Expand your horizons and get a better grip on market patterns
• Understanding psychology, mathematics and history can add value to investment decisions
IT’S NOT HARD TO SEE HOW INVESTORS MIGHT BENEFIT FROM A BETTER UNDERSTANDING OF PSYCHOLOGY
THE WORLD OF THE FINANCIAL MARKETS FOLLOWS A PATTERN SIMILAR TO ONE FOUND IN OUR NATURAL WORLD
There’s the story of a sociologist, an economist and a political theorist attending a lecture by a renowned professor. After the presentation, the economist raved about the lecture. He thought it was great, except for the segments dealing with economics. The sociologist was similarly enthusiastic, but with a reservation. He felt the lecturer knew too little about sociology. The political theorist also enjoyed the lecture except for the fact that he felt the professor lacked political savvy.
The point being that they were impressed with what the professor had to say except for that which lay within their specific area of expertise.
Why would they then assume he was any better in those areas where they lacked the knowledge to correctly assess the content? As it turns out, it’s a fairly common mistake. People assume that because they are knowledgeable in one field they are capable of effectively understanding most of the information that comes their way. Experts are particularly prone to not recognising their limitations in other areas.
“That’s why poetry professors, by and large, are so unwise in a worldly sense,” says Charlie Munger. “They don’t have enough models in their heads.”
Munger believes most of us could achieve better investment results if we employed a “latticework of models” acquired from a range of different disciplines. He challenges investors to broaden their view of the market, of finance and of economics in general; to see them “not as separate disciplines but as part of a larger body of knowledge, one that incorporates psychology, engineering, mathematics, physics and the humanities”.
In this way, for instance, an engineer’s knowledge of breakpoint might enable him to realise the importance of keeping investment decisions to a minimum to reduce the likelihood of getting one wrong.
“In this broader view,” says Munger, “each discipline entwines with, and in the process strengthens, every other. From each discipline the thoughtful person draws significant mental models, the key ideas that combine to produce a cohesive understanding.
“Those who cultivate this broad view are well on their way to achieving worldly wisdom, that solid mental foundation without which success in the market — or anywhere else — is merely a short-lived fluke.”
It’s not hard to see how investors might benefit from a better understanding of psychology, maths and history. As Jesse Livermore pointed out: “A trader, in addition to studying basic conditions, remembering market precedents and keeping in mind the psychology of the outside public, must also know himself and provide against his own weaknesses.”
“Mathematics is the language of investing,” claims William Bernstein. As for history, to quote Livermore, “What has happened in the past will happen again, and again, and again. This is because human nature does not change, and it is human emotion, solidly built into human nature, that always gets in the way of human intelligence.”
What is less obvious is how incorporating the physical sciences such as physics, chemistry and the earth sciences into one’s body of knowledge might contribute to a better understanding of the markets. But here too there are surprising benefits to a broader base. Researchers at the Massachusetts Institute of Technology (MIT), for instance, have found that stock prices follow a distribution that is almost identical to that of earthquakes.
As MIT economics professor Xavier Gabaix explains: “We have found that the artificial world of the financial markets follows a pattern similar to one found in our natural world. Trading on the stock market has a lot of randomness, but at the end of the day you find that a pattern emerges that matches power-law patterns found empirically in data from systems as diverse as earthquakes and human language.”
The scientists say they want to understand financial earthquakes to protect people whose financial wellbeing is tied up in the markets. “In Tokyo they build buildings so that they don’t succumb to earthquakes. We need to do the same thing in economics.” Unfortunately, that’s easier said than done.
“Our research suggests that the forces that give rise to the power laws of stock market fluctuations are extremely robust,” says Gabaix. “So, such crashes would be very hard to
prevent. When applied to a precise computer model the power laws might allow market analysts to predict a crash but not necessarily prevent it.”
Other disciplines also have their limitations when it comes to making us better investors. As BH Liddell Hart points out in his book Why Don’t We Learn From
History?: “Those who read history tend to look for what proves them right and confirms their personal opinions.”
When it comes to confirmation bias and other shortcomings, if one recognises the potential benefits of acquiring knowledge from a broad range of different disciplines it shouldn’t be too difficult to also accept Munger’s assertion that it is “better to have common sense and be ‘worldly wise’ than futz around with a lot of models that are precisely wrong rather than approximately right and that have us calculating too much and thinking too little”.