Nothing to add’ seems to be an odd way to begin a piece. Making statements about the future is based on probabilities that can change, sometimes dramatically, over short periods of time and, hence, I would hesitate to make them on any public platform. So, I must confine myself to penning reflections except that, after some time, it feels like stepping into an echo chamber where the noise is still reverberating. But surely it may not be inappropriate given the New Year costume parties to dress up old ideas in new words. And hope, like some annual ritualistic stock market studies, that they look new.
Within two years of the publication of Charles Darwin’s ‘On the Origin of Species’, a critic claimed that Darwin’s book was too theoretical (even today, most critics find that the easiest way to attack any presentation is to label it as academic while they themselves are busy copying some other theory). Shortly afterwards, Darwin wrote to his friend Henry Fawcett, explaining the proper relationship between fact and theory: “How odd is it that anyone should not see that all observation must be for or against some view if it is to be of some service.”
The statistical way to follow Darwin is through Bayesian probability, because a prior conjecture is tested through new data which either lends credence or decreases confidence in the conjecture. The confidence level should either increase or decrease with inputs from the new data. When trying to make sense of events, investors should never forget Darwin and Bayes.
The investor must continuously guard himself from becoming a member of the ‘interpretive communities’ (a term used by philosopher Stanley Fish) that populate the capital markets. While arguments are marshalled one way or the other in these communities, the standards of judgement are relative, community specific and, hence, herd-like. It is very difficult to be truly independent and find that Archimedean point for honing more objective yardsticks of judgement.
Benjamin Graham’s metaphor of the market as a pendulum swinging between extremes of optimism and pessimism is well known to many practitioners of value investing. Many, however, especially those without a background in physics, may never have heard of Foucault’s pendulum.
Leon Foucault was a French physicist who wanted to prove that the earth rotates on its axis. In 1851, he carried out a famous experiment by hanging a pendulum from the roof of the Pantheon in Paris. And the pendulum, like the stock market pendulum, did behave in a strange way for as time passed, it changed the direction in which it was swinging. Foucault believed that the direction change was illusory and that while the pendulum always swung in the same direction, it was the earth that turned.
And he stopped there, which he should not have. The pendulum when pointed to an unmoving celestial body, like the Sun, and observed over a few weeks will show a clear shift of the Sun from the pendulum’s swing. Only the most distant galaxies, situated at the edge of the known universe, do not drift away from the pendulum’s swing.
The stock market, like Foucault’s pendulum, is influenced by so many near and distant things, so that in the short term, it is pointless to try to predict its movement or direction.
Investors are told to avoid the narrative fallacy, but some stories make a point better than numbers do. Ancient India had some strange kings and one of them who did not like the roughness of the earth touching his feet, ordered that his whole territory be covered with skins. A wise man proposed that the same result could be achieved more simply by taking a single skin and cutting it into small pieces to bind the feet. Those were the first sandals! This is not an investment case for some footwear company, but an illustration that a ‘margin-of-safety’ cannot come from a control mindset, but from an adaptive one. For, powerful winds can blow away the skins covering the ground but not those that are worn. Adaptation is the first rule for survival which is what having a ‘margin-of-safety’ approach to investing is all about.
At the core of a ‘margin-of-safety’ approach is intellectual humility. Strangely mathematics proves the basis for such humility from the incompleteness theorem named after the famous mathematician Kurt Godel. The theorem implies that we are always limited in our knowledge of any system while we are ourselves a part of that system. The same humility to the acquisition of knowledge is one of the foundations of the Austrian School of thought in economics.
Alexander Herzen, the nineteenth century Russian writer and thinker, was also a brilliant debater, dazzling audiences with his daring metaphors. He was known to suddenly switch sides and make fun of his own ideas, a capacity which investors should try to develop. Rather than some ill informed critic making fun of your ideas, why not do the job yourself for him? Some investors change their minds very quickly, and it is probably based on this capacity to be in constant dialogue with oneself.
Fyodor Dosteovesky, the famous Russian novelist, admired this quality of Herzen and observed in his ‘Diary of a Writer’: “Self-reflection - the ability to make an object of one’s deepest feelings, to set it before oneself, to bow down to it, and perhaps immediately after, to ridicule it - was developed in him to the highest degree.”
As important as tipping points in the analysis of companies and industries, should be flipping points in the minds of investors. A flipping point is when an investor changes his mind and is a significant contributor to investment success.
Go back to Darwin. During his travels to the Galápagos Islands, he spent a whole day on a river bank and noticed nothing of importance, only pebbles and water. A decade later, when he returned to the same place, due to the studies he had made since his first visit, he expected to find evidence of an ancient glacier. And this time he found obvious evidence. Darwin only found what he was searching for when he knew what he was searching for.
Whether studying companies, sectors or asset classes, investors must, like Darwin, know what they are looking for. Sounds blindingly elementary, but many investors do not. Take an asset class such as gold. The reasons for buying gold cannot be the same as buying equities. Physical gold, in these times, should be viewed more like money which will prove its value only in times of severe financial stress. Its global price is currently being manipulated. Physical gold should be viewed quite distinctly from ‘paper’ gold or ‘unallocated’ gold held by banks. The risks that are sought to be hedged are of the financial sector as a whole. Comparing returns of gold over short periods to other asset classes probably means that an investor does not know why an asset allocation in gold has been made in the first place.
There is so much wisdom from the ‘eminent dead’ and the eminent living, that there is usually ‘nothing to add’.