STREET DOGS

From Investors Chronicle: Friedrich Hayek said that economic knowledge is never fully possessed by a single individual, but instead consists in dispersed and fragmentary titbits across thousands of people. This, he thought, was why centrally planned economies couldn’t work. But companies are forms of centrally planned economy, too. Just as economic planners cannot know the whole ground truth, nor sometimes can managers — and certainly not outside investors.

Hayek thought the solution to this was to use free markets: these, he thought, aggregated the dispersed knowledge of individuals. Prices, he thought, revealed ground truth.

But this isn’t always the case. Some knowledge isn’t embedded into share prices because insider trading is illegal, because many investors are unable or unwilling to short-sell sufficiently, or simply because [some stocks] are illiquid.

Markets can select not the wisest managers but the luckiest. Highly geared companies thrive when interest rates are low and the economy is growing but suffer in recessions. And markets select only for past success, which is no guarantee of future survival.

Investors need to know ground truth to avoid profit warnings or impending financial crises, but we cannot rely on markets or management to reveal this truth in a timely manner. So what can we do? One possibility is scuttlebutt investing: getting our shoes dirty by visiting companies and talking to workers, suppliers and customers about how they are really doing. This … can create an illusion of knowledge that fosters overconfidence.

Instead, what we need is humility. Share prices, like election results, are the result of complex processes. It also makes a case for holding cash. Cash limits our losses to the negative real rate and protects us from the worst that complex processes can produce.