Investing: The Last Liberal Art

Robert Hagstrom

• Publisher: Columbia University Press
• Year: 2013
• ISBN:
  9780231531016
• Edition: 2
• Topic: Negocios y empresa
• Subtopic: Negocios en general

Robert G. Hagstrom is one of the best-known authors of investment books for general audiences. Turning his extensive experience as a portfolio manager at Legg Mason Capital Management into valuable guidance for professionals and nonprofessionals alike, he is the author of six successful books on investment, including The Warren Buffett Way, a New York Times best-seller that has sold more than a million copies.

In this updated second edition of Investing: The Last Liberal Art, Hagstrom explores basic and fundamental investing concepts in a range of fields outside of economics, including physics, biology, sociology, psychology, philosophy, and literature. He discusses, for instance, how the theory of evolution disrupts the notion of the efficient market and how reading strategies for literature can be gainfully applied to investing research. Building on Charlie Munger's famous "latticework of mental models" concept, Hagstrom argues that it is impossible to make good investment decisions based solely on a strong knowledge of finance theory alone. He reinforces his concepts with additional data and a new chapter on mathematics, and updates his text throughout to reflect the developments of the past decade, particularly the seismic economic upheaval of 2008. He has also added a hundred new titles to the invaluable reading list concluding the book.

Praise for the first edition: "I read this book in one sitting: I could not put it down."—Peter L. Bernstein, author of Against the Gods: The Remarkable Story of Risk "Elegant and irresistible. Robert G. Hagstrom makes the complex clear as he confidently crisscrosses through the disciplines of finance, biology, physics, and literature. The only way to understand investing better, [Investing] shows, is to understand the world better. Ideas spark off the page at every turn. This is simply a gem of a book."—James Surowiecki, New Yorker "Investing is a brisk and engaging read, and it is a pleasure to be in the presence of Hagstrom's agile mind."— International Herald Tribune

1

A Latticework of Mental Models

In April 1994, at the Marshall School of Business of the University of Southern California (USC), students in Dr. Guilford Babcock’s Student Investment Seminar got a rare treat: a powerful dose of real-world knowledge from a man whose thoughts on money are widely considered priceless.

Charles Munger—Charlie, as he is known throughout the investment world—is vice chairman of Berkshire Hathaway, the holding company run by Warren Buffett, the world’s most famous investor. Trained originally as an attorney, Charlie is Buffett’s business partner, friend, and straight man. He commands attention whenever he speaks.

Charlie Munger is an intellectual jewel somewhat hidden behind his more celebrated partner. The anonymity is not Buffett’s fault. Charlie simply prefers the lower profile. Except for his occasional appearances such as the one at USC and his prominent role at Berkshire Hathaway’s annual meetings, Charlie remains largely out of public view. Even at those annual meetings, he deliberately keeps his remarks brief, allowing Buffett to answer most of the questions from shareholders. But occasionally Charlie does have something to add, and when he speaks, the shareholders straighten and shift forward to the edge of their seats, straining to get a better view, to catch every word.

In Dr. Babcock’s classroom that day in April, the atmosphere was much the same. The students knew whom they were listening to, and they knew they were about to receive the benefit of considerable investment expertise. What they got instead was something infinitely more valuable.

At the outset, Charlie mischievously admitted that he was about to play something of a trick on his audience. Rather than discussing the stock market, he intended to talk about “stock picking as a subdivision of the art of worldly wisdom.”¹ For the next hour and a half, he challenged the students to broaden their vision of the market, of finance, and of economics in general and to see them not as separate disciplines but as part of a larger body of knowledge, one that also incorporates physics, biology, social studies, psychology, philosophy, literature, and mathematics.

In this broader view, he suggested, each discipline entwines with, and in the process strengthens, every other. From each discipline the thoughtful person draws significant mental models, the key ideas that combine to produce cohesive understanding. Those who cultivate this broad view are well on their way to achieving worldly wisdom, that solid mental foundation without which success in the market—or anywhere else—is merely a short-lived fluke.

To drive his point home, Charlie used a memorable metaphor to describe this interlocking structure of ideas: a latticework of models. “You’ve got to have models in your head,” he explained, “and you’ve got to array your experiences—both vicarious and direct—on this latticework of models.” So immediate is this visual image that “latticework” has become something of a shorthand term in the investment world, a quick and easily recognized reference to Charlie’s approach.

It is a theme he returns to often. At the Berkshire Hathaway annual meetings, for instance, he frequently adds to Buffett’s answers by quoting from a book he has recently read. Often the quote at first appears to have no direct link to investing, but with Charlie’s explanation it quickly becomes relevant. It is not that Buffett’s answers are incomplete. Far from it. It is just that when Charlie is able to connect Buffett’s ideas to similar ideas in other disciplines, it tends to elevate the levels of understanding among the group.

