More on this book
Community
Kindle Notes & Highlights
Read between
February 15 - May 7, 2019
It is no longer enough to just acquire and master the basics in accounting, economics, and finance. To generate good investment returns, I believe, requires much more. It is driven by a keen mental appetite to discover and use new insights regardless of what Dewey decimal number they bear or how unrelated they may at first appear.
“Benjamin Franklin’s success as an educator was based upon three standing principles. First the student must acquire the basic skill sets: reading, writing, arithmetic, physical education, and public speaking. Then the student was introduced to the bodies of knowledge, and finally the student was taught to cultivate habits of mind by discovering the connections that exist between the bodies of knowledge.”
KL liked this
In this view, learning new concepts has less to do with a change in a person’s learning ability than with the existence of commonalties. We do not learn new subjects because we have somehow become better learners but because we have become better at recognizing patterns.
According to Holland, innovative thinking requires us to master two important steps. First, we must understand the basic disciplines from which we are going to draw knowledge; second, we need to be aware of the use and benefit of metaphors.
true learning and lasting success come to those who make the effort to first build a latticework of mental models and then learn to think in an associative, multidisciplinary manner.
“Worldly wisdom is mostly very, very simple. There are a relatively small number of disciplines and a relatively small number of truly big ideas. And it’s a lot of fun to figure out. Even better, the fun never stops. Furthermore, there’s a lot of money in it, as I can testify from my own personal experience.”
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.
Believing that, on average, neither buyers nor sellers possessed any great insight, Bachelier made a startling conclusion. “It seems that the market, the aggregate of speculators, at a given instant can believe in neither a market rise nor a market fall, since, for each quoted price, there are as many buyers as sellers.” Thus, according to Bachelier, “the mathematical expectation of the speculator is zero.”9
The concept of equilibrium is so deeply embedded in our theory of economics and the stock market, it is difficult to imagine any other idea of how these systems could possibly work. As we have seen, equilibrium is not only the backbone for classical economics, but it also serves as the foundation for modern portfolio theory. To question the validity of the equilibrium model is to enter into combat with a legion of scholars who have made it their career to defend this ideal.
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. No thoughtful person, looking at the present stock market, can fail to conclude that it shows all the traits of a complex adaptive system.
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.
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. Letting go of such deeply embedded ideas is not easy. However, in the spirit of Newton, Galileo, and Copernicus, we must be willing to see the world as it is, and that means making room for new ideas.
In an environment of complexity, simple laws are insufficient to explain the entire system.
“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.”8
Lastly, Schumpeter explained, great innovations led by great entrepreneurs can thrive only in certain environments. Such things as property rights, stable currencies, and free trade are all important environmental factors, but credit is paramount. Without access to credit, the ability to promote innovation would be hamstrung.
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.
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. It is wise to enjoy what is possible without hoping for the continuance of a favorable conjuncture and the persistence of good luck. The third principle: Profits on the exchange are the treasures of goblins. At one time they may be carbuncle stones, then coals, then diamonds, then flint-stones, then morning dew, then tears. The fourth principle: Whoever wishes
...more
According to Surowiecki, the two critical variables necessary for a collective to make superior decisions are diversity and independence.
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.
The most important discovery in prospect theory was the realization that individuals are, in fact, loss averse. Kahneman and Tversky were able to prove mathematically that individuals regret losses more than they welcome gains of the exact same size—two to two and one-half times more.
In 1963, Samuelson asked a colleague if he would be willing to accept the following bet: a 50 percent chance of winning $200 or a 50 percent chance of losing $100. The colleague politely turned down the bet but then announced he would be happy to play the game 100 times so long as he did not have to watch each individual outcome. That counterproposal sparked an idea for Thaler and Benartzi. Samuelson’s colleague was willing to accept the wager with two qualifiers: lengthen the time horizon for the game and reduce the frequency in which he was forced to watch the outcomes. Moving that
...more
In my opinion, the single greatest psychological obstacle that prevents investors from doing well in the stock market is myopic loss aversion. In my twenty-eight years in the investment business, I have observed firsthand the difficulty investors, portfolio managers, consultants, and committee members of large institutional funds have with internalizing losses (loss aversion), made all the more painful by tabulating losses on a frequent basis (myopic loss aversion).
