Robert Hagstrom's book "Investing: The Last Liberal Art" explores how a broad, liberal arts education can deepen and enhance the decision-making skills required for effective investing. The book's core argument revolves around the idea that understanding multiple disciplines provides a strategic advantage in the multifaceted investment world. Here's a deeper look into the connections Hagstrom draws between various disciplines and investing:
Connections to Various Disciplines
Physics:
Hagstrom discusses how concepts from physics, particularly those related to complex adaptive systems, can be applied to the stock market. The idea is that markets, like physical systems, are constantly adapting and changing, influenced by the interactions of numerous participants. Understanding this can help investors anticipate and react to market movements more effectively.
Biology:
The biological evolution concept of adaptation and natural selection is mirrored in economic markets through creative destruction, where new ones replace old, inefficient businesses. This biological parallel provides investors with a framework to identify companies that might thrive due to their adaptability and innovative capacities.
Sociology:
Sociological insights, particularly regarding crowd behavior and the influence of group dynamics on decision-making, inform investors about market sentiment and potential irrationalities in market trends. Understanding how and why people act in groups can help predict market movements, especially in volatile times.
Psychology:
Psychological elements play a crucial role in investment decisions. Hagstrom emphasizes how cognitive biases such as overconfidence and loss aversion can distort decision-making processes. Recognizing these biases in oneself and the market at large can lead to better investment choices.
Philosophy:
Philosophy provides a foundation for critical thinking and ethical considerations, essential in making investment decisions that require a deep understanding of markets and their impacts on society and individuals. Philosophical inquiry helps clarify what we know and how we know it, guiding more informed and principally sound investment strategies.
Literature:
Literature teaches empathy and understanding of human motives and behaviors, enriching an investor's ability to assess management quality and company culture, which are critical factors in long-term investment success.
Mathematics:
Mathematical models in probability and statistics help investors quantify risks and potential returns. Understanding mathematical concepts helps create models forecasting market trends and evaluating investment opportunities.
Decision Making:
Hagstrom discusses Kahneman’s theories on intuitive (System 1) and analytical (System 2) thinking. Investors benefit from balancing quick, intuitive judgments with careful, analytical reasoning to make optimal decisions.
Interdisciplinary Approach to Investing
Hagstrom proposes synthesizing knowledge from these diverse fields into a cohesive strategy allows investors to see individual investment opportunities more clearly and understand the broader market dynamics. This approach encourages continuous learning and curiosity, which is essential for adapting to the ever-changing investment landscape.
Broader Implications
The book also contemplates the broader implications of an interdisciplinary approach. In a world increasingly dominated by specialization, Hagstrom’s advocacy for a well-rounded education resonates not just in investing but in various aspects of personal and professional development. By promoting a culture of broad-based knowledge, individuals can approach problems with a richer set of tools and perspectives, leading to more innovative solutions and effective decision-making across all areas of life.
Direct and Rephrased Quotes and Phrases
1. A Latticework of Mental Models
o We do not learn new subjects because we have become better learners but because we have become better at recognizing patterns.
o According to Holland, innovative thinking requires mastering two important steps.
o First, we must understand the basic disciplines from which we will draw knowledge;
o Second, we need to be aware of the use and benefit of metaphors.
o True learning and lasting success come to those who make the effort first to build a latticework of mental models and then learn to think in an associative, multidisciplinary manner.
2. Physics
o Our ability to answer even the most fundamental aspects of human existence depends largely upon measuring instruments available at the time and the ability of scientists to apply rigorous mathematical reasoning to the data.
o The critical variable that makes a system both complex and adaptive is the idea that agents (neurons, ants, or investors) accumulate experience by interacting with other agents and then change themselves to adapt to a changing environment.
o If a complex adaptive system is, by definition, continuously adapting, it is impossible for any such system, including the stock market, ever to reach a state of perfect equilibrium.
o In an environment of complexity, simple laws are insufficient to explain the entire system.
3. Biology
o “Natura non facit saltum” - “Nature does not make leaps.”
o “The central point of his life work is that capitalism can only be understood as an evolutionary process of continuous innovation and creative destruction.”
