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

Many generalise when they invest.

Examples:

• Tech is becoming more important; tech stocks will do well.
• Artificial intelligence is 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.
• Bitcoin has no store of value. Cryptos are scams.

Such statements may seem insightful and simplify a complex world, but they can mislead us.

Generalisations can be dangerous.

Here are some ways people generalise:

• What happened in the past will happen in the future.
• What happens to the country, a sector or a company will affect every company in the country or the sector.
• A change in a variable (interest rates, depreciating currency) can have a huge impact on many companies.
• We read the headlines and form our conclusions.
• We form our conclusion about news media and social media without validating their claims.

Generalizations can be useful for forming quick judgments or making decisions, but do beware 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.

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. They do not adapt in their 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 generalization. They’re at one end of the bell curve, defying common beliefs. These companies have been 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. 

We need to make an effort to study in detail to find these exceptional winners, develop the conviction to keep holding them and have the right emotions to buy at the right prices and keep holding them. 

We cannot find and hold great companies to invest in by generalising. The daily news and market actions will easily shake us. We need the conviction to buy with a good portfolio allocation and keep validating them to hold long. Doing in-depth research to identify exceptional companies and keep validating them is important.

Similarly, when we generalise the sector to be good and have been rallying, we also buy the wrong ones. We invest in those that have not rallied or smaller caps without doing due diligence into these individual stocks.

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

Using generalisation to your advantage

Track your performance
Generalisations illuminate broad trend trends and guide our investment strategies. Beware of the possibility of inaccuracies and their extent.

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?

To mitigate the potential dangers of generalisation, it is important to approach generalisations critically with an awareness of their limitations and inaccuracies.

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.

ETFs instead of individual stocks
When we generalise and not delving into the details of individual stocks, it is better to invest in ETFs instead of individual stocks and diversify into different sectors and countries with ETFs.

• Do due diligence to ensure what we generalise is still valid and accurate.
• Don’t follow generalisations blindly. Understand the reasons behind them before jumping in.
• Diversify. Investing based on generalisations can be dangerous as they can be inaccurate.

Do track the performances to ensure that we are on the right track.

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Validate and go against the wrong generalisations
When we understand how people have generalised, the valuations are attractive and we believe to be wrong, we should investigate in detail whether they provide good investing opportunities.

We can observe these in social media and with friends. Many do not study the markets and stocks in detail, they (blindly) follow others and generalise wrongly. Hence, the market may not be right. This is how the broader market cycles develop where strongly held generalisations create strong biases and this creates the psychology of market cycles with rallies and crashes.

Be non-consensus and right

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