Author: James Sagan
"An investment in knowledge pays the best interest"- Benjamin Franklin
"A wise man proportions his belief to the evidence," proclaimed the great Scottish philosopher David Hume. You would be hard-pressed to find someone who stood in disagreement with this sentiment, and ironically, equally dismayed at the paucity of people whose beliefs are actually informed by evidence. Perhaps it is our penchant for certainty that compels most people to disregard what they don’t know, and place undue faith in what they think they know. Philosophy, as a form of thinking, prioritizes incredulity and denounces certainty. Questioning our most basic assumptions can often illuminate our mistakes and provide perspective on our beliefs, and in our case, our investing strategy. In regards to investing culture, perhaps a philosophical lens could provide financial pundits a dose of humility, in an effort to dampen the rather prevalent hubris apparent in the culture.
When it comes to finance, the problem of acting on false assumptions becomes all the more problematic for the investor. Because money occupies such an important part in our lives, our ordinarily rational minds find themselves at the mercy of fear and greed. The fear of losing money and the prospect of enormous wealth distract most of us from the principles of investing which can somewhat reliably protect our principle and better our chances of appreciating our capital. This is precisely why a disinterested and calculated philosophy relying chiefly on value metrics is necessary.
Those who can convey unfettered conviction in their beliefs typically succeed in raising money, but rarely in producing returns. Certainty and returns work in direct opposition. As a true value investor, knowing what you don’t know is an indispensable attribute. A value investor invests based on risk averse principles, while preserving the possibility of producing inordinate returns. Risk averse investing seems easy in principle, but a great many risks appear innocuous to the uninitiated investor. Over confidence and a lack of critical attention to latent risks has been the defining factor of failure. Voltaire echoed this timeless principle in the eighteenth century when he said, “Doubt is not a pleasant condition. But Certainty is absurd”. This sentiment has been repeated by many great thinkers from different disciplines, and it is nearly impossible to exaggerate its importance for sound thinking.
The skill set of a promoter and an investor are diametrically opposed. An investor must be calculated, humble, and understand the extent of his or her ignorance. Rarely will you find someone in the business of predicting market movements utter the words, “I don’t know”. A lack of conviction is unfortunately perceived as a lack of confidence. The “Wolf of Wall Street” perfectly epitomizes the success one can garner with skills chiefly attributable to salesmanship, as opposed to investing acumen. As a consequence of this flawed mentality, bubbles and financial crises develop as an artifact of a self-affirming culture unbridled by fundamental analysis. As Nietzsche once said, “Insanity in the individual is rare. But in groups, parties, nations and epochs, it is the rule.”
Distancing ourselves from the culture of finance has been a staple of our past success and will assuredly serve us well in the future. The most visible financial thinkers, paraded on CNBC and Bloomberg, have failed us on more than one occasion. The reason for their failure lies not in their abilities, but in their faith in an insulated culture. Investing requires tremendous discipline and a certain contrarian streak. Luckily, there is an elite class of investors we can draw tremendous insight from, whose ability to distinguish themselves came as a result of careful reflection and disassociation from the prevailing thinking at the time.
As a student of philosophy at Tufts, I often discovered profound parallels between my readings in both philosophy and investing. Philosophical analysis can be reduced to the activity of questioning your assumptions. Similarly, superior investing, by definition, must question basic assumptions underlying the prevailing thinking of the time. Make no mistake, investing is a zero sum game, and winning requires a truly subversive way of thinking. I am not the first to find these parallels - George Soros, Carl Icahn, Peter Thiel, and a host of other financial thinkers were heavily influenced by philosophers and academic thinkers alike.
The methods subserving investing parallel those of building academic theories. As George Soros says, “Making an investment decision is like formulating a scientific hypothesis and submitting it to a practical test. The main difference is that the hypothesis that underlies an investment decision is intended to make money and not to establish a universally valid generalization.” Soros studied under Karl Popper at the London School of Economics and Popper’s ideas were of great import to Soros, as is reflected in many of his writings. Soros revolutionized investment thinking when he challenged the prevailing economic theory at the time. Most notably, he challenged the idea of a natural market equilibrium and an inherent efficiency in liquid markets.
