Inputs and Outputs

Some time ago, I found one of the lesser known gems of wisdom about investing that can be found on the internet. This is a speech on investing that was delivered almost forty years ago by an otherwise forgotten investment manager of a long-gone fund management firm named Batterymarch. The speech has now become something of a legend, being passed along on the web and on social media as one of the classics of clear thought and fundamentally useful ideas about investing.

The title of this speech is "Trying Too Hard," which itself sounds odd. Surely, there's no such actual thing as trying too hard? It turns out that there is. Do a Google search for the speech and read the whole thing. One of the most interesting bits of the speech is the analogy between physics and investing.

The foundation of Newtonian physics was that physical events are governed by physical laws. Laws that we could understand rationally. And if we learned enough about those laws, we could extend our knowledge and influence over our environment. That was also the foundation of most of the security analysis, technical analysis, economic theory and forecasting methods you and I learned about ... There were rational and predictable economic forces. And if we just tried hard enough...If we learned every detail about a company...If we discovered just the right variables for our forecasting models...Earnings and prices and interest rates should all behave in rational and predictable ways. If we just tried hard enough.

However, just as in physics, the investors' reality is more like quantum mechanics. Those events just didn't seem subject to rational behavior or prediction. Soon it wasn't clear whether it was even possible to observe and measure subatomic events, or whether the observing and measuring were, themselves, changing or even causing those events...There is just too much evidence that our knowledge of what governs financial and economic events isn't nearly what we thought it would be.

Most equity investors believe that if they (or someone else) just gather enough knowledge and apply it all, they can know what is going to happen to an investment. All of it adds up to trying to know where stock prices will head tomorrow and thereby make some money. We all implicitly believe that a research report or an article in the business press have a good chance of predicting the future. But do they? It depends on what you mean by the future. Do you mean the near future financial numbers of well-known companies, or do you mean something that has a bigger impact?

The answer to this question becomes clear when we look back into the past and see what was predictable and what was not. Think of what has happened in the last quarter century in Indian economy and stock markets. Could any of it be forecast? Think of both the big long-term trends as well as short-term ones. In the late eighties, could you have forecast the astonishing rise of the Indian software services? Was the rise in urban Indian living standards predicted by anyone? Was the coming drop in interest rates and the easy-money economy predictable in 1995? Was the resultant housing boom predictable? In 1996, when a cheap, basic mobile phone cost 20,000 of those days' rupees, did anyone make a correct prediction of how many mobile connections India would have in 2008? Was the near collapse of the global financial system in 2008 foreseen two years before that? In 2009, when the equity markets hailed the return of Manmohan Singh as India's Prime Minister with a stronger mandate, was the sorry mess of the next five years predictable? And of course, recent events are so firmly a part of this list that it's pointless to mention them.

Needless to say, there are many experts that can 'predict' these events in hindsight now. There's a kind of person who will now say that the vast pool of english-speaking and technical manpower made the rise of IT and ITES services exports inevitable, and that mobile telephony followed a predictable path in the fall in price of electronic goods. However, they're saying this now. And the movements of the stock markets have been just as much of a surprise. The direction as well as the sharpness of each bull market and bear market of the last two decades has been utterly unpredictable even a year or two before they happened.

So does that mean that investors have no basis on which to try and forecast what direction their investments should take? Not quite. In fact, the lack of predictability means that what remains is truly valuable. Which is, to judge quality businesses on the basis of long track record, and hold large and diversified portfolios so that the negative effects of company and sector-specific events can be evened out. In fact, even though they appear to be part of the same spectrum kind of activity, these are two fundamentally different approaches to investing. One is about trying to predict the future. And the other about taking a reasoned look at the present to try and judge what are the things that happened that will stay the course.