Pop Quiz, Hotshot

“Pop quiz, hotshot. There’s a bomb on a bus. Once the bus goes 50 miles an hour, the bomb is armed. If it drops below 50, it blows up. What do you do?”

This is literally the second act of the movie Speed. Never seen Speed? You’re missing out. It’s a pretty hokey movie, truth be told. Funnily enough, it is mostly concerned with decision-making under uncertainty.

We have our own version of this pop quiz in investing, and we are tested regularly. The quiz goes something like this:

“Pop quiz, hotshot. You hold a 10% position in [whatever]. It draws down [a lot]. Average down? Sell? Or hold? What do you do?”

I don’t think you should ever own anything without being able to answer that quickly and succinctly. It’s a good test of whether you understand what you own. If you don’t know what you own, a violent drawdown will shake you out of the position. Likewise, repeatedly averaging down losers is a recipe for bankruptcy. Conviction gets you nowhere if all your ideas suck.

A while back, John Hempton explored the pitfalls of averaging down pretty comprehensively. He wrote, in part:

At a very big picture: averaging down when you are right is very sweet, averaging down when you are wrong is a disaster.

At the first pick the question then is “when are you wrong?”, but this is a silly question. If you knew you were wrong you would never have bought the position in the first place.

So the question becomes is not “are you wrong”. That is not going to add anything analytically.

Instead the question is “under what circumstances are you wrong” and “how would you tell”?

So “know what you own” is Level 1 advice. Level 2 runs along these lines: “how do I know if I’m wrong about what I believe I know about what I own?” (There’s no point in asking how you know if you’re right about what you own. You can’t prove a positive with inductive reasoning)

An Embarrassing Example

One of the first stocks I ever bought turned out to be a classic value trap. I got suckered so bad I actually averaged it down after a dividend cut. I had been seduced by a stock that was statistically cheap and statistical cheapness overrode my objectivity. In reality the dividend cut said everything I needed to know. The nature of the position had changed. The stock had crossed over from a value play to a deep value or even distressed situation. I had not underwritten a distressed situation. This was the “tell” that I was wrong and I missed it (badly).

In fact, to date all of my worst mistakes have come from trying to catch falling knives. Going forward the goal isn’t to avoid these mistakes completely. That’s not realistic. Rather I need to be extra careful about minimizing the damage when they occur. That’s what the pop quiz is all about.

I Don’t Know

I think of myself as a reasonably intelligent person. I like to imagine myself as an independent thinker who is reasonably well-read. So for a long time, it was nearly impossible for me to say “I don’t know.”

I think there were several contributing factors here. Youthful arrogance (it seems young people chronically overestimate their competency); ambition (“it is good for my development and career prospects to be seen as capable and intelligent”); anxiety (“if I cop to ‘not knowing’ I am admitting I am not as smart and well-read as I line to think”).

These days I try to make “I don’t know” my default answer.

Charlie Munger models this behavior well. I read a transcript of the most recent Daily Journal Meeting, and it’s littered with stuff like this:

Question 2: My question relates to BYD. Given that you’ve successfully invested in commodities in the past, how do you view investing in things such Cobalt, Lithium, and Helium as technologies of the future?

Charlie: Well I’m hardly an expert in commodity investing, but certainly cobalt is a very interesting metal. It’s up about 100% from the bottom. And it could get tighter, but that’s not my game. I don’t know much about…I haven’t invested in metals in my life much. I think I bought copper once with a few thousand dollars. I think that’s my only experience.

And this:

Question 8: Your thoughts on the valuation of software companies like Apple, Facebook, Google, Amazon, Alibaba. Are they over-valued, potentially under-valued, too early to tell?

Charlie: Well my answer is I don’t know. (laughter) Next question. (laughter)

There are a couple of important benefits that come with a willingness to say “I don’t know.”

The first is that it helps combat conformation bias. Of all the behavioral biases, the one I suffer most from is confirmation bias: a tendency to seek out only information that confirms my (usually contrarian) view. Openly admitting “I don’t know” helps me maintain a more open mindset, and to loosen my grip on my ideas. If you get too entrenched in a position you risk developing what Dealbreaker jokingly refers to as “Ackmania.” Or some new strain of it, anyway.

