The last post covered a few things in the FCIC interview with Warren Buffett. One thing I want to touch on briefly is something Buffett kept mentioning – models.
I wish the interviewers would have asked a few follow-up questions because he kept referencing it. Here’s Buffett:
And the rating agencies, they have models, and we all have models in our mind, you know, when we’re investing. But they’ve got them all worked out, with a lot of – a lot of checklists and all of that sort of thing.
I don’t believe in those, myself.
All I can say is, I’ve got a model in my mind. Everybody has a model in their mind when they’re making investments.
But reliance on models, you know, work 98 percent of the time, but it’s – they never work 100 percent of the time. And everybody ought to realize that, that’s using them.
There’s a tendency for investors to lean on models or formulas to do a lot of the heavy lifting – the work – that we really don’t want to do. Buffett distills it down to “do your own analysis” instead of only relying on models.
What often happens is someone builds a model, based on a few ratios or a formula that has beat the market in the past, that is right almost all the time. The fault is taking the leap that because its right nearly every time, it’s never wrong. They round up – 98% becomes 100% – because it’s close enough.
We know multiple models failed during the housing bubble. The basic one, that housing prices roughly track inflation broke – at least deviated – long enough for people to believe a “new normal” of house prices growing at 10% (essentially you could say people rebuilt the model on a false premise of 10% price growth in houses).
Asset allocation is another concept built upon a model reliant on rational markets. Yet, we use it – almost to a fault – while knowing the markets don’t always follow the rational path.
I don’t think there’s anything inherently wrong with using models unless you stop ignoring outside factors that say it might be broken. Models are a good first step. Asking where it might be wrong is a good second step. If you’re going to rely on models, you must understand the limits, where it falls short, and that it won’t work all the time. Those limits, when there is uncertainty involved, become limitless.
Essentially, the modellers account for most of the risks – thanks to history – except for the ones they don’t know. The real risk is in thinking history accounts for all the risks they’ll encounter.
Long Term Capital Management relied on models too. They built a complex mathematical monstrosity that only a genius could understand. It worked great until it didn’t. Their shareholders found out how painful a perfect model can be when it runs up against an irrational market.
The problem with math, formulas, and modelling, in general, is the utmost need for rational behavior. The biggest lesson from history, when you look beyond the numbers, is that investors are hardly the most well-behaved rational creatures all the time.
- Stocks for the Long Run? – Fortune Financial
- The Stock Market’s Secret Weapon – A Wealth of Common Sense
- The Ache for Order, the Virtue of Chance – Undark
- Two Powerful Mental Models: Network Effect and Critical Mass – Andreessen Horowitz
- Negative Interest Rates: Impossible, Unnatural or Just Unusual? – Musings on Markets
- You May Be A Better Investor Than You Think – M. Housel
- The Value of Value Factors – J. O’Shaughnessy
- Jack Bogle: Masters in Business (podcast) – B. Ritholtz
- Todd Sullivan: Fortunes are Born in Bear Markets (podcast) – StockTwits
- The Hoaxster Who Revealed Sad Truths About America – Priceonomics