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.

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