Shadows & Traps

Plato's Allegory of the Cave and how it relates to investing and markets

Investors are like prisoners in Plato’s Allegory of the Cave. They are chained and cannot see reality — only shadows of reality.

What are the shadows in investing?

• An obsession with the Fed and monetary policy

• Macroeconomic analyses and reliance on economic figures

• Credit ratings and analyst price targets

• Coffee shop chatter and media narratives

• Price multiples, correlations and oversimplification

• Using historical analogies to prove predictions/expectations

• Unreal themes and theories about the future

And anything that market participants think is related to the ultimate business value of the company — that really is not.

At the heart of the confusion lies the effect these “shadows” have on prices. What’s more real to an investor than the value of his portfolio? The gains, the losses, the ups and downs of volatility…

And so those that are imprisoned by the markets and the noise surrounding them are chained to their desks forced to look at their screens all day.

But one day in Plato’s allegory by sheer will and persistence one of the prisoners breaks free from his chains - for our purposes today, think of them as ideological chains.

The prisoner escapes the cave of shadows and sees that he was blind all along. He realises that he was only looking at shadows of reality, not reality itself.

Looking around him he sees so many things — first and foremost the sun and its strong light, which he never knew existed.

He rushes back to tell the others

“We have been living a lie! All the things we thought we knew as market participants were false and misleading. And cognitive biases and mental blind spots are preventing us from seeing it! Price is what you pay, but value is what you get.”

We are focusing on the wrong things! A true investor can’t worry about impending recessions or swings in his P&L all day long. He can’t worry about what others will say about his companies or if ABC hedge fund has a short position on one of his stocks.

“The value of a business is the present value of the cash flows it can generate over its lifetime.”

The other prisoners shrug this last realisation off like they haven’t heard anything new. They act as if they knew that, but still don’t want to leave their caves.

It takes work to escape the cave

Why escape the cave and go create a new life for themselves? They will have to get their own information and make calculations they have never done before. They will have to think long and hard about businesses and their long-term competitive advantages - that’s hard.

It’s easier to just lie to themselves. Besides, they agree with each other! Isn’t social proof a strong signal that they are right?

But the free investor no longer requires their validation. The free investor will continue to do what makes sense, regardless of their bullying and disregard.

After having seen the real world he is no longer willing to execute a short-sighted strategy of picking stocks. He now wants something bigger, something rational and something much more profitable - he wants to play the long game.

Layers to reality

When you look back at multi-year moves of stocks you can’t always explain it away with recessions, global pandemics, fleeting trends and fads or shifts in Central Bank or OPEC policy.

Looking at a broad equity index like the S&P 500 or the Nasdaq 100, you can’t explain it away with lowering or increasing rates — there are other trends happening behind the surface.

The philosophical investor understands that what he sees on a price chart is not the whole reality, that there is a greater reality to be discovered. And the philosophical investor, now freed from his ideological chains, returns to the hypothetical cave to tell the investor-prisoners still stuck in the cave.

But the others could not understand what they did not experience — they ridiculed the idea of leaving the cave and wanted to punish those who tried. They were dismissive and afraid of what they did not understand.

Prisoners don’t want to be enlightened, they want to stay in their cave. And when something happens that does not fit their world view, they explain it away with a list of concepts.

Investing lessons from Plato’s allegory of the cave.

The market is not efficient, what you see is not always what you get. There are many levels of reality.

This means you can’t go far with just a linear first-level type of thinking. You need to add nuance and more levels of thinking to your mindset.

If you are a macro guy, you only see macro and economic figures. If you are a technical analyst, you think charts are the only truth. If you are a fundamentally-oriented investor, you think only your company’s fundamentals should influence price. No.

If your perspective is limited, you only know what you see. This is the trap that macro-intellectuals fall into, they only know economic theories, news and economic figures. They end up believing their own theories and for them — those things must happen, they must play out.

Every additional data point is used to confirm their biases and pre-conceived notions. Then, when their thesis doesn’t play out they move the goal posts and find excuses.

The Reversal

But here’s what Plato missed with regards to investing. Great investing is not a science, and it isn’t an art either - great investing is alchemy.

Even if you have the best analytical skills and the best companies in your portfolio — you still may not win the race for long-term total return.

If total return adjusted for risk is the aim then the shadows do matter, and in this instance they are a part of reality. The investor alchemist needs the shadows to create a confusion and uncertainty that would distort the prices of the assets he wants to buy. He needs to balance his own reality (his assessment of business value) with the pseudo-reality of the shadows that influence price and valuation.

The investor alchemist needs to use the shadows to his benefit rather than to his detriment. He will use his analytical skills to get as better grasp of reality as possible (long-term business value) but he will wait for a sufficiently discounted price before buying — and by doing so transmute a simple idea into gold.

The Philosopher’s Journey

His journey starts from inside the cave where he spends his life metaphorically trying to escape. He reads, thinks, studies, tries and tries again until he breaks those chains and finds his way out of the cave. He discovers what was previously unknown to him and now he wants to crawl back down and help the others.

But humans are resistant to philosophers that preach their teachings —they aren’t willing to be changed or told they don’t know something.

And so the prisoners will attack the philosopher and try to destroy him for daring to come back and try to teach them. They will find one imperfection, one flaw, one minor detail — and use it to defame the philosopher and disregard his work.

But regardless of the risks attached to philosophy, the true philosopher will still go back to the cave and try to be of service even if he may only influence the very few.

The individual has always had to struggle to keep from being overwhelmed by the tribe. If you try it, you will be lonely often, and sometimes frightened. But no price is too high to pay for the privilege of owning yourself.

-Friedrich Nietzsche