'Yes, it's rational' doesn't mean it works

“For every complex problem, there is an answer that is clear, simple and…wrong.”

While the American essayist H L Mencken had written a version of the above statement in 1920, Germany had proved it a few decades earlier. Towards the end of the 19th century, Germany had a novel idea. Since certain trees provided greater capital returns, it made “sense” to create homogenous forests of these trees alone. To do so, existing forests were cleared of underbrush and new trees were planted in straight lines to facilitate counting and cutting. To duplicate the original forests, the state also created birdhouses and anthills, and even imported spiders. This experiment failed miserably and the “scientific forests” died, largely due to what’s better known these days as the problems of monoculture (all complex systems need their ecosystem to survive).

James C Scott writes about this example in his book, Seeing Like a State (about how modern states simplify complex phenomena of societies that they wish to control). He introduces the idea of “legibility” essentially to suggest that when we see a complex natural system, we assume that just because it “looks” messy, it must be out of order. We then impose our own order to make it “legible”. However, eliminating messiness removes the essential components of the system that we couldn’t grasp, and the system fails.

The recipe for disaster, then, is fairly straightforward: (a) Look at a complex and confusing reality; (b) fail to understand all the subtleties of how complex reality actually works; (c) mistake your own inability to understand for the irrationality of what you see; (d) come up with plain vanilla vision of what reality “ought” to look like; (e) argue that relative simplicity and orderliness represent rationality; and then (f) watch your rational utopia fail miserably.

Sounds familiar? How about the last time you heard an expert making sense of the markets or how they have formulated a singular investment strategy that beats the market across cycles?

The reality, unfortunately, is much more complex than that. Markets (equity or otherwise) are an extremely complex ecosystem. They represent the cumulative psyche of all participants, and yet, the view of the majority has little bearing on it, until they become participants at the margin. For example, let’s assume that a company has 100 shareholders (each holding an equal number of shares, for simplicity’s sake). While 95 of them believe it is a good investment and it should be held onto, five decide it’s not worth it and start selling. The stock price on that day will be determined by those five shareholders. The opinion of the other 95 does not count, not unless they decide to turn buyers, i.e., become participants at the margin.

Devising a strategy that will outperform the broader markets all the time based on thorough back-testing of models is like creating a “scientific forest”. It is bound to fail, as there will always be elements of the complex ecosystem that one would have failed to consider. Unless that investment strategy encounters market conditions on a real-time basis and ends up outperforming in different market cycles, the probability of correctly predicting that it ought to is meagre at best. As they say, in order to have a track record of a decade, you need to have been around for a decade.

I have collated the returns profile of five mutual fund schemes and transcribed my assessment of their investment styles in the accompanying table. Nevertheless, the probability that my assessment is incorrect should be assumed to be high. The critical point, however, is that in different market cycles, there is a different fund scheme — and possibly, different investment style as well — that outperformed others.

Like any complex organism, the markets are messy. Several factors, like global and domestic macro-economic indicators, demand and supply within the industry, product pricing, international asset allocation, the available share float and several other factors contribute to the complexity of the ecosystem that surrounds markets. Creating an all-weather back-tested portfolio of stocks that outperforms in all market conditions is akin to creating the “scientific forests” that will eventually fail. Yes, it is “legible”; yes, it appears “rational”; unfortunately, like utopia, it simply does not exist.    

The writer is co-founder, Buoyant Capital