Principle 6

This is a continuation of my reflections on 'Factfulness' by Hans Rosling. Whilst I finished reading the book almost a year ago, I was unable to complete my series of posts. Through these posts, I am attempting to draw principles which are applicable to the world of investing, from the eye-opening book.

The Size Instinct 

Learning 1: The Size Instinct and Noises.

In Factfulness, Rosling says that by "Paying too much attention to the individual visible victim rather than the numbers can lead us to spend all our resources on a fraction of the problem." He also says that "We tend to assume that all the items on a list are equally important, but usually just a few of them are more important than all the others put together."

In today's world, there is an unprecedented level of access to information. In some sense, this should make investing harder. Theoretically, as more information is readily available in the public domain, the market value should converge to the fair value more quickly; hence, there are fewer market inefficiencies that can be exploited. Whilst this has occurred, the above description of the efficiency resulting from easy access to information is not complete. This is because with our unprecedented levels of access to information we have also gained an unprecedented level of access to noise. 

Thus, it is very important not to be non-discriminatory when we are trying to follow current events. Indeed, several newspapers print over twenty pages every day. They simply do not have the time to produce high-quality, balanced, in-depth analyses every day. Instead, some print eye-catching headlines, and produce superficial and provocative recounts of ongoing events. Whilst these stories may be entertaining, they elevate these noises to a pedestal of significance. Hence, reading these stories could lead you to make poorer investment decisions. So, be more discriminatory when you are reading, and choose your sources of information carefully. That way, you will be better able to keep things in proportion and focus on those things that are really important. As a solution, Hans Rosling suggests the 80/20 rule; the idea is that one should focus on trying to understand those 'items on a list', that account for 80% of the total. 

Whilst we must strive to filter through the noise, I must strike a cautionary note. We must remember that our pre-existing views and biases may influence our classification of "noise". Indeed, this could be dangerous as it may lead you to ignore literature which would force you to test - and defend - your perspective. Thus, it is important to actively seek out literature and people with an alternative views. This will likely help you make better investment decisions.

Learning 2: The Size Instinct and Market size.

Rosling states that "The world cannot be understood without numbers. And it cannot be understood with numbers alone." This is certainly true in the investment world. Indeed, several fundamental value investors would argue that "investing is more art than science". This is because it is about "Narrative and Numbers"; any numbers we use in a financial model are the output of assumptions, which must be set in a story. Whilst numbers are very important, using just numbers can lead you to make grave mistakes in valuation. For example, you may say that because a company has grown at 15% p.a. it will continue to do so. However, if you have not thought carefully about your story, you may forget to account for the capital expenditure needed to produce that growth. Or, you may say that a company (in the USA) , which has been growing at 60% p.a. , will grow at 6% to perpetuity. To do this you would have to fail to realise that this would mean that it would account for the entirety of the US economy - which grows at roughly 3% - at some point in the future. 

We have said that numbers are very useful; however, some types of numbers are more useful than others. Indeed, Rosling says that "Amounts and rates tell very different stories," and that "Rates are more meaningful". Whilst this may not necessarily be true in all circumstances, it is true for investing. Even value investing, which is about 'present' value, can't help dealing with the future. Thus, before one decides what a company is worth, one must try to determine its future: "What is happening to the market as whole? Within this market, how is this company's market share going to change? "  Present market share - whilst it is still important - is less important than future marketshare. How the environment in which a firm operates is changing is of utmost importance. This is because, as I have said before, understanding structural changes in an industry offers opportunities, or - at the very least - helps avoid losses. 

Thus, when you are next using numbers, make sure to (i) base them on a story; and (ii) try to use rates and changes as opposed to absolute quantities.