Many of his ideas were borrowed from Popper’s controversial theory challenging the former understanding of the scientific process. According to his view, the scientific model begins with conjecture, which is then subject to empirical testing. This theory stands in opposition to the canon at the time, which suggested associations in nature were observed, which led to a theory, and then ultimately subject to empirical scrutiny. Additionally, he re-envisioned the criteria for scientific knowledge. His standard of “falsifiability”, which laid bare the groundwork for discerning between theorizing and speculating. In his own jargon, he was concerned with the principle of “demarcation” - separating genuine scientific theories from those that were inherently unscientific. His newly invented standard elevated the criteria required to belong to the class of genuine scientific ideas, and in turn, levied a much needed scrutiny on putatively scientific theories. The process of intelligent investing requires first building a thesis built off of an intuition. Investing ideas don't come from observing large amounts of data, but instead rely chiefly on the ingenuity of the investor. Once an investing idea is arrived at, you must build a model or a theory, and then test the model in the market. Great thinking tends to transcend individual disciplines, and investigating the process subserving good thinking is necessary for success in any field.
Beginning with the assumption shared by most critical thinkers- we are inherently limited in our understanding of the world- Popper sought to codify this idea in scientific literature. At the time, a variety of pseudoscientific thoughts were taken seriously by a growing number of people. These bodies of doctrine include, but are not limited to: creationism, astrology, and a host of other unfounded bodies of “knowledge”. They gained momentum precisely because of a lack of critical scrutiny paid to the assumptions these theories were built. Popper sought to re-enliven the spirit of skepticism, a principle that tends to diminish as people are swept away by dubious forms of thinking. This theme tends to percolate Although Popper applied this theory to science, much can be gained by abstracting and applying a heightened standard to investment thinking. The same phenomenon often permeates the investment world as evidenced by such “irrational exuberance” that so often marks the precipitous fall of a bull market.
His theory is rather elaborate, and should be given much greater attention than I can give in this limited piece. Popper’s improved standard of “falsifiability” was in part a response to David Hume’s “problem of induction”- the idea that no amount of observable evidence can lead to verifiable knowledge. From a limited observation of swans, for instance, we might conclude that all swans are white. As we now know, black swans, although rare, do exist. By the same token, just because the sun has risen reliably every day for recorded history, this observation would not justify forecasting this trend in the future (this might sound extreme, but Hume was viewing this not as a practical problem, but as a metaphysical point). If we wanted to have certainty of this trend persisting, we would need to establish a causal connection that accounts for the sun rising every morning. Because we can’t discount the possibility that the sun rising is merely incidental, we can’t impute any causality to this reliable trend observed in nature.
These are two separate problems at hand. The first is that we can’t gain knowledge from observing trends in nature, because of the necessarily limited amount of observable possibilities available. The second is that we can’t impute causality in the world, because we can’t discount the possibility of there being a “black swan” that evades our observation. Of course, in ordinary life we can get by fairly well by ignoring these philosophical concerns.
In the world of investing capital, these philosophical concerns gain substance. Ordinary assumptions that have worked perfectly well for years often turn out to be disastrous. Some could say that a single, incorrect, assumption was the sole basis for the 2008 recession- that housing prices will keep rising. For years, the default assumption was that housing prices would continually rise indefinitely. So long as that was the case, borrowers and lenders alike would The best we can do is to grapple with the best theories posited so far, and tentatively adhere to those theories which give us the best chance of succeeding. Perhaps Warren Buffett said it best- “If past history was all there was to the game, the richest people will be librarians”.
