From the August 2014 issue of Research Magazine • Subscribe!

3 Sentences That Explain Investing

Getting back to basics in investment philosophy

Investors who go out into the world without sensible core principles to direct their choices risk finding themselves out to sea without a paddle. Investors who go out into the world without sensible core principles to direct their choices risk finding themselves out to sea without a paddle.

During the course of its long descent, a snowflake passes through a multitude of different weather conditions. The variability of temperature, atmospheric pressure and humidity produces an infinite variety of possible designs. The future of each snowflake is a structure that has never existed before and will never occur again—at no point in its development can we know exactly what it will look like when it finally lands. This is pure uncertainty—a completely unknowable future.

Investing is an activity that exists because we believe that the future can be knowable enough to justify making choices whose outcomes are likely but not guaranteed. As normal as this feels to us today, in historical terms it is a relatively recent phenomenon. It isn't that our ancestors weren't concerned about the future—of course they were. But all they had to part the curtains were oracles, prophets and soothsayers—whose success was clouded in mystery and superstition. Accordingly, the ancients’ view of the future was simple: It was uncertain—and most definitely outside of their control.

The source of everything investors today take for granted germinated approximately 1,500 years ago when Hindus invented the modern numbering system. Its brilliant centerpiece was the introduction of a groundbreaking new idea: Zero. This released us from a system of numbers useful mostly for counting and replaced it with something capable of revealing the inner workings of the physical universe.

But it took another thousand years before some brilliant and curious 16th-century minds saw the mathematical implications of simple games of chance, and created a working model for what we now know as probability theory. To get an idea of just how big this development was, try to imagine life without probability: no gambling, no insurance, no drug testing, no safe air travel, no traffic control, no banking, no cell phones, no Google, no Internet and—without a doubt—no investing.

The catalyst for all this reflection is the nature of the current bull market in combination with the immense popularity and growth of financial products and investment strategies that encourage investors to focus only on the market and/or its component asset classes: essentially an “all forest and no trees” paradigm where investors know little and care less about the individual components of whatever financial product they own.

This form of investing has become the accepted wisdom throughout the investment world, and its popularity has been built on considerable success. But success often has the nasty habit of sowing the seeds of its own vulnerability, something I have learned both from observation and personal (and painful) experience.

Over the last five years the market has been moving along quite swimmingly and investors have been able to make money by just showing up. During market environments like this it is rare indeed to find a discussion about the importance of getting down to basics. That kind of discussion is in greatest demand only after a severe market decline—especially one where the change in direction has been sudden and dramatic—and investors are left reeling, looking for answers and advice. Of course by then the damage has already been done and whatever prescription is proffered will be merely palliative.

On One Foot

The idea that I can distill all of investing into three sentences is obviously a bit of a gimmick. My goal is to get your attention. Many know the famous story of Rabbi Hillel, who was asked by a cynic to teach him the entire Torah while standing on one foot. Hillel told the scoffer, “What is hateful to you do not do to your fellow: this is the whole Torah, the rest is commentary.”

My point in this little exercise is that the critical lesson from this 2,000-year-old story is eminently applicable to the world of investing: Hillel's message to the cynic was that the wisdom of even the most brilliant, most learned, most holy person on earth would be ultimately worthless if it didn't reflect the core principle imbedded in what we all know as the “golden rule.”

Investors who go out into the world without sensible core principles to direct their choices risk finding themselves out to sea without a paddle at the worst possible time. My prescription is to make sure that we are all clear about the “basics” at the start of our journey—so we have plenty of paddles, rudders and sails when we’ll need them most.

Within that context below are three sentences I use to ground myself in reality and that direct my investment and advisory behavior:

1. The natural state of affairs in the world is uncertainty—it means that more things can happen than will happen.

How are you going to feel when you wake up exactly one year from today? How many mistakes will you make over the next six months? What will be the most popular form of personal communication in 10 years? Where will the S&P 500 index close next Wednesday? Who will win the third game of the World Series in 2018? These and an infinite number of other questions are unknown and unpredictable. Uncertainty is the paradoxical fact that makes the future uncomfortable but exciting.

My apologies and admiration go to Prof. Elroy Dimson, whose well-known quote (“Risk means more things can happen than will happen”) is so well put that even though I have always disagreed with it (I hold that it is uncertainty that is being defined), I could not find better words to use.

2. Risk is when we can identify and quantify those things that are more likely to happen than others.

Without numbers there could be no probability theory; and without probability theory risk would be something that exists only in our “gut.” We are standing on the very broad shoulders of those who came before us, whose curiosity and brilliance have given us incredible tools that empower us to convert the future from something mysterious into something useful.

3. Investing is the process of methodically and creatively exploiting the information gleaned from our calculation of risk, while accepting the fact that uncertainty can never be completely eliminated.

The wonderful, but frustrating, part of investing is that the more competent you get, the more you realize that you will never ever get to a place where you can fully relax—there is always something lurking just out of reach.

The early-20th-century author G.K. Chesterton sums up the dilemma eloquently: “The real trouble with this world of ours is not that it is an unreasonable world, nor even that it is a reasonable one. The commonest kind of trouble is that it is nearly reasonable, but not quite. Life is not an illogicality; yet is a trap for logicians. It looks just a little more mathematical and regular than it is; its exactitude is obvious, but its inexactitude is hidden; its wildness lies in wait.”

So, do my three sentences encompass everything one needs to know about investing? Of course not! But they do represent the core principles that are (hopefully) reflected in all of my investment decisions. And that really is the point: All of us need to get back to basics—all of the time. And the basics are those principles that connect your decisions with fundamental reality. Without those principles you can spend money, make choices, buy stocks and bonds—and even write a column about it. But you won't be investing.

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More by Marshall Jaffe on ThinkAdvisor:

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