Laws of Investing - Part 2 — Hunter Lewis LLC

Whether investment laws exist is part of a larger question of whether economic laws exist, because investment thinking is a subset of economic thinking. A 2013 article in the Atlantic concluded that “The Laws of Economics Don’t Exist.” My book One Hundred Economic Laws puts me in the opposite camp.

To say that economic/investment laws exist does not mean that they are identical to those of the physical sciences. The differences are considerable. We watch an apple fall from a tree, as Newton did in developing his notion of gravity. Ignoring for the moment the subtleties of Quantum Physics, our watchful eye does not influence either apple or tree. By contrast, when we watch billions of human beings making their decisions and taking their actions, which is the subject matter of economics and investing, what we see not only influences our own behavior, it may also influence the behavior of those we are watching. I discussed this in Are The Rich Necessary?

“ Assume that people study stock market history and decide that stocks are the best and safest place to put their money. What will they do then?
Naturally they will buy more and more stocks. But, by doing so together, they will [increase demand relative to supply and thereby] raise prices dramatically, and this will make stocks more and more risky. Eventually, almost all the potential buyers will already have bought, so that people who must sell (such as retirees) will have…[few] left to whom to sell. At that point, prices may collapse, leaving investors poor and bewildered.
This is not a hypothetical example. Something similar happened in the great American stock crashes of 1929, 1973, 2000, [and 2008].

The lesson here is clear: just when we all decide that something is ‘true,’ it may cease to be true, at least for a time.

This can be generalized to: once a successful investment idea is very widely embraced, it is likely to start to fail. In this generalized form, it is easier to recognize as a well known logical error called “the fallacy of composition.” Because something is true for a partial sample (eg. the first investors) does not mean that it will be true for the complete sample (eg. all investors). For a list and explanation of several hundred such fallacies, I recommend Robert Gula’s little book Nonsense.

The preceding example should give us a clue about the nature of investment laws. Whether we refer to them as rules or principles or laws, they either reflect logical rules such as the “fallacy of composition” or are derived from such rules.

Logic need not be complicated. It tells us what should be self evident eg. It is oxymoronic to speak of a triangular square. A triangle has three sides, a square or other rectangle has four. It is less obvious, but equally false, to assume that what works for some investors will necessarily work for all.

Simple or complicated, logic is also a remorseless teacher. It teaches us to be orderly, organized, clear, relevant, consistent (at least not directly self contradictory), unemotional, and generally focused on external reality, not on our internal wishes.

A market, which is just an abstract term for the behavior of masses of people organized in a certain way, may be exceptionally emotional in the short run, but eventually must come to terms with reality. Investors try to use logic and its derivative rules/principles/laws to get to reality first.

Rationality works in investing not because markets are rational, but because they are so often irrational. If you read the often quoted statement by economist John Maynard Keynes: “Nothing is more suicidal than a rational investment policy in an irrational world,” you might want to know that it is a fake quote. It was attributed to Keynes by someone sixteen years after the economist’s death, and there is no evidence he ever said it. Having read the entire body of Keynes’s written thought in order to write my own book on Keynes, I can also tell you that it is not something he was likely to have said.