In a very real sense, Hume was right, there is no way to draw sweeping conclusions from limited experience. Popper found the problem described above as misleading- of course we can’t draw conclusions from regularities in experience, the best we can do is prefer one conjecture to another. That is, we can only improve our understanding from criticism of theories that don’t withstand empirical scrutiny, but we can never “prove” that a theory is ultimately correct. Popper insisted that the act of induction (developing theories after making observations) is a myth. Popper, instead, proffered that observation only serves to falsify theories, but plays no role in the act of originating theories. In other words, scientists create theories that find errors in past theories and then build upon them. Knowledge is instead created by conjecture, or the act of criticizing existing theories, and offering possible testable explanations. Thus, the standard shifted from “verifiability” - the act of verifying a theory through observation - to falsifiability. The latter concludes that no amount of observation can confirm a theory, but one instance that does not comport with the theory proves it categorically wrong.
By the same token, any theory that currently withstands empirical scrutiny can never ultimately proved. Popper’s incredulity is often cited as stating that there can never be progress in science. His theory absolutely allows for progress, it merely assumes that ultimate success is never possible, there will never be a theory that will end in ultimate knowledge of the physical world. In regards to investing, there has never been and will never be a theory that hasn’t been proven wrong. However, in investing, with so much outside of the control of the investor, we must insist that a certain type of failure can only prove it wrong.
For instance, if I were to invest in a stock that was priced at a substantial discount to
value and management was insidiously cooking the books, my theory did not fail, the company was dishonest. This type of failure is tantamount to a scientific experiment incorrectly measuring a theories predictions. Thus, in investing, a good working theory can only provide a probabilistic advantage over the general market, but not a guarantee as would be the case in science.
Another element of falsifiability involves necessitating a reliable explanatory mechanism behind making correct predictions. If I were to correctly predict the weather for the next year, I have merely happened upon chance, and however unlikely the outcome, there was no strategy that subserved my predictions. Mystics abound and their methods are unequivocally indescribable- a magician never reveals his trick. By the same token, their prophecies can never be tested because there is no fundamental method to their predictions. Many theories are sufficiently vague that any observable evidence will comport with their predictions. A fortune cookie tends to strike people with amazement, because after all, their predictions are sufficiently vague where almost everyone can relate. In the same way, academics and economists cloak their theories in uncertainty in an effort to immunize themselves from failure. This type of vacuous speculating has predominated economic theory post-2008, for obvious reasons.
To summarize, we can cleanly separate robust theory from speculation, borrowing from Popper’s standard of falsifiability. There are three primary tenants which all explanatory theories share in common.
1) They must be sufficiently specific and aim to make particular predictions.
2) They must contain a causal mechanism or explanatory measure that is consistent with incoming evidence.
3) They must be amenable to change in the case of contrary evidence.
If we apply this standard to investing, I think it would become clear that there are certain investing philosophies that are much more sound than others. More importantly, Popper’s theories can help us understand success due to good thinking from success due chiefly to luck. The importance of applying this framework to investing lies in constant self-evaluation and adjustment to the current prevailing mentalities. Great investors learn from their mistakes, as opposed to justifying them, and seek to rectify their flawed thinking. Soros concedes, “I’m only rich because I know when I’m wrong”.
Soros recognized the importance of building a robust philosophy as a scaffolding for his future investments that is amenable to contrary evidence. In the vein of Popper’s deep incredulity, he posited both the theory of reflexivity and fallibility. His theory of fallibility is obvious- we are imperfect thinkers and therefore will make imperfect decisions. The world is complicated beyond our abilities to comprehend it. The colorful analogies we concoct in our heads, tasked with mirroring the world, are mired with imperfections that further distance us from perfect understanding. For this reason, the idea that we harbor perfect information is not more than a comforting illusion, drawing from Popper’s deep skepticism. The principle of reflexivity directly follows that the prevailing investment theories, which are inherently imperfect for the reasons mentioned above, have a profound and distorting influence on the market.
For instance, given that the majority of investors believe in the efficient market theory, they will invest according to those principles. In turn, the market will experience a tangible effect, although not necessarily making the market more efficient. These rather obvious statements are generally ignored in the investment community as well as the philosophical community. There is a recursive as well as circular mechanism between the world and our subjective realities which distort markets and make the idea of equilibrium or efficiency thoroughly nonsensical. The market is a manufactured subjective feature of the world, and imputing qualities to it which are somehow disconnected to human behavior is absurd. This view necessitates a much more thoughtful outlook on investing.
