Financial Planning

Book Review: The Engineer’s Investing Mindset

Investors can learn from engineers' approach to our nonlinear world.

Applied Minds: How Engineers Think - Guru Madhavan

It's often said engineering is the bridge between theory and reality, from concept and abstraction to tangible and physical things. It's fine to know a bit of math, but can you use it to build a suspension bridge?

In my early years, I often thought of investing as a kind of engineering-the bridge between all the economic and financial theories I'd learned versus the chaotic, messy truths of wading through the markets and creating successful strategies.

Some years ago, actually, on the day I turned 30, I was in Texas giving a presentation to clients with Ken Fisher on our current market outlook. During the Q&A one client asked, "What's the formula, or set of rules you follow to beat the market? I don't see what the formula is in your presentation." Without missing a beat, Ken said, "I'll bet you're an engineer. I can tell by the way you phrased that question. Markets aren't generally kind to engineers-you want the world to be an ordered, linear place. Markets aren't linear, and they don't work intuitively the way an engineer's mind works."[i]

It's these little moments in life that matter. I thought about this exchange for at least seven years, and continue to. It was the spark leading me to what has become a personal philosophy of seeing markets as complex adaptive systems. Specifically, stock markets are a particular kind of system-they take the views of millions of participants and reflect them in a single unit of information: a price. There is no equilibrium in markets. They constantly flow as new information is digested each second. Markets adapt, change and flow. Systems, not machines. And they produce counterintuitive effects: Because markets discount known or widely believed information, they tend to move on surprises, shifts in relative expectations. They're counterintuitive, nonlinear, chaotic-yet, the system itself displays patterns that don't work each time, but do in general, and with use of probability. Basic bull and bear cycles are the prime example-each one is unique as it unfolds in real time, but the general features of bulls' and bears' cyclical behavior are remarkably consistent. Which means the idea is to be disciplined, act using probabilities and never ever expect to be right all the time (which means diversify and find the smoothest path possible to your long-term goals, among other lessons). That's what markets are to me.

What's great about Guru Madhavan's pithy book on engineering, Applied Minds, is that he describes a vision of engineering that includes the nonlinearities of the world. This is engineering for the 21st century: It thinks in terms of information, signals, systems, and networks as well as tangible physical structures or machines. The Internet, for example, is an incredible engineering intersection of network and information theory with the reality of use by actual humans.

He says the disposition of problem solving is "deliberate, disciplined, open-minded, yet grounded in reality." Engineers are integrators-they pull what's useful from many subjects and disciplines and "work at the intersection of feasibility, viability, and desirability." These are broad generalizations (indeed, the generic quality of this book makes much of it feel tautological rather than insightful), but nevertheless vital for investors. Too many folks think they have a great investing strategy or idea, but haven't taken the time to understand the investing universe they're dealing with-how indexes are actually structured, what types of companies are out there and investable, and so on. That's the engineering part of investing, and it takes time and a ton of effort.

Madhavan acknowledges in today's world few things are standalone or stationary-everything is linked and moves. Which is what markets do, too. He admonishes "modular systems thinking" and "step-wise refinement"-which is effectively taking big problems and isolating them into digestible chunks. And, much like the great cognitive psychologist Steven Pinker did with the human mind, Madhavan wants us to "backward engineer" our problems. That is, to try and understand the outcome we want, and work backwards to get to the beginning of the problem. In these things, there are pitfalls for investors. Because there is so much interconnectivity, so many nonlinear and unintuitive effects within markets, we have the constant temptation to assign rationales and explanations for market events that, in reality, we are truly ignorant of. Simply looking at interest rates in a bubble doesn't do the job-rates are connected to all else in the economy and in a constant feedback loop. Or, just dial up any market-watching webpage-all of them have neat and tidy explanations about why the market is doing what it's doing each day tied to a single cause. Nobel Prize winner Daniel Kahneman and author Nassim Taleb have listed this basic deceit as among our biggest biases, and they're right.

Here's my favorite quote: "Engineering is at the center of producing utility under constraints." You could replace "engineering" with "economics" and plop it at the front of every econ textbook out there. Designing under constraints, understanding trade-offs and resources, the concept of continuous optimization and adaptation-these are all economic ideas, market ideas. And it's the ethos we need versus the old-line thinking of static equilibrium and purely theoretical, mechanical economic thought still dominant today.

[i] I'm paraphrasing. I don't remember the exact words used ... it was a while ago. But as it turns out, yes, Ken was right. The client was an engineer.

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