Every political movement appears to be split into an idealistic and a pragmatic wing. That is not to say that everyone falls exactly into one of these two categories. It is more a scale than a binary system. However, few people seem to be in the middle, most tend to identify more with one side over the other. We also find some true radicals in both camps.

Technically, being pragmatic simply means to do whatever works. Who could be against that? In reality however, the word is used for people who reject the idea that having strong principles is important. Pragmatists seem to believe that principles hold people back in achieving their goals. Therefore, it is important to stay openminded and change strategies and opinions quickly, if something suggests that they are not working. In particular, people are often called pragmatists, when they don’t care too much about the means with which they achieve their goals.

I disagree with pragmatism. I have always been far on the idealist side. I think principles are a good guide in life and should not be lightly abandoned. I have a deep mistrust of people who do not show any signs of having principles. I even feel a strange bondage with other idealists, even if their ideals are completely contrary to mine. I simply cannot help to have some respect of principled people, even if I think their principles are wrong. More often than not, it is following principles that really work in this world.

Don’t get me wrong. I love critical thinking too. But I would mainly use it to find better principles. The idea that principles are irrational and an unnecessary constraint on our thinking and actions is deeply flawed. Reality is too complex. We cannot afford to completely newly assess it all the time. Good, tested principles help us to move forward. Most importantly they help us avoiding repeating the same mistakes over and over again. If evolution is true, than the fact that so many people feel passionate about their principles shows that this mechanism has an important survival function.

There are many examples in which following principles appear to lead to better outcomes than more pragmatic, active approaches. Of course, we can also find occasional instances in which principles indeed seem to hold us back. I feel however, that most of the time they are a superior strategy.

A field that I have been very fascinated by for years is the world of investing. It turns out, investing is a good example of the power of principles over pragmatism. A lot of principles we hold are linked to emotions, which have evolved in the cause of evolution. Indeed, pragmatists often reject principles on the basis that they perceive them as being emotional, which they interpret to mean irrational. They are very confident in the ability of people to come to correct conclusions through active rational thinking. While active rational thinking can certainly be useful, putting to much value on it seems like a mistake.

Why is investing a good example of the power of principles? Other than with, for example, moral principles, our brain was not made to be a good investment tool. Throughout most of human history, investing, as we know it today, did not exist. It was not until humans settled down and started to plan for winters that building up capital, and therefore long term investing into material things, became necessary. For that reason, we cannot rely on our instincts to be good investors. This might sound like an argument for pragmatism at first, but it turns out it isn’t. We are still well advised to follow good principles in order to become good investors. It is the most rational thing to do.

Everyone will agree that the objective of investing is to buy low and sell high, which simply means to make a profit. Yet, even though everyone agrees with that, most people tend to buy high and sell low. Why is that? The answer is that they follow short term reasoning and let their emotions lead them astray. We seem to be hard wired to reason that something that has repeatedly happened in the immediate past, will continue in the future. As a result, we reason that if an asset, like a stock, has gone up lately, it will continue to do so. That means, before people invest, most wait to see confirmation that what they are investing in really is going up. Only after having watched prices increase for a while they feel the asset is save enough to put their money into it.

However, by doing that they are doing the opposite of what they are trying to do. They are not buying low if what they are buying has gone up for a while. It only seems low compared to the projected future prices. These prices however might never come. Once they feel confident enough to buy, a lot of other people, with the same reasoning, feel confident to also put their money into it. The problem is, once all these people are invested in the asset, who is going to be the new buyers who will drive prices up even further? With a lack of new buyers, supply and demand for the asset turns in favour of too much supply. In other words, prices turn down. As a consequence, many people often get invested in a market at the very top. This is not stupidity. Our brain, even the best brains, simply work like this. Sir Isaac Newton, probably one of the smartest people that ever lived, famously bought back his stock near the top of the South Sea bubble in 1720. He lost a huge fortune. Projecting past trends into the future is how our brain works and it is very difficult to go against that reasoning.

