Reading Around: The Latticework Framework

By Joachim Klement, CFA Posted In: Behavioral Finance, Drivers of Value, Economics

Twenty years ago, stock markets were also in turmoil. Back then it was the Asian flu and the Russian sovereign debt crisis that triggered a pretty sharp correction in global stock markets and led to the demise of Long-Term Capital Management (LTCM). Founded by John Meriwether, the hedge fund included Nobel Prize–winning economists like Myron Scholes and Robert C. Merton on its board. But in the end, LTCM required a massive bailout from a number of banks to avoid a catastrophic collapse of the global derivatives market.

The eternal question that has been pondered again and again is: How was it that these extremely smart people could screw up so badly? It is a variant of the famous query: If you are so smart, why aren’t you rich?

The problem with these questions is that in order to become a good investor or a successful entrepreneur, intelligence is not enough and sometimes even a hindrance. First of all, many “smart people” tend to specialize in one kind of smart. They become specialists in one particular field, say finance, and excel in it. Today, such specialization is a prerequisite for success, but it can also serve as a pair of blinkers. Specialists in a particular area tend to think that their field is the most important realm of scientific inquiry and that a wide range of problems could be solved if only people listened to them.

To someone with a hammer, everything looks like a nail. But in real life, there are many different problems that require insights from a variety of disciplines to solve. Financial markets pose such problems. Financial markets can be analyzed with the tools of an economist and that will lead to some insights. But as the performance of macro hedge funds shows, an excessive focus on macro trends or trend following in general is not sufficient to create sound performance in every situation.

Physicists and computer scientists have entered financial markets over the last three decades and helped develop quantitative finance. But as high-profile failures such as LTCM demonstrate, these insights are also no panacea.

And so, it continues. In truth, the best investors I know follow Charlie Munger’s latticework framework: They don’t read in their field but around it. If they are trained in finance or economics, they explore history, politics, psychology, biology, etc. Why? Because developing a deeper knowledge about these disciplines helps them come up with a more comprehensive understanding of human nature and the interaction of investors and traders in financial markets. And as a result, they have a distinct advantage over “specialists” as soon as market environments change — and they do change all the time. Their advantage comes from having an easier time adapting to a shifting and evolving landscape and designing creative new solutions to succeed in the new environment.

So where should an investor start who wants to read around the field and not in the field? Here are a few books that I recommend putting on the holiday wish list:

Robert Hagstrom’s Latticework is a great primer on the entire concept of latticework thinking for investors.One of the most important fields to understand — in my view — is complex dynamic systems theory. Sounds awful, but in The Origin of Wealth, Eric Beinhocker has managed to write an entertaining and insightful book about it.If you want to understand why humans are competitive animals, David Buss’s Evolutionary Psychology will help.Human behavior cannot only be understood from a psychological perspective but also from a moral one. Jonathan Haidt’s classic The Righteous Mind offers a great starter course in moral philosophy and its explanations for our tribal nature.One of the key advantages an investor can have in real life is to think differently and come up with differentiated investment ideas. The topic of differentiation is fascinating in all its facets and Youngme Moon’s Different helps explain how and why straying from the herd can lead to success in business.Finally, one of the key underlying drivers of functioning markets is trust in institutions, be they public exchanges, central banks, or — simply — other people. The fantastic The Trusted Advisor provides an introduction into how trust can be built, maintained, and lost.

For more from Joachim Klement, CFA, don’t miss Risk Profiling and Tolerance: Insights for the Private Wealth Manager, from the CFA Institute Research Foundation, and sign up for his regular commentary at Klement on Investing.

If you liked this post, don’t forget to subscribe to the Enterprising Investor.

All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.