“I find it amazing how many people who are really very smart get off track and
manage to engage in so many self-destructive actions… I think a lot of people make things more complicated than they need to.”

—Warren Buffett

Common sense is a quality we all supposedly possess; and yet, paradoxically, it is not always commonly found. It is our innate wisdom and know-how, ingrained or learned, which is often overridden by ostensibly higher forms of reasoning. Common sense is relevant to everything we do, from crossing the road to governing a country, and is recognized as a valuable element both in designing our laws and in the trial-by-jury system. When it comes to investment decision-making, however, it is the application of common sense, or the failure to apply it, that is of interest to investment professionals.

“We have to ask ourselves, what’s the purpose of the stock market? It’s supposed to be a source of capital for growing business. It’s lost that purpose.” 

 —Mark Cuban,
U.S. media and sports entrepreneur and investor

Over the past century, the application of such sciences as economics, econometrics, probability, statistics, and electronic computing, as well as the behavioural sciences, to investment decision-making has sometimes had the unwanted effect of displacing our inherent basic reasoning. Of course, we should not dismiss the benefits of those advancements. Rather, our innate wisdom and common sense should be brought to bear in a complementary fashion, as described later in this article.

What is common sense? 

But what is common sense? Common sense includes the ability to tell the difference between what we know and what we don’t know: in other words, it includes intellectual humility. Common sense allows us to accept wider truths and balance our thinking and conclusions in a way that takes all aspects of a problem into account while recognising those limitations inherent in our human nature. 

Common sense can be defined broadly as sound and prudent judgment based on simple perceptions of situations or facts in practical terms.

People who have good common sense are typically reasonable, down-to-earth, reliable, stable, and practical as opposed to emotional, erratic, or ideological.

People who have common sense also recognize when sophisticated, complex lines of thinking are leading us into unnecessary confusion and conflict, and when a reversion to more fundamental lines of reasoning, based simply on logic and on human nature, is called for. 

Another element of common sense is the ability to understand the law of unintended consequences, or that any action involving a complex system, and that cannot be easily or fully understood, is certain to have unintended consequences. 

To be able to use common sense requires a basic knowledge of history. Without the lessons of history human beings have in effect been born yesterday. We all stand on the shoulders of ancestors who have created the foundations on which we build our lives. 

Prudence and respect dictate that we fully consider the legacies they have left us and that we develop them wisely. Disruption as a goal, emanating from a restless desire for change, is not consistent with common sense. 

Finally, common sense must be comprehensive. It must be based on thinking that is both broad in scope and inclusive of all relevant considerations. 

In summary, we can think of common sense as being based on twelve principles: moderation, proportionality, practicality, pragmatism, social responsibility, attention to history, respect for human nature, experience, inquiry, comprehensiveness, reasoning, and balanced judgment. 

How common sense relates to investment decision-making

Using common sense when investing in the stock market was traditionally thought to mean investing conservatively in established companies on the basis of an assessment of their fundamentals: that is, their financial positions, sales, profits, dividends, growth prospects, and risks. In other words, it meant viewing shares as what they actually are—ownership stakes in business enterprises which fluctuate in price based on business conditions and profitability. That approach is quite distinct from regarding stocks as figures on a screen or a page, which are moved up and down in value by factors and forces that we may attempt to determine scientifically or otherwise, but seen without taking account of the businesses they represent. 

Today, of course, there are other methodologies for investment. On the basis of current trading volumes, these new methodologies can be more influential in the short to medium term than fundamentals-based investing. They include quantitative analysis, technical analysis, modern portfolio theory, and behavioural economics.

Until the second half of the twentieth century, the stock market was very much driven by fundamental analysis with a strong tendency towards follow-the-herd behaviour. In recent decades, however, it has also been driven by quantitative analysis and other techniques that are often conducted at near lightning speed. 

Common sense still enters into the design and testing of quantitative and technical models of market behaviour and their use in price forecasting; but, unlike fundamental analysis, the formula and the computer play the major role in forecasting.

