How system-level thinkers define their eras that other investors can only copy
Majority of money being traded in America is now “managed” by algorithms rather than by humans.
-- Max Weber (1919 i.e. four years after the discovery of the Arthashastra)
Four hundred years before the birth of Christ, Chanakya (or Kautilya), the most senior minister in the court of Chandragupta Maurya, created the first set of recorded rules for managing an economy and a polity. As a work of political economy, “The Arthashastra” is astonishingly comprehensive combining as it does the ethics of being a ruler alongside law (civil & criminal), governance (civil service regulations, selection of officers), political strategy, battlefield tactics and economics (how much to tax, what to tax, the role of the state vs the private sector).
No text before or since has captured the roles and responsibilities of a ruler as comprehensively. Historians believe that the Arthashastra laid the foundations of the Mauryan empire, which reached its zenith 200 years later under Ashoka.
Fast forward 21 centuries to eighteenth century Scotland to encounter another original system-level thinker. Adam Smith actually studied philosophy, not economics, at the University of Glasgow and at Balliol College, Oxford, but his insights into economics – and specifically – the following words from his 1776 magnum opus An Inquiry into the Nature and Causes of the Wealth of Nations transformed our understanding of how the economy worked:
Every individual, therefore, endeavours as much as he can both to employ his capital in the support of domestic industry, and so to direct that industry that its produce maybe of greatest value; every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he’s promoting it. By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce maybe of greatest value, he intends only his own gain, and he is in in this, and in many other cases, led by an invisible hand to promote an end which was no part his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest, he frequently promotes that of the society more effectually than when really intends to promote it.”
With these words, Smith captured the essence of what allows the free market economy to deliver, not just at the level of the individual, but for society as a whole. Just as the Industrial Revolution was kicking-off, Smith legitimised commerce and laid the economic premise on which our world rests.
Two hundred years later, a young American investor in Omaha, Nebraska, took Smith’s thinking to the next level. From the late 1950s onwards, Warren Buffett started buying big chunks of undervalued listed companies with the aim of selling them for a big profit. His success in doing so over the next twenty years and his use of Berkshire Hathaway from 1972 onwards as his publicly listed investment vehicle legitimised stock market investing which until then was seen as the domain of speculators.
Buffett seared into the American psyche the notion that if after careful analysis of companies’ financial statements, you buy “moated” (an evocative term coined by Buffett long before Michael Porter discovered “competitive advantage”) businesses at reasonable prices, you can make a lot of money. Buffett’s success underpinned the subsequent popularity of the US equity mutual fund industry and created a template for the yet to be born American Private Equity industry.
A decade later, as Buffett was becoming a multi-billionaire and as equity mutual fund managers like Peter Lynch and John Neff were becoming household names, an award winning maths professor and Head of the Maths department at Stony Brook University laid the foundations for a new mode of investing.
Jim Simons founded Renaissance Technologies in 1982 and with the help of other mathematicians, statisticians, physicists and programmers created the paradigm for a novel form of investing. Renaissance used high end maths and physics to look for patterns – not just in the prices of financial instruments but also in financial statements, in weather, in politics, in almost everything that could be number crunched.
Without using anybody with a conventional Wall Street background, Renaissance’s Medallion fund became one of the most successful hedge funds ever. It has generated a CAGR of 72 per cent per annum, before fees, from 1994 through to 2015. Renaissance’s success drew a whole generation of quants to the investing profession. Now, thanks to firms like Bridgewater, Two Sigma, AQR and Research Affiliates, the majority of the money being traded in America is now “managed” by algorithms rather than by human beings.
Why we should care about system-level thinkers?
The smartest thinkers of every epoch are able to understand how the economic system works in its entirety whilst most of the rest of us only understand the world at an episodic and literal level. Whilst in Chanakya and Adam Smith’s eras, they could not parlay their insights into personal fortunes, both enjoyed widespread influence in their lifetimes. Buffett and Simons’ massive fortunes are well known.
Whilst many other investors have successfully copied what these two titans’ techniques, none have made as much money as these two men. Even in today’s inter-connected world, the reward for building a systematic understanding of the world from an original perspective is massive even if others can copy what you are doing.
(Saurabh Mukherjea is the author of The Unusual Billionaires and Coffee Can Investing: the Low Risk Route to Stupendous Wealth, and Founder of Marcellus Investment Managers. Views are his own)