Book Review of Investing: The Last Liberal Art by Robert G. Hagstrom

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Genre: Commodities Trading
Author: Robert G. Hagstrom
Title: Investing: The Last Liberal Art (Buy the Book)


Robert G. Hagstrom, chief investment strategist and managing director for the Legg Mason Investment Counsel and author of eight investment books, found his inspiration for this book in Charlie Munger’s concept of a “latticework of mental models.” Charlie Munger is a man who believes strongly that the general acquisition of wisdom can lead to a better approach to investing.

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This book explores theories from seven academic disciplines – physics, biology, sociology, psychology, philosophy, literature, and mathematics – in each chapter to build a latticework that will help us better understand financial markets and eventually become more sound in our investing decisions.

Hagstrom provides a brief overview of each of these academic disciplines, with more detailed looks at certain topics in each of these areas. He then presents a series of frameworks of understanding drawn from these disciplines for the reader to better comprehend how the economy works.

This book offers a convincing plea for a liberal arts approach to investing, and harsh criticism of business schools for their emphasis on a narrow focus of studies that eliminates a larger view of life and a multidisciplinary skill set.

The objective of this book is not to give the reader an investment technique or strategy, but to encourage investors to develop a multidisciplinary attitude that connects different academic disciples and applies them to investing.

Hagstrom notes that those who approach investing as an exercise of the mind, as well as an extension of their latticework of mental models, will be fascinated by his thoughts. He also argues that those who seek only a model for quick profits will miss out on the point of the book.

Introduction: A Latticework of Mental Models

“True learning and lasting success come to those who make the effort to first build a latticework of mental models and then learn to think in an associative, multidisciplinary, manner.” – Charlie Munger

Robert G. Hagstrom, chief investment strategist and managing director for the Legg Mason Investment Counsel and author of eight investment books, found inspiration for this book in Charlie Munger’s notion of a latticework of mental models.

The technical definition of a latticework is a “framework consisting of a crisscrossed pattern of strips of building material, the design is created by crossing the strips to form a network.” This book uses the term to explain how a general knowledge of many disciplines enables an investor to form patterns, or a latticework, significantly increasing the chances for successful investing.

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Modern-day college institutions, even the top tier universities, are primarily concerned with making sure students have the ability to master one particular subject and eventually pursue a career in that field.

Hagstrom found that universities are increasingly ignoring how critical it is for students to develop a broad skillset that allows them to form a latticework of mental models.

This book demonstrates how it is no longer enough just to acquire and master the basics in accounting, economics, and finance for a successful career in investing. To generate above-average returns, Hagstrom believes that it requires a lot more than technical knowledge.

Investment decisions have a better chance of success when ideas from other disciplines lead to the same conclusion.

This book explores the big ideas from 7 academic disciplines – physics, biology, sociology, psychology, philosophy, literature, and mathematics – that enable us to form a latticework of mental models to aid in the process of understanding financial markets.

Broader understanding makes us better investors, leaders, citizens, parents, spouses, and friends. This development of understanding starts with diving into significant concepts from many areas of knowledge, and then learning to distinguish patterns of connection among them.

The goal of this book is to develop the ability to think of finance and investing as one piece of a unified whole, one segment of a body of knowledge. Hagstrom promises, “Extraordinary rewards are possible for those who are willing to undertake the discovery of combinations between mental models.”

Physics: Equilibrium in the Economy

Physics is the science that investigates matter, energy, the interaction between them, and how our universe works. Equilibrium is one of the fundamental concepts in the field of physics, and the primary focus of this chapter as to how the discipline compares to our financial markets and the economy.

Equilibrium is scientifically defined as a state of balance between opposing forces, powers, or influences. Breaking down this concept yields the terms static equilibrium, which typically identifies a system at rest, and dynamic equilibrium, which is reached when competing offset in a system.

For more than two hundred years, economists have relied on the equilibrium theory to explain the behavior of economies.

Alfred Marshall, British economist, was the chief proponent of the concept of dynamic equilibrium in economics. He used this concept to explain the relationship of demand, supply, and price. Marshall believed that equilibrium is the natural state of the economy, and competition ultimately always determines the equilibrium price.

Thus, there are always forces driving supply or demand back to its respective equilibrium state, and the marketplace consistently corrects any imbalance. He used the following analogy, “Just as a stone hanging by a string is displaced from its equilibrium position, the force of gravity will at once tend to bring it back to its equilibrium position.” This would make for a predictable economy if this were truly the case.

Paul Samuelson, Nobel Prize winner in Economics in 1970, believed that stock prices shift because of the perceived uncertainty over a stock’s future. Interestingly enough, he believed that people make rational decisions consistent with their individual preferences and that at any point in time, stock prices are a reflection of these rational decisions.

