Big Money Thinks Small: Biases, Blind Spots, and Smarter Investing

CAPTAIN RENAULT: I’m shocked, shocked to find that gambling is going on here.

CASINO ATTENDANT: Your winnings, sir.

—CASABLANCA (MOVIE, 1942)

Gambling, Speculation, and Investment

IN THE PUBLIC EYE, it all looks like gambling, and sometimes it is. Wall Street confuses things further by calling all of its customers “investors.” Awkwardly, every investment involves some form of speculation about future events. More dangerously, many who believe that they are investing are actually speculating. The distinctions matter because investors gather information and manage risk and uncertainty differently than speculators.

My aim in this chapter is to warn you away from unintentional gambling and from speculating on prices, psychology, and topics that are unknowable. Unlike at casinos, most of the people who gamble on Wall Street aren’t aware that that’s what they are doing. Some categories of speculation deserve their bad reputation, while others are necessary for our whole capitalist system to exist. People speculate to prepare for the future when vital information is missing and sometimes unobtainable. In my opinion, you’ll invest more profitably if you speculate on factors that affect the stream of profits generated by an enterprise, rather than on market prices or crowd psychology.

The spectrum splits along two dimensions. First, event or holistic? Are you looking for an identifiable trigger or catalyst to produce a winning trade, or rather for a holistic (comprehensive, long-term) sense that capital and income are secure? Second, is this well-researched or not? Have you done thorough research, sloppy research, or none at all?

The possible combinations of an event-based trade with diligent, slapdash, and no investigation into whether the odds are favorable, are mapped out in table 3.1. I would call an event-based trade based on careful research a shrewd speculation. With casual research, it becomes a reckless speculation. With zero research, it’s gambling. Likewise, the same range of depth of research can be mapped out for holistic trades. An investment is the product of thorough research that indicates that capital is broadly secure and an adequate return should be earned. Cursory research and a holistic approach add up to a risky investment. A generalized faith that somehow everything will come up roses, without supporting evidence, is gambling.

Table 3.1

Possible Combinations of Levels of Research and Focus of Research

	Event	Holistic
Thorough research	Shrewd speculation	Investment
Sloppy research	Reckless speculation	Risky investment
No research	Gambling	Gambling

Know the Odds

Once you have grasped probability and statistics, gambling usually loses its charm. There’s a famous story about a team of card counters from MIT, but they weren’t gambling—because they had analyzed their chances. When you don’t know your odds, or care about them, gambling truly is a tax on ignorance. For example, suppose collectively lottery players get back only 65 percent of the proceeds from ticket sales. Probabilistically, you lose 35 percent of your money the second you buy the ticket. The final outcome is typically a complete loss.

I did once gamble in financial markets, but at the time I thought I was speculating on interest rates. I’m sure most stock market gamblers do it unwittingly, as I did. As I discuss later, I quickly made, and lost, what was then a huge amount of money to me, bullheadedly thinking that my early victory proved that I was right. Some telltale signs of gambling include betting on discrete events, near-instantaneous timelines, use of leverage, overcommitment to one story, and no way to gauge whether the odds are in your favor.

Unwise Speculations

Speculation, properly done, isn’t gambling. Like sex, speculation has a shady reputation but is universally practiced, often enjoyed, and none of us would be here without it. Going back to the Latin root word, speculare means “to observe or look out as from a watch tower.” The only way we can prepare for and possibly shape what fate brings us is if we observe and try to imagine it. Businesses must somehow anticipate what customers might want, where materials will come from, and the quantities required. Investing can’t be done without conceiving when and how capital might be in danger, or where it might be super-productive. The process of envisioning and creating the future can never be flawlessly logical, but without it rational economic man has no basis for his calculations.

Investors must unavoidably speculate, but many of the most popular topics of speculation are not amenable to research that gives them an edge. Among the most treacherous speculations are on share prices, commodity prices, and crowd psychology—unless you have something that can tell you that you are wrong, like a notion of fair value. If markets are efficient, past price movements should tell you nothing about the future path of prices. If true—and it is true enough—this means that research into historical price changes won’t be rewarded.

