Highlights From Recent Hedge Fund Letters: 2019Q3
I love reading investment fund letters. This business requires a rare combination of variant insight and brutal intellectual honesty, which the best managers express in their writing. My highlights from the best letters I read this quarter are below, in no particular order. In this piece I mostly avoid quoting on specific stocks, and focused on broad investing and psychology themes. You can find plenty of investment ideas by following the links to the letters. This quarter several funds discussed the value/growth divide, the underappreciated risk of inflation(or deflation), business impact of negative interest rates, and mental model challenges in investing.
Thanks to the generous curators that make this possible. Mine Safety Disclosures is probably the best single source for hedge fund letters. They’ve sought out and organized many off the beaten path managers that I wasn’t reading before. The investment letter page on Reddit is another great source. I found several of these letters on twitter as well.
Vtltava Fund had one of my favorite letters this quarter. Here is their perspective on hyperbolic discounting :
I always say that one can learn a lot just by looking around oneself, seeing how the world works as well as how people perceive it. The way people perceive the world is then reflected in how investors (a subset of people) perceive the events on the capital markets (a subset of the world). The aforementioned tendency to overestimate short-term events and underestimate the importance of longterm trends is very strongly demonstrated in both cases. (Finance theory even has a name for this: hyperbolic discounting.)
On long term vs short term:
If we as investors were to profit from shortterm events, we would have to be able to recognize the truly fundamental ones in real time as they are happening. This is practically impossible, and even the effort to do so might bring very negative results, because in most cases it will transpire that one has overreacted to something that in the end will have been of no practical importance. We find it is much better to take the approach of betting on long-term expected developments in society.
One of the most cogent defenses of the valuable role that the finance sector can play in society:
For the capital market to work well and efficiently and for it to allocate capital at low costs, there must exist a sizeable number of entities of various types. Vltava Fund is one of those entities. Our role in the overall system is twofold: we act as intermediaries and analysts. We collect free capital from investors who want to invest and then analyse the individual investment opportunities to determine those into which we invest the collected capital. Even though we are just a tiny cog in the gigantic global markets machine, I am very proud of the work we do and how all of us associated with investing in Vltava Fund contribute collectively to the general progress, growth of wealth, and betterment of society.
Tollymore on epistemic humility and the Gell-Mann effect:
Serious media publications invent stories to explain outcomes, without the resources or inclination to determine causality. This often manifests itself in major descriptive U-turns as the outcome changes with the wind. The matters about which financial and political journalists opine are complex. This limits the mechanism to scrutinise these stories and hold their authors to account. And there is value to their readers and listeners, who can paraphrase talking heads’ memorable soundbites at cocktail parties rather than acknowledging ignorance or retrieving the relevant facts from their addled brains. Authority bias plays a role: media appearance confers credibility, the belief in which is counter to independent thought and self-awareness. Unsubstantiated conjecture is rife. As Mr. Crichton puts it: “one problem with speculation is that it piggybacks on the Gell-Mann effect of unwarranted credibility, making the speculation look more useful than it is”.
The goal of epistemic humility is consistent with maintaining a careful distance from today’s media. To exercise good judgement, we should shield ourselves from the Gell-Mann effect. Financial markets, political and economic systems, unlike meteorology, are reflexive; participants are second guessing one another and the bases on which decisions are made are altered by the decisions themselves. Speculation thrives because it is cheap and speculators are not held to account, but forecasting is foolish when nobody knows the future.
Epistemic humility is a key concept I try to apply in my approach to life.
Greenhaven Road discussed how they subdivide investments in high quality companies into those that are bets on the status quo continuing, vs those that are bets on the status quo changing.
They are also SPAC curious. They rarely do SPACs, but interesting what he goes through when he does they go to extreme lengths to compete due diligence, which they discuss in a case study.
Also, they have decided to make an investment in South Africa, which is a bit unusual for them. Here is some of their reasoning:
Why Bother with South Africa? For me, there are two parts to the answer. The first is a desire to hold some non-U.S. companies. While it is true that the world catches a cold when the United States sneezes, South Africa is in the interesting position of having not meaningfully participated in the last decade’s equity market growth due to poor political leadership, poor policy choices, and corruption. I believe that new leadership and positive reforms are likely to place South African equity markets in a position to be less correlated to developed equity markets yet produce positive returns, albeit more volatile. This is intended to be rational diversification.
The second and more important reason to venture to South Africa is the potential for returns. With a bit of continued growth, operating leverage, and anything approaching a fair multiple, I believe that the price of the shares we are acquiring could very realistically go up 5X. A hundred things can prevent that type of return from being realized, but given how absolutely beaten down South Africa is from a valuation perspective, any return to normalcy could produce abnormally positive returns.
They have some great points. We’ve also found opportunity in Africa.
Alta Fox Capital
Alta Fox on the concept of zooming in and zooming out:
The concept of “zooming in and out” is an important one for my investment process, both from a single idea and a portfolio construction perspective.
