11 January, 2019
I recently read a short but very insightful book “On Dialogue” by David Bohm. David Bohm was an American scientist and one of the most significant theoretical physicists of the 20th century. Besides physics, he worked on unorthodox ideas in the fields of neuropsychology and philosophy of the mind. One of the topics Bohm raised is the difference between problem and paradox. According to Bohm, when one puts forth an idea in the form of a problem, there are certain largely tacit and implicit presuppositions which must be satisfied if the activity is to make sense. Among these is, of course, the assumption that the questions raised are rational and free of contradiction. Very often, without our noticing it, we accept problems with false or self-contradictory presuppositions.
In the practical and technical realm, however, we can usually sooner or later detect that our question is absurd, and we then drop the “problem” as meaningless. All of this, according to Bohm, is rather clear and straightforward in the practical and technical domain. But when we consider psychological or social problems the situation changes completely and we are confronted with the paradox that can be defined more simply as the paradox of “the observer and the observed.”
As those working in financial markets know, this was widely popularized by George Soros, through his investment philosophy and books where he describes his theory of reflexivity. According to Soros’ own words, he is a failed philosopher. I think he acknowledged this truth because there is really no philosophy in the theory of reflexivity itself. It is not some outlook on life that has meaning. Theory of reflexivity is just an alternative description of the paradox of “the observer and the observed” applied to financial markets: investors make decisions based on information provided by the market while they themselves are part of this same market and information.
In my view, Soros approached the paradox (and, judging by his returns, succeeded in resolving it) by a tactic of dancing at two weddings simultaneously. He achieved this by being constantly aware of the paradox while occasionally putting himself into a position of an objective, outside observer. In other words, he was constantly in the game but every once in a while jumped out of it. He danced at a wedding, but during breaks instead of resting, socializing and having a drink he crossed to another hall across the street to participate in the second party.
Other famous investors addressed the same paradox but implemented different methods to resolve it. Take, for example, Ray Dalio, with his culture of radical truth and transparency. I find it hard to believe that all of the two thousand people working at his firm are actually needed to make smart and efficient investment decisions. One can easily find many hedge funds with excellent track records that achieve this with a team of ten, twenty or maybe thirty employees. As I personally understand it, he needs all these people in order to create a sub-segment or a micro-culture, if you will, of the investors and people working in financial markets as a whole. This sub-segment then allows him to solve the “observer and the observed” paradox by calibrating his decisions with the help of this sample of market participants.
David Bohm suggested creative dialog as an important tool that can be used to overcome many paradoxes we face when trying to solve problems by our unique and individual thought. It seems that both Bohm and Dalio anticipated, in a certain way, a more recent trend of applying big data methods to decision making. Bohm with ideas of dialogue and collective consciousness and Dalio with a corporate culture of radical truth and transparency.
The generation of Soros, on the other hand, went along a different path. Famous value investors, with Buffett probably being the best example, pursued a reductionist approach. The idea of reductionism can be easily grasped through its application in science. Scientists reduce complex processes and problems to smaller, simpler components. They do it because it makes it much easier to do the research. For example, to understand brain activity.
In the investment world, value investing, quantitative investment strategies, and factor-based investment models aim to achieve the same. All these methods reduce complex processes, in this case, economy and the stock market, to a simple formula, model, or a set of rules.
The same principles were implemented in the art world by modern artists, but they approached the problem from the opposite direction. Artists make us start with “simple” and “reduced” elements of visual representation and “move” towards more complex ideas. Picasso destroyed the form. Mark Rothko reduced everything to color. Jackson Pollock integrated chance and accident into painting. But it is not the tricks of color or form that artists want to share with us. Otherwise, their paintings would not be worth millions. They want to share with us their complex and unique vision of the world. The depth and strength of feelings. The philosophical, religious or cultural concepts. It is just that modern artists feel it is very hard, if not impossible, to relay their vision except through a reduced and simplified form. But it remains our task to take it as a starting point and work all the way up to deeper understanding.
The approach of modern artists is very important because it highlights a weak element of the investment strategies grounded in reductionism. Through these models, the complex reality is reduced and is more easily understood, but one can easily forget that it is only a reduced, simplified version and not an eternal truth. And once the reality changes, sticking to the same models is a sure way to mediocre performance as a minimum and to a disaster as a maximum.
This weak side of the reductionism was summarized nicely by Bohm. Reductionist science has great power in understanding isolated things, and in applying this knowledge to create new things like new technologies. But its efficacy hinges on it being able to fragment or isolate its subject matter. It fails and may become actively dysfunctional when confronted by wholes, by the need to understand and take effective action in a highly interdependent context.
According to Bohm, “the whole is too much. There is no way by which thought can hold the whole; because thought only abstracts; it limits and defines.” Bohm believed that the alternative way toward understanding a whole arises through participation rather than abstraction. “A different kind of consciousness is possible among us, a participatory consciousness.”
