That markets are generally efficient is a foundation of the modern finance paradigm. Given all the different definitions and degrees of efficiency, one very simple explanation is that, on average, beating the market is difficult. In competitive environments, if everyone tries to beat the market, economic profits are driven to zero. Self-interest and the drive for profit promote market efficiency. Earning profits higher than the norm for an industry requires an edge, a way of besting the competition. Over time, these edges generally diminish as the market learns about the anomalies that give rise to them.
In More Than You Know: Finding Financial Wisdom in Unconventional Places (Updated and Expanded), the prominent investment strategist Michael Mauboussin proposes a means of obtaining an edge. His core conviction is that investors can get a leg up by using interdisciplinary thinking, or consilience, a concept borrowed from the natural sciences and developed by the renowned biologist Edward Wilson. Mauboussin argues for unifying the investment decision process among disciplines. Investors, he maintains, can improve their performance with financial consilience: the use of concepts outside traditional market thinking. The edge arises through deriving novel perspectives from alternative disciplines or by searching in unconventional places for insight into market behavior.
The book’s premise is that finance as an economic subdiscipline must move from the high-and-mighty plane of an “imperial” science, grounded exclusively in theory and math, into a discipline using input from the other social sciences. Mauboussin rejects “homo economicus,” the unfailingly rational economic man, for a more nuanced explanation of behavior. In his construct, markets are driven by “incentive man,” who does not always act as predicted by a one-track, rationalistic interpretation of individuals’ actions. Mauboussin contends that investors sometimes commit behavioral errors, even though they ultimately react correctly if given sufficient incentives.
An investor seeking an edge must understand incentive man and what drives his behavior. This drive could be rooted in psychology, the sociology of the crowd, or simply the plain quest for profits. The answers may not always be found in a finance or accounting textbook. Successful investing in this complex environment requires self-awareness that goes beyond conventional thinking. And translating new insights into an investment edge requires a model for synthesizing interdisciplinary thought. The author presents his synthesizing approach through four major themes that provide a framework for managing assets effectively. First, the manager must operate within a philosophical structure and with the realization that investing is a business. Mauboussin’s second theme is the need to avoid psychological barriers and decision traps. Third, investors must recognize the importance of innovation. Mauboussin’s fourth theme is that markets are complex, adaptive systems that move to extremes. This insight reflects the fact that incentive man is constantly adapting to the world around him through invention.
The first set of chapters emphasizes the overarching theme that money management must be viewed as a business and not as an art. Investment managers should focus on calculating the odds and then making the best decision in an uncertain world. Decision making is not about being right but, rather, about using a process that accounts for the complexities faced. The focus should be on process, not outcome; skill, not luck; and frequency of success, not the magnitude of gains. A good money manager should strive for success that is both repeatable and measurable.
Some pundits refer to the stock market as a casino, but the message of these first chapters is that the investor should aspire to be the house or at least the card counter, who measures the risk and contemplates the odds of success without emotion. Investors must not be fooled by luck but rather must be driven by the measurement of risk-adjusted potential gains. Written in an easy-to-read fashion, these chapters reintroduce the reader to Nassim Taleb’s warnings against being “fooled by randomness.”
Mauboussin’s second theme is the psychology of investing. Much of the material in this section has been presented previously in the behavioral finance literature, but the author provides a fresh perspective on the subject. Behavioral finance is a great storytelling device for explaining many market quirks. For example, price extremes may arise because investors are subject to persuasion by others and have a strong desire to imitate others so as not to be out of step with the market. The practical question, however, is how investors can capitalize on such anomalies through their actions. Mauboussin goes beyond cataloguing behavioral oddities to develop a method for using knowledge of behavioral effects to make better decisions. Acknowledging group behavior without responding to the crowd creates potential gains. Exploiting this effect is possible, however, only with a well-thought-out strategy.
The book’s third theme—innovation and competitive strategy—will seem straightforward to those who perceive capitalism as, in the words of economist Joseph Schumpeter, a process of creative destruction. Regrettably, Schumpeter’s ideas have not been taught to many business students. Consequently, there is a freshness to Mauboussin’s key notion that innovation destroys the status quo and generates wealth. At the same time, innovation creates uncertainty, which is at odds with Mauboussin’s dictum that gains should be based on repeatable successes. Investors must strike a balance between known risks and events that are not objectively measurable. The latter is termed “Knightian uncertainty,” after economist Frank Knight. Uncertainty generated by innovation cannot be quantified by analyzing a company’s financial statements.
Innovation is not friendly. A new industry may have many losers as the market sorts out which companies have the winning formula. Therefore, picking a successful industry is not the same as identifying a successful company. Another pitfall for investors is the reality that growth trends cannot continue forever. Extrapolation is easy but dangerous because reversion to the mean is ever present. Success breeds replication; so, incumbent companies’ growth slows as new competitors emerge. The author’s short, attention-grabbing essays bring together some of the most important maxims in competitive strategy to warn investors of obstacles to companies’ attempts to maintain their edge by continuing to innovate.
The book’s final theme is markets as complex, adaptive systems. These chapters cover concepts in mathematics and the natural sciences that can enhance investors’ understanding of market behavior. The concepts include the statistical importance of outliers and the impact of the power law, a type of polynomial relationship that characterizes such natural phenomena as gravitation and electrostatic force. In addition, Mauboussin describes markets as adaptive systems, much like those found in animal behavior. Just when readers thought they should not follow the crowd, Mauboussin suggests the existence of collective wisdom.
This tension is one of several between certain of the author’s arguments that cannot be resolved in a collection of essays. Mauboussin is a fine writer who can turn a good phrase, but his book would have benefited from a stronger connection of his thoughts across chapters. For example, one well-established notion in decision theory is the division of decision makers into “lumpers” and “splitters” (i.e., those who find commonality and those who find uniqueness). Mauboussin argues for both approaches; an elaboration of the comparative merits of these contrasting styles of decision making would have been helpful. In another seeming contradiction, the author stresses the value of focusing on repeatable successes, yet his showcase interdisciplinary approach is applicable mainly to investment choices that are unique and thus not repeatable. By omitting a careful exploration of such dichotomies, the author sometimes leaves the reader confused.
Written from the analyst’s viewpoint, More Than You Know is aimed at professional money managers, but all investors can profit from its wisdom. Mauboussin has a breezy prose style that makes his concise chapters easy to read. He enlivens ideas that originated in dry academic corridors by furnishing insightful parables about ways of looking at a problem. By opening the door to the rich concept of consilience, Mauboussin gives helpful guidance to investors who hope to find an edge.
—M.S.R.