For any individual idea, it is important to “zoom in” to understand the unit economics of a business, appreciate the finer nuances of the financial model, and to develop a sound valuation technique. However, it is equally important to “zoom out” and to understand at a higher-level what could go wrong, develop intuition for risk and uncertainties that transcend a few valuation scenarios, and know when to ride winners or when to fold losers. For a broader portfolio management perspective, it is also important to zoom in and out. It is important to track performance relative to indices over time as that is ultimately the measuring stick, and if the market is disagreeing with you, it is important to know why. However, one has to zoom out and focus on the process because too much focus on short-term performance is absolutely detrimental to day by day decision-making.
The abilities to zoom in and out are different skills. This is one of the primary distinctions between a good analyst and a good portfolio manager. They have complementary, but different, skill-sets. An analyst is most often tasked with “zooming in,” which normally involves ripping a business apart and understanding the filings at a very rigorous level. A portfolio manager, on the other hand, must have an overarching philosophy on how to allocate scarce research time to specific ideas, passing on others, how to size positions, etc. The best investors are capable of simultaneously zooming in and out.
Firebird on negative interest rates:
In theory, companies trade at the present value of all future earnings. There are two key inputs to this: earnings and the discount rate. Companies that are growing earnings faster should be valued higher than companies with a slower growth rate, but how much more depends on the discount rate.
Consider a simple thought experiment at different interest rates: Company A is growing earnings at 2% per annum while Company B is growing at 15%. At a 7% blended discount rate, Company A is worth 17x this year’s earnings, while company B is worth 107x! Company B is value higher but has a much higher sensitivity to interest rates. A mere 1% change in the blended discount rate leads to 35% drop in value of Company B, while Company A valuation drops by only 15%
Note we also wrote up an extensive Negative Interest Rates Thought Experiment here. The implications across the economy are startling.
Of course, so are the implications of reversing negative interest rates, as Firebird points out:
In the U.S. market, growth companies have been outperforming value dramatically since the beginning of 2015, when we first started seeing corporate debt trading in negative territory. We believe that this outperformance is in large part due to repricing the cost of capital in light of the likelihood that low rates could persist for longer than originally anticipated. With the negative impact of low rates becoming more apparent every day, it is not surprising that the market reacted to the possibility that the policy of low negative interest rates may be in question.
According to Third Point, the markets aggregate results have masked a “tumultuous factor rotation” taking place underneath the surface.
In August, equity portfolios tied to momentum or the near inverse – “laggards” – outperformed, as markets inflated assets reflecting economic weakening in a low inflation/low growth world. These momentum asset biases – favoring large cap over small cap stocks, growth versus value, or “min vol” strategies – became increasingly correlated, crowded, and sometimes expensive. The equation extended itself more acutely in secular growth names and similarly punished unloved shorts.
Third Point has increased its emphasis on activism. Currently activist names account for 40% of their assets, the highest percentage in history.
Askeladden Capital’s letter this quarter reflected a maturing process. They discuss the limitations of primary research, and how their approach to risk has changed:
In certain circumstances (such as levered companies), we have become far more conservative, and less willing to underwrite certain outcomes with any confidence whatsoever. In other circumstances (such as recurring revenue businesses), we have become far less conservative, and far more willing to underwrite certain outcomes with a high degree of confidence. We have become more aggressive in underwriting knowable factors which we can understand better through thorough research and become far more conservative in underwriting unknowable factors which we generally believe cannot be elucidated by research to a degree helpful for the investing process. When we aren’t sure if something is knowable or unknowable, we like to default to ´unknowable for conservatism -overconfidence is killer in our business.
Nuances like these are what drive outperformance …
The letter was also full of links to articles on mental models. Separate letter for clients that includes specific positions. I won’t disclose any specific positions , but I will say as a client that performance has been solid, and there are several intriguing investments currently in the portfolio.
Comus Investment’s letter had some intriguing criticism of dividend investing:
Firstly the term dividend- investor makes no sense at all to me, and it makes even less sense than the fabricated demarcation between supposed growth and value investors. Dividend- investing often implies that one is investing with the goal to receive a currently yield at the expense of long term capital appreciation as if the two sources of returns are distinct(they aren’t)
Also, notable discussion on absurdities in the valuation in SAAS companies
Any tech investors reading this will likely roll their eyes given how often they are mentioned but I have to bring up the SAAS basket of stocks. I believe it is lower now, but last I saw the entire group of public SAAS-related stocks was valued above 10x sales. This is similar to 100 fishermen at a single lake estimating they can each catch a fish a day with only 10 fish in the lake- for the fishermen to be right the fish will have to reproduce extremely quickly. The entire industry is valued as if every investor will do extraordinarily well and each business is valued as if it will experience organic ROE’s of 20%+ for decades.
