The fox knows many things, but the hedgehog knows one big thing.

—Archilochos

Within the fragments of ancient Greek poetry found among archaeological remnants was the short but insightful line by the poet Archilochos, quoted here.¹ In the 2,700 or so years since those words were written, the distinction between foxes and hedgehogs has been used countless times, perhaps made most recently famous by Isaiah Berlin's entertaining essay titled “The Hedgehog and the Fox,” which was written in 1953.

Berlin expands on the ancient Greek poet's insight to develop the difference between the ideological hedgehog and generalist fox:

There exists a great chasm between those, on one side, [the hedgehogs] who relate everything to a single central vision, one system, less or more coherent or articulate, in terms of which they understand, think and feel—a single, universal, organizing principle in terms of which alone all that they are and say has significance—and, on the other side, those [the foxes] who pursue many ends, often unrelated and even contradictory, connected, if at all, only in some de facto way, for some psychological or physiological cause, related by no moral or aesthetic principle.²

The basic underlying logic of Boombustology has been that, when it comes to spotting financial bubbles before they burst, it is better to be a fox. Foxes are more suited to attack mysteries. Hedgehogs, with their depth of understanding, are more effective in solving puzzles.

Ultimately, we adopt a framework for thinking about uncertain future events in the hope that we might be able to gain insight into the probabilities of various scenarios. Is there any way to tell if foxes are genuinely better than hedgehogs in making predictions? Actually, recent research conducted by Philip Tetlock does just that. Tetlock conducted a 201-year study of 284 professional forecasters and asked them to predict the probability of various occurrences both within and outside of their areas of expertise. By 2003, Tetlock had accumulated data on more than 80,000 forecasts.

The results indicate that experts are less accurate predictors than non-experts vis-à-vis predictions in their area of expertise.³ Two members of the faculty at The Wharton School note that this finding “assaults common sense with evidence.”⁴ Tetlock himself uses the language of hedgehogs and foxes to summarize his results:

If we want realistic odds on what will happen next, coupled with a willingness to admit mistakes, we are better off turning to experts who embody the intellectual traits of Isaiah Berlin's prototypical fox—those who “know many little things,” draw from an eclectic array of traditions, and accept ambiguity and contradiction as inevitable features of life—than we are turning to Berlin's hedgehogs—those who “know one big thing,” toil devotedly within one tradition, and reach for formulaic solutions to ill-defined problems.⁵

Tetlock's conclusion that those with the ability to incorporate new information, to update their beliefs, and to adapt to a changing reality by employing multiple perspectives are better predictors provides strong support for the Boombustology approach.

The frameworks presented in this book are explicitly designed to avoid the “one big thing” approach and to generate a “many little things” approach. Ideological reliance on any single lens might prove, as suggested by Tetlock, detrimental to our ability to navigate uncertain, vague, or poorly defined situations. The multidisciplinary approach presented in this book mitigates the likelihood of falling into the “hedgehog trap.”

“So what?” you may say. Let's say you're a fox, and you've identified a bubble using the multi-lens approach. Now what?

Getting to the right answer starts with seemingly boilerplate language that is no doubt heard all the time from investment professionals: it depends. It depends because everyone's situation is different. The reason this phrase is repeated in one form or another is that it's true. You and your (human) financial advisor, if you use one, are the best people to determine your risk tolerance and the need for cash you may or may not have at various points in the future. No book or article, however well-considered, can give you a definitive answer to your needs.

And on top of that is another variable we have to manage: it's impossible to know everything and to be certain of what will happen. As the saying goes, s%*t happens. Life is probabilistic, and certainty is forever elusive.

But just as the five-lens Boombustology focus can elevate your confidence level that you are in fact witnessing a bubble, so too can we make decisions with a higher level of confidence about what to do with this insight.

