Do you have a set of rules with which you invest? Then Michael Mauboussin would like to know if those rules account for context as well as fixed principles. It’s one subject covered in chapter four in his 2013 book, "More Than You Know: Finding Financial Wisdom in Unconventional Places."
In his language, there are "attributes" and "circumstances." Attribute refers to a fixed characteristic such as low price-earnings multiples or the like; while the numbers may change, the principles behind the ratio do not. On the other hand, a circumstance is defined by Merriam-Webster as “a condition, fact, or event accompanying, conditioning, or determining another: an essential or inevitable concomitant.”
The author was vague about what constitutes an attribute and what constitutes a circumstance, but given their definitions, we might forge an example like this: Normally own a diversified portfolio (which is an attribute or principle that remains fixed), but note that many outstanding investors have relatively concentrated portfolios.
In other words, it’s normally a good idea to have a diversified portfolio, but in some circumstances, it is better to own a concentrated portfolio. He wrote, “Investment approaches based solely on attributes, without considering the circumstances, also don’t make sense. Sometimes a stock that looks expensive is cheap, and what looks cheap is expensive. It’s context dependent.”
When discussing attributes, it’s possible Mauboussin is referring to investing styles such as value and growth (he also makes a reference to “low multiples,” as an example). In another reference, the author wrote, “Investment consultants encourage, nay, compel most investment professionals to articulate an attribute-based investment approach and stick with it.” He followed that with references to growth and value investing.
The key to covering off the circumstances—it appears—is to develop categories within which an infinite number of possible circumstances are enclosed within a manageable number of categories. I write “it appears” because Mauboussin does not make explicit the connection.
His linkage to the second subject of the chapter, the development of theory, is also murky. But he did write, “A sound theory helps predict how actions or events lead to specific outcomes across a broad range of circumstances.”
To explore theory, Mauboussin turned to an article by Clayton Christensen, Paul Carlile and David Sundhahl, who break the process of theory building into three parts:
- “Describe what you want to understand in words and numbers.” Observation, description and measuring dominate this stage of the process, as researchers try to identify a specific idea that other researchers can test as well.
- “Classify the phenomena into categories based on similarities.” This allows the researcher to reduce that infinite number of possibilities into a finite number, and thus capable of being enumerated. Mauboussin added, “Investing has many variations of categorization, including value versus growth stocks, high risk versus low risk, and large- versus small-capitalization stocks. These categories are deeply ingrained in the investment world, and many investment firms and their products rely on these categories.”
- “Build a theory that explains the behavior of the phenomena.” A good theory will explain the cause and effect connection, why the cause and effect works, and under what circumstances the cause and effect operates.
Once a theory is articulated, it can be tested in practice and under different circumstances. If the results are inconsistent, then the theory may be false or it may need to be changed or merely tweaked. Mauboussin observed:
“Anomalies force researchers to revisit the description and categorization stages. The goal is to be able to explain the phenomenon in question more accurately and thoroughly than in the prior theory. Proper theory building requires researchers to cycle through the stages in search of greater and greater predictive power.”
Christensen and associates also argued that good theory cannot exist without proper categorization. Further, theories evolve from attribute categories to circumstance-based categories as they get better.
Put another way, theories built on circumstance-based categories have better predictive powers than attribute-based categories. Unfortunately, according to the author, investors rely too much on attribute-based categories.
He offered the example of investing based on low price-earnings multiples; over the past 125 years, that strategy has “fared poorly”, but “This doesn’t mean that low P/Es are bad but does mean that buying the market when the P/E is low is not a valid theory for generating superior long-term returns.”
A more successful strategy has been to take an eclectic approach, meaning these successful investors based their decisions on circumstances, rather than attributes. Mauboussin pointed to manager Bill Miller of the Legg Mason Capital Management Value Trust. He beat the S&P 500 for a remarkable 15 years in a row, yet did not stick to the accepted practices of value investing.
Mauboussin wound up the chapter with: “All investors use theory, either wittingly or unwittingly. The lesson from the process of theory building is that sound theories reflect context. Too many investors cling to attribute-based approaches and wring their hands when the market doesn’t conform to what they think it should do.”
Conclusion
Perhaps it’s just me, but I found this chapter difficult to understand. It’s obviously helpful and interesting to know we can improve the robustness of our investing processes by thinking in terms of circumstances (and categories) rather than just by attributes.
The value in this chapter, it seems, is better predictability. To cite an example of my own, I would find it helpful to go into a discounted cash flow analysis with a more comprehensive understanding of a company’s anticipated growth over the next 10 years.
However, there were not enough details or examples to make the connections between attributes, circumstances and categories clear. As the old saying goes, “There’s gold in them thar hills,” but I need a better map before I go prospecting.
Read more here:
- More Than You Know: How Often You're Right Isn't All That Matters
- More Than You Know: Should Investing Be a Profession or a Business?
- More Than You Know: Be the Casino, Not the Gambler
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