Do you remember the first investment you ever made? How nervous you were? Worrying about whether the stock would grow or tank? What things you had missed or whether the information you had was outdated? We’ve all been there; that perilous moment when you first dip your toe into the investment pool, all while asking yourself whether a piranha lurks just out of sight beneath the surface.
Now, as a comparison, take an investment you made recently and compare how you felt. I bet your comfort levels are much higher these days. As is your confidence. So what’s the difference? Knowledge and Experience, that’s what. You’re more confident now because you know more and have experienced more. Many parts of your investment activity have become intuitive, or second nature.
What can past market crashes teach us about the current one?
One of my favourite books that deals with this type of thinking, and one coincidentally recommended by numerous Investment Masters, is Josh Waitzkin’s ‘The Art of Learning‘. Josh was the US National Chess Champion at age nine and later became World Champion in the martial art, Tai Chi Chuan.
As an adult, Josh now trains high level performers as well as many successful investment managers. I recently watched an interview with Josh on the Alan Howard Series, which prompted me to write a post on this subject that I've been thinking about for a long time. Like the financial markets, chess is a dynamic endeavour involving complexity, uncertainty and emotions. It follows that Josh's approach to chess and martial arts have striking parallels with the approach of many of the Investment Masters [refer study notes for more detail].
Two powerful concepts Josh discusses in his book are the focus on the 'end-game' and the concept of 'the study of numbers to leave numbers'.
Josh tells the story of how, as a child competing in chess tournaments, he would confront other children who had been drilled in the 'opening variations' of the game. These children had been taught to memorise strong opening positions to overcome their opponents early in the game. In contrast, Josh spent his time looking at'end-games'. He would study chess with just two or three pieces on the board, learning the subtlety of pieces, and gaining an intuitive feel for their power. Layer by layer, he learnt the principles of opposition and the hidden potency of empty space and built up the knowledge to transform axioms into fuel for creative thought. At first, he practiced with just the pawn and the king, and then moved to rook endings, bishop endings, and knight endings. By focusing on what was essential he internalised a methodology of learning - the inter-play between knowledge, intuition and creativity.
"Bruce and I also spent a lot of time studying endgames, where the board is nearly empty and high-level principles combine with deep calculations to create fascinating battles. While my opponents wanted to win in the openings, right off the bat, I guided positions into complicated middle games and abstract endings" Josh Waitzkin
"Bruce began our study with a barren chessboard. We took positions of reduced complexity and clear principles. Our first focus was king and pawn against king - just three pieces on the table. Over time, I gained an excellent intuitive feel for the power of the king and the subtlety of the pawn .. Most of my rivals, on the other hand, began by studying openings .. Why not begin from the beginning, especially if it leads to instant success? The answer is quicksand. Once you start with openings, there is no way out. Lifetimes can be spent memorizing and keeping up with the evolving Encyclopedia of Chess Openings. They are an addiction, with perilous psychological effects." Josh Waitzkin
Such a deep understanding of the pieces and their inter-connectedness gave Josh an edge once the opening variations developed into complex random and chaotic game-play. By spending time studying end-games Josh would be at ease as the game unfolded. In contrast, his opponents would crumble if the game was not won quickly, as both their memories and confidence would fail them as the game ventured into the unpredictable and unexpected.
Josh's success came from adopting a different perspective from the typical chess player. Likewise, many of the Investment Masters have succeeded by adopting a different perspective and focussing on the end-game.
In investing, like chess, most players are focused on the opening game. They spend their time deciphering the factors impacting the stock right now, and trying to answer questions such as - will next quarters earnings meet expectations? In contrast, the Investment Masters lengthen their time horizons, move away from the current stock market noise and spend more time focusing on the end-game. They learn the subtlety of what makes a company strong, the factors that have allowed the company to thrive in the past and the two or three key factors that will ensure a profitable future. They lengthen the time horizon to an area where other investors aren't focused. They ask - how will the business look in three to five years? Will the company be able to maintain its competitive position? Will the earnings be significantly higher and how will the market value those earnings? This process of looking towards the future is often referred to as time arbitrage.