Theye also had an interesting point about how accounting changes (ASU 2014- 09B) will influence SAAS accounting
Punch & Associates
In their latest letter, Punch & Associates frames a fascinating discussion around the parallels between the Screwtape Letters (great book) and the emotional and psychological challenges investors face. Screwtape Letters are fictional letters from Screwtape, to his nephew Wormwood, part of an underworld organization charged with taking souls from people trying to live a righteous life.
parallels exist between the forces (temptations, distractions, habits) acting on the Patient and the forces impacting the hearts and minds of individual investors. While these forces may not be described as demonic (some may be), and while the fate of one’s soul may not hang in the balance, the fact that these forces exist and that we are all vulnerable at times does indeed matter. The world is not perfectly architected so that you can get rich, beat the S&P 500, or even reach your financial goals. Quite the opposite.
People’s lives go through peaks and troughs, and this impacts thaeir ability to live a good life. Similarly, peaks and troughs in the market impact people’s ability to make rational decisions.
Closely related, there are great lessons for dealing with temptation of noise:
Noise is something that we all deal with in investing and in our lives. Like Wormwood’s whisperings, it’s constant. Noise can enter into your life and cloud both your judgement and priorities. People are subject to it one moment, and then they are not. The effect of noise, therefore, undulates. It’s not enough, however, to occasionally ignore noise, because mistakes are made in moments. Wormwood’s efforts are like the noise we encounter today, constantly whispering in our ears.
Pangolin Investment Management
Pangolin Investment Management is focused on Asia, and their August letter made some interesting points about tax policy in Southeast Asian countries . Also they have some commentary on a challenging history/geopolitics situation in Indonesia. In their October letter Pangolin discussed car racing in Malaysia, and the broader meaning implications for emerging markets.
Lifestyles are changing quickly in Asia. Motor racing with all its glamour is a million miles away from Lombok’s subsistence padi farming of 20 years ago. Here, income growth lifts people from being poor farmers to basic consumers, and then on to becoming middle class discretionary spenders.
It’s not just about a GDP growth, but the massive change in people’s lifestyles that accompanies it.
Ensemble Capital on the three types of traps they avoid:
We’ve identified three traps we want to avoid. First, the commoditization trap. This is when there’s strong management in place and an easy-to-understand business, but either a non-existent or narrowing moat. Much of a company’s intrinsic value is driven by its so-called “terminal value” – the value the business will create over the very, very long term. As such, if we’re not confident that a company can maintain or widen its economic moat beyond 5 or 10 years, estimating terminal value becomes increasingly difficult. In this circumstance, long-term returns on invested capital and growth – the two pillars of our valuation model – can decline faster than might otherwise be expected. Some investors are comfortable making a bet on a company decline being slower than market expectations – and that’s another way to make money – but we think that’s a dangerous game and one we intentionally avoid.
The second trap is a stewardship trap. This is when there’s evidence of a durable moat and an easy-to-understand business, but we lack confidence in management. We live in a hyper-competitive economy where cheap and abundant capital and new advertising platforms have made it easier than ever for challengers – whether that’s a startup or Amazon – to take on lazy incumbents and chip away at their business. Because of this, we require our companies to be managed by what we consider to be good business stewards. Our management teams need to understand how to create sustainable value and thoughtfully allocate capital.
The final trap is the complexity trap. This is when we like management and think there’s a durable moat, but we just can’t get comfortable understanding the business. Sometimes the reason is that we lack requisite domain knowledge in a specialized field. Other times, the financials are opaque, or the business operates in multiple competitive arenas and we struggle to grasp unit economics. Before investing in any company, we want to appreciate the known risks and the so-called “known unknowns” about the business, and a lack of understanding prevents us from achieving this.
Artko Capital’s latest letter included discussion on investment business challenges of focusing on microcaps. Although returns in the space are lucrative, structural reasons that opportunities are left for smaller funds. Also includes a great case study on handling portfolio responsibilities as a portfolio manager when investing in turn around type situations.
Andaz Private Investment
Andaz Private Investment’s latest letter includes some provocative commentary on the real meaning of inflation statistics:
There is a prevailing argument out there that inflation is nowhere to be seen, and that deflationary forces are at play e.g. technology replacing workers, offsetting the effects of money printing. In our view, this is naive. The metric used to measure inflation (CPI) is misleading and we would argue, deceptive. In fairness, the Australian Bureau of Statistics makes no attempt to hide this and has the following disclaimer:
“In practice, no statistical agencies compile true cost of living or purchasing power measures as it is too difficult to do.”
Other bodies are not so forthcoming. Central banks have decided that this garbage-in, garbage-out statistical measure is their sacred metric, that 2.0% is their precise target, and will print money until that figure is very close to 2.0% but not over it.
The most crucial criteria for investment over the foreseeable future will be to hold assets and securities which can outrun inflation (e.g. businesses which can raise prices or use levers to increase profits/earnings on a per share – again undiluted – basis).
The East 72 Quarterly letter had some interesting macro discussion on company earnings trends.