Abstracting from this theory, we must accept that any doctrine, however successful in the past, is capable of failure and must never be taken too seriously. It must be understood that an investment doctrine is principled in nature and uncovers a causal mechanism for enhanced value. For several fundamental reasons the only source of sanity in the markets is a value oriented philosophy. Given that markets are irrational, mercurial, and often driven by unwarranted enthusiasm or depression, we can be relatively confident that there will be mispricings. Presumably, over time, these mistakes will be rectified. The party has to end eventually, and upon sober reflection, a correction will ensue. Benjamin Graham, in his book “Security Analysis”, alludes to this point well before the emergence of modern bubbles. He cites the “new era” mentality as a stark departure from former methods of valuations.
Warren Buffett is often hailed as the king of value investing, and his principles have served him very well. He finds positions that are undervalued because of unfounded mispricing, either due to irrational fear or irrationally inspired disfavor. His premise follows that if these companies keep producing solid returns, their valuation must follow. Additionally, a value oriented investor must be willing to remain sober while everyone else is intoxicated from earning ostensibly easy money. By remaining true to your principles, value investing anchors you when you might be most tempted to participate.
These principles ground value investing as a testable theory, where there is an explanatory element to the theory. Just as astrologers claim to make predictions based on fictional literature, many financial thinkers claim to predict market changes based on incidental “trends”. However, there is no explanation of why these trends will persist or whether they are merely incidental. On the other hand, value investing is based on a mechanism tightly associated with human behavior, which we have reason to believe will persist. In any event, our best efforts should be spent crafting theories that can be tested empirically, and if they work, we should place some conviction in those theories until proven otherwise.
Drawing from this perspective, we are certainly value oriented. There is a nearly infinite variety of methods that can properly belong to the category of value investing, but the underlying principles remain constant. The point of departure for investing is that, while science operates outside of our influence, markets don’t. There is a psychological feature of markets that add degrees of uncertainty to predictive theories. As Soros contends in his theories of fallibility and reflexivity, the concept of efficiency or equilibrium are no more than fictions. The best we can do as investors is make decisions based on the actionable information at hand, while understanding those decisions in context, and acting according to our principles. In other words, we can only hope to realize a probabilistic advantage over the general market. In the same way that a casino has a probabilistic advantage over its patrons, we believe to have a probabilistic advantage over the markets. Over time, we will surely benefit from a value oriented philosophy, notwithstanding certain risks involved in the process that will cause certain perturbations to our business.
While not rigidly adhering to any existing doctrine, our investment philosophy centers around appraising value and paying substantially less than the imputed value. Of course, attributing a value to an asset or business is only a rough metric, which is why paying significantly less than the lower bound is our only protection. The chances of winning the lottery are slim, but the chances of someone winning the lottery are nearly certain. I would rather place my fate in the hands of a more favorable philosophy. Choosing an investment philosophy based on an individual’s success is nearly tantamount to filling out a lottery ticket with the same numbers as a past winner. Of course, the longer an investor outperforms, the greater the likelihood that his or her success can be attributable to robust underlying philosophical approach.
Given a set of assumptions, we can build a rough scaffolding for investing wisely. Although the investing landscape will assuredly change, likely in a precipitous way, this set of principles provides a tentative guide into our general thinking. Our first assumption is that we only have a very limited ability to predict the future. By this same token, we only have a rough idea of the value of any given security. In response to our imperfect ability of appraising an asset with any exact precision, the only reasonable principle that we can properly adhere to is by paying far less than the lower limit of our valuation range. Prioritizing protecting your capital as opposed to focusing on potential upside differentiates investing from speculating. Limited upside potential is expected in many of our investments, the most obvious are our debt investments. That is okay with us, so long as we have taken every measure possible to invest or lend at a deep discount to value. Loss of principal is much more costly than limited upside.
