There’s an absolutism to the way human beings naturally think, and you don’t have to be a psychologist to recognize it. For instance, let’s say you go shopping and you see a new outfit that has just been released by your favorite clothing brand. When you see it, do you think “this item is 80% appealing, 10% unappealing, and 10% acceptable, with the possibility of 30% of its unappealing features becoming appealing in the next 12 months”? Of course not—you think, “I like it” or “I hate it” and move on.
The problem is, this is a really bad way to think in modern society.
On the African Savanna, it’s great. One needs to make snap decisions on whether something is prey, predator, or other. To survive, decisions must be binary, absolute, and made quickly with little input.
Unfortunately, this may be the worst way possible to think about investing, modern business, or many other things about modern civilization.
This creates a disconnect between the way people naturally think and the way people should think to understand capital markets and perform well in them. One must learn a new way of assessing the world and thinking about it.
For instance, pros do not think in terms of a stock or market going up or down. They think in terms of the probability that it will go up or down, and what probability one ascribes to different scenarios and why. In short, no judgment about value is absolute; they all exist relative to other options, and their potential movement can only exist proportional to alternatives within a system of varied options.
The relativism of movements and potential action in markets is absolutely everywhere, and forgetting to think in this weird and highly unnatural way will mean making really big mistakes.
A very common one that retail investors make is failing to distinguish between various vectors. Take inflation, for instance. Many retail investors confuse accelerating inflation, decelerating inflation, disinflation, and deflation. It is very common to see people confuse a decline in something with a decline in the growth of something—albeit the difference between the two isn’t just one between growth and recession, it’s also the difference between a company, nation, or even the entire planet collapsing. Yet it isn’t uncommon for retail investors to speak in vague and uncertain terms that, to an outsider, make it sound like they are casually talking about an apocalyptic event when they’re really just talking about CPI numbers changing a few basis points.
While first-year analysts are given a lot of leeway, if they do not learn these distinctions quickly and begin to think in terms of relativistic value, potential, and strength, they won’t last long. Knowing the correct words to describe precisely the relationship between two numbers or vectors is a fundamental building block for the budding financier; without knowing the language and avoiding malapropisms which imply a 5% decline (“sales has fallen by 5% from 95% yoy growth”) instead of 90% growth (“sales growth has fallen 5 percentage points from 95% yoy growth”). Take even these phrases:
Sales has fallen by 5% from 95% yoy growth
Sales has fallen to 5% from 95% yoy growth
Sales has fallen by 5 percentage points to 95% yoy growth
These all mean very different things and cannot be used interchangeably. While the first year analyst may mistake these a couple times, the second-year analyst absolutely cannot.