Additionally, they also discussed a bunch of super cheap, esoteric investment/asset holding company investments. Listed investment companies in Australia seem like an especially interesting hunting ground these days.
It has been noteworthy that the mania surrounding Australian LIC’s, rather than subsiding, has turned to near derision in some cases. This is leading to a number of corporate actions and activist behaviour designed to close up value gaps or force liquidation against hefty fee imposts for “me-too” investment strategies. …
We have always held the belief that having permanent capital available means that a far more esoteric/illiquid investment strategy can be pursued (in essence, that’s the basis of East 72 itself). However, in these situations, care needs to be taken to retain liquidity to ensure discounts to NAV do not blow out.
Great discussion on the different types of edge in the Saber Capital letter. This comment on time horizon edge is key for long term investors:
….the deterioration of the info edge has actually increased the size of the “time horizon” edge.
GMO recently released a letter called Shades of 2000:
..many investors made the case in 2000 that long-term averages were not meaningful anymore and the future would be far different from the past. From the standpoint of the world from 200-2010, those investors proved to be wrong as asset prices
Value investing is way out of favor these days, but GMO believes the current environment that value investors have had in 20 years.
Horizon Kinetics 2019Q3 letter summarizes their current investment positining this way:
The composition of our equity portfolios is intended to avoid making their performance dependent on the continuation of the status quo.
They discuss what type of companies might do well under different scenarios, and include this handy diagram:
Horizon Kinetics’ points out that most investors are all invested in the same group of stocks, and are not prepared for any inflation. Enroute they point out some of the absurdities of ETF land, such as the fact that the same stocks are classified as both growth, value, low vol, high dividend in different indexes.
A couple of interesting statistics, since this discussion is all about diversification. This year through September, the daily price correlation of the following indexes with the S&P 500 were all between 0.86 and 0.98, meaning that their price behavior varied almost identically with the S&P 500: S&P 500 Growth ETF, the S&P 500 Value ETF, the Russell 2000 ETF of small-cap stocks, and the All Country World Index Ex-U.S. The greatest variance, among the major equity classifications was from the Emerging Markets ETF, and that fund mirrored the S&P 500 77% of the time.
People think they are diversified, but they aren’t.
Focused Compounding discusses different types of price risks in their investments. They explains why they look for a combination of low share turnover , and low beta in order to identify underfollowed stocks. It contained this gem of a quote :
In investing: beta is like syphilis. If art, cash, gold, or bonds are inherently lousy, low returning assets (barren islands) – then, institutions and individual investors can simply switch into inherently more productive assets like stocks, farmland, timberland, real estate, etc. (fertile islands) and collectively lower the risk they won’t achieve their long-term financial goals.
They use a couple case studies to discuss why their experience has led them to personally prefer “compounders” to asset plays as well.
Silver Ring Value Partners
Silver Ring Value Partners mostly follows a bottom up stock picking strategy. However, they have decided to put on a Minsky style tail hedge, which they discuss in detail in the letter. They looked for for companies that have high debt levels and will need to refinance soon. These companies are most likely to decline severely in a panic. Its a great example of combining micro and macro- of a bottom up investor, productively worrying from the top down.
See also: Thinking and Applying Minsky
Templeton & Phillips Capital Management
Tempelton & Phillips latest letter has interesting commentary on how the value and growth divide is blurring when you look carefully. (see also: Why All Great Investors Are Intellectual Cross Dressers)
Excellent analysis of how intangible assets influence modern balance sheet analysis:
…the assets driving economic gains today are more closely related to Mickey Mouse in nature, than they are to the tangible assets that statistical measures, accounting methods, and valuation methods were designed around in the last century. This reality has created significant challenges for today’s economists and accountants, who still struggle to account for intangible assets that defy being touched, seen, measured, valued, and in some cases even fully understood. Rather than tackle the anomalous values of Mickey Mouse, or the formula for Coke,
economists and accountants today are tasked with collecting, interpreting and recording data representing a widely expanded realm of intangible assets including: in-house proprietary software, customer databases, customer network effects, business processes, and organizational structures. So, while the assets listed above are very real to shareholders, and tend to be more durable than not, the business activities used to create them flow through the income statement as expenses, rather than get recorded on the balance sheet as an investment. In sum, the financial parties that collect and report data to the markets are failing to capture an increasing amount of economic activity tied to today’s growth in intangible assets.
One final note here is that we believe in order for a Ben Graham style asset-based valuation approach to be successful today—such as the widely used price to book ratio—the analysis would need to make an estimate regarding the value of intangible assets (not fully reported in financials) in order to calculate a reasonably accurate ratio. Since many intangible assets are not counted in traditional book value, the price to book value without any adjustment appears inflated (and expensive). Similarly, a low price to book ratio without any adjustments implies to us the possible need for asset write-downs or a firm’s reliance on underperforming tangible assets. Since low price to book ratios are a key focus for the “value” indices, we believe
these measures have a bias towards selecting firms with less productive assets. To the extent this is true, this collection of assets are very likely to underperform the overall market, much less the growth stocks where earnings estimates are growing even faster (but may not be sustainable).