Also, when you say “I don’t know” in conversation with someone else, you leave them an opening to teach you something new. No only that, but you are likely to develop a deeper relationship with that person. People love to talk about themselves and their areas of expertise.

Now, I am still more than willing to hypothesize about different things. Sometimes, for entertainment purposes, I even frame these hypotheses as statements of facts. But in my mind they are still just hypotheses.

Because most of the time I just don’t know.

Skin In The Game

I am paid to evaluate investment managers for a living. In doing so I’ve come to believe you aren’t really qualified to sit in judgement of money managers without going through the exercise yourself. When you underwrite a name yourself and have to watch it sell off 20% on a quarterly earnings miss and make the add/trim/sell decision and feel the hit to your own net worth you develop a new and healthy appreciation for investment processes.

You then begin to cultivate two other important qualities: empathy and enhanced BS detection.

Empathy is important because investing is an activity where things can go against you for a long time, and for no particularly good reason. If you are going to hire and fire managers based solely on statistical performance reviews and rankings versus peers you will end up chasing your tail. When you can look at the world through the eyes of the people you are evaluating you realize the right decision is usually to be patient.

Enhanced BS detection is important for obvious reasons. However, people are worse at BS detection than you might think. Investment managers tend not to be complete idiots. In fact they have a habit of dazzling you with their brilliance. Everything always sounds great on paper and in pitch meetings. And yet out in the wild things have a habit of going horribly awry.

Listening to real estate people talk, for example, you would think everyone who has every done a real estate deal has earned a 30% compound annual return with no risk. Yet, real estate investments go to zero all the time.

This doesn’t happen because the real estate itself ends up worthless. It happens because you’re levered maybe 4x into the deal and there is a delay in the project or a hiccup in occupancy and, oops! the debt ahead of you in the cap structure is about to mature. So some enterprising soul comes in with a slug of equity and dilutes you to the point where you’re unlikely to make any money. Or she demands a massive preferred return, with the same result.

Anyway, after getting hosed on a couple “can’t miss” opportunities you wise up. You begin to appreciate just how unfair the universe can be in dishing out random dollops of catastrophic loss. Risk management becomes a bit more intuitive. You are more humble about your ideas, your intelligence and your fallibility.

You don’t get that from reviewing manager peer group rankings.

You get it from risking (and, occasionally, incinerating) real dollars of your own net worth.

Noble Lies

The noble lie is a concept that originated in Plato’s Republic. In The Republic, Plato is concerned with the ideal structure for society (spoiler: it’s not democracy). The noble lie is a myth taught to everyone in Plato’s hypothetical society. It justifies the social order and encourages people to do their civic duty. According to the myth this is consistent with the order of the natural world. Even if it means doing things like handing your infant child over to another social caste.

Here in the investing world we push our own noble lie. We’ve built up a mythology around asset allocation, where the long-run risk and return characteristics of different asset classes are assumed to be both knowable and relatively consistent over time.

This is simply not true. The long-run risk and return characteristics of different asset classes are neither knowable nor consistent. What we’re really doing with asset allocation is making inferences based on historical data. From an epistemological perspective, we’re just winging it.

But, as in Plato, our noble lie has a purpose. In our case it’s to facilitate the creation of financial plans. Even though every plan we create is deeply and fundamentally flawed.

I have never tried explaining the epistemological issues involved in asset allocation to a client. In fact, I have never heard of anyone, anywhere explaining this to a client. Sure, there are folks who soft-pedal the idea of “uncertainty.” But I’ve never seen it hammered home. (You would know if the blow landed because the client’s head would explode)

That’s not a criticism. The whole point of our noble lie is that this stuff shouldn’t be hammered home to clients.

It’s simply not productive to get hung up on epistemology. Most people just need to be encouraged to increase their savings rate. They also need talked off the ledge before doing dumb shit like going all-in on PonziCoin or cashing out at a market bottom or allocating 100% of retirement savings to a small biz employer’s ESPP.

