Millions of investors have read Ben Graham’s The Intelligent Investor, Warren Buffett’s annual letters to Berkshire Hathaway shareholders, and other pieces of investment wisdom. Few, however, have consistently beaten the major stock market indices. This somewhat surprising outcome conforms to the view that investing is at least as much art as it is science (presumably, science can be taught, while art cannot). There is obviously no formula for investment success and each investment opportunity is slightly different. The good news, however, is that much of the art of investing can be taught and learned. To do so, we must reach deeper than financial statement analysis and P/E ratios. We must build intuition for value.
No Free Lunch
The assertion that you can’t get “something for nothing” goes a long way toward building economic intuition. The things we want typically exist in limited supply, making them valuable in exchange for other goods. (An exception is oxygen, which is plentiful in air and therefore rarely bought or sold.) If you internalize the “no free lunch” principle, you will have already made a small step toward investment success.
In the debate over the stock option expensing a few years ago, one side—the “cons”—essentially asserted that there was such a thing as a free lunch. The cons wanted companies to record no expense for something of value given by a company to its employees. Warren Buffett and others intuitively dismissed the cons’ position.
In the immediate aftermath of Hurricane Katrina in September 2005, the U.S. stock market rose because investors predicted that companies would benefit from reconstruction work that would surely follow the destruction of New Orleans and the surrounding areas. The bullish reaction contradicted the “no free lunch” principle and should have been viewed with suspicion. “Intuition for value” would have told investors that destruction, in the aggregate, was bad, not good for the stock market. Were this not so, we could just keep destroying and rebuilding parts of the country, and stock prices would go ever higher.
We see the “no free lunch” principle violated almost daily in the political arena, with politicians promising bailouts or tax cuts with little regard for how the bills will be footed. We are constantly bombarded with messages that one can get something for nothing. The truth, meanwhile, is quite different.
Embrace Multidisciplinary Inquiry
We liken approaches such as Charlie Munger’s “latticework of mental models,” which infuses investing with multidisciplinary knowledge, to the curricula of the nation’s best colleges, where undergraduates earn liberal arts rather than professional degrees. Yale, for instance, does not offer an undergraduate major in business or accounting. You study economics instead, thereby gaining a broader understanding of the forces that underlie the conduct of business. An accountant who understands business management is a better accountant, and a manager who understands accounting is a better manager.
The best investors are not only expert at finance, accounting and corporate strategy. They also study other disciplines, seek to understand human nature, and realize that our world is uncertain and probabilistic. Multidisciplinary insight can be developed through academic study and reading but also through extreme personal experiences, such as growing up in a war zone or living in a country with a hyper-inflationary economy. The first-hand experience of extreme events produces a gut-level appreciation for the aberrations that periodically occur in society. Such aberrations may be several standard deviations removed from normal experience, but they tend to recur more frequently than statisticians would expect (this phenomenon is sometimes referred to as “fat tails” or “black swans”).
You would obviously gain a huge advantage in the stock market if you had the ability to anticipate fat tails or at least avoid being caught entirely off-guard by them. Academic finance does a poor job of developing such ability, perhaps because it ignores the possibility of simultaneous irrational behavior by a large herd of market participants. George Soros points out that economics isn’t designed to predict or prevent market mania: “…imposing the standards and criteria of natural science on the human sciences gives rise to false claims and misleading results. It encourages theories such as rational expectations that do not correspond to reality…” Soros’s comment echoes Aristotle’s admonition in the Nicomachean Ethics that we cease looking for precision where none is to be found: “Our discussion will be adequate if it has as much clearness as the subject matter allows. Equal precision cannot be found in all discussions. Political science investigates many things with much variety and volatility. It is the mark of an educated person to look for precision only as far as the nature of the subject allows.”
The fact that today’s investment professionals tend to be somewhat narrow-minded finance practitioners reflects a broader trend in society. Businessmen and fund managers are highly paid “stars,” while other intellectuals—doctors, scientists, and writers—rarely acquire significant wealth or win public acclaim. The question is whether the ever-greater specialization in specific financial and business disciplines has reached the point of diminishing returns. Can an investment manager focused on the data networking industry, for example, succeed in the long term thanks to his intimate knowledge of technology, products and relative market share trends, or will that manager sooner or later “blow up” because she will miss a broader trend that will significantly diminish the value of companies in the entire industry?