White Crane discusses the bifurcation of the credit markets between companies that can raise tons of easy money on easy terms, and those unable to raise any at all.
Such bifurcation of credit markets is often witnessed in the latter stages of credit cycles, as the availability of capital erodes. With credit availability becoming finite, lenders allocate only towardsselect borrowers, while others are either forced to pay exorbitant rates or seek other forms of Capital.
In order to take advantage of this market bifurcation, and a potential transition into a broader credit downturn, the Fund has built short positions in a basket of corporate credit securities.
These short positions can be grouped into two categories:
1) Investment grade credits that currently have access to unlimited amounts of low-costcredit; and
2) High yield credits that, in our opinion, do not have access to capital markets – yet are being priced as if they are investment grade credits with unlimited access to inexpensive
The common theme between all the credits in our short basket is that the all-in negative carry is low and they each have specific catalysts that we believe will result in a re-rating of the securities. Through this basket, we have created inexpensive capital structure put options where our downside is limited (i.e. essentially the negative carry) and our potential upside is substantial should our identified catalysts unfold. We expect to continue adding to this basket of credit shortsas the credit cycle becomes increasingly elongated and additional opportunities emerge.
Saga Partners latest letter on investing in a time of heightened uncertainty
… when is there not a heightened sense of uncertainty in the markets? And when markets do inevitably panic again, as they did in the fourth quarter of last year, will investors then overcome their fears and say now is the right time to invest? Or will they wait until things calm down and become less uncertain?
We are certain that another recession will happen sometime in the future, but we do not know when it will happen, how long it will last, or how extreme it will be. We do not even know how the market will react going into and coming out of it. We do know during 2008 following the Lehman Brothers bankruptcy and subsequent financial meltdown, the outlook at the market lows was far from certain. We prefer to keep our heads down, ignore the noise, and simply look for the best opportunities we can find given the information we have today. As we’ve noted before, more money has been lost waiting for corrections or trying to anticipate them than has been lost in the corrections themselves.
On value vs growth:
A company is neither cheap nor expensive because of where it sells relative to recent fundamentals. These classifications of value or growth are just a convenient box ticking, quantitative oriented practice used by consultants which can distort the investing process. While different styles, genres, or investing factors may go in and out of favor at times, at the end of the day, the value of a stock is all the cash that can be taken out of a company going forward.
They also had a detailed discussion on how fee structure impacts ultimate returns to investors.
In contrast with Horizon Kinetics, Forager Funds argues that it might actually be deflation for which investors are most egregiously underprepared.
Many investors assume that “what goes down must go up”. Many of our clients lived through the inflation of the 70s and 80s and seee its return around every corner. But what if that period was the anomoly rather than the rule. We all thought that the stimulus andgrowth in money supply after the financial crisis was certain to kick start an inflationary spiral. It hasn’t. In fact, inflation has been worryingly low. Best prepare, I would suggest, for a sustained period of zero rates.
More importantly, what do these zero rates imply about the future of the economy? What if, rather than rates going up, we are headed for a long period of low growth and deflation?
Low nominal rates are not necessarily a panacea for borrowers. It feels like it because the interest payments today are so low. But if we are headed for a deflationary world, its repayments later in life that you need to worry about.
The world might be “turning Japanese. Forager’s research into ASX listed Japanese property trusts leads to some startling conclusion of what that might be like. They were initially intrigued by how the companies were, but then realized that with wages, and rents falling in 18 out of 20 years, they might think they were earning a good return only to one day find the property was worth less than the debt.
Today’s low rates are sending a very important signal. The world is turning more and more Japanese.
If that is the world we are headed for, be very wary of debt.
In addition to this macro commentary, the letter includes a lot of intriguing off the beaten stock ideas in Asia.
What great managers did I leave out? Send me your favorite hedge fund letters.
Test counter-intuitive things because no one else ever does
Alchemy one of a small set of books that helped fill out important gaps in my understanding of how the world works. Its essential reading for people who think they are logical, and valuable for everyone else. I’ve organized my (copious) notes and highlights around key themes below. But seriously you should just get the book.
- Not everything that makes sense works, and not everything that works makes sense.
- Test counterintuitive things and ask dumb questions .
- Never denigrate something as irrational until you have considered what purpose it really serves.
- Try to understand the real reason for things(not the surface reason)
- Cooperation has major evolutionary value, but most deductive logical thinking ignores it.
- If you optimise incentive systems(or anything else) in one direction, you may be creating a weakness somewhere else.
- People are way too confident in traditional technocratic approaches and big data solutions relative to how well they actually work
- Hacking personal improvement: Many important features of the human brain are not under our direct control but are instead the product of instinctive and automatic emotions.
- Embrace uncertainty.
Not everything that makes sense works, and not everything that works makes sense.
