saurabhprasad (98.05)

Insight, did you say? Get rid of that. (Lesson 3 of 'Two years in rearview')

March 23, 2008 – Comments (8) | RELATED TICKERS: VIGN , SCSS , MSFT

This is counter-intuitive to the extent of sounding inexcusably stupid. Allow me to elucidate.

Why 'insight' could very well be wrong
Insight can be defined as better understanding or more accurate information about a particular industry or firm. And how can that be bad at all?
Anyone with an analytical bent of mind will agree that more information means more data-points, allowing a theory to be tested more number of times. If the theory is ill-conceived, it is much more likely to be caught as so with more number of data points than less. If there are no data-points that defy the theory, it raises the status of the theory to as close to water-tight as possible. So far, so good.
Now, look at the inherent assumptions in the last paragraph.
(1) Known variables
(2) Controlled environment
If you have had the luxury(?) of reading scientific theses, you'd see the two items above come up again and again. Without an explanation of how all known variables were controlled (temperature, pressure, humidity etc), the paper is not complete.

Financial markets are not known for controlled environment or known significant variables. So, even if you have enough additional insight to write Encyclopedia Britannica ten times over, it may not be enough. Having said that, should we give up, not look for further data, order Chinese and put on Family Guy? Of course, not. Unfortunately, the remedy is even more counter-intuitive - get more data and if possible, try to prove the opposite of your favorite theory. I am always surprised how much data exists on the the other side of the beach and how much it can convince you to switch sides. If you barbecue with George Bush, you're not going to like this exercise. Questioning yourself is the name of the game. If you are a champion of sticking to your guns, remember that there's a possibility that the guns might be pointing at you.

Even if you're indeed a proud owner of an insight...
Now, for the sake of the argument, let us say our theories are perfect. Let us say that we have constructed them in such a way that they are impervious to any other data. Let us say that we have hand-crafted them to be axioms and they need no proof and they're equivalent of saying 2+2=4, rain or shine. After we celebrate being Einstein's distant nephews over that episode of Family Guy and Chinese take-out (I know, I have no life), here are some other pitfalls to consider...

(1) Beware of localized insight: Knowledge of only a part of the issue can lull into a sense of complete understanding of the issue. As an example, in our firm we use Vignette (VIGN) content management products and lately they have been coming out with a lot of Web 2.0 functionalities (comments, recommendations, blogs etc.) which they demonstrated to us in a customer seminar. Now, there's no doubt that this is a good thing for Vignette, as they are adding all these key bells and whistles to their product making it much more attractive. I rushed to add it to my CAPS and no surprise, it tanked immediately after a poor quarter. It didn't make sense to me and as I asked my other IT friends as to why it is dropping like a stone in water, they mentioned that they are increasingly using Open-Source content management systems like Drupal, which are free and lot less regimented. This is a good example of why localized knowledge can take your pants down right when you get on the stage.
This is also the reason the Enron employees kept their retirement savings in Enron stock, almost all tech consultants of 1999 lost aplenty in the dot-gone and companies keep buying back their stock even when their business is being hampered for foresee-able future (SCSS, MSFT anyone?) If companies themselves cannot judge their standing the market appropriately, who are we to claim "insight" on basis of a tip from someone who is in the industry or a $25 report from Ken Fisher?

(2) Selective data selection: Think for a second on how you find more data about the stock. Now, think again. I am not being facetious, just want you to have a clear thought process in your head. Now, how I do is that I chance upon a stock (on CAPS, in news or on my screen) and then I start looking it up. After 30 minutes or so, I am interested in learning more. But by now, I have already made up my decision to a good extent - Buy, Pass, Short. Any further 'research' that I do, I constantly veer towards proving what I my gut feel is. It is very hard for me to be unfeeling and I feel an incredible unidentifiable logical bend to prove my initial judgment right. If I let myself go unchecked, I end up selecting data that prove what I have already decided unconsciously. If you're free from this, more power to you. It always stuns me that I create smoke and mirrors for myself in garb of collecting more insight.

(3) Breeds false confidence: As we all know, a little knowledge is much worse than none. More so in markets. Not only because it sends you on the wrong path, but also because it does making you feel very confident. On such a path, we ignore warning bells and sign and walk right into a tornado because we know there are no tornadoes in March in Texas.

And that brings us to the last point...
(4) Most information is just that - more information, NOT insight: We assume every piece of information brings us more clarity to the situation; it is absolutely not the case. Million miles far from it. It could be mis-quoted, a cover-up, a statistically misrepresented data, obvious data never reported before, or simply nothing. Information has be accurate and clarifying to be an insight. If you're a starter, you can't judge if the information reflects the situation effectively. So treat it as information, period. It is not an insight, period.

Now that I have convinced you that fishing piranhas barefoot in Amazon is safer than investing, here's are the rules that I try and live by.
(a) Never buy a stock within a week of first hearing about it (removes emotionality)
(b) Find data for both the bull case AND the bear case. Pit the data against each other, pick the winner. If no one wins, move on.
(c) Don't act on a tip without doing a and b - even if it is a trusted source.
(d) Remind oneself that all information is not insight