In my opinion, summertime is the best time of year. The weather is nice and I get to spend my time taking the kids to swimming lessons, bbqing outside, and just enjoying life not bundled up under 3 layers of clothing.
I ‘ve definitely been enjoying this summer and haven’t been spending nearly as much time in front of the computer like I usually do. So this means less time research investing ideas and reading investing books.
But this doesn’t mean I don’t have investing on the brain. I do… and sometimes the strangest of investing notions hit me.
The most recent of which happened when I was hanging-out during my kid’s swimming lessons…
Pavlovian Association And The Human Brain
My kids have been going to swimming lessons this summer and they are learning the basics of swimming — floating, kicking, crawl strokes, jumping into the pool, etc. The basic foundational stuff that everyone has to learn when learning how to swim.
But kids aren’t born knowing how to do these things, they have to build up that muscle memory. Most of the time the instructors will describe to the kids what they want them to do, but the kids actually pick it up faster when the instructor physically grabs their arms or legs and takes them through the motions. Building that muscle memory up.
After a few times, the kids can repeat the pattern and see success as their swimming skills improve. Learning many skills works like this. We recreate a pattern of behavior that leads to success.
Repetition, repetition, and then eventually improvement. Repeat this many more times and even more improvements occur.
Pavlov trained his dogs using this kind of conditioning, and most vertebrates (including humans) learn the exact same way.
It struck me that most investors learn to invest like this — They find some pattern or methodology, apply it, and then either find success or failure from doing so. Then, they rinse and repeat.
Over time individuals build up a conditioned series of behaviors about what works or what doesn’t in investing.
The problem is, these patterns the investors learned could be completely wrong, due to luck (or perhaps misfortune).
Let’s look at a couple of the more common “pattern recognition” investing styles to illustrate this point a little further.
Technical Analysis is the study of stock price and volume metrics to determine future price movements. With fancy names like Japanese Candlestick analysis and Eliot Wave Theory it sounds like a really cool method of investing.
By matching shapes and patterns in the movement of stock prices, Technical analysts believe that price history will repeat itself and they can trade their way to wealth by finding geometric patterns in the stock price that predict the future.
But does it work?
Well it might… sometimes. The research on technical analysis is pretty limited, but some researchers have found that there could be some small amounts of predictability by looking at certain patterns in price/volume data.
But that research is hardly conclusive.
It doesn’t work all the time, and later researchers have upheld the idea that stock market prices are really just random walks. Individuals who practice technical analysis might say things like “it worked for me”, and it might have … some of the time. This is called a clustering illusion.
But how about long term? Does technical analysis work with larger and longer data sets?
Not really… and certainly not conclusively. There are no billionaires that invested to that level of wealth using technical analysis. Human judgement is far too big of a factor for technical analysis to work consistently for long periods of time. Eventually they lose and lose big.
Why does this eventual ‘failure’ happen?
Humans can create patterns in data where none actually exist. They can see the number “13” everywhere they look, or find geometric shapes in stock price data.
That doesn’t mean these imagined “patterns” have any real meaning.
The other big method of stock analysis is called Fundamental Analysis. Practicers of this methodology look for patterns in historical business metrics to predict future stock movements — usually this means buying stocks at a low prices and then selling again at a higher prices when certain fundamental metrics apply.
Here’s some of the more popular patterns fundamental analysts look for:
- Low PE ratios.
- High growth rates.
- Low Price to Book values.
- High returns on equity.
- High returns on incremental invested capital.
- Low Price To Free Cash Flow levels.
- Big dividend yields.
- Large % share buybacks.
- and so on.
There has been some significant academic research that’s found some fundamental analysis methods might actually work.
For example — at certain points in history buying small cap stocks would have outperformed large caps.
The problem is, once a scientific paper gets released which details a specific pattern that outperforms with historical data, the advantage quickly disappears as hedge funds and stock traders pick up the new methodology.
Essentially destroying any advantage that ‘fundamental’ pattern may have had.
