Table of Contents
Title Page
Epigraph
Dedication
Acknowledgements
Introduction
Part 1 - Investment Philosophy
INTRODUCTION
Chapter 1 - Be the House
Hit Me
From Treasury to Treasure
Prioritizing Process
Chapter 2 - Investing—Profession or Business?
The Scouting Report
Evaluating the Winners
The Investment Profession Versus the Investment Business
Chapter 3 - The Babe Ruth Effect
Batting with the Babe
The Downside of Hardwiring
Bulls, Bears, and Odds
From OTC to OTB
A Useful Analogy
Chapter 4 - Sound Theory for the Attribute Weary
Circumstance Over Attributes
The Three Steps of Theory Building
When, Not What
Chapter 5 - Risky Business
Rocket Science
From Uncertainty to Probability
How Predictions Change Future Payoffs
Chapter 6 - Are You an Expert?
Man Versus Machine
Where Do Experts Do Well?
Chapter 7 - The Hot Hand in Investing
Finding the Hot Shot
Streaks and Skill
Toss Out the Coin Toss
Streaks and Luck
Chapter 8 - Time Is on My Side
One or One Hundred
Explaining the Equity-Risk Premium
The Value of Inactivity
Pictures Worth a Thousand Words
Chapter 9 - The Low Down on the Top Brass
Management Counts
Leadership
Incentives
Capital Allocation
The Bottom Line
Part 2 - Psychology of Investing
INTRODUCTION
Chapter 10 - Good Morning, Let the Stress Begin
Why Zebras Don’t Get Ulcers
Why Money Managers Do Get Ulcers
Shortening Horizons
Imitating Ulysses
Chapter 11 - All I Really Need to Know I Learned at a Tupperware Party
A Tip from Shining Shoes
You Can Fool Mother Nature
All I Really Need to Know . . .
The Psychology of Investing
Chapter 12 - All Systems Go
Emotions and Decisions
Two Follows One
The Affect Heuristic
When the Experiential Fails
Affect: Individual Versus the Collective
Chapter 13 - Guppy Love
Guppy See, Guppy Do
Feedback—Negative and Positive
Follow the Ant in Front of You
Herding from the Grapevine
Chapter 14 - Beware of Behavioral Finance
Sorry Syllogism
Mug’s Game?
Bombs Away
Money See, Money Do
Chapter 15 - Raising Keynes
What Do You Expect?
Speculation and Enterprise
Visiting El Farol
Kidding Yourself
Chapter 16 - Right from the Gut
Guns and Better (Decisions)
Chopping Down the Decision Tree
Investing au Naturel
The Fine Print
Chapter 17 - Weighted Watcher
I Do—Do You?
Sifting Weights
Misleading by Sample
Tell Me Something the Market Doesn’t Know
Part 3 - Innovation and Competitive Strategy
INTRODUCTION
Chapter 18 - The Wright Stuff
Take Off with Recombination
How Does Wealth Happen?
Sic Itur ad Astra (This Is the Way to the Stars)
Creative Destruction—Here to Stay
Chapter 19 - Pruned for Performance
Too Clever by Half
The Dynamics of Innovation
Investors: Use the Brain
Chapter 20 - Staying Ahead of the Curve
Losing Pride
Goldilocks Expectations: Too Cold, Too Hot, Just Right
Out with the Old, In with the New
The Mind Makes a Promise That the Body Can’t Fill
Expectations and Innovation
Chapter 21 - Is There a Fly in Your Portfolio?
Fruit Flies and Futility
Speed Trap?
Investor Evolution
Chapter 22 - All the Right Moves
Managing for the Long Term
Deep Blue’s Lessons
Strategies for Winners
Strategy as Simple Rules
Chapter 23 - Survival of the Fittest
A Peek at Another Peak
Fitness Landscapes
Look Before You Leap?
Tools of the Trade-Off
Chapter 24 - You’ll Meet a Bad Fate If You Extrapolate
Social Versus Security
Nonstationarity and Historical P/Es
Why the Past May Not Be Prologue
Bounded Parameters
Unpacking the (Mental) Baggage
Chapter 25 - I’ve Fallen and I Can’t Get Up
Returns and Growth
Death, Taxes, and Reversion to the Mean
I’ve Fallen and I Can’t Get Up
Chapter 26 - Trench Cooperation
The War Metaphor—Death or Life?
Why a Date and a Marriage Are So Different
Price and Quantity
Chapter 27 - Great (Growth) Expectations
Compounding and Confounding
Reality Check
The Bigger They Are, the Slower They Grow (or Don’t Grow)
Refuse Refuge in Castles in the Air
Part 4 - Science and Complexity Theory
INTRODUCTION
Chapter 28 - Diversify Your Mind
Ant Brain
A-Mazing
Getting a Diversity Degree
Creativity and Investing
Chapter 29 - From Honey to Money
Smart Ant
Traveling Salesman? Follow the Ant . . .
Delphic Decision Markets
The Stock Market—the Ultimate Hive?