That stuff alone can be a lot to handle. So when it comes to asset allocation, it’s usually best to just throw up some historical numbers and talk “stocks for the long run.” No one does this better than Warren Buffett. He functions as high priest of our cult, and he gives a hell of a sermon. Take this one from 2016:

It’s an election year, and candidates can’t stop speaking about our country’s problems (which, of course, only they can solve). As a result of this negative drumbeat, many Americans now believe that their children will not live as well as they themselves do.

That view is dead wrong: The babies being born in America today are the luckiest crop in history.

American GDP per capita is now about $56,000. As I mentioned last year that – in real terms – is a staggering six times the amount in 1930, the year I was born, a leap far beyond the wildest dreams of my parents or their contemporaries. U.S. citizens are not intrinsically more intelligent today, nor do they work harder than did Americans in 1930. Rather, they work far more efficiently and thereby produce far more. This all-powerful trend is certain to continue: America’s economic magic remains alive and well.

There are actually multiple layers of mythology at work here. I won’t bore you with a play-by-play. (I have written about Buffett’s public persona before. See here) Suffice it to say this is tremendously effective writing. But from an epistemological point of view it’s meaningless. It’s just an inference–naive extrapolation from historical data.

I suspect if you carefully examine the world around you, you will find more and more noble lies hidden in plain sight. Mythology is quite powerful. And, as demonstrated by Plato and Warren Buffett, it can also be quite useful.

Book Review: Principles By Ray Dalio

dalio_principles Ray Dalio’s Principles is two books in one. It is half autobiography and half instruction manual for living a meaningful life, both at home and at work. This book is more about philosophy, personal values and self-improvement than financial markets. Supposedly Dalio is working on a second book about investment principles, however.

For those who may be unfamiliar with Ray Dalio, he is the founder of Bridgewater Associates, one of the most successful investment firms of all time. Bridgewater more or less invented risk parity strategies with its All Weather Fund.

What I did not realize until reading this book was that Dalio went through an extremely difficult period in the early 1980s, where he was on the edge of bankruptcy in the wake of a bad macro bet. This experience informed much of his personal development, and it shows in the book.

Summary

The essence of Principles comes through in the following lines:

There is nothing more important than understanding how reality works and how to deal with it. The state of mind you bring to this process makes all the difference. I have found it helpful to think of my life as if it were a game in which each problem I face is a puzzle I need to solve. By solving the puzzle, I get a gem in the form of a principle that helps me avoid the same problem in the future. Collecting these gems continually improves my decision making, so I am able to ascend to higher and higher levels of play in which the games gets harder and the stakes become ever greater.

All sorts of emotions come to me while I am playing and those emotions can either help me or hurt me. If I can reconcile my emotions with my logic and only act when they are aligned, I make better decisions.

The book lays out a model for living a meaningful life, however you choose to define “meaningful.”

Who Should Read This Book

There is something here for everyone, regardless of whether you have any interest in Ray Dalio, Bridgewater Associates or financial markets. You could skip the autobiography and go straight to the principles themselves if you prefer, though I felt they were more impactful with the autobiographical details in mind.

Investment nerds will enjoy delving into he history of Bridgewater from Dalio’s point of view, as well as some high level insight into Bridgewater’s investment process and culture.

Lies, Damn Lies and Active Share

These days it is fashionable to evaluate investment managers on a statistic called active share. Active share measures the similarity between a fund and a benchmark. Specifically, it compares the weighted portfolio holdings of a given portfolio to those of a benchmark index.

If I own everything in the S&P 500 portfolio in the same proportions my active share is 0%. In theory an index fund would have 0% active share but transactional frictions will create small differences.

Anyway, if I want high active share I can get it in several ways:

Own things that aren’t in the benchmark
Refuse to own things that are in the benchmark
Underweight things versus the benchmark
Overweight things versus the benchmark

All active share can tell you is that a thing is different from a given index. Full stop.

Shrewd marketing people have done their best to distort this to mean “funds with high active share are better.” This is nonsense. If I pick 10 stocks outside the S&P 500 at random I will show an active share of 100%. You would have to be an idiot to buy my fund on the basis of its active share.