Lawrence Krauss of Case Western University’s physics department adds some perspective:
We live in a society where it’s considered okay for intelligent people to be scientifically illiterate. Now, it wasn’t always that way. At the beginning of the 20th century, you could not be considered an intellectual unless you could discuss the key scientific issues of the day. Today you can pick up an important intellectual magazine and find a write-up of a science book with a reviewer unashamedly saying, “This was fascinating. I didn’t understand it.” If they were reviewing a work by John Kenneth Galbraith, they wouldn’t flaunt their ignorance of economics.
It seems self-evident that well-rounded individuals should make the best investors. Charlie Munger devours knowledge across a wide variety of disciplines and uses such knowledge to build—and continually improve—his latticework of mental models. These models allow Munger to think strategically about the long-term prospects of industries and companies. To give you a flavor for the breadth of Munger’s interests, consider one of his book recommendations: Gino Segre’s A Matter of Degrees: What Temperature Reveals About the Past and Future of Our Species, Planet, and Universe.
Individuals often use the words “I’m sure” to assert things of which they are not entirely sure. We know—we’ve done it many times. These days, however, we seem to be “sure” much less often. Instead, we tend to be “quite sure” about some things and “less sure” about others. Probabilistic thinking has replaced categorical or binary thinking. While the latter made us more comfortable about many things (“this plane will arrive safely”), the former reflects more accurately the uncertain nature of our world (“most likely, this plane will arrive safely”).
Many famed investors will attest that they view the world through the prism of probability. Such thinking is ideally suited to dealing with an unknowable future, whether you care about tomorrow’s weather or the completion chances of a merger. Former U.S. Treasury Secretary Robert Rubin, whose reputation has been tarnished amid Citigroup’s recent woes but whose talents Warren Buffett describes as “extremely rare,” considers himself a probabilistic thinker:
What has guided my career in both business and government is my fundamental view that nothing is provably certain. One corollary of this view is probabilistic decision making. Probabilistic thinking isn’t just an intellectual construct for me, but a habit and a discipline deeply rooted in my psyche. I first developed this intellectual construct in the skeptical environment of Harvard College in the late 1950s, in part because of a year-long course that almost led me to major in philosophy. I started to employ probabilistic decision making in practice at Goldman Sachs, where I spent my career before government.
As an arbitrage trader, I’d learned that as good as an investment prospect might look, nothing was ever a sure thing. Success came by evaluating all the information available to try to judge the odds of various outcomes and the possible gains and losses associated with each. My life on Wall Street was based on probabilistic decisions I made on a daily basis.
Probabilistic thinking presents some obvious advantages: For example, it allows you to calculate more accurately the expected return on an investment, and then decide whether the return is worth the risk. Consider the case of an airline that is believed likely to file for bankruptcy. Many investors would say, “The airline will go bankrupt and shareholders will get wiped out. I don’t want to own the stock.” A more enlightened investor (you!) might say, “There is a 90% chance the airline goes bankrupt and the stock is worthless. If the airline doesn’t go bankrupt, though, the stock should be worth at least $10.” If the stock can be bought meaningfully below $1, it may be a good investment even though you expect the company to go bankrupt. If the company fails, it doesn’t mean investing in it was a bad decision. As Rubin points out, “even a large and painful loss didn’t mean that we [his arbitrage team at Goldman] had misjudged anything.” One outcome simply isn’t enough to judge. Tens of similar situations would need to be tallied up in order to decide whether the investor has a good grasp of the probabilities and payoffs involved. Even so, evaluating probabilistic judgments can be tricky.
Warning: Skip This Part If You Want to Believe in Miracles
Scientific American writer Michael Shermer invokes the striking example of death premonitions to show how probability theory can debunk seeming miracles:
A common story is the one about having a dream or thought about the death of a friend or relative and then receiving a phone call five minutes later about the unexpected death of that very person.
[…] In the case of death premonitions, suppose that you know of 10 people a year who die and that you think about each of those people once a year. One year contains 105,120 five-minute intervals during which you might think about each of the 10 people, a probability of one out of 10,512—certainly an improbable event. Yet there are 295 million Americans. Assume, for the sake of our calculation, that they think like you. That makes 1/10,512 x 295,000,000 = 28,063 people a year, or 77 people a day for whom this improbable premonition becomes probable.