Swarm Smarts
Chapter 30 - Vox Populi
The Accuracy of Crowds
Needle in a Haystack
Weighing the Ox with the Vox
Estimating Printers with Populi
And Now, For the Real World
Chapter 31 - A Tail of Two Worlds
Experience Versus Exposure
Tell Tail
What Fat Tails Mean for Investors
Chapter 32 - Integrating the Outliers
Bernoulli’s Challenge
What’s Normal?
St. Petersburg and Growth Stock Investing
Integrating the Outliers
Chapter 33 - The Janitor’s Dream
Beyond Newton
Sorting Systems
The Stock Market as a Complex Adaptive System
Using What You’ve Got
Chapter 34 - Chasing Laplace’s Demon
Evolution Made Me Do It
Laplace’s Demon
Interpreting the Market
Investor Risks
Chapter 35 - More Power to You
Zipf It
The More Things Change . . .
Catch the Power
Chapter 36 - The Pyramid of Numbers Firm Size, Growth Rates, and Valuation
Why Big Fierce Animals Are Rare
Find Your Niche
Dear CEO: We’ve Made It to the Fortune 50! You’re Fired
&nbs
p; Extrapolative Expectations
Chapter 37 - Turn Tale
Hush Puppies and Dogs of the Dow
Ah Choo
Economists, Meet Mr. Market
No Progress in Human Nature
Maintain Perspective
Chapter 38 - Stairway to Shareholder Heaven
I Could Do That
Stairway to Shareholder Heaven
Making the Art Less Abstract
Order and Disorder
Conclusion
NOTES
References
Further Reading
INDEX
Copyright Page
A balanced perspective cannot be acquired by studying disciplines in pieces but through pursuit of the consilience among them. Such unification will come hard. But I think it is inevitable. Intellectually it rings true, and it gratifies impulses that rise from the admirable side of human nature. To the extent that the gaps between the great branches of learning can be narrowed, diversity and depth of knowledge will increase.
—Edward O. Wilson, Consilience
To my parents
Who always stood behind me but were never too close
ACKNOWLEDGMENTS
I wrote the original versions of these essays while I was at Credit Suisse (formerly Credit Suisse First Boston). In my dozen years at CSFB, management consistently offered me marvelous opportunities for professional development. Allowing me to launch The Consilient Observer—the offbeat offering that provided the basis for More Than You Know—is a tribute to the firm’s open-mindedness and support. In particular, I am indebted to Brady Dougan, Al Jackson, Terry Cuskley, Steve Kraus, and Jim Clark. Credit Suisse was also gracious in granting me the copyrights to these works.
Two names were listed on The Consilient Observer’s original masthead. The other belonged to my research associate, Kristen Bartholdson, who made significant contributions in research, editing, number crunching, and producing exhibits. She also helped update material for this edition. Smart and talented, Kristen is also a delightful person to work with.
Dan Callahan, my research associate at Legg Mason Capital Management, picked up where Kristen left off, working tirelessly on all aspects of this book. He was instrumental in updating the material for both editions, getting the exhibits and manuscript in shape, and coordinating all communication. Dan is resourceful, productive, and bright. He’s also a great guy, and I’m really pleased he is on my team.
All of my coworkers at Legg Mason Capital Management have been terrific, providing valuable support and cooperation. LMCM also allowed me to use copyrighted material. Thanks to all of you.
Two people have had a major professional influence on me. The first is Al Rappaport, with whom I wrote Expectations Investing. I have learned an enormous amount from Al, and he remains a tremendous source of inspiration and constructive feedback.
The other is Bill Miller, whom I now have the honor of calling a colleague. Bill stimulated many of the ideas in these essays, either directly or indirectly. It’s one thing to write about how the mental-models approach helps investors, it’s quite another to use the approach to generate excess returns. Bill has done both, and for that he deserves all of the admiration he receives.
Both Al and Bill have always been gracious with their time, and have taught me with patience. They are great role models, and I feel privileged to be associated with both of them.
These essays draw from the work of many fabulous scientists, too many to list individually. But a handful of thinkers deserve special mention, including Clayton Christensen, Paul DePodesta, Norman Johnson, Scott Page, Jim Surowiecki, and Duncan Watts. Thanks to each of you for sharing your ideas with me so generously. Steve Waite’s suggestions were also of great benefit to me.
I’d like to thank Myles Thompson, my publisher and editor at Columbia University Press, for his boundless enthusiasm and unwavering belief in the power of these ideas. Assistant editor Marina Petrova has also been an immense help in all aspects of the project. Michael Haskell improved the book’s flow with his thoughtful edits and supplied the new, comprehensive title. Nancy Fink Huehnergarth was instrumental in shaping the original manuscript, providing both valuable editorial input and a fantastic sense of humor.
I also appreciate Sente Corporation’s very talented Jay Smethurst and Bryan Coffman for their artistic contributions. They were with me from the very beginning of the consilient journey. At CSFB, Marian Toy and Ann Funkhouser were great editors to work with: efficient, constructive, and thoughtful. My administrative assistant at CSFB, Melissa Little, also helped in key areas such as exhibit production and distribution.