Although we all make mistakes, we all also have a choice about which mistake we make: an error of omission (not doing something) or an error of commission (doing something). In situations you may deem “bubbly” using the framework proposed in this book, I suggest you make the error of omission. Resist the urge to ride to the top for that last bit of profit. If you recognize that the market has worked its way to the unsustainable conditions determined through application of the five-lens approach, it is better to get out early than late. This may seem to be a perfectly sensible and obvious statement, but imagine the situation in which all of your friends are excited about their daily gains and are chalking up some impressive weekly and monthly returns. The urge to stay invested is like a siren's song drawing you in.

No less a mind than Isaac Newton succumbed to this pressure. In the early 1700s, a British company called South Sea Co. was given a monopoly on South Seas trade by the British government in exchange for assuming debt from a war against Spain. In March 1720, Newton bought some shares of South Sea in the high £100 range. A couple of months later, after the shares had rallied almost threefold for Newton, he sold his stake and exited happy, with a handsome profit. The problem for Newton was that his friends remained invested in South Sea. His envy at their continued success pulled him back into the market. As shares hit £700 in July of that year, Newton invested three times as much money as he originally invested. Doing so (briefly) seemed wise, as company shares peaked at £950 shortly thereafter.

Unfortunately, South Sea Co. was a classic bubble, driven by investor mania stoked by false stories (planted by company management) of fantastical discoveries in the Pacific. Four months later, Newton exited his position at a £20,000 loss—all his savings. For the rest of his life, it is said, he forbade anyone to mention South Sea in his presence. “I can calculate the movement of stars, but not the madness of men,” Newton noted.

Legendary trader Paul Tudor Jones made his reputation by successfully calling the Black Monday crash of 1987, making a then-unheard-of $100 million profit from it. He makes no secret that a core of his investing strategy includes constant worry that he is overconfident and therefore on the wrong side of a market. In a 2000 interview, he explained that his focus begins with protecting what he has: “At the end of the day, the most important thing is how good you are at risk control—99% of any great trade is going to be the risk control.”⁶

Like Jones, it's best to focus on capital preservation rather than accumulation during times of bubbly dynamics. The reason is the law of percentages, which is simply this: whatever percentage decline you experience, it will take a greater percentage rise to get you back to break-even.

Let's say the Carefree Carrolls of Chapter 2 decide to invest $1,000 in the stock of a very attractive, if purely theoretical, farming enterprise: Unicorn Dairy, Inc. Despite the obvious appealing characteristics of the farm, it has a terrible year, and the value of the investment falls 50% during their first year of holding it.

Luckily for the Carefree Carrolls, the depressed share price allows for a takeover by another publicly traded company, a successful poultry business named Phoenix Farms, Ltd., which can leverage its existing relationships with suppliers and retailers to turn Unicorn Dairy around very quickly. The business combination is a great success, which the market soon recognizes. Just one year after the merger, the Carrolls are thrilled to open their brokerage statement and see the value of their investment has risen 50%! Imagine their disappointment when they see the dollar value listed as $750.

The harsh reality hits them: a 50% fall requires a 100% gain to get back to break-even. For the next three years, Phoenix Farms executes its dairy-poultry–driven business well, and the stock appreciates 10% per year (about the historical average S&P 500 annualized return). Another blunt fact: the Carefree Carrolls won't see their investment value return to its original $1,000 until the fifth year after their horrible first negative year (see Table C.1).

The math of losses confirms that it is better to make the error of omission in times of elevated risk, and the Boombustology framework is designed to help you identify times of elevated risks. It takes discipline to do this, but it can be done. It's worth noting that in December 1999, an authority no less than Barron's declared that Warren Buffett, who had sat out the dotcom boom, was “losing his magic touch” by refusing to invest in internet stocks.⁷ He opted to err on the side of omission rather than risk making an error of commission. After the dotcom bubble burst and technology investments plunged in value through 2003, Berkshire Hathaway gained 25%.

In the aftermath of the Great Recession, a team of managers from one of the world's largest sovereign wealth funds came to Boston to speak with a handful of investors and academics, and I had an opportunity to talk with them. The managers had read the first edition of this book, which came out in early 2011. Here's a quick summary of their thoughts (paraphrased): “We have read the academic literature that says bubbles don't exist,” they said to me, referring back to the efficient market hypothesis. “The bursting of the supposedly non-existent U.S. real estate bubble was very painful and disruptive to our investment plans. We lost a ton of money. We'd like your help thinking about how to navigate some of the uncertainty.”