Shrewd marketing people get traction with the notion that “funds with high active share are better” because it IS true that dramatic outperformance results from being 1) very different, and 2) very right. Very different on its own doesn’t get the job done. Being very different and very wrong for example is ticket to the poorhouse.

Active share is a popular statistic because it is easy to calculate and easy to understand. People are always on the lookout for that “one weird trick” they can use to hack the system for more money, better looks and lots of sex.

Unfortunately that’s not how quantitative analysis works.

Quantitative analysis isn’t “pure” mathematical reasoning. It’s inductive reasoning. When we prove things in mathematics, we know they are true. We don’t actually prove anything using statistics. Rather, we “fail to reject the null hypothesis at such-and-such a confidence interval.” This is the problem of induction.

Doing a statistical analysis of an investment strategy is like trying to assemble a puzzle where the pieces are constantly changing shape (albeit pretty slowly and by pretty small amounts). Active share is just one of those pieces. Even then you have to recognize that the results of the analysis are backward looking. There’s no guarantee those statistical relationships will persist in the future.

So, you know, caveat emptor.

When Obnoxious Salespeople Attack

A couple days ago I listened to one of the worst investment pitches I have ever heard. Its manifest awfulness had nothing to do with the investment strategy on offer and everything to do with the presenter.

My colleagues and I endured approximately half an hour of some guy literally shouting at us about how great this fund was and how the fund’s investments have averaged 24% IRRs. The presenter paced like a caged animal for the duration of his monologue, punctuating the pitch with exclamations of “got it, people?!” and “okay, people?!”

I imagine this is kind of what it was like listening to Mussolini speak publicly (if Mussolini had been a real estate guy, anyway). Browbeating prospects into submission was the cornerstone of this guy’s sales process. Not a good look.

Of the myriad varieties of aggressive salespeople, aggressive financial salespeople are probably the most hazardous to your wealth. They are almost always selling you something pro-cyclical and frequently there is financial leverage on top of the cyclicality. (Where do you think the 24% IRRs come from?) This is stuff with significant go-to-zero risk. Caveat emptor.

Nonetheless, I’m fascinated by the psychology of aggressive salespeople. They are okay at making money but in my personal experience at least pretty lousy at hanging on to it. I think that has to do with pro-cyclicality, willingness to take on lots of leverage and a general predisposition toward gambling. These guys live like Thanksgiving turkeys.

turkey_happiness_graph — Source: Attain Capital via ValueWalk

Early in my career I had a number of colleagues who spent time in subprime lending. One of them described how at the peak of the cycle the reps would all be driving sports cars. Then when the cycle rolled over tow trucks would show up to repo the cars as the reps defaulted on their auto loans, same as their customers. You would think people in the subprime lending business would have a better grasp of the credit cycle. But you would be wrong.

To me this is further anecdotal evidence that pro-cyclicality and herd behavior are hard-wired into human nature. But it doesn’t make listening to obnoxious salespeople any easier.

Cause and Effect

This is a quick follow-on from an older post. That post discussed the issue of low interest rates and their impact on justified valuation multiples. I wrote:

A popular contrarian narrative in the markets is that central bankers have artificially suppressed interest rates, and that absent their interventions the “natural” rate of interest would be higher (implying a higher discount rate and thus lower sustainable valuation multiples). The key risk to this thesis is that low rates are not some exogenous happening imposed on the market by a bunch of cognac swilling technocrats, but rather a consequence of secular shifts in the global supply and demand for funds. Specifically, that these days there is a whole boatload of money out there that needs to be invested to fund future liabilities and too few attractive investment opportunities to absorb it all.

If low rates are actually a function of the supply and demand for funds, it doesn’t ultimately matter what central bankers intend do with monetary policy. Market forces will keep rates low and elevated valuations will remain justified.

A friend questioned what I was driving at here, and whether it would be possible to falsify this thesis. For the record, I have no idea whether I’m right or wrong. I’m just trying to envision different possibilities.