After prices have turned at the top, the reverse happens. Disbelieve kicks in that this market really has stopped increasing. Investors convince themselves that soon prices will continue to go up. Only after a while, when the market has already gone down significantly, and the pain becomes too big, they finally give up hope and cut their losses by selling. But you guessed it, just like at the top, this is usually the time when the market runs out of sellers and turns around to the upside. These turns are called mean reversion and they eventually happen in almost every investment market.

If you now think that knowing this easy to understand psychology makes you immune to making these kind of mistakes, think again. This psychology is not a new inside. It has been known for a very long time. And yet, most people, even most professional money managers who are aware of this psychology, end up buying high and selling low. As Warren Buffet says, investing is simple, but not easy.

The reason why most people repeat this mistake over an over again is that prices are usually low when an asset is very much disliked and has gone down for a while. Mostly there is a good reason why investors don’t touch the asset. The industry is in decline, the company is making losses or the management is incompetent, to name just a few. And of course, some industries and companies really never do recover. Going against the crowd and investing in despised assets is therefore psychologically challenging.

On the other hand, going with the crowd and buying stuff that everyone agrees is great, seems easy. Yes, you know you should not buy high, but you see, this time is different…. house prices in London cannot go down, Tesla is a revolutionary company, and you don’t understand, Amazon does not need to make profits, so forget about the astronomical P/E ratio. Evidence suggests that in the end, it never was different that time. But people only figure that out when they sell at the next bottom.

Is there anything that might help becoming a better investors? The answer is yes: good principles! Almost every successful investor has solid investment principles that they follow slavishly. And the evidence suggest that the more slavishly they follow their principles the better their returns.

In 2005, Joel Greenblatt published a book with the title “The little book that beats the market”. Greenblatt is an investor with a very successful track record. He has managed to produce much higher than average return since he started professionally managing money in 1985. For his book, he wanted to find out whether it was possible to construct a simple formula that could automatically produce very high returns.

The benchmark for investing in stocks is usually “the market”. Technically this means the combined returns of all trading stocks. In practice however, it usually means the return of the major stock indexes like the S&P500 or the FTSE100. Everyone can easily get that return by buying a tracker fund. This is a very cost effective way of investing, as these funds charge very low fees. And most people don’t seem to be able to beat the returns of these indexes via active investing, which is why it seems wise to simply buy the market. But Greenblatt thought it might be possible to construct simple metrics with which it would be possible to just buy the biggest winners within the indexes and therefore beating the average.

Since Benjamin Graham, the founder of value investing and mentor of Warren Buffet, published his books “The Intelligent Investor” (1949) and “Security Analysis” (1934), it is well known that buying stocks that are cheap compared to the underlying assets of the company will produce very good returns. Stocks seem to eventually mean revert to their intrinsic higher value. This strategy makes sense, because remember, the goal is to buy low and sell high.

Knowing this, Greenblatt had the idea that the metric he was looking for would need to be able to divide the stock universe into cheap and expensive stocks. Without going into detail (read the book if you are interested), it was not very difficult to come up with such a metric. He called it the magic formula. As other research suggests, it is actually not that magical. Simply dividing stocks by P/E, P/B or EBITDA/EV works just as well if not better. But anyway, he came up with his own metric. He used it to rank the largest 3500 stocks trading in the US from cheap to expensive, with 1 being the cheapest and 3500 the most expensive. Once he had the ranking, he bought a portfolio of the cheapest 30 stocks. He then rebalanced his portfolio annually, meaning after one year he sold all the stocks and then bought the new 30 cheapest.

The result was more than satisfying. Testing the formula with old stock market records, he could show that over longer periods, his formula seemed to outperform the market but a significant margin. While the S&P500 gave investors a long term average compounded return of around 10% per year, his formula could beat the index by 2 to 1 or even 3 to 1.