We used to have a shortage of conventional deductive logic. Now we have too much. Conventional deductive logic is often a good thing. However we have venerated this manner of thinking so much that we have become blind to the situations in which it doesn’t work. Complex and evolved systems are not consciously designed, and often second order consequences that aren’t readily apparent are more important than what can be analyzed on the surface. Evolution doesn’t care if things make sense- it only cares if things work. Therefore, trial and error usually works better than reasoning everything out before acting.
Often when a phenomenon or group behavior doesn’t seem logical/rational, it is because the observer has an incomplete model of reality.
Not everything that makes sense works, and not everything that works makes sense. The top-right section of this graph is populated with the very real and significant advances made in pure science, where achievements can be made by improving on human perception and psychology. In the other quadrants, ‘wonky’ human perception and emotionality are integral to any workable solution. The bicycle may seem a strange inclusion here: however, although humans can learn how to ride bicycles quite easily, physicists still cannot fully understand how bicycles work. Seriously. The bicycle evolved by trial and error more than by intentional design.
There are two separate forms of scientific enquiry – the discovery of what works and the explanation and understanding of why it works. These are two entirely different things, and can happen in either order. Scientific progress is not a one-way street. Aspirin, for instance, was known to work as an analgesic for decades before anyone knew how it worked. It was a discovery made by experience and only much later was it explained. If science did not allow for such lucky accidents,* its record would be much poorer – imagine if we forbade the use of penicillin, because its discovery was not predicted in advance? Yet policy and business decisions are overwhelmingly based on a ‘reason first, discovery later’ methodology, which seems wasteful in the extreme. Remember the bicycle. Evolution, too, is a haphazard process that discovers what can survive in a world where some things are predictable but others aren’t. It works because each gene reaps the rewards and costs from its lucky or unlucky mistakes, but it doesn’t care a damn about reasons. It isn’t necessary for anything to make sense: if it works it survives and proliferates; if it doesn’t, it diminishes and dies. It doesn’t need to know why it works – it just needs to work.
Perhaps a plausible ‘why’ should not be a pre-requisite in deciding a ‘what’, and the things we try should not be confined to those things whose future success we can most easily explain in retrospect. The record of science in some ways casts doubt on a scientific approach to problem solving.
Like thinking fast and slow, Alchemy makes an intellectual reader see the value of humility:
Once you accept that there may be a value or purpose to things that are hard to justify, you will naturally come to another conclusion: that it is perfectly possible to be both rational and wrong. Logical ideas often fail because logic demands universally applicable laws but humans, unlike atoms, are not consistent enough in their behaviour for such laws to hold very broadly.
It’s true that logic is usually the best way to succeed in an argument, but if you want to succeed in life it is not necessarily all that useful; entrepreneurs are disproportionately valuable precisely because they are not confined to doing only those things that make sense to a committee
… if we allow the world to be run by logical people, we will only discover logical things. But in real life, most things aren’t logical – they are psycho-logical. There are often two reasons behind people’s behaviour: the ostensibly logical reason, and the real reason
Test counterintuitive things, ask dumb questions
Alchemy provides the blueprint for a type of inversion one can do in approaching problems.
Test counterintuitive things, because no one else ever does.
Here’s a simple (if expensive) lifestyle hack. If you would like everything in your kitchen to be dishwasher-proof, simply treat everything in your kitchen as though it was; after a year or so, anything that isn’t dishwasher-proof will have been either destroyed or rendered unusable. Bingo – everything you have left will now be dishwasher-proof! Think of it as a kind of kitchen-utensil Darwinism. Similarly, if you expose every one of the world’s problems to ostensibly logical solutions, those that can easily be solved by logic will rapidly disappear, and all that will be left are the ones that are logic-proof – those where, for whatever reason, the logical answer does not work.
Most political, business, foreign policy and, I strongly suspect, marital problems seem to be of this type.
Similarly, if you expose every one of the world’s problems to ostensibly logical solutions, those that can easily be solved by logic will rapidly disappear, and all that will be left are the ones that are logic-proof – those where, for whatever reason, the logical answer does not work. Most political, business, foreign policy and, I strongly suspect, marital problems seem to be of this type.
The mental model at work here is like a broader application of the case in World War II , where Navy analysts had to figure out how to build stronger planes not by thinking about the missing bulletholes.
Closely related is how great insight comes from asking dumb questions. Leaders must allow and encourage their team to ask dumb questions:
This freedom is much more valuable than we realise, because to reach intelligent answers, you often need to ask really dumb questions.
Never denigrate something as irrational until you have considered what purpose it really serves.
There are a lot of social psychology lessons in Alchemy Many of them are more fun(and easier to process) examples of the phenomonen revealed through evolutionary case studies in Secrets of Our Success.