4. Sociology
o The first principle is never to advise anyone to buy or sell shares.
o The second principle is to take every gain without showing remorse about missed profits.
o The third principle: Profits on the exchange are the treasures of goblins.
o The fourth principle: Whoever wishes to win in this game must have patience and money since values are so little constant and the rumors so little founded on truth.
o Characteristic a self-organizing system must contain to produce emergent behavior. That characteristic is diversity.
o The collective solution is degraded if the system is limited to only high-performing people. The diverse collective appears to be better at adapting to unexpected changes in the structure.
o The system, as long as it is adequately diverse, is relatively insensitive to moderate amounts of noise.
o Not until the system reached its highest noise level did the collective decision-making process break down.
o “As a crowd member, he at once becomes a blockhead.”
o “The mass never comes up to the standard of its best member.”
o “Under the right circumstances, groups are remarkably intelligent and are often smarter than the smartest people in them.”
o Two critical variables necessary for a collective to make superior decisions are diversity and independence.
o Suppose a collective can tabulate decisions from a diverse group of individuals with different ideas or opinions on solving a problem. In that case, the results will be superior to a decision made by a group of like-minded thinkers.
o Independence, the second critical variable, does not mean each group member must remain in isolation, but rather, each group member is free from other members' influence.
o A group composed of very smart and less-smart agents always did better at solving the problem than a segregated group of smart agents.
o “Diverse predictive models enable crowds of people to predict values accurately.”
o If the stock market is adequately diversified and, most importantly, if the decisions of its participants have been reached independently, then it is likely the market is efficient.
o What if the decisions of the market's participants are not independent but are now coalesced into one opinion? When this occurs, the system has effectively lost its diversity and along with it any chance of generating an optimal solution. If diversity is the key to how collectives can best reach solutions, then diversity breakdowns are the cause of suboptimal outcomes—or in the case of the stock market, diversity breakdowns cause the market to become inefficient.
o “Information cascades (which can lead to diversity breakdowns) occur when people make decisions based on the actions of others rather than on their private information. These cascades help explain booms, fads, fashions, and crashes.”
o Diversity breakdowns are not just a large group phenomenon but can also occur in smaller groups. Whether it be a committee, jury, or small working team, information cascades, which lead to diversity breakdowns, are often the result of a dominant leader operating with limited facts, sometimes even with no facts.
o Group decisions, even noticeably poor ones, have a profound influence over individual decisions.
o Large complex systems composed of millions of interacting parts can break down because of a single catastrophic event and a chain reaction of smaller events.
5. Psychology
o In essence, Kahneman and Tversky discovered that people are generally risk averse when making a decision that offers hope of a gain but risk seeking when making a decision that will lead to certain loss.
o Loss aversion and a frequent evaluation period contribute to an investor’s unwillingness to bear the risks of holding stocks.
o The single greatest psychological obstacle that prevents investors from doing well in the stock market is myopic loss aversion.
o “Most of the time, common stocks are subject to irrational and excessive price fluctuations in both directions as the consequence of the ingrained tendency of most people to speculate or gamble—i.e., to give way to hope, fear, and greed.”
o “The investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage,”
o The investors sold and repurchased almost 80 percent of their portfolio yearly.
o Two amazing trends:
o the stocks that the investors bought consistently trailed the market, and
o the stocks that they sold actually beat the market.
o On average, the most active traders had the poorest results, while those who traded the least earned the highest returns.
o The vast amount of information online enables investors to easily locate evidence that confirms their hunches, which leads them to become overconfident in their ability to pick stocks.
o “When people are given more information on which to base a forecast or assessment, their confidence in their forecasts tends to increase more quickly (and this is the important part) than the accuracy of the forecasts.” Information overload, they claim, can lead to an illusion of knowledge.
o People sense that they control their environment and decisions about their life. People who believe they have this control are called “internals.” In contrast, “externals” think they have little control; they see themselves as being like a leaf blown about by the wind.
o People will consistently select moderate to high risk options when they perceive the outcome depends on skill. But if they think the outcome is governed largely by chance, they will limit themselves to a much more conservative array of choices.
o People are information processors and construct mental models of reality to help anticipate events. With a “small-scale model of external reality and possible actions” in our head, we are able to “try out various alternatives, conclude which is the best of them, react to future situations before they arise, utilize the knowledge of past events in dealing with the present and the future, and in every way react in a much fuller, safer, and more competent manner to the emergencies which [we] face.”
o Mental models typically represent what is true but not what is false.
o Ongoing research has shown that our use of mental models is frequently flawed overall. We construct incomplete representations of the phenomena we are trying to explain. Even when they are accurate, we don’t use them properly.
o People are pattern-seeking creatures. Indeed, our survival as a species has depended on this ability. Shermer writes, “Those who are best at finding patterns (standing upwind of game animals is bad for the hunt, cow manure is good for the crops) left behind the most offspring [and] we are their descendants.”
o The Age of Science worked to reduce errors in thinking and irrational beliefs. But it did not, Shermer believes, eliminate magical thinking entirely.
