Tuesday, June 28, 2016

The Power of "Because"

Superior investment results are usually attributed to some combination of better information, better analysis, and better emotion management. The first of these, information, is central to any investing endeavour. Analysis is the synthesis of information; information is its foundation. Similarly, no amount of emotion management can overcome deficiencies in the original analysis. It's no wonder, then, that investors go to great extremes (occasionally crossing ethical lines) to obtain information that can provide them with a competitive advantage. In this age of continuous, real-time data, many investors satisfy their information cravings with a steady diet of business news on TV and the Internet. But this unceasing flow of news rarely provides the advantage that some investors think it does. If anything, it's probably harmful to the investment process.

T.S. Eliot had something to say on this subject, famously writing, "Where is the wisdom we have lost in knowledge? Where is the knowledge we have lost in information?" We are confronted today with a surfeit of information, but significantly less knowledge and wisdom. The financial press is always quick to construct facile narratives for market movements. "The market fell today on fears of a hard landing in China," we hear, or, "The market rallied today in anticipation of a more dovish Fed." It's much harder to admit that markets are both random and complex. 

Chalk it up to the power of "because." Harvard social psychologist Ellen Langer demonstrated this in a series of experiments asking a small favor of people waiting in line for a library copying machine. The first request was, "Excuse me, I have five pages. May I use the Xerox machine because I'm in a rush?" An impressive 94% of those in line allowed her to skip ahead. This fell to just 64% when participants were confronted with the request, "Excuse me, I have five pages. May I use the Xerox machine?" But the real kicker was the final experiment, where participants were asked, "Excuse me, I have five pages. May I use the Xerox machine because I have to make some copies?" Amazingly, 93% of those asked agreed, even though the request contained no new information. Some justification, no matter how flimsy, was enough to secure compliance. 

In the world of investing, we see this when investors get locked into a prevailing narrative. In his book "Common Stocks and Common Sense," value investor Edgar Wachenheim recounts a winning investment in Southwest Airlines. Other investors failed to realize that a tightening in airline capacity would lead to higher pricing for airline seats. But Wachenheim is most critical of sell-side analysts, who had become so focused on short-term developments that they ended up missing the bigger picture. The so-called experts, he writes, "had become reporters of recent news, not analysts."

I prefer to leave the reporting to reporters. Intelligent contrarianism, which Philip Fisher described as "correctly zigging when the financial community is zagging", is at the heart of fundamental investing. But this is hard to do when we confuse the news with information or knowledge. We all need to stop and think a little bit harder, especially when the news offers that most seductive of words: "Because."


  1. Well said. But you must also consider / appreciate human psyche.

    Unless a sell side analyst calls clients every few days, and is on a top of mind recall, sometimes even with trivial news, she will not get client votes (read business).

    The business is skewed in favor of the sell side analyst's firm (brand image) and the frequency of her calls, that ensure to keep her on the top of mind recall of clients.

    Instead of blaming them, why doesn't Buy side actually differentiates QUALITY from MARKETING?

    1. Very true. Plenty of blame to go round. For example, clients who want high investment returns with low volatility often skew their managers' incentives.