Why you need a framework as a fallback
Investing from first principles — Part 1
Laziness is an integral part of the human condition.
Mental shortcuts, or heuristics, are in valuable in helping us filter and process information. They enable us to act instinctively, preserving our mental horsepower for more complicated tasks. Without heuristics, we’d be paralyzed by every small decision.
But heuristics also pervade our self-conscious and can blind us to the information which matters most.
This is sometimes the case with investment decision-making. Gathering the requisite data takes time, effort, and discipline. Often, we get halfway there, land on an answer that seems ‘about right’, and justify the decision with our gut (or ‘instinct’, if you want to rationalise further through diction). The consequences can be disastrous.
The way to make better decisions is to be prepared.
Have a pre-existing framework which you can apply to bring simplicity and order to complex — and perhaps conflicting — ideas.
We can divide this framework into four sections.
1: Irrefutably true (what we know we know)
- The power of compound growth
2: Well-established, based on empirical evidence (what we think we know)
- Stocks outperform bonds in the long run
- The value and momentum factors
3: Of limited or questionable validity (use with caution and caveats, rather than formulaically)
- The Black Scholes option pricing model
- Fashionable factors (apart from value and growth, which themselves undergo long periods of underperformance)
- Measures of risk that fixate on volatility (and generally rely heavily on the normal distribution)
This section is meant as a reference and is continually updated. I will expand on each component of the framework in separate posts.