Life is a dance of pattern

An extract from our 2011 Annual Letter

There is in all things a pattern that is part of our universe.”

― Frank Herbert, Dune

Some of the most pressing problems of the world (and life) would be better understood by recognizing the patterns which produce them. To separate signal from noise, wheat from chaff.

Indeed, life itself is a dance of pattern (hat tip, Alan Watts).  Right down to the level of DNA in cells and up to the level of cosmic supernova there are structures – patterns – which underpin reality.

Survival itself is predicated on success in rapidly recognizing meaningful patterns. Snake! Our peripheral vision and autonomic nervous system (“fight-or-flight”) is wired to respond to threats.  Wild berries!  Our acute frontal vision is wired to locate camouflaged prey or gather nuts and berries. 

To get the pattern wrong – or to miss it entirely - can be fatal. Don’t eat the red berries.

To Err is Human

In response, the human brain has evolved over eons as an incredible pattern-recognition technology. We learn – to walk, to read, to think, to play – by observing the past and present and projecting hypotheses into the future.

Indeed this ability is what separates us from our animal ancestors. Apes are pretty smart and even adaptable, but they can’t compose music, play chess or drive a car. 

It’s no surprise then, that we are all drawn to excellence in those who master patterns in all domains of human endeavor:  Copernicus, Michelangelo, Mozart, Galileo, Marie Curie, Albert Einstein, Benoit Mandelbrot, Henry Ford, Garry Kasparov, Warren Buffett, Michael Jordan, Jack Nicklaus.  Inspirations all.

Nevertheless the thinking brain is not infallible. To err is indeed human. The list of intrinsic biases is looong:  loss aversion (prospect theory), anchoring, recency bias, over-optimism, availability heuristic etc. As Daniel Kahneman says, just ask your spouse!

Why do we even have these biases?  Well most of the time they serve us well – they help us move forward or quickly assess danger without too much cognitive load.

Nevertheless, the brain’s powerful pattern recognition function hits its natural limits when faced with complex, noisy, data-rich problems … like investing.

The Madness of Markets

Most people who invest in markets - that is, become fractional owners of companies, do so to grow their capital. To plant seeds now for a later harvest; to reap what they sow.  And so they should – saving for a better future and allocating capital wisely underpins … almost everything.

Part of the faith required to invest now for an uncertain future return rests on markets being fair and efficient. As it pertains to the stock-market, the report card is probably an A- for the former and a C+ for the latter.

Ben Graham’s allegory of Mr Market remains a useful frame of reference: a manic-depressive type who constantly offers to buy from you and sell to you, but who is driven in turns by panic, euphoria and apathy. Graham stresses that Mr Market is there is serve you not guide you.

To say another way, in markets what you see is not necessarily what you get. Risk and reward are not perfectly matched.  The madness of mobs trumps the wisdom of crowds.  The mathematics of efficient market theory are elegant and compelling … and wrong. Their fatal flaw is the assumption that errors (among market participants) are independent. Really!?

That said, markets are mostly efficient, most of the time. Really good investment opportunities are ephemeral and rare. 

So how to find these rare investment opportunities?  More importantly, how to avoid catastrophic investment errors?   Well thousands of books are written on that – and there are 10,000’s of data-points at a company level that could be assessed to make a determination.

A good investment process first needs to find the signal in the noise, persistent patterns which predict company success.  But that’s not enough.  The process then needs to be executed in a way which combines paradoxical qualities, such as:  patience and aggressive action; discipline and adaptability; being aware of the crowd psychology but not swayed by it.

To compound the difficulty, the stock market is a wicked learning environment. Feedback (essential for learning) is ambiguous, delayed and clouded by randomness. To misappropriate Churchill:  the market is a riddle, wrapped in a mystery, inside an enigma.

G2 was established to bring machine intelligence to fundamental investing. To systematize stock selection and redefine investing. In short, to beat humans at their own game.