In our annual letter to investors this year, we discussed the difficulty of evaluating past decisions for validity without contaminating the assessment with present knowledge of the outcome.
Over time, careful consideration of what can go wrong with an investment is critical to effective risk management and long-term results, yet it is perhaps the hardest thing to do. The reason for this is that what must be ascertained are the negative spaces and gaps in your thesis. What we must effectively answer is the question, “but what if we’re wrong?”
The shortcut typically employed is to point to the embedded forecasts; by definition these are not known and thus potential sources of error. One then allows for some range of possibilities to present an upside and downside along with the base case. But if forecasting the future were as simple as bracketing the present with error bars, why then do we stink so badly at it? Often what goes awry with predictions is that they are typically made as straight-line projections from the present, along the most probable direction. But the further out we range from the present, the more likely it is that this approach will be way off the mark. So how can we do a better job?
Charlie Munger: Invert And Use “Disconfirming Evidence”
But What If We’re Wrong?: Thinking About the Present As If It Were the Past by Chuck Klosterman
The recently published book, But What if We’re Wrong tries to teach ways around the mental fallacies that can lead to such simple errors in future projection. If you are familiar with Taleb’s The Black Swan, this book could be considered a companion piece. Klosterman is essentially arguing that our linear thinking inherently creates the “blackness” of the swan by failing to consider fully the possibility of “But what if we’re wrong?” This book not only underlines the importance of asking this question, it walks the reader through some case studies that show practical examples of how to reframe thinking. His examples draw from literature, music, TV, politics, science, and are written with a cracking good sense of humor. It’s a meandering intellectual’s dream of a book- a group we unabashedly claim membership in.
“If what I say now seems to you to be very reasonable, then I’ll have failed completely.” -Arthur C. Clarke, speaking in the year 1964, attempting to explain what the world might be like in the year 2000
One of the first issues with straight line projections is that we so often taint them with notions of taste and preference. In imagining the future, we are defining what will be lasting, not what we are fans of. The first example in the book takes the reader through a consideration of what might be the Moby Dick in a hundred years. Generally, this could be thought of as how to locate the potentially timeless in a sea of the merely popular. Here is Klosterman’s take on shaking loose from our predilections:
“Taste is subjective, but some subjective opinions are casually expressed in the same way we articulate principles of math or science. There isn’t an ongoing cultural debate over the merits of Moby Dick: It’s not merely an epic novel, but a transformative literary innovation that helps define how novels are supposed to be viewed. Any discussion about the clichéd concept of “the Great American Novel” begins with this book. The work itself is not above criticism, but no individual criticism has any impact; at this point, attacking Moby Dick only reflects the contrarianism of the critic.”
Playing the devil’s advocate for the mere sake of expressing individuality does not add value.
We must understand why something remains (or might remain) significant long after its creation outside of our subjective opinions. Our own personal preferences or singular experiences with Android or iOS devices will not add credence to an AAPL or GOOG thesis.
Once the subjective has been properly dispensed with, the next things to be discarded should be the concepts of merit and worth. Why is this so? These quality arguments must go because the definitions are inherently linked to the structure and constituency of present-day society and its whims with respect to “excellence.” Klosterman suggests a better starting point:
“When trying to project which contemporary books will still be relevant once our current population has crumbled into carbon dust and bone fragments, it’s hopeless to start by thinking about the quality of the works themselves. Quality will only matter at the end of the argument, but not at the beginning. At the beginning, the main thing that matters is what that future world will be like. From there, you work in reverse.”
The closest investment parallel here is the oft-repeated caution that good companies may or may not be good investments. Company A may be the most well-managed company on the planet and make the finest “thingamabobs,” but if the future world doesn’t want “thingamabobs,” and/or their management style is not compatible with a future economic structure, then Company A may perish.
So what ought to be considered? In the music chapter, Klosterman points out that in selecting the timeless, we tend to pick out a diverse handful of examples to display the width and breadth of a category. However, the historical record of the future typically only preserves one example per genre to sum things up in a tidy, memorable package, e.g. Bob Marley for reggae. How can we journey away from the “top ten” answers and break out into a tangential direction away from these obvious and often wrong selections? Try to envisage how the emergence of an ultimate selection from posterity would shape the entire historical rear view perspective on what the thing is. The example in the book is to contrast the future vision of what rock was if Elvis were to be the scion versus Bob Dylan. It would completely alter the meaning of “rock music!” A more probable choice might be a more stereotypical and perhaps inherently lower “quality” choice that embraces the essence of “rock,” not its edgy mavericks and trendsetters. Perhaps the simple music of Chuck Berry will come to represent what rock music meant, but we can hope it will at least be “Johnny B. Goode” and not “My Ding-a-ling”!
The lesson for the investor in this exercise is that the long-term winner from a batch of start-ups or caterers to a current economic trend is often not the flashiest, the most innovative, or the first to market. Look to the middle of the pack for those which most represent the class or category. You can keep Dylan and The King on your playlist, but they might not be right for a long-range portfolio soundtrack.
By far, the loudest cautionary messages from the book concerns the peculiar incongruity that occurs with well-respected, but still subjective, “facts”:
“There is, certainly, an unbreachable chasm between the subjective and objective world. A reasonable person expects subjective facts to be overturned, because subjective facts are not facts; they’re just well-considered opinions, held by multiple people at the same time. Whenever the fragility of those beliefs is applied to a specific example, people bristle – if someone says, “It’s possible that Abraham Lincoln won’t always be considered a great president,” every presidential scholar scoffs. But if you remove the specificity and ask, “Is it possible that someone currently viewed as a historically great president will have that view reversed by future generations?” any smart person will agree that such a scenario is not only plausible but inevitable. In other words, everyone concedes we have the potential to be subjectively wrong about anything, as long as we don’t explicitly name whatever that something is.”
Even worse, we often do not even realize or even know how far our subjective experience extends! Consider the example of temperature, which is cited in the book. All temperature really measures is molecular motion. Our brains subjectively create related sensations of warmth or coolness on an individual basis. And how about vision – remember that ludicrous white/blue and gold dress debate on the internet?
The point of these examples cited by Klosterman is to encourage an intentional move away from the mindset of naïve realism when trying to think about the future:
“I suspect most conventionally intelligent people are naïve realists, and I think it might be the defining intellectual quality of this era. The straightforward definition of naïve realism doesn’t seem that outlandish: It’s a theory that suggests the world is exactly as it appears. Obviously, this viewpoint creates a lot of opportunity for colossal wrongness (e.g., “The sun appears to move across the sky, so the sun must be orbiting Earth”). But my personal characterization of naïve realism is wider and more insidious. I think it operates as the manifestation of two ingrained beliefs:
- When considering any question, I must be rational and logical, to the point of dismissing any unverifiable data as preposterous,” and
- When considering any question, I’m going to assume that the information we currently have is all the information that will ever be available.”
Naïve realism is one of the most important traits for a successful long-term investor to avoid. We understand that the world is not always as it seems. We have been wrong in the past and we will be wrong again in the future. But by continuing to ask ourselves the question “But what if we’re wrong?” we can evaluate and contain the damage of this possibility. This is key to avoid becoming the Federal Reserve chairman who said about home values in 2005: “It’s a pretty unlikely possibility. We’ve never had a decline in house prices on a nationwide basis.”
Article by Andrea Sefler, Broyhill Asset Management