With the well-known cognitive phenomenon of confirmation bias firmly in force (where we notice the hits and ignore the misses in support of our beliefs), if just a couple of these people recount their miraculous tales in a public forum (next on Oprah!), the paranormal seems vindicated. In fact, they are merely demonstrating the laws of probability writ large.
Shermer’s example shows that probability theory is powerful because it debunks events that may otherwise go unexplained or spawn fantastic claims. In investing, there is no room for an individual to say a major catastrophe was a “miracle” that could not have been anticipated. It is the job of each investor to construct a portfolio that can withstand “miracles,” including a severe credit contraction and near-meltdown of the financial system.
Soros on Philosophy
George Soros, a renaissance man among today’s fund managers, believes that philosophy is a worthwhile pursuit for investment managers. Soros’s love of philosophy grew under his former mentor, philosopher Karl Popper. According to Soros, “Our knowledge is not so securely based that we can afford to stop asking the eternal questions about the relationship between thinking and reality, the meaning of meaning, and so on, even if we cannot find satisfactory answers to them, or, more exactly, even if the answers always raise new questions. We are fed up with philosophy because the questions never end. But the questions are inherent in the human uncertainty principle. If the principle is valid, we must never stop questioning. A critical mode of thinking is indispensable to a better understanding of the world and also for making the world a better place.” As further reading on this topic, we highly recommend Soros’s Alchemy of Finance, Popper’s The Logic of Scientific Discovery, and books on epistemology, the philosophy of knowledge.
More Intuition: Real versus Monetary Property
Things such as your car, house, land, gasoline, and orange juice constitute “real” property. “Monetary” property, on the other hand, denotes dollar bills and other means of exchange, which possess value because others are willing to exchange real property for them. Internalizing this distinction is important to developing the right investment mindset. The difference between real and monetary is easily comprehended but often disregarded, as real property can be converted quite effortlessly into monetary property, and vice versa, under normal circumstances. This caveat is critical to understanding the risk implications of investing in monetary versus real property.
Imagine the following scenario: It is the year 2050, and American retirees have saved enough money to pay for a carefree retirement. However, they wake up one day to find that most young Americans have emigrated to pursue a better future elsewhere. As a retiree, you may still find the window of the local barber shop advertising a $20 haircut, but there is no barber to provide it. You may have the same amount of money (monetary property) as before, but it would be more difficult to convert it into a haircut (real property/service). If lucky, you would have to pay a little more than $20, perhaps $25, to get a haircut. If unlucky, there simply wouldn’t be a barber around, regardless of price. Convertibility of monetary into real property would have become impaired. (This scenario is a form of “extremist” thinking, which we discuss below.)
What is the point of the foregoing example? Monetary property has no intrinsic value; its value is derived solely from the willingness of owners of real property to accept money in exchange. When the supply of real property is constrained, as above, monetary property becomes worth less (a $20 haircut may cost $25). Inflation alters the terms of trade.
This intuition is sometimes lost when we talk about less easily conceptualized issues, such as the future of social security. Ultimately, the schemes political parties propose to save social security involve different ways of accumulating financial property. As the above example illustrates, however, no financial scheme, no matter how well conceived, will succeed if there isn’t enough real property around (read: working-age Americans or equivalent immigrants) when the financial assets need to be converted into real goods and services. To be sure, most goods could be purchased from overseas, but other, “non-tradable” goods and services, such as a haircut, would have to be rationed or would become much more expensive. As a result, we can say with near certainty that a flare-up of inflation, regardless of what social security scheme is implemented, would be inevitable if America’s population pyramid became too “top heavy.” This insight may help you steer clear of long-term government bonds in countries that have bad demographics.
Economics Nobel Laureate James Tobin, summed up the good features of monetary property, while elucidating the problem of convertibility, as follows:
By enabling individuals to hold wealth in fluid, flexible, and generalized forms and to consume wealth at will, our monetary and financial institutions create an illusion. […] One individual’s wealth is both consumable in total and fluid in form without loss of value, but only so long as most other owners refrain from exploiting these same characteristics. […] It is quite impossible for all individuals in the nation to consume their wealth at the same time.
Tobin’s quote succinctly explains why you could retire on $1 million tomorrow, but why not every person in the world could retire tomorrow, even if each were given $1 billion today.