The great investing myth (11): Generalisations to make money

Many generalise when they invest.

Examples:

• Tech is becoming more important. It is driving all sectors.
• Artificial intelligence, nuclear and quantum computing are the future!
• REITs are good for dividends. Singapore assets are good for REITs.
• Dividend investing is the way to invest to provide passive income to retirement.
• Rising interest rates are bad for stocks and REITs.
• The oil and gas sector is too cyclical to invest.
• China is uninvestable.
• Singapore is boring and it is difficult to make money.
• Family businesses are bad.
• Government scholars and retired soldiers are bad leaders.
• Bitcoin has no store of value. Cryptos are scams.

How true and accurate are they?
Such statements may seem insightful and simplify a complex world, but they can mislead us.

Generalisations can be dangerous.

They create biases with inaccurate and misleading investing theses that can be harmful (losses and missed opportunities):

• What happened in the past may not happen in the future.
• What happens to the country, a sector or a company may not affect every company in the country or the sector.
• A change in a variable (interest rates, depreciating currency, inflation) may not have the same huge impact on companies.
• We read the headlines and form our conclusions which may not be accurate in the longer term.
• From the mainstream news and social media, we form our conclusions which may not be correct and accurate.

Generalizations can help quick judgments but do be aware of the following:

1. Oversimplification: Generalizing can lead to oversimplification, where complex and nuanced phenomena are reduced to broad statements or stereotypes. This oversimplification can result in a distorted or incomplete understanding of reality.
2. Ignoring individual differences: We overlook each company’s unique characteristics when we generalise. Different companies have different competitive moats, quality and different financial situations — different quality. By ignoring these individual differences, generalizations will fail to capture the complexity and diversity within a sector and country.
3. Inaccurate conclusions: Generalising from a limited or unrepresentative sample can lead to inaccurate or misleading conclusions. Drawing sweeping statements based on a few instances or a biased subset of data can result in flawed judgments. It is crucial to consider the variability and context of the information before making broad generalizations.
4. Change: In business, the only constant is the constant change. What we generalise may not be true over time.

Here are a few traps when investors rely on generalisations to invest:

• Conventional wisdom, herd mentality or market consensus: Generalizations often stem from past experiences, media, or social influences, becoming common beliefs that are hard to change—and may not even be true.
• Ignore individual company’s performance: We assume that every company will perform and react in the same way under the same operating conditions. In reality, every company is different. They do not adapt in their own ways.
• Diversification: We may invest in the wrong sectors and countries based on what we generalise to be attractive.
• Cynicism: Over-generalisation can lead to cynicism. This can become a liability as it is not accurate.

Relying on generalizations leads to two critical mistakes:

• Type I Errors: Investing based on false assumptions, leads to poor decisions.
• Type II Errors: Avoiding opportunities because they don’t fit conventional wisdom.

You can’t generalise to find (exceptional) winners.

Exceptional winners—the outliers—don’t follow the rules of generalisation. They’re at one end of the bell curve, defying common beliefs. These companies had been small startups. They kept building, adapting and thriving through changing and challenging operating environments. Their growth seems unaffected by the macro events happening throughout the years. The winners are the very few high-quality companies that achieve exceptional performance. They are winners precisely because they defy generalisations.

We cannot find and hold great companies to invest in by generalising. We need to make an effort to study in detail to find these exceptional winners and have the conviction to buy at the right prices and keep holding them. 

Similarly, when we generalise the sector to be good and have been rallying, we may buy the wrong ones. Investing in those that have not rallied or smaller caps without doing due diligence can be a mistake.

Challenge conventional wisdom, do thorough due diligence, and seek outliers by digging deeper into metrics and fundamentals.

Using generalisation to your advantage

Be conscious of our generalisations; track our performance
Generalisations illuminate broad trends and sentiments. Beware of the possibility of inaccuracies and their magitude.

Track our investing performances.
What have we generalised when we make the investments?
How have these investments fared?
How can we improve our investing performances?

Always ask: How true and accurate are they?

It is essential to seek diverse perspectives, gather sufficient evidence and be mindful of individual differences and contextual factors when making generalisations. In addition, fostering open-mindedness, empathy, and a willingness to challenge stereotypes can help mitigate the negative effects of generalisation.

Non-consensus: Validate and profit from wrong generalisations
When the generalisations are incorrect and wrong, they can be good investing opportunities to go contrarian with.

We can observe how social media, investors and friends generalise wrongly. Social media can amplify these misleading generalisations and biases. The viewers do not study the markets and stocks in detail, they can be easily convinced and (blindly) follow others.

The market may not be right. Be non-consensus and right. Find the mistakes and profit.

Simplify, don’t generalise

Both involve a level of abstraction, ignoring some details to focus on the bigger picture. Both aim to make things more efficient.

• Generalization helps you apply past experiences to new situations without learning everything from scratch.
• Simplicity helps you process information or complete tasks more quickly and easily.

Generalization is about finding common ground and creating broader categories, while simplicity is about making things easier to understand or use.

Many of us (including me) like shortcuts. We want to spend less effort to make more money (low effort, high returns).

When we simplify our investing approach, we need to ensure that we are still able to capture “the essence” correctly and make money. In most situations, a few simple variables matter.

The key takeaway is that simplification in investing requires a strong foundation of understanding to avoid oversimplification and what we simplify is representative. Hence, we need a thorough understanding of the companies and their sectors to know what information and metrics are important and relevant to filter out the high-quality companies we want to invest.

Here is the post in which I explain my approach: The Picasso Bull of Investing : How to identify high-quality companies with a few metrics