12 Cornerstones of Investing - Cornerstone 1: Powerful Ideas Across Disciplines

Large concepts across multiple disciplines enhances the efficiency and effectiveness of the investment process. I came across this idea in some of my reading-I love to read. I was interested in different industries and creative ideas and then I had one of those ah-ha moments. I thought why would I not apply ideas that I found while reading, to my own industry and my own career? It was at that moment I began reading for ideas. Almost all of my best, most creative ideas have come from industries other than my own.

Down the road, through reading, I realized that in any discipline there seemed to be 2-4 main ideas. Ideas that have been tested over time within that particular discipline. Ideas like Decision Trees from Mathematics, Social Proof from Psychology and Alpha from Investment Banking.

Decision Trees are simple applications to improve the decision making process regardless of your field. If you are a teacher, investor, athlete or a physicist the principle is applicable and does not change in simplicity or function. If you are thinking of investing and have a choice between two separate investments, a Decision Tree analysis will quickly show the logical choice. Human nature will commit trickery. It will always cause individuals to underestimate the risks and overestimate the returns. We may be able to trick ourselves but numbers are constant and reliable. If I have an idea that will produce $1M, but has a 2% chance of ever happening and I have another idea that will produce $500k but has a 98% chance, which one mathematically is a better choice?

Social Proof from the Psychology discipline states that people will trust and buy from people other people trust and buy from. Why do you look for referrals? Why did you choose your Contractor, Painter, Investment Advisor, etc? When AllState says you're "In Good Hands" and then shows 3 different scenarios of satisfied clients, or when Coke says "I'd like to buy the world a Coke" and then shows smiling faces from across the globe of all races and colors, these are examples of Social Proof. This idea is important from an investing perspective to avoid folly. The residential real estate market in 2006-07 when things were over inflated and irrationally hot is a great example of this phenomena. Everyone flocked to real estate because "everyone else was doing it." This was very similar in a historical sense to the real estate market in the late 80's, early 90's. Want some more examples? Think back to the stock market crash of 1929 and the tech crash around 2001. These investors were victims of Social Proof. Social Proof can be an ally or an enemy, in these examples you want to look at the phenomenon, learn from it and avoid the whole situation. The nice thing about this powerful red flag is that it gains momentum over a few years and doesn't just happen ove
ight. Figure out where the crowd is and do the opposite.

From Investment Banking comes Alpha; a simple idea that states the goal is maximum return for the minimum amount of risk. So what exactly do we look for when analyzing an investment. We don't look for the home run with maximum amounts of risk, we look for the base hit or a double that is consistent. Something that will be a bit more predictable with solid returns based on the risk. Think about it, if one is always going for the home run the outcome is the opposite of Alpha. You are looking for the highest return, but ignoring the higher risk, which puts you into the category of a Venture Capitalist (VC). the difference is that VC's are hedging their bets with many investments over time. Their business model works because they know statistically that most of their investments will fail and they are forced to look for the home run. Investors looking at only one or two of any investment should not follow the same business model. Keep in mind, risk usually matches return.

As an investor who builds companies and operates as a capital allocator, thinking across many disciplines provides the platform to learn much faster than the average person who focuses on their discipline exclusively. Even if the competition is smarter, learning the bigger ideas and their implementation across disciplines over time will give you the investing edge.

This is the 1st of 12 articles on the cornerstones of investing. Next month will Paul Martinez will be writing Cornerstone #2.