Investing and “The Name of the Rose”
I recently had the pleasure of being a guest on Patrick O’Shaughnessy’s podcast, “Invest like the Best.” Among many other topics, we discussed my personal belief that being in the highly subjective, impossible to accurately define and arbitrary “top 1%” of knowledge on a stock is an important part of how I invest. However, I did not explain why this heuristic is important to me, so I wrote a Twitter thread explaining my logic. There were a lot of interesting responses to the thread, so I thought I would elaborate here. Simply said, I believe that being rational when wrong is essential to success in public equities — and for me — believing I have a high knowledge level on a stock helps me be more rational when wrong.
The ability to be rational when wrong is important because I believe that in any career other than public equity investing, success can generally be predicted within a band of expected outcomes by multiplying intellect by work ethic by charisma with luck being the most important modifier to the equation. However, this equation breaks down in public equity investing. There are many brilliant, hardworking, charismatic people who fail as public equity investors. In some ways, public equity investing seems harder for those with the most glittering resumes. There is a missing factor in this equation for public equities and I have come to believe that it is the ability to be rational when wrong.
All our lives, we are told that being wrong is shameful. Being wrong on a test is a failure as a student. As a result of this conditioning, it is hard for many people to admit when they are wrong and even harder to make good, rational decisions when wrong. And there are so many ways to be wrong in public equities. Beyond mistakes of commission (losing money), there are mistakes of omission (the stocks one did not buy after careful consideration that went up dramatically). Investors in public equity markets are uniquely able to almost always see the road not taken; to see exactly what would have happened if they had made a different choice. This magnifies and multiplies incorrect decisions in a way that is unusual relative to most other decision making arenas where seeing the road not taken is impossible.
Mistakes of omission are inevitably more numerous and painful than the mistakes of commission. The resulting volume of mistakes may be one reason that those with the most impressive academic resumes often struggle as public equity investors — they simply aren’t used to being wrong in a way that is difficult to deny. i.e. Either losing money or choosing not to buy/selling a stock after careful consideration that then goes on to outperform everything else in one’s portfolio. I should note that all of this goes for all publicly traded securities — credit, fx, etc. — I just focus on equities as that is where I have spent my career.
An inability to be rational when wrong is therefore particularly painful in public equity investing given most are wrong a lot and can take action when wrong. So I think investing success in public equities largely depends on finding a philosophy/system that helps one be rational when wrong. As I noted in my first thread on this, Ned Davis perhaps said it best when he drew a distinction between “Being right or making money.” Wanting to be right is the most expensive habit an investor can have.
This is why I don’t think debates about investing philosophy are productive. There are many ways to succeed and success is highly measurable. Outcomes matter most in investing. The investors with the best numbers are the best investors — not the ones with the best philosophy or the best process. As a good friend of mine says, “there are only two things in investing: Numbers and excuses. If you don’t have the first, no one cares about the second.”
Every investor has to find a philosophy that works for their own intellectual and emotional makeup; a philosophy that helps them be rational when wrong and thereby outperform. For me, believing that I have factual and analytical mastery — a knowledge level that is in the (self-defined) top 1% of all investors on a given stock — helps me be more rational when I am wrong. Not a philosophy per se, but a necessary condition for me. When I am wrong and don’t believe I have a high knowledge level, I rarely make good investment decisions. This is a big part of why I have historically destroyed alpha in energy, industrials and financials — I have a low knowledge level in these sectors, I am wrong a lot and I make terrible decisions when wrong given the low knowledge level. As a result of this low knowledge level in these sectors, I generally focus on the consumer and technology sectors where my knowledge level is higher.
Low decision quality when my knowledge level is low is often due to the fear that if I was wrong because of something I could have known but did not know, what else do I not know about the stock? What other knowable facts or analytical prisms are there? A particularly terrifying and upsetting thought. Regardless, I don’t make good decisions when I am wrong and my knowledge level is low. This is why I’ve never had a large position in Chinese internet stocks despite believing they are some of the world’s most impressive and innovative companies — there is no way I could be in the “top 1%” of knowledge level despite having studied the companies closely and having gone to China annually for almost 20 years.