"The forecasting horizon trap lures you into spending all your time on what's more knowable - the same immediate horizon that occupies everyone else. If you fall into the trap, competing with all the other investors concentrating on these short term events, it is impossible to outperform the market. You have to escape to a longer term horizon" Ralph Wanger
"Over the last few decades, investors' timeframes have shrunk. They've become obsessed with quarterly returns. In fact, technology now enables them to become distracted by returns on a daily basis, and even minute-by-minute. Thus one way to gain an advantage is by ignoring the "noise" created by the manic swings of others and focussing on the things that matter in the long term" Howard Marks
The Investment Masters also work backwards from the end-game. They try and imagine that the company has failed and then ask - what could have been the contributing factors that led to failure? Inverting the questioning process opens up avenues of creativity to identify potential investment risks that others may miss. By putting themselves into the future they create different perspectives that may not be obvious to those anchored in the present.
"Charlie Munger is famous for the pioneering concept of inverting as an investor, of thinking backwards to find one's way to the beginning of an idea or concept. In our application, an advantage can be gained in the competitive world of active investment management by preparing for the unknown by inverting, reasoning backwards to attempt to learn how others in the past have coped with the unforeseeable and the unpredictable" Frank Martin
"When Charlie [Munger] thinks about things, he starts by inverting. To understand how to be happy in life, Charlie will study how to make life miserable; to examine how business become big and strong, Charlie first studies how businesses decline and die; most people care more about how to succeed in the stock market, Charlie is most concerned about why most have failed in the stock market. His way of thinking comes from the saying in the farmer’s philosophy: All I want to know is where I’m going to die, so I will never go there." Li Lu
The second insightful concept Josh discusses is the 'study of numbers to leave numbers'. In essence this refers to mastering a discipline to the extent that it becomes intuitive, or second nature.
"As I struggled for a more precise grasp of my own learning process, I was forced to retrace my steps and remember what had been internalized and forgotten. In both my chess and martial arts lives, there is a method of study that has been critical to my growth. I sometimes refer to it as the study of numbers to leave numbers, or form to leave form. A basic example of this process, which applies to any discipline, can easily be illustrated through chess: A chess student must initially become immersed in the fundamentals in order to have any potential to reach a high level of skill. He or she will learn the principles of endgame, middlegame, and opening play. Initially one or two critical themes will be considered at once but over time the intuition learns to integrate more and more principles into a sense of flow. Eventually the foundation is so deeply internalized that it is no longer consciously considered, but is lived. This process continuously cycles along as deeper layers of the art are soaked in." Josh Waitzkin
“It is important to understand that by numbers to leave numbers, or form to leave form, I am describing a process in which technical information is integrated into what feels like a natural intelligence” Josh Waitzkin
"Most people would be surprised to discover that if you compare the though process of a Grandmaster to that of an expert (a much weaker, but quite competent chess player), you will often find that the Grandmaster consciously looks at less, not more. That said the chunks of information that have been put together in his mind allow him to see much more with much less conscious thought. So he is looking at very little and seeing quite a lot. The Grandmaster looks at less and sees more, because his unconscious skill set is much more highly evolved" Josh Waitzkin
"In my opinion intuition is our most valuable compass in the world" Josh Waitzkin
Studying broadly and consistently produces a detailed database of information that an individual can draw upon. Creativity is provoked by the association and integration of disparate pieces of information. So to the Investment Masters recognise the role of intuition in successful investing.
"[Intuition, instinct, hunch] .. it's critical. And it's also, by the way, what the computer can't do well. In other words, it's the subconscious. As you know, man, although it's only 200,000 years old, the brain is much older. And we came programmed with many of these things in our brain, intuition and those things. And they're in our subconscious. And so by opening up one's subconscious to one's consciousness so they come up, you know, creativity comes from not working hard at it, it comes from relaxation. It bubbles up from the subconscious. Transcendental meditation has been invaluable to me because it helps to do that. But that intuition, that creativity, man is still unique at being able to do those things. So you let that bubble up, but you have to reconcile it with your logic. So when the subconscious creativity and intuition comes up and replicate it with your logic, it's fabulous." Ray Dalio
"Superior results generally require insight, judgement and intuition" Howard Marks
One of the greatest investment minds of all time, Charlie Munger, certainly understands the concept of 'the study of numbers to leave numbers' ...
“The deep structure of the human mind requires that the way to full scope competency of virtually any kind is to learn it all to fluency—like it or not.” Charlie Munger
So how does your thinking look by comparison? Are you anchored in the present and distracted by the noise in the market? Focused on quarterly earnings and the price of the stock today? Or are you inverting; deciphering the future by working backward from potential outcomes? It's time to leave the now behind and study the end-game, looking at what's to come and using your intuition to the right advantage. And if you do it right, then its check-mate to you...