PART A :ARTICLE
INVESTING: THE LAST LIBERAL ART
Prasanna Chandra
The heart of liberal arts education is a broad- based approach to understanding that draws on a variety of disciplines. In this book, Investing : The Last Liberal Arts Robert Haegstrom argues that investing calls for a liberal arts approach that draws on insights drawn from a array of disciplines. As he says, “It is no longer enough to acquire and master the basics in accounting, economics, and finance. To generate good investments returns, I believe, requires much more. It is driven by a keen mental appetite to discover and use new insights regardless to what Dewey decimal number they bear or how unrelated they may at first appear.”
Investors must appreciate this because we have become a society that prefers specialization over breadth.
As John H Holland, a professor of psychology and engineering and computer science, says innovative thinking required us to master two important steps:
Haegstorm looks at the following disciplines and their basic insights: physics, biology, sociology, psychology, philosophy, literature, mathematics, and decisions making.
Physics
Physics has always enjoyed an enviable position among sciences. Thanks to its mathematical precision and immutable laws, it gives the comfort of absolute answers. It is not surprising that other disciplines generally looked first at physics in search for order underlying the messiness of nature.
Here are some examples:
Biology
The failures of the existing theory to explain the stock market crash of 1987 and the global financial crisis of 2007 -2009, opened the potential for competing theories. Chief among them was the idea that the market economy is best understood from a biological perspective.
Charles Darwin’s 1959 magnum opus The Origins of Species changed humanity and of life, forever. It also influenced our view of other areas of knowledge, including economics.
Clearly, Alfred Marshal, a founding father of economics, saw the virtue in viewing economics through a Darwinian prism. In the eighth edition of Principles of Economics (1920), Marshal eloquently presented his views on evolutionary economics. He wrote:
“The Mecca of the economist lies in economic biology rather than economic dynamics. But the biological conceptions are more complex than those of mechanics.”
Evolution is generally steady, slow, and continuous (biologists call it ‘gradualism’) and not easily recognisable, but sometimes it is swift and dramatic (biologists call it ‘punctuated equilibrium’). Irrespective of its pace, remember that there is always change and hence economists would do well to leave Newton’s word of equilibrium and embrace Darwin’s world of evolution. Recognising this Brian Arthur and others have embraced the Complex Adaptive System.
Andrew Lo has tried to strike a balance between the alternative paradigms and suggested that economic systems simultaneously possess the effects of both a Newtonian efficient market hypothesis a Darvinian biological view.
Lo said, “I realized that the behavioural finance folks and the efficient markets folks were both right. They were both observing the same phenomenon, but from different angles .. when logic and emotion are in proper balance, markets operate in a relatively efficient market.”
Using the principles of evolution, competition, and natural selection, Lo seeks to bridge the gap between market efficiency and behavioural inefficiency.
Sociology
Sociology is the study of how people function in society. Two distinct paths have been followed in developing social sciences: a search for a unified theory and a move toward narrower specialisation. French philosopher August Comte advocate a search for a unified theory. Despite his efforts for synthesis, social science moved n the direction of distinct specialisations such as economics, political science, and anthropology.
Beginning of 21st century however, witnessed a growing interest in a unified approach called complex adaptive system. “Complex” means that there is a lot of interaction, “adaptive” means that the agents change and evolve , and “system” implies that the whole is greater than the sum of the parts. This model appears to be more consistent with what is know in disciplines like physics and biology.
The central characteristics and properties of a complex adaptive systems are as follows:
Aggregation The collective interactions of many less- complex agents produces complex, large- scale behaviour.
Adaptive Decision Rules Agents in the system take information from the environment and develop decision rules. The competition between various decision rules ensures that eventually the most effective decision rules survive.
Non – Linearity Unlike a linear system, wherein the value of the whole is equal to the sum of its parts, a non- linear system is one wherein the aggregate behaviour is very complex because of interaction effects.
Feedback Loops In a system that has feedback loops the output of one interaction becomes the input of the next. A positive feedback can magnify an effect, whereas a negative feedback can dampen an effect.
Psychology
Psychologists have identified the errors that investors are prone to. Perhaps the single greatest obstacle that prevents investors from doing well in the stock market is myopic loss aversion.
Warren Buffett, one of the world’s most successful investors, seems to have mastered myopic loss aversion. He has benefited immensely from a unique perspective gained as the CEO of Berkshire Hathaway which owns both common stocks and wholly owned businesses. As he claimed he is “a better investor because he is businessperson and a better businessperson because he is an investor.”
