The South Sea Apple that hit Newton. My issue with economists. Crowd Behavior in bull and bear markets. What the markets taught me
Isaac Newton(yes, the Mechanics and the Calculus guy) invested and made a tidy profit of around £7000 by trading shares of “The South Sea Company”. It was the hot stock of those days. He exited the market sensing that market was getting overheated. But the rally was just getting started. Enthusiasm ran wild among the public and Newton couldn’t hold missing out on the rally. He jumped back into the market at a higher price and with a higher amount and lost £20000. This is equivalent to greater than 3 million USD in today’s time. For the rest of his life, no one was allowed to speak the words ‘South Sea’ in his presence. He famously muttered that he “could calculate the motions of the heavenly bodies, but not the madness of the people”.
Human beings are great at fitting explanations for events that are many times random. Just read the financial newspapers as a case study. Any 2% decrease in the price of any security or commodity is given a bullshit reason that is just retrospective fitting of explanations. I have seen online news headlines change quickly within a day when a certain commodity went from having a bear day to a bull day. Journalists are often forced to invent reasons that are not even there just to make up for a good story and get some clicks.
The Paranoia of Bull Markets
Isaac Newton would arguably be one of the most intelligent humans who ever lived. When I used to practice Calculus and Mechanics, I often admired Newton for the fact that he managed to come up with stuff that was difficult for me to just understand alone to practice some lousy questions. He was certainly magnitudes smarter than me and I wouldn’t be able to come up with the discoveries he made in multiple lifetimes although I love Mathematics.
The paranoia of the bull markets fooled Newton. And if it fooled someone as smart as him then it can certainly fool me. The Apple of the South Sea hit Newton’s head and this time it hurt him. It is very hard not to be bothered by the allure of a rising bull market and Newton found himself dragged into the pit at the acceleration of 9.8 m/S2.
I think that learning about cognitive biases and heuristics is much more useful than learning balance sheets and business analysis while investing in the market. I am fairly convinced that most of the advantages successful investors have are temperamental rather than analytical (If you go fundamentally long, not for quantitative trading. Also not accounting for informational/ insider trading). It’s so hard to keep a level head when matters regarding money are involved. It’s extremely easy to get fooled and I always try to remember that the easiest person to fool is myself.
The smartest people often lose the most money in the market. Not because they are not skillful enough or because they are shit out of luck. But because at the end of the day, they are dealing with irrational people. And they are too nerdy for their need of data that they take data at face value. Not everything can be represented in numbers or Excel sheets and there is a lot of uncertainty in the world that cannot be accounted for or formulated. They aim for certainty in an uncertain world. Uncertainty is loathed in many academic circles such that they try to minimize it but on the contrary, I believe it is something to be cherished and accepted.
Obsession with numbers
One of my favourite authors, Nassim Taleb makes fun of economists and advices that most of it is bullshit. And I agree with him. The whole discipline is laden with hindsight bias. It is extremely complex for quantitative representation as the majority of economic activity is a function of innate desires of human beings who are emotionally driven rather than rationally and that is extremely hard to map on a paper. My major complaint about economics (among others) as a discipline is that it assumes humans are perfectly rational. I cannot prove it through a complicated research paper but the only thing humans are not is ”perfectly rational”. We are sometimes rational, only sometimes. On the contrary, we are emotional creatures and some of us try hard to be rational. Also, what might seem rational to someone will seem irrational to someone else. There is a lot of grey area and subjectiveness regarding this which can be discussed in a similar way Philosophers argue with each other regarding 10,000-year-old questions. The useless intellectual ejaculations among self-proclaimed “thinkers” in Philosophy can go on for millenniums without reaching a satisfactory conclusion (Philosophy is good to make you learn “how to think” and be a fearless thinker in my opinion).
Humans often don’t have complete information as economists suggest. Neither are they any good at analyzing large chunks of information effectively. If you give a piece of information and distribute it among different people like hotcakes, there are going to be some completely contrasting views about it depending upon incentives and understanding of the persons involved. If you make all of them interact with one another, they may slowly come up to a similar conclusion (We often ape the conclusions of the larger populace because we feel comfortable in social proof and confirmation bias. We feel okay to be a sucker if everyone else is one too).
But the idea is that there is a lot of “physics envy” among social scientists and practitioners of social disciplines. Subjects such as Economics, History, etc. should be taken with a pinch of salt. You can learn a lot from History but only that much, some models arising from history are bound to fail as it is not as robust to variation as phenomena in physics such as Optics or Gravity. Physics and Math have extremely low variance(mostly zero) in their results. You can also do controlled experiments in scientific subjects to test your hypothesis and the results can be reproduced in any given condition. But not in unscientific disciplines such as Finance, Economics, or anything that involves future predictions. You can’t do controlled experiments in economics and finance without regularly blowing up banks and causing recessions. So, I always look at experts in such fields with skepticism. They are too complex for anyone to master and make accurate predictions regularly.
‘Efficient market hypothesis’ and ‘Modern Portfolio Theory’ which are generally accepted and taught are in my opinion complete bollocks. I won’t even try to explain as I can write a full treatise on it. Many economists are no doubt great analytically and logically but they are always bringing a knife into a gunfight. If they take their theories into real-world practice, they will be slaughtered like RCB gets every IPL season. Almost all of their predictions fail. Nevertheless, I have never seen a rich economist (do inform me if you know one).
