Principle 3

The Importance of Comparing Effectively With The - Often Rose-tinted - Past

I am using this opportunity to consider the use of comparisons with historical performance in relation with investing. Following that, I will consider the implications of Hans Rosling's view that we look upon history through a 'rose-tinted' lens.

In investing, an effective comparison with the long term historical track record, serves as a reference point. Similarly, when we think about the world today, we are – often subconsciously – comparing it with the past. For example, when we say that the word is really well connected, we are subconsciously comparing the level of connectivity today, with the level of connectivity in the past. There is one significant difference, however, which is that in investing, a relative comparison with the past -- although it is used as a reference -- is somewhat meaningless; history never exactly repeats itself, and the markets ‘move’ randomly. We are forced to use historical data - cautiously - as they are the only reference points we have. 

Before I proceed to consider how we rose-tint the past, and how we distort it, I must stress that in investing, any attempt to time the market based on historical highs or lows does not work. For example, someone may say, that Company X is a great investment, because of a solid long-term track record, and because the shares are trading at a 52-week low. This would be foolish. Just because a company is trading cheaper than it has for the last year, doesn’t mean it is trading cheap. 

This is because of two reasons. Firstly, changes in price are theoretically supposed to be - although they aren’t necessarily in reality - a result of changes in the economics of a business. So, when you see a company trading at a 52-week low, you should first wonder if there has been any substantial change in the business’ economic position. If the company is now worth less due to the changes in its profitability, then the reduced share price may be correct. In fact, when this happens, the company could even remain slightly overvalued, as people may get anchored to the original price and value of the company. 

Now, to understand the second reason the above thesis for investing in X is incorrect, let us assume there has been no change in the business’ economics. Then you must consider whether it was previously over-valued; just because the price is lower than it used to be, it doesn’t mean it is low enough. Indeed, the business may now – finally – be valued fairly, or might still be overvalued, depending on the previous price and the percentage change. To exemplify this, let us say Company X’s shares – which we believe are worth $9.40 each - were trading in a range between $9.90 and $9.70 per share for a period of 364 days. Now, on the 365^th, they are trading at $9.60 per share. That is a 52-week ‘low’, but is not really a low price. If you buy shares in company X, you will be overpaying, and as the price slowly converges with the value, you will make a loss. So, the best way of making a good investment is determining how much a company is worth, and buying a part of it for less than this value.

This is not to say that a 52-week low is not a useful way of looking for companies which may well be undervalued due to short-term ‘turbulence’. However, it is a useful - and simple (and arguably superficial) - way of finding out where to look for a bargain. Treating it as any more than one of many screening processes you could use to identify potentially undervalued companies would result in traumatic failure.


...and finally...the principle and one its implications

The above paragraphs about the misuse of a comparison with the past are very important. There is, however, another noteworthy instinct, which one must be aware of. This is what Hans Rosling refers to as the human tendency to reflect upon the past through a ‘rose-tinted’ lens. Essentially, this human instinct is the “good old days-attitude”. On the non-investing side of things, this instinct causes us to underestimate progress, and not recognize how the world is slowly improving. In investing, the “rose-tint” may lead people to forget how horrifying and frightening a stock market crash can be. This ability to forget the cyclical, boom-bust nature of the stock market leads to an irrational euphoric epidemic of exuberance, as the stock market booms. Remembering how bad things can be will probably encourage a more cautious investing approach during ‘bubbles’.