People construct mental models of the phenomena around them. According to Kenneth Giaik with a small- scale mental model of external reality we “try out various alternatives, conclude which is the best of them, react to future situations, before they arise, utilize the knowledge of past events in dealing with the present, and in every way react in a much fuller, safer, and more competent manner to the emergencies which (we face).”
Philosophy
Philosophy is the study of the fundamental nature of knowledge, reality, and existence. There are three broad areas of philosophy : metaphysics (that which is beyond the physical world and is concerned with concepts of God and afterlife), epistemology (that which seeks to understand the limits and nature of knowledge), and other areas (such as aesthetics and ethics). Our focus here will be solely on epistemology.
An important theme of this book is the idea that the market is a complex adaptive system (CAS).
The emergent properties of CAS poses challenge because a CAS must be studied at the level of description that preserves the whole system. As McIntyre explains, “Thus a central idea behind complexity theory is that there are limits to our knowledge of some systems, even though they are ordered, because we must study this order only at the level of inquiry at which the complexity of the system is ineliminable.” This means that the reductionist methods that look at simplified or reduced version of CAS are not helpful.
McIntyre believes that CAS are not inherently enigmatic but appear so because of our limited descriptive abilities. As he says, “Once one accepts that complex systems are only complex as described, there is always the possibility that some alternative description - redescription – of the system will yield regularities that are simpler and can be handled by science.”
Thus, to be a successful investor, we must be prepared for redescriptions. Fortunately, the philosophy of pragmatism provides a useful guidepost in this endeavour. As a school of philosophy, pragmatism originated in the U.S., fathered by Pierce and William James. As James said a belief is true not because it can stand up to logical scrutiny but because holding it puts a person into more useful relations with world. As he put it bluntly in a famous statement, “What is the cash value” of a belief in terms of a person’s practical experience.”He added, “Truth is the name of whatever proves itself to be good in the way of belief.”
In this sense, pragmatism is the exact opposite of most previous schools of philosophy which regard their version of truth (however, it is theorised) as absolute and unchangeable. James, however, believed that we can never expect to receive absolute proof of thing. For example, he said asking whether God’s existence can be proved is a futile exercise because the answer is irrelevant. Just ask what difference does believing or not believing in God makes to your life.
Pragmatism thus is more a way of doing philosophy. As Haegstrom says, “It thrives on open minds and gleefully invites experimentation. It rejects rigidity and dogma; it welcomes new ideas. It seeks new understanding by redefining old problems. In short, pragmatism is the perfect philosophy for building and using a latticework of mental models.”
Investors relying on pragmatism quickly recognise the difference between first order models (like the DCF model ) and second – order models (like the P/E ratio) and never become a prisoner of the second- order absolutes. Further they draw insights from a variety of disciplines beyond the field of finance and economics. As Haegstrom says, “The successful investor should enthusiastically examine every issue from every possible angle, from every possible discipline, to get the best possible description – or redescription – of what is going on. Only then is an investor in a position to accurately explain.”
Literature
In the famous liberal arts programme of St. John’s, students are required to, over a four year period, read classic works in literature, philosophy, theology, psychology, biology, government, economics , and history and intensively discuss them in seminars of 18-20 students.
A fund manager who studied at St John’s said, “My education at St John’s gave me a sense of perspective, a broader view of the world .. Not just the tunnel vision from standard finance classes.” Another St John’s product in the investment world observed, “One other thing I learned at St John’s that was immensely helpful was how to have a meaningful discussion with others on sensitive topics in a constructive fashion .”
Decision Making
In his popular essay, “The Hedgehog and the Fox: As Essay in Tolstoy’s View of History,” Sir Isaiah Berlin classified thinkers and authors into two categories: hedgehogs and foxes. Hedgehogs view the world through the lens of one big idea and follow through, regardless of what the logical implications of doing so are. Foxes, on the other hand, are skeptical of a single grand theory. Instead, they stitch together a collection of big ideas. The fox seems to be the perfect mascot for the College of Liberal Arts.
Dysrationalia In his book What Intelligence Tests Miss: The Psychology of Rational Thought, Keith Stanovich coined the term ‘dysrationalia.’ It refers to the inability to think and behave rationally despite possessing high intelligence.
According to cognitive psychologists, there are two major causes of dysrationalia: a processing problem and a content problem. Stanovich argues that we process poorly. As cognitive misers, human beings tend to rely on processes which require less computational effort. This compromises the accuracy of processing.
