Attention Traps

Dear investors,

The Brazilian stock market began the year with an unexpected surge, resulting from foreign capital entering the country. The most plausible explanation is that the movement was not caused by any merit of Brazil, but by the collateral effect of increased apprehension about the American economy, which led global investors to seek diversification in emerging markets. This hypothesis fits well with recent events, but it does little to predict what will happen in the future.

In six months, will global investors be more or less apprehensive about the American economy than they are today? Among emerging markets, will a favorite emerge, or will investments remain fragmented? Will what happens in Brazil during this period help attract or repel foreign capital?

The initial impulse is to understand the situation as best as possible and try to infer what the next move in the global market will be, but efforts are only rewarded if they generate tangible results, and these questions are quite broad. Before dedicating all available time to studying the topic, it is worth discussing whether it is possible to reach conclusions assertive enough to support investment theses.

The scarcity of time

The first difficulty is that it's impossible to gather in one mind all the news happening around the world. The time it would take to read about everything is many times greater than the available hours. Consequently, it's necessary to balance depth and breadth: to stay informed in detail about very specific topics or to have a superficial understanding of a wider range of subjects. Each choice has its benefits and drawbacks.

Opting for depth reduces uncertainty about the conclusions reached, but increases the risk that factors external to the analyzed sample space may interfere unexpectedly and render the conclusion irrelevant. For example, if the problem were to determine the life expectancy of a young person, detailed medical examinations might conclude that he is perfectly healthy and should live for many more decades. If this young person is a soldier in a war zone, the risk of natural death is almost irrelevant to the answer we seek.

Prioritizing the breadth of analysis creates the opposite problem: it reduces blind spots but increases uncertainty related to a lack of detail in the analyses. We could investigate the young person's entire life context, but only apply routine medical exams. We might fail to notice a serious condition that hasn't yet manifested symptoms, but would be easily detectable in detailed examinations.

To achieve successful investing, there's no single, obvious answer to this problem. Different strategies can prioritize either depth or breadth of analysis and yield good results. We will share the approach that best suits our investment philosophy, which aims to generate secure, long-term returns.

We invest time in developing detailed knowledge only about companies with a good chance of becoming investment targets, which is the core of our activity, and about topics that we expect to have a long lifespan and can be used to expand our ability to properly judge situations that arise before us over the years. We study the dynamics of sectors relevant to the economy, business cases that can help understand future theses, we follow technological trends that may permanently transform certain industries, and we read about the history of companies and countries. This effort forms what is called apperceptive mass, the set of knowledge, experience, and memories about the possibilities of the world that allows people to recognize patterns and quickly understand complex situations analogous to what they have analyzed before. This mechanism allows a good doctor to quickly diagnose the ailment afflicting their patients and a good investor to identify which opportunities may be profitable and deserve further study.

The remaining portion of our time is dedicated to keeping up-to-date on market news, but we only filter out what could have a major or lasting impact before devoting substantial time to any news. We will be interested in new laws relevant to target investment industries, declarations of war, major trade agreements, and severe political changes. We don't spend time watching presidential interviews, dissecting the details of routine macroeconomic reports, or investigating possibilities regarding the evolution of commonplace political intrigues. The logic is to keep the radar on, but only mobilize when there is something very suspicious on the horizon.

The limit of working memory

Besides the limitation imposed by the speed at which we can absorb new information, our minds are only capable of paying attention to a few things at a time. When we assemble a jigsaw puzzle, we memorize the outline of a few pieces at a time and scan all the others in search of a fit. The activity is much more laborious than it would be if we were able to retain in our immediate memory all the outlines of the pieces already seen. Research conducted in 1956 by psychologist George Miller established that the human mind can retain between 5 and 9 simple items simultaneously, and fewer than that in the case of complex information.

The limitation is relevant to the investment analysis process, where the challenge usually lies in the enormous number of factors that can interfere with the case being analyzed. Since it is not possible to consider all of them simultaneously, it is necessary to resort to methods that circumvent the limitation.

The main one is to divide the analyzed scenario into several blocks of a size that our intellect can grasp and, after each analysis, simplify these blocks into a condensed representation that becomes a single unit of information. We do this intuitively when we need to add several numbers. We don't try to add them simultaneously. We perform several sums of two or three numbers, then add the results of the first cycle, two or three at a time, and so on. This process forms a pyramidal structure of compartmentalized information. The apex of the pyramid, which is the final conclusion of the analysis, rests on some blocks in the layer immediately below, and each of these blocks rests on some other blocks in the next layer below, until it reaches the base.

Even with the technique of condensing data into logical pyramidal structures, our minds can handle pyramids with few layers without suffering confusion and reasoning failures. In complex analyses, it is necessary to externalize our working memory by writing, creating diagrams, and so on. In this way, it is possible to surpass many times the degree of complexity that we could naturally encompass. In other words, writing is one of the best ways to utilize the full potential of human intelligence. This has been known for millennia, but the fact seems to receive less emphasis than it should.

Market biases

High-quality analyses of investment opportunities, economic scenarios, geopolitical conflicts, and the like require considerable effort and time. Few people are able to dedicate themselves fully to this activity, so they resort to the best shortcut available: trusting the opinions of experts or assuming that what receives significant media attention must be the most important thing happening.

Even with the best intentions, experts and media outlets need to format their messages into rather simplified discourses, without room for the details and caveats that would be advisable under more rigorous analysis. The public wants to be informed in 15 minutes and retain a few concluding sentences in their memory, without having to go through long, pyramidal structures externalized across hundreds of pages. This creates some problems.

The first is that a discourse becomes predominant based more on aesthetic than strictly rational criteria. What is most elegant and seems compatible with the major events of the moment gains more popularity. As the number of people repeating the same argument increases, an "echo chamber" is formed and, in a short time, most of the market adopts the same opinion.

The second problem is that the importance attributed to the themes that are part of this "collective opinion" tends to be exaggerated. We pay attention to only a few things at a time, and our objects of reflection always seem more important than they actually are while we are thinking about them.

The consequence is that simple and elegant discourses become the center of attention and direct investment decisions in the market for a while, until a new narrative about what is happening takes the lead. Anyone who follows the financial market for some time will see that this dynamic soon becomes quite clear.

What to do

In the current complex scenario, dependent on a vast number of external factors, trying to know everything that is happening in the world and creating hypotheses about how the stock market will behave in the short term is an endeavor doomed to failure. There are feasible hypotheses pointing in all directions, and the pace of events is impossible to determine.

Our approach is to identify the points of greatest uncertainty, or those that could be strongly impacted by binary events, and avoid them. Investors suffer the greatest losses when they believe in hypotheses that time proves to be false. Admitting ignorance and avoiding risks doesn't lead anyone to ruin.

What we believe will bring us good returns during this difficult-to-predict period is dedicating ourselves to analyses with the highest probability of accuracy: the microeconomic dynamics of each business and a few points in the macroeconomic scenario where we can gain clarity. Based on the insights developed in this way, for each investment opportunity, the best strategy is the traditional one: buy what becomes very cheap and sell what becomes expensive. Without speculating on how the flow of international capital, or politics, or commodity prices might cause a price we consider wrong to reach an even more wrong level.

This doesn't prevent our portfolio from being subject to short-term price fluctuations, along with the rest of the market. But, over the years, we've learned to only worry when the profits generated by our invested companies are worse than we anticipated. Random price variations are just attention traps. Noise that doesn't matter in the long run, but drains investors' time trying to find explanations for something that has already happened and is unlikely to repeat itself predictably.