When you invest, remember to commune with the dead

There are two ways to learn to invest. You can study success. What do successful investors do? What do they have in common? What traits contribute to their achievement? You learn through examples by following the path of those who have succeeded. Or you can study failures. Those who lost everything. How did it happen? What are their mistakes so I can make sure it doesn’t happen to me? When Charlie Munger wrote “all I want to know is where I’m going to die so I’ll never go there”, the emphasis is on what not to do. Avoiding mistakes are more valuable since every dollar that’s not loss has a longer time to grow. If that’s the case, perhaps there’s something we can learn from life survival. How does disaster happen? Why do some lives while other die in a disaster?

In Deep Survival, Laurence Gonzales describes nature as the beast that’s unforgiving and unpredictable. When you step into the wild, whether that’s river kayaking, skiing at the snowy mountain, or trekking in the forest, you engage in a dynamic system that’s complex and uncertain. Far from saying bad things will happen to you, it just means accident can happen anytime without any reason. It doesn’t need to be nature activities either. Man-made technologies from a plane, car to the power grid are all subjected to the same forces. The reason complex system can be hard to predict is because there’s a disproportion between cause and effect. Also called the Butterfly Effect, a small change in the initial conditions can lead to large differences in later state. Imagine when you try to squeeze the ketchup out of the bottle. It won’t come out and suddenly splatter all over the plate. You never know what is going to happen next.

Short of calling it a beast, Benjamin Graham draws a similar metaphor characterizing the stock market as the manic depressive Mr. Market. Depending on his mood, Mr. Market will quote you a different price every day. You have the option to either take the offer or ignore him. To be clear, just as disaster doesn’t happen all the time, Mr. Market is not always a mania. In Ubiquity, Mark Buchanan discover while earthquakes, forest fires, and stock market are all unpredictable, they follow a unified scaling law. Smaller earthquakes happen more frequently than bigger ones; minor market fluctuations are more common than large swings. Most of the time, Mr. Market is just under the weather. Occasionally, he gets depressed; and under one of those rare occasions, he goes berserk, precipitating a 20% fall. This is where the danger lies. Given the rarity of mega catastrophe-grade market collapse, it’s easy to get seduced by the market under the promise of a quick profit. In Fooled by Randomness, Nassim Taleb describes reality as a revolver with a thousand chambers that delivers the fatal bullet infrequently, “after a few dozen tries, one forgets about the existence of a bullet, under a false sense of security.” The mesmerizing beauty of the wilderness, the tranquility of the ocean and the taste of a quick profit are powerful temptations that are hard to resist. The beast is always there. We just underestimate what he is capable of in the form of extreme climate, rip current and a sudden market collapse. This has to do with the way we perceive risk.

Risk homeostasis is a theory that explains every individual has an acceptable level of risk. If you perceive an event to be less risky, you’ll take more risk to maintain that balance. On the other hand, if something looks risky, you’ll be more careful. Take airbag. Drivers in airbag equipped cars drive more aggressively on the road, knowing the airbag is there if an accident happens. This risk-taking behavior compensate the effect of the airbag and at times, cause a higher fatality.¹ The same can be said for antilock brakes and seat belts. In investing, we follow the market 24/7 with the notion that it reduces the risk of losing money because more information and the ability to make a snap decision is invaluable. But what was supposed to protect us turn out to do the opposite as a result of overconfident and more trading.² There’s a tendency to ‘do something’ with all the information on hand. The irregularity of market disaster and recency bias further encourage you to push the envelope. Until you’re caught by surprise.

There is a fine line between staying prudent and doing silly things. What sits on that line separating both is emotion self-control. As Laurence Gonzales reflects on the cause of accidents, “how well you exercise that control often decides the outcome of survival situations.” I used to think to become a better investor, you’ve to leave all your emotions aside and stay as rational as possible. I was only half-right. Emotion is a double-edged sword, it can either save you or get you killed. Emotion such as fear has a negative connotation in investing. It is believed you should banish fear to avoid mistakes. But being fearless is dangerous. It is like becoming Rambo. If you act like Rambo in the wild or in the market, you’ll be the first to die. Great investors are not fearless. Instead, they manage their fear by turning it into focus. They consider all possibilities how an investment can go wrong and demand a huge margin of safety. They exercise a fine balance between having the conviction, being sure enough to take a position, and being fearful, having the humility to acknowledge the uncertainty and unpredictability of how things will turn out.

While emotion drives us to take precaution, the other side of it is just as true. You want to avoid impulsive behavior triggered by undue excitement or stress. Emotion such as fear of missing out (FOMO) or panic creates anxiety that causes you to tunnel. You zone everything out and focus on reaching your goal, whether that’s not to miss out buying a hot stock or selling to escape the pain of loss without considering the consequences. This is why checklist can be a powerful tool that forces reason to kick in and take control of your monkey brain before it does something stupid.

