Euclidean Q1 Letter

Also see

2017 Hedge Fund Letters

With the recent election and markets moving to ever more-expensive highs, there are a number of salient stories in the air.  It is worthwhile to reflect on how these and other stories impact the way investors think and influence their investment decision making.  Doing so highlights the logic of adhering to a systematic process for purchasing good companies at discounted prices.

Several recent books have generated widespread discussion around the power of stories and the limitations of our intuition as we process the ones around us.  Michael Lewis’ Undoing Project tells the story of two pioneering behavioral psychologists, Daniel Kahneman and Amos Tversky, who categorized dozens of mental glitches that cause people to repeatedly and predictably make bad decisions.  Jonathan Gottschall’s Storytelling Animal explores how people rely on stories to simulate different approaches to life’s big problems.  And, Yuval Harari’s Sapiens provides a compelling thesis that the emergence of imagination and story-telling enabled our species to dominate the earth.

When you digest these books, it’s clear that there have been evolutionary benefits to developing the skill to tell and seek stories.  They allow us to simulate potential futures in our brains and plan our actions, navigating our lives like a great chess player navigates a match.  They also enable us to tell high-resolution stories to others, influence their views, and build affinity around imagined concepts such as laws, myths, and culture.  This quality, argues Harari in Sapiens, allowed our Homo sapiens ancestors to coordinate action across complex societies and wield a collective force that brought other humanoid species to extinction.  It wasn’t our muscles, but our storytelling and story-seeking, that solidified our domination of the planet.

And yet, despite this power and legacy, our attraction to stories left us with serious baggage.  Namely, we are wired to embrace a good story, even when it is untrue.  We latch onto the tales that are most easily processed in our brains, which are often ones that confirm what we already believe and resemble what we have recently seen.  Thus, people are susceptible to lazy thinking, with a tendency to ignore statistical evidence that may contradict their views and yield better long-term decisions.

We would like to provide some examples of how this can be dangerous for investors.  Then, we explain how we limit Euclidean’s exposure to stories’ negative consequences by grounding our investment approach in a detailed analysis of what has been fruitful over the long-term.

The Availability Heuristic & Answering Easier Questions

People have a strong tendency to make decisions based on the stories that most quickly and easily come to mind.  Often, this kind of mental shortcut gives decent answers.  But in complex situations, it often causes decisions to hinge on feelings of like and dislike, with little consideration of available statistics.

From an investment perspective, this can be financially slimming.  Difficult questions such as, “Is ACME Corporation attractively priced?” can be subconsciously substituted with questions relating to the moment’s dominant stories, such as, “How do I feel about ACME Corporation, its CEO and its products?” or “How excited or fearful am I about the world right now?”

The Difficult Important Question.png

These easier-to-answer questions are susceptible to making an investor feel better about investments surrounded by enthusiasm (and enthusiastic prices) and worse about opportunities created by fear and pessimism.  But, of course, such an instinct is the opposite of what often leads to good investment returns, namely buying when others are fearful and selling when others are greedy.

Confirmation Bias

The double-whammy with this inclination to unknowingly substitute hard questions for easier ones, is that once people form an opinion, they are wired to fortify it like a castle.  People favor news that supports their opinions and prefer spending time with people that share their views.  Likewise, they tend to avoid and discount information that might challenge their beliefs.  This tendency is often called “confirmation bias.”

Why would this quality have survived across the evolutionary process that made humans what we are today?  Evolution is supposed to pass on genes that are helpful to survival!  Shouldn’t confirmation bias eventually have disappeared as our human software was progressively refined around making great decisions based on all available information?  Perhaps the following perspective, from the cognitive scientists Hugo Mercier and Dan Sperber, explains why this question is naive.

“Humans’ biggest advantage over other species is our ability to cooperate.  Cooperation is difficult to establish and almost as difficult to sustain. For any individual, freeloading is always the best course of action.  Reason developed not to enable us to solve abstract, logical problems or even to help us draw conclusions from unfamiliar data; rather, it developed to resolve the problems posed by living in collaborative groups.” [1]

This makes sense.  For example, if you lived in 16th century Italy, you might be more successful in school and in life if you embraced the idea that the world was flat.  To challenge accepted wisdom (“the world is not flat!”) might get you excommunicated, or worse.  There is always some safety that comes from sticking with the crowd.  And, if you are wrong, well, there is comfort in having been wrong with company.

However, in the world of investing, we want to succeed, and the comfort of failing conventionally is bittersweet at best.  So, as one seeks neglected, or misunderstood, opportunities that are favorably priced, it is hard to imagine a more severe design flaw than confirmation bias.  In the public markets, outside of inside information and fast trading capabilities, generating exceptional returns requires contrarian views formed through better analysis of the facts, and the conviction to sustain those views despite overwhelming pressure to conform to the crowd.

It is therefore crucial to protect against both our ingrained difficulty seeing what we do not want to see, and our great ease embracing further what we already believe.

Recency Bias

Right up there with embracing stories that confirm existing beliefs is our tendency to expect whatever we have recently encountered to persist in the future.  When things are going well, we tend to expect them to continue going well.  The flip side is also true.

“A person who has experienced a tragedy will overestimate the potential for risk, danger, and a hostile universe.  A person untroubled by suffering will underestimate pending danger.  When a friend gets cancer we get a check-up.  When nobody we know gets cancer we ignore the risk.” [2]

Right now, with markets and growth stocks having been so strong for so long, investors are wired to expect things to continue on their current course.  But, markets are forever cyclical. Long-periods of strong results tend to be followed by poor returns and vice-versa.