An investing lesson from Hayek
Betting big while knowing nothing is bothersome. To resolve this contradiction, I invoke Hayek’s distinction between sculptor and gardener. (3rd essay of series on greyness & contradictions)
Contradiction that’s at the core of investing is that we make big bets with no clue as to how they’ll turn out. It’s unnerving to invest 10% of fund into a single business without knowing what returns I’ll make. Conviction + ignorance = dissonance. While I have tiptoed around this conundrum using probabilistic language, I haven’t tackled it head on. I’ll do so here, using borrowed wisdom.
Friedrich von Hayek’s a genius. He understood human frailty better than any, especially in matters of dealing with messy world. Like his work, title of his Nobel prize lecture is sublime: The Pretence of Knowledge. His lecture starts by framing the problem with our typical approach to the social world.
“We have indeed at the moment little cause for pride: as a profession we have made a mess of things. It seems to me that this failure of the economists to guide policy more successfully is closely connected with their propensity to imitate as closely as possible the procedures of the brilliantly successful physical sciences – an attempt which in our field may lead to outright error. It is an approach which has come to be described as the “scientistic” attitude – an attitude which, as I defined it some thirty years ago, is decidedly unscientific in the true sense of the word, since it involves a mechanical and uncritical application of habits of thought to fields different from those in which they have been formed.“
While his direct reference is to economics, finance is as guilty of misplaced scientism. Our pretence of knowledge rests on idealized humans, invalid theory and mathematical sophistry. We don’t account for complexity and feedback loops. We reduce risk to a number unconnected to underlying businesses. We hide behind Greek letters and decimal points. No wonder the best practitioners disdainfully ignore professors. Fortunately, Hayek offers an alternate approach that’s more adept at handling our messy world.
“If man is not to do more harm than good in his efforts to improve the social order, he will have to learn that in this, as in all other fields where essential complexity of an organized kind prevails, he cannot acquire the full knowledge which would make mastery of the events possible. He will therefore have to use what knowledge he can achieve, not to shape the results as the craftsman shapes his handiwork, but rather to cultivate a growth by providing the appropriate environment, in the manner in which the gardener does this for his plants.”
Most investing is based on craftsman approach. Instead of accepting unknowability, we seek to conquer it. To use a topical reference, we become prediction-jeevis. We forecast each line item till eternity. We build in operating leverage and three convenient scenarios. We rationalize dubious assumptions with macro gibberish around themes and tailwinds. Dozens of unknowable variables magically coalesce into expected returns or price targets. All this effort offers great comfort but poor results. Forecast inaccuracy and active manager underperformance are evidence. Craftsman approach wishes away our core contradiction without resolving it. It’s more pretence than knowledge.
While I have tried to avoid craftsman approach (no forecasts, forward PE, DCF, macro, themes), I have used craftsman language. Instead of admitting ignorance, I discuss the future in fuzzy probabilistic terms. Asymmetric risk-reward. Favourable odds. High chance of reasonable return. Low chance of ruinous outcome. If you push me to go deeper, I’ll draw a blank. My descriptors (high, low, favourable, reasonable) are hollow. Just as I don’t know what returns I’ll make, I have no idea what my odds are.
So, let me abandon my pretence of knowledge and fully embrace Hayek’s gardener mindset. There’s no other way to truly resolve our core contradiction. Gardener approach entails an exclusive focus on controllable inputs, while entirely ignoring uncontrollable outputs. When we find right management, industry, company, moat & valuation, it’s analogous to lining up seed, soil, nutrients, sunlight & water. Long history suggests that doing so yields a good crop. As we can do no better, we’re done. Conviction rests on knowing that right inputs are in place. Conviction isn’t based on pretending to know individual outcomes. Asking how high a particular sapling will grow is as silly as it’s unanswerable.
Hayek’s distinction also helps foster the right temperament for investing. Sculptors believe in precisely shaping outcomes. They’re in control. They’re creators. Gardeners know their limitations. It’s mostly outside their control. They’re more likely to pray to a Creator than think they’re one. In addition to fostering humility, gardener mindset helps with inaction. If inputs don’t line up, there’s no point trying. Even when they do, there’s no way to rush outcomes. Waiting patiently is part of job description. This also helps distinguish investment from speculation. Since future is unknowable in both, it’s sometimes hard to tell. In investment, inputs are known, outputs are unknowable. In speculation, even inputs are unknowable. I dump on shiny things and dodgy money because no one knows what inputs need to line up for a decent harvest.
A Hayekian worldview requires professional investors to be responsible about public proclamations, especially in talking one’s book. When we make an investment, we don’t know jack shit about outcome. Even folks who’ve had good harvests in the past haven’t earned the right to talk up a specific sapling’s prospects. Those following such ‘advice’ have a responsibility as well. Figuring out a set of inputs that work in your context cannot be outsourced. There’s a big difference between seeing a gardening video on Youtube and replicating results at home. If investing in stocks is too hard or ineffective, please shift to SIPs. Don’t coat-tail.
Hayek’s gardener approach is a good way to think about messy world outside of investing as well. Every good business is run with a focus on controllable inputs and fostering an environment where good people can thrive. This is especially important in listed companies where volatile quarterly outcomes can mess with minds. In public administration too, competence is about creating a conducive environment, not gory central planning. Five decades after Hayek’s lecture, economists and bureaucrats continue to make a mess of things with their Sculptor complex.
Hayek’s method is as efficient as it’s effective. It’s low on wasted effort, fake precision and self-delusion. As everything is parsed through knowability and controllability filters, messy world becomes less overwhelming. I can bet big without having to feign knowledge. Conviction and cluelessness can coexist without dissonance.
PS. Hayek’s 1974 lecture is at: