Capital Beliefs

 

We make better choices when we understand all information that can impact a choice. In most cases it is easy for us to identify when we are dealing with a straightforward choice or when we are dealing with a complex one. Investing is different, it adds uncertainty around whether a choice is really simple or complex. What might first appear to be straightforward later becomes an expensive lesson in misjudgment.

 

In the age of information and endless investment noise, most of what we absorb encourages investors to make quick and unthoughtful decisions. To overcome this challenge, investors must understand key aspects of investing, partially because the market is unaccommodating to those who don’t. The idea is not to obsess over the details but to develop the right framework to gain a better understanding of how the investment-person interacts with investment markets.

 

Insight Needed

 

As discussed in the Core Concept that follows, the human mind has a strong and persistent tendency to be critical of others decisions but not our own.  Webster’s Dictionary states: "critical — in its strictest sense — implies an attempt at objective judgment so as to determine both merits and faults.” All investors use judgment to fill in gaps in what we can know about reality but not all investors fill those gaps in a critical way.

 

These days all that it takes to open an investment account is ten minutes and an internet connection. Not surprisingly most people logging into their accounts focus on generating good returns. But having returns as a core focus is harmful because returns are an unstable part of the investment landscape. Similarly, investors strong tendency to focus on returns takes their focus away from what’s much more important: the actions, attitudes and economic drivers that bring about investment returns.

 

In fact, the factors that drive long-term returns are much more stable than the returns themselves. This disproportionate emphasis on unstable factors ultimately leads to an unstable investment process. So it’s very important to have, at a minimum, a basic understanding of certain stable factors that impact investment returns.

 

Without a good grasp of the most relevant factors, investors are unprepared to think critically.  On a day to day basis an uncritical approach never seems problematic, partially because most investment risks and inflection points rarely make themselves visible. When unexpected events occur — as they always do — it's the uncritical investors who are most impacted. Sound strategies that are poorly understood are just as likely to be sold after periods of disappointment. And because 100% of strategies go through periods of disappointment, even good investment approaches are often abandoned. Jumping from one sound strategy to the next is no different than embracing a wealth destroying strategy for a very long time.

 

The ancient story of the Blind Man and the Elephant provides good perspective on the what’s needed to help investors determine the merits and faults in our decisions, ahead of time:

 

A king calls for the blind men of the capital to be brought to his palace. He has an elephant brought in and asks the men to describe it. The king asks the blind men, “Can you tell me, what sort of thing is an elephant?” One man, who felt the elephant’s head, says it is like a large pot. Another, who felt the tail, says it is like a rope. Another, who felt the ear, says it is like a hand fan. Another, who felt the side, says it is like a wall. More blind men are called, and they say that it is like a pillar, a pipe, and so on. Each describes a different part of the elephant based on his personal experience. The blind men begin to argue and come to blows, each asserting that he is right and the others are wrong. (version of story from Liminal Thinking)

 

Just because each blind man knew something was true — what they could feel in front of them — doesn’t mean they had a better understanding of reality. The same is true for investors. While we will never know the whole truth, improving our framework for making choices will help us better see things for what they are. 

 

While this may sound boring, it can be incredibly powerful and profitable. Jeff Bezos is a good example of how:

 

“The way I made the decision to leave Wall Street and do this was, and this may sound geeky to you, was through a regret minimization framework….I don’t go in for Carpe Diem, I go in for a regret minimization framework”  

                                                       -Jeff Bezos, 1999 interview 

 

It's unlikely Bezos would have possessed the resolve to stick with his decisions had he gone the route of "Carpe Diem." Famed investor, Howard Marks would likely call Bezos' regret minimization framework, "risk control."

 

Howard Marks:

 

While risk control is essential, risk bearing is neither wise nor unwise per se. It’s inevitably part of most investment strategies and investment niches. It can be done well or poorly, and at the right time or the wrong time. If you have enough skill to be able to move into the more aggressive niches with risk under control, it’s the best thing possible. But the potential pitfalls are many, and they must be avoided.

 

While it's very unlikely an investor will replicate the success of Bezos, building such aspects into our thinking should increase the odds of maximizing what we truly want and minimizing what we don’t.

 

Michael Mauboussin has written some of the most insightful things on effective ways to improve one's investment framework. Mauboussin — whose admirers include a number of legendary investors but also Bezos — has often emphasized the importance of distinguishing the "inside-view" from the "outside-view."   

 

Mauboussin on the frame of mind we naturally gravitate toward:

 

There is a natural and intuitive approach to creating a forecast of any kind. We focus on an issue, gather information, search for evidence based on our experience, and extrapolate with some adjustment. Psychologists call this approach the “inside view.”

 

An important feature of the inside view is that we dwell on what is unique about the situation. Daniel Gilbert, a psychologist at Harvard University, suggests that “we tend to think of people as more different from one another than they actually are.” Likewise, we think of things we are trying to forecast as being more unique than they are.

 

The inside view commonly leads to a forecast that is too optimistic, whether it’s the likely success of a new business venture, the cost and time it will take will take to build a bridge, or when a term paper will be ready to be submitted.

 

Too much inside view vastly increases the risk of making the type of poorly calculated bets that so often hurt investors. 

 

Mauboussin on how the "outside view" helps balance out the investment-framework:

 

From Think Twice:

 

 

The outside view asks if there are similar situations that can provide a statistical basis for making a decision. Rather than seeing a problem as unique, the outside view wants to know if others have faced comparable problems and, if so, what happened. The outside view is an unnatural way to think, precisely because it forces people to set aside all the cherished information they have gathered.

 

Lastly, in a separate note, Mauboussin states:

 

Considering the outside view is useful but most executives and investors fail to do so. Dan Lovallo, Carmina, Clarke and Colin Camerer, academics who study decision making, examined executives making strategic choices and found that they frequently rely either on a single analogy or a handful of cases that come to mind. Investors likely do the same.

 

Using an analogy or small sample of cases from memory has the benefit of being easy. But the cost is that it prevents a decision maker from properly incorporating the outside view.

 

This blog's focus is on the exploration of timeless insights that relate to both the investment-self and the investment markets, which I hope will help investors have better tools for understanding the outside-view.