Seeking Alpha

Living In A Cloud Of Possibilities

by: Ensemble Capital
Ensemble Capital
CFA, registered investment advisor, INTRINSIC INVESTING

By Sean Stannard-Stockton, CFA®

"Reality is a cloud of possibilities, not a point." - Amos Tversky

Amos Tversky is one of the most important economic thinkers most people have never heard of. Along with Daniel Kahneman, Tversky upended classical economic thinking by demonstrating that the key assumption of classical economics - that humans are rational actors who seek to maximize their own best interest - bears no resemblance to how the world actually works.

That Kahneman was the sole author of the groundbreaking book Thinking, Fast and Slow and the sole winner of the Nobel prize in economics (despite being a psychologist, not an economist) was due only to the sad fact that Tversky's life was cut short by cancer. The remarkable intellectual partnership of these two men was described in what can only be called loving detail by Michael Lewis in his book The Undoing Project: A Friendship That Changed Our Minds.

Far too many economists and investors have what has come to be called "Physics Envy", the unattainable wish that the social sciences can be "figured out" by discovering some unifying mathematical theory that will allow us to predict the future (and yes, physicists really can Predict The Future). What Tversky and Kahneman showed the world, however, is that this dream will never be realized because economics and investing are driven by non-rational, unpredictable human behaviors, not natural laws.

Every time you read an economist or an investor (including us!) talk about their expectations for the future, remember Tversky's quote:

"Reality is a cloud of possibilities, not a point."

Is the market overvalued? Is a recession about to occur? Will the economy ever return to strong growth? Will Apple's (NASDAQ:AAPL) new iPhone sell well? Will self-driving cars transform the world?

The fact is, we simply don't know. There is no correct answer to these questions, only a cloud of possible futures.

This is why an investment strategy cannot be based on the idea that an investor can predict what is going to happen, but instead must involve a process that is prepared for a range of possible futures. If the future is unpredictable, the right approach to investing is not to pick the most likely point and assume it will occur but to build a portfolio of investments that are prepared for a range of possible futures, while doing your best to understand what areas of the "cloud of possibilities" are more likely to occur.

When you evaluate an economist or investor, one of the most important things to look for is whether they frame their expectations in terms of predictions or probabilities. Those who claim they know which "point" economic or financial market reality will gravitate towards in the future are operating under a discredited economic model that is based on the assumption that humans are rational. Those who recognize that we live in a probabilistic, rather than a deterministic world, at least have a fighting chance to arrange their affairs in such a way that they are prepared for the uncertainty of tomorrow.

We know that our own writing and thinking sometimes falls into the trap of believing the future is predictable, but recognizing this trap exists and working hard to avoid it is one of the most fundamental underpinnings of any successful approach to investing.

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