My wife, Michelle, is a constant source of love, support, and counsel. My mother-in-law, Andrea Maloney Schara, is the rare grandmother who can explain systems theory and throw a football. Finally, I thank my children Andrew, Alex, Madeline, Isabelle, and Patrick for allowing me to see diversity firsthand.
INTRODUCTION
More Than You Know’s core premise is simple to explain but devilishly difficult to live: you will be a better investor, executive, parent, friend—person—if you approach problems from a multidisciplinary perspective. It’s the difference between moving into a fixer-upper home with a full set of power tools versus a simple screwdriver. You are going to be a lot more successful and efficient if you have the proper tool for each job at hand.
The reality is that the majority of us end up with pretty narrow slices of knowledge. Most occupations encourage a degree of specialization, and some vocations, like academia, insist on it. And there are the time constraints. We are all so busy talking on the phone, answering e-mails, and going to meetings that we don’t have any time left to read, think, and play with ideas.
Following the publication of this book’s first edition, a lot of readers contacted me to say they enjoyed the exposure to non-traditional ideas. Most people easily appreciate the value of diverse thinking. But many readers view diversity as something that’s nice to have, not something that’s essential to success. In contrast, I have come to believe cognitive diversity is crucial to solving complex problems.
The case for cognitive diversity is based on theory and practice. In his book The Difference, social scientist Scott Page demonstrates the logic of diversity. He shows, using mathematical models, how and why diversity is necessary to solve certain types of problems. Page deftly nudges the diversity discussion away from metaphor and anecdote toward grounded, timeless theorems.
Notwithstanding Page’s theoretical contribution, you might ask whether there’s any actual evidence for diversity’s value in predicting the outcomes of complex problems. The answer, a resounding yes, is based on psychologist Phil Tetlock’s remarkable research summarized in his book Expert Political Judgment. Tetlock asked hundreds of experts to make thousands of predictions about economic and political events over a fifteen-year span. He then did something quite rude. He kept track of their results.
Expert forecasters were, on balance, deeply unimpressive. But Tetlock found some were better than others. What separated the forecasters was how they thought. The experts who knew a little about a lot—the diverse thinkers—did better than the experts who knew one big thing.
Two sources in particular have inspired my thinking on diversity. The first is the mental-models approach to investing, tirelessly advocated by Berkshire Hathaway’s Charlie Munger. The second is the Santa Fe Institute (SFI), a New Mexico-based research community dedicated to multidisciplinary collaboration in pursuit of themes in the natural and social sciences.
Charlie Munger’s long record of success is an extraordinary testament to the multidisciplinary approach. For Munger, a mental model is a tool—a framework that helps you understand the problem you face. He argues for constructing a latticework of models so you can effectively solve as many problems as possible. The idea is to fit a model to the problem and not, in his words, to “torture reality” to fit your model.
Certain character traits encourage the mental-mode
ls method to blossom. Fortunately, these are mostly traits you can choose: intellectual curiosity, integrity, patience, and self-criticism. Problem-solving success is not just a matter of IQ. As Munger notes, the great naturalist Charles Darwin’s worldview-changing results reflect more his working method than his raw intellect. On the flip side, examples abound of smart people making bad decisions, often showing inflexibility or a failure to appreciate psychology’s lessons.
A mental-models approach does not come without a cost, though. You need to spend substantial time and effort learning about various disciplines. Without a doubt, too, your learning may not be useful right away (in fact, it may never be useful). The good news is there are typically only a few big ideas in each discipline that you’ll need to master.
I have learned a great deal from Munger’s musings over the years, and his influence is clear throughout these pages. Fortunately, Peter Kaufman assembled Munger’s background and speeches in Poor Charlie’s Almanack, a terrific book offering plenty of insight on the mental-models approach.
The Santa Fe Institute sprung from a group of like-minded scientists who decided the world needed a new kind of academic institution. These scientists, each distinguished in his field, recognized that universities often operate in academic isolation; professors spend a lot of time with colleagues in their field but rarely cross disciplinary boundaries. The founders felt strongly that much of the fertile scientific ground was between disciplines, and they were determined to cultivate it. Spend some time at SFI’s campus and you are likely to see physicists, biologists, and economists all chiming in with their diverse perspectives on a topic of interest.
The unifying theme at SFI is the study of complex systems. In both the physical and social sciences, lots of systems emerge from the interaction of many heterogeneous parts. Examples include human consciousness, the immune system, and the economy. SFI scientists were early in identifying the salient features of these systems and in considering the similarities and differences across disciplines.
The SFI-inspired idea that has most deeply influenced me is viewing the stock market as a complex adaptive system. Embracing this mental model compelled me to revisit and question almost everything I learned in finance: agent rationality, bell-shaped price-change distributions, and notions of risk and reward. I believe the complex-adaptive-systems framework is not only a much more intuitive way to understand markets but also more consonant with the empirical record.