Gurus

Latticework of Mental Models: Physics Envy - Anshul Khare

Tan KW
Publish date: Mon, 24 Apr 2017, 05:34 PM

 

A group of tourists was visiting a dinosaur museum. A guide was entertaining them with interesting trivia about various dinosaur species. Just when they were passing by a huge skeleton of an ancient carnivore, an inquisitive member of the tourist group asked the guide, “How old is this skeleton?”

“Oh, that big T-rex skeleton? It’s about 100 million and 5 years old.” quipped the guide.

“That’s quite an odd figure. I understand the 100 million part but how are you so sure about the last 5 years?”

With all earnestness, the guide replied, “Well, that’s the most accurate part of the figure because exactly 5 years ago a world famous expert on dinosaurs told me that the skeleton is 100 million years old.”

The guide was honest in his attempt to provide an accurate information but he confused accuracy with precision. His answer was precise but was it really accurate? In fact, a better question to ask would be – did the guide make expert’s answer anymore useful by making it more precise? I think no.

Sir John Maynard Keynes said, “Better roughly right than precisely wrong.”

When it comes to investing, precision has much less practical application than a new investor would think. This tendency to look for precision where none exists is a human bias. Charlie Munger calls it Physics Envy.

In 2003, in his lecture on Academic Economics, Munger said –

It’s my view that economics could avoid a lot of this trouble that comes from physics envy. I want economics to pick up the basic ethos of hard science, the full attribution habit, but not the craving for an unattainable precision that comes from physics envy. The sort of precise, reliable formula that includes Boltzmann’s constant is not going to happen, by and large, in economics. Economics involves too complex a system. And the craving for that physics-style precision does little but get you in terrible trouble…economics should emulate physics’ basic ethos, but its search for precision in physics-like formulas is almost always wrong in economics.

Our mind is wired in such a way that it hates ambiguity and anything that can’t be measured by assigning a precise number to it is ambiguous to a human brain.

In Poor Charlie’s Almanack, Peter Kaufman writes –

Charlie strives to reduce complex situations to their most basic, unemotional fundamentals. Yet, within this pursuit of rationality and simplicity, he is careful to avoid what he calls “physics envy,” the common human craving to reduce enormously complex systems (such as those in economics) to one-size-fits-all Newtonian formulas. Instead, he faithfully honors Albert Einstein’s admonition, “A scientific theory should be as simple as possible, but no simpler.” Or in his own words, “What I’m against is being very confident and feeling that you know, for sure, that your particular action will do more good than harm. You’re dealing with highly complex systems wherein everything is interacting with everything else.”

Paul Graham, a very successful venture capitalist and founder of Y-Combinator, in his wonderful book Hackers & Painters, writes –

Everyone in the sciences secretly believes that mathematicians are smarter than they are. I think mathematicians also believe this. At any rate, the result is that scientists tend to make their work look as mathematical as possible. In a field like physics this probably doesn’t do much harm, but the further you get from the natural sciences, the more of a problem it becomes. A page of formulas just looks so impressive. (Tip: for extra impressiveness, use Greek variables.) And so there is a great temptation to work on problems you can treat formally, rather than problems that are, say, important.

Excessive quantification is the norm in physics and mathematics, but dangerous in investing. When looking at numbers in investing, always ask as to what do they mean and in what context were they arrived at.

Making investing decisions involves dealing with a lot of moving parts, including but not restricted to human behaviour, market conditions, competition, future prospects, and industry dynamics. Which means it’s nearly impossible to predict the final outcome accurately. Trying to put a lot of false precision into a complex system like the stock market is the source of severe errors.

The legendary investor John Bogle wrote in his book The Clash of the Cultures

When applied to the physical world, scientific techniques have been successfully used to determine cause and effect, helping us to predict and control our environment. This success has encouraged the idea that scientific techniques can be productively applied to all human endeavors, including investing. But investing is not a science. It is a human activity that involves both emotional as well as rational behaviour. Financial markets are far too complex to isolate any single variable with ease, as if conducting a scientific experiment.

There’s a famous saying in the value investing community – more fiction has been created using Excel than Word.

Excel, or any spreadsheet software for that matter, is a dangerous tool. Relying too much on Excel driven models (like DCF etc.) can divert your attention away from things that really matter. There’s a lot of wisdom in the adage – Everything that can be counted doesn’t necessarily count.

