when they believe that the stock market outcomes are more dependent on skill and information rather than luck.

People prepare mental models to help anticipate events. Johnson-Laird “Mental Models” observed several ways that people perform systematic errors in their thinking. Firstly, we weigh multiple mental models the same, ie not probability-weighted, secondly, we may use only one model, mental models also typically represent what is true but not what is false. We construct incomplete representations of the phenomenon we are trying to explain. We use models that leave out details and become unstable. Finally, we can create mental models based on superstition and unwarranted beliefs. Because mental models enable us to understand abstract ideas, good mental models are particularly important for investors.  People are pattern-seeking animals and need explanations even for the unexplainable. We build mental models to try and explain the unexplainable (eg. ST market movements).

Fisher Black 1986 talk American Finance Association. “Noise”

Rather than pure information leading to rational prices, Black believed that most of what is heard in the market is noise, leading to nothing but confusion. Noise is what makes our observations imperfect. The process of making rational decisions is the accurate communication of information. Errors can occur in the transmitting or receiving the information or over the channel used. Firstly we need integrity of data coming from the source, to remedy this we need to improve our ability to gather and analyse information and use it to further our understanding. We need to verify the information is properly passed through and accurately received, without interference from psychological biases. -this is challenging. We must make ourselves aware of all the ways emotion-based errors and errors of thinking can interfere with good investing decisions. We must constantly be on guard against our psychological missteps.

Munger warns against mental shortcuts, he thinks we jump to conclusions too easily, we are easily misled and prone to manipulation. First, he considers what are the factors that really govern the interests involved, rationally considered? Secondly, what are the subconscious influences where the brain at a subconscious level is automatically doing these things, which by and large, are useful, but can often misfunction.

What all investors need to internalise is that they are often unaware of their bad decisions. To fully understand the markets and investing we have to understand our irrationalities.

My Take: assessing every investment situation on its own merits takes a lot of work. Humans naturally try shortcuts to make quick decisions. Sometimes this works, but when we are confronted with complex decisions these shortcuts can lead to errors, due to embedded biases. I've made plenty. There is no easy way to a good outcome except taking your time, analysing all data and using your experiences and mental models in a disciplined, rational process. Very important.

 

6.     Philosophy

Philosophy can be broken down into three areas, in this book the focus is on epistemology, the study of the theory of knowledge. Specifically, how the process of thought formation occurs and how good thinking skills can be acquired. By learning to think well we can better avoid confusion, noise and ambiguities.

The goal of investors is to explain the market in terms that accommodate its basic principles. That redescription is used to change and understand how we think about a problem. See it from another angle while keeping to the basics of investing theory.

Failure to explain is caused by a failure to describe. That is, the description is wrong, the reality may differ from how consensus sees an investment.

People are very good at storytelling, they are also decent at statistics. But rarely does the storyteller import a statistical defence for the story. Likewise, people are capable of citing good statistics but rarely can they put the statistical revelation into proper context…ie they consider the numbers coming from a different realm than narratives and not as distillations, complements, or summaries of them. People often cite the numbers in bald form, without the supporting story and context needed to give them meaning.**

BOOK—Paulus—Once Upon A number: the hidden Mathematical Logic of stories.

Errors are Type 1 is where we observe something that is not there and type 2 errors where we fail to observe something that is actually there.

For investors, it is important to realise the slippery slope of narratives.—the focus of stories is on the individual rather than the average, on motives rather than the movements, and on context rather than raw data.

One of the most difficult intellectual confessions is to admit when you are wrong….we misjudge stubbornness for conviction. It is difficult to navigate our faults, particularly if they are steadfast and deeply held beliefs. To be a successful investor we must be prepared for redescriptions.

William James..a belief is true, not because it can stand up to logical scrutiny but rather because holding it puts a person into more useful relations with the world. (positive practical effects).

Pragmatism holds that truth, in statements, rightness, and in actions, are defined by their practical outcomes. The truth will evolve as circumstances change, the truth evolves.

The great use of beliefs is to help summarise old facts and then lead the way to new ones. ..remember all beliefs are man-made.

The change comes slowly as new information contradicts the existing beliefs, often we will save as many beliefs as we can, modify slowly, or try and incorporate the new while maintaining the old. The new truth is adopted while the older truths are preserved with as little disruption as possible. The new truths are simply go-betweens that help us get from one point to another.

Pragmatism is a process that allows people to navigate an uncertain world without becoming stranded on the desert island of absolutes.

Pragmatism thrives on open minds, invites experimentation and rejects dogma and rigidity. It insists all possibilities should be considered without prejudice. For the pragmatist, the reliance is not on absolute standards and abstract ideals but rather on results. Pragmatists will not hold onto an ineffectual model for as long as others.

My Take –being pragmatic is useful, it is having an investment philosophy wide enough to incorporate different investment cases over time and styles. Being too rigid can impact returns, especially missing out on opportunities. Many of these errors come from deciding too quickly and not thinking through alternative scenarios. An investment philosophy and process that proves, inflexible, built on absolutes, is vulnerable in an evolving complex market.

