Inspired by Charlie Munger (Trades, Portfolio) and his latticework of mental models, Robert Hagstrom took up a similar quest: to help individuals become better investors by showing them a broader perspective on understanding the economy and the stock market.
In the first chapter of his book, “Investing: The Last Liberal Art,” he showed how economics borrowed the idea of equilibrium, both static and dynamic, from physics. In the next chapter, he moved on to the science of biology and its big idea, evolution.
Hagstrom wove together the many strands of thoughts originating from equilibrium and evolution to provide a synthesis for modern economies and markets. In chapter four, he introduced the social science of sociology, to add yet another dimension to our understanding.
Tellingly, he began the chapter with the words of the great physicist, Sir Isaac Newton: “I can calculate the movement of heavenly bodies, but not the madness of men.” He expressed that sentiment after losing heavily in the South Sea Company bubble of 1720.
It was all the more disappointing for Newton because he had had tripled his stake in a previous round of speculation. But he could not leave well alone and plunged back in; he bought in at 700 pounds per share and after the crash sold at about 100 pounds.
Newton’s words also help Hagstrom emphasize the uncertain nature of investing and trading:
“Together, Joseph de la Vega [author of 'Confusion of Confusions', 1688], Isaac Newton, and Charles McKay [author of 'Extraordinary Popular Delusions and the Madness of the Crowds', 1841] are telling us something very important: The relationship between the individual investor and the stock market, which in itself is nothing more than a collection of individuals, is a profound puzzle. For over four hundred years, it has perplexed the rich and the poor as well as the genius and the dimwitted, and it is the story of our current chapter on social systems.”
Stock markets are made up of many millions of individual investors, but the totality of individuals also breaks out into groups. Consider, for example, value investors and growth investors; both groups have the same goals but use different systems in pursuit of those goals.
To aid in our understanding come social scientists, which is to say people who apply scientific principles to social situations with the expectation of learning more about individuals and institutions. The bedrock of the scientific system begins with the development of a hypothesis, followed by controlled, repeatable experiments, and then conclusions.
Within the social sciences are specialties such as economics, political science and anthropology. Hagstrom pointed out that anthropology divided itself into two classes, physical and cultural. The latter, cultural, examined social aspects of human institutions. Out of cultural anthropology came two types of scientists: cultural anthropologists (primitive societies) and sociologists (contemporary societies).
Part of the sociological approach is a new attempt to develop a unified theory (previously tried in the late nineteenth century). This means looking at whole systems, or about the ways that individuals and groups interact with each other, and how those interactions affect subsequent behavior.
Out of that idea comes another line of study, “complexity theory.” Economies and stock markets are, of course, complex systems. This means they are interwoven. When individuals and groups within economies and markets interact with each other, they adapt, and we can now say of such institutions that they are made up of “complex adaptive systems,” an idea we first encountered in chapter one.
Hagstrom continued:
“One aspect of these systems is the formation process. How do people come together to form complex systems (social units) and then further organize themselves into some sense of order? This question has led to a new hypothesis that may provide a common framework to describe the behavior of all social systems. It is called the theory of self-organization.”
A system that is self-organized has no central authority or director. No one person starts or directs such a system. Instead, it evolves out of “the spontaneous process of self-organization.” Economist Paul Krugman used the development of a city like Los Angeles to explain the idea. The city was not so much structured by urban planners as by residents self-selecting themselves for certain areas. For example, Korean Americans moved to Koreatown to be closer to other Koreans (and services they prefer).
There is another important aspect of complex adaptive systems, which is known as the “theory of emergence.” This refers to individuals combining to create something greater than the sum of the parts. According to Krugman, Adam Smith’s “invisible hand” is a perfect example of emergent behavior.
Hagstrom put it this way, “Many individuals, all of them trying to satisfy their own material needs, engage in buying and selling with other individuals, thereby creating an emergent structure called the market.”
Within the context of complex adaptive systems, social scientists have also discovered that collective solutions are generally more accurate that individual solutions, regardless of how smart the individuals are. But for the collective to outperform, it must be made up of diverse individuals.
From there, Dr. Norman Johnson has argued that a stock market is more robust when made up a “diverse group of agents—some of average intelligence, some of below-average intelligence, some vey smart—than a market singularly composed of smart agents.”
Journalist and author James Surowiecki demonstrated that there was another critical variable, in addition to diversity. That was independence, meaning each individual is not influenced by the other members of the collective.
Surowiecki used the example of Francis Galton, who in the early 20th century experimented at a fair in the west of England. For a sixpence each, 787 people guessed the weight of a large ox. A few of the guessers were experts, such as farmers and butchers, while most had little knowledge of farm animals. Galton’s hypothesis was that the collective answer would be far off the mark.
He was wrong. The collective guess was 1,197 pounds; the actual weight was 1,198, just one pound of difference between actual and the collective guess. Errors on the right and left tails of the distribution curve canceled each other, leaving just the “distilled information.”
Hagstrom summed up the situation so far as:
“So now we come to the crossroads. Is the stock market Charles Mackay’s unruly mob of irrational investors who constantly unleash booms and busts or is it Francis Galton’s county fair attendees who can miraculously make the right prediction? The answer is context dependent. In other words, it depends.”
It depends on how diverse and independent the market players are. The greater the diversity and independence, the more efficient the market and vice versa. If diversity in the market breaks down, individual investors make decisions based on what others are doing rather than depending on their own private information.
Wall Street investment strategist and author Michael Mauboussin wrote, “Information cascades (which can lead to diversity breakdowns) occur when people make decisions based on the actions of others rather than on their own private information. These cascades help explain booms, fads, fashions, and crashes.”
Next, Hagstrom presented a key idea from physicist Per Bak, “self-organized criticality” and “According to Bak, large complex systems composed of millions of interacting parts can break down not only because of a single catastrophic event but also because of a chain reaction of smaller events.”
In a paper written with two colleagues, Bak developed a basic model that would explain the behavior of two types of agents active in a stock market. The two types were noise traders and rational agents. Hagstrom substituted trend followers for noise traders, and fundamentalists for rational agents.
If the value of a stock is greater than its current price, fundamentalists buy; if the value is less than current price, they sell. On the other hand, trend followers, “seek to profit from changes in the market by either buying when prices go up or selling when prices go down.”
Generally, there is a reasonable balance between trend followers and fundamentalists, and stock prices are reasonably stable. However, when stock prices climb robustly, the number of trend followers increases and they buy more, pushing prices up even further. At the same time, fundamentalists cannot find bargain stocks and instead sell into the rising price trend and exiting the market.
Most of us would recognize such a situation as being part of a growing bubble. To that, Hagstrom adds context, “when the mix of fundamentalists and trend followers becomes unbalanced, we are heading toward a diversity breakdown.” As we saw earlier, the market becomes increasingly unbalanced as diversity wanes.
Summing up, Hagstrom wrote:
“At this point, we have a fixed compass on how to analyze social systems. Whether they are economic, political, or social, we can say these systems are complex (they have a large number of individual units), and they are adaptive (the individual units adapt their behavior on the basis of interactions with other units as well as with the overall system). We also recognize that these systems have self-organizing properties and that, once organized, they generate emergent behavior. Finally, we realize that complex adaptive systems are constantly unstable and periodically reach a state of self-organized criticality.”
In a more pragmatic vein, through another of Hagstrom's mental models we can now better understand the dynamics of the market and see why bubbles emerge out of human action.
Read more here:
Learning to Think Like Charlie: Biology and Evolution
Learning to Think Like Charlie: Physics and Equilibrium
Learning to Think Like Charlie: Building on Charlie Munger’s Mental Models
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