The individual who is credited with taking Paul Samuelson’s theory of the market to the next level is Eugene Fama.

His University of Chicago doctoral dissertation titled “The Behavior of Stock Price” is the foundation of the “modern portfolio theory.” Fama’s message is that stock prices are unpredictable because the market is too efficient.

In an efficient market, many intelligent investment professionals have simultaneous access to an incredible amount of relevant information, and they aggressively apply this information in a way that causes stock prices to adjust instantly – thus restoring equilibrium – before anyone can profit. He believes because of this, share prices fully reflect all available information.

A number of scientists have begun to question the equilibrium theory that dominates our view of the economy and the stock market. The book continuously defines the stock market as a “complex adaptive system,” which is a system with many interacting parts that are continuously changing behavior in response to changes in the environment.

If such a complex system is continuously adapting then it would seem impossible for any such system, including the stock market, to reach a state of perfect equilibrium.

This places the theories of consistent economic equilibrium into serious question. If true market equilibrium existed, there would be no booms or crashes, no black swan events, no differences in supply and demand, nor any surplus or shortages in the economy.

The traditional counterview suggests the opposite; a market is not rational because its investors are not rational. Individual investors, or agents, are irrational and will inevitably misprice securities. This creates opportunities for profitability.

Hagstrom firmly believes that, at any given point, both equilibrium and disequilibrium exist in the market. If the Newton perspective of equilibrium is inherently insufficient by itself, what other mental models should we add?

Biology: An Evolutionary Economy

The market crash of 1987 caught most scholars and investment professionals by surprise. According to the equilibrium-based view of the market, almost nothing could have predicted the crash in 1987. Fast forward twenty years later and the same problem occurred again with the market crash of 2008.

These two events led to the belief that there must be alternative theories to describe the behavior of the economy. Among them was the idea that the market is best understood from a biological perspective. In this chapter, Hagstrom focuses on the core idea of evolution in biology and how it relates to an evolutionary nature of the economy.

Numerous traits of Charles Darwin’s principles of evolution can be observed throughout the history of the stock market.

Most notably, a “survival of the fittest investment approach” results in a continuous need for adjustment much like Darwin’s idea of natural selection. For many years, Darwin recognized this process in the animal world. “Being well prepared to appreciate the struggle for existence, it at once struck me that under these circumstances favorable variations would tend to be preserved and unfavorable ones destroyed.

The result would be the formation of a new species.” Darwin’s theory not only was intended for specific species, but also accounted for individuals within the same species. As we know, generations of small, gradual changes in the species began to add up to a larger change, which is described as the process of evolution.

Hagstrom reminds us to remember that there is always change, regardless of its pace. He urges investors to discard Newton’s theories of no change and embrace Darwin’s world theory, which is very similar to the economy in the sense of how it evolves.

Hagstrom has identified five trading strategies that existed as major trends and how they have gradually adapted over time:

  1. 1930s and 1940s: First proposed by Benjamin Graham and David Dodd, the “discount- to-hard-book value” strategy was dominant.
  2. 1950s: The dividend model dominated this era; investors were progressively more attracted to stocks that paid high dividends. This strategy became so popular the dividend yields dropped below bond yields, a historical first.
  3. 1960s: Investors were straying away from the dividend strategy and leaning more towards companies that were expected to grow their earnings.
  4. 1980s: Warren Buffett stressed the need to focus on companies with high cash flows.
  5. Today: An emerging fifth strategy is cash return on invested capital.

Evolution took place in the stock market via economic selection. Hagstrom believes that if you choose to believe in this theory of economic evolution, then the market will never become efficient. The market will always maintain some level of diversity and this is essentially the main proponent of evolution.


Sociology is the study of how people function in society, with the ultimate goal of understanding group behavior. All areas of social science are platforms that help us think about how human beings form themselves into groups, or societies, and how those groups behave.

Hagstrom details how individual behavior is highly influenced by interactions with other individuals in the collective group. We have also come to understand that economies and stock markets are adaptive systems, meaning their behavior constantly changes as individuals in the system.

A characteristic of complex adaptive systems, their adaptability, is embedded in the theory of emergence. The theory of emergence refers to the way individual units (cells, neurons, or consumers) combine to create something greater than the sum of the parts. Many individuals trying to satisfy their own needs engage in buying and selling with other individuals, thus creating an emergent structure called the stock market.