Price is what you pay and value is what you get, instructed Benjamin Graham. So as a value investor, the first thing I learned is to ensure that I don’t pay more than the intrinsic value of a company. Now, this poses a challenge. We are being asked to compare the price, which can be measured precisely, with the value which is largely an estimate i.e., inherently imprecise. But most new investors attempt to do that i.e., try to arrive at a precise number for intrinsic value. It’s a classic case of Physics Envy in action.

Calculating the intrinsic value of Berkshire Hathaway is a challenge, says Warren Buffett, “Present that task to Charlie and me separately, and you will get two different answers.” In his 2006 letter to shareholder, Buffett wrote –

…calculations of intrinsic value, though all-important, are necessarily imprecise and often seriously wrong. The more uncertain the future of a business, the more possibility there is that the calculation will be wildly off-base.

If you are a long term investor, then price target is a misleading number to follow because the preciseness of target price builds a false sense of confidence. And this false confidence makes you vulnerable to serious mistakes.

The majority of the small investors are not mentally wired to handle this counterintuitive aspect of investing. That’s why most people never make money in stock market. And that’s why the best strategy for most of the small investors is to invest through mutual funds. But there lies another paradox. To be able to select a good mutual fund, you need to learn the fundamentals of long-term investing. And once someone learns the nuts and bolts of investing, it’s almost impossible to resist the urge to pick stocks directly.

So dear investor, if you’re going to get your hands dirty in the stock market, in spite of all the warnings, beware of the pitfalls of Physics Envy.

http://www.safalniveshak.com/latticework-mental-models-physics-envy/

Discussions
1 person likes this. Showing 34 of 34 comments

stockmanmy

hahahaha


isn't this just good writing with what I have been been writing all along?

Physics envy is what I find in all value investing tool box and all IB research tp. investing. Especially of the Newtonian physics kind.....but the real world is controlled by quantum physics.

intrinsic values.....nothing is more intrinsic than cash companies ...go buy Puncak and miss the bull run.

2017-04-24 18:29

probability

This article is stupid:

This statement is wrong:

"Excessive quantification is the norm in physics and mathematics, but dangerous in investing."

This statement is a little better:

When looking at numbers in investing, always ask as to what do they mean and in what context were they arrived at.


Physics and maths is not excessive quantification...
Its excessive inclusion of variable and parameters where the magnitudes has little implications....drowning the bigger picture...drowning the variable which has the greatest impact and significance is what we can say dangerous.


Quantum physics does not contradict Newtonian physics..one deals with precision at much smaller scale and the other implies for daily practical application.

Only a confused nuts (maths failure) cant see the connection.

2017-04-24 18:50

stockmanmy

Love this – more fiction has been created using Excel than Word.

Excel, or any spreadsheet software for that matter, is a dangerous tool. Relying too much on Excel driven models (like DCF etc.) can divert your attention away from things that really matter. There’s a lot of wisdom in the adage – Everything that can be counted doesn’t necessarily count.

80% sometimes 90% of DCF valuations are the terminal values. Its practically all fiction.

2017-04-24 19:08

probability

DCF is a tool....the practical usefulness depends 90% on how the user uses it. Do not blame the tool....if you can't use it correctly.

2017-04-24 19:12

stockmanmy

Physics, especially quantum physics is another hobby of mine. Don't try to challenge me.

Newtonian physicists at one time think they can calculate every thing.

The so called value investors are akin to those dead Newtonian physicists...they think they can calculate every thing.......lol

2017-04-24 19:21

Ricky Yeo

I am a value investor, but I never tried to calculate everything. And on the other side, just because many important things cant be calculated, doesn't mean you don't need to measure it and resort to using hope, wishful thinking and astrology

2017-04-24 19:48

stockmanmy

.The author, Anshul Khare certainly know what he is writing about.....

The issue is.....do you?

ricky? probability, even KC? OTB? IB analysts? eyes?

2017-04-24 20:00

stockmanmy

In the Superforecasting book...the problem is laid squarely as follows....there is hardly ever any attempts to measure previous predictions ....economists, talking heads on TV, research analysts, ..another piece of news, and everybody forgets the previous predictions........lol......

