The Heart of Our Investment Philosophy – Predicting Trends
The future is not written, so nobody can predict it right? This thought, whether true or false, remains at the core of our understanding of the cosmos and our role in it. Most Westerners were raised believing in “free will”, which leads us to the conclusion that any human action is possible. The corollary of that thought, of course, is that “nothing is preordained”. And if nothing is preordained, if follows that change cannot be predicted. If change is not predictable, you cannot benefit in your investments by predicting change.
But I reject that conclusion. At the risk of appearing blasphemous, I think the concept of “free will” is very tenuous at best. While we have the impression that we go through life making choices which we are at whim to alter, the choices we make are entirely framed by our past experiences, by the culture passed down from our parents and societies, by our natural environment and by our biology. So these choices are inevitably predetermined to fall within a predictable range of possibilities.
If you accept that conclusion, does it necessarily follow that we can predict the future?
Of course not. We don’t have all the relevant data at our disposal – and if we did – we certainly don’t know yet how to factor in all the variables that impact a given process. You may expect to be able to
watch the news report tomorrow morning as you eat breakfast. But that likely event could be prevented by a natural disaster you did not foresee, taking out your electricity. Or your television could break down suddenly. Too many variables impact every thing we experience and do, to be able to predict simple events accurately. And if simple events cannot be accurately predicted, how can more complex events be foreseen?
Well, because the law of averages and probability come into play. The larger the scale of the item under consideration, the more predictable it becomes. Nobody know when I, a 56 year old somewhat overfed, but otherwise healthy individual, will finally meet my maker. But insurance companies have created highly successful businesses predicting exactly at what age most 56 year old Americans will die.
Consequently, it still makes sense to try anticipate the natural changes around us, man-made or natural, and to weigh how those changes create trends upon which we can successfully make investment decisions. We’ll be wrong at times, but we can hope to be right far more often then we are wrong.
To understand change, we can start by classifying it into three types:
- Cyclical change
- planting and harvesting
- birth and death
- day and night
- tides and phases of the moon
- stock prices
- economic recessions and expansions
- building and real estate activity
- seasonal sales
- interest rates
- Linear Change
- aging (of individual)
- growth of population
- cell growth and senescence
- Exponential Change
- technological process
- spread of disease
- growth of data and knowledge
- growth of networks
The most difficult part of attempting to predict change is to analyze whether the force or forces under consideration fall into the first or the latter two categories. Cyclical changes revert in a fairly predictable manner (the bell curve) back to a given starting point, then subsequently swing to its opposite. Linear and exponential changes feature trends that never revert to their starting point.
If a force is found to be guided by cyclical patterns, reaping profit from that takes a careful application of determining when a cycle is likely at its peak or trough and betting (or investing) on the impending reversal. By being patient, one is bound to be right. Thus has Warren Buffett, America’s most successful investor, made his fortune, following his motto: “Be greedy when others are fearful, and fearful when others are greedy.”
Similarly, look for biological roots in cycles and identify how those cycles impact economics. For those thinking that America’s real estate slump is purely a question of greedy bankers and lax regulators, you may want to more closely examine the 5 and 7 year cycles of the adjustable loans granted to home mortgage owners. It is more than coincidence that the boom of 2002 finally burst in 2007 – the same year all those balloon payments started coming due.
Recognizing that cycles exist – and are overpowered by other cycles – adds complexity to these issues, but does not prevent their analysis. Thus anyone predicting a resurgence of real estate in another 5 to 7 years – a turn of that cycle – would be wise to pay attention to the larger generational cycle : namely how 80 million people are going to retire and downsize their homes due to aging of the population at a time only 50 million new generation X’s step into the markets to buy homes. The laws of supply and demand allow a confident prediction of continued pricing declines.
A trader recognizes cyclical changes and knows how to benefit from them. As Shakespeare wrote: “There is a tide in the affairs of men which, taken at the flood, leads on to fortune.” A modern-day Wall Street trader might reword that as “sell when the price is overbought on both the stochastic and rsi charts”.
Linear and exponential changes are what bring about the “new” in change, and actually permit progress over time. Identifying those trends accurately is probably what distinguishes an investor from a trader. Finding investments in companies or industries likely to benefit from linear and exponential growth are the essence of successful long term investments.
One of the foremost scientific and literary minds of our time is Ray Kurzweil, who in his book “Approaching the Singularity”, dissects the forces guiding technological change. Understanding these forces – the distinction between linear and exponential growth – is actually one of the most difficult processes of human understanding.