The boom in quantitative investing over fundamental investing represents progress only if the quantitative techniques are well designed and well handled by humans. If computer calculations are used to replace human thinking and decision-making exclusively, or in a way that is poorly guided, then it can be counterproductive. 

Stock market trading activity today exceeds the amount required for economic purposes 

Through all these changes in methods of investing, and helped by declining trading commissions, the volume of stock market trading activity has grown. That volume has come to far exceed the amount necessary to provide for the capital needs of businesses and the liquidity needs of long-term fundamental investors, which are essentially the economic purposes of a stock exchange, and stock trading has become a targeted profit source in itself. This is a normal development under free-market capitalism, but—to the extent that short-term trading for profit becomes a dominant force—it lends a casino quality to the markets, which tends to make them less attractive to common sense investors. 

Most famous stock market investors, such as the legendary Ben Graham and Warren Buffett, built their reputations as fundamental investors employing what they routinely referred to as common sense, although, periodically, their approaches came under criticism from some quarters for being “out of touch” with modern markets. 

In a lecture to students at the University of Nebraska in 1994, Buffett stated that over-complication is possibly one of the biggest reasons why investors struggle to achieve good results. He went on to say the best way to invest is to construct a simple, easy to understand investment thesis, one that can fit on just one side of paper. If you cannot do that, then perhaps, he suggested, you should not be buying the stock. 

Pragmatic, common sense investors sometimes prefer to invest on the basis of fundamentals or common sense because, if they underperform, the reasons will usually be obvious; whereas investors who use quantitative methodologies often find it hard to understand what went wrong. 

Nevertheless, many quantitatively managed funds have generated excellent returns, and fundamental investing does not always provide good results because stock market prices reflects the totality of our ever-changing body of knowledge and emotions. In other words, quantitative and other tools may at times be better at optimizing returns than sensible human beings applying common sense and fundamental analysis. 

Applying the principles of common sense to investing

The principles of common sense as applied to the stock market give us the following guidance which we ignore it at our peril: 

• The case is strong for using fundamental analysis as the primary, though not necessarily the sole, basis of investment decision-making. Shares are ownership interests in businesses and should always be recognised as such. Moreover, fundamental analysis is firmly rooted in the essential truth that the stock market exists to be a source of capital for growing businesses and providing liquidity for investors who have supplied that capital. 
• Moderation should be employed by avoiding extremely concentrated or risky positions in a small number of companies or industries and by employing a broad diversification of holdings. It should also encourage us to avoid companies with extreme business strategies or risk exposures and to avoid extreme share price valuations—high or low—while acknowledging that share pricing forces may be at work that may not be within our ability to fully comprehend. We should reject the criticism of those who claim that diversification merely dilutes our best investment choices. 
• Practicality should be followed by avoiding illiquid holdings that cannot be freely traded and selecting shares of companies involved in established industries with trustworthy managements. We should not make the mistake of regarding start-up entities as established businesses.
• Social responsibility should be practiced by only investing in companies that produce products and services that are not detrimental to society and preferably are beneficial to it.
• Of course, proportionality should apply so that the fundamentals and prospects for the businesses involved should always be the dominant criteria for selection and no enterprises should be selected simply for their social responsibility. 
• History and past experience should be considered when studying trends and developments in the economy, industries, and stock markets, together with an analysis of human behaviour as it pertains to demand for particular products and services and for the shares of business enterprises. 
• Investigations of investments should be comprehensive and done with due diligence and carefully balanced judgement. We should be wary of overly complicated strategies and conclusions based on too many error-prone
  or risky assumptions.