o Magical thinking invades all people regardless of education, intelligence, race, religion, or nationality. We were not born in the prehistoric period, argues Shermer, but our minds were built there, and we function largely as we have throughout human history. We still succumb to magical thinking because as pattern-seeking animals we need explanations even for the unexplainable. We distrust chaos and disorder, so we demand answers, even if they are a product of magical rather than rational thinking. That which can be explained scientifically is. That which cannot is left to magical thinking.
o Through a long process of evolution, acutely uncomfortable and anxious in the face of uncertainty, so much so that we are willing to listen to those who promise to alleviate that anxiety. Even though we know in the rational part of our minds that market forecasters cannot predict what will happen tomorrow or next week, we want to believe they can because the alternative (not knowing) is too uncomfortable.
6. Philosophy
o The word philosophy is derived from two Greek words, usually translated as “love” and “wisdom.” A philosopher, then, is a person who loves wisdom and is dedicated to the search for meaning.
o The study of philosophy is divided into three broad categories.
o First, critical thinking as it applies to the general nature of the world is known as metaphysics. Metaphysics means “beyond physics.” When philosophers discuss metaphysical questions, they are describing ideas that exist independently from our own space and time. Examples include the concepts of God and the afterlife.
o The second body of philosophical inquiry is the investigation of three related areas: aesthetics, ethics, and politics.
§ Aesthetics is the theory of beauty. Philosophers who engage in aesthetic discussions are trying to ascertain what it is that people find beautiful, whether it be in the objects they observe or in the state of mind they achieve. This study of the beautiful should not be thought of as a superficial inquiry, because how we conceive beauty can affect our judgments of what is good and bad.
§ Ethics is the philosophical branch that studies the issues of right and wrong.
§ Politics is what is right or wrong at the societal level, political philosophy is a debate over how societies should be organized, what laws should be passed, and what connections peoples should have to these societal organizations.
o Epistemology, the third body of inquiry, is the branch of philosophy that seeks to understand the limits and nature of knowledge. Epistemology then is the study of the theory of knowledge. To put it simply, when we make an epistemological inquiry, we are thinking about thinking.
o When philosophers think about knowledge, they are trying to discover what kinds of things are knowable, what constitutes knowledge (as opposed to beliefs), how it is acquired (innately or empirically, through experience), and how we can say we know a thing. They also consider what kinds of knowledge we can have of different things.
o By learning to think well, we can better avoid confusion, noise, and ambiguities. Not only will we become more aware of possible alternatives, we will be more capable of making reliable arguments.
o Disorder is nothing more than order misunderstood.
o “Failure to explain is caused by failure to describe!”
o A fractal is defined as a rough or fragmented shape that can split into parts, each of which is at the least a close approximation of its original self. This is a property called self-similarity.
o The world we see is defined and given meaning by the words we choose. In short, the world is what we make of it.
o Reality is shaped by the words we select. Words give meaning.
o The two types of errors in formal statistics.
o Type I error occurs when we observe something not really there.
o A Type II error occurs when we fail to observe something that is there.
o “The focus of stories is on the individual rather than the averages, on motives rather than movements, on context rather than raw data”
o “A thousand stories which the ignorant tell, and believe, die away at once when the computist takes them in his gripe.”
o It is through thinking that people resolve doubts and form their beliefs, and their subsequent actions follow from those beliefs and become habits. Therefore, anyone who seeks to determine the true definition of a belief should look not at the belief itself but at the actions that result from it.
o The meaning of an idea is the same as its practical results. “Our idea of anything is our idea of its sensible effects.”
o “The whole function of thought is to produce habits of action. To develop its meaning, we have, therefore, simply to determine what habits it produces, for what a thing means is simply what habit it involves.”
o A belief is true, not because it can stand up to logical scrutiny but because holding it puts a person into more useful relations with the world.
o An idea or an action is true, real, and good if it makes a meaningful difference.
o Truth will change as circumstances change and as new discoveries about the world are made. Our understanding of truth evolves.
o We can never expect to receive absolute proof of anything.
o No one theory is the “absolute transcript of reality, but any one of them may from some point of view be useful.”
o We learn by trying new things, by being open to new ideas, by thinking differently. This is how knowledge progresses.
o The only way to do better than someone else, or more importantly, to outperform the stock market, is to have a way of interpreting the data that is different from other people’s interpretations.
