Stuff we think we know: transcending wrongthink

In the middle ages, theologians debated how many angels can dance on the tip of a needle. Let's not be smug: today we debate whether men can get pregnant.

In his 1921 volume, "Risk, Uncertainty and Profit," widely considered as one of the top five most important books on economics, Frank Knight suggested that, "If we are to understand the workings of the economic systems we must examine the meaning and significance of uncertainty; and to this end some inquiry into the nature and function of knowledge itself is necessary." This is a far greater challenge than what's commonly recognized. The path from acquiring knowledge to achieving clarity about the way our world works does not progress along a straight line. Advanced university degrees don't confer wisdom nor guarantee that their holders will be smart. Many are in fact, what Nassim Taleb calls, intellectuals yet idiots. 

The question of how we know stuff is central to just about every aspect of life including managing our investment portfolios. As I'd suggested many times in the past, the key ingredients to long-term success in investment management should be (1) truth, (2) strategy, (3) discipline, and (4) patience in that order.

Truth is perhaps the only ingredient that’s controversial. How do we know what's true? Much of the information we analyze is biased, distorted or outright false. Some of the distortions are deliberate, and discerning what's true from what's false can be difficult, especially when falsehoods are disseminated by supposedly reputable sources. Our understanding will also depend on hypotheses and theories that form our worldview. But theories that may seem compelling at first, with time often prove flawed. The trouble is, once we adopt some theory, we’re liable to form an attachment to it and as a result we're susceptible to misinterpreting information, leading us to mistaken conclusions. 

Education is not a reliable cure for this. If anything, individuals with advanced degrees tend to form passionate attachments to their worldview and often simply reject any ideas that clash with their convictions. As Thomas Jefferson wrote, "State a moral case to a ploughman and a professor. The former will decide it as well, and often better than the latter, because he has not been led astray by artificial rules."

In modern societies, we have rightly embraced rational thought as the best means to formulate valid theories about the world. We may chuckle that medieval theologians indulged in earnest debates about how many angels could dance on the tip of a needle, but we should not feel too smug. Rational thought can lead us to truth, but it can equally lead us astray and it is extremely important that we recognize this and guard against it.

Here's just last week's example: a new poll by WPA Intelligence found that among U.S. democrats, 22% believe that the statement, "Some men can get pregnant" was TRUE. Among white, college-educated female democrats, 36% deemed that the statement was true. That's more than one in three!! Incidentally, 'only' 29% of female democrats (with or without college education) think men can get pregnant, so it seems that college education makes things much worse as Thomas Jefferson had suggested. 

Of course, many people might chuckle at this too, believing themselves to be immune to such folly, but again, let’s not be smug. Instead, we should apply rigour and discernment to our thinking, question everything we think we know, loosen up all attachments to ideas and theories that might be flawed and be willing to throw them overboard if they prove false. As Stopford Brooke said, "If a thousand old beliefs were ruined in our march to truth we must still march on."

The consistent failure rate among experts

The ability to understand how the world works is clearly an essential prerequisite in the domain of investment management. This universe in fact offers a unique perspective about the magnitude of that challenge, and the ability of experts to master it, since success and failure can be readily and objectively measured. By now we have many decades' worth of empirical data about the performance of active investment managers who are among the best educated, most experienced and highest paid professionals in the world, commanding vast information resources and analytical talent. They are also highly incentivized to outperform their market benchmarks through security selection and market timing.

But as a group, these experts have a very robust tendency to fail at the one challenge they're pursuing.  The data consistently paints a picture that could be summed up as follows: in any given year about two thirds of all active managers underperform their benchmark. Among the managers who do outperform in any given year, most fail to repeat that success from one year to the next. Measured over longer intervals (5-10 years), more than 90% underperform. 

Trend following transcends wrongthink

To transcend this problem and avoid all the pitfalls of wrongthink, I-System Trend Following is entirely based on the one source of market information that is unquestionably true, objective, and available in real time: the price of securities itself. The only hypothesis we rely on is the idea that markets move in trends. From there it is a matter of formulating effective, reliable strategies of capturing value from trends and adhering to such strategies with iron discipline and a great deal of patience. This approach is what has enabled many of our peers to generate impressive performance track records that span not a few years or a business cycle but literally decades. With that challenge mastered, we are immune to misinformation, false assumptions and flawed theories and can navigate markets profitably with confidence and peace of mind. Some systematic trend followers have consistently outperformed market benchmarks since the 1980s and even 1970s.

Going for clear thinking

The cure for wrongthink isn’t education alone; perhaps it is a pound of education + ten pounds of common sense, or clear thinking. Over the years I’ve observed that highly educated folks feel that they should have an instant ‘rational’ explanation for everything and anything. Ask them why climate change will result in more hurricanes and they’ll conjure up an answer on the fly. Ask why lower interest rates lead to more economic growth, and they’ll have that answer too. The less sure they are about what they’re saying, the more big words they’ll tend to use so their theorizing might have a better chance at impressing you. But feigning knowledge is not the same as true knowledge.

The first step toward clear thinking should not be to shoot off explanations for anything off the hip, but to begin by asking the right questions and then patiently building up our understanding, allowing it to converge upon the right answers in due course. And with regards to “experts,” Lord Acton warned us long ago: “Guard against the prestige of great names; see that your judgments are your own; and do not shrink from disagreement; no trusting without testing.”