Wednesday, March 14th, 2012
analogies and anomalies

I seem to be in the throes of alliteration and firmly stuck on the first letter of the alphabet — the last essay concerned assumptionsthe research puzzle | It was on the need for “assumption hunters.” and now the topics are analogies and anomalies.  Come to think of it, those three words make a nice triangle of analysis (another “a”!).

Recognizing patterns comes with the territory for an investment person, whether the nature of your analysis can be described as fundamental, quantitative, technical, or some combination thereof.  Each of those approaches is driven by historical information and events, with the patterns of the past leading to decision rules of various kinds, whether that happens consciously or subconsciously.

There’s no doubt that the stories of the markets flow largely based on comparisons that are readily at hand.  The key questions are whether we are any good at recognizing patterns and whether our analogies help us or hinder us.

Many years ago, a leading light in the investment business wrote that one of the best predictors of investment success was how someone scored on the Miller Analogies Test.Pearson | This is the home page for the test.  If you take it, let me know what you think.  I have never taken the test or read research about it, but from my experience I agree with the provider’s assertion that the ability to understand analogies is “one of the best measures of verbal comprehension and analytical thinking.”

As does the reader of a novel, an investor seeks an apt and insightful analogy, not a worn or misplaced or stretched one.  Of course, that’s true in most every human endeavor and economic decision making activity.  In 2005, Harvard Business Review published an article about how great business strategists “know both the power and peril of such comparisons.”Harvard Business Review | Here is the article preview.  Unfortunately, everyone is so busy making analogies that they often fail to recognize the peril part of the equation.

Which brings us to anomalies.  Unearthing them is not only part of vetting analogies, but it’s a necessary step of “best practice” in investment endeavors of all types.

However, if you do a web search on “investment anomalies,” you’ll get pages of links about supposedly persistent anomalies (such as those related to value, momentum, and size in equity investment) and how you can exploit them.  Those incongruities have provided years of academic debate and research (and have been the foundation of countless investment strategies), but they are anomalies relative to a set of theories about how markets work, so the debate is likely to go on ad infinitum, and that’s not what this posting is about.

That said, it is the “story” of those theories that provides the backdrop against which the things that don’t fit can be seen.  In that sense, they are similar to the stories against which any investment sleuth works, seeking anomalies to be explained.  The examples are endless, such as an analyst catching a footnote that puts the apparent reality of a company in question; a corporate bond portfolio manager seeing a bond that isn’t priced to fit the matrix of characteristics that define it; or someone doing due diligence who is faced with a small clue that an asset manager’s process doesn’t seem to fit with what it says it does.

Differential information is critical and early warnings are highly prized, yet as an industry we waste a lot of time borrowing and reinforcing conceptual structures that are already formed rather than trying to shoot holes in them.  And most strive too hard to find analogies when anomalies are staring them in the face and going unrecognized or unexamined.  Often they seem minor and are therefore easy to brush off as unimportant.

As I’ve tried to say in various ways since I started this blog,the research puzzle | The very first posting was “look at the little things.” in order to solve a particular research puzzle you need to approach it from all angles.  No one loves creating an analogy more than me, but finding anomalies adds the most value.