The second cause of dysrationalia is inadequate content. Psychologists who study decision making call it a ‘mind ware gap’. According to David Perkins, a Harvard cognitive scientist, mind ware refers to knowledge, strategies, rules and procedures people have at their mental disposal to help solve a problem. Mind ware gaps generally arise from a lack of broad education. As Perkins says, ‘What is missing is the meta curriculum the ‘higher order’ curriculum that deals with good patterns of thinking in general and across subject matters’. Liberal arts education is helpful in improving mind ware.
PART B : SNIPPETS
HOW TO READ A BOOK
How should a book be read? Mortimer Adler, America’s foremost expert on reading books, proposes that all active readers need to keep four fundamental questions in mind:
Read the preface, table of contents, index ,and bibliography and skim the book here and there for 30 to 60 minutes. If you find the book worth your time, start with a complete but somewhat superficial reading.
If the book deserves deeper examination, move to what Adler calls analytical reading. It is a thorough and complete way to absorb a book. After reading the book, integrate its insights and knowledge into your latticework of mental models.
So far we talked about learning from careful reading of expository works. Insight and wisdom, however, are not limited to works of non fiction. Novels, poetry, plays, and short stories- collectively referred to as imaginative literature- can nurture and replenish our understanding of the world we live in.
While expository books convey knowledge, imaginative books convey an experience. As readers we must welcome this experience. As Adler says, “Don’t try to resist the effect that a work of imaginative literature has on you. Let it do whatever work it wants to do.”
When reading a work of imaginative literature, you may come across a sentence that perfectly expresses something you have felt but never been able to put so well in words. As Robert Hagstorm said, “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.” He added “Anyone who has read the work of Shakespeare has learned much about human nature while also being thrilled by the beauty and drama of words the characters speak.”
Behavioral Risk Management
In his thought- provoking book Behavioral Risk Management, Hersh Shefrin seeks to improve the practice of operational risk management by helping managers develop pyschological skills to complement their quantitative skills.
Risk is generally classified into three categories viz., market risk, credit risk, or operational risk. Although academicians and practitioners focus more on market and credit risk, some of the most catastrophic risk management failures in history have emanated from operational risk stemming mainly from behavioural biases such as excessively high aspirations, groupthink, inordinate optimism, overconfidence, and Bayesian avoidance (this is defined as not updating the probabilistic judgments of risk when new information arrives).
In order to mitigate the effect of these biases, organisational leaders should develop strong organisational cultures that emphasise risk management. Shefrin recommends a process- pitfall framework, which is based on two concepts, Open Book Management (OBM) and Risk Management Profile (RMP).
The OBM seeks to minimise groupthink. The major processes that underpin OBM are standards, planning, incentives, information sharing, and, operations. It emphasises Devil’s advocacy during the planning process.
RMP measures the cultural strength of an organisation. Like OBM, applying a risk management process to a organisation calls for asking direct and specific questions.
Earn, Save, Grow, and Preserve
A successful accumulator is one who spends most of his 20s just trying to improve his earnings enough to save, focuses on sustaining his savings (and avoiding lifestyle creep) in his 30s and early 40s, allows compounding to work through the rest of 40s and 50s, and emphasises risk management in his 60s and later.
This framework of ‘Earn, Save, Grow, and Preserve’ is a helpful way of thinking about the progression of accumulating for retirement. The shifting dynamic in that framework implies that after about two decades of ongoing contributions, the most important driver of the final outcome is not the spending behavior or ongoing contribution, but the ability to grow the portfolio. In the earlier years improving returns by 1 percent per year has a trivial impact compared to saving another Rs. 1000 per month. In the later years, however, improving returns by 1 percent per year is highly material.
PART C: WIT AND WISDOM
HUMOUR
Principle
Economists are trying to figure out why the girl with the least principle attracts the maximum interest.
Weight
In a St. Louis hospital the nutritionist put up a chart titled “Desirable Weight for Women.” The chart showed the optimal (desirable) weight for different heights. Most of the female doctors and nurses in the hospital were overweight. So, they groaned looking at the chart. The following day the nutritionist put up another chart by adding 20 pounds across all height categories and labeled the chart “Weight for Desirable Women.” All the groans turned into grins.
WISE SAWS
1.The larger the island of knowledge, the longer the shoreline of wonder.: Ralph Sockman.
2.No matter how much cats fight, there always seem to be plenty of kittens. : A .Lincoln