Gustave Le Bon was a vocal critic of the intellect of crowds, They can never accomplish acts demanding a high degree of intelligence

They are always intellectually inferior to the isolated individual. Contrary to Le Bon’s beliefs, the book Wisdom of Crowds by James Surowiecki, contradicts the idea of the “madness of crowds.” According to Surowiecki, two critical variables necessary for investors to make superior decisions are diversity and independence.

“The stock market is more robust when it is composed of a diverse group of agents (smart and dumb alike) than a market singularly composed of only smart agents.” When diversity is lost, also known as diversity breakdown, it causes the market to become inefficient.

Information cascades cause diversity breakdowns, and these occur when people make decisions based on the actions of others rather on their own private information. Consequently, these information surges can help explain market booms and crashes.

Hagstrom then addressed the sociologic idea of fundamentalists versus trend followers that can lead to explaining market behavior.

Trend followers seek to profit from changes in the market by either buying when prices go up or selling when prices go down. Fundamentalists buy and sell based on the difference between the price of a security and its underlying value.

When the relative number of fundamentalists is small, market bubbles develop. Essentially, when the mix of fundamentalists and trend followers becomes unbalanced, a diversity breakdown is likely to occur.

It is not necessary that all investment professionals possess identical information, but they must maintain mutual knowledge of the different choices that are available. The lower this level of mutual knowledge, the greater the likelihood of instability.


Psychology studies how the human mind works, while psychologists are concerned with understanding the part of the brain that controls cognition (process of thinking and knowing), as well as the part that controls emotion.

As of the late twentieth century, a notion has developed that believes psychology has a role in economic decision-making. Because modern portfolio theory relied on the assumption of rationality, the proposal that individuals make decisions irrationally was groundbreaking.

A significant behavioral finance term that Hagstrom stresses in this chapter is loss aversion.

Loss aversion exists when people choose the option that they think has the best chance of not losing when making a decision with an uncertain outcome. In 1979, Daniel Kahneman and Amos Tversky wrote a paper titled, “The Prospect Theory: An Analysis of Decision Under Risk.”

Their most important discovery was the realization that individuals are inherently loss averse. They were able to prove mathematically that individuals regret losses more than they welcomes gains of exact same size.

For example, why are people willing to hold bonds when we know that over the years, stocks have consistently outperformed bonds? Loss aversion can help to explain this.

Diving further into loss aversion presents us a term called myopic loss aversion, which reflects a combination of loss aversion and the frequency with which an investment is measured. Myopic loss aversion is the single greatest psychological obstacle that prevents investors from doing well in the stock market.

Terence Odean, behavioral economist at the University of California, published a paper titled Why Do Investors Trade Too Much?

He investigated over 7 years of trades and tracked over 97,000 trades among 10,000 investors. He found that the most active traders had the worst results, while traders who traded the least had the highest returns.

This brings us to the conclusion that the people who might have suffered the most from myopic loss aversion and acted upon it by selling stocks didn’t do as well as those who resisted their natural impulse to sell and hold their ground.

Psychologists say that people are information processors; they construct mental models of reality to help anticipate events. Therefore, poorly crafted mental models built on information that is not carefully thought out lead to poor investment performance.

Our brains are engines that naturally look for patterns, and then search for meaning within the patterns. We look for information that confirms what we believe and we discard information that contradicts what we believe.

Hagstrom examines some of the inherent pattern-seeking tools of the human brain and investigates why these tools result in market instability.

The human brain, Hagstrom explains, is not designed for optimal processing of stock market information, thus resulting in system instabilities that cause fluctuation.

By compensating for these inbuilt flaws, however, investors distinguish themselves from speculators on the stock market. This allows them to ignore trends and focus on the intrinsic value of shares. This allows investors to take advantage of psychologically based fluctuations to purchase shares at a discount.

Philosophy: A Pragmatic View of Investing

The word philosophy is derived from two Greek words, usually translated as “love” and “wisdom.” A philosopher, then, is one who loves wisdom and is dedicated to the search for continuous wisdom.

There are three major sections in the study of philosophy, but Hagstrom dedicates this chapter to the subsection of philosophy called epistemology, which seeks to understand the limits and nature of knowledge. Hagstrom points out that if we can consciously adopt an epistemological framework, we can go a long way towards improving our investment results by avoiding confusion and ambiguities.

Again, the stock market is a complex adaptive system.

Hagstrom then poses the question, “Are complex adaptive systems really complex and unexplainable or are they complex only because of our limited ability to understand them?

One of Hagstom’s favorite phrases in this book is, “Failure to explain is caused by failure to describe.” The narratives investors use to explain the market sometimes lack statistical firmness required for an appropriate description of an event in the financial markets. So if the description is faulty, the explanation is likely wrong.