7. Literature
o There are four main questions you need to ask of every book:
o What is the book about as a whole?
o What is being said in detail?
o Is the book true, in whole or part?
o What of it?
o “You must check your opinions at the door, you cannot understand a book if you refuse to hear what it is saying.”
o Good readers are good thinkers; good thinkers tend to be great readers and in the process learn to be even better thinkers.
o Dupin’s methods, what lessons can we learn?
o Develop a skeptic’s mindset; don’t automatically accept conventional wisdom.
o Conduct a thorough investigation.
o Holmes’s methods?
o Begin an investigation with an objective and unemotional viewpoint.
o Pay attention to the tiniest details.
o Remain open-minded to new, even contrary, information.
o Apply a process of logical reasoning to all you learn.
o What does Father Brown have to teach us?
o Become a student of psychology.
o Have faith in your intuition.
o Seek alternative explanations and redescriptions.
o “We should be reading for the sake of reading rather than reading for the sake of having read.”
8. Mathematics
o “A bird in hand is worth two in the bush.”
o Investors pick stocks similarly to how a newspaper might run a beauty contest in which people are asked to pick the most beautiful woman from among six photographs. The trick to winning the contest was not to pick the woman you thought was the most beautiful, but the one you thought everyone else would consider the most beautiful.
o The intrinsic value of a common stock, for example, is the present value of the future net cash flows earned over the life of the investment. You count the cash flows the business will generate for a period into the future and then discount that total back to the present.
o Nature's patterns are only partly established, so probabilities in nature should be thought of as degrees of certainty, not as absolute certainty.
o “We modify our opinions with objective information:
“Initial Beliefs + Recent Objective Data = A New and Improved Belief.”
o Abstractions: Most of us tend to see the world along a bell-shaped curve with two equal sides, where mean, median, and mode are all the same value. Nature does not always fit so neatly along a normal, symmetrical distribution but sometimes skews asymmetrically to one side or the other. In a right-skewed distribution, the measures of central tendency do not coincide; the median lies to the right of the mode and the mean lies to the right of the median. “Our culture encodes a strong bias either to neglect or ignore variation; we tend to focus instead on measures of central tendency, and as a result, we make some terrible mistakes, often with considerable practical import.”
o “Many shall be restored that now are fallen, and many shall fall that are now in honor.”
o Reversion to the mean is not always instantaneous. Overvaluation and undervaluation can persist for a period longer—much longer—than patient rationality might dictate.
o Volatility is so high, with irregular deviations, that stock prices don’t correct neatly or come to rest easily on top of the mean. Last, and most importantly, the mean itself may be unstable in fluid environments (like markets). Yesterday’s normal is not tomorrow’s. The mean may have shifted to a new location.
o “Nature has established patterns originating in the return of events, but only for the most part.”
o Risk involves situations with unknown outcomes but is governed by probability distributions known at the outset. We may not know exactly what is going to happen, but based on the past events and the probabilities assigned, we have a pretty good idea what is likely to happen.
o Uncertainty is different. We don’t know the outcome with uncertainty, but we also don’t know what the underlying distribution looks like, and that’s a bigger problem. Knightian uncertainty is both immeasurable and impossible to calculate. There is only one constant: surprise.
o A “black swan,” as described by Taleb, is an event with three attributes:
o “it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility,
o it carries an extreme impact,
o In spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable.”
o The world is shaped by wild, unpredictable, and powerful events, which is called “Extremistan.” In Taleb’s world, “History does not crawl, it jumps.”
o “Our knowledge of the way things work, in society or in nature, comes trailing clouds of vagueness. Vast ills have followed a belief in certainty.”
o “When our world was created, nobody remembered to include certainty; we are never certain; we are always ignorant to some degree. Much of the information we have is either incorrect or incomplete.”
o The real trouble with this world of ours is not that it is an unreasonable world, nor even that it is a reasonable one. The commonest trouble is that it is nearly reasonable but not quite. Life is not an illogicality, yet it is a trap for logicians. It looks just a little more mathematical and regular than it is; its exactitude is obvious, but its inexactitude is hidden; its wildness lies in the wait.
9. Decision Making
o System 1 thinking is intuitive. It operates automatically, quickly, and effortlessly without voluntary control.
o System 2 is reflective. It operates in a controlled manner, slowly and with effort. The operations of System 2 thinking require concentration and are associated with subjective experiences that have rule-based applications.
o There are indeed cases where intuitive skill reveals the answer, but that such cases are dependent on two conditions.
o First, “the environment must be sufficiently regular to be predictable.”
o Second, there must be an “opportunity to learn these regularities through prolonged practice.”
o Intuition appears to work well in linear systems where cause and effect are easy to identify. However, in nonlinear systems, including stock markets and economies, System 1 thinking, the intuitive side of our brain, is much less effectual.
o “The situation has provided a cue; this cue has given the expert access to information stored in memory, and the information provides the answer. Intuition is nothing more and nothing less than recognition.”