 

7.      Literature

When reading, differentiate between gathering facts and increasing your understanding.

We need an authenticating device for information, one is the ability to read analytically and think critically.

Due to the huge volume of reading, we must be able to winnow out the good from the not-so-good. We need to make good choices about what to read and read in an intelligent, perceptive way to enhance knowledge. To gain understanding is not the same as reading for information.

BOOK-How to read a Book-Mortimer J Adler

Much of what we read is to collect information, we collect more data, but our understanding of the matter does not generally increase.

When you come across a work that makes you stop, think and reread for clarification, chances are this process is increasing your understanding.

Adler proposes that readers keep four fundamental questions in mind. 1. What is the book about as a whole, 2. What is being said in detail, 3. Is the book true, in part or in whole, 4. What of it? Part one should take 30 minutes, read the preface, look carefully at the table of contents, run through the index, and the bibliography, after that systematic skimming, read the summation by the author. Then decide whether you should spend your valuable time reading it. Part two, if you decide to pursue reading the book, start with a complete but superficial reading. Pay attention to what you understand and skip over the difficult parts. Stay concentrated, do not daydream, do not get bogged down. Look for clues as to whether the book deserves a deeper examination. Part three-Analytical reading. This entails three goals, to develop a detailed sense of what the book contains, to interpret the contents by examining the author's point of view on the subject, and to analyse the author's success in presenting that point of view convincingly.

Decide for yourself whether the author has fulfilled his original goals, defended his arguments, and convinced you of the main thesis. You will always be concerned about the fundamental question, what is the book about in detail and is it true?

Part four, what is the significance of the material? Adler calls comparative or synoptical reading. Compare and contrast the work of several authors. It involves two challenges, first searching for other possible books on the subject and then deciding, after finding them, which books should be read. Inspect each book to make sure it has something important to say and discard the others. The first step in comparative reading is to locate the relevant passages in each book. You are not doing a full analysis of each book individually but finding the important parts of each separate book that relate to what you need to know. This is a fundamentally different approach from analysing a book in its entirety. In analytical reading, you accept information from the author as it is given; in comparative reading, your investigation must serve your own needs. Develop your list of questions, expressed in your own language, and analyse how well the selected books answer those questions. The final step in comparative reading is analysing the discussion between the authors. The more you can resist jumping to conclusions the better will be your overall understanding.

Note practicable books and theoretical books are completely different.

The challenge is to integrate the knowledge gained into our mental models. How well we can do so is a function of two separate considerations: the author's ability to explain and our skills as careful, thoughtful readers.

You must check your opinions at the door, you cannot understand a book if you refuse to hear what it is saying.

Summary—the mental skill of critical analysis is fundamental to success as an investor. Perfecting that skill, and developing the mindset of thoughtful, careful analysis, is intimately connected to the skill of thoughtful careful reading. Good reading and good thinking are tied at the hip.

Detective work, 1 begin an investigation with an objective and unemotional viewpoint,2. Pay attention to the tiniest detail, 3. Remain open-minded to new, even contrary information. 4. Apply a process of logistical reasoning to all you learn.

My take: the ability to read information and transfer the knowledge in an unbiased and clearly objective manner is critical. We are likely to make fast decisions, overlook contrary facts, embed favourable opinions, and not be critical enough when we read, particularly new information.

8.      Mathematics

Discounted PV of future cashflows is the intrinsic value of a stock. The inputs are very difficult to predict.

Decision theory is the first essential step in managing risk. The issue is the quality of information which formed the basis for the probability estimates.  In real life, relevant information is essential in understanding the probability of an outcome. Nature's patterns are only partly established, so probabilities in nature should be thought of as degrees of certainty, not absolute certainty.

Bayes theorem is strikingly simple, when we update our initial belief with new information, we get a new and improved belief. Ie initial beliefs + recent objective data =a new and improved belief. Bayesian analysis is an attempt to incorporate all available information into a process for making inferences, or decisions. Decision trees can be expanded to incorporate various time horizons and growth rates. Probabilities can be derived from actual hard data over a certain timeframe (frequency probabilities-gambling, car accidents, death rates) or where no hard data is available, ie in most investment scenarios, subjective probabilities must be used. A subjective probability is not based on precise computations but is often a reasonable assessment made by a knowledgeable person. A decision tree is only as good as its inputs and its static probabilities. Many inputs and assessments are not reasonable or knowledgeable and can contain personal bias. It is only through a process of continually updating probabilities with objective information that the decision tree will work.

The Kelly Optimization Model, allows the calculation of the size of a portfolio bet, given the probability of winning, an investor should make. It is 2P-1=x, so if the probability of winning is 55%, you should bet 10% of your bankroll. Note that the progression is non-linear, it goes up quickly. The Kelly criterion is optimal under two scenarios, the minimal expected time to achieve a level of winning, and the maximal rate of wealth increase. That is to win, you need an unlimited bankroll and unlimited time horizon. Adjusting bet sizes is probably required in the stock market.

