Imagine if scientists operated on emotions and hunches instead of sound data calculations and processes.
Take chemistry for example:
Combining the elements fluorine (Fl) with helium (He) results in no reaction since helium is an inert gas and typically doesn’t react with other elements. Substituting helium (He) with hydrogen (H) however, can result in death. Adding fluorine to hydrogen to create hydrogen fluoride causes an explosion and the resulting gas corrodes the mucous membrane and walls of the lungs if it enters the respiratory tract.
In the chemical experiment above, what if the chemist had operated on a hunch? His gut feeling was that substituting helium with hydrogen would be fine. What is the worst that could happen? Death.
Why is it that with portfolios, investors are often far too willing to operate on hunches and emotions instead of relying on data and math?
Why, on the other hand, is it that the most successful investors treat their investments like competent scientists treat their experiments – by insisting on relying on data and math?
Why do scientists rely on data and math? Because they want predictability. They want to account for all variables, unknowns, and circumstances because a miscalculation can mean the difference between life and death.
Shouldn’t we treat our investments like our financial lives depended on them? If that’s the case, then why subject ourselves to investments and assets that are far too often far driven by emotions and factors that have nothing to do with data, math, or underlying economic fundamentals?
Why should investors insist on data and math when making their investment decisions? For predictability. Predictability allows for financial modeling and planning.
If you were acquiring a business, what are some basic financial questions you would want to be answered about the business?
- What are current revenues, expenses, and net operating income?
- What has been the financial performance of the past three, five or seven years?
- Anything in the market or business model that would potentially disrupt financial performance?
Why would you ask these questions when evaluating a business?
Because before you put a price on what you’re willing to pay for the business, you want to know the historical and present financial performance of the company and whether that performance can be sustained going forward.
You want to know if and when you can expect to recoup your investment and how much you can potentially earn over time. Math and data are vital to your investment decision.
If math and data are vital to making business and investment decisions, why do so many investors ignore them when making investment decisions?
Last year, after the stock market crashed in March and in the wake of the first round of stimulus checks, the stock market was suddenly flooded with new investors flush with stimulus cash – itching to make a return on their investment.
The stock market boomed – recovering all of its losses in March by August of the same year. The big problem with the boom however as investors weren’t basing their decisions on underlying economic data. They were basing their choices on emotions, the news, social media chatter, and FOMO (the fear of missing out).
The result was investors snatching up stocks of questionable companies – even ones that filed for bankruptcy. Hertz, Whiting Petroleum Corp., and J.C. Penney were all companies that saw their shares more than double last summer despite filing for Chapter 11 bankruptcy protection.
Why do sophisticated investors insist on evaluating an opportunity’s economic fundamentals when making investment decisions?
When investing, fundamentals are essential to wise investors for valuing an asset and for making financial projections to assess the viability of an opportunity and project its returns with confidence. Math and data take the emotions out of the decision.
Supply, demand, income, and macroeconomic factors like employment, household income, and other economic indicators are what matter – not what the herd is buzzing about or what’s hot on social media.
How do wise investors take emotion and mob mentality out of the equation? They don’t play in the same sandbox. They prefer private markets that eliminate emotion from an investment decision.
Private investment opportunities with long lock-up periods prevent investors from making rash exit decisions that can harm the long-term prospects of the venture and their investment capital. It’s like the chemist locking up the hydrogen so that he can never mistakenly mix it with fluorine and cause a deadly explosion.
These days, in the public markets, an asset’s price has nothing to do with any underlying economic principles.
When a group of Redditors can band together to drive up the stock price of floundering brick and mortar gaming retailer Gamestop from $7 to around $469 in less than a month to wage war on short-selling hedge funds, economic fundamentals, and any math or data all go out the window. Then when Robinhood steps in to limit trades to save the hedge funds, the situation becomes even more ridiculous and less market-driven.
Why inject yourself into the fray of market madness? Wise investors just walk away and play in another sandbox – the alternative sandbox.
Retail investors may be turned off by math and data-driven decisions, but wise investors insist on math and data to make well-informed decisions.
Financial projections needed to assess the long-term prospects and expected returns from an investment depend on reliable data and sound mathematical calculations.
That is why sophisticated investors gravitate towards assets that follow the rules of math and data and not emotion, social media, and talking heads.