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Robert Abbott
Articles (547)  | Author's Website |

Learning to Think Like Charlie: Philosophy

How two different descriptions of Amazon led to widely different forecasts

July 11, 2019 | About:

The ways in which we search for meaning in the world, philosophy, can help us become better investors. That was the claim of Robert Hagstrom in his 2013 book, “Investing: The Last Liberal Art.”

Inspired by the thinking of Charlie Munger (Trades, Portfolio), Hagstrom set out to create his own latticework of mental models for investors. So far, he has examined the relationships between the financial world and physics, biology, sociology and psychology. In chapter six, he added philosophy to his set of mental models.

Broadly speaking, there are three categories in the study of philosophy:

  • Critical thinking about the general nature of the world, or metaphysics. The meta part of the world refers to beyond, and physics refers to the tangible world. Thus, metaphysics refers to the world of the mind and issues such as religion.
  • Second, a group of three subjects: aesthetics (theory of beauty), ethics (what is moral and what is not) and politics (how societies should be organized).
  • Epistemology, the third category, is the study of the theory of knowledge.

The author explained that in this chapter about philosophy, he would focus on epistemology because “I am interested in learning how the process of thought formations occurs and how good thinking skills can be acquired.”

He connected this to market behavior through complex adaptive systems, an idea first explored in chapter one. According to philosopher Lee McIntyre, what often appears complex to us is only that way because we do not have descriptions capable of capturing it.

With that comes the concept of “redescription,” which Hagstrom called “a critical tool for non-scientists who search for understanding. If things remain a mystery, our job then is to shuffle our descriptions and offer redescriptions.”

Benoit Mandelbrot, an acclaimed mathematician who developed the field of fractal geometry, applied this idea to physics, biology and finance. He argued that “failure to explain is caused by failure to describe.”

Ludwig Wittgenstein, an Austrian philosopher, sought to identify how language and reality related to each other, and more specifically how reality is shaped by the words we select. For example, Hagstrom cites the case of Amazon.com Inc. (NASDAQ:AMZN) in the immediate aftermath of the dot-com crash. Bears expected Amazon’s share price to keep on falling. Why? Because they compared it to Barnes & Noble (NYSE:BKS), a brick-and-mortar book retailer, and Walmart (NYSE:WMT). The bulls, on the other hand, expected Amazon’s price to keep rising because they compared it with Dell Computer (NYSE:DELL) instead.

Novelist and scientist C. P. Snow claimed the major obstacle to solving many of the world’s problems was a breakdown in communication between humanists and scientists. Hagstrom added:

“Why should investors care about a half-century-old debate between humanists and scientists? Because the narratives investors use to explain the market or economy sometimes lack the statistical rigor required for a proper description. And as we have learned, if the description is faulty the explanation is likely wrong.”

John Allen Paulos, author of “A Mathematician Reads the Newspaper” and “Once Upon a Number: The Hidden Mathematical Logic of Stories,” explained that people are very good at storytelling and reasonably good at statistics. However, storytellers rarely add a statistical defense for the story. At the same time, people who are good at citing statistics can rarely put “statistical revelation” into suitable context.

Building on that, Hagstrom wrote, “For investors it is important to realize the slippery slope of narratives. Storytelling inadvertently increases our confidence in propositions as the story itself becomes its own proof.”

He went on to argue that the lessons from Mandelbrot, Wittgenstein, Snow and Paulos are all connected. He wrote, “The right description is critical for providing the right explanation. However, there is often more than one obvious description.” He went on to add:

“To be a successful investor we must be prepared for redescriptions. Fortunately there is a philosophical guidepost that will make our journey easier and more sensible. We find such a guidepost in the philosophy of pragmatism.”

The concept of pragmatism was popularized by the philosopher William James. He, in turn, was building on an idea first expressed by his friend and fellow philosopher Charles Sander Peirce.

For Peirce, pragmatism was the idea that people resolve their doubts and form beliefs, and then based on those beliefs they take actions and form habits. Thus, a true definition of belief should be based on the actions resulting from it, rather than the belief itself. Hence, the term “pragmatism,” as in the sense of being practical. Peirce saw pragmatism as a tool for solving philosophical problems, for establishing the meaning of things specifically.

James wanted to apply the idea more broadly, as in thinking in general. He agreed with Peirce that philosophers had “wasted” time trying to prove abstract principles. He thought philosophers should be asking about the practical effects of following one philosophical view as compared to another.

Hagstrom summarized the idea this way: “To state the matter as simply as possible, pragmatism holds that truth (in statements) and rightness (in actions) are defined by their practical outcomes. An idea or an action is true, and real, and good, if it makes a meaningful difference.”

Of beliefs, James noted their greatest use was to “help summarize old facts and then lead the way to new ones.” More than a half century before Thomas Kuhn, James gave us an explanation for shifting paradigms. Like scientists following a formal process, the rest of us have a set of opinions or beliefs, and then encounter new experiences that challenge--and sometimes change--those existing beliefs.

We go through the same process when we select investing styles. Hagstrom uses the example of value investing and argued that some investors think John Burr Williams’ discounted cash flow theory is the best model of economic value. He calls this a “first-order model.” However, some investors have difficulty using it and opt instead for a “second-order model,” which might be something like low price-earnings ratios.

Hagstrom continued, “The stock market is a giant discounting mechanism that is constantly repricing stocks.” Therefore, no one metric can be absolute, and our investing styles evolve. He wrote:

“The philosophic foundation of successful investors is twofold. First, they quickly recognize the difference between first- and second-order models, and as such they never become a prisoner of the second-order absolutes. Second, they carry their pragmatic investigations far from the field of finance and economics. It can be best thought of as a Rubik’s Cube approach to investing.”

He also wrote, “The only way to do better than someone else, or more importantly, to outperform the stock market, is to have a way of interpreting the data that is different from other people’s interpretations.” This means redescribing what is going on in the markets.

Finally, the author concluded:

“In studying the great minds in investing, the one trait that stands out is the broad reach of their interests. Once your field of vision is widened, you are able to understand more fully what you observe, and then you use those insights for greater investment success.”

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

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About the author:

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995 and in 2010 added options -- mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate-level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the "unseen revolution." In his book, "Big Macs & Our Pensions: Who Gets McDonald's Profits?" he looks at the ownership of McDonald’s and what it means for middle-class retirement income.

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