Hagstrom called philosopher Ludwig Wittegensteinthe philosophical father of investing.”In particular, he focused on Wittegenstein’s work in language, concentrating on the phrase “the meaning of the word is its use in language.

He went on to explain how the language used by analysts to describe Amazon in its early days clouded investors’ perceptions of the company, and simply was not true. Since Amazon started out selling books, many investors first compared the company to Barnes & Noble.

As Amazon’s inventory diversified, investors began to compare it to Wal-Mart, but Hagstrom said the comparisons were not accurate, and Amazon was much more similar to Dell.

Everybody had the same information from the SEC about Amazon, but groups of investors chose different words and those words had different descriptions, and those descriptions had different outcomes.” If the meaning of a word is its use in language, then the “meaning” of a company can be found in language as well.

Truth will change as circumstances change and as new discoveries about the world are made, we must constantly strive to gain knowledge to keep up with whatever is true. It is through thinking that people resolve doubts and form their beliefs.

These beliefs guide their subsequent actions and result in habits. When searching for the true definition of a belief, one should look to the actions that result from it – this proposition is called pragmatism. The function of thought is to produce habits of action.

When describing what exactly pragmatism means, Hagstrom said, “Pragmatism holds that truth (in statements) and rightness (in actions) are defined by their practical outcomes. An idea or an action is true, and real, and good, if it makes a meaningful difference. To understand something we must ask what difference it makes, what its consequences are.”

Pragmatism is the perfect philosophy for building and using a latticework of mental models.

The only way to perform better in the stock market relative to other investors is to have a way of interpreting relevant data that is different from other investors. However, having said this, your interpretations also have to be correct.


Rather than exploring how specific literary techniques or approaches can provide insight into economics, the stock market, or general investing, Hagstrom makes a petition for reading as a productive exercise, particularly for investors and those in the finance industry.

In this chapter, Hagstrom interviews graduates of St John’s College, a liberal arts college that focuses exclusively on intense study of Western literature.

He speaks to graduates of this college who currently work in the finance industry, who feel that this curriculum based on intensive reading made them better thinkers, which helped them both as investors and in other aspects of life.

Charlie Munger once said, “We must educate ourselves.

The key principles, the truly big ideas, are already written down, waiting for us to discover them and make them our own.” Munger and Warren Buffett constantly stress the importance of understanding the fundamentals of any company or industry you invest in.

By this, they mean not just gathering data about the company or industry, but truly understanding it on a deep level. The purpose of this chapter is for investors to broaden their horizons while reading for understanding, and not just reading to accumulate information.

There’s a copious amount reading material available on a daily basis for investors to read – WSJ, New York Times, training manuals, etc. – that add facts instead of increase understanding. This kind of reading contains new information, but not necessarily new insights.

Once we develop skills as a sharp reader, it becomes increasingly easier to decide what should and what should not pass through our communication channel, which is critical for a successful career in investing.

According to Hagstrom, analytical reading has three goals: (1) develop a detailed sense of what the book contains, (2) interpret the contents by examining the author’s own particular point of view on the subject, and (3) analyze the success in presenting that point of view convincingly.

As readers, Hagstrom urges us to determine whether or not the book is true, not whether it supports what you already think. He says we must check our opinions at the door.

At the end of the chapter, Hagstrom draws a parallel for his love for detective books and his interest in investing.

When investing, he is skeptical and looks to connect the dots. Both investing and being a detective are concerned with gathering clues (financial data) to determine whether or not the market is accurately pricing a security.

Reading in areas outside of finance is key to developing a latticework of mental models. Benjamin Doty, senior investment director at Koss Olinger, said of reading, “Literature adds what most business nonfiction cannot, it dramatizes the complexity of events. It places you, the reader, right alongside the characters as they confront consequences of their actions.


This chapter examines several mathematical concepts that are critical to smart investing. All investors know that models help quantify risk and put themselves in a better position to navigate approximations that possess uncertainty.

One concept Hagstrom introduced was the Bayesian analysis. More popularly known as the decision tree theory, the Bayesian analysis is an attempt to incorporate all available information into a process for making decisions.

Let’s look at discounted cash flow (DCF), which has been considered the best method of valuing a certain company, in relation to the Bayesian theory.

The probability theory and the Bayesian analysis can help us overcome the uncertainty of the future.

However, even though these available tools help alleviate some uncertainty and make an educated valuation, the DCF still has many unknowns to consider such as horizons, growth rates, ups and downs of an economy, fickle consumers, and new competition. So how do investors compensate for all possibilities? Hagstrom responds, “It is only through the process of continually updating probabilities with objective information that the decision tree will work.”

