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How Physics Taught Me About Stock Investing

Andrew is a self-educated business owner and entrepreneur with plenty of free advice (which is worth exactly what you pay for it!).

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Using Compulsion For Good

I've been a compulsive person for all my life. When I was a kid, this meant collecting comic books with an intensity few of my friends shared or could understand, or knowing the arcane rules of Advanced Dungeons and Dragons so we could play a really fun campaign (first edition only, please), or wrestling in high school. As I grew up, my interests continually shifted every few years, but when I was into something, I was really, really into it. This extended well past college and into my so-called "adult" life, where nonfiction reading and very early streaming course lectures (we're talking mid-2000s here, so you can visualize potato-level quality video) combined to offer the opportunity to learn physics from my home. Now I was a math- and science-oriented kid when growing up, so this wasn't too much of a weird stretch for me, and I had some background in physics, calculus, and chemistry from school that made it a little easier to just dive in and start learning more advanced (and more up-to-date) physics. Fast forward a decade and a half, and here I am using some of the principles I learned from studying how things have been discovered or inferred in the world of physics, in my daily life. I'm not using these skills in any sort of way I would have guessed as a kid growing up. Instead, I am drawing wisdom from the field to apply to stock buying and selling, and it's helping more that I could have imagined.

Physics Teaches You To Think

The most important takeaway here is that learning the history of scientific discovery has a great deal of value in and of itself. It's not that you're going to dominate your local trivia night when the next question about where Enrico Fermi was born, or that you'll be able to fall asleep at night better (although that's potentially true). Instead, the real value takeaway is learning how things were discovered. The scientific method provides an amazingly effective playbook for how to determine what is true and what is not, based on observations others can make. The process is transparent and easy to understand, and it has brought me to two key insights from the world of physics that I use when investing. The first of these principles, that nature is far stranger than we might have guessed, is used to define the other one.

A Weird World

The quantum world, with dimensions much, much smaller than those of an atom, isn't exactly what we might think it is. Virtually all of the intuitive rules we might automatically want to apply to the realm of the very small, simply don't apply here. Examples from the world of quantum physics abound, including the fact that particles can simply pop into existence from nowhere, things can be in two places at the same time, and there is a smallest amount—a quantum—that there can be of anything and everything, maybe even including space itself.

The world of the very large, very heavy, and very fast isn't much more like what we'd expect. Light always travels at the same speed, no matter who's looking at it or how fast they're traveling, and even if you shoot out a light beam from your fast-moving rocket ship while I'm holding perfectly still, it will look like it's moving at the speed of light to both you and to me. The faster you move, the heavier you are. Time moves slower for you as you move faster or feel the effects of gravity more and more. We humans live in a world where we're pretty comfortable with something as small as a grain of sand or as large as a few hundred miles, and anything much smaller or bigger than that can be unlike anything we could have imagined. As it turns out, nature is stranger than our imaginations in some cases.

What this means for us is that there are arenas in which we don't know much, and what we would guess might happen, might be really, really far off from what actually happens. In other words, we should insist on data to corroborate any assumptions (or guesses) we're making about nature, and this is a simple concept I've insisted on for some time with regard to my investment portfolio. If you assume you already have everything figured out and aren't constantly testing your assumptions, your portfolio is relying on luck, not science.

Life Is Probabilistic, Not Deterministic

One particularly shocking conclusion for many people is that life itself is probabilistic, not deterministic. In other words, you can guess how many times out of, say, 10,000 that a particular event will occur with a very high degree of accuracy, but you can't say whether one particular event will have a particular outcome or not. This is wildly nonintuitive, since everything we see at our scale seems to be predictable, like whether a fastball will go over home plate or not based on the trajectory of the ball when it leaves the pitcher's hands, for instance. But we only think this is the way nature operates because we can only glimpse the tiniest fraction of the universe and its near-infinite variance in scale between the very small and the very large.

