Jan. 29, 2020
A few years ago, our firm went through the process of hiring a new investment research consulting firm. In each interview, I asked the investment consultants the same question: What is your favorite investment book?
Most of them named classic works such as The Intelligent Investor by Benjamin Graham or A Random Walk Down Wall Street by Burton Malkiel, which left me underwhelmed. These are great books, no doubt, but the responses made me wonder whether these investment professionals ever dig beneath the surface.
For me, reading lots of investment books is part of being a lifelong learner. No matter how many years I’ve been in the business, sitting down to learn about new theories and frameworks lets me step back and look at the bigger picture. It challenges my current beliefs and expands the base of knowledge from which I filter investment information going forward.
I am not alone in this practice. Warren Buffett says he spends 80% of his day reading and thinking. And his business partner, Charlie Munger, vouches for it.
“If you take Warren Buffett and watch him with a time clock, I would say half of all the time he spends is sitting on his ass and reading,” Munger told an auditorium filled with law school graduates during his 2007 commencement speech at the University of Southern California. “You’re not going to get very far in life based on what you already know.”
Many investment professionals read the news and day-to-day investment information but skip reading books. As Munger asserts, that doesn’t cut it. Without the deep thinking and reflection that books require, you will end up living in an echo chamber and be more susceptible to confirmation bias. Here are five books on investing that I’ve found mind-expanding to get you started:
- The (Mis)behavior of Markets: A Fractal View of Financial Turbulence by Benoit Mandelbrot and Richard L. Hudson
Few people are aware that many of the ideas espoused by Nassim Taleb in his groundbreaking book The Black Swan: The Impact of the Highly Improbable are based on the work of Benoit Mandelbrot. Known as the “father of fractals,” Mandelbrot was a mathematician who founded a new branch of geometry in the 1970s. This branch, called “fractal geometry,” recognizes that much of the natural world is a hodgepodge of rough, irregular shapes – not the smooth-edged triangles, circles, and rectangles we studied in high school geometry.
In the 1980s, Mandelbrot applied this concept to the financial markets. He observed that the mathematical models used to explain and predict market fluctuations were too simple because they are based on the false assumptions that price changes are independent and follow a normal distribution. He proposed that fractal geometry does a better job of modeling price movements because it incorporates the periods of relative calm and stability in the market as well as the extreme movements that occur much more often than standard mathematics suggests.
Learning this concept made me question everything I had learned about investing. Mandelbrot’s work caused me to conclude that the investment markets are more chaotic and unpredictable than the standard mathematics of finance led me to believe. As a result, our firm more readily recognizes the limitations of financial models used by the industry and don’t rely on them in creating all-weather portfolios for our clients.
- The Success Equation: Untangling Skill from Luck in Business, Sports, and Investing by Michael L. Mauboussin.
This book takes on one of the biggest questions in investing: How much can we attribute our success to skill versus luck? To explain, Mauboussin introduces the skill-luck continuum, with competitions like chess and running races on one end (total skill) and roulette and slot machines on the other (complete luck). He places sports such as football and basketball closer to the skill side and investing closer to luck.
The concept that struck me the most was the Paradox of Skill, which says that as the skill level rises in any specific discipline, luck accounts for more of the results. For example, if you have two top football teams playing each other, the outcome of that game will depend more on luck – whether a field goal attempt hit the upright or a player caught a hail mary pass – than on the skill of the players since their skill is evenly matched. If you have two teams playing each other that aren’t evenly matched, the outcome will depend more on skill.
The Paradox of Skill hit home for me. Most areas of the market resemble Alabama playing LSU in football: highly competent opponents with nearly equal skill battling it out. The high skill across the investment management industry means that luck plays a huge role in the relative returns of investment managers. This knowledge has led our firm to focus more on an investment manager’s process and less on their returns over shorter-term periods when evaluating and hiring investment managers.
- Successful Investing is a Process: Structuring Efficient Portfolios for Outperformance by Jacques Lussier
This book is required reading for all of our firm’s investment personnel, most of whom are CFAs, yet still end up learning a lot. One of the critical points Lussier makes is that because the market is capitalization-weighted, both the market and market-indexed portfolios are over-allocated to overvalued stocks and under-allocated to undervalued ones. So, the capitalization-weighted market is not an optimal basis for structuring a portfolio even though most active managers can’t beat it.
As a result, instead of trying to “outperform the market,” an investor is better off structuring his portfolio with non-market-cap based constructions so that the market will underperform the portfolio. It’s a subtle but significant difference that has dramatically affected my views of investing. I now believe outperforming the market is more a matter of structure, discipline, and behavior and less about predicting what the market will do in the future.
- Adaptive Markets: Financial Evolution at the Speed of Thought by Andrew W. Lo
Andrew Lo is an MIT economist best known for his research showing that market prices have memory, and price movements are not entirely independent; they have momentum, which is why past prices matter.
In this book, Lo proposes a new theory he calls the “Adaptive Markets Hypothesis,” which seeks to synthesize the theories of the behavioral school of investing ( investors are biased and irrational) and the efficient markets school ( investors are rational, profit-maximizing machines) . His theory encompasses both: people sometimes behave irrationally but learn from their mistakes and adapt out of self-interest.
The Adaptive Markets Hypothesis draws heavily on biology and evolution to explain how markets develop, change, and evolve. The comparison of the markets to biology rings true for me. Economists tend to try to capture how the markets work with complex formulas and grand rules similar to those in physics. According to Lo, the markets behave more like an organism: changing and adapting as its environment changes over time (or facing extinction if it doesn’t change). The Adaptive Market Hypothesis has increased our firm’s awareness that strategies that have worked for us in the past may not work in the future as the markets evolve and change. Merely taking past information and extrapolating into the future doesn’t always work.
- The Known, the Unknown, and the Unknowable in Financial Risk Management: Measurement and Theory Advancing Practice , edited by Neil A. Doherty and Francis X. Diebold.
Each chapter of this book about managing investment uncertainty is written by a different economist. The authors break risk into three buckets: known risks, unknown risks, and unknowable risks.
The critical point for me, which runs throughout the book, is that investment managers and academics tend to focus their risk management efforts on known risks, which is misguided because it’s the unknown and unknowable threats that cause the biggest problems. They tend to do this because according to one of the authors, known risks are “often amenable to statistical treatment, whereas unknown and unknowable risks are usually not.”
The authors don’t offer specific solutions for managing unknown risks because they are by their nature…unknown. Instead, they posit that recognizing and acknowledging the unknown and unknowable should lead investors to rely less on standard risk measurement metrics because much more can go wrong than these analyses can predict. Consequently, our firm builds portfolios knowing that standard asset optimization models will not capture the unknown and unknowable risks. That’s why we build in large market shocks beyond what standard investment theory predicts when stress testing our portfolio designs.
Now that I’ve got you hooked
These five books will expand your investment worldview and may challenge some beliefs that you have held long for a long time.