I also want to reiterate that “top 1%” is obviously subjective. There is no way to “know” that one is in the “top 1%” of knowledge level on a given stock. For me, the test is internal — can I look myself in the mirror and believe that I have done enough work and that my knowledge level is high enough to make good decisions when wrong. 1% is simply an internal heuristic. Maybe my internal barometer is off and I have never been in the top 1% of knowledge on any stock.
However, for me, it generally takes many years to feel like my knowledge level on a stock is high — I cannot do six to twelve months of intense research and believe that my knowledge level is differentiated. Context and experience matter for the way that I invest and I have not found any shortcuts. I would also note that being mis-calibrated on your own knowledge level — believing that you have a high knowledge level when it’s actually relatively low — is quite dangerous.
It was interesting to me that on Twitter many were curious how I defined being wrong. For me, if I have lost a significant amount of money on a position, either relative or absolute, over an 12–18 month period of time, I was wrong. Even if I eventually make money, I could have had a lower cost base. As a former colleague once said, “sometimes being too early is the same as being wrong.” Similarly, if a stock I carefully thought about buying but did not buy has outperformed dramatically over a similar time period, I was wrong. Outcomes matter most in investing.
Good, rational decision making when wrong does not equate to doubling down or holding through the volatility which many on Twitter seemed to believe was the case. Sometimes that is the right decision. Other times selling and moving on is the right decision. After a mistake of omission, sometimes it is the right decision to buy a stock that is up 10x from where the investment was first analyzed. Other times it’s not. What matters is having enough knowledge to understand what the three to five most critical variables are, how they are changing and have conviction in this view. Simple is always beautiful. If someone cannot explain something simply, odds are high they do not really understand it.
@LibertyRPF suggested on Twitter — in response to my first Twitter thread on this topic — that “being able to change your mind or admit you’re wrong is a skill. Like a muscle, it has to be trained. Making public remarks increases the frequency at which we can train. It might seem easier all alone in the dark, but we train less. Most people by default see admitting they were wrong as a defeat. I think we should internalize that the goal is to be correct, and that any time we change our mind to something more correct it is a victory, not a loss. I want people to change my mind on things and seek that out.”
Said another way, intellectual humility and its attendant open mindedness to one’s own mistakes is powerful in investing, which is at some level a competition about who can have the most accurate understanding of the present and likely future state of the world. I recognize that believing that I am in the “top 1%” of knowledge is at odds with intellectual humility even considering that it generally takes me many years of work to believe this.
The unfortunate reality is that I make almost as many mistakes on positions where I believe — rightly or wrongly — that I am in the top 1% as those where my knowledge level is lower. But I do think that I make better decisions post initial mistake if I believe that I’m in the top 1% of knowledge level. And at some level, investing is all about finding the right balance between the arrogance to believe you have a correct variant perception vs. the entire market and the humility to admit when you are wrong. Conviction vs. flexibility.
Umberto Eco is one of my favorite writers & “The Name of the Rose” is my favorite of his books. In many ways it is a meditation on the importance of intellectual humility and dangers of intellectual or moral arrogance. “What do you fear most in purity? Haste.” One of my all time favorite quotes.
William of Baskerville, the hero, is described as “moved as he was solely by the desire for truth, and by the suspicion — which I could see he always harbored — that the truth was not what was appearing to him at any given moment.” William later says “The Devil is the arrogance of the spirit, faith without smile, truth that is never seized by doubt.” And yet William constantly struggles with his own intellectual vanity and ego. Adso’s last words about William were “I pray always that God received his soul and forgave him the many acts of pride that his intellectual vanity had made him commit.” Arrogance vs. humility. Conviction vs. flexibility.
The ability to be rational when wrong is less relevant in private equity and venture capital where it is harder to take action when wrong and marks (being “wrong”) are infrequent. This may actually be a contributing factor to the “illiquidity valuation premium” although the central contributor is that modern finance defines risk solely as volatility. Hence illiquid assets are “less risky” and therefore merit a lower return premium on the efficient frontier, resulting in higher valuations for less liquid assets. This is, of course, at odds with another tenet of modern financial theory, that liquidity is valuable. But that is perhaps a topic for another Medium post.