Lately, few large hedge funds pursued the direction highlighted by Bohm, more or less, and developed alpha capture programs to collect data from many sources. These sources, when combined, achieve the same: they form a sample that captures the whole of the market’s thinking and collective behavior. Once you have it, it becomes easier to cross the street and put yourself into a position of an outside objective observer.
And the last but not least, the most recent fourth tactic of dealing with “the observer and the observed” paradox: active influence on reality. Winston Churchill said: “It is better to be making the news than taking it; to be an actor rather than a critic”. Activist investors aim to achieve exactly that: they do not just observe and “passively” react to “objective” reality but become an integral part of it and try to change it. As a result of the financial and credit market crisis of 2008, we saw tremendous growth of shareholder activism. There were too many people who were not satisfied anymore with sitting passively and waiting for others to take care of problems. Concurrently with the growth of passive index-based investing, there emerged a considerable need for players who would take on themselves this “dirty”, active work. Investors understood that if everybody acts in accordance with the same thought paradigm, nothing good can be expected.
So we can see a certain evolutionary process at work here. Investors went from a reductionist paradigm to trying to grasp the whole of complex reality. Once they decipher the collective consciousness of the market, either through big data models and alpha capture programs or through a sample and sub-culture dialogue, there is a choice to be made on how one should react to this “objective” reality. At this stage, one is presented with a choice: to be the actor or the critic. Just to react to reality or to take a more active stance and change it. So far it seems that most market practitioners are taking less active route.
Up until now, the passive attitude paid off well. But an important question surges into one’s mind following such a conclusion. As more and more market participants start to perceive reality not only through their individual thought but through this collective consciousness as well, it is reasonable to assume that this perception, in and of itself, will not serve as a competitive advantage. The paradigm according to which the only thing one should do is outsmart others will not work anymore.
A recent article “Hedge Funds Have Lost Their Rhythm” by Matt Levine raised exactly this point. He quotes one well-known hedge fund manager: “The last few years have become particularly difficult for active managers. Financial markets have significantly evolved over the past decade, driven by new technologies, and the market itself it becoming more difficult to anticipate as traditional participants are imperceptibly replaced by computerized models.” The point raised by Levine is that complaints by managers that it becomes harder to make money have a positive angle to them: it also means that markets are becoming more efficient.
However, the competitive nature of humans will not disappear so quickly. Not everyone will become a peaceful socialist overnight. Capitalism is probably here to stay. So there will still be a need and desire (by large segments of market participants, at least) to outperform and be above average. So what thinking might be relevant in the future? How one should think and behave in order to attain this goal? How financial markets might look 5, 10 or 20 years from now? Where are we going from here?
I think that markets will evolve along two main “dimensions”. First, they will become more and more segmented. As this trend will accelerate, less and less influence will be brought about by any one group of “players”. For example, up until now, a lot of influence on the market was exercised by passive index investors and such instruments as ETFs. I believe that going forward it will not be the case anymore. The influence by large segments of market “participants” will still be felt because some old “paradigms” will not evaporate suddenly overnight, but their “weight” will decline.
Second, the dimension of meaning. Here comes to mind a nice quote by Jean Tinguely, a Swiss sculptor: “The dream is everything; the technique can be learned.” The techniques employed by market professionals will keep changing: mutual funds, value investing, active management, hedge funds, passive index investing, algorithmic trading, alpha capture programs, shareholder activism, etc. But the need for a meaning and final objective (of outperformance, in the case of investors) will always be there. In the past, one could take a passive route, “separate” oneself from the market and relegate the task of implementation as well as the task of feeling on himself the burden and responsibility of following the dream and being actively “involved” (in creating the meaning itself, so to speak) to others.
I think that this will not be possible anymore. As financial markets evolve to a point where every market participant comprehends and acts according to a collective reality (of which he is a part as well), the option of “separation” from this collective reality will become less and less viable. To borrow a term from a recent book by Nassim Taleb, everyone will be required to have “skin in the game”. And obviously, this can not be accomplished by investing your savings into index funds. A more active, more involved approach is called for. In what form this will be achieved is another question, but the task of acting with meaning and dream in mind will fall on everyone’s shoulders and not only on investment or hedge fund managers.
In any case, you will have to develop a meaning both of the market and of your own investing actions and objectives: how the market works, in what companies to invest, what is the right valuation standard (as old ones might change a lot), what is the investment thesis for a certain company, what are the objectives and needs of other people (company’s management, other shareholders), etc.
The problem though is that in order to accomplish this one has to glue together a complex and sophisticated puzzle. I think that the only possible way to do this (or to cope with it in some way, at least) is through a narrative mode of thinking. Investors will have no other choice but to put greater emphasis on the idea of working with stories and narratives: both in simpler, individual situations (such as developing an investment thesis of a company) and when a much more complex picture of reality is being painted (with the help of big data models). Only the story format can help one organize disparate facts into a coherent picture, to create meaning out of chaos.