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Horizon Kinetics - Q1 2014 Commentary

April 17, 2014 | About:

Prefatory Remarks:

One could do worse than to begin a new year with a fresh mindset—mindfulness, even—and in this review, the mind’s eye is turned toward the most basic considerations in investing today. At the outset, it is important to note that modern investing has become heavily quantitative. A modern portfolio finance paper is virtually unintelligible to someone without an advanced degree in mathematics. There are probably more equations than words, and the words that are used, although written with the Latin alphabet and in English, and pronounceable, are nevertheless impenetrable. Know what a Jensen’s alpha is? While it sounds like something that might require a visit to the doctor, it is actually a critical concept and formula in modern finance. It has been used to hire and fire many a portfolio manager.

The reason it is critical to understand just how quantitative modern investing has become, from the academic grounding, through a trustees’ strategic plan, to the tactical implementation by the manager, to the annual review and assessment by the self‐same trustees or their appointed consultant, is that this is all considered to be quite scientific. But it is not, and it cannot be. The essential misunderstanding is that in science as we generally think of it, physical science, there are certain physical or electromagnetic or chemical properties, constants and relationships that are measurable, repeatable and not subject to change, neither by human effort nor by will. One might believe, or one’s entire town, state or even national legislature might believe something about the motions of the planets, the shape of the earth, the speed of light, but those facts cannot be changed, because the reality is independent of those beliefs.

Investing, though, is a human activity, occurs in the marketplace, and is therefore a phenomenon of social, not physical science. In the social sciences, reality is affected by belief. Any of you who, alone (or nearly alone), believes that the path to riches lies, for example, in purchasing bank‐owned foreclosed homes at a 50% discount to construction cost, or stocks selling below the replacement value of their hard assets, and if that idea has merit, have a very good chance of walking that path. Unfortunately, if that belief comes to be widely accepted, it will no longer have merit—others acting on that belief will inflate the prices until that path to riches either disappears or ends at a cliff.

The reason to pay attention to universally accepted views is not to implement them, but to think about them and implement or make use of the valuation paradoxes they create. Just about any technical, scientific‐seeming, rules‐based approach to investing, once it becomes the accepted wisdom (and woe to those who don’t subscribe to that accepted wisdom), will become inoperative and, taken too far, absurdly so. Here, then, we will examine some of the most basic such propositions about how we invest our money. They can’t be discussed all at once, so from the following list, to which we might add or detract as time and circumstance dictate, we will choose one or two at a time during the course of the year.

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