I was reading the new Money Magazine the other day and found the article on Warren Buffett very interesting. Unfortunately it was of the few articles that I found interesting. This is unusual for Money Magazine – I still consider it some of the best money I spend each month.
I love psychology and I think it greatly impacts how we invest. As humans we have a lot of strengths and weaknesses. When it comes to recognizing patterns, we are particularly good. Sometimes it is as if we are almost too good and want to find patterns when there aren’t any. I think we do this to try to make sense of a world that is full of random events (I apologize to the fate-believers, I’m just not with you.).
Turns out this belief in false patterns has a name: Apophenia. (I can’t decide if it sounds more like a Greek Goddess or a very short-lived Godfather character.) Sometimes it is called “patternicity” which I like a little better.
All of this shot into my brain when I saw this image in Money’s Buffett article:
I encourage you to click it for a larger version.
This image shows that if you simply invested evenly in all ticker symbols starting with the letters W-A-R-R-E-N, you would have handily whopped the S&P 500 over the 20 years.
The article explains why this has worked over the 20 years. Smaller companies have done better than larger ones and investing them equally gives them a greater weighing than the S&P 500. The S&P 500 consists of larger companies and doesn’t have the small companies at all.
If someone didn’t know any better, they might say, “Hey this is clearly a pattern showing you how to beat the market.” Hopefully we are smart enough to know that there really isn’t anything special with ticker symbols starting with the letters that spell W-A-R-R-E-N.
This reminds me a little of the funny website spurious correlations that helps us understand correlation does not imply causation. My favorite chart on that website is the correlation of divorce rate in Maine to the US Per capita consumption of margarine.
However, what happens in a scenario where the pattern isn’t so arbitrary? I think that’s where things get difficult for a lot of people, professionals included. If the chart didn’t use the ticker symbol gimmick and instead with something like return on small companies when equally weighed, it presumably (from the article’s explanation) would show a similar trouncing of the S&P 500 over the last 20 years. That would lead one to believe that such investing is the clearly the way to go. There’s no kooky red flag to tell us, “This pattern is crazy.” It’s hard to determine what is causation and what is correlation in a complex system like the stock market.
What does this all mean? I wish I had a super conclusion to wrap it all together. Unfortunately, I do not. What I do have is the thought that diversification is even more important than I thought it was.