Irrationality, Exuberance, and Bad Decisions
The world may appear to be a rational, deductive place if you are a scientist. But not if you are an investor attempting to understand how markets work. Financial markets are human creations, and humans are irrational.
Economics, a truly dismal social science, is an attempt to look backward and create explanatory algorithms about what happened and why. They may have some success with this. But as predictive models, they are mostly useless. More often, they destroy value versus conveying any understanding about economic and business functions, and therefore, give not only useless but awful and typically value-destroying predictions.
Participating in the markets requires a broader, more methodical, and disciplined approach. Since irrationality pervades most activity, markets move dramatically with uncertainty, and investors react with dramatic moves based on even more uncertainty and lack a reasonable level of understanding and longer-term perspective about what is going on.
Superficiality and Stupidity
Market participants think they know something they simply do not. There is a belief that at a basic level, they possess an understanding that most investors do not have and can never achieve. Investment success requires understanding many elements ranging from global economics, geopolitics, human behavior, and even game theory. So many interrelated factors add challenges to understanding what is going on, and what elements matter. Not those that are influential, but those that make a difference.
Value is impacted by many elements, and sudden events can have outsized and magnified impacts. Current examples include what is happening in Ukraine, but also China and US trade and geopolitical relationships. Other impacts include competitive analysis, micro-level understanding of each firm and its industry sectors, understanding of how management may react, and many other forces acting upon any specific situation. Many may seem unrelated, but all can be impactful. Understanding the relative impacts and how they interrelate is a rare and valuable perspective.
Understanding how humans behave and predicting emotion-based decisions escapes simple descriptions. Humans are not machines and do not behave according to economic predictions or econometric models. A dispassionate objective perspective driven by only rational actors is misguided.
All Prices are Anchored and There is No Inherent Value
As described by Daniel Kahneman, one basic element of irrational human behavior is “price anchoring.” This is where all prices are considered relative to others, but there is no analysis of fundamental value. If I tell you a car is worth $100,000, and you buy it for $90,000, you believe you got the bargain. But, that’s just a construct of relativity. There’s no reason you shouldn’t have paid $50,000 other than the initial anchoring. There is no inherent value or objective analysis to determine an absolute value.
Price anchoring is the fundamental basis of financial markets. Everything is priced relative to everything else. When a company goes public, it is compared to its “market comparables.” There is little sense of inherent value, only where something will trade relative in value to something else.
This is fundamental and essential to understanding that all markets are based on price anchoring, supply and demand determining price, and that demand is generated from a price anchoring perspective. Supply is purposely limited, and a market is simply a convergence of all these factors.
There is no such thing as inherent value to anything – only what a willing buyer wants to pay a willing seller.
Wisdom and Predicting the Future
Investment success depends on predicting the future. Either buying something today that you expect (or hope) will go up in value or selling because you are convinced something will decrease in value. Fundamentally, you’re predicting the future. Being able to make those choices with confidence is the fundamental foundation of investing. Many times, truly successful investing means you are making choices that the majority are not.
First, an investment choice must be made, but more importantly, an investor must have the fortitude to stay with their choices and determine what factors would change their mind. Unfortunately, irrationality and human emotion play a big part in generating bad decisions. The stock went up, so book a profit, right? When was this a good idea if you owned either Apple or Amazon for the last 20 years, for example?
There is a more fundamental question to ask.
Why did I buy it in the first place? If those reasons haven’t changed, even if everyone else’s opinion has changed, thorough research and fundamental understanding can provide the fortitude to stay with choices even if, in the short term, majority opinions vary.
Of course, the corollary to this is the mistake many investors make buying something simply because everyone else is. There are examples of investment managers shouting “transformation!” and attracting investment lemmings to unsustainable values. So the other question to ask is, “why did I avoid it in the first place, and has that reason changed?”
Either way, it is this fortitude to either stick with or stay away from choices you have analyzed sufficiently that determines success more than any other element or combination of factors.
Predicting the future combines a broad range of observations into a set of knowledge that enables an investor to effectively use this knowledge – where the value of an investment will be, and then make investment decisions based on this collection of knowledge. This is investment wisdom, and it is the essential component of successful investing.
No Lazy or Quick Thinking
There is no simple formula for determining investment wisdom, and no easy algorithm. Formulas oversimplify but give the impression they are capturing more complex factors and are conveying an understanding that is simply not there. Every single investment requires unique analysis to determine what factors are not merely influential, but what makes the difference.
Multiple influences ultimately are meaningless if they do not change an outcome. Success requires understanding, from a family of unrelated complex factors, what makes a difference. What changes an outcome. Predicting these outcomes from the handful of factors that matter, and how those factors might interact, is truly challenging and requires deep thought and sometimes multidisciplinary analysis. But that, and nothing less than it, is what is required.
To paraphrase Daniel Kahneman, while we are evolutionarily programmed to think fast, it is “slow thinking” that leads to success when managing complex and challenging circumstances. Slow thinking also requires demanding work, and thoughtfulness, and is the antithesis of the breathless, media-based recommendations that pervade social media and television.