There is an important lesson in evaluating human behaviour: never denigrate a behaviour as irrational until you have considered what purpose it really serves
Try to understand the real reason for things(not the surface reason)
Sometimes behavior that seems illogical has a hidden evolutionary value. People make mistakes when they judge others by surface actions, without considering things working below the surface.
there is an ostensible, rational, self-declared reason why we do things, and there is also a cryptic or hidden purpose. Learning how to disentangle the literal from the lateral meaning is essential to solving cryptic crosswords, and it is also essential to understanding human behaviour.
….Sometimes human behaviour that seems nonsensical is really non-sensical – it only appears nonsensical because we are judging people’s motivations, aims and intentions the wrong way. And sometimes behaviour is non-sensical because evolution is just smarter than we are. Evolution is like a brilliant uneducated craftsman: what it lacks in intellect it makes up for in experience.
….One problem (of many) with Soviet-style command economies is that they can only work if people know what they want and need, and can define and express their wants adequately. But this is impossible, because not only do people not know what they want, they don’t even know why they like the things they buy. The only way you can discover what people really want (their ‘revealed preferences’, in economic parlance) is through seeing what they actually pay for under a variety of different conditions, in a variety of contexts. This requires trial and error – which requires competitive markets and marketing.
There are no universal laws of human behaviour:
Our very perception of the world is affected by context, which is why the rational attempt to contrive universal, context-free laws for human behaviour may be largely doomed.
Cooperation has major evolutionary value, but most deductive logical thinking ignores it
Humans are a social species. This is not exactly a big insight, yet much of standard applied psychology and economics actually ignores this in practice. Indeed many ostensibly logical people ignore this in attempting to understand the world. This is made worse by the contrived nature of a lot of academic research.
Robert Zion, the social psychologist, once described cognitive psychology as ‘social psychology with all the interesting variables set to zero’. The point he was making is that humans are a deeply social species (which may mean that research into human behaviour or choices in artificial experiments where there is no social context isn’t really all that useful).
Humans are willing to forgoe short term expediency in order to cooperate and sacrifice for other people.
This is not irrationality – it is second-order social intelligence applied to an uncertain world.
There is an important biological reason:
Unlike short-term expediency, long-term self-interest, as the evolutionary biologist Robert Trivers has shown, often leads to behaviours that are indistinguishable from mutually beneficial cooperation. The reason the large fish does not eat its cleaner….
If fish (and even some symbiotic plants) have evolved to spot this sort of distinction, it seems perfectly plausible that humans instinctively can do the same, and prefer to do business with brands with whom they have longer-term relationships. This theory,
As a result, like any social species, we need to engage in ostensibly ‘nonsensical’ behaviour if we wish to reliably convey meaning to other members of our species.
One of the most important ideas in this book is that it is only by deviating from a narrow, short-term self-interest that we can generate anything more than cheap talk. It is therefore impossible to generate trust, affection, respect, reputation, status, loyalty, generosity or sexual opportunity by simply pursuing the dictates
There is a parallel in the behaviour of bees, which do not make the most of the system they have evolved to collect nectar and pollen. Although they have an efficient way of communicating about the direction of reliable food sources, the waggle dance, a significant proportion of the hive seems to ignore it altogether and journeys off at random. In the short term, the hive would be better off if all bees slavishly followed the waggle dance, and for a time this random behaviour baffled scientists, who wondered why 20 million years of bee evolution had not enforced a greater level of behavioural compliance. However, what they discovered was fascinating: without these rogue bees, the hive would get stuck in what complexity theorists call ‘a local maximum’; they would be so efficient at collecting food from known sources that, once these existing sources of food dried up, they wouldn’t know where to go next and the hive would starve to death. So the rogue bees are, in a sense, the hive’s research and development function, and their inefficiency pays off handsomely when they discover a fresh source of food. It is precisely because they do not concentrate exclusively on short-term efficiency that bees have survived so many million years.
If you optimise incentive systems(or anything else) in one direction, you may be creating a weakness somewhere else.
Incentives, incentives incentives.
In institutional settings, we need to be alert to the wide divergence between what is good for the company and what is good for the individual. Ironically, the kind of incentives we put in place to encourage people to perform may lead to them to be unwilling to take any risks that have a potential personal downside – even when this would be the best approach for the company overall. For example, preferring a definite 5 per cent gain in sales to a 50 per cent chance of a 20 per cent gain.
If you optimise something in one direction, you may be creating a weakness somewhere else.
In any complex system, an overemphasis on the importance of some metrics will lead to weaknesses developing in other overlooked ones. I prefer Simon’s second type of satisficing; it’s surely better to find satisfactory solutions for a realistic world, than perfect solutions for an unrealistic one. It is all too easy,
See Also: Goodhart’s Law and the Fall of Nick Schorsch , Department of Unintended Consequences, The Value of Improvisation and Informal Processes
People are way too confident in traditional technocratic approaches and big data solutions relative to how well they actually work
We don’t need to throw out economic models- but we need to spend time considering what htey ignore.
By using a simple economic model with a narrow view of human motivation, the neo-liberal project has become a threat to the human imagination.
