While investing too, most people just want to be proven right, and hence, it is easier to drift towards data that reinforces the existing hypothesis. Opposing data is almost always assumed to weaken the investment case.
This assumption, however, is absolutely wrong!
The Insecurity Analyst
“I am not a professional security analyst. I would rather call myself an insecurity analyst.” – George Soros
In the book, Soros on Soros: Staying ahead of the curve, George Soros mentions that recognising that one can be wrong in decision making, and thereby being insecure about it, is actually a strength.
Knowing what can go wrong in an investment actually strengthens the case. Understanding the risks associated with a security doesn’t make it uninvestible. In fact, contrarian investors hunt for stocks where people have overestimated the risks. Actively seeking the opposing view provides an investor with a checklist of areas to be monitored.
Ultimately, event-based ‘sell’ triggers can be incorporated into the investment thesis based on signals from these areas.
According to Sir Karl Popper (20th Century’s most influential philosophers of science), falsifiability defines the inherent testability of any scientific hypothesis. In investment, falsification of a hypothesis would mean knowing under what conditions would the argument fail. Not knowing these scenarios can put an investment to significant risk.
Incorporating Falsification in Investment Process
It is important to introduce falsification as part of one’s thinking and investment process. Some ideas on how to implement are provided below:-
1. Always take an outside view
Nobel Prize winner Daniel Kahneman, in his early days at the Hebrew University, decided to join a few colleagues to write a textbook for students. The group was confident they can complete this project in two years. Kahneman decided to take an outside opinion from the Dean of the University on how many years it took other groups to finish such projects. The Dean gave a number that shocked him: “Not less than seven years” and 40% of the groups failed to complete.
Kahneman and his colleagues, confident that they can do much better than average, pursued the project. Unfortunately, the project took eight years!
The story reveals the problems of relying on the inside view or focusing on the specific case and basing the decision on a narrow set of inputs. In contrast, outside view helps determine base rates and experiences of others in similar conditions.
2. Invert. Always invert!
Charlie Munger often quotes Algebraist Jacobi saying “Invert, always invert,” which means solving the problem looking backward rather than forward. He explains the logic by saying “I wish to know where I was going to die, and then I’d never go there.” Under this technique, one approaches a question of “whether event X will occur,” by turning it backward, that is, by studying “what can prevent event X.”
If forward thinking is about ‘trying to be smart’, inversion is about ‘trying not to be stupid’.
While forward thinking comes quite naturally to us, inversion needs to be incorporated as a step in the investment process to follow with discipline.
3. Practice second-level thinking
Many market participants move in a herd, swinging like a pendulum between euphoria and panic and generating average returns. However, an investor who wants superior returns will have to stand out from the crowd, and hence, needs to have a better framework of thinking about investments. Second-level thinking is about looking beyond what looks obvious.
Imagine a scenario where a company declares good growth in profits for the quarter. The first-level thinker will rush to buy it. A second-level thinker may find that the good growth was expected by the market and hence priced in the valuation. In fact, if the investors are still rushing to buy, the stock may be overvalued, and it is time to sell.
4. Weighing data versus anecdotes
A lot of our decisions are driven by anecdotes and narratives. In several cases, the anecdotes start overshadowing the important data collected for the decision. Typically, anecdotes are small sample cases generalised by investors while taking an investment decision. Some of them may not be true representative of their population. The same holds true for quick polls and surveys too.
If the surveys are not properly planned and extensively conducted, they may show patterns that are significantly different from the ones in the total population. While discussing companies to invest in, it is important that data and anecdotes are weighed in the correct manner to generate superior outcomes.
5. Do the opposite of Joe Bloggs
Adam Robinson is an American educator, author and a US Chess Federation life master. During his early days in tutoring, he found a pattern in the mistakes that students made in writing SATs. The math question papers during those days used to have three sections with multiple choice questions, arranged with increasing level of difficulty: easy, medium and hard. He found the students got the easy and the medium sections correct, but did not score well on the hard ones. The answers to the hard questions were tough purely because they were counter-intuitive. To help the students, he created an imaginary character, called Joe Bloggs, and asked them to imagine at every question “what would Joe Bloggs do?”
Joe would provide the answer which seems right and comes to mind first. For the first two sections, the students were advised to select the answer that Joe would give and in the last section, do the opposite of what Joe would do.
In Investment decisions, similarly, it is better to do the opposite of what Joe Bloggs would do. In a highly competitive market, the crowd won’t leave any easy questions unanswered (easy investment decisions) for you. Don’t do the obvious!
6. Course correction
Trying to falsify the investment hypothesis using these mental models will highlight areas of risks. Identifying and measuring risks increases the strength of the investment case and helps improve investment decisions, which can lead to better outcome in the long run. This analysis can also indicate a course correction when the actual path of developments does not conform to the investment hypothesis.
An intelligent investor should not hesitate to change the portfolio when the situation demands. Like Seth Klarman said, “In investing, it is never wrong to change your mind. It is only wrong to change your mind and do nothing about it.”