Thinking Like A Kid

I believe that the propensity to learn new things decreases as a man ages (ie) a 1 year old kid learns a lot more in a day as compared to a 10 year old, who instead learns a lot more as compared to 25 year old.

“A high school teacher drew a dot on the blackboard and asked the class what it was. ‘A chalk dot on the blackboard,’ was the only response. ‘I’m surprised at you,’ the teacher said. ‘I did this exercise with a group of kindergartners and they thought fifty different things it could be: a squashed bug, an owl’s eye, a cow’s head. They had their imagination in high gear. As Picasso put it, ‘Every child is an artist. The challenge is to remain an artist you grow up.”—Creative Whack Pack (card no: 16)

I think one way to maintain our artistic caliber as we grow up is to learn to think gray, and free. I will draw the lessons from my understanding of an excellent book “The Contrarians Guide to Leadership” by Steven Sample and this wonderful post by Prof. Sanjay Bakshi.

Thinking Gray:
“The essence of thinking gray is this: don’t form an opinion about an important matter until you’ve heard all the relevant facts and arguments, or until circumstances force you to form an opinion without recourse to all the facts (which happens occasionally, but much less frequently than one might imagine)”—Steven Sample.

Understanding why ‘thinking gray’ is difficult to follow can help us overcome the difficulty. One possible reason could be social conventions. For ex: we generally tend to relate a successful person with good instincts, quick judgments, being decisive… Those are indeed some of the pre-requisites to become a good decision maker, but we should not forget to bring in an important factor, situation. There are situations when one has to think black and white (ie) make instinctive decision, say playing tennis. On the other hand there are situations where the best decision is to not decide at all. (Please read this excellent post by Prof. Sanjay Bakshi in which he has discussed ‘preserving optionality’ at length)

“Never make a decision today that can be reasonably put off till tomorrow”—Steven Sample.

Thinking gray requires us to overcome the tendency of being decisive just for the sake of it. For example we have a tendency to record first impressions of people and try to check if our impression is right or wrong. This when supported by anchoring bias can lead to Munger’s ‘man with a hammer’ tendency. Thus it can be said that instead of reaching conclusions, we can just record the events or news as pieces of information and preserve our options to reach conclusions.

“The test of the first rate mind is the ability to hold two opposing thoughts at the same time while still retaining the ability of function”—Scott Fitzgerald

Thinking Free:
“Much of our thinking is associative: one idea makes you think of another—no matter how logical the connection. Use this ability to generate new ideas. Look at something, and make associations based on whatever you can think of: function, location, size, shape, sound, personal, opposite, weird, etc…” Creative Whack Pack (card no: 15)

The importance of the above paragraph lies in the fact that it advises us to overcome first conclusion bias, which when combined with inconsistency avoidance tendency results in human mind functioning like a human egg (ie) when one sperm gets into a human egg, there’s an automatic shut-off device that bars any other sperm from getting in. It is fine with human egg, but when something of that sort happens to human mind; it tends to hold onto its beliefs irrespective of their validity. Thinking about the consequences of such a condition reminds me of a wonderful quote by Ben Franklin.

“When you’re finished changing, you’re finished”

Understanding why ‘thinking free’ is so difficult to follow might help us in our endeavor. One possible reason could be people’s aversion to failure. I mean to say that just as people prefer avoiding losses over acquiring gains (as explained by ‘Prospect theory'), people tend to avoid experimenting with thought process if it carries with it the possibility of embarrassment. This could well be the reason behind people blindly falling prey to ‘herd mentality.’ That is, fear of getting caught as a group is very different from getting caught all alone, whatever be the pursuit.

It is easier said than done but with persistent practice we can learn to overcome such shortcomings and learn the art of thinking free. This reminds me of a quote by Warren Buffett,

“Practice does not make perfect; it makes permanent”

Conclusion:
All in all, I think that we should have these important cognitive tools in our repertoire of mental models. The more we practice with such tools, the better informed we can become of their limitations and eventually their advantages.

"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.

Is There Time for Timing?

(This is a response to a question asked by Shai to me and Bill of NoDoodahs. You can read Bill's reply from here)

Shai’s Question: What role should the exploration of stock price charts play in a value investor's intelligent analysis of equity?