…The alchemy of this book’s title is the science of knowing what economists are wrong about. The trick to being an alchemist lies not in understanding universal laws, but in spotting the many instances where those laws do not apply. It lies not in narrow logic, but in the equally important skill of knowing when and how to abandon it. This is why alchemy is more valuable today than ever.
…The technocratic mind models the economy as though it were a machine: if the machine is left idle for a greater amount of time, then it must be less valuable. But the economy is not a machine – it is a highly complex system. Machines don’t allow for magic, but complex systems do. …
…We should absolutely consider what economic models might reveal. However, it’s clear to me that we need to acknowledge that such models can be hopelessly creatively limiting. To put it another way, the problem with logic is that it kills off magic. Or, as Niels Bohr* apparently once told Einstein, ‘You are not thinking; you are merely being logical.’ A strictly logical approach to problem-solving gives the reassuring impression that you are solving a problem, even when no such process is possible; consequently the only potential solutions considered are those which have been reached through ‘approved’ conventional reasoning – often at the expense of better (and cheaper) solutions…
The advent of big data doesn’t change this:
We should also remember that all big data comes from the same place: the past. Yet a single change in context can change human behaviour significantly. For instance, all the behavioural data in 1993 would have predicted a great future for the fax machine.
Tangentially related, Alchemy connects economics with psychology and evolutionary biology in a better way than just about anything else I’ve read(some other examples see: Ecological Consequences of Hedge Fund Extinction)
Because they offer competing choices, consumer markets provide a guide to our unconscious in a way that theories don’t. For this reason, I have called consumer capitalism ‘the Galapagos Islands for understanding human motivation’; like the beaks of finches, the anomalies are small-but-revealing.
Hacking personal improvement: Many important features of the human brain are not under our direct control but are instead the product of instinctive and automatic emotions.
Alchemy has many insights for how one can approach personal improvement, and “hacking oneself.” Many important features of the human brain are not under our direct control but are instead the product of instinctive and automatic emotions:
There is a good evolutionary reason why we are imbued with these strong, involuntary feelings: feelings can be inherited, whereas reasons have to be taught, which means that evolution can select for emotions much more reliably than for reasons. To ensure your survival, it is much more reliable for evolution to give you an instinctive fear of snakes at birth than relying on each generation to teach its offspring to avoid them. Things like this aren’t in our software – they are in our hardware.
Useful to have a machine metaphor. I think of it like a computer. He uses a car:
…The truth is that you can control the gearbox of an automatic car, but you just have to do it obliquely. The same applies to human free will: we can control our actions and emotions to some extent, but we cannot do so directly, so we have to learn to do it indirectly – by foot rather than by hand.
Closely related, he had some insights into the placebo effect:
The placebo effect, like many other forms of alchemy, is an attempt to influence the mind or body’s automatic processes. Our unconscious, specifically our ‘adaptive unconscious’ as psychologist Timothy Wilson calls it in Strangers to Ourselves (2002), does not notice or process information in the same way we do consciously, and does not speak the same language that our consciousness does, but it holds the reins when it comes to much of our behaviour. This means that we often cannot alter subconscious processes through a direct logical act of will – we instead have to tinker with those things we can control to influence those things we can’t or manipulate our environment to create conditions conducive to an emotional state which we cannot will into being.
The actions required to create such conditions may involve a certain degree of what appears to be bullshit – but it is only bullshit when you don’t know what its reason is. It is this oblique hacking of unconscious emotional and physiological mechanisms that often causes suspicion of the placebo effect, and of related forms of alchemy. Essentially we like to imagine we have more free will than we really do, which means we favour direct interventions that preserve our inner delusion of personal autonomy, over oblique interventions that seem less logical.
Many problems come from seeking out false certainty. Avoiding uncertainty can have social benefits within certain institutions, and it can abodi discomfort. But ultimately certainty is an illusion, and pretending it is reality is a disaster. Embracing uncertainty is a prerequisite to major breakthroughs. See also: Thinking in Bets
The modern education system spends most of its time teaching us how to make decisions under conditions of perfect certainty. However, as soon as we leave school or university, the vast majority of decisions we all have to take are not of that kind at all. Most of the decisions we face have something missing – a vital fact or statistic that is unavailable, or else unknowable at the time we make the decision. The types of intelligence prized by education and by evolution seem to be very different. Moreover, the kind of skill that we tend to prize in many academic settings is precisely the kind that is easiest to automate.
If you want to look like a scientist, it pays to cultivate an air of certainty, but the problem with attachment to certainty is that it causes people completely to misrepresent the nature of the problem being examined, as if it were a simple physics problem rather than a psychological one.
Related Ockham’s Notebook Posts
- Why its Wise to Think in Bets
- The Ecological Consequences of Hedge Fund Extinction
- Empty Spaces on Maps
- Goodharts Law and the Fall of Nick Schorsch
- Department of Unintended Consequences
- The Value of Improvisation and Informal Processes