2017-04-24 20:08

stockmanmy

After examining all the intrinsic valuations, target prices, DCF, Margin of safety, NTA, cash at bank, EV, not electric vehicle, ROIC, and comparing them to KYY earnings change, and catalysts, ....I would say approximately accurate is far better than precisely inaccurate.

2017-04-24 21:35

kcchongnz

Posted by stockmanmy > Apr 24, 2017 08:00 PM | Report Abuse
.The author, Anshul Khare certainly know what he is writing about.....
The issue is.....do you?
ricky? probability, even KC? OTB? IB analysts? eyes?


Anshul is definitely a great investor and his article here is great. But do you, an accountant(?) with absolutely no knowledge in accounting for investing, understand what message is Anshul trying to convey?

No, you don't. You got the completely wrong interpretation.

Does he say you forget about having a feel of the value of the company?

He is talking about false sense of precision in intrinsic value. We need to have a feel of the IV, but not a precise number.

We need to use spreadsheet to make analysis, but we do not need elaborate models, complicated assumptions.

Got it?

You are so superficial. OMG!

2017-04-24 21:50

cheoky

Nothing wrong with this article. Equivalent to mohnish pabrai 'yeh mota hisaab hai'. Still they categorized themselves as value investors. U only try to draw attention of people by Sorchai dynamite investing, apa pivotal moment, sailang, no humility. Tak malu. You are only good at confusing to the extent lu sendiri pun tahu lu tengah cakap apa. Poor snake oil salesmen.

2017-04-24 21:53

stockmanmy

calm down...cheoky, kc, who else?

your world falling down? Good.

out with the old, the new can come.

that is why an MCE / O level boy can beat all the CFAs and CPAs in the world. , at least in HK.....lol.

approximately accurate far better precisely inaccurate

the human brain tendency must first be conquered....without conquering that, how to conquer the world?



"Our mind is wired in such a way that it hates ambiguity and anything that can’t be measured by assigning a precise number to it is ambiguous to a human brain."

but it is the ambiguities that are far more important. The business sense and the people. The human brain can't handle too many lies....better focus on what is important than focusing on misleading stuffs.


At the end of the day...it is the MCE O level boy who do much better......lol.


Nothing like an outsider to show the experts how to do it properly.

2017-04-24 23:19

stockmanmy

After examining all the intrinsic valuations, target prices, DCF, Margin of safety, NTA, cash at bank, EV, not electric vehicle, ROIC, and comparing them to KYY earnings change, and catalysts, ....I would say approximately accurate is far better than precisely inaccurate.

far better....straight to the point.

2017-04-24 23:26

stockmanmy

KYY earnings change, and catalysts,

almost as easy as E = mc 2

almost as powerful

2017-04-24 23:28

stockmanmy

Physics envy...people cannot think without numbers and maths formulas.


But investors are better off if they spend time understanding the business and why they will win if they buy it now. Forget about valuation......focus on the business and the catalysts and coming results.

forget target price, forget intrinsic valuations for the time being....focus on why good? why bad?

2017-04-25 00:38

Ricky Yeo

You are just like a hedgehog, if you have read superforecasting.

2017-04-25 07:10

没怎么读到书的市集人

Aiya, stockman only worked as account clerk one or 2 years, what do you expect an account clerk to know investment? He relies heavily on news & rumours rather than figures because he doesn't know how to use those tools.

2017-04-25 07:36

没怎么读到书的市集人

Most account clerks always thought they were accountants.

2017-04-25 07:37

stockmanmy

This is one of the best articles there is....if you have read enough research reports, you will know all good analysts needs to read and reread this article until it is in their veins.





没怎么读到书的市集人 > Apr 25, 2017 07:36 AM | Report Abuse

Aiya, stockman only worked as account clerk one or 2 years, what do you expect an account clerk to know investment? He relies heavily on news & rumours rather than figures because he doesn't know how to use those tools.

2017-04-25 07:49

stockmanmy

"Everything that can be counted doesn’t necessarily count."

yet, I am sure all of you have seen analysts reports full of numbers and counting this and that......but they count for nothing in the final analysis.

Misplaced their attention, and the end result, a lousy report....lousy recommendation.

2017-04-25 07:56

stockmanmy

please remember, approximately accurate is far better than precisely inaccurate.

Physics envy is the term used to describe analysts who lost the forest for the trees. They jump into PE ratios and margin of safety and their magic formulas without even understanding their companies and their industries. ...no business sense.