o Increasing the amount of information stored in memory increases our skill at intuitive thinking. Further, the failure of System 2 to override System 1 is largely a resource condition. “In some judgmental tasks, information (in System 2 thinking) that could serve to supplement or correct the heuristic (occurring in System 1 thinking) is not neglected nor underweighted, but simply lacking.”
o Like the rest of us, experts are penalized by thinking deficiencies. Specifically, they suffer from overconfidence, hindsight bias, belief system defenses, and a lack of Bayesian process.
o We rush to make an intuitive decision, not recognizing that our thinking errors are caused by our inherent biases and heuristics. Only by tapping into our System 2 thinking can we double-check the susceptibility of our initial decisions.
o Hedgehogs, who viewed the world through the lens of a single defining idea, and foxes, who were skeptical of grand theories and instead drew on a wide variety of experiences before making a decision.
o Calibration, which can be thought of as intellectual humility, measures how much your subjective probabilities correspond to objective probabilities.
o Discrimination, sometimes called justified decisiveness, measures whether you assign higher probabilities to things that occur than to things that do not.
o Hedgehogs have a stubborn belief in how the world works, and they are more likely to assign probabilities to things that have not occurred than to things that actually occur.
o Foxes have three distinct cognitive advantages.
o They begin with “reasonable starter” probability estimates. They have better “inertial-guidance” systems that keep their initial guesses closer to short-term base rates.
o They are willing to acknowledge their mistakes and update their views in response to new information. They have a healthy Bayesian process.
o They can see the pull of contradictory forces, and, most importantly, they can appreciate relevant analogies.
o Intelligence tests typically measure mental skills that have been developed over a long period. But remember, the most common thinking errors have less to do with intelligence and more with rationality—or, more accurately, the lack of it.
o What Intelligence Tests Miss: “Humans are cognitive misers because our basic tendency is to default to the processing mechanisms that require less computational effort, even if they are less accurate.” Humans are lazy thinkers. They take the easy way out when solving problems and as a result, their solutions are often illogical.
o “A piece of mindware is anything a person can learn that extends the person’s general powers to think critically and creatively.”
o Metacurriculum: the ‘higher order’ curriculum that deals with good thinking patterns in general and across subject matters.”
o As Charlie Munger has said, “It is only by reading that you are able to continuously learn.”
o Find a way to use productively what we already know and at the same time actively search for new knowledge—or, as Holland adroitly phrases it, “we must strike a balance between exploitation and exploration.”
o As investors, "we too must strike a balance between exploiting what is most obvious while allocating some mental energy to exploring new possibilities."
o Never stop discovering new building blocks.
o If we stop exploring new ideas, we may still be able to navigate the stock market for a while, but most likely, we are putting ourselves at a disadvantage in tomorrow’s changing environment.
o “To a man with only a hammer, every problem looks pretty much like a nail.” Now, said Charlie, “One partial cure for man-with-hammer tendency is obvious: if a man has a vast set of skills over multidisciplines, he, by definition, carries multiple tools and therefore will limit bad cognitive effects from the ‘man with a hammer’ tendency. If ‘A’ is a narrow professional doctrine and ‘B’ consists of the big, extra-useful concepts from other disciplines, then, clearly, the professional possessing ‘A’ plus ‘B’ will usually be better off than the poor possessor of ‘A’ alone. How could it be otherwise?”
o The challenge we face as investors and very much as individuals has less to do with the available knowledge than with how we choose to put the pieces together.
o The art of achieving what Charlie Munger calls “worldly wisdom” is a pursuit that appears to have more in common with the ancient and medieval periods than with contemporary studies, which mostly emphasize gaining specific knowledge in one particular field.
o The Roman poet Lucretius writes: “ nothing is more sweet than full possession of those calm heights, well built, well fortified by wise men teaching. To look down from here, at others wandering below, men lost, confused, in a hectic search for the right road.”
o Those who constantly scan in all directions for what can help them make good decisions will be the successful investors of the future.
o “The good education of youth has been esteemed by wise men in all ages as the sweet foundation of happiness.”
Conclusion
Robert Hagstrom's "Investing: The Last Liberal Art" provides a compelling argument for applying a broad, interdisciplinary approach to learning as a key tool in effective investing. By understanding and applying knowledge from various fields, investors can develop a more comprehensive view of the market, leading to better decision-making. Hagstrom’s work serves as a guide to investing and a call to cultivate a deeper appreciation for learning across life’s many spectrums. His insights encourage us to look beyond narrow specialties and embrace a more holistic view of knowledge and its practical applications in everyday decisions, particularly in the complex investing world.