Recognizing cyclicity is an important acknowledgment in investing. The market is indeed a manic depressive, and there isn’t a cure in sight, nor will there ever be. This assumption has a causal mechanism subserving it. Robert Shiller, in his book Irrational Exuberance, outlines the basic idea of the psychological element underlying market cyclicity. Essentially, optimism fuels further optimism, which eventually will reach an inflection point where any disappointment in growth will result in a precipitous downfall. The reasoning is simple, prices must fall rapidly because the reason they have reached such great heights is simply built off previous enthusiasm, not on fundamental financial metrics. The more that prices are distanced from value, the more that investors rely on the prevailing enthusiasm or optimism, a very fragile fever that can be perturbed at any moment. This discussion is fairly topical in behavioral economics, and although Shiller himself thinks that these boom and bust cycles can be dampened with federal intervention, this is not a real possibility in my estimation. In fact, it can be argued that the federal reserve has contributed to these cycles through the use of quantitative easing and other policies.
In any event, judging from history, cycles have been an intrinsic feature of markets. Further, cyclicity is essentially an abstraction from the idea of ‘reversion to the mean’. On average, tremendous performance will be balanced by underperformance, and the mean of the fluctuations is the rough earning capacity of a company. Accounting for cyclicity is an important element in appraising value. Prior to 2008, irrational exuberance hijacked the real estate markets, which consistently propped up values for a span of ten years. Expectations that real estate prices would continue to rise at a rate of 11% per annum greatly exceeded the historical average, but did not betray the current trend. This is why adjusting for cyclicity can be a valuable tool for finding investments at a true discount to value. It would be unwise to bet that a basketball player will replicate or exceed his performance in his best game. A better figure to bet on would be his career average.
Lastly, we reasonably assume that glamorous investments are bad investments. While starting a company that becomes exceptionally popular would be wonderful, as an investor in startup operations, it is undoubtedly a curse. We hear countless stories of angel investors earning ungodly amounts of money with early technology startups. This type of glamorous investing harkens back to the goldmine of 1849, incidentally also a California-based phenomenon. Of course, the winners were few and widely publicized, and the losers cast into obscurity- nobody wants to interrupt the great bull market. The allure of quick wealth draws investors like casinos draw gamblers, with the loss of principal only a distant after thought. Warren Buffett’s mantra, “be fearful when others are greedy and greedy when others are fearful”, is a timeless and invaluable principle that remains relevant today. The job of an investor is conceptually to create wealth through buying securities at a cheaper price than he can eventually sell them for, period. One obvious and standard way for this mispricing to surface is in unglamorous investments where the majority of people don’t see the value. Boring businesses tend not to animate the imaginations of the speculators where they can put their cash in stocks with ostensibly unlimited upside.
This same concept applies to our lending activities, where we have been able to achieve exceptionally high rates of returns on very safe investments in San Francisco real estate. Because of the explosion of wealth in the Bay Area, real estate prices have skyrocketed as a result. We have been lending against land development and have taken full advantage of their unrelenting optimism. They don’t mind paying us our lousy 10% when they can triple their money, or so they have convinced themselves. In glamorous businesses it is best to be a lender, where you are protected on the downside, and they will pay you inordinately more because of the perceived upside potential. Of course, this is not always the case. Apple doesn’t need to pay a lender 10%, but it is a possibility when the equity holders are exceptionally optimistic.
The tenets of value investing are the only sound principles to adhere to while investing. Although there are a variety of methods that are value oriented, the principles are common among these methods. Unless you are speculating, the only way to make money investing is through buying securities at a discount to value. In essence, you are buying more than you are paying for, with a reasonable degree of certainty. Abstracting from the principles of philosophers like Karl Popper and investors like George Soros have provided invaluable depth to our investing philosophy. A sizeable majority of investors focus primarily on making money by thinking about making money, whereas we see tremendous value in constructing much more defensible theoretic frameworks before making investment decisions.