The logic of price momentum is shifting and fickle. Numerous studies have shown that in the short term, rising prices do accurately predict further gains, and declines accurately predict further losses, sometimes even more powerfully than indicators of value. About a year or so later, momentum starts to reverse, so traders must be nimble. In the Internet age, it seems utterly ridiculous that momentum reflects slow dissemination of information or underreaction to news. More likely, momentum reflects overreaction to news, social proof, and piling on. That said, companies often dribble out bad news, and the issues that cause falling profits are often slow to fix. Value buyers must ensure that their expectations have been shaken down enough.

Momentum is a fast-paced game with a complex interplay between how far out you look, and how far out you think the crowd is looking. Consider a game in which each participant enters a whole number between zero and one hundred. The winner is the one who chooses the number, rounding down, nearest to half the average guess of the other participants. So have you picked a number yet? Some people might enter fifty, which is the average of numbers between zero and one hundred. But if you are aiming for half of the average guess, you might divide fifty in half and pick twenty-five. Knowing that your opponents might also do that calculation, it might be better to guess twelve. Long-term investors try to look out as far as the eye can see. Further iterations would indicate six, three, and one. A mathematician would say that at the limit, the endgame is zero.

When this game is played in real life, the winners gaze a step or two ahead, but no further. Those who answered fifty or twenty-five weren’t thinking enough about second-order effects, the reactions to events. For example, a sharp spike in a commodity price will bring on more supply, which might blunt price momentum. Look slightly ahead and ask: If these are the obvious facts, how are others likely to respond? Because it’s a game, it all depends on who else is playing. Conversely, zero never wins in these games because other participants rarely consider how it ends. Still, to me, speculating on how long others will remain shortsighted verges on gambling.

Research into group behavior can pay off, but usually not with the exact date and number sought by speculators. Stock market bubbles occur when traders latch onto a compelling initial premise and extend the logic too far. Speculators take rising prices as proof that they were correct. Their error becomes apparent to them only in the fullness of time. People avoid reason until they have tried everything else. If you fancy that there will be clear signs as to when the party will wind down, as most speculators do, you will surely be drawn into the thundering herd, despite knowing the inevitable result.

The other set of impossible inquiries lies in the distant haze. For example, the current dividend yield of the S&P 500 is 2 percent. At that rate it would take you fifty years to recover your purchase cost in dividends. Should we therefore handicap whether in decades hence the economy will be in a boom, chugging along, or depressed? I don’t know enough to say. Instead, I look for situations in which it is less absurd to visualize the distant future and steer away from speculations that would be upended if I somehow did know the state of the economy decades out.

Speculations of Enterprise

Topics that are worth speculating on include whether management will make the right decisions when the time comes, whether an industry is prone to failure because of commoditization, obsolescence, or financial overreach, and what a security’s value might be. Because we’re anticipating responses to challenges and opportunities that have not yet presented themselves, no one really knows. However, the track records of executives and industries can provide useful indications. For example, bricks-and-mortar retailers will have to sell on the Internet, or risk being destroyed by Amazon. My speculations center on which categories of merchandise will move more slowly to the Internet, how Internet and in-store transactions might combine, and which chains have the systems and adaptability to serve customers in both formats.

It’s impossible to invest successfully in early stage biotech and Internet companies without speculating on whether the science works, whether customers will like the product, and how large the potential market might be. If you’re clueless about beta agonists or B2B CRM wave analytics, and why customers might want them, and you buy the shares anyway, you’re gambling. But for savvy insiders who are close to the industry, the payoffs can be incredible. Without the specialized category of extreme speculators called venture capitalists, many of these science projects would never get the cash needed to turn ideas into products. Progress depends on this sort of speculation, in which income and certainty about the future are afterthoughts.