Perhaps Buffett had read Joseph de la Vega’s fourth principle in Confusion of Confusions: “He who knows how to endure blows without being terrified by the misfortune resembles the lion who answers the thunder with a roar and is unlike the hind who, stunned by the thunder, tries to flee.”
We must all come to terms, he insisted, with the idea that common stocks have both an investment characteristic and a speculative characteristic. That is, we know the direction of stock prices is ultimately determined by the underlying economics but we must also recognize that “most of the time common stocks are subject to irrational and excessive price fluctuations in both directions, as the consequence of the ingrained tendency of most people to speculate or gamble—i.e., to give way to hope, fear, and greed.”
“That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by another person’s mistakes of judgment.”6
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.
We must start with the premise, generally accepted by psychologists, that people are pattern-seeking creatures. Indeed, our survival as a species has depended on this ability. Shermer writes, “Those who are best at finding patterns (standing upwind of game animals is bad for the hunt, cow manure is good for the crops) left behind the most offspring [and] we are their descendants.”16 Through the forces of evolution we are hardwired to seek patterns to explain our world, and those patterns form the foundation of our belief systems, even when they are inherently specious.
In his newest book, The Believing Brain (2011), Shermer tells us our superstitions are a product of the spurious identification of patterns. As such, beliefs precede reasoning. Our brains are belief engines that naturally look for patterns, which are then infused with meaning. Not surprisingly, we look for information that confirms our beliefs while ignoring information that contradicts them.
Black believed that most of what is heard in the market is noise, leading to nothing but confusion. Investor confusion, in turn, further escalates the noise level. “Noise,” said Black, “is what makes our observations imperfect.”17 The net effect of noise that builds in the system, he explained, makes prices less informative for the producers and consumers who use them to guide their economic decisions.
It is easy to say we should ignore noise in the market but quite another thing to master the psychological effects of that noise. What investors need is a process that allows them to reduce the noise, which then makes it easier to make rational decisions. That process is nothing more—and nothing less—than the accurate communication of information.
A communication system consists of five parts: 1. An information source, which produces a message or a sequence of messages. 2. A transmitter, which operates on the message to produce a signal that can be transmitted over the channel. 3. A channel, the medium used to transmit the signal from the transmitter to the receiver. 4. The receiver, which reconstructs the message (the inverse operation of the transmitter). 5. The destination, the person for whom the message is intended. What is the communication system of investing? Our information source is the stock
...more
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.
Psychology—the study of what makes us tick—is endlessly fascinating. I’m especially intrigued that it plays such a strong role in investing, an arena generally thought to be made up of cold numbers. When making investment decisions, our behavior is sometimes erratic, often contradictory, occasionally goofy. Sometimes our illogical decisions are consistently illogical, and sometimes no pattern is discernible. We make good decisions for inexplicable reasons and bad decisions for no good reason at all. What all investors need to internalize is that they are often unaware of their bad decisions.
...more
I firmly believe, for instance, that one reason we have such difficulty understanding markets is that we have been locked into an equilibrium description of how they should behave. To reach a higher level of understanding, we must remain open-minded to accepting new descriptions of systems that appear complex, whether they are financial markets, social and political systems, or the physical world.
One of the most difficult intellectual confessions is to admit you are wrong. Behaviorally we know we are subject to confirmation bias. Eagerly we wrap our minds around anything and everything that concurs with our statement. Too often, we misjudge stubbornness for conviction. We are willing to risk the appearance of being wrong long before a willingness to personally confess our own errors.