Falling in Love
If you want to fall in love and get extremely biased with an investment, just start buying it. Automatically, all the negative qualities that you would have previously considered will evaporate as quickly as Nirav Modi fled India after getting caught. Your brain would like to be consistent with your actions so the narrative can be easily changed in your head. And a word of advice, don’t publicly endorse your investments. There would be immense pressure to prove yourself right and your fragile ego might not be able to accept being wrong. And if you see some anger building up within you when someone criticizes your investment, then I suggest you take some time to reflect, not on your investment thesis but on yourself. For some case studies, just criticize Tesla or Bitcoin in public and see the wrath that flows on your handles (Not against them but the lengths investors would go to defend them is a great place to learn about biases). The more irrational the view, the more violent, biased, and loud its defendants will be. True for cults, True for religions, True for ideologies, and certainly True for a whole lot of investors. If anyone is humble enough to introspect and accept, please avoid this behavior. You might spare yourself a ton of misery.
Here is a note about markets I have usually observed with a couple of bull and bear runs. These are general observations regarding crowd behavior. Don’t take them at face value. They are just general observations.
In Peak of Bull Markets
- Mediocre companies are trading at high valuations. They are now considered quality and earnings are extrapolated for many years into the future. Investors often find reasons for expensive valuations for their stocks.
- The stock of every company you see begins to rise. A mediocre growth in QoQ results is rewarded with a great uptick in stock price.
- The majority of the people around are suddenly interested in stocks. Many new investors enter the stock market. Most of them start making money and a lot of it.
- The higher the market rises, the higher the confidence among people that it will rise in the future. Recency bias is at play. Fear of Missing Out is extremely high and even cautious investors aren’t immune to taking some crappy positions.
- Value stocks are hard to find and value investors run out of patience. They buy into growth stories. Many experienced investors also find reasons why certain cheap companies will remain there. It is easy for someone to change their investment strategy it took years to form.
- All economic data supports the major rise in the stock market. Not true in the case of a pandemic but one can see many theories regarding recovery, vaccines, etc.
- Everyone you meet on the street turns out to be a self-proclaimed investment genius as he made good money in a bull market.
- Your eyes often hurt upon seeing countless advertisements regarding investments and funds.
- The stock you wanted to be cheaper gets more expensive and you buy at a much higher price(Which happens to me so often)
- It is often easy to confuse a great company with a great investment. This confusion is at its peak when idiots are making money
In the Peak of Bear Markets
- Many people are saying “that this time it is different”. It is easy to get caught in their narrative.
- Seasoned investors often don’t buy stocks at cheap multiples because many of them expect them to fall more.
- Companies that fake their balance sheets, and accounts or commit fraud often get pounded and retail investors lose money. Bear markets are great in a way that they clean up misbehaving management for good.
- Like sunshine on planet Earth, there is a bull market at one section of the market due to some specific reason.
- Many investors lose hope or exit the market. Others run out of cash and just hold their positions.
- A large portion of the market does expect a recovery someday as they all have read or seen the history of the markets on Google Images. However, they are afraid to take positions and are not confident.
- Companies that show growth are often immune to the pounding that takes place. And if they get beaten down, they are the first ones to recover. Liquidity often chases growth and not value.
- Financial companies do suffer more and become cautious about lending. Banks and NBFCs are often one of the most affected sectors during an economic downturn or financial crisis. Other asset-heavy sectors like Automobiles also get pounded.
- Stocks of companies posting great results does not increase. Investors begin to wonder about the reasons for that.
The teacher
These are general observations and many of them may be wrong. I am happy to be proven wrong regularly. But with every overheated bull market, it is painful to see many newbies lose their hard-earned money when the downturn comes. Hearing stories of people losing money in the dot-com boom is a great reminder that there is no place for being irrational, biased, or having an ego in markets. But markets are really brutal and not being careful can bring you really expensive lessons.
One can be wrong yet make a ton of money in a stock and worse, can attribute it to skill. It is paradoxical yet seems as true as possible.
I admire Michael Burry as an investor. He is the guy who predicted the housing bubble. He tweeted a while back along the lines that markets do not care about you, reflect you, contemplate you, and think like you. I agree with that. It’s always nice to be skeptical and humble when invested. The stock doesn’t know and neither cares that you own it. And Luck does play an extremely important role.
Most of my investments have zoomed like crazy in this bull run. But even though I have made some good money, I know that this crazy liquidity-fueled circus will come to a halt someday soon abruptly.
One of the things being in the market teaches you is that it is extremely easy to lose focus. It is true for life in general also. Investors often focus more on the price than the business itself. I try to be the exact opposite( sometimes fail at it too).
Markets often remind me to regularly change my views and reaffirm to me that there can be more than one correct way to view certain things. It is equally true in life as well. It has taught me to be an independent thinker yet listen to the opinions of people you admire. Two extremely knowledgeable and smart people can have completely contrasting views and sometimes, they both can be right. It has helped me learn a lot about myself and my emotions and biases which play within my misfiring brain. Whatever might happen, I always remind myself that I am not smart enough to know everything and I don’t need to. I often think of myself as an idiot who tries hard not to be a sucker. Charlie Munger often says along the lines of “ It is much better for you to try avoiding stupidity than try to chase genius” and that is most of my philosophy in investing.