Friday, January 04, 2019

The Model Thinker #1 : The Wisdom Hierarchy

Image result for the model thinker

As we enter 2019, I will also be beginning a new series covering one really good book that I would like to digest very slowly. After some deliberation, I have decided to cover Scott Page's The Model Thinker  as it suits the level of an intermediate to advanced reader.

Naturally throughout the series, I will be personally trying to show-horn to adapt the ideas in this book to my personal style of investing. I hope that readers will find this new column useful and information.

Today I will be covering the Hierarchy of Wisdom. It is a great way for a novice to start thinking about models and how they can clarify things for us.

The Hierarchy of Wisdom consists of four ways in which we can explain the phenomena around us :

a) Data

Anything that lacks meaning can be considered data. Data can be a timestamp or a string of 1s and 0s. For a dividends investor, a 2 cts dividend payable on 2 December can be considered data since it is a timestamp of when money is to be credited into the shareholder's account.

On its own, a dividend does not have a lot of meaning.

b) Information

When data gets partitioned into categories, it becomes information. For example, when we sum up the dividend payments of a stock over a year, we get the total amount of dividends received in 2018. This becomes information. The information can be enriched further when we divide the annual dividends by the market price of a share and obtain the dividend yield of a company stock.

c) Knowledge

Knowledge is justified true belief.

When information can be correlated with each other or tied up with causal or logical relationships, we start to attain knowledge. If after a backtest, we find that picking dividend stocks tends to outperform the market index, this appears within the realm of knowledge. Deeper knowledge is gained when we figure out that picking for sustainable dividends from a high free cash flow can result in further outperformance.

Most financial providers show a student how to get to this level.

d) Wisdom

Wisdom is the highest level that can be attained. Wisdom is the ability to apply the right mental models to the proper situation. If you have his idea that higher dividends tend to outperform and have the tests to show that it works for equities, the question you need to ask yourself is whether the same principle can apply to REITs ( So far the backtests say yes. )

Problem arises is that you have many situations that use a regular cash-flow to tempt you into investing in something new. If you apply this model to bonds or crowdfunding projects, you will end up taking too much credit risk. Worse, there are now platforms that allow you to convert cryptocurrencies into a regular payment scheme.

Wisdom is to take a step back and perhaps understand that a better model to value these assets lies elsewhere.

e) I hope to be wiser in 2019

Some question in finance cannot be sufficiently answered with knowledge. One example is the question of whether a crash is imminent for the local stock-market. Academics have tried in vain to develop models to detect an inflection point in the stock-market but the best ones are, at best, accurate to about 75%.

I can't claim to teach wisdom to my class, but I adopt three models to provide an assurance that perhaps our markets are not in such a bad shape after all :

  • I examine the trending differences between the earnings yields of the SGX versus bond yields.
  • Next I look at CAPE Shiller PE of our markets to see if markets are overpriced.
  • Finally I look at the Sothebys stock and see whether it is experiencing a peak.  

The markets seem fine so far based on these measures.

So I don't wait for wisdom, I just stay invested and do not have a war chest for now.

No comments:

Post a Comment