In creating his own latticework of investment ideas, Robert G. Hagstrom began with physics. And if you immediately want to know how physics could possibly be linked to investing, then the author has an answer.
In his book “Investing: The Last Liberal Art,” he asked readers to imagine visiting an antiques store. If the owner has too much inventory, then he’s likely to offer a discount. On the other hand, if a customer falls in love with a certain piece, they will likely pay the asking price, even if it seems too rich.
He added, “What happens in the shop is governed by the rule of supply and demand, which in turn is a pure, classic example of the law of equilibrium at work. And equilibrium is one of the fundamental concepts in the field of physics.”
Inspired by Charlie Munger (Trades, Portfolio)’s idea of a latticework of mental models, Hagstrom’s objective in this book is to help his readers learn how to become better investors by looking at concepts beyond the financial and mathematical. So, knowing a big idea from physics can help us understand the law of supply and demand, which in turn helps us figure out what’s going on with stock market prices.
Chapter two began with a profile of Sir Isaac Newton, one of the greatest scientific thinkers ever. Born in 1642, he was a premature and sickly boy, raised by his grandmother because his father died a few months before he was born, leaving his mother destitute.
Still, he got into Trinity College at Cambridge University and into a world of science and mathematics. Beyond the classroom, where the world was believed to governed by the powers of God, Newton learned about the dissident new scientists, including Johannes Kepler, Galileo Galilei and Rene Descartes.
Hagstrom wrote that Newton took a key idea from Kepler: “Our ability to answer even the most fundamental aspects of human existence depends largely upon measuring instruments available at the time and the ability of scientists to apply rigorous mathematical reasoning to the data.”
From Galileo, he learned that scientists should discover the relationships in nature using logic. From Descartes, he adopted a new view of the world: “This mechanical view provided a powerful research program for seventeenth-century scientists. It suggested that no matter how complex or difficult the observation, it was possible to discover the underlying mechanical laws to explain the phenomenon.”
Forced from Cambridge by an outbreak of the plague, Newton retreated to the family farm in Lincolnshire. With time to think, he had an exceptionally fruitful year. He produced what we now call calculus, developed a theory of optics and, most memorably, the universal law of gravitation. Legend has it that he watched an apple fall from a tree and conceived the idea of gravitation in a flash.
Out of that came the idea of equilibrium, that the planets stay in their fixed orbits because of two equal and opposed forces: the velocity of their forward motion, which would take them away from the sun, and force of gravity pulling them toward to the sun.
In an equilibrium model, a system that is not changing is in a state of static equilibrium. A system in which competing forces are equally matched, as is the case with the planets, is in dynamic equilibrium. Hagstrom offers the example of a bathtub with its drain closed and its faucet shut off to illustrate static equilibrium. However, if you unplug the drain and turn on the faucet so the same amount of water comes in and goes out, then you see dynamic equilibrium at work.
Economists have long used equilibrium theory to explain how economics works. The theory allowed them to develop the mechanical relationships among demand, supply and price. British economist Alfred Marshall used the concept in his seminal textbook, “Principles of Economics,” published in 1890, to explain economic equilibrium in individuals, companies and the marketplace.
Hagstrom also brought in the American economist Paul Samuelson. He wrote, “Samuelson took the concept of equilibrium in the economy and moved it to the stock market, connecting the idea of stock price movement with the classical idea that price and value exist in equilibrium. His notion that investors act on the basis of rational expectations is what upholds the concept of equilibrium in the stock market.”
Eugene Fama, the academic behind Modern Portfolio Theory, introduced the idea that stock prices are unpredictable because the market is too efficient. In other words, many smart people all have simultaneous access to all relevant information available and, therefore, there can be no undervalued or overvalued stocks.
Also on Hagstrom’s list of contributors was William Sharpe, who developed “a market equilibrium theory of asset prices under conditions of risk.” Out of that came the idea of a linear relationship between risk and return; simply stated, it means that if you want greater returns, you must take greater risks.
In recent years, though, the idea that equilibrium theory is the major driver of the economy and the stock market has been challenged. At the Santa Fe Institute, Hagstrom reported, the think tank is exploring “complex adaptive systems.” In other words, systems with many parts that continually modify their behavior as they respond to changes in their environment. Examples of complex adaptive systems include the human nervous system, political systems and social structures.
“No thoughtful person, looking at the present stock market, can fail to conclude that it shows all the traits of a complex adaptive system. And this takes us to the crux of the matter. If a complex adaptive system is, by definition, continuously adapting, it is impossible for any such system, including the stock market, ever to reach a state of perfect equilibrium.”
Previously, our intellectual heritage drew a mechanistic picture of life and the stock market, one in which there is a direct relationship between supply and demand. The new approach sees systems such as stock markets as organic and far less predictable.
Hagstrom added that we investors still think of the law of equilibrium as being absolute, and we do so because “the entire Newtonian system, of which equilibrium is one part, has been our model for how to think about the world for three hundred years. Letting go of such deeply embedded ideas is not easy.”
Finally, he wrote:
“Equilibrium may indeed be the natural state of the world, and restoring it when it is disturbed may be nature’s goal, but it is not the constant condition that Newtonian physics would suggest. At any given moment, both equilibrium and disequilibrium may be found in the market… In much the same way, the balance between supply and demand, between price and value, will always be in evidence in the daily operation of the market, but it no longer gives us the full answer.”
If physics cannot provide us with the full answer, what can? Hagstrom follows up in the next chapter.
Read more here:
- Learning to Think LIke Charlie: Building on Charlie Munger's Mental Models
- Big Mistakes: Chris Sacca
- Big Mistakes: Charlie Munger
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