Being vaguely right
My simple point in this post is that uncertainty around the economy, the stock market and business generally can really work to the advantage of the smart investor.
Let’s begin by stating the problem that all investors face. George Soros explains: “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) p.230 Wikipedia tells us that George Soros is a Hungarian-American billionaire investor and philanthropist. As of October 2023, he had a net worth of US$6.7 billion, having donated more than $32 billion to the Open Society Foundations, of which $15 billion has already been distributed, representing 64% of his original fortune
Here’s a take 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, One Up on Wall Street. 1989,1990) p.69. Many readers will know that Lynch was manager of the Magellan Fund at Fidelity Investments between 1977 and 1990, and achieved an average 29.2% annual return.
Two paths
Soros offers his prescription: “The course of events is inherently indeterminate. We must be content with hunches and alternative scenarios instead of determinate predictions.” (Soros, 2008,2009) p.45
Let’s just keep those two thoughts in mind for a moment. First the use of hunches. This runs the gamut from intuitions to what Daniel Kahneman calls heuristics. Another way of describing them would be decisions from the gut, rules of thumb and being vaguely right.
The second of Soros’ prescriptions is ‘alternative scenarios’.
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.
Before we dig further, a couple of side observations are in order.
Some things don’t count
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 purport to measure risk adjusted returns. The problem is that volatility and standard deviation are not a measure of risk nor are they a proxy for risk. So, Sharpe ratios count things that don’t count. The answers they give are precise and superficially credible because they are precise and backed by spreadsheets and algorithms.
Some things can’t be counted
Risk in investing cannot be measured. It cannot be counted. But it does count. Risk in investing is real and is something humans can get a feel for. Some things are high risk and others low risk. But, about risk we can only ever be vaguely right.
Warren Buffett offers his solution to the problem. It is the desire to be vaguely right. He uses the vaguely right technique in working with a concept he calls owner earnings. He is able to inspect financial statements and come up with a rough estimate. He writes of his rough and ready technique: “We agree with Keynes’s observation: “I would rather be vaguely right than precisely wrong.” (Buffett W. E., The Essays of Warren Buffett: Lessons for Corporate America. 1998) p.86.
From the gut and rules of thumb
Andrew W. Lo, a professor at the MIT Sloan School of Management and director of the MIT Laboratory for Financial Engineering has written a book titled Adaptive Markets, Financial Evolution at the Speed of Thought. His thesis revolves around the idea that humans get along in life and in investing by developing rules of thumb through a process of trial and error. These are called heuristics. He writes: “Natural selection also gave us heuristics, cognitive shortcuts, behavioral biases, and other conscious and unconscious rules of thumb – the adaptations that we make at the speed of thought.” (Lo, 2017) His idea is that market participants and market behavior adapt to a changing financial and economic environment not to optimize their outcomes but to make them good enough. Optimizing outcomes is simply not possible in a complex market system.
Heuristics and decisions from the guts are a broad category in the psychology of decision theory. In investing one subcategory would be rules of thumb like Price Earnings ratios, Return on Invested Capital and Price to Book. In truth, all we get from these ratios is mere suggestions about a stock. The conclusion is at no higher level of certainty than a hunch.
We can also employ hunches and our gut to avoid companies where the language employed by the CEO in quarterly reports or annual reports raises little red flags, or to warm to a company when the CEO acknowledges mistakes or shows a commitment to long term thinking.
Alternative scenarios instead of determinate predictions
The most stimulating writing on uncertainty I have read recently is the 2022 book by Erica Thomson titled Escape from Model Land – How mathematical models can lead us astray and what we can do about it. She writes: “Those who make a career facing day-to-day decisions up close to this uncertainty have generally learned strategies for coping with it. Some of that involves humility, remaining skeptical of any optimization and adding margins for error.” (Thomson, 2022) p.134 (Emphasis added) Thomson is a senior policy fellow at the London School of Economics and has a PhD from Imperial College.
“Rather than relying on improved point forecasts or probabilistic predictions, robust decision-making embraces many plausible futures, then helps analysts and decision makers identify near-term actions that are robust across a very wide range of futures…” (Thomson, 2022) p.213 And of course, margins for error make us think of Ben Graham and his margin of safety.
How do we put this into practice? It’s relative straightforward. We can ask ourselves as of today’s date: what is the worst-case recession scenario for the next five years? What kind of scenario would have to unfold to make the products and services offered by the companies in my portfolio become obsolete? And so on. You don’t have to worry too much about the upside because that doesn’t present a risk of harm to the portfolio.
This kind of plausible future thinking fits well with the use of hunches, rules of thumb and calculations about the fair value of a stock that are no more than vaguely right.
In short one approaches portfolio diversification and balance with a view to maintaining a portfolio ‘team’ that will be robust across a wide range of futures.
Conclusion
I began this post with the provocative suggestion that uncertainty is the investor’s friend. I believe that to be true. Uncertainty produces, amongst other things, the wonderful risk premia that investors in common stocks enjoy over bond investors and other investors who can’t cope with uncertainty. There are also lots of investors, including professionals, in common stocks who can’t or don’t cope with uncertainty and thus offer wonderful companies at very attractive prices from time to time.
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