Our brain is naturally wired to think things in the future will change at about the same pace as things changed in the past. We have grave conceptual problems dealing with exponential growth.
There is an old fairy tale that perfectly exemplifies this inability to conceptualize exponential growth. The fairy tale starts with a king who is very thankful towards one of his counselors who delivers a simple herbal remedy that saves the kingdom’s livestock from a fatal disease. The king is so thankful that he offers the counselor a castle, or the hand of one of precious daughters or anything the counselor wishes, if it is withing his means to grant. To his infinite surprise, the counselor asks for nothing more than one grain of wheat for the first square on a checkerboard. But for each subsequent square, the king is to double the quantity of grains. Thus 2 grains for the second square, 4 for the 3rd square and so forth.
The king immediately grants the counselor his wish. Little does he realize, that by the time he’s gotten to the 64th square, he owes the counselor more grain than is produced in his entire kingdom. Such is the power of exponential growth.
This same difficulty of thinking in anything but linear fashion caused the entire American Academy of Sciences to predict it would take 30 years to map the human genome by deploying a majority of scientists to the task. It took scientific maverick, J. Craig Venter, to understand the impact on genome research of an exponential increase in computer power. Venter confidently predicted he could do it with a small team in one – sixth that time, and one hundredth the budget. The Academy of Sciences scoffed at the notion but Venter went on to do just that.
Similarly, today, we repeatedly hear technological experts and investments gurus scoff at the idea that solar power will play an important role in solving energy problems within our lifetimes. They are once again demonstrating the human brain’s reluctance to accommodate exponential growth. They are thinking that a technology that represented about 1% of our total energy consumption in 2003 could not possibly make a meaningful difference over the next few decades. What they ignore is the fact that technology improvements are doubling the capacity and halving the costs of solar energy every two years. Consequently, as pointed out by Ray Kurzweil in a 2011 University of Florida speech, solar energy will overtake oil-based energy in cost efficiency within 6 years , most likely by the year 2017.
The implications for any investing strategy are obvious: expect the sales of solar energy companies to grow at rates of 35% and more over the next decade.
From there to knowing which solar company to invest in is more difficult, but their is little doubt this will be a dominant industry within the next decade. The stock prices of the leading companies in the sector will increase manyfold.
Do you like investing in the automobile sector? If you think people will still be driving cars – and I do – you’d better make sure the car companies you invest in are leaders in electric car technologies.
More and more fields of discipline and human endeavor are being impacted by the digitalization of knowledge. Identify those fields, and you can make savvy investments in industries sure to grow.
Medicine, for example, for years was a field that was labeled a science of discovery. New advances resulted from careful observations and trial and error of the administration of different remedies, some of which proved beneficial and others fatal. Consequently, the advance of knowledge in the medical field was one that grew in a linear fashion.
The advent of the personal computer and the exponential power increases in chip technology changed all that. These gave tremendous impetus to new developments in the fields of microsurgery, biotechnology, drug testing and microphotography, which in turn led to our understanding of the human body as a complex mechanism which responds to the software embedded in our DNA. Having mapped the human genome, we are now not only learning which gene controls which bodily function, but also are able to directly manipulate those genes to affect our health outcomes. As a consequence, medicine itself has now become a field of knowledge growing at
an exponential pace, rather than a linear one.
One simple implication of that, but a far reaching one, is that human longevity will increase at a faster pace than most of us can conceive of. For a middle-aged Americans, their grandparents lived into their late 60′s, parents into their 80′s. They tend to see themselves living into their 80′s and perhaps their 90′s. Yet many of them – due to the rapid pace of scientific advances – will live to be centenarians. Their grandchildren, futurists like Kurzweil claim, will be able to choose to live forever.
An investor today who wishes to successfully invest over the next 10 years must keep the following precepts in mind:
- Learn to distinguish the cyclical trends that affect the investment.
- Assess when a larger cyclical trend will override a smaller one.
- Distinguish between linear and exponential changes, and favor investments that benefit from the latter
- Do not ignore our tendency to overestimate the speed of technological change at first, then to grossly underestimate it thereafter.
- Realize that the pace of change is increasing constantly, so whole fields of human endeavor will rise and fall ever faster. Yesterday’s burgeoning software giant (Microsoft or Intel ?) quickly can become today’s dinosaur. Conclusion: don’t fall in love with any one company or industry.
- Finally, realize that you will be wrong in a few of your predictions. Plan for contingencies to limit your losses when you are wrong.