Know Why
First Principles Reasoning Series
Fellow Partners,
As we’ve noted before, history can’t tell you what to do, and, whatever you do, don't compete with robots.
The pitch
A few years ago a firm pitched me an investment as follows:
Look at the chart below. What do you notice? No sector has consistently been the best performer year after year. Our investment product takes this into account and buys all sectors in equal amounts because we don’t know what will perform best over the next few years. Our research has shown that this strategy outperforms the market.
Pitch guy
Interesting thought. And a common philosophy: we don’t know what the market will do, so let’s assume we can’t know much and invest accordingly.
Different philosophies
I raised some initial questions as I evaluated the strategy:
Why did this strategy outperform the market? Do we know? Can we know?
Are there good reasons for outperformance of this strategy to continue?
Would it have made sense to invest this way without the aid of hindsight?
As we talked it over, his answers to my questions came back to the same themes:
We don’t know the future
Historical data tells us this strategy outperforms the market
The strategy works because the data tells us it works
On his first point: we indeed do not know the future. Anyone who does need only be right twice, and with the right financial instruments they’ll become very wealthy and likely stay off the radar. Therefore, we either (a) don’t have perfect prognosticators or (b) they’re hiding from us. Either way, we can’t benefit.
On his second two points: the logic is viciously circuitous. Does the strategy work? It worked in the past. How would we have known in the past that it would work in the future? It worked in the past.
To me this was an obvious non sequitur. To him this was simple logic.
The strong differences in our philosophies stuck with me. Even if we disagreed, why couldn’t we understand the others’ perspectives?
I eventually concluded that we were approaching the question of “how should we invest?” from polar-opposite angles. To him, we couldn’t know anything, so we shouldn’t even try (not even to know why a strategy worked). Rather, we must assume that the future will behave similarly to the past (a big assumption), mine data about the past to tell us what worked then, and invest accordingly for the future.
Durability
My approach was the opposite: one must know why something worked and why we should have conviction that it will continue to work in order to follow it. This requires understanding markets and businesses as complex adaptive systems and understanding that some things never change, and others do. It requires application of practical wisdom to discern timeless principles from time-sensitive context, and systems thinking and first principles reasoning to understand how a business may behave in the midst of a changing and uncertain future.
This is likely a more difficult path, but also a more durable one. The challenge with seeking patterns and assuming they never change is that they do. As I’ve said before perhaps the biggest dogma of the past 5-10 years has been simply buying the market (e.g., an S&P 500 index fund) and leaving it alone. This has absolutely been one of the best performing strategies of the past decade, and a great option for people who would otherwise treat capital markets like casinos. But some forget that the strategy returned exactly 0% in the prior decade. Or that the significant majority of stocks within the index have actually performed poorly, but a few monster performers have more than compensated for the poor performance of the majority.
Closing thoughts
Will this continue? We don’t know — but we do know that if there is enough outperformance in a repeatable strategy, then over time it will be competed away. I prefer the company of uncertainty and first principles reasoning. The road may be less certain, but we will know why we are acting, and have the opportunity to build durable strategies in the midst of a changing and uncertain future.
All the best,
John
Founder and Managing Partner
Notes and references
[1] https://novelinvestor.com/sector-performance/
[2] https://awealthofcommonsense.com/2014/07/equal-weighted-sector-sp-500/