He believes that investors are always vulnerable to a high degree of personal bias due to subjective probabilities; this is the challenge that investors face. Whether we recognize it or not, nearly all decisions that investors make are extensions of probability. It is critical that their probability statements combine historical record with the most recent data available.

Hagstrom declares that it is essential to recognize the difference between the trend of the system and the trends in the system.

For example, one of the more famous sideways markets occurred between 1975 and 1982. The Dow Jones Industrial Average stood at 784 at the beginning and the end of this period. Some stock market forecasters are drawing analogies to what happened then and what is happening today.

Investors could face a prolonged period where the market does not seem to bulge, and where they would be advised to avoid stocks. Is it true that sideways markets are not profitable for long-term investors? No, this is not true. Warren Buffet generated a cumulative return of 676% during this period, and his friends Bill Ruane and Rick Cunniff posted a 415% cumulative return.

Investors during this period who focused on the trend of the system (the market average) came to the wrong conclusion. The variations in the market were dramatic, which led to many opportunities to earn high returns. The investors who focused on this were looking for trends in the system.

Whenever you hear someone say, “It will all average out,” that is typically a rendition of regression of the mean.

Sir Francis Galon, a British intellectual who had no interest in business or economics, possesses the mathematical discovery of regression to the mean. This is essentially a concept that says, eventually, variance will be corrected in the system.

Regression is commonly used on Wall Street as a forecasting tool; it is a simple mathematical estimation that allows investors to predict the future. However, if this is so simple and effective, why is forecasting so difficult?

Well, for one, reversion to the mean is not always instantaneous; overvaluation and undervaluation do not have a set time period in which they exist. In markets, the mean itself may be unstable; yesterday’s mean might not be tomorrow’s mean. The mean is capable of shifting to a new location, which tends to be a very difficult concept for investors to grasp.

An example to explain how this could happen lies in the S&P 500 Index. This Index is not a passively managed basket of stocks that rarely changes. Each year Standard and Poor’s subtracts companies and adds new ones (roughly 15% of the Index is changed per year).

The S&P Index evolves in a Darwinian fashion, continuously adding stronger companies.

Fifty years ago, manufacturing, energy, and utility companies dominated the S&P 500 Index. Today technology, health care, and financial companies dominate it.

The average return on equity is higher for today’s set of three industries than the set of industries 50 years ago, thus illustrating a perfect example of how the mean has shifted. It is very important that investors remain flexible in their thinking and remember that the regression to the mean theory, although important, is not indestructible.

The mathematical concepts discussed in this chapter are important to helping investors understand the “returning events.” Mathematics leads us towards precision and away from ambiguity; however, there will always be uncertainties, irregularities, volatilities, and black swan events.

Decision Making

Hagstrom introduces us to the concept of the two different modes of thinking, System 1 and System 2. System 1 thinking is intuitive; it operates automatically, quickly, and effortlessly with no sense of voluntary control. Psychological biases penalize System 1 thinking.

We rush to make an intuitive decision, not recognizing that our cognitive errors are the result of our inherent biases. On the other hand, System 2 thinking is reflective, as it functions in a controlled manner, slowly and with effort. The operations of System 2 thinking require concentration and are associated with subjective experiences that have rule-based applications.

In nonlinear systems, such as the stock market and the economy, System 1 thinking (intuitive side of our brain) is much less effective than System 2 thinking. Hagstrom points out, “Improving the resource condition of our System 2 thinking – deepening and broadening our reserves of relevant information – is the principle reason this book was written.”

Those who constantly scan in all directions for what can help them make good decisions will be the successful investors of the future.

Those who study the art and science of investing are better prepared for incorporating the rules, strategies, and knowledge from several different disciplines. Our investment model must be dynamic; it must have the ability to change with the environment just as a biological organism evolves.

Charlie Munger asked his classmates at the 15th reunion of the Harvard Law School class of 1948, “Was our education sufficiently multidisciplinary?” The challenge we face as investors has less to do with the knowledge that is available to us and more to do with how we choose to piece that knowledge together.

Hagstrom continuously preaches, “Our failures to explain are caused by our failures to describe.” The lesson learned from this book is that descriptions based solely on financial theories are not enough to describe the behavior of markets. It is an incredibly imperative skill to think creatively and construct a latticework of mental models to think in multidisciplinary terms. would like to thank the Titans of Investing for allowing us to publish this content. Titans is a student organization founded by Britt Harris. Learn more about the organization and the man behind it by clicking either of these links.

Britt always taught us Titans that Wisdom is Cheap, and principal can find treasure troves of the good stuff in books. We hope only will also express their thanks to the Titans if the book review brought wisdom into their lives.

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