Cognitively Yours 1.19

 

Raja R, Author

"First level thinking and luck may help you achieve average returns but to achieve more than the ordinary and superior returns, you have to resort to second level of thinking and also predict what others will think"

A Keynesian beauty contest is a concept developed by John Maynard Keynes and introduced in Chapter 12 of his masterwork, General Theory of Employment Interest and Money (1936), to explain price fluctuations in equity markets. Keynes described the action of rational agents in a market using an analogy based on a contest that was run by a London newspaper where entrants were asked to choose a set of six faces from 100 photographs of women that were the "most beautiful". Everyone who picked the most popular face was entered into a raffle for a prize.

A naive strategy would be to choose the six faces that, in the opinion of the entrant, are the most beautiful. A more sophisticated contest entrant, wishing to maximise his chances of winning a prize, would think about what the majority perception of beauty is, and then make a selection based on some inference from his knowledge of public perceptions. This can be carried one step further to take into account the fact that other entrants would also be making their decision based on knowledge of public perceptions. Thus the strategy can be extended to the next order, and the next, and so on, at each level attempting to predict the eventual outcome of the process based on the reasoning of other rational agents. ‘It is not a case of choosing those [faces] which, to the best of one’s judgment, or really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligence to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degree. - (Keynes, General Theory of Employment Interest and Money, 1936).

Keynes believed that similar behaviour was at work within the stock market. This would have people pricing shares not based on what they thought their fundamental value was, but rather based on what they think everyone else thinks their value was, or what everybody else would predict the average assessment of value was. Keynes likened professional investment to a newspaper beauty contest in which the aim was to pick the face that the average respondent would deem to be the prettiest.

The mathematical and the more objective version of the game was to pick a number between 0 and 100 and the winner would be the player who picked the number closer to two-thirds of the average number chosen.

James Montier had over 1000 respondents, who were professional investors. The average number picked was 26, giving a two-thirds average of 17.4. Some 14% chose 0 as the rational equilibrium. If we were 100% rational, everyone should choose 0. As all are not rational, logically I should not choose 0. However, I cannot bring myself to believe that people are not irrational. I therefore stick with 0.

Many clients suffered a curse of knowledge. One particular form of the curse of the knowledge is once we know something, we can’t ever imagine thinking otherwise. This makes it hard for us to realise that we know may be less than obvious to others who are less informed. Some 41% of those identifying 0 equilibrium chose a number other than 0 as their estimate of the likely outcome. Effectively they are taking a rational view on the degree of irrationality or the amount of bounded rationality that governs the market. Theoretically, the answer should be zero, but I am choosing a number closer to zero as I feel some may not be totally rational. They suffered from a false consensus effect - to think that others are just like us. Ask a group of mixed smokers and non-smokers how common smoking is in the population and the chances are you will find that the smokers think more people smoke and the non-smokers will think that smoking is a minority pastime.

The average number picked was 30 giving a two thirds average of 20. Most players assume that the starting point should be 50 i.e the mean from a random draw. Hence, level 0 players chose 50 (15% of total sample). Level-I players chose the best reaction to the level-0 players i.e they picked two-thirds of 50, providing a spike at 33 (14% of our sample. Level-two players best react to a 33 yielding the massive spike at 22 (7% of our sample) Level 3 players end up with 15% as their pick (2% of the sample). Once past level 2 or 3 reasoning, players frequently slide down the slippery slope towards multiple iterations and produce zero (11% of the sample).

Our market can be characterisd by the following facts:

·  Market players use one, two, three or infinity levels of thinking.

·  A significant number who reach 0 choose a number greater than 0 because they believe others are bounded rational. In the end, all of them chose too low a figure.

·  A significant chose either 0 or 1 - doomed by their own rationality or curse of knowledge.

In short, “It’s not supposed to be easy. Anyone who finds it easy is stupid”- Charlie Munger.

“The art of investment has one characteristic that is not generally appreciated. A creditable, if unspectacular, result can be achieved by the lay investor with a minimum of effort and capability, but to improve this easily attainable standard requires much application and more than a trace of wisdom.” Ben Graham, The Intelligent Investor. To improve on the easily attainable standard you require more than the trace of wisdom. You may be right for short term but wrong for long term and vice versa. What matters really is that you should be right consistently over long term to achieve your financial goals. 

