Investing: The Last Liberal Art – A Short Book Review

This is a short book review of Investing: The Last Liberal Art by Robert G Hagstrom. It was written by Trevor Myers who you can follow on twitter for regular reviews of investing books and podcasts.

Investing: the Last Liberal Art by Hagstrom Will Forever Change How You Think About The Stock Market

In his book Investing the Last Liberal Art, Robert Hagstrom offers a way to think about investing by drawing on first principles within seemingly unrelated disciplines; sociology, biology, psychology and literature to name a few. The basic idea is that we should ground our cognitive frameworks in fundamental truths (called first principles) to enable us to solve complex problems.

As our understanding of first principles across new fields grow, so too does our toolbox of mental models, and our ways to think about the world and the problems we encounter. We add a unique perspective or process to address new problems. By broadening our experiences, either directly or through proxy, each new model interlinks with and strengthens the others. However, this only works if we understand each model and the phenomena it describes. Fortunately, we need only understand the fundamentals, we do not need to become experts.

Hagstrom explores the idea that as our repertoire of mental models increases we begin to recognise similar patterns among them. One concept reinforces another, and then another. The Last Liberal Art argues that the key is to find these connections. Hagstrom argues our best hope for long-term investment success is “developing the ability to think of finance and investing as one piece of a unified whole, one segment of a body of knowledge…”

Below, we look at how Hagstrom applies first principles to investing, in just two disciplines; Biology and Psychology. We hope these examples will give you an insight into the nature of The Last Liberal Art, though we cannot hope to do it justice in such a short review. The book itself includes eight different frameworks, as well as a chapter on how these frameworks fit together to form “a latticework of mental models”.

How Biology First Principles Can Inform Your Investing According To Hagstrom

While exploring the Galapagos Islands Darwin encountered the “species problem” and hypothesised that, over time, species evolve. The idea was radical at the time.

Darwin set out to prove his hypothesis. He turned to work by economist Thomas Malthus exploring the relationship between food supply and human population. Malthus found population increased geometrically while food production progressed arithmetically. Darwin was able to connect this seemingly unrelated truth to his own work. As population growth will always exceed food supply, favourable variants would be preserved, and unfavourable ones removed. The result, natural selection; a new species.

Hagstrom believes there have been 5 major strategies across the history of the stock market. In the 1930’s and 40’s it was Graham and Dodd’s discount to hard book value, then the dividend model, then growth in the 60’s, followed by Buffett’s emphasis on “owner-earnings” or cash flows, and now a focus on cash return on invested capital as the newest strategy.

What Darwin observed in the biological world we see in the financial world. As each investing strategy gains in popularity it is pushed too far past equilibrium. Too many people are employing it and the excess gains diminish. Just as population growth exceeds food supply, something has to give.

“In a word, evolution took place in the stock market via economic selection.”

Hagstrom’s belief is biological systems, including stock markets, will never possess a stable mean. They are constantly evolving. This concept in itself is challenging to the battle-weary investors who love to mock the claim that ‘this time it’s different.’ And yet, Hagstrom’s arguments arehard to refute; sometimes, it is indeed different, this time.

How Psychology First Principles Can Inform Your Investing According To Hagstrom

Psychology is essentially the study of our emotions, decisions, behaviours and how we think and learn. How does the study of the human mind relate to investing? The author introduces us to Michael Shermer’s work on our belief system. Psychologists argue we are pattern seeking. That our survival has depended on it. As a result, beliefs precede logic. We start with our beliefs and look for confirming evidence. Shermer calls this the “belief dependent reality” and Hagstrom links this back to investing:

“Even though we know in the rational part of our minds that market forecasters cannot predict what will happen tomorrow or next week, we want to believe they can, because the alternative (not knowing) is too uncomfortable.”

Social psychologist Dean Pruitt argues that our risk tolerance varies depending on market conditions; what he calls the “Walter Mitty effect”. Walter Mitty was a fictional character who was meek and timid around his domineering wife but daydreamed of being confident and courageous. Pruitt argues, like Walter Mitty, investors are brave and eager to accept more risk in bull markets but in bear markets they scare more easily and tend run for the exit.

Research shows that the riskiness of our choices depends on whether we believe our decisions are based on skill or luck. Is it any surprise we’re seeing new investors buying stocks in speculative companies with no revenue or sometimes even no product? Having entered the market after the crash, can we blame them for thinking their high portfolio returns are based on skill? Combine this with the Walter Mitty effect and we get more confident and risk seeking investors, a recipe for disaster when the zeitgeist changes. Hagstrom’s chapter on psychology is especially relevant today.

Investing: the Last Liberal Art is a must read and one of my favourite investing books. It will forever change how you think of the stock market.

“Travelling more quickly down well-worn roads is not the answer. Rather, looking down from the calm heights of knowledge gained from wise men’s teaching is. Those who constantly scan in all directions for what can help them make good decisions will be the successful investors of the future.”

Robert Hagstrom – Investing The Last Liberal Art

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