Why Investing Success Demands Embracing Paradox

Johnny Hopkinsinvesting insightsLeave a Comment

During their recent episode, Taylor, Carlisle, and Jim O’Shaughnessy discussed Why Investing Success Demands Embracing Paradox. Here’s an excerpt from the episode:

Tobias: JT, top of the hour. Do you want to do your veggies?

Jake: Yeah. And couldn’t be a better transition, to be honest, as you might find out. So, as I was reading Jim’s book, Two Thoughts, which we’ll talk more about after I get through this, I was struck by how often these two selected quotes, which is what makes up the book. All these really super smart people and kind of the two smartest things that they ever said in their lives. But those two things were often in conflict or paradox with each other. And somehow, yet both were strikingly true, which kind of defies some internal logic for me at least. And I think I have a possible answer that was inspired by a recent read which is one of my friend, Nima, in his 2024 investor letter, he runs this firm called Rumi.

He talked about this and I’m going to see if I can weave this all together for us. So, I think the distinction lies in convergent versus divergent problems. I don’t know if you’ve seen this mental model before, but to step on the punchline a little bit. Convergent problems have a clear single solution that can be reached through logical analysis. While a divergent problem is usually related to human values and complex systems, it doesn’t have a single definitive answer, and it requires a more holistic approach, and you have to consider multiple perspectives and nuance. So, this breakdown of that terminology originally comes from a statistician and economist, E. F. Schumacher. And he actually led a pretty interesting life.

He was born in Bonn, Germany in 1911 and he witnessed the rise of the Nazi regime, and he was pretty disillusioned by all the fascism. He fled for Britain, and it didn’t really go much better for him once he got there. During World War II, he was interned as an enemy alien and it’s an experience that shaped a lot of his views on power and resilience and human dignity. But basically, the British didn’t trust that he wasn’t a German spy. But John Maynard Keynes recognized Schumacher’s acumen in economics, and he broke him out of the internment camp basically and took him on as a protege at Oxford.

And fun fact, Schumacher’s brother-in-law was the renowned physicist, Werner Heisenberg. And yes, that was an actual guy and not just a chemistry teacher dealing drugs in New Mexico.

Jim: [laughs]

Jake: So, after the war, Schumacher, he helped rebuild the UK and Germany and was a leader of the British National Coal Board, which was actually a pretty big responsibility at the time because coal was a very dominant resource still of energy, still is today, but– And his economic thoughts and writing were very influential post war period. In 1973, he published a book called Small Is Beautiful: A Study of Economics as if People Mattered, which is a great title and it was well received, sold well. And one of his main arguments in the book was that we can’t consider the problem of technological production solved if it requires us to recklessly erode our finite natural capital and deprive future generations of its benefits.

So, this is a little bit of the Ehrlich-Simon arguments, but it also actually to me sounds a lot like the position that Charlie Munger took. He was a big fan of actually saving the hydrocarbons for future use because they’re too valuable as chemical feedstocks for our grandkids than to be used to go get groceries, basically. Anyway, Schumacher, he understood this paradox of growth and sustainability long before it was a mainstream concern.

And so, just to summarize a little bit here and drive it home, convergent problems, they’re typically technical issues with well-defined parameters like designing a bicycle or solving a Sudoku puzzle where you can gradually converge towards an optimal outcome. It just takes a lot of elbow grease. And I think AI is probably like really good for that. Think of maybe finding the most efficient way to produce solar panels or something like that, there’s a clear, measurable solution.

Divergent problems are often philosophical, ethical questions. There’s no single correct answer. Maybe think about what’s the best approach to education. Do you instill discipline and kind of cram it into the kid’s head? Or, do you allow free learning? How much? What’s the balance? Or, maybe deciding between economic growth and environmental sustainability. And so, Schumacher’s big insight was that if you show up to a divergent problem with convergent solutions, you’re likely to run into a lot of issues.

And this actually rhymes quite a bit with Jim’s friend, Rory Sutherland’s book in Alchemy, where he talks about engineering solutions versus human or psychology solutions and how different those can be.

So, let’s get this all back to investing and see if we can try to stick this landing here. My hunch is that the world would be a lot easier in investing if it was just purely convergent problems like plug in the right numbers, carry the one, you get this unequivocally correct answer. And because it would be nice if it was easier, there’s a lot of wishful thinking done by people to view it as a convergent problem. If you just work hard enough, there’s always the right answer to distill down. But there are some parts of finance are probably like that, like maybe you know, understanding the payment schedule of a mortgage or something. So, it’s not all divergent problems, but most of the time I think it tends to be divergent problems.

Let’s take the balance of trust versus skepticism. If you trust everything, you’re likely to get taken advantage of. But if you’re skeptical about everything, you’re likely to miss big opportunities. So, as a thought experiment, I’ve often wondered if you took everyone who has ever owned Berkshire Hathaway over the last 50 years, 60 years, and you lined them up in the order of multiple of return on the invested capital and we had just everyone stand in a big line and you force rank them, my hunch is that you would actually probably end up with the inverse row of that population on how they would score on an accounting exam.

So, the people who made life-changing money, they just trusted Buffett to figure it out. And if they knew a bunch of accounting or valuation, they may have talked themselves out and sold Berkshire along the way when it felt like it was too rich. I mean, it’s just human nature. But if you did that exact same exercise with Bernie Madoff or Enron, you’d probably get the inverse where if you could understand a simple cash flow statement, you could plainly see this wasn’t sustainable. So, there’s always these paradoxes, right?

And another paradox might be patience versus urgency. Obviously, patience is crucial for long term success. We’re finding that out in the value world, how much patience you actually need. But you should be waiting for that fat pitch, right? But if you’re too patient, it might look like continually sucking your thumb, not pouncing aggressively, and then you’re letting your few precious trips to the pie counter slip away. Those are all Mungerisms, by the way. So, urgency can drive action, but too much of it leads to impulsive decision making. So, how do you find that right balance?

And even transparency kind of has its own paradox. Investors crave openness from their CEOs, LPs want transparency into their GP’s processes. How is the sausage actually made? But maybe over explaining in volatile times leads to premature decisions. Are you making the right investment or are you making one that you can actually explain to your constituents? And maybe in the CEO case, they don’t want to be open because that’d be giving away some material trade advantage.

So, there’s all these parts of the investment process. Some require intuition that never fits necessarily into words. So, it can be hard to explain to someone else to get their buy-in and so you only choose things that you know that you can explain, which might actually be quite suboptimal. It’s like being in love, like when you know, you just know.

Circle of competence also, I think, has its own paradox. If you only stay firmly within your circle of competence, you’re likely not to expand it very much if you’re not pushing on the edges, which makes you intellectually brittle. I think we all agree the world’s always changing. And any organization, including your collection of synapses in your head, it risks being disrupted if its pace of change internally is slower than the pace of change outside of the world. There’s The Half-Life of Facts, great book by Sam Arbesman of that title. Many mental models have a shelf life to them.

And then conversely, it’s super easy to push against that circle and then end up tumbling outside of it and you think you know what you’re doing, but the market’s going to give you a very expensive reminder that you were fooling yourself and you really didn’t know what you were doing.

So, I think the takeaway of all of this is because of the divergent nature of many problems, you have to be comfortable with some paradox. You have to embrace paradox, and that’s the title of this segment. And at a minimum, when you’re faced with a problem, you should pause to ask yourself, “Is this likely a convergent or divergent situation?” And then, that should dramatically change which toolkit you decide to pull out.

You can find out more about the VALUE: After Hours Podcast here – VALUE: After Hours Podcast. You can also listen to the podcast on your favorite podcast platforms here:

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