Nine Rules to Fight Deception in the Investment Process
/Independent, critical thinking is an unnatural process, especially for investors. It’s easier to go with our gut instinct, instead of relying on the facts. It’s easier to go with our emotion than diligently follow the evidence. Above all, we gravitate towards stories and promises rather than logic and reason.
Carl Sagan was one of the great astronomers and scientists of the 20th century. He published more than 600 scientific papers, co-wrote Cosmos, the most widely watched T.V. series in American history, and wrote the novel Contact, which was made into a movie.1
Sagan was an fervent proponent for independent, skeptical thinking. He advocated applying the scientific method to our daily interactions. In his book, The Demon-Haunted World: Science as a Candle in the Dark, Sagan includes a chapter called “The Fine Art of Baloney Detection.”2 Sagan proposed 9 simple rules on how to apply the scientific method to better understand the world around us and protect against deception. It’s advice that fights against lazy thinking and raises our standard on what we choose to believe.
The investment world is complicated. It’s a world absent certainty and predictability – we struggle to understand the past and have little chance of predicting the future. No one has complete knowledge. Everyone makes mistakes. Everyone operates under the same fog of war. Because of that fog, sloppy, unorganized thinking goes unchecked. We’re overburdened with data, noise, news, explanations, forecasts, and predictions. It’s more important than ever to remain vigilant and protect against false claims.
Everyone wants a piece of your assets or fee dollars. Separating the competent from the incompetent means methodically deconstructing the validity of arguments, claims, and explanations. Sagan’s advice is essential in this process.
Below, I’ve listed in bold Sagan’s 9 principles mentioned in his book. I’ve then elaborated on how investors can adapt these lessons to the investing world.
1. “Wherever possible there must be independent confirmation of the ‘facts’.”
In the investment world, “facts” are vague and ambiguous. Investing isn’t like physics. Immutable laws don’t exist in investing. Distinguishing truth from conjecture is a messy process. Many facts began as weak opinions repeated enough times to appear as fact. The original context and meaning vanishes. Few people take the time to verify what nuances underlie the collection and verification of economic figures or if a performance figure reflects the many ways to measure and define performance. Material claims need independent confirmation. That takes effort, which not all investors want to expend.
Facts rarely stand alone. You need the confirm context and underlying assumptions to understand reality.
2. “Encourage substantive debate on the evidence by knowledgeable proponents of all points of view.”
Debating and arguing are not a natural nor enjoyable process for most people. Even those who enjoy arguing, do so because they enjoy the element of conflict, not due to their desire to learn or understand the truth. And for investors, truth is what we constantly seek.
Individuals struggle to accept evidence contrary to initial opinions and prior beliefs. Furthermore, organizations don’t train teams to debate well. So many discussions devolve into a mess of conflict and animosity. Productive debates require candor and a commitment to disagree well.
Substantive debate is a trainable skill, but one that is neglected. Leaders assume people will just figure it out, but it won’t happen without guidance. If it isn’t trained, the only things that ultimately get agreed upon is 1) these discussions are painful and a waste of time and 2) how can we end these as quickly as possible.
3. “Arguments from authority carry little weight — “authorities” have made mistakes in the past. They will do so again in the future. Perhaps a better way to say it is that in science there are no authorities; at most, there are experts.”
Appeals to authority are common in investing. Managers refer to their educational backgrounds, pedigree, and network to establish credibility for the statements they make. But these attributes are of secondary importance. The primary importance is to reason based on the evidence and principles of the argument. References to other factors can provide context, but should not replace, the validity of the argument itself.
Exercise caution anytime the focus is on general attributes rather than the specific details of the issue.
4. “Spin more than one hypothesis. If there’s something to be explained, think of all the different ways in which it could be explained. Then think of tests by which you might systematically disprove each of the alternatives. What survives, the hypothesis that resists disproof in this Darwinian selection among “multiple working hypotheses,” has a much better chance of being the right answer than if you had simply run with the first idea that caught your fancy.”
The path of least resistance is to go with the first plausible explanation rather than continue the search for the best explanation. We like to find a decent explanation and move on.
The investment media rely on one-liners and clichés to appear knowledgeable and convincing, but successful investors know reality is complicated and ambiguous. Convenient explanations are rarely right.
5. “Try not to get overly attached to a hypothesis just because it’s yours. It’s only a way station in the pursuit of knowledge. Ask yourself why you like the idea. Compare it fairly with the alternatives. See if you can find reasons for rejecting it. If you don’t, others will.”
We love our own opinions and ideas and so do investment organizations. Organizations attach more importance to ideas they create internally than those sourced externally.
The source of ideas should always be irrelevant. The evidence and logic behind an idea is what matters, not where it came from.
This dynamic is dangerous because it insulates the team from vital feedback. Organizations become dislodged from reality as tunnel vision focuses on a smaller and smaller set of homegrown, inferior ideas.
6. “Quantify. If whatever it is you’re explaining has some measure, some numerical quantity attached to it, you’ll be much better able to discriminate among competing hypotheses. What is vague and qualitative is open to many explanations. Of course there are truths to be sought in the many qualitative issues we are obliged to confront, but finding them is more challenging.”
Translate vague and imprecise language into quantifiable language. Vague statements are an indication of lazy thinking. Forcing people to quantify their statements reveals their knowledge and specifies support for their claims. Make people take a stand and say something meaningful.
7. “If there’s a chain of argument, every link in the chain must work (including the premise) — not just most of them.”
Many investment managers use long-winded narratives in place of succinct, specific language. I’ve sat through presentations where managers launch into a barrage of random facts and ideas, hoping that I’ll be overwhelmed enough to simply accept what they say. The key is to slow people down and take every claim one at a time. As soon as you let too many claims merge together, you’ll be in an impossible position to understand and refute what they say.
8. “Occam’s Razor. This convenient rule-of-thumb urges us when faced with two hypotheses that explain the data equally well to choose the simpler.”
Many consultants and managers overcomplicate the investment process to appear like they are adding substantial value or working hard. Most of this is a mirage. A lot of busy work and effort is merely for show. There’s always an urge to make the investment process appear more complicated and sophisticated than it really is. It’s a way to ensure job security. Much of the work you’ll see is either unnecessary, unrelated, or too ambiguous to be of value. Complexity and effort become virtue signaling.
9. “Always ask whether the hypothesis can be, at least in principle, falsified. Propositions that are untestable, unfalsifiable are not worth much. Consider the grand idea that our Universe and everything in it is just an elementary particle — an electron, say — in a much bigger Cosmos. But if we can never acquire information from outside our Universe, is not the idea incapable of disproof? You must be able to check assertions out. Inveterate skeptics must be given the chance to follow your reasoning, to duplicate your experiments and see if they get the same result.”
This principle is closely related to #6. Investment conversations should be focused on ideas that can be tested and falsified. It makes no sense to debate generalized propositions that are so vague they can’t be proven wrong. If a statement can’t be falsified, it has little value. The solution is the same as mentioned earlier – make people quantify and explicitly state their assumptions and claims. If you don’t, discussions will form an endless loop of unverifiable statements.
Sources
1. https://en.wikipedia.org/wiki/Carl_Sagan
2. Carl Sagan. The Demon-Haunted World: Science as a Candle in the Dark