So far so good. The interesting thing about this is that when Greenblatt actually tried to use his formula with real money, he found it to be a lot more difficult than he thought. The reason was the exact psychology that I outlined earlier. There was a reason why the 30 cheapest stocks were so cheap. Having been a professional value investor for a long time, Greenblatt immediately saw the big problems with these low ranking companies. It made him think twice about buying the stocks. The return of the formula is only a long term average. Individual companies within the 30 cheap stocks portfolio might, and often will, indeed not perform well or even go bankrupt. So the temptation for Greenblatt was high to cherry pick a little bit, leaving out a few particularly bad apples he thought would likely not make it.

And so he did. With lots of hard earned skills about judging the quality of a company and a great track record of doing just that in the past, Greenblatt was confident that at least he could outperform his formula by using his skills to eliminate the worst stocks among the cheapest. But he was about to find out that it is better to stick to good principles. By eliminating the worst stocks, he also eliminated some of the cheapest. While not every of these companies made it, some did. Those who did survive often turned around to become the best performers. That means they become responsible for a big part of the good overall performance. By cherry picking, he had eliminated more good performers than bad ones and therefore ended up underperforming his formula.

Evidence like this very much suggest that in investing, once you have a good method that has been tested over a long period of time, you better stick to it slavishly. Being pragmatic, meaning assessing every situation with an open mind and not being principled will most likely lead you to underperformance, often significantly.

This is a very good example of how it literary pays to have good principles and stick with them, even if it sometimes looks like they are outdated. The world is too complex to constantly reassess it. Of course, we still need active rational thinking to figure out which principles work and which ones don’t. But at the end of the day, it seems we are well advised to aim for principles rather than approach every situation unbiased.

What seems to be true for investing, applies just as much to politics. The pragmatists often consider the idealists to be a bit immature. However, the pragmatic track record does not convince me very much. Pragmatic people seem to do little more than ending up supporting the ever same status quo. For example, what good did Milton Friedman’s pragmatic support for the welfare state and the fiat money system do? He thought it would give him more credibility and a bigger voice. And indeed, it did, but unfortunately for the wrong things. I fail to see the good in this. In fact, I am convinced that a principled Ron Paul, who, because of his libertarian leaning principles, was nothing but ridiculed by the mainstream, has done more for liberty than Friedman.

Principles simply mean that you have learned a lesson from the past and expect that lesson to be true in the future. The pragmatists on the other hand seem to think that mistakes need to be constantly re-evaluated, if it looks like this time is different. But this more often than not leads to repeating the mistakes. In the process, they often loose site of the bigger picture and start to do terrible things in order to achieve their currently preferred goal.

Take another current self proclaimed pragmatist, James Rickards. Rickards is well known among libertarians, since he criticises the monetary system and promotes gold. He is very much worth reading, despite his pragmatist leanings. However, his clear lack of principles is exactly what has always bothered me about him. He talks about politics as if it is just a big strategy game without any implications that there are real people involved in it. And so I was shocked, but not surprised, to find out that he supports exchange controls and the Tobin tax. According to him, there is too much liquidity in the system, and therefore we need some political tools that reduces it. Never mind the human implications of these terrible policies and never mind the terrible side effects for a lot of parts of the economy. Let’s not get too moral and emotional about this. It is a game and we just introduce another tool. The destructive force of pragmatism at work.

John Maynard Keynes is another example of a destructive pragmatist in that sense. That is why Rickards admires him. But Keynes too thought he could just rewrite economic insides at a heart beat, as soon as he felt those old insides where wrong.

I have very little use for pragmatism. The furthest I would go towards this ideology is to say that principles should not be dogmatic. Once enough evidence suggests that there is something wrong, it might be wise to move to better principles. But this should not be done too quickly. Pragmatists appear overconfident in their ability to gain knowledge and assess the world. It is often tempting to overwrite principles of behaviours when new information presents itself. But just like Greenblatt was not able to outperform his formula, it seems a lot of evidence suggests that we are better off to not lightly abandon previous knowledge and behaviours. To me, a good foundation of principles is key to success in almost every strategy in life.