Charlie’s attention to other disciplines is purposeful. He operates in the firm belief that uniting the mental models from separate disciplines to create a latticework of understanding is a powerful way to achieve superior investment results. Investment decisions are more likely to be correct when ideas from other disciplines lead to the same conclusions. That is the topmost payoff—broader understanding makes us better investors. It will be immediately obvious, however, that the ramifications are much wider. Those who strive to understand connections are well on the way to worldly wisdom. This makes us not only better investors but better leaders, better citizens, better parents, spouses, and friends.

How does one achieve worldly wisdom? To state the matter concisely, it is an ongoing process of, first, acquiring significant concepts—the models—from many areas of knowledge and then, second, learning to recognize patterns of similarity among them. The first is a matter of educating yourself; the second is a matter of learning to think and see differently.

Acquiring the knowledge of many disciplines may seem a daunting task. Fortunately, you don’t have to become an expert in every field. You merely have to learn the fundamental principles—what Charlie calls the big ideas—and learn them so well that they are always with you. The following chapters of this book are intended to be a starting point for this self-education. Each one examines a specific discipline—physics, biology, social studies, psychology, philosophy, literature, and mathematics—from the perspective of its contribution to a latticework of models. Of course, many other sources are available to the intellectual explorer.

A protest is commonly heard at this point. “Isn’t that what a college education is supposed to do for us, teach us critical concepts that have been developed over the centuries?” Of course. Most educators will tell you, in passionate terms, that a broad curriculum grounded in the liberal arts is the best way, perhaps the only way, to produce well-educated people. Few would argue with that position in theory. But in reality we have become a society that prefers specialization over breadth.

This is wholly understandable. Because students and parents spend a small fortune on a college education, they expect this investment to pay off promptly in the form of good job offers after graduation. They know that most corporate recruiters want workers with specialized knowledge who can make an immediate and specific contribution to the organization. It is little wonder that most of today’s students, faced with this pressure, resist a broad, liberal arts education in favor of a specialty major. Understandable, as I say. Still, I believe we are all the poorer for it.

At one point in our history, we were given a superb model of what constitutes a good education. Perhaps we should have paid better attention.

In the summer of 1749, subscribers to the Pennsylvania Gazette received, along with their newspaper, an additional pamphlet written by the newspaper’s publisher, Benjamin Franklin. He described this pamphlet, entitled Proposals Relating to the Education of Youth in Pensilvania, as a “Paper of Hints” to address the regret that the “youth of the Province had no academy.”² The young men in Connecticut and Massachusetts were already attending Yale and Harvard, Virginians had the College of William and Mary, and students in New Jersey were served by the College of New Jersey (later called Princeton). But Philadelphia, the largest and richest city in the Colonies, known as the Athens of America, had no institution for higher learning. In his pamphlet, Franklin explained his proposal to remedy that with the establishment of the Public Academy of Philadelphia.

Franklin’s concept was unique for its day. Harvard, Yale, Princeton, and William and Mary were schools for educating the clergy; their curricula stressed the classical studies rather than the practical lessons that prepared young men for business and public service. It was Franklin’s hope that the Philadelphia Academy would stress both the traditional classical areas (which he termed “ornamental”) as well as the practical. “As to their studies,” he wrote, “it would be well if they could be taught everything that is useful and everything that is ornamental. But art is long and their time is short. It is therefore proposed that they learn those things that are likely to be most useful and most ornamental, regard being had to the several professions for which they are intended.”

Today Franklin’s Public Academy of Philadelphia is the University of Pennsylvania. The former dean of its College of Arts and Sciences, Dr. Richard Beeman, describes the scope of Franklin’s achievements.³ “Benjamin Franklin proposed the first modern-day secular curriculum,” he explains, “and the timing was perfect.” In the eighteenth century the world’s knowledge base was exploding with new discoveries in math and sciences, and the classical curriculum of Greek, Latin, and the Bible was no longer sufficient to explain this new knowledge. Franklin proposed including these new areas in the academy, and then he went further still: he also recommended the students acquire the necessary skill sets to become successful at business and public service. Once students mastered these basic skills, he said, which at that time included writing, drawing, speaking, and arithmetic, then they could devote attention to acquiring knowledge.

“Almost all kinds of useful knowledge would be learned through reading of history,” wrote Franklin. But he meant much more than the definition we customarily attach to a history discipline; for Franklin, “history” encompassed all that is meaningful and worthwhile. By encouraging young men to read history, Franklin meant for them to learn philosophy, logic, mathematics, religion, government, law, chemistry, biology, health, agriculture, physics, and foreign languages. To those who wondered whether such a burdensome task was really necessary, Franklin replied that it was not a burden to learn but a gift. If you read the universal histories, he said, “it would give you a connected idea of human affairs.”

Benjamin Franklin was the originator of a “liberal arts education,” Beeman points out. “He was in the business of cultivating habits of mind. The Philadelphia Academy was a broadly based platform for lifelong learning. Of course Franklin is the perfect role model. He kept his mind open and his intellectual ambition fully fueled. As an educator he is my hero.”