“When I disagree with a rational man, I let reality be our final arbiter; if I am right, he will learn; if I am wrong, I will; one of us will win, but both will profit”—Ayn Rand

When Shai asked me to become a part of this debate, I reminded myself the above quote and agreed. (Moreover there is no winner or loser, we all can learn something) I have decided to use Charlie Munger’s two-track analysis to answer the above question,

“One approach is rationality—the way you'd work out a bridge problem: by evaluating the real interests, the real probabilities and so forth. And the other is to evaluate the psychological factors that cause subconscious conclusions, many of which are wrong”—Charlie Munger

Rational Consideration:
“Extrapolation may give you the ability to see what’s coming down the street but not what is coming around the corner”—Henry Kaufman

The maxim on which value investing is based is ‘Margin-of-safety.’ To put it simply one tries to buy a dollar bill for, say, 40 cents and waits for the stock market to appraise it to its intrinsic value.

Instead of trying to refute the validity of technical analysis, I think it will be much more rewarding if we think in terms of opportunity cost because at the end of the day we are trying to find if technical analysis can be of any help in ‘value investing.’ Let us assume that technical analysis works and work backwards to see what effects it can have on our perfomance.

Presume that a dollar bill is selling for 40 cents and technical analysis suggests that it will fall to 30 cents. If technical analysis holds then you will buy it and end up making 70 cents. (For the sake of simplicity consider that market will quote the dollar bill at $1 sooner or later) On the other hand what if, technical analysis does not hold and you end up waiting for it to fall to 30 cents and it never does? For an extra return of 10 cents, one can end up missing upon an opportunity to make 60 cents.

Now assume that technical analysis holds 7 out of 10 times. As a result, you would have made an extra return of 70 cents, but you would have missed out on an opportunity to make $1.80. This could be the reason that one is able to find well-to-do technical analyst, but not in the Forbes list!

Thus it is fairly clear that instead of trying to make value investing complicated by linking it to technical analysis we would, rather, do well to keep it as simple as it is. This reminds me of a wonderful quote by Albert Einstein,

“Everything should be made as simple as possible, but not simpler”

Psychological Consideration:
“What we wish, that we readily believe”—Demosthenes.

Apart from realizing that it might not be reasonable to try and predict market prices, I think it is equally important to understand the psychological tendencies that make people do that, so as to try and avoid falling prey to these biases.

Availability Bias:
“An idea or fact is not worth more just because it is readily available to you”—Charlie Munger.

We have a tendency to focus excessive attention on a particular fact or event, rather than the big picture, simply because it is more visible or fresher in our mind. I am not saying that one should not pay any attention to the stock price, all I am saying is that think of the stock price fluctuations as a function of demand and supply for the stock, which varies from time to time for all sorts of reason, which we cannot explain, let alone foresee. But when we have any reason to relate price movement to changes in the business or industry we should classify it as information and make necessary changes in our assumptions.

Social Proof:
“If you want to stand out of the pack, you have to stand outside the pack”—Ralph Wanger.

It is easier said than done. But if it had been that easy, everybody would have done that and in effect we would have found ourselves standing in the pack again, sooner or later [Tragedy of the commons]. So I think before jumping to conclusion that ‘majority is right,’ we should consider our actions as means to a desired end and not confuse with the fact that repeating other people’s moves will not result to that end.

Representativeness heuristic:
“It has struck me that all men’s misfortunes spring from the single cause that they are unable to stay quietly in one room”—Pascal.

We have a tendency to treat events as representative of some well-known class or pattern. This gives us a sense of familiarity with an event and thus confidence that we have accurately diagnosed it. This can lead us to ‘see’ patterns in data even where there are none.

I don’t have any facts to prove that stock prices are random, but I have not come across any convincing explanation that stock prices are not random, either. Hence I think we should stick to what is provable and lies in our circle of competence. This reminds me of a wonderful quote by Ben Franklin,

“There is none deceived but that he trusts”

Conclusion:
We should make sure that we realize which school of thought we belong. We either believe in technical analysis or we don’t. But please avoid taking an intermediate stand because the consequences of being uncertain about something can be worse than being certain about a fallacy. I think this is applicable not only to the current topic but generally speaking. This is very well explained by Benjamin Graham,

“Where an intermediate stand is taken, the result will usually be confusion, clouded thinking and self-deception.”