Acting with imperfect information


The benefits of sound Principles of Operation

It is the complexity paradox. Things are so complex and uncertain that we despair of making sense of them. If we try to simplify them we are at risk letting Kahneman’s System 1 make the decisions using heuristics (rules of thumb) which can lead us astray. But, because of the complexity and uncertainty we can only make decisions using heuristics, by simplifying things.

It is all very good to recommend caution, but decisions must be made. In truth, many policies must be established and decisions made with imperfect understanding of the facts and of the risks.

The comfort for the individual investor is that professional investors operate under the same debilitating conditions. The playing field is more level than one might expect. Professionals do not have the welters of precise information and high level analysis many individuals think.

The primary problem with investing is uncertainty. As Maynard Keynes put it: ‘uncertainty refers to something that cannot be measured because there are no objective standards to express probabilities’.

There is a marvelous quote that makes you stop and think. Einstein is widely believed to have said: “Not everything that can be counted counts, and not everything that counts can be counted.” It seems however that the author was a Professor of Sociology named William Bruce Cameron who wrote these words in the 1960s.

A lot of investors with high powered computers count thing that don’t count. Sharpe ratios come to mind. They also try to count things that can’t be counted such as uncertainty.

Consider the following from Peter Lynch:

“It’s also important to be able to make decisions without complete or perfect information. Things are almost never clear on Wall Street, or when they are, then it’s too late to profit from them. The scientific mind that needs to know all the data will be thwarted here.” (Lynch, 1989,1990)p.69.

George Soros highlights the problems. “It is difficult to accept uncertainty. It is tempting to try and escape it by kidding ourselves and each other, but that is liable to land us in greater difficulties.” (Soros, The Crash of 2008 and What it Means, 2008,2009) P230

Soros reminds us that everyone is in the same boat: “Market participants act on the basis of imperfect understanding at all times. Consequently market prices usually express a prevailing bias rather than the correct valuation. In the majority of cases, the valuations are proven wrong by subsequent evidence, and the bias is corrected, only to be replaced by a different bias. Only once in a blue moon does a prevailing bias set in motion an initially self-reinforcing but eventually self-defeating process. It happens only when the prevailing bias finds some kind of short circuit that allows it to affect the fundamentals. This is usually associated with some form of leveraged debt or equity.” (Soros, The Crash of 2008 and What it Means, 2008,2009) P71

Here he is also referring to his theory of feedback mechanisms in the stock market.

It is heartening to think that the solution to our uncertainty dilemma is actually quite simple. At least it’s easy to state; although, in practice, it requires skill to execute. The answer is to invest using sound Principles of Operation. These are introduced in the Motherlode in Part 4: Principles of Operation. The essential principles are describes briefly in Chapter 27. Sound Principles of Operation. There you will find cross references to the main text of the Motherlode where each of the Principles of Operation are discussed in full.

For a deeper read into the issues raised in the post also see Chapter 23. Decision making under uncertainty

Want to dig deeper into concepts behind successful investing?

Click here for the Motherlode – introduction.

If you like this blog, tell your friends about it

And don’t hesitate to provide comments