If any of those pundits are correct, is merely by coincidence. Their statements are shallow, misguided, and superficial ideas that represent quick thinking, and these are the enemies of a successful investor.
Numerical models, regardless of how complex the algorithm, tend to be mostly useless or even destructive. Fundamentally, they assume a static view of the market to analyze complex factors and generate an outcome. But all markets and factors are dynamic, and these algorithms cannot capture this and will fail when most needed.
Complex in-depth and dynamic factors forged into simple and misleading formulas give the misguided impression that a simple tool will lead to effortless success. Perhaps the best example is the Black Scholes option pricing model. Great minds (Nobel Prize winners) developed a simple formula to price complex securities that trade in dynamic and hyperactive environments. Not surprisingly, for all its academic rigor and impressiveness, a static formula can work well within a couple of standard deviations of an average but is massively inaccurate when it matters most. Implementing this model dramatically mispriced options leading to several financial meltdowns, including a crisis in the late 1990s and the financial crisis in 2008.
It’s Precise and Irrational
Formulas give a comforting precision, and it takes market stress before its inaccuracy emerges. Unfortunately, it is during those times of market stress that the failure of these investment formulas becomes catastrophic. The formulas implied precision that may work during average conditions over short time periods, but when stressed, they typically fall apart with unprecedented speed.
Why the continued reliance on static algorithms? Irrationality is the answer. It’s not that these investors aren’t being rational, it’s that they understand the market is irrational and unpredictable, and success depends on factors outside of their control.
Formulas imply a level of control and predictability in an irrational and unpredictable world. We are not comfortable with uncertainty, so we look for ways to offset that. These can work most of the time but fail tragically when needed. But, that doesn’t mean we give into irrationality.
This is why understanding human behavior is so essential to investment success.
A formula cannot predict the iPhone, Amazon Web Services, Netflix’s video-on-demand, Microsoft Office’s development, or even the Windows operating system. In other words, this approach to investing typically misses the most significant value creation developments.
A successful multifactor approach understands markets are complex and dynamic, innovation, technological advancement, transformation, and disruption create more value, and cannot be predicted with any algorithm.
About the Rest of the World
“Globalization is dead” scream some of the largest investment firms and influential politicians. Of course, looking at Ukraine, China, and US geopolitical and economic relationships, and global supply chain interruptions, it’s easy to conclude the world will be more fragmented and not interact globally on any meaningful basis again.
Perhaps. But, more accurately, rules may change, but betting against globalization might be a fool’s errand. Let’s be clear, some minor economy with a big army and even larger energy reserve (Russia) doesn’t change the world on a long-term basis. Russia’s actions are certainly disrupting the world right now, but that is not sustainable.
Leadership, fiscal and monetary policy, and political discord are defining the US right now, but factors that determine success do not come from economics textbooks. So, these factors may play an influential role, but real performance comes from understanding that there are many elements on a macro and micro level that influence investment choices. Globalization, to put it in economic terms, is simply a comparative advantage – and that does not go away. While some pathways and infrastructure may change, global interaction will not.
Innovation will continue to create the most value, fortitude will capture that value for thoughtful and “slow thinking” investors, and the dynamic convergence of technological innovation with thoughtful business models will still determine the most transformative, disruptive, and successful business models. That will create the most substantial value for anyone who’s paying attention.
The X Factor
Great leaders forming great teams and motivating those teams to be successful are the most under-looked and perhaps most valuable factors. Depending on great teams doesn’t appear in any economics textbook, yet, as irrational as this sounds, understanding leadership and its efficacy may be the single most crucial factor in determining economic value.
Leadership determines value. Many decisions can be made with a basic understanding, reasonable data, and a straightforward analysis. But the decisions that create the most value require judgment. Valuable distinctive companies have, at their core, leadership teams that display excellent judgment. Great leadership puts together teams that can act effectively to work together.
Key decisions requiring judgment are those that are not easily reversed. Most decisions can be reversed. As Jeff Bezos has said, almost every decision has a reversible door. If it doesn’t work, it can be undone. But, the critical decisions that create value and require keen judgment cannot be easily reversed, require substantial capital and company commitment, and, more than anything, determine success and failure.
Great companies are dynamic and in highly competitive environments. Important decisions requiring insightful judgment are essential. These factors remain dynamic and cannot be reversed quickly.
These components cannot be captured in any algorithm or general statement.
The world now is more dynamic, volatile, uncertain, and unpredictable. Irrationality drives most market decisions and rising above the noise to be more thoughtful, think deeply and slowly to understand what’s going on and identify the handful of factors (typically very few) that make all the difference to investment success is the true challenge we face today.
That challenge takes work and thoughtful strategies in our irrational world. That world will remain fundamentally irrational from now on, and thoughtful strategies are the only way to succeed in this irrational environment.