Investors are constantly faced with difficult decisions everyday.
Should I sell x company?
Should I read x company’s 10K?
Where should I start to look for ideas?
This company looks promising where do I start looking?
How do I value this company?
How will management utilize the extra cash?
Does the company have advantages over competition that are sustainable?
What are the industry barriers to entry?
Is it highly probable that a new entrant could enter the industry
and cause a lot of disruption?
Do I actually understand this company?
All of these questions and many more swirl through investors’ heads constantly. It is hard to think of new ways to tackle all of these problems as one question leads to another. Our brains are wired in a way that can get us to overlook facts when we approach our problem from only one aspect.
You sit and feel somewhat defeated by how much time you are spending on a difficult problem. We have all been there. It shouldn’t have to be this way, however. There are techniques that allow us to look at our difficult problems and give us fresh perspectives that allow us to devise creative solutions to these difficult problems. We’ll be looking at the techniques used by those in the past who have tackled the most challenging problems of their day. In the process, they developed solutions that were well ahead of their time that we still use today. We will then see how these techniques can be included in our investment related problems and become a staple of our investment processes.
You might have heard Charlie Munger (Trades, Portfolio) repeat the great mathematician Jacobi’s maxim “Invert, always invert” as he said “Many hard problems are best solved when they are addressed backward.” Conceptually speaking, inversion is easy to grasp, just flip the problem. Thankfully, much has been written about the framing cognitive bias — which inverting tries to overcome — and how it works. Methods of overcoming framing bias were described by Aristotle, one of ancient Greece’s greatest thinkers. He was inverting his problems thousands of years ago, and he described his process in the book “On Interpretation.”
Aristotle rightly believed that word choice and the orientation of words of a given problem are very important in how we approach that problem. Take this as an example: Say that fruit flies double their population every 10 minutes. Two fruit flies are now swirling above the rotten bananas in your kitchen. Fifteen days later your kitchen ceiling is covered with fruit flies. When was the ceiling half covered?
Key words like “double” and “fifteen” steer most people into dividing fifteen by two. Since population growth — especially fruit fly population — is geometric and exponential, roughly 10 minutes before the fifteenth day is when the ceiling is half covered, not noon of the seventh day. Think, the world population wasn’t 3.5 billion — or half today’s approximately 7 billion — 250,000 years ago or half the time since modern humans have been around. USCB estimates that 1967 was when the world population hit 3.5 billion. The wording influenced how our mind went about framing the problem. It is as if the word choice and word sequence forces us to look through one lens, usually the incorrect one.
Thought Experiment from The Framing Decisions and the Psychology of Choice (Tversky and Kahneman 1981):
You are asked to choose between two treatments for 600 people affected by a deadly disease. You are told that if treatment A is adopted, 200 people will be saved, whereas if treatment B is adopted, there is a 33% chance that everyone will be saved, but 66% chance that no one will be saved. Which treatment would you choose?
There are two other treatments also available. You are told that if treatment C is adopted 400 people will die, whereas if treatment D is adopted there is a 33.3% chance that nobody will die, and 66.6% chance that 600 people will die. Which of these treatments would you choose?
We are guessing that many people chose treatment A in the first situation. A guaranteed 200 saved is better than a 33.3% chance of saving 600 lives, right? In the second situation we guess that you chose treatment D because a guaranteed 400 lives lost is worse than 66.6% chance all 600 people will die, right?
The problems above all have the same exact outcomes. A 33.3% chance that 600 people will live is equal to 200 or a 100% chance of 200. A 66.6% chance that 600 people will die is equal to 400 or 100% chance of 400. So why would we choose different choices that have the same solution? It all comes down to how the problem is worded. When faced with a choice implicating gains, humans tend to be risk averse. On the other hand, when faced with a choice implicating losses, humans tend to take more risks. Seeing how investing involves gains and losses, investors might be unknowingly falling victim to the framing cognitive bias.
Change the words. Aristotle highlighted that key words drive meaning and by simply changing them, we can add a different perspective. From the thought experiment above the key word initially was “saved” but later changed to “die.”
Long-term investors might ask management or themselves, “Does management have a focus on the long term?”