That said, I am pretty sure the answer lies in the shape of the yield curve.

As many, many, many commentators have already observed, the Treasury yield curve hasn’t made a parallel shift upward as the Fed raised short-term rates. The short end of the curve has come up pretty significantly but the long end has basically held steady. This is important because central banks tend to have less influence over long-term rates than short-term rates.

As the Fed continues to shrink its balance sheet, what we would hope to see is the yield curve making a nice, steady, parallel shift upward. What we do not want to see is the 30-year Treasury yield stuck at 3%. The 30-year Treasury yield stuck at 3%, in the absence of Fed intervention, would support the theory that there are structural factors holding down future expected returns. Namely: an excess supply of financial capital relative to opportunities.

My previous posts on this subject have dealt with the risks of naively extrapolating very low interest rates forever. You can attack the issue from different angles but each case more or less boils down to overpaying for risky cash flows.

What I have not done is explored strategies for taking advantage of such an environment. As with the risks, you can attack the issue from a number of different angles. But again, they share a common thread. Here each strategy more or less boils down to taking on duration.

I want to examine this further in a future post, but here is a little teaser…

Duration is most commonly used to analyze interest rate risk in the fixed income world. But the concept can also be applied to other asset classes. Long duration equities are things like venture capital and development stage biotech companies, where cash flows are but a twinkle in your eye when you invest. Long duration equities usually can’t sustain themselves without repeated infusions of investor cash. They thrive when capital is cheap. They die when capital gets expensive.

If you knew capital was going to be remain cheap forever, you would probably want to make long duration equities a significant portion of your portfolio. You could get comfortable investing in really big ideas that would take a long time to be profitable. I am talking about massive, capital intensive projects with the potential to change the world (think SpaceX).

And here’s where I might start getting a little loopy…

…because what if an excess of financial capital is a precondition for tackling the really big projects that will advance us as a species?

Time Horizon Alignment

In a previous post I discussed the idea of time dilation. Time is not absolute. This idea comes to us from physics, which is a fairly exacting and mathematical discipline. The measurement depends on the relative velocity of the observer and whatever it is she is observing. It’s relative. Hence, “relativity.”

Likewise with portfolio management, the velocity of activity in your portfolio will tend to reflect your investing time horizon. Someone managing money trying to think about what a business will look like in a decade may go entire years without placing a single trade. However, this is unlikely to be the case for someone operating on a one to three year time horizon. Especially if that person is managing other people’s money. And doubly so if the other people whose money is being managed are evaluating performance on a quarterly or annual basis.

The tendency among institutional investors these days is to track performance on shorter and shorter intervals. I follow hedge funds that provide weekly performance estimates. This despite offering quarterly liquidity or less! I haven’t the slightest idea what someone is supposed to do with that information. It’s random noise. (Someday I mean to do a piece on the collective delusions of institutional investment committees)

I am convinced the way you should deal with this is to scale your input data to your time horizon. So for example if you are trying to puzzle out what a business might look like in five or ten years you probably should limit your focus to annual reports and proxy statements (at least once your initial due diligence is done). Even quarterly results are likely to introduce a lot of unwelcome noise into the picture.

What if something material changes halfway through the year?

Well, you can still risk manage the portfolio on more frequent intervals (an underlying assumption here is that you are thesis-driven versus trading on technicals). If something nasty, unexpected and material happens to a stock halfway through the year you are going to see it sell off sharply. That’s the trigger to dig in further to see if the investment is impaired. If you own a good business with a strong balance sheet it is going to decline over a period of years, not months. You will have time to get out before things get catastrophically bad.

Now, this only works with high quality businesses. It doesn’t work with classical value investing. It doesn’t work with merger-arb type special situations. It definitely doesn’t work with distressed investing. I watch value investments much more closely. Also cyclicals. Particularly if there is leverage involved. Levered cyclicals (think banks) can deteriorate very rapidly, and fatally.

So it’s not that a long time horizon is always superior.

It’s that mismatches create problems.

Oh, and if anyone happens to know what those weekly performance estimates are good for, drop me a line in the comments.