Pragmatic investors can, and should, apply any second-order model that is fruitful and discard any that are worthless, all without violating the first order.
James tells us that even “the most violent revolutions in an individual’s beliefs leave most of his old order standing.” Even when we adopt a new idea, we can still preserve the older ones with minimum modification. From a pragmatist’s point of view, it is permissible, even advisable, to search for those explanations that work.
The philosophic foundation of successful investors is twofold. First, they quickly recognize the difference between first- and second-order models, and as such they never become a prisoner of the second-order absolutes. Second, they carry their pragmatic investigations far from the field of finance and economics. It can be best thought of as a Rubik’s Cube approach to investing.
In studying the great minds in investing, the one trait that stands out is the broad reach of their interests. Once your field of vision is widened, you are able to understand more fully what you observe, and then you use those insights for greater investment success. We live and work in a world in which the pace of change is staggering; just when you think things can’t possibly move any faster, the pace once again accelerates. In such a world, successful performance demands flexible thinking. In an environment of rapid change, the flexible mind will always prevail over the rigid and absolute.
Adler proposes that all active readers need to keep four fundamental questions in mind:6 1. What is the book about as a whole? 2. What is being said in detail? 3. Is the book true, in whole or part? 4. What of it?
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. Each one reinforces the other in a kind of double feedback loop. Good readers are good thinkers; good thinkers tend to be great readers and in the process learn to be even better thinkers.
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.
Have you ever found, when reading a work of fiction or poetry, that you are stopped cold by a sentence that perfectly expresses something you have felt but have never been able to put so clearly into words? The thought is not new, but suddenly it seems stronger and more real. The recognition of truth can be as strong and sudden as a shot of electric current, and the insight you gain will stay with you. This is the power of imaginative literature: it helps us more poignantly know what we know, feel what we feel, believe what we believe.
The Kelly criterion, as applied to investing, is also known as the Kelly Optimization Model, which in turn is called the optimal growth strategy. It provides a way to determine, mathematically, the optimal size of a series of bets that would maximize the growth rate of a portfolio over time, and it’s based on the simple idea that if you know the probability of success, you bet the fraction of your bankroll that maximizes the growth rate. It is expressed as a formula: 2p − 1 = x; where 2 times the probability of winning minus 1 equals the percentage of one’s bankroll that should be bet. For
...more
Mathematics, like physics, has a seductive quality about it. Math leads us toward precision and away from ambiguity. Still, there is an uneasy relationship between quantification of the past in order to predict versus subjective degrees of belief about what the future might hold. The economist and Nobel laureate Kenneth Arrow warns us that the mathematically driven risk management approach to investing contains the seeds of its own self-destructive technology. He writes, “Our knowledge of the way things work, in society or in nature, comes trailing clouds of vagueness. Vast ills have followed
...more
“The recognition of risk management as a practical art rests on a simple cliché with the most profound consequences: when our world was created, nobody remembered to include certainty,” said Peter Bernstein. “We are never certain; we are always ignorant to some degree. Much of the information we have is either incorrect or incomplete.”22
The real trouble with this world of ours is not that it is an unreasonable world, nor even that it is a reasonable one. The commonest kind of trouble is that it is nearly reasonable, but not quite. Life is not an illogicality; yet it is a trap for logicians. It looks just a little more mathematical and regular than it is; its exactitude is obvious, but its inexactitude is hidden; its wildness lies in the wait.23
For years, psychologists have been interested in the idea that our cognitive processes are divided into two modes of thinking, traditionally referred to as intuition, which produces “quick and associative” cognition, and reason, described as “slow and rule-governed.” Today, these cognitive systems are commonly referred to as System 1 and System 2. System 1 thinking is intuitive. It operates automatically, quickly, and effortlessly with no sense of voluntary control. System 2 is reflective. It operates in a controlled manner, slowly and with effort. The operations of System 2 thinking require
...more
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
...more
