Systems are everywhere in our world. They have been the backbone of the modern economy and help us prepare for the next push of advancement. Systems pose a threat now because they are transitioning to a stage where they supersede humanity's intellectual skills. We can forecast and guess what happens, but I would rather delve into why they have been so successful and what aspects of them we can embed in our investing to emerge a better investor.
Feedback loops
I consider this the biggest reason for anyone's success. Why does hard work triumph over talent? We are all bound to go wrong somewhere, and hard work ensures that we learn from it. Systems around us have been built for continuous improvement, and hence, this plays a vital role.
Let me give you an example. The trajectory of chess changed at that moment when AlphaZero was introduced. What is it? So, a company called DeepMind created a supercomputer that would create an AI capable of playing chess. It was allowed a few hours to play against itself and learn from its mistakes. In those hours, it became the best chess engine there ever was and ended up beating the strongest chess engine called Stockfish.
The reason for its success is continuous feedback. It kept learning from its mistakes and eventually became near perfect.
In our lives as well, we get feedback. You don't work well enough for exams: your feedback is a bad grade. Your performance at your job isn't good enough: you don't get a promotion or bonus.
Feedback is everywhere; the key is to filter it. Not all of it is useful. The more quickly you learn to identify good feedback and accept and incorporate it, the more progress you will make toward your goals.
Problems arise when we fail to respond to feedback for too long. Many people are astute believers in buying at any price, but they have been suffering for the past few years. Is this a sign of feedback that should be taken seriously? Probably.
Getting fast and accurate feedback is the key. But that is the exact problem with investing. Investing outcomes take time, and hence, the feedback you get is slow. This elongates the learning curve, and Investing is not a game of certainty but a game of odds. You won't always know what you did was right or wrong; you just need to live with it.
To incorporate the feedback system well into your investing outcome, study history. Why not take advantage of the lessons of the past? What you face has been faced before, and if you can identify the variables that matter the most, you can develop some level of foresight.
Bottleneck
Imagine holding a plastic bottle upside down; the water is pouring from the neck. Now imagine the same bottle but with the neck cut off. The pace at which the water flows will be way faster.
This is the bottleneck of a system, basically something that slows down the system and its efficiency.
What I really like about this concept is that Bottlenecks are relative in nature. You improve the bottleneck, and now it's five times faster than the whole system; now, the entire system is the bottleneck. Bottleneck encourages continuous improvement because there are multiple variables at play for systems at any given time, and their efficiency depends on each other. Hence, you need to lift them simultaneously( or ensure they all improve) for a significant improvement in the system.
Its the same in investing. You must improve the skill that decreases your returns the first such as lack of understanding of forensics inherent biases or failure to pick themes and then only can you work at the rest. For example, I need to work at picking the right ideas the most.
Churn
In any system, components keep changing and get replaced for the better. If you imagine our body to be a system, skin cells are replaced every day with new ones. Churn can mean a lot of things, but I am only interested in delving deeper into investing.
Despite being a student, I consider myself an active investor and invest directly in stocks. Moreover, I consider myself very new, and hence, I am always coming across new businesses that are interesting. Now, it becomes quite clear that my investments will be risky because they are direct investments and will demand higher returns(i.e., I chase growth). Secondly, it also becomes clear that I have invested in 10 businesses out of the 100 I might have studied. This means thatI am ignoring the other 6000 firms out there.
It is foolish to stick to the 10 businesses as I expand my reach: how can I expect them to have the best growth prospects in the whole stock market even though I have barely covered any? In such a scenario, Churn becomes a part of the journey and a necessity. I see objective rationale backed Churn as continuous learning or kaizen. Churn shows that you are ready to change your mind and are dedicated to constant learning.
Churn, at the right level and for the right reasons, can be the healthiest element for a higher XIRR.
Margin of safety
Of course, a holy grail of investing. Recently I had this worry: Most of my thesis is based on the guidance given by the promoters and I find that very risky because I see an incentive to lie and I also see helplessness because the promoters will always know the industry and their business better than me. So how do I tackle this problem?
The first and lengthy way is to research at a deeper level, where you rely on primary and secondary data to gain insight into the industry. Of course, you won't be right all the time, but you do not have to be. However, this is a problem for me; I am a GARP investor and, hence, have been in the business for 2-3 years. So, the time taken to study at such depth will probably result in the business running too high. After some thinning, I realised the answer was staring right at me. GARP entails growth AND valuations. The margin of safety is all about allowing yourself to go wrong without a considerable loss. Entry multiple is crucial, and hence, so is the margin of safety. If you can rightly interpret the margin of safety, half of the work is done.
Credits:
Beaubien, Rhiannon ; Leizrowice, Rosie. The Great Mental Models Volume 3: Systems and Mathematics. Latticework Publishing Inc. Kindle Edition.
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