The advice I offered was the same as what I've offered here: in times of elevated risks (defined by using multiple lenses to confirm a high probability of bubbly dynamics), make the error of omission. I suggested they consider surrendering upside when they grew concerned. The key, I said, was to increase the odds of avoiding a catastrophic error of commission.

As Jeremy Grantham of GMO once told me, when you see a bright light coming toward you (and you happen to be in a tunnel) and it appears to be approaching rapidly, it's smart to step off the train tracks. You're allowed to use common sense in the face of investing orthodoxy that commands otherwise. While this may not be an exact quote, the sentiment of his message to me was, “You don't need to get run over by the train to prove you're a long-term investor.”

Blinded by Focus

Recall the distinction made earlier in the book between mysteries and puzzles. The ideal approach to addressing one is usually ineffective in addressing the other. We learned that focus and expertise were essential to address puzzles, but that they could be detrimental in the domain of mysteries. The key, when addressing mysteries, is to utilize multiple perspectives and connect, rather than generate, the proverbial dots.

Yet think about the incentives our world has presented us. Business thinkers, organizational psychologists, and leadership trainers point to domain expertise as an enduring source of advantage in today's competitive environment. The logic is straightforward: learn more about your job and acquire expert status, and you'll go further in your career.

A 2015 analysis⁸ by Georgetown University of employment data in the United States confirmed that specialization pays. A new computer science college graduate makes about 50% more than the average made by recent graduates with humanities and liberal arts degrees. In this environment, what would you want your child to study?

Yet there are many examples of generalists who made groundbreaking contributions to a very specialized field. Alexander Graham Bell was a speech therapist and amateur telegraph user who pursued the telephone, whereas telegraph specialist competitor Elisha Gray didn't. Or what about the fact that many of today's leading tech companies (Facebook, Microsoft, Apple) were founded by college drop-outs who never had the time to specialize? Beyond such anecdotal evidence, academic research on everything from jazz to theoretical mathematics has found extensive evidence that specialization hinders creative thinking by embedding certain thought patterns and heuristics into a person's approach.⁹

New ideas emerge from a combination of seemingly unrelated information. Highly organized approaches work in training the brain to react in normal circumstances but make us less apt to recognize and react to potentially informative anomalies. And given that bubbles generally are not normal-course events, the need for mold-breaking approaches is essential to spot them before they burst.

Creative thinking—seeing more possibilities from the pieces of information you are provided with—makes you more likely to piece together an unexpected answer. It will help you identify times of elevated risks when others are lulled into complacency by all the good news.

As the saying goes, to a man with a hammer, every problem appears to be a nail. Globalization and economic and financial interconnectedness are the reality of today's socio-political-economic existence. This means you need to adapt your thinking to be a toolbox, rather than a specific tool. National economies and large corporations are increasingly in need of dynamic, flexible human capital that knows how to think, not what to think.

The five-lens methodology of identifying bubbles before they burst is built on the philosophical foundations of liberal education. Richard Levin, president of Yale University, noted that “it is not subject-specific knowledge but the ability to assimilate new information and solve problems that is the most important characteristic of a well-educated person.”¹⁰ He goes on to explain the rationale for this belief: “The logic behind this approach is that exposing students to multiple disciplines gives them alternative perspectives on the world, which prepares them for new and unexpected problems.”¹¹ Given that few financial bubbles are “expected” or are certain, a liberal arts approach is ideally suited to thinking about such ambiguous developments.

As you utilize the frameworks presented in this book, remember that the only thing that appears certain is uncertainty. Remember that the dynamic, interconnected world in which we live is likely to present situations that transcend the tools provided by single disciplinary lenses. Remember that there are inherent differences between puzzles and mysteries. Last, but not least, remember that despite the allure of “it's different this time” explanations, it's usually not different.