These approaches might be expected to be automatically adopted by investors but many of them are frequently ignored, consciously or subconsciously. For example, computer models of future business performance and share price projections are only as good as their assumptions, yet they are frequently relied upon unduly, even by their designers, when often these assumptions are highly tenuous. Also, investments are often made without careful reference to diversification considerations or without adequately taking into account certain customer and inter-industry dependencies. And, notably too, investments are often made in industries or in companies which either abuse their workers, produce harmful products and/or sell dangerous products. Furthermore, in today’s technology-focused world, there are many enterprises that are in such early stages of their business development that they lack substantial sales or earnings and belong more in the high-risk realm of start-up financing and venture capital than in the universe of investable common stocks traded in the mainstream stock market. 

If the definition of common sense investing seems like ethical or socially responsible investing, it is because it is good common sense and business policy to be ethical and socially responsible. Good ethics in the treatment of clients has long been recognised as good business in the financial services industry and modern social responsibility is viewed in the same way. 

Stock market prices and trends reflect the ever-changing sum of investors’ knowledge and judgements about individual stocks and stock markets and present a never-ending challenge to investors. As part of a fundamental approach to investing or as a “reality check” applied to investment decisions made on the basis of technical, quantitative, behavioural or other disciplines, common sense guidance is invaluable. Common sense principles alone will not guarantee investment success but should tend to reduce the potential for blindsiding errors, sleepless nights, and negative returns over the long term. 

Identifiable elements of common sense

Moderation and restraint are among the most important elements of common sense. The philosophers of ancient Greece held moderation in high esteem, calling it “the noblest gift of heaven.”

Emotional intelligence (EI) is the ability to recognize and identify our own emotions and those of others and to use this information to guide our thinking and behaviour. 

Proportionality ensures that relatively small issues with limited consequences are not be allowed to influence important issues with far-reaching results; major benefits should not be foregone for minor reasons, and minor benefits should not be sought at the expense of major costs. 

Pragmatism, a philosophical approach that has its origins in the late 19th-century U.S., evaluates theories or beliefs according to the success of their practical application. Pragmatists contend that most philosophical topics and concepts are best viewed in terms of their practical uses and successes. However, while common sense is firmly grounded in pragmatism and practicality, it is not necessarily opposed to idealism, which encourages human beings to seek the best or ideal objective rather than the most easily achievable one. Common sense recognises that idealism as a concept can be good, but it also tells us it should not be a substitute for realism.

Technopoly is a word coined by media theorist and cultural critic Neil Postman to describe the surrender of culture to technology due to the automatic and rapid adoption of all new technologies without duly considering their merits, their inherent risks, and their potential for unintended consequences. Common sense is not biased against technology, but opposed to technopoly.

GREAT MOMENTS IN COMMON SENSE

Aristotle (~350 BCE) – Aristotle was the first person reliably known to have discussed common sense around 350BC, but it was in the years just  before and during the Enlightenment,  an 18th century intellectual and philosophical movement in Europe, that common sense acquired its modern meaning which centres on reason as the primary source of knowledge.

The Age of Enlightenment – The 17th-century French philosopher, mathematician and scientist René Descartes stated that everyone has a similar and sufficient amount of common sense (bon sens), but it is rarely used well. Therefore, he devised a skeptical and logical method which he maintained should be followed as well.

18th-century common sense – In the 18th century, a realist school of philosophy known as the Scottish School of Common Sense that originated in the ideas of Scottish philosophers Thomas Reid, Adam Ferguson, James Beattie and Dugald Stewart, emphasised man’s innate ability to perceive common ideas and maintained that this process is inherent in and interdependent with judgement. The Scottish School of Common Sense influenced Thomas Paine, one of the Founding Fathers of the United States, who discussed the topic in 1776 in his pamphlet titled Common Sense: “Common sense is sound practical judgment concerning everyday matters, or a basic ability to perceive, understand, and judge that is shared by nearly all people.” Paine went on to say that the person who has common sense relies in substantial part on his or her lived experiences and reasoned perceptions of them.

Samuel Taylor Coleridge (1772–1834) – English poet Samuel Taylor Coleridge wrote, “Common sense in an uncommon degree is what the world calls wisdom.”