Fighting the Last War

Note: This post was originally published in the November 2017 issue of our premium newsletter – Value Investing Almanack (VIA). To read more such posts and other deep thoughts on value investing, business analysis and behavioral finance, click here to subscribe to VIA.

In Safal Niveshak’s Value Investing workshops, when we discuss the mental biases, we show the following video to our participants.

I would suggest that you pause here and watch this video before reading further.

It’s a test of your awareness so don’t cheat 🙂

I hope you watched it.

How did you do? By now you know that I am not interested if you got the count right. Did you spot the Gorilla in your first attempt? Yes? You have already seen this video before, haven’t you?

The intention of the Gorilla experiment, as you must have learned in the video, wasn’t to test your observation skills. It was to demonstrate a critical behavioural bias called Inattentional Blindness. It’s one of the big ideas from the field of psychology. If you want to know more about it, you can read our earlier post.

The learning here is that when we’re focussing intently on one thing, we may miss something else which is there in plain sight.

However, there is something more interesting going on here. Watching a video about invisible dancing gorilla isn’t going to make you immune to inattentional bias. And I am going to prove this in a minute.

Here’s another version of the gorilla experiment. Let’ see if you can win this one. Again, don’t read further before watching this video.

How did you do? I am sure you never counted the ball passes. Moreover, the gorilla was too easy to spot this time. Right?

But the question is – did you notice the change in the colour of the curtain in the background? Like the first experiment, most people fail in this one too.

Reminds me of what a wise man said, “Fool me once shame on you. Fool me twice shame on me.“ It’s the inattentional bias that’s fooling you, not the gorilla.

German philosopher Friedrich Hegel wrote, “What we learn from history is that we don’t learn from history.”

My version of Hegel’s saying: What we learn from the gorilla experiment is that we don’t learn from the gorilla experiment.

The setup in the first video deliberately steered your attention away from the gorilla. Soon after that, you’re shown how you missed the dancing gorilla. Now your brain is primed with the idea of an invisible gorilla. So by the time you’re ready to watch the second video, you’ve been subtly manipulated to look for the gorilla. As a result, most people start trying to win the first game (find the gorilla) but don’t realize that the game has already changed (curtains).

And you are not alone. France made the same mistake in World War 2. In his wonderful book, All I Want to Know is Where I’m Going to Die So I’ll Never Go There, Peter Bevelin writes about how France was defeated by Germany because France was fighting the last war. He writes –

The Maginot Line was a chain of defensive concrete fortifications France built along its eastern border between WW1 and 2 and named after the French Minister of defence who proposed the idea. Based on experiences from WW1 it was designed to prevent future invasions from German ground forces. Unfortunately, in WW2, German ground forces instead attacked France through the weakly hold Ardennes forest near Luxemburg and its Luftwaffe flew over the fortifications.

It is often referred to as the danger of only relying on precise past experiences – preventing a disaster tomorrow with a strategy that worked in the past. The French prepared for a defensive war similar to WW1 and didn’t consider that they may face new conditions – new technologies and tactics. WW2 was a different kind of war. WW1 was more of trench war while Germany brought more of mechanized blitzkrieg – tanks, motorized infantry, and air support – to WW2.

Trouble often comes from the direction we least expect. French prepared themselves for old threats and plugged the past vulnerabilities. Unfortunately, they forgot that past provides limited ability to adapt to changing situations.

It’s all too common to learn little too precisely from the past bad experiences (personal and others’) and focus all our energies towards preventing the yesterday’s dangers. There’s no denying that yesteryears’ dangers can hurt us but they can distract us from the present reality. The reality may be that the conditions, objectives, and the enemies have changed.

We prevent something from happening again – until something else happens. It’s true in life and in investing. Warren Buffett, in his 1982 letter to shareholders, wrote –

It’s not only generals that prefer to fight the last war. Most business and investment analysis also comes from the rear-view mirror…Future profitability of the industry will be determined by current competitive characteristics, not past ones. Many managers have been slow to recognize this.

It comes natural to learn from past experiences, writes Bevelin, “and especially bad ones and then try to prevent the same from happening again. Just like people assume some past disaster would never exceed its historical maximum and only protect for that.” (Lucretius Problem)

Am I suggesting that that one should ignore the lessons from the past? Far from it. The argument here is that the lessons from the past aren’t always obvious. For example, in the gorilla experiment if the lesson you take home is – “look for the invisible gorilla” then you’ve missed the point.

Bevelin explains –

Both the French and the Germans learned the right lesson from WW1 – that it was mostly a defensive war. But while the French adopted the lesson, the Germans adapted to it. And as any good military strategist know – when you want to surprise an enemy, go where they are not – hit hard where not expected.

So, what does it mean for an investor to fight the last war?

The poster child of 2000 stock market crash were tech companies. In 2008 it was infrastructure and power. If that history makes you averse to tech, power and infra companies, you’re probably focusing too much on the past. Past tells us that a stock market crash comes every 8-10 years but if you’ve sold all your stocks, stopped your SIPs and waiting for the crash – you’re behaving like French.

Discounted cash flow calculation is another area where many investors get sucked into the trap of fighting the last war. DCF is a favorite tool to estimate the value of a company. Most investors forget the two fundamental characteristics of DCF are: first, it’s based on the past and second, its output is only an estimate. Those two words – past and estimate – aren’t just characteristics of DCF. They are a caveat. A serious caveat. They’re telling you that future is rarely a mathematical extrapolation of the past.

If you’re looking for the next 10-bagger, for the next Page Industries or Eicher Motors, then you’re expecting a gorilla while missing the red curtains that are turning green.

Don’t just adopt. Learn to adapt.