What is deconstruction?
The late investing legend Chandrakantbhai Sampat, who I remember and whose presence I miss, used to always talk about philosopher Jacques Derrida’s deconstruction theory. I’m going to try to explain this in absolutely simple language. If you have ever listened to someone explain a book, a movie or even a magazine article and you wanted to interrupt and say that you had seen something that contradicts what he or she were saying, then you have practiced deconstruction. I’m using the term here as a philosopher and not as a systems engineer, who would define deconstruction as breaking down a larger system into its modules. The philosophical interpretation is that the world is understood in terms of binary oppositions, one element of which is generally suppressed. Deconstruction is central to good investing.
What is Michael Steinhardt’s variant perception but holding a strong viewpoint that is substantially different from the market or consensus viewpoint? Or, take second-level thinking, which Howard Marks writes is thinking that is different and better. Here is how Marks describes it: “The first-level thinker simply looks for the highest-quality company, the best product, the fastest earnings growth or the lowest P/E ratio. He’s ignorant of the very existence of a second level at which to think, and of the need to pursue it.
The second-level thinker goes through a much more complex process when thinking about buying an asset. Is it good? Do others think it’s as good as I think it is? Is it really as good as I think it is? Is it as good as others think it is? Is it as good as others think others think it is? How will it change? How do others think it will change? How is it priced, given its current condition; how do I think its condition will change; how do others think it will change; and how do others think it will change? And that’s just the beginning. No, this isn’t easy.” It’s what George Soros’ calls fertile fallacies. Essentially, some knowledge seems to be very true and early experiments confirm its veracity, but eventually the fallacy catches up and you end up in a worse situation: a self-reinforcing cycle followed by a self-defeating cycle.
Natural selection teaches us that the chances of being extinct are higher in some places than in others. The interesting thing in investing is the circumstances that cause portfolio cropping or selling. Logically, it is when the odds of earning a decent rate of return go against the investor. The Grahamian system has two broad cropping principles: when the price appreciates by a certain amount or when the stock does not perform over a certain time frame. The Buffett/Munger methodology allows for a much greater focus on the dynamics of the business and deterioration of the moat quality rather than price or time. It is inherently more subjective. Of course, for the right business, the holding period is forever, which rules out any need to do any cropping. After all, as Peter Lynch remarked, you don’t want to pluck the flowers and water the weeds.
A ratchet effect is the instance of the restrained ability of human processes to be reversed once a specific thing has happened, analogous with the mechanical ratchet that holds the spring tight as the clock is wound up. Ratchets allow continuous linear or rotary motion in only one direction while preventing motion in the opposite direction. Examples can be found in many fields: in government, environment and cultural anthropology, among others. But let’s keep the discussion limited to investing. There are lots of psychological reasons that make it hard to admit a mistake: over-optimism, overconfidence, deprival super-reaction, loss aversion, denial, commitment and consistency.
The pure Grahamian system is fairly automatic if followed rigorously: a time period for the investment to work out or a specified pre-committed gain and a cash level dependent on the overall valuation of the market. It is psychologically easier to keep gains if the system is somewhat mechanical, as a pure Grahamian system would be. The Buffett/Munger framework tends to be somewhat more subjective, given that the holding period for the ideal company is forever. But there would be chances to sell — they would be dependent more on the delta in moat quality and valuations. It is easy to explain away facts that contradict our beliefs, rather than changing our beliefs.
A phrase that is used to explain this is ‘knowledge shields’, that help people hold on to inaccurate beliefs. Munger once said, “It is, of course, irritating that extra care in thinking is not all good but also introduces extra error. The best defense is that of the best physicists, who systematically criticise themselves to an extreme degree as follows: the first principle is that you must not fool yourself and you’re the easiest person to fool.” And he said somewhere else “part of what you must learn is how to handle mistakes and new facts that change the odds.” This is not psychologically easy. A quasi-mechanical system like the original Grahamian one makes it somewhat easier to deal with denial. The only other way is to develop the habit of not agonising over errors but acknowledging and analysing them.
It is easy to see how investment performance can be improved – reduce errors and increase insights. However, they might often be in conflict with one another. Steps to reduce investment errors may, then, get in the way of acting on investment insights. Let me give you an example. Checklists are important to reduce errors, but their overuse can increase mindlessness and automaticity, which comes in the way of playfulness and curiosity, both of which are necessary for gaining insights. Furthermore, the fear of making errors of commission can lead to an increase in errors of omission. Finally, while the focus from the beginning of my presentation has been on the down arrow, I don’t want to end that way. The up arrow is a call to think in a different manner — independently and against convention — which I believe is a necessity for investment success.
The value of virtues
Think boats or moats, it does not matter, as long as one thinks independently and knows what one is doing. Whichever school of value investing one follows, it is important to remember that in the end, the practice of value investing is about developing a certain sort of character — rational, detached, curious and patient. The last quality, patience, is of paramount importance when one is a Buffett/Munger investor. In my personal experience, there have been long periods of severe underperformance in my family portfolio with its concentrated 25-year-old holdings that have tested my patience and my convictions. But I always used to keep in mind a Warren Buffett quote with which I will end: “You cannot get a baby in one month by making nine women pregnant.”