Lessons on Investing From Unlikely Places
It used to be believed that all one required to make money in the financial markets was a good head for figures.
But as the ever-changing markets frustrate a new generation of investors, it is clear that other subjects are needed as well: history, biology and psychology, for example.
Michael J. Mauboussin has been commenting from a broad academic perspective at Credit Suisse First Boston and now Legg Mason Investment Management. His inspiration comes from Edward O. Wilson, the Harvard University biologist who argued, in his book “Consilience: The Unity of Knowledge,” that the study of arts and sciences could fruitfully be integrated. “More Than You Know” brings together many of the essays and research notes that Mauboussin has written in an attempt to follow Wilson’s example.
As a result, the book has the strengths and weaknesses of any such compendium.
Mauboussin draws on a breathtaking variety of examples, from the feeding patterns of ants through the betting strategies of the late poker expert Puggy Pearson to the golf swing of Tiger Woods. Few readers could come away from this book without being stimulated and intrigued. But occasionally the essays are too short; one wants Mauboussin to probe the subjects further and to bring out the practical lessons for investors more clearly.
Finance has gone through waves of academic fashion over the last 40 years. The first wave saw academics decide that markets were efficient, and that the attempt to outperform other investors by detailed analysis of the fundamentals was doomed to failure. This view was dismissed by much of the investment community but seemed to be borne out by the data.
But standard economic models depended on consumers and investors to be rational, pursuing the optimal strategies to maximize their wealth and happiness. The second wave of academic theory -- known as behavioral economics or finance -- showed that people were in fact prone to psychological biases that could distort their judgments.
Mauboussin’s book draws on much of this work -- showing, for example, how investors seem to have become more active in turning over their portfolios in recent decades, even though managers with the lowest turnovers seem to have the best records.
The existence of these motivations, such as loss aversion, offers the possibility that more sober investors might be able to exploit these biases. The markets might not be efficient after all.
Mauboussin also draws on the new field of biological economics, which studies both the actions of other animals and the inner workings of the brain. We are starting to understand that some decisions may be driven by particular parts of the brain or certain hormones, such as testosterone. This may be the field that offers the most interesting advances in coming years.
Alas, there is little hope for those looking for get-rich-quick ideas. At best, readers may gain an insight into their own flaws and biases, and thus work out ways of avoiding them. The problem is that markets are complex adaptive systems, in which the actions and beliefs of participants affect events.
As Mauboussin writes, “the aggregate behavior is more complicated than would be predicted by totaling the parts,” and “efforts to assert top-down control of these systems generally lead to failure.”
As a result, any insights into the working of the system that has become widespread will change the system. If it becomes easy to spot the best-performing fund managers and avoid the worst, all the money would be given to the best and the worst would go out of business. Because the overall market return would be unchanged, some of the best fund managers would now inevitably underperform.
As Mauboussin points out, there is much to be gained from the free-market system that allows the economy to benefit from the decision making of a diverse group of individuals.
Studies show that such decision-making processes produce results that are better than any individual guess.
But there is one important caveat. Collective thinking works best when individuals are unaware of others’ views. When they do become aware, herd-like behavior can set in and the group can veer away from the correct decision. That kind of process creates tulip mania or the dot-com bubble.
It is too much to hope that we can reform the system, or individuals’ thinking, so that future bubbles can be avoided. But it is just possible that those who think more broadly can avoid being sucked in with the rest.
Reading Mauboussin’s book would be a good first step along that long road.
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Philip Coggan is investment editor of the Financial Times, where this review first appeared.