Beware averages and natural distributions can hide underlying volatility in the data. Large tails, skew, dispersion, significant variation in returns that average to zero etc. data should be examined the average may not indicate the median return or the possibility of variable return.

The book then examines regression to the mean. The issues are the timeframe may be long, the mean may be volatile and the outcomes may be volatile around the mean.

Risk v Uncertainty. Risk involves situations with unknown outcomes but is governed by probability distributions known from the outset. We may not know what exactly is going to happen, but based on past events and the probabilities assigned, we have a pretty good idea of what is likely to happen.

Uncertainty is different. We don’t know the outcome, but we also don't know what the underlying distribution looks like, and that’s a bigger problem. This uncertainty is unmeasurable and impossible to calculate.

We are never certain we are always ignorant to some degree.

My Take, update your probabilities or you will be left behind. That process can be incredibly frustrating, as the market moves with the change,  but it is the correct process.  The descriptions of risk and uncertainty are quite useful.  Economies of scale not mentioned?

9.      Decision Making

System 1 thinking is intuitive and system 2 thinking is reflective and requires concentration. Be patient in answering questions. Allow enough time for rationality to engage. For intuitive skills to be useful, the environment must be sufficiently regular to be predictable, secondly, there must be an opportunity to learn these regularities through prolonged practice.  Intuitive skill exists mostly in people who operate in simple, predictable environments, and people in more complex environments are much less likely to develop this skill. –Kahnemann's Intuition is nothing more or less than recognition.

Tetlock—experts suffer from thinking deficiencies, specifically, overconfidence, hindsight bias, belief system defences, and lack of Bayesian process.  Psychological biases. Need to double-check through system 2 thinking.

Hedgehog v Fox—hedgehogs tend to fall in love with pet theories, which leads to overconfidence in forecasting. HH are too slow to change their views in response to disconfirming evidence. Foxes move 3X as much as HH. Foxes update their Bayesian inference much better than HH. Foxes have better calibration and discrimination than HH. Calibration is intellectual humility that allows their subjective probabilities to correspond to objective probabilities. Discrimination describes justified decisiveness, which measures whether you assign higher probabilities to things that occur than not. HH’s are stubborn.

Foxes' advantages, they begin with reasonable starter probability estimates, therefore closer to the truth, they also acknowledge their mistakes and update their views with new information, ie healthy Bayesian process finally, they can see the pull of contradictory forces and most importantly, they can appreciate relevant analogies. HH start with a big idea (belief) and follow it through regardless.

The most common thinking errors have less to do with intelligence and more with rationality. The errors are processing problems or content problems.  Humans are lazy thinkers, they take the easy way out and often the solutions are illogical. The content problem comes from an inability to think critically and creatively. Some authors credit the lack of broad knowledge as a cause of poor content.

Summary of actions to become a better investor.

1.      Slow down your thinking and also consider the possibility that the market's biological function could be altering the outcome

2.      EMH the market is efficient until the efficiency of crowds disappears through lack of diversity

3.      Avoid the irrational urge generated by loss aversion

4.      Stop looking at daily price moves, knowing it works against your better judgment.

5.      Don’t rest with your first description of events.

6.      Will you read to expand your knowledge of a situation?

As well as learning new ideas outside of the investing world, we must be able to use metaphors to link what we have learned back to the investing world. Metaphor is the device for moving from areas we know and understand to new areas we don’t know much about. That is the ability to think metaphorically.

On a flight simulator, a pilot's thought processes go something like this, I haven’t seen this exact situation before, but I saw something like it, and I know what worked in the earlier case, so I'll start there and modify as I go along…Pragmatically speaking we are searching for the right combination of building blocks that best describe the current environment….One thing to remember is that effective decision-making is very much about weighing the right building blocks and putting them into some hierarchical structure….if we have a sufficient number of building blocks, then model building becomes very much about reweighting and recombining them into different situations. We must strike a balance between exploitation (known models) and exploration (new ideas). When the model reveals readily available profits, we should exploit it, but never stop exploring new models.

If the new building blocks prove useful, then keep them and give them the appropriate weight. But if they appear to add no value, you simply store them away and draw them up again someday in the future.

One thing we have learned thus far is that our failures to explain are caused by our failures to describe. If we cannot accurately describe a phenomenon, it is fairly certain we will not be able to accurately explain it.

OVERALL SUMMARY

Several big takes for me relate to potential issues in my decision-making process. Firstly, do not be dismissive, think slowly and broadly. Do not jump to conclusions too quickly. Secondly, be pragmatic and a bit more flexible in approaching market situations. That is, do not be overly rules-based or quantitatively based. Think of alternative scenarios. Thirdly, read new information carefully, maybe several times. The effective transmission of information is critical. Separate fact from opinion and think of the broader consequences. Do not be dismissive.