Self-control requires a delicate balance between emotion and reason. But how does the line of self-control get established in the first place? In other words, how do we make the judgment whether taking a certain action will give us the reward we’re after or kill us because it ends up being too risky? We don’t see reality. Reality is complex. Rather, we create a mental model of how the world is supposed to work based on our perception. When a climber tackles a new peak, he relies on his mental model, which consist of all the mountains he ever attempted to make the right judgment. In a similar way when you invest, your mental model create a representation of how an investment is likely to turn out based on what has worked so far. That’s why there is a risk when an amateur enters the market. His mental model has no inventory of how a disaster looks like since he never experienced one before. He’ll do things he considered safe when in fact borders on lunacy. He thinks he knows but he doesn’t know what he doesn’t know. This point to a subtle yet important lesson about experience.

Experience and practice are invaluable to improve the accuracy of our mental model on how reality works. Seasoned firefighters, pilots or sailors rely on their knowledge to navigate the environment and stay alive in a disaster. But experience is only relevant as long as the environment remains the same. The survival of the climber depends on how fast he can adapt when conditions around the mountain changes. Moreover, experience is domain specific. If you drop a seasoned sailor into a raging forest fire, how he acts matters more than his sailing experience. The moment you step into the unknown, your experience is as good as an amateur in the stock market. That’s why it pays to stay within your circle of competence and know your stuff. In other words, know the limits of your knowledge. Know when to discard your knowledge is as important as knowing when to use it.

In addition, understand the system. Whether that’s the mountain, industry dynamic, or the market, you want to understand how they work so you don’t get surprised. Not being surprised is critical. We panic when things go wrong. Stress creates a closed attitude. As Laurence Gonzales recalls an incident involving a disoriented hiker, “[he] smash his compass with a rock because he thought it was broken. He didn’t believe we were heading in the right direction.” We force reality to fit into our own beliefs instead of adjusting our mental model to match reality in a stressful situation. When your investment thesis no longer stands, failure to change your mind can lead to disastrous outcomes.

Having a plan and a backup plan reduce surprises. You don’t go into an investment only to decide whether to hold or sell after the unexpected happens. Always be prepared that anything can happen because they will. Have a premoterm. At the same time, be ready to abandon your plan when the environment changes. That is, have a beginner’s mind. Seeing things through the eyes of a beginner cultivate an open-mindedness instead of a closed attitude. It allows you to accept uncertainty as it is and avoid the illusion of knowledge. Rather than seeing things as black or white, you see different shades of grey and start thinking in degrees of belief. If you are 75% certain about a subject, you’ll still be wrong 25% of the time. Learning to ask “What if I am wrong?” changes your perspective from trying to be right to finding contradictory information that reduces your chance of being wrong. You become more interested in getting to the truth than upholding your own ego. Learning to be wrong also teaches humility. Aware that you know far less than you think you do. When in doubt, always bail out. You don’t have to make the call on every single investment. Know when to do nothing is as important as knowing when to act.

Gregory Milanowycz was stranded on the 93rd floor when United Airlines 175 hit the World Trade Centre’s South Tower at 9.03am, 11th September 2001. He was his way down the building but turn back after an announcement advised everyone to stay in the office. He grieved in the phone conversation with his dad before the tower collapse, “Why did I listen to them? I shouldn’t have.”³ Investing is like most survival situations, you have to make decisions under incomplete information. We tend to follow someone’s advice when we are unsure of what to do. Now, this is not to say rules and advices are bad. But following them can sometimes blindside one from seeing what’s in front of them. The core of every investing and survival situation comes down to this: Think for yourself. Thinking for yourself is not about ignoring what others tell you. That would be a closed attitude. It is about taking responsibility for your own actions. When you held yourself accountable for the consequences of your own actions, your mindset switch from a victim who relies on others to save him to a survivor who takes actions to ensure his own survival. You know doing all the right things doesn’t guarantee a good outcome, but luck favors the prepared mind. Having a prepared mind further means commune with the dead so you can stay humble, avoid impulse behavior, and learn to appreciate how little you know.

Notes

  1. Peterson S, Hoffer G, Millner E. Are drivers of air-bag-equipped cars more aggressive? A test of the offsetting behavior hypothesis. Journal of Law and Economics 1995;38:251–64.
  2. Brad M. Barber & Terrance Odean. (2000). Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors. The Journal of Finance. 55(2), 773-806.
  3. Jim Dwyer, Eric Lipton, Kevin Flynn, James Glanz & Ford Fessenden. 102 MINUTES: Last Words at the Trade Center; Fighting to Live as the Towers Die. New York Times. 26 May 2002. Retrieved from https://www.nytimes.com/2002/05/26/…enter-fighting-to-live-as-the-towers-die.html

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