I don’t think it would be wrong to say that no pattern works all the time, either in fundamental analysis or technical analysis.
But pattern recognition and pattern training is how we humans learn… does the fact that none of these methods work all the time mean we should just give up and invest in some low cost index funds?
Perhaps… and to some extent I’ve followed this line of thinking myself. We hold a significant percentage of our net worth in low cost index funds.
But I haven’t given up on investing entirely. I still make individual stock investments when all the stars align just right.
The Man with a Hammer Syndrome
The problem arises when most investors learn a new tool ,they attempt to apply it everywhere. This is the man with a hammer syndrome — To a man with a hammer the entire world looks like a nail.
But any good carpenter can tell you that you need A LOT of different tools to build a house properly. A simple hammer just isn’t going to cut it.
To quote one of my favorite investor’s, Charlie Munger:
“You must know the big ideas in the big disciplines, and use them routinely — all of them, not just a few. Most people are trained in one model — economics, for example — and try to solve all problems in one way. This is a dumb way of handling problems.”
To be a really good investor, according to Munger (who’s arguably one of the best investors in the world) you need to have a lot of different “tools”. No one simple pattern can provide the answer:
“When you’re trying to determine intrinsic value and margin of safety, there’s no one easy method that can simply be mechanically applied by a computer that will make someone who pushes the buttons rich. You have to apply a lot of models. I don’t think you can become a great investor rapidly, no more than you can become a bone-tumor pathologist quickly.”
To be perfectly fair, there actually was a series of trading algorithms run by a hedge fund that almost worked. Back in the 1990’s Long-Term Capital Management (LTCM) used some fancy qualitative models to exploit price inefficiencies across various asset classes.
Some very smart Nobel prize winning economists were involved in this hedge fund, and for a time there methods did work (with annualize returns in the 20-40% range). However, the price inefficiencies LTCM was exploiting were very small and required significant leverage to exploit — at times LTCM had a debt to equity ratio over 25-to-1.
As you might expect, LTCM eventually collapsed when the models stopped working during the Asian financial crisis — and nearly brought the entire US economy with it. Most initial investors in the LTCM fund were completely wiped out.
It’s stories like these I find extremely instructive — some of the world’s smartest people find patterns and attempt to exploit small advantages… and it eventually fails. There’s a great book written about the rise and fall of LTCM that needs mentioning here — it’s called When Genius Failed. I highly recommend it if your even slightly interested in investing.
This says to me that pattern recognition isn’t really the answer on how to become a great investor. Patterns can’t be fully trusted … Yet the investing world is completely obsessed with pattern recognition (probably because that’s fundamentally how our brains work).
I believe patterns are only a part of the investing riddle.
Finding Lollapalooza Effects
While I don’t claim to be a great investor, I do like to study them. Charlie Munger is by far my favorite, partly because he’s just so “out there” and different from everybody else.
He’s not the richest, not the smartest, and not even the most popular, but he does have some very unique ideas about investing I’ve never heard anywhere else.
One of which, is called the Lollapalooza Effect.
The Lollapalooza Effect is when multiple “models”, biases, incentives, patterns, and psychological tendencies all act together in the same direction — Much like learning to swim. Your arms and legs all have to pull together to make significant forward motion in the water.
Munger believes that outstanding investment results can be achieved when Lollapalooza effects occur.
As I’ve mentioned in the past, predicting the future is extremely hard to do. Most people fail at it miserably. But investing itself is really the study of predicting the future… at least in small places where you can do some accurate predicting.
When Lollapalooza effects occur, suddenly the job of predicting that future becomes a much easier task for the investor.
The trick is in identifying those Lollapalooza effects. They aren’t just simple patterns to be recognized. They can come from a wide variety of discipline — biology, psychology, economics, and of course competitive pressures.
I can’t say that I’m good at finding lollapalooza investments yet, but at least I’m learning.
Maybe one day I’ll be able to swim in the deep end.
Image Credit [Flickr]