Why is investing way more about temperament than intellect or judgment? There’s no right answer, but my starting point is an unusual, warped feature. Investing has a broken scoreboard.
Buggy humans mostly deal with functioning scoreboards, even in a messy social world. CGPA, ATP rankings, batting average, market share, TRP, retweets, votes. While scoring doesn’t perfectly correlate with input metrics, it’s generally reliable. More time on previous years’ question papers improves CGPA. A tennis player can tell soon enough if a new coach or regimen is effective. Arnab’s rage and NYT’s sanctimony are calculably effective at boosting respective scores.
Now, imagine an alternate universe. A student gets random grades, sometimes D-, sometimes A+, uncorrelated with underlying answers. For added joy, D- can be unpredictably revised to A+ at short notice. A tennis player’s ranking fluctuates between single-digits and triple digits over the year, just like that. Parachute coconut oil has 80% share one day, 30% next day, leading to existential questions about South Indian hair and aviyal. How does one rustle up the energy to study, train or advertise? How does one know what works and what doesn’t? How does one even stay sane?
Herein lies the problem. Investing’s scoreboard (aka returns) is dysfunctional and manic. Over months, quarters or even years, a coherent set of inputs produces such extreme variations in output that it’s hard to tell if there’s any link between the two. Swings between bottom decile and top decile performance are surprisingly frequent, for no apparent reason. The golden rule of incentives, which is to tie it to controllable factors, is dead on arrival. If scoreboard is entirely broken, we could all give up and go home. Unfortunately, it is partially broken. Over decades, sense emerges, giving us just enough hope to keep trying. By then, careers have been undeservedly made and broken. Minds messed up. Others’ retirement savings irredeemably dented.
What does partially broken mean? As I was an engineer before becoming a parasite, I use a technical reference. Scoreboard isn’t broken but noisy. Extremely and variably noisy. Over the short-run, it’s mostly noise, little signal. Even over a year or two, signal-to-noise ratio is poor. As it approaches five years, some signal can be filtered out. Over decadal timeframes, signal-to-noise ratio improves sufficiently for price data to become a meaningful reflection of the world that it represents.
I believe markets are unique in combining a game with significant real-world consequences with a broken scoreboard. Trillions of dollars of hard-earned money, squirrelled away for retirement or children’s education, sloshes in, out, up and down like a drunk kindergartner (a possibility, if virtual school persists long enough). Academics, economists and columnists aren’t reliably scored for their theories, but world’s savings doesn’t ride on them. A closer look reveals their actual scoreboard to be peer approval, tenure or readability rather than accuracy of prognostications. If ignored, they’re harmless. Salesmen, CEOs, politicians, Uber drivers, soldiers, doctors and others in consequential jobs get robust feedback from reality, even if an odd exception or two come to mind.
Why fret over scoreboards? They aren’t merely for incentives and satisfaction. Scoreboards offer a crucial feedback loop that lets us refine controllable inputs in a quest for improved outcomes. After each season, cricketers review performance, statistics and videos in great detail, to fix own chinks or exploit others’. In contrast, an investor who bought a stock gets nothing out of his scoreboard for many seasons. I’ve looked really stupid for really long in some of my soundest decisions. I’ve looked like a Rockstar, metaphorically, when I had been a horse’s ass. The broken scoreboard and feedback loop muddle up everything: luck, skill, process, outcome, business reality, market perception. Given my innate bias to ascribe good outcomes to skill and bad ones to luck, my scoreboard isn’t merely useless but debilitating.
Broken scoreboards horribly mess up buggy human minds. My analogy for such an extreme, unknowable, uncontrollable environment is the one our prehistoric ancestors faced. They couldn’t make sense of the world around them. Bountiful harvests and devastating calamities. Clear skies and a horrific flash. Scenic hill that blew its top. We react exactly as they did. By seeking solace in rituals and superstitions. Shamans and prophecies. Flat-earthers and geocentricism. Our witch doctors are better groomed, not better qualified. Incantations are still gibberish, only more sophisticated. New normal, democratization of data, swoosh shaped recovery. We blindly follow whatever seemingly worked for others. Envy and FOMO consume us. Articulate idiots with a hot hand become prophets attracting groupies. CNBC and Twitter are viewed as counsel, not comedy or counterparties. As with all analogies, mine isn’t perfect. Our ancestors were incapable of knowing what was knowable. We’re incapable of accepting what is unknowable. Either way, we flail pointlessly.
I have belaboured about owning businesses, focusing on company performance and ignoring Mr Market unless expedient. While this approach works, human nature and institutional constraints make it impossible for a typical investor to follow it 100%. Short-run scores impact flows and reputation. Pontifications are nice, but meter has to (eventually) tick as no one can spend philosophy. While signal-to-noise improves with duration, there’s no magic switching point at T=5 where I can suddenly move from ignoring scoreboard to studying it. It’s grey all the way and no one can entirely ignore noise. One can at best look through it to extract whatever little signal is available.
This isn’t an academic or philosophical topic. Rewind a few months. After waiting years to buy into a company I’ve studied for over a decade, my purchase halves in a few weeks. To add to markets calling me a dolt, headlines and ‘experts’ scream that Armageddon is here. Although I know it’s pure noise, it’s non-trivial to ignore and average down with added conviction. Magically, a few months later, the same scoreboard suggests that I’m the greatest thing since Sri Krishna Mysurpa, arming me with my most dangerous weapon – a false sense of superiority.
Broken scoreboard is why temperament is everything. The core problem of staying with a process without really knowing if it is working is psychological, not intellectual. As is not letting luck get to my head or mess with my guts. Broken scoreboard is my opening essay in a foray into discussing temperament. Given author limitations and subject complexity, I am unsure of path, destination or quality of output. However, I know where I’ll go next. From broken scoreboard to importance of having an inner scorecard.
[Let me log a bug in my code before you point it out. A reasonable case can be made that investors’ actual scoreboard is fees, not returns. Getting overpaid for shuffling around others’ money doesn’t score high on skin in the game. We may even be worse than the commenting class I dumped on. Empirically, this might have better explanatory power than the more noble scoreboard that I have sneakily assumed. My best defence is that I write about sound investing, not all investing. While some of us try to do right by our clients, your and my quantification of ‘some’ may vary.]
Wow...such a broad sweep of mental models.........
Ben Graham's suggestion of splitting the price of a stock into investment and speculative components is one of the bright sparks I see in this long, dark tunnel..........of course, the approach is not 100% scientific and has its own set of challenges.... but it does turn the scorecard from being fully broken to slightly less broken......
Rightly said.The ability to average down when a stock is falling is a real test of one's conviction and independent analysis.