Thursday, December 29, 2005

Understanding Cause & Effect

Perception is our understanding of reality & we understand reality by relating cause & effect. When what we perceive is in line with reality, the perception becomes an information. Mental blocks of such information collectively consititutes our knowledge. But sometimes what we perceive, because of cognitive illusions, can be in contradiction to reality.

"When perception does get through to man’s brain, it is often misweighted, because what is registered in perception is in shockingness of apparent contrast, not the standard scientific units that make possible science and good engineering"-Charlie Munger

I think understanding the limitations in relating cause and effect can help us reduce the perception-reality gap.

"Just as a man working with his tools should know its limitations, a man working with his cognitive apparatus must know its limitations"--Charlie Munger.

Cause & Effect:
"Today is yesterday's effect & tomorrow's cause"--Philip Gribble

The above quote highlights the importance of the fact that the present can be seen in context of past & future. Similarly we can use our thought process in two different, both equally important, modes, Forward thinking & backward thinking. None of the these is limited to relating present to past or future, as the name may suggest. Instead, backward thinking suggests relating causes to some known effect & vice versa.

Backward Thinking:
"'Invert, always invert,' Jacobi said. He knew that it is in the nature of things that many hard problems are best solved when they are addressed backward"--Charles Munger.

It is the process of working backwards from the effect & attributing causes, based on our understanding of the effect. We all do this almost on a daily basis. But we often forget a very important property of cause & effect,

"Causes & effects can be widely separated in time & space" by Joseph Connor in 'The Art of Systems Thinking'

The reason behind that is human mind has limited circuity & it can easily get influenced by psychological tendencies (like availability bias, first conclusion bias while attributing) The point is while attributing we tend to overweigh the elements which are readily available for our cognition to assimilate.

"Cognition is ordinarily situation-dependent so that different situations often cause different conclusions, even when the same person is thinking in the same general subject area"--Charlie Munger

This could be dangerous as we could end up without attributing any cause to the effect or even worse we can end up attributing wrong cause to the effect. Operating with such a disadvantage can be cited as similar to Mr. Munger's, 'disadvantage of one legged man in an ass kicking contest'

Forward Thinking:
"If corporate pregnancy is going to be the consequence of corporate mating, then the time to face that fact is before the moment of ectasy"-Warren Buffett

This is the bottom up approach where we work from a cause & think of various effects that the cause could induce. But we often forget an important property of cause & effect,

"Effect can be disproportionate to the cause" by Joseph Connor in 'The Art of Systems Thinking'

Think of a conglomerate which enters into a new business. Once the new business is created it gets a life of its own. The reason behind that is 'effects of effects' (ie) effect can become cause & induce further effects, which may become uncontrollable. The point is while thinking we should incorporate the effects of effects, where the smallest of causes can lead to a larger effect & vice-versa.

The cornerstone for successful investing is "Take care of the downside & the upside will take care of itself." Similarly, I think the cornerstone for successful use of our cognitive apparatus is

"Take care of the limitations & the advantages will take care of themselves"

Friday, December 16, 2005

Responding to Noise

"There is lots of noise that comes with information and one needs to train himself to separate noise from information" -- Naseem Taleb (in substance)

Over the past few weeks, I have realised that two areas where discerning information from noise can be of great help are decision making & interpretaion of financial information.

I will use a famous experiment done by Tversky & Kahneman & quote Charlie Munger, Buffett, & Ralph Wanger to drive home the point.

Decision Making:
Success or failure is a consequence of decisions that we make over our lifetime. We can control our decision making process but not how they will fare out. This reminds me of wonderful quote by Ayn Rand,

"One can evade reality but he cannot evade the consequences of evading reality."

To understand how to make decisions I think it is important to realise how decisions are not to be made & work backwards from there.

Psychological tendencies (or) Noises:
We all get, to varying degrees, influenced by psychological tendencies while making decisions. Some of the most common are Availability Bias, Doubt avoidance tendency, Inconsistency avoidance tendency & Psychological denial. (List of other tendencies)

Tversky & Kahneman's Experiment:
Question: 'Are there more words in english language starting with letter 'K' (or) with 'K' as third letter?'

Tversky: "The responses to the question illustrate the general principle that people use to reason under the conditions of uncertainty. They try to think of examples of the word starting with 'k' & with 'K' in the third place. Just because it is much easier to recall words starting with 'K' they assume that there must be more letters starting with K whereas in reality there are twice as many words with K in the third place. We refer to this as Availability Heuristics."

Charlie Munger on Human misjudgment:
"The brain of man is programmed with a tendency to quickly remove doubt by reaching some decisions" (Doubt Avoidance Tendency)

"The brain of man conserves programming space by being reluctant to change, which is a form of inconsistency avoidance." (Inconsistency Avoidance Tendency)

"It is easy to see that a quickly reached conclusion, triggered by Doubt avoidance tendency, when combined with a tendency to resist any change in that conclusion, will naturally cause a lot of errors in cognition for modern man."

I think that we should train ourselves on how to deal with these biases while making decisions and one of the ways of doing that is to try what Charlie Munger has done all through his life,

"I have long looked for insight by inversion in the intense manner counseled by the great Jacobi: 'Invert, always invert.' I sought good judgment mostly by collecting instances of bad judgment, then pondering ways to avoid such outcomes."

Interpretation of Financial Information:
The movement of stocks or markets is a function of how a given news or event is interpreted by the group of investors & traders. If we interpret those news or events the way most of the investors do then we will end up doing the same things as most of the investor & with the same results too. This is where I think we need to train ourselves to think differently than the herd which we are trying to outrun. This is well explained by Ralph Wanger as,

"If you want to stand out of the pack, you have to think out of the pack"--Ralph Wanger.

Having said that I would like to add that being contrarian for the sake of being one can be cited as similar to markets overreaction to good news.

Buy & Sell Decision?
We all aspire to be successful. But confusing that aspiration with the means to attain that objective can be dangerous (ie) while deciding when to buy & when to sell, we should not let our subjective aspirations clash with what the current situation--based on the value of the underlying stock-- warrants us to do.

Taking a loss should not make us feel like a stupid, if our process is right & taking a profit as genius, if our process if wrong. One can hope to achieve what he aspires in the long run. But, in the short run, we have to learn to accept what we deserve & keep on improving.

During the last decade or so, with the development of internet, ease with which the information gets transmitted from one place to other has increased substantially. Thus it becomes even more important that we respond to information that we think are information & not noises.

"You don’t need 99 percent of the information out there for investments”-Warren Buffett.

Thursday, December 01, 2005

Lessons taught by a Coin

"Your idea has to be original only in its adaptation to the problem you are working on"-Edison.

In the last chapter of Security Analysis (1934), Ben Graham mentioned about an experiment done by Frederick Macaulay to prove the invalidity of technical analysis.

"...Frederick Macaulay plotted the results of tossing the coins several thousand times (heads = one point up; tail = one point down) & had thereby obtained a graph resembling in all respects the typical stock chart--with resistance points, trend lines, double tops, areas of accumulation, etc. Since the chart could not possibily hold any clue as to the future sequence of heads or tails, there was a rather strong inference that stock charts are valueless." (Pg no: 608)

I got fascinated & wanted to try it out myself. The plan was to plot a chart with 100 coin tosses & see how it looks like. But then I looked at the chart & wanted to check if regression to mean holds. In the process I ended up with 400 coin tosses & few important lessons.

Invalidity of Technical Analysis:
Everybody will agree that it would be fallacious to look at the above chart and conclude that there will be a more head or tails in the next 50 tosses.

One argument that, I think, people who believe in technical analysis can use against the logic here is 'Each coin toss is an independent event, whereas daily stock price moments may not be independent events. How do you rationalise it?'
I don't know the answer but it reminds me of wonderful quote by Ben Franklin,

"There's none deceived but that he trusts."

Gambler's Fallacy:
There were many instances where I had sequence of 5 heads or tails in a row. I could clearly hear in the back of my mind, while the coin went up in the air, that this time it should be head or tail based on the past vivid sequence.

All this even after being aware of the fact that each coin toss is an independent event & it has got nothing to do with the past events. This is also one of the reason that I continued till 400 (ie) I did it until I stopped predicting, subconsciously. This reminds me of what Tversky & Kahneman have said,

"Under some conditions, when the conditions are knowable, we should not trust our intuition because we are liable to predictable errors & biases. Also the fact that we can predict in advance, when intuition might falter, gives us some hope of implementing procedures to avoid the errors."