The investing corollary here could not be more clear: you can't predict individual movements, but you can assign probabilities to events occurring, especially when you consider a longer time horizon. If I try to predict where the S&P 500 will be in a month, I'll have to admit that I have pretty much no idea at all. I don't know if it'll be up or down, and while it might be a fun game to try to guess, it's not particularly useful to me as a buyer of individual businesses. However, I can say with a high degree of confidence that the market will go up over the next 30 years, and probably by a lot. Consider how you can make other predictions based on probabilities, not based on individual, short-term predictions.

The Standard Model of Particle Physics

The Standard Model of Particle Physics

The Particle Zoo

This begs the question: how do you proceed with creating a useful set of rules or action items for your portfolio, given how much uncertainty there is out there? After all, the average active investor actually does a lot worse than the overall market due to our tendencies to misread all sorts of signals (and to act based on emotion). Quantum mechanics provides one excellent and useful framework here: classification into understandable categories, even if you don't have all of the info you'd like to have.

For the last century, we've been in the process of discovering all sorts of new particles—the particle zoo. This incredibly unexpected barrage of novel fundamental particles that nobody expected to see based on then-current understanding of the way things worked invited one physicist to quip, "Who ordered that?" So, a system of categorization was devised by Murray Gell-Mann and others to come up with a reasonable way to classify what they had seen so far. Even more importantly, Gell-Mann's intention was to be able to predict particles that nobody had ever seen. It turns out, this approach worked extremely well, leading to scores of additional discoveries that have continued to improve our understanding of the quantum world for more than a half century now.

For particles, the great minds of physics thought about common characteristics certain particles shared with one another, like mass, charge, or spin, and then created categories based on these groupings. Gell-Mann in particular added the notion that if there were three of a certain particle that had been discovered so far, but only two of another type of particle, perhaps there should be a third particle in the latter category as-yet undiscovered. It's important to understand that nobody knew for sure if this guidance was going to turn out to be right, but as predictions started coming true, it became evident that the model could be used to help us figure out where and how to look for the next missing particles. Most recently (and famously), the Higgs Boson was finally spotted at the LHC.

Murray Gell-Mann

Murray Gell-Mann

Create Your Own Standard Model

Given the knowledge that creating a model that is based on categorizations of things we've observed, in order to predict things we haven't seen yet, how can you incorporate this into your investing routine? One way to do this is to look at stocks you've bought and sold in the past, to determine if there are common categories among outperformers or laggards. Is there something the outperformers tend to have in common? Are you personally better at identifying great businesses in a particular industry? Is there another factor you haven't considered? Answering these questions may help you to create broad categories of stocks you might one day want to own, so that you can much more easily filter and identify what to watch (and, eventually, buy). Peter Lynch suggests one method of categorizing stocks that you can follow, based on his so-called famous numbers. Lynch's categories very likely won't match the way you think about stocks, nor should they, but they can prove an extremely useful filter nonetheless, and you can use this idea to come up with your own way to classify stocks you're interested in. Lynch's six categories are

  1. Slow growers
  2. Stalwarts
  3. Fast growers
  4. Cyclicals
  5. Turnarounds
  6. Asset plays

For more research, read Lynch's One Up on Wall Street, one of the best (and easiest to read) books on investing out there. Lynch's categories should offer inspiration for you to classify the stocks in your universe, but shouldn't just become your de facto classification strategy. Instead, the process of discovering how to classify stocks will make you think about things differently, and you'll find yourself considering variables you might not have noticed before.

Teaching Someone To Fish

In a very real way, physics has taught me how to think about thinking. This is analogous to teaching a villager to fish instead of just giving them fish for the day; with the knowledge of how to solve problems and create your own framework, you can solve a much wider range of problems than just the one in front of you right now. Applying the lessons from physics into your investing strategy can help you to think probabilistically, to think about categorizing stocks into useful lists or classifications, and to stop relying on your intuition when making investment decisions. Remember: Mother Nature is weird, and so is the stock market. Use this knowledge to draw conclusions that help you do more thoughtful research and make more informed decisions with your portfolio.

This content reflects the personal opinions of the author. It is accurate and true to the best of the author’s knowledge and should not be substituted for impartial fact or advice in legal, political, or personal matters.

© 2021 Andrew Smith

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