Beware the Grand Theory

Many smart investors and money managers employ theories adapted from physics, biological systems, chaos theory, and other complicated top-down methods in an effort to beat the market. Often, this only results in making the difficult task of finding great investment ideas only harder. The great investors, such as Warren Buffett and Walter Schloss, spend their time looking for cheap stocks, not cosmic theories, to beat the market averages over time.

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By Zeke Ashton
May 22, 2002

One of my favorite mutual fund companies is called IPS, which manages a small family of three funds. But it's not their stock-picking prowess that interests me -- I don't have a dime invested in any of their funds. And it's not because I've learned a lot about investing from their website (though it is extremely informative.)  Rather, it's because they are funny.

If you don't think it's possible that a mutual fund website can be every bit as entertaining as a good Saturday Night Live skit, take a minute to head over to their home page. Click on one of the funds, and hit the link that says "Risk Disclosure: Human Language." Prepare to bust a gut laughing -- no, really, this stuff is hilarious.

The website is very different from those of most mutual funds. For one thing, the portfolio manager posts a diary describing what he is buying and selling and why. There's a lot of other good stuff on the site as well. IPS projects a smart yet fun-loving image, and makes an effort to really include their investors and make them feel almost like a part of the organization. They've even got a fund where they let the customers make the investing decisions. I've got to say, it's darn refreshing.

I bring up IPS Funds today because, while I am entertained and charmed by the company's website, I don't think the IPS funds will be better investments than your average mutual fund. The head honcho at IPS Funds is a likeable guy named Robert Loest, who has a Ph.D. in biology and likes to rollerblade. Here's his bio from the site.

Robert Loest is a biologist, and models the economy using Complex Adaptive Systems (CAS) theory. A good analogy of a CAS is a biological ecosystem. Such systems tend to behave in very different ways than those predicted by classically trained economists and financial people who view the economy as a complicated machine. Applying CAS to stock selection often results in radically different ways of understanding the economy, the behavior of securities in the economy, and in understanding and explaining the process of value creation.

Here's a little more about how IPS looks at things from their "Philosophy and World View" section, which begins with:

When you buy a stock, you are placing a bet on the future. A manager without a view of the future is handicapped from the start. IPS Funds' management believes its view of the future is the major determining factor in its performance, and that you should understand it before you invest with us.

That sounds reasonable enough. But it gets a little bit complicated after that. Due to space constraints, I'm going to have to edit out some stuff here, as dangerous as that might be. Here are some selected excerpts from the company's explanation of how they view the capital markets.

We believe the world is entering a period of rapid transition to a higher level of "connectedness." We believe this phase shift will be more extreme, and occur far faster, than any previous change in history. We expect new, complex, emergent behaviors to result from this phase shift. We believe that extensive, broadband connectedness in our civilization has attained a momentum that makes similar complex, emergent behavior in humans inevitable. For those who see this coming, there are obvious investment implications.

Our view of the world is conditioned by the models, metaphors, or paradigms we employ to interpret reality. Most money managers, in our opinion, use models that are rapidly becoming obsolete. At IPS Advisory we believe that classical economics, and many investment assumptions that derive from it, are based on a fatally flawed model, that of Newtonian mechanics, that assumes a universe where things are predictable, unchanging or static, reductionist and mechanical, where output is proportional to input. It is only due to an accident of history that economists adopted such an inappropriate model. The biological model first described by Darwin is, we believe, far more appropriate in describing economic systems, but was unavailable at the founding of economic theory.

We use what we have termed Evolutionary Ecosystem Mechanics (EEM) to describe how we view economic systems (ecosystems!). The advantages of this model over classical economics are overwhelming. Classical economics does not explain how corporations move up the learning curve, which is a biological concept. It doesn't explain how this can determine the dominant companies during periods of rapid technological change when many industries have been forced back to the beginning of new learning curves. EEM describes the interactions of human societies and economics much better. For example, unlike classical economics, EEM predicts complex, dynamic, evolving systems with multiple, interdependent feedback loops. Such systems typically are highly stable, but dynamic and uncontrollable. When such systems are perturbed, they respond in unpredictable ways, but always attain a new equilibrium. A natural property of these systems is that they move toward greater complexity and interdependence, which is what we are seeing in most industrial sectors today, from airlines to Internet software companies. Classical economics does not predict such dynamic, evolving systems, and is especially useless during times of rapid change.

OK, I think you get the idea. If this weren't complicated enough, IPS also incorporates Stern Stewart's Economic Value Added analysis in their investment decisions. As you can see, these guys use some impressive-sounding theories to help them figure out where to invest money.

I used to be really impressed by brilliant people with impressive sounding theories of investing (maybe because I've never come up with one.) Now I'm just skeptical. The results of these impressive theories are often less than impressive. Readers should carefully consider the case of Victor Niederhoffer who, back in the mid-'90s, wrote a best-selling book. It was mostly about how smart he was and how he used theories of biological systems or physics or modern game theory or some such mumbo-jumbo to make bets in the capital markets. Everyone seems to agree that Niederhoffer is a real smart guy, but real smart guys have a tendency to make investing more complex than it needs to be -- and that can get them into a lot of trouble. Niederhoffer blew up his hedge fund in 1997 and lost everything. He now writes investing articles, the best of which share a common theme of how hubris leads to bad endings, though he is still tinkering with some atomic theory of markets (or something).

The problem is that layering one of these multi-variable cosmic theories like Complex Adaptive Systems or Atomic Theory or whatever over the already difficult task of finding great investments is just so... well, hard. Let me quote from a section of the IPS Millennium Fund's 2001 annual report to shareholders:

The strength, and the major weakness, of our management style is that we rely normally on adverse stock price movements that are at odds with publicly available information, management statements, and favorable analyst opinions, as an early warning that something is wrong with a company. Historically this has often gotten us out of stocks well ahead of the eventual negative news, and saved us a great deal of money.

Unfortunately, drastic and rapid market declines such as we experienced in 2001 mask the signals that we normally rely on to get out of stocks before disaster strikes. We did not recognize that worse was to come, and failed to move our sell stops up soon enough to avoid some major losses in our aggressive stocks.

See what I mean? Complex Adaptive Theory, or whatever it is, may be perfectly valid, but it's probably really, really hard to apply to the stock market.

Everything I have ever read about Warren Buffett suggests to me that he spends his time looking for undervalued companies and doesn't spend much time thinking about cosmic theories or trying to predict interest rates or other economic variables. Another of my investing heroes, Robert Olstein, has a great saying: "Spending ten minutes a year predicting economic variables is a waste of ten minutes."

Value investing legend Walter Schloss has spent almost 50 years buying dirt-cheap stocks and compounding money at 20% annually. I've never met the man, but I'd be willing to bet that Walter Schloss hasn't spent the past 50 years trying to detect some mysterious signals that might indicate that it's time to get out of stocks before he loses money. Instead, he buys stocks so cheaply that it's almost impossible to lose a lot of money.

The stock market is a pretty complex system. Those who have beaten it have generally used simple approaches that require discipline and patience, but not grand theories. As for IPS, I'd like nothing better than for them to succeed. But I suspect that if they do, it will be because they learn how to buy undervalued stocks and not because they understand complex adaptive systems.

Zeke Ashton did not own shares of any IPS mutual fund at the time this article was written. The Motley Fool is investors writing for investors.