2017-04-25 08:04

stockmanmy

not easy for you to change your bad habits...but change you must if winning is the objective....and winning is the only objective in the game.

Engineers are most guilty of this physics envy thing when they come to investments...an engineer in the stock market would have to read and reread this article every night before they sleep so it gets into their veins.




没怎么读到书的市集人 > Apr 25, 2017 07:37 AM | Report Abuse

Most account clerks always thought they were accountants.

2017-04-25 08:27

stockmanmy

that is why it is not surprising it takes an outsider, an MCE /O level boy to perform extraordinarily in this game....And this Dato Sri Cheah is not the only MCE /O level boy who has done well.

2017-04-25 08:32

stockraider

This mammy miss the point loh.....!!

What it mean is in investing no need to be so precise like maths and physic loh....!!

Thats why w.buffet and charlie munger says just rough estimate of intrinsic value....no need be precise to the dot mah....!!

W.Buffet also says value investment....just needs basic arithmetic thats is sufficient, no need calculus....loh...!!

Thus it is alot easy for value investor....as it only need add...substract....multiply and divide loh....!!

2017-04-25 08:51

stockmanmy

too bad that raider cannot move without numbers and margin of safety and moats and PE and I don't know what else......but never even understanding or show understanding of business sense.

2017-04-25 08:57

Ricky Yeo

I'm always so curious why you spent so much time toiling in this forum, not that there's anything wrong spending time here (although personally, I think there's far better things to do). But my conservative guess you are here 80% to satisfy your own ego and self confidence and 5% on educating others, the other 15% only you can explain to yourself. Here's why.

Everyone know's you have been preaching (not teaching) dynamic investing. Which is good if it is a sound method and add value to someone's life is the best thing one can do. But I place it at 5% because you never provide a proper framework that is tested with empirical evidence. So at the end it is just an untest theory that remains a ideological theory that satisfy your belief but disconnect from reality. 2nd reason why i place it in 5% is because if you are so passionate about teaching dynamic investing, how many value investor have you convinced to switch into dynamic, which you preach to be a better method? If that number is nil, then shouldn't you be examining your approach of preaching/teaching? Clearly if something doesn't work there's no point trying to force everything to look like a nail (hence my deduction that you think like a hedgehog).

So the deduction is simple. No one could care less whether dynamic is better than value when you can't provide a clear framework to reason and explain what you are trying to say. You never win by accumulating enemies (Dale Carnegie if you want to read). And if your real incentive here is to satisfy your ego by lowering others, which is a fixed mindset (read Carol Dweck's book), the net loser is going to be yourself not others. And im not writing this to defend value, growth or whatsoever investing approach. I am giving you an honest opinion just like how any respectful person would deserve. And you deserve no less.

2017-04-25 09:02

stockmanmy

Ricky


I don't owe you or anyone in this forum a favour.

I do what I do because you can benefit if you want but if not, none of my business.

2017-04-25 09:30

jayalbert

i like your style n thinking.. same like mine.

2017-04-25 09:31

stockmanmy

I do what I do mainly to benefit myself...to improve my own trading / investment skills.

2017-04-25 09:36

Ricky Yeo

Yes, and im not quite sure how does arguing with everyone else here and failing to win anyone over count as benefit yourself. You don't owe anyone here, but you do owe yourself a serious reflection if all these are worth it at all.

2017-04-25 10:40

stockmanmy

want to talk about hedgehogs? look no further than the raider here.

2017-04-25 10:55

stockmanmy

beware of the pitfalls of Physics Envy.

you will do much better after you have liberated yourself.

2017-04-25 13:43

stockmanmy

IB research reports that count a lot of stuffs that don't count

but miss out the stuffs that count

very very common.

2017-04-25 14:10

stockmanmy

The fact you can post this means you do not understand human nature and common errors.

If you don't understand human nature and common errors, there is no way you can win in the stock market.





cheoky > Apr 24, 2017 09:53 PM | Report Abuse

Nothing wrong with this article. Equivalent to mohnish pabrai 'yeh mota hisaab hai'. Still they categorized themselves as value investors. U only try to draw attention of people by Sorchai dynamite investing, apa pivotal moment, sailang, no humility. Tak malu. You are only good at confusing to the extent lu sendiri pun tahu lu tengah cakap apa. Poor snake oil salesmen.

2017-04-25 15:40

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