Tourist: This is a dangerously steep road with a sharp bend. Why isn’t there a hazard sign for motorists to slow down?
Guide: We had a warning sign untill yesterday. But since accidents were rare, officials concluded that the spot isn’t that dangerous after all. So they removed the sign.
Tourist: Don’t you think the rarity of the accidents was precisely because of the warning sign?
Amused at the stupidity of the officials? That’s because it’s easy to spot the cause and effect relationship between ‘presence of warning sign’ and ‘frequency of accidents.’ You can test the hypothesis. Remove the warning sign and if too many cars start plunging down the valley, there we have it – a clear correlation between an action and its consequences.
But the world of business and financial markets rarely present such tight feedback loops. An effect and the action that caused it, could be separated in time by years, even decades. That’s why most people fail to get a proper grip on the nature of risk in life and in stock markets.
A child, in spite of all the warnings, touches the flame and learns the lesson immediately. A quick feedback loop. Drink too much coffee and you wake up the next morning with a discomforting headache. That’s an example of a delayed feedback loop.
The interesting thing about feedback loops is that they can be interrupted. If the prediction – too much coffee will cause a headache the next morning – changes the behaviour, i.e., limiting the coffee intake then the prediction comes to naught. Does it mean the knowledge – too much coffee causes a headache – was useless or wrong?
In the 19th century, Karl Marx predicted the collapse of the capitalist system. But capitalists took Marx’s warning seriously and embraced many of the tools and insights of Marxist analysis. As people adopted Marxist diagnosis, they changed their behaviour accordingly and Marx’s prediction never materialized, precisely because people took him seriously and acted on it.
Yuval Noah Harari, in his brilliant book, Homo Deus writes –
This is the paradox of historical knowledge. Knowledge that does not change behaviour is useless. But knowledge that changes behaviour quickly loses its relevance. The more data we have and the better we understand history, the faster history alters its course, and the faster our knowledge becomes outdated.
If you know something today that’s not known to many people, it’s an edge. But the moment it’s widely known, it becomes common knowledge. It’s no more an edge.
In the stock market, if you don’t know what everyone knows, you’re a sitting duck waiting to be slaughtered. But if you know what everyone knows, it doesn’t hand you any special advantage. Isn’t that how capitalism works? A business with high-profit margin will soon attract competition and before you know it the margin is gone.
So what’s my point?
As you start exploiting the edge that knowledge gives you and as the benefits of that advantage start accruing, begins the deterioration of that edge. The paradox of knowledge requires us to become a learning machine. You have to keep upgrading your understanding about the world, about the business and above all about yourself.
I’ll leave you with this quote from the Chinese military strategies Sun Tzu. He said –
It is said that if you know your enemies and know yourself, you will not be imperiled in a hundred battles; if you do not know your enemies but do know yourself, you will win one and lose one; if you do not know your enemies nor yourself, you will be imperiled in every single battle.