Monday, November 2, 2015

Pattern-Seeking, Story-Telling Animals

One of my favourite quotes about macroeconomics comes from Ed Leamer, who wrote, "We are pattern-seeking story-telling animals." The brilliance of this quote (which he originally heard from a radio commentator) is that it applies to many other aspects of human thought, such as physical and social science, as well as religion. I've been thinking this week about the ways in which we seek patterns and tell stories, both in trying to understand past events and trying to predict future ones. The original impetus was a captivating talk by Bruce Riedel on JFK and the Sino-Indian crisis of 1962. One of the most remarkable things about this crisis is how many unanswered questions remain, despite it involving some of the world's largest and most scrutinized countries, and the passage of more than 50 years. Many questions will never be answered. These are the hypothetical "what if?" questions that are amusing fodder for speculation but will never be answered definitively.

I was reminded of a wonderful passage from Ed Catmull's "Creativity, Inc." (a book I wrote more about last year). Catmull writes:

"In thinking about...the limits of our perception, a familiar, oft-repeated phrase kept popping into my head: "Hindsight is 20-20." When we hear it, we normally just nod in agreement - yes, of course - accepting that we can look back on what happened, see it with total clarity, learn from it and draw the right conclusions.

The problem is, the phrase is dead wrong. Hindsight is not 20-20. Not even close. Our view of the past, in fact, is hardly clearer than our view of the future. While we know more about a past event than a future one, our understanding of the factors that shaped it is severely limited. Not only that, because we think we see what happened clearly - hindsight being 20-20 and all - we often aren't open to knowing more. "We should be careful to get out of an experience only the wisdom that is in it - and stop there," as Mark Twain once said, "lest we be like the cat that sits down on a hot stove-lid. She will never sit down on a hot stove-lid again - and that is well; but also she will never sit down on a cold one anymore." The cat's hindsight, in other words, distorts her view. The past should be our teacher, not our master."

The Catmull quote identifies 2 distinct issues related to hindsight:

1) Looking back and thinking something was obvious, when it wasn't
2) Looking back and drawing the wrong lesson, i.e. that the future will resemble the past.

It's easy to look back at a 10-year chart of the S&P and think to oneself how easy it should have been to have picked the bottom on Mar 6 2009. Indeed, I have lauded the courage of investors who were steadfastly buying cheap securities in the face of financial panic. But only some of these people are worthy of praise. I think of these as mainly being (a) those who made well-reasoned estimates of valuation, (b) those who understood the likely mechanisms of QE and Fed policy, and (c) those who, for other, thoughtful reasons decided that the odds of investing were in their favour. The common thread is that these groups relied on facts as the inputs to weigh the odds of investing. This is intelligent speculation rather than hopeful gambling.

The fact of the matter is that it was far from clear that the economic and financial panic were over. Most investors faced genuine uncertainty as to the efficacy of Federal Reserve policies, and the implications for financial assets. One of many communication problems we have in finance is the double meaning of the word "cheap". Some mean it to mean "low-priced". Many mean it to denote "lower than fair value". I prefer the latter definition, and by that definition, assets are cheapest not when their prices are the lowest, but when their prices deviate most significantly from an informed view of their true value. Apart from the groups listed above, there are others who may have bought in the depths of 2009, but were merely lucky (or perhaps foolhardy). For some, the lesson was to buy the dip, and in particular the most leveraged, economically sensitive assets. I hardly recommend that lesson. For others, hindsight has taken the form of stricter drawdown control measures, and a heightened jumpiness when faced with any market turbulence. These nervous investors seem sure to forego the benefits of long-term compounding as they sell winners prematurely.

It seems to be that the follies of hindsight and extrapolation are closely related. John Templeton reportedly said that the four most dangerous words in investing are "This time it's different." This is usually taken to mean that only the foolish ignore the fact that asset prices are cyclical, and mean-reverting. To me, this is second-order thinking and assumes the deluded investor has enough knowledge of history to believe that this time will be different. I actually think most people respond in a far simpler fashion. The more dangerous words for them are "this will go on". Most people are probably not as greedy as we may them out to be after the bust. Rather, they make the perfectly understandable error that the future will look similar to the recent past. Nominal GDP will grow at rates similar to the past. Interest rates will look similar to the past. Corporate profits and economic moats will look like they did in the past. Markets will look like they did in the past (up, down or flat depending what they looked like most recently). Megan McArdle had it spot on when she wrote: "Bubbles are not fundamentally about evil people doing evil things. They are not even about stupid people doing stupid things. No, the problem with bubbles is worse: It's quite ordinary people, doing stupid things that a trick of the light has made appear very smart."

I don't have any bold prescriptions for these problems. Acting in an unknown and unknowable environment is the central problem of investing. I defer here to the thinking of Richard Zeckhauser, who says some very interesting things in "Investing in the Unknown and Unknowable" (some of which the most conservative value investors will disagree with). Nassim Taleb is clearly another deep thinker on these issues. My modest additions include the recommendation to document our beliefs in real time, and judge ourselves honestly on how events match up to our predictions. Another of my favourite quotes is physicist Richard Feynman:"The first principle is that you must not fool yourself - and you are the easiest person to fool." It's also an argument for focusing on process, rather than individual outcomes. But again, caution is warranted: the process should be well thought through, and not merely "Sell when the market is down X%" (the investor's version of "Don't sit on stove-lids"). This focus on process makes us simultaneously harsher on ourselves, when we've been lucky rather than good, and more forgiving, when we made the best possible (but ultimately wrong) decision with the information available. If we can avoid getting knocked out of the game on any one bet, a robust process should deliver returns over time.

But don't take it from me. I'm just another pattern-seeking, story-telling animal.