Investment, like economics, is more than art than science. Few people have what it takes to be great investors. Some can be taught but not everyone. Valid approaches work some of the time but not all. And investing can’t be reduced to an algorithm and turned over to a computer. Even the best investors don’t get it right every time.

No rule always works. You cannot paint everything by the same brush. There is no single silver bullet for all investment decisions. The environment isn’t controllable and circumstances rarely repeat exactly. An investment approach may work for a while, but if the same approach is emulated by others, its effectiveness will be blunted and a new approach is needed.

The definition of successful investing is doing better than the market and other investors. To achieve this, you need either good luck or superior insight. Counting luck isn’t much of a plan, so you would better concentrate on better insight. In basketball they say, “You can’t coach height”, meaning all the coaching in the world won’t make a player taller. It’s almost hard to teach insight.

Millions of people are competing for each available dollar of investment gain. Who will gain? The person who is a step ahead. In some pursuits like sports, getting to the front of the pack means more schooling, more time in the gym or the library, better nutrition, more perspiration, greater stamina or better equipment. But in investing, where these things count for less, it calls for more perceptive thinking - what Howard Marks call it second level.

First level thinking says, “It’s a good company, let’s buy the stock”. Second level thinking says “It’s a good company, but everyone thinks it’s a great company and it’s not. So the stock is overrated and overpriced; let’s sell”.

First level thinking says, “The outlook calls for low growth and rising inflation. Let’s dump our stocks”. Second Level Thinking says, “The outlook stinks, but everyone else is selling in panic Buy”.

First level thinking says, “I think the company’s earnings will fall; sell”. Second level thinking says, “I think the company’s earnings will fall less than what people expect, and there will be a pleasant surprise in the stock, buy”.

First level thinking says, “The fund is the top most in one year returns, invest”. Second level thinking says “What is the past track record? It has done well when the market was bullish? How is its performance when the markets were bearish?”

First level thinking says, “This is the top most fund in performance, invest”. Second level thinking says, “How this fund is different from others? Has it taken additional risk that other funds have not taken”.

Second level thinking means,

·  What is the range of likely future outcomes?

·  Which outcome do I think will occur?

·  What’s the probability I am right?

·  What does the consensus think?

·  How does my expectation differ from the consensus?

·  How does the current price for the asset comport with the consensus view of the future, and with mine?

·  Is the consensus psychology that is incorporated in the price too bullish or bearish?

·  What will happen to the asset price if the consensus turns out to be right, and what if I am right?

First level thinkers look for simple formulas and easy answers. Second level thinkers know that success in investing is the antithesis of simple.

For your performance to diverge from the norm, your expectations and thus your portfolio have to diverge from the norm, and you have to be more right than the consensus. Different and better, that’s pretty good description of second level thinking.

Those who consider the investment process simple generally aren’t aware of the need for or even the existence of second level thinking. Thus many people who are misled into believing that everyone can be a successful investor. Not everyone can. But, the good news is that the prevalence of first level thinkers increases the returns available to the second level thinkers.

Always be willing to see both sides of every argument or investment stance you take. You have to be willing to actively seek out opinions that are different than your own. No one is right all the time and thinking about where you could be wrong shows intellectually honesty and the self-awareness to know you’re not infallible.

To sum up, investment though simple is not easy. First level thinking and luck may help you achieve average returns but to achieve more than the ordinary and superior returns you have to resort to second level of thinking and also predict what others will think.

We should reach the level where we devote our intelligence to anticipating what average opinion expects the average opinion to be. And there may be need to practice even the fourth, fifth and higher degrees.

The important Lessons for us , as Howard Marks point out are: 

·  Think in terms of probabilities, never certainties.

·  Don’t judge your decisions based on the outcomes; judge them by the process you took to make them.

·  Remember to think in terms of relatives, not absolutes. Markets are all about expectations, especially over the short to intermediate term. It’s not always about things getting better or worse, but less good or less bad. A misunderstanding of this concept has cost plenty of investors a lot of money over the past few years, more so in the last one year. 

·  Be humble or the market will do it for you.

·  Always consider the difference between price and value. Any security or asset class can make for a good investment at one price and a poor one at another.

·  Never become too confident in your own abilities.

References: The most important thing by Howard Marks, The Intelligent investor by Benjamin Graham, Behavioral Investing by James Montier

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