We can add more insight by changing one key word:
“Does management have a target for the long term?” Some companies might say they have a focus on the long term but the ones that actually do have clearly stated targets.
“Does management have a spotlight on the long term?” A spotlight provides imagery that management has an intense clearly defined focus on the long term.
We can change other keywords in the sentence:
“Does the whole company have a focus on the long term?” We might then start to think, are management’s incentives and other employees' incentives aligned with long-term value creation?
“Does the company’s culture emphasize the long term?” Not all employees have a majority of their pay based on performance, nor should they. A company with a culture and philosophy that emphasize entrepreneurship and thrift are generally cultures that are best prepared to be able to create long term value. The company that we write about this month is a great example of a company with a strong entrepreneurial and thrifty culture.
We can change the key word with its antonym:
“Does management have the long term in their periphery?” This would indicate that the company really doesn’t have the long term in the forefront of their actions but might sprinkle some long term talk in shareholder correspondence to fool shareholders into believing that they really do care about the long term. Management pay and actions speak much louder than some of the words that they choose.
Totally different words and word orientation:
“If I was in their shoes, would I be incentivized to tread water or invest in the future?” - Sometimes it might be hard to guess how someone else might act, so asking the question like this will provide extra insight. A million dollar salary and large stock options for 2% revenue growth would not make you want to shake the boat. Inflation would be beating the companies growth so you are incentivized to pretty much run on the treadmill. Now if you had 100% of your wealth tied to the company you worked for, received a moderate salary and stock options only if you beat industry indexes, then you are more likely to try things that will provide you and your fellow shareholders the best long term returns.
We can transpose the order of our words:
Edward Jenner the man who has been said to have “saved more lives than the work of any other man” transposed his problem from why people got small pox to why milkmaids never got small pox. From this insight he postulated that the puss milkmaids had from cowpox protected them from smallpox. He inoculated cowpox into subjects and found that his idea was correct and discovered immunization.
We might change our sentence above to:
“Does management’s long term have focus?” - Management might “focus” on the long term but how clearly can they see it? This could be like the three blind mice; they might try their darnedest to see that one open door that can get them to freedom, but they are blind and the farmer’s wife will catch them well before they randomly find the exit. Management who have incentives and the right mind set are properly prepared to clearly see the long term and be successful. Other management teams are blind and no matter how hard they try, they just will never see it.
Peter Lynch was a great example of an investor who changed the wording of his questions to gain multiple perspectives to better make his decisions. In Hersh Shefrin’s book Beyond Greed and Fear he asked Bob Saltmarsh, the treasurer and head of investor relations at Apple when Lynch’s Magellan Fund bought Apple, if Peter Lynch was just plain lucky. Saltmarsh said “ His questions were different. They were more focused and insightful.” Saltmarsh gave an account of an investor conference in 1987 where he recalled Lynch as being the only fund manager probing Apple about its cash position. Lynch was doing so by asking the same question nine or ten different ways. Saltmarsh couldn’t get what Lynch was getting at and asked what he wanted to know. Lynch responded with several different questions “Is that money burning a hole in your pocket? Will you stick to your knitting, or will you go off and try something that you don’t understand?”
All too often investors look at companies as if they are in a buying mood. From here they try to find the reasons that would justify their buy. By inverting our pre-analysis mind set from why to buy to why we shouldn’t buy a company, then we can get some interesting insights we might not have gotten from strictly a buying mood.
So when investing try not to ask more questions. Try to take the questions that you have and ask them differently to gain new insights. Change key words with synonyms and then antonyms. Change the orientation of the words and transpose the word order. From here, you will be looking at the same problem with different lenses which can give you the edge over other investors who constantly look through one or very few lenses. As Warren Buffett (Trades, Portfolio) says if you have a high IQ, give away 20 or 30 points because they won't help you. What will help you is how many different ways you can look at a problem.
Approaching your problem(s) from many different angles gives you the best chance to find a solution. Before you make your next investment or are faced with a difficult decision, try to utilize the steps above. If inversion has worked for Charlie Munger (Trades, Portfolio), Carl Gustav Jacobi and Aristotle, then its probable inversion can help you too. Your future self will more than likely be happy you did.