A (non)obvious framework for investing

A framework for quantifying investing ability

In this post, I will discuss a few biases of investors and present a framework for quantifying investing ability.

Facebook is obvious. Uber is obvious. Netflix is obvious. They were not obvious ideas when they were getting started. Hindsight is 20/20.

We live in a world where the time to reach a state of retrospective obviousness is radically compressing. Take smartphones as an example.

When the iPhone launched in 2007, Microsoft dismissed the idea that consumers would prefer to have email, MP3, games and other features bundled into one device. Today, close to 40% of the world’s population uses a smartphone. In North America and Europe smartphone penetration has reached about 75% (source).

Many investors have been right (or lucky) with one bet. Few have been able to replicate their success over time. Most investors — and people in general — think they are smarter than the average and overestimate their abilities (see Illusory Superiority effect).

I doubt anyone can reasonably and consistently predict winners from losers. The difference between a successful and mediocre investor lies in their ability to recognize mistakes.

The best investors tend to delay jumping to conclusions for as long as possible, and instead are continuously processing new information to test their theories. The common denominator among accomplished investors is an ability to think in terms of dynamic probabilities as opposed to in binary outcomes. In other words, they are never certain of their decisions and are determined to process new information in order to continuously adjust their models.

Investing Ability Framework (I = L/T)

In essence, the best investors share one common trait: they listen more than they talk. A simple framework for assessing someone’s ability to invest (I) can be expressed as follows:

I = L/T, where:

L = time spent listening

T = time spent talking

My theory is that talented investors have a “I score” at least greater than 1 — but not too high. When I is less than 1, the investor is doing most of the talking and precluding him/herself from learning new information. When I is very high, the investor is not doing enough talking and likely not asking enough questions — simply listening but not processing information. All said, a successful investor must have a sufficiently high ratio of listening-to-talking. Next time you’re in a conversation, take note of this and measure your “I score.”

The game of investing is less about predicting the future, and more about recognizing mistakes early on. Listening and not dismissing conflicting information is half the battle. In order to stand a reasonable chance to win in this game, I believe it requires the ability of taking comfort in possibly being wrong — very wrong — and having both the mental fortitude to think probabilistically as opposed to in binary terms, as well as having the mental flexibility to adapt to changing conditions. This combination creates antifragility — a property of systems that gain strength as a result of mistakes.

The Most Successful Trades Are Not That Obvious

Google is one of the most successful companies in recent history. So much that the name has become a ubiquitous verb for searching. Google’s path to success has not been linear or straightforward as is perhaps commonly thought. Let’s turn to stock charts to visualize the success of Google ($GOOGL) over time.

Source: Google Finance (as of 03/08/19)

IPO price = $85

Current price (as of 3/8/19) = $1,150

Return = 14x (not adjusting for stock splits)

Looking at the all-time chart, the trajectory of Google seems rather smooth and obvious. Why would anyone decide to sell Google stock along the way?

Many did. If we zoom in at a random time interval, then the chart paints a different picture. The price of Google has fluctuated throughout the past year and is flat from where it started.

Source: Google Finance (as of 03/08/19)

This pattern is not only true for Google. You can do the same for almost any stock, and the process of zooming in and out will yield conflicting views about the trajectory of the company.

Over an extended and sufficiently zoomed out time period, what appears to be a rather linear and obvious path is full of volatile episodes.

You may be wondering: so what is the point of looking at charts?

Visualizing the trajectory of one the most successful companies in recent history illustrates the challenges of investing. It’s neither easy nor obvious. George Soros, one of the most accomplished investors in recent history, said it best: “markets are constantly in a state of uncertainty and flux, and money is made by discounting the obvious and betting on the unexpected.”

We are better served operating under the assumption we and others will tend to be wrong. Soros continues: “once we realize that imperfect understanding is the human condition there is no shame in being wrong, only in failing to correct our mistakes.” Paradoxically, assuming we will be wrong by design increases our probability of being right.

When in doubt, just remember to keep your I score above 1. ☝️