Beeman continues: “Benjamin Franklin’s success as an educator was based upon three standing principles. First the student must acquire the basic skill sets: reading, writing, arithmetic, physical education, and public speaking. Then the student was introduced to the bodies of knowledge, and finally the student was taught to cultivate habits of mind by discovering the connections that exist between the bodies of knowledge.”

In the 250 years since Franklin’s proposal, American educators have continued to debate the best method to train young minds, and college administrators have continued to adjust their curricula in the hope of attracting the best students. Critics of our current education system remain, and many of their criticisms seem valid; yet for all its faults, our education system today has done a reasonably good job of providing skills and producing knowledge—the first two of Franklin’s key principles. What is often lacking is his third principle: the “habits of mind” that seek to link together different bodies of knowledge.

We can change this. Even if our days of formal schooling are behind us, we can search on our own for the linkages between ideas in various arenas, the connections that illuminate real understanding.

It is of course easy to see that cultivating Franklin’s “habits of mind,” to use Professor Beeman’s wonderful phrase, is the key to achieving Charlie Munger’s “worldly wisdom.” But seeing this is one thing; acting on it is another. For many of us, this goes against the mental grain. After having invested many years in learning one specialty, we are now being asked to teach ourselves others. We are told not to be bound by narrow confines of the discipline we were trained in, but to leap over the intellectual fences and look at what’s on the other side.

For investors, the rewards for making the effort are enormous. When you allow yourself to look beyond the immediate fences, you are able to observe similarities in other fields and recognize patterns of ideas. Then, as one concept is reinforced by another and another and then another, you know you are on the right track. The key is finding the linkages that connect one idea to another. Fortunately for us, the human mind already works this way.

In 1895, a young graduate student named Edward Thorndike began to study animal behavior under the psychologist and philosopher William James at Harvard University. We shall meet William James later in this book, in another capacity; for now our interest in Thorndike is his groundbreaking research into how learning takes place, in humans as well as animals. Thorndike was the first to develop what we now recognize as the stimulus-response framework in which learning occurs when associations—connections—are formed between stimuli and response.

Thorndike continued his studies at Columbia University, where he worked closely with Robert S. Woodworth. Together they investigated the process by which learning is transferred. They concluded, in a paper published in 1901, that learning in one area does not facilitate learning in other areas; rather, they argued, learning is transferred only when both the original and the new situation have similar elements. That is, if we understand A, and recognize something in B that resembles A, then we are well on our way to understanding B. In this view, learning new concepts has less to do with a change in a person’s learning ability than with the existence of commonalties. We do not learn new subjects because we have somehow become better learners but because we have become better at recognizing patterns.

Edward Thorndike’s theory of learning lies at the core of a contemporary theory in cognitive science called connectionism. (The cognitive sciences encompass how the brain works—how we think, learn, reason, remember, and make decisions.) Connectionism, building from Thorndike’s studies of stimulus-response patterns, holds that learning is a process of trial and error in which favorable responses to new situations (stimuli) actually alter the neural connections between brain cells. That is, the process of learning affects the synaptic connections between neurons, which are continually adjusting as they recognize familiar patterns and accommodate new information. The brain has the ability to link together related connections into a chain and to transfer what was learned to similar situations; intelligence, therefore, can be viewed as a function of how many connections a person has learned.

Connectionism has received a great deal of attention from business leaders as well as scientists because it is at the heart of a powerful new system of information technology known as artificial neural networks. These neural networks, as they are more commonly called, attempt to replicate the workings of the brain more closely than has been possible with traditional computers.

In the brain, neurons function within groups called networks, each with thousands of interconnected neurons. We can therefore think of the brain as a collection of neural networks. Artificial neural networks, in turn, are computers that mimic the basic structure of the brain: they consist of hundreds of processing units (analogous to neurons) that are cross connected into a complex network. (Surprisingly, neurons are several orders of magnitude slower than silicon chips, but the brain makes up for this lack of speed by having a massive number of connections that afford enormous efficiencies.)

The great power of the neural network, and the quality that sets it apart from a traditional computer, is that the weighting of the connections between its units can be adjusted, just as the brain’s synapses adjust, becoming weaker or stronger or even rewired altogether as needed to perform different tasks. So, just like the brain, a neural network can learn. Just like the brain, it has the ability to recognize complex patterns, classify new information into patterns, and draw associations between the new data.

We are only beginning to understand how this technology can be applied in the business world. A few examples: A manufacturer of baby foods uses the technology to manage trading cattle futures. Soft drink bottlers use it as an “electronic nose” to catch and analyze unpleasant odors. Credit card companies use it to detect forged signatures and to spot fraud by identifying deviations in spending habits. Airlines use it to forecast flight demand. Postal services use neural networks to decipher sloppy handwriting, and computer companies use them to develop software that will recognize handwritten notes sent via email and engineering schematics sketched on a cocktail napkin.

The process of building and using a latticework of mental models is an innovative approach to thinking, and one that can be intimidating to many, to the point of mental paralysis. Fortunately there is a road map to the process that is easy to understand.

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