The Laws of Investing

The Laws of Investing

By Morgan Housel

Think of how big the world is. And how good animals are at hiding. Now think about a biologist whose job it is to determine whether a species has gone extinct. Not an easy thing to do.

A group of Australian biologists once discovered something remarkable. More than a third of all mammals deemed extinct in the last 500 years have later been rediscovered, alive:

We identified 187 mammal species that have been missing (claimed or suspected to be extinct) since 1500. This number includes all such mammals for which we were able to find key variables for analysis. In the complete dataset, 67 species that were once missing have been rediscovered.

A lot of what we know in science is bound to change. That’s what makes science great, what makes it work, and what distinguishes it from religion. Science is filled with rules, evidence-based theories, and probabilistic observations. Laws – immutable truths lacking exceptions – are rare. Most fields only have a handful.

But the handful of laws that exist have a special function: they’re the great grandmothers, the old wise men, of the day-to-day theories and rules used to discover a new truth. There’s a hierarchy of science: laws at the bottom, specific rules above that, then theories, observations, hunches, and so on.

The higher you go on the pyramid the more exciting things become. That’s where discovery and opportunity live. But everything at the top of the pyramid must respect the laws at the bottom.

The idea of flexible rules deriving from unshakeable laws applies to every field. John Reed writes in his book Succeeding:

When you first start to study a field, it seems like you have to memorize a zillion things. You don’t. What you need is to identify the core principles that govern the field. The million things you thought you had to memorize are simply various combinations of the core principles.

Same thing in investing.

What’s an investing law? There’s no definition, so I’ve taken some liberties here. I try to limit them to forces that influence all types of investments, in all sectors, in all countries, throughout all of history, with few exceptions, and some explanation for why it will continue indefinitely.

A theme here is that investing is not just the study of finance. It’s the study of how people behave with money. So most of these “laws” describe a universal feature of how people respond to risk, reward, and scarcity.

They are simple. But they are, I think, part of a foundation that governs most of what happens in investing, and will keep happening as long as investing exists.

Law #1: Optimism and pessimism will always overshoot because the boundaries of both can only be known in hindsight, once they’re passed.

The correct price for any asset is what someone else is willing to pay for it, because all asset prices rely on subjective assumptions about the future. And like a blind man who doesn’t know where a wall is until his cane touches it, markets cannot know when optimism or pessimism has gone too far until they bump into the limits and enough investors protest in the other direction.

The peaks and bottoms of market cycles always look irrational in hindsight, like they went too far. But in real time markets are just trying to find the limits of what people can endure. And they have to do that because any gap between an asset’s potential and what investors are willing to endure creates opportunities that will be exploited.

Yale economist Robert Shiller won the Nobel Prize for a paper he wrote in 1981 about a similar idea. The bottom line is that markets aren’t really rational; they’re just pretty reasonable.

Law #2: Calm plants the seeds of crazy.

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