Saturday, February 13, 2016

Linear Thinking.........

Linear Thinking  

Linear thinking  is the process by which "linear thinkers" put things in order as they experience them and how they express them. Their thinking process proceeds in a sequential manner, like a straight line. A straight line between two points is the most efficient way to get from one place to another. Both intake and outflow are predictable and efficiently and orderly presented, considered, learned and written.  

To continue to look at something from one point of view. To take information or observations from one situation, place this data in another situation, and make a conclusion in the later situation. 
Linear thinking is a shortcut for completely thinking through a problem.

Linear thinking can be very dangerous. It is the easiest form of reasoning, lying on the path of least resistance. The simpler the path, the more readily people will march along it. Linear arguments are easy to make, as they require the least amount of evidence — past data points with a straight line drawn through them. 
However, the larger the crowd that follows the wrong line of reasoning, the more people pile in, and the greater the consequences if they are proved wrong.

A lot of things in nature, and thus in investing, are not linear. A past trend may or may not persist into the future. Events don't happen in a vacuum; they are observed, studied and capitalized on — which in the case of investing may preclude a company's future from resembling its past. As I write this, I think of successful companies whose achievements attracted competition, which then marginalized them.

Some things are inherently nonlinear, their behavior reminiscent of a pendulum's: The further they swing in one direction, the harder they'll go in the opposite direction. It is very dangerous to default to linearity with such nonlinear phenomena, as the more confident we become in the swing (the more linearity we observe), the closer we are to the pendulum's reversing course.

Price-earnings ratios often follow a pendulum behavior. If you look at high-quality dividend-paying stocks — the Coca-Colas and Procter & Gambles of the world — they are now changing hands at more than 20 times earnings. Their recent performance has driven linear thinkers to pile into them, expecting more of the same in the future. Don't! These stocks were beneficiaries of a swing in the P/E pendulum as it went from low to average and then to above-average levels.

Pattern recognition is an important contributor to success in investing. Mark Twain once said that history doesn't repeat itself, but it rhymes. If you can identify a rhyme (that is, see a pattern) relating to the current situation, then you can develop a framework to analyze and forecast it. But what if the current situation is very different — if it doesn't rhyme with anything in the past? This is where the ability to draw parallels becomes helpful. It allows you to overlay rhymes (patterns) from other companies, industries or even fields. Building analogous frameworks is a cure for linear thinking; it helps us see nonlinearity and facilitates the creation of nonlinear mental models.

Linear thinking and estimations are everywhere, a casual read of the news or research papers would leave one with the impression that we live in a linear world.  The problem is we don't, People like linear trends because it makes them feel like they can guess what the future might look like. 

Investors have a  strange fondness for linear thinking that's often not found outside of investing.  When two sports
teams play each other a non-committed bystander usually roots for the underdog.  A very common plot for American movies is an underdog achieving greatness against all odds. Yet when it comes to an underdog company the standard expectation is it will just decline into oblivion in a straight line. Conversely great companies like Apple or Starbucks will just grow to the sky forever with investors enjoying sunny days and endless dividends.

Linear thinkers believe that all net-nets go to zero, why else would a company trade for less than NCAV?  Of course the evidence says otherwise.  Linear thinking says that big giant companies with steady growth will continue to grow forever, a quick look at the Dow over the past 100 years says otherwise. 

The average lifespan of a company has shrunk from 67 years in 1920 to 15 years in 2016. So when someone says to think 10 or 15 years out that means thinking about the successor or bankruptcy of the company you're examining, a sobering thought. 

Conventional wisdom is a relentless enemy of thoughtful analysis. A serious analysis strategically avoids making predictions and forecasting. It detests ideological labels and it certainly loathes the compartmentalization of values and vision. It does, however, lay out a clear and concise assessment of a given event or a situation and builds on a solid foundation of historical understanding and fully crafted conceptual framework.

Because of this, certain occupations and expertise have no conceptual ability to grasp the beauty of a serious analysis. It is for this reason, that one must realize, the task of forecasting in a social science, especially economics
 is a dangerous path. Economic outcomes and social order do not work in a linear fashion. They have no set mechanism to operate from and within.

The human world has a unique and cruel way of punishing the followers of linear thinking when it comes to
 analyzing the grand questions of economics, social order, justice, power and how nations rise and decline.

Beware of linear thinking, and take advantage of it when the opportunity presents itself.

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