I often meet people who conflate investing and gambling. Their confusion is understandable. There are many similarities between gambling and investing, but also important differences. As with most complex topics the devil is in the details.
How Investing And Gambling Are Similar
Both investing and gambling are exercises in decision-making under uncertainty. In both activities one places bets (takes positions) based on one’s appraisal of future expected value. Critically, both gambling and investing outcomes are subject to randomness. These are probabilistic activities. And therefore in both investing and gambling, it is difficult to disentangle luck and skill.
Professionals: let’s not kid ourselves. It is better to be lucky than skilled.
Another reason investing resembles gambling is that many people exhibit a preference for lottery ticket-like “investments.” Penny stocks and cryptocurrencies are excellent examples. People like to buy lottery tickets because the downside is small and well-defined, while the theoretical upside is very large. They say: “I’m just going to put $100 in BTC or this marijuana penny stock and maybe it goes up 100x.”
However, these individuals do not realize that many lottery ticket-like investments are, like lotteries themselves, negative expectation propositions. For example, some penny stocks and cryptocurrency ICOs are in fact fraud schemes with zero probability of success over the long run. Which brings us to…
How Investing And Gambling Are Different
Almost all casino games and lotteries are negative expectation games. That is, the odds are rigged against the players (in mathematical terms: the probability-weighted value of the payouts is less than zero). Were this not the case, neither lotteries nor casinos would last very long!
A casino underwrites risk in a similar way to an insurance company. Broadly speaking, the goal is to price risk in such a way that the insurance losses (gambler wins) will be more than offset by the insurance premium income (gambler losses) over long time periods.
Below is a table showing the house edge for various craps bets from the Wizard of Odds. As you can see, the best advice you can give to any craps player is to limit her bets to pass/don’t pass, taking the odds when the point is set (one of the best bets in the casino!), and maybe a place bet on the 6 or 8 to keep things interesting.
Investing, on the other hand, may or may not be a negative expectation game. Historical data leads us to believe investing is a positive expectation game (at least in the aggregate). If you have ever worked with a financial advisor, you have probably been told something to the effect that “in the long run the market always goes up” before being shown a chart like this one as “proof:”
However, by naively extrapolating from historical data we are subject to the problem of induction. To make the issue more concrete, consider Nassim Taleb’s graph of a Thanksgiving turkey’s happiness:
The turkey doesn’t realize it until it’s too late, but she is playing a negative expectation game. So are volatility shorts…
There is a neat post on Redfin’s blog. It is the CEO’s “IPO diary.” Read the whole thing for a fascinating look at the process from the inside. A couple of sections really resonated with me:
Masters of the Universe
In other ways too, the roadshow had the feel of a bygone era. For example, almost everyone on the buy-side we met that week was a man: in one group lunch, all 24 of the portfolio managers in attendance were male. We may have met more portfolio managers who were Israeli special forces veterans than women. I asked our bankers how long it would take the first one to kill me with his bare hands.
Almost all of them took notes on tablets. Some of them tried to look up as you spoke, but with their eyes focused on nothing except the numbers in their head. They weren’t just capturing the highlights of a meeting; it was a nearly verbatim transcription of what we’d said, so we could be held accountable for it later. Information in every form is the currency of Wall Street, and drops of it never seem to fall on the floor.
Chess with Bobby Fischer
Most of the fund managers were exotically, obviously smart. Except for one person who fell asleep in a meeting, none of the fund managers we met was anyone I’d want to be on the other side of a trade with, buying what he sold, or selling what he bought. This is what I realized I had been doing my whole life as an E-Trade stock-picker; it had been like challenging Bobby Fischer to a game of chess. I spent a long time that first week trying to judge whether it made sense to have so many brilliant people decide where our society allocates capital, as opposed to making cars or software or hospitals.
The Last Ideology-Free Realm
What impressed me most about these people was their willingness to change their minds. No one in our society seems to change her mind about Donald Trump or Hillary Clinton based on a new fact, but a fund manager on the wrong side of a bad trade has to change her mind in a moment or lose her job. This is why investing is the world’s last ideology-free realm. It would be easier to accept the premise that our society can’t agree on one version of the truth anymore, about whether temperatures are rising or the economy is growing, except that’s exactly what happens when every public company reports its earnings every quarter. You can believe what you want to believe, but not with a million dollars on the line.
And, perhaps most interesting to me:
The Last, Best Order
One of my favorite meetings was with a Scottish fund manager in San Francisco. His firm was known for buying only a few stocks, and holding each for as long as a decade. In a hotel meeting room with enough prospectuses, pitchbooks, cookies, fruit, cheeses, crackers and popcorn for 30 people, he came in alone. And rather than rattling through twenty or thirty questions about our metrics, he just asked me why I ran the company.
I found myself talking about my older brother, who had died just before I became Redfin’s CEO, and the feeling I had then that my life so far hadn’t made the world a much better place. He asked me about whether Redfin’s sense of mission would survive our public offering. He didn’t write much down. His order was one of the last, and the best, to come in.
My aspiration as an investor is to be that “last, best order.” There’s a reason I classified this post under Finance, Investing, Learning and Values. There is some real insight here.
I met with a UK-based portfolio manager yesterday and our conversation eventually led to a fascinating discussion of the differences in distribution and compensation structures in the US versus Europe.
In the US, for example, we have well-developed retail distribution channels for financial products (wirehouses, RIAs, broker-dealers, banks).
In continental Europe, distribution is dominated by the banks. For many reasons, there is simply not much of a retail investing culture in Europe. The end users of UCITS (European mutual funds) tend to be very wealthy families with multi-generational wealth management needs.
While here in the US we are preoccupied with what a fiduciary standard for investment advisor conduct and compensation should look like, the discussion in Europe is much different (to the extent there is any discussion at all).
Which leads me back to the title of this post, and why I want to be reincarnated as an Italian mutual fund manager…
In Italy, the standard compensation structure for an equity manager is apparently a 2% management fee with a performance fee assessed monthly, but with no high watermark or preferred return hurdle (!!!)
That is to say, if you are an Italian fund manager operating under this scheme, you get a cut of the profits every month you post a positive return. Even if your clients are underwater on their original investments. It is a hedge fund manager’s dream!
(Usual disclaimer applies: this is not financial advice. I do not own any Netflix. Nor am I short Netflix at pixel time (though the thought has crossed my mind). Netflix is actually a super dangerous stock to short at this juncture as it appears to trade purely on momentum as of 3/7/18)
Netflix happens to be a stock market darling.
Netflix’s earnings numbers also happen to be garbage.
To those readers who own NFLX in any real size, I have a simple question for you: how does NFLX generate half a billion dollars of GAAP earnings while simultaneously burning $1.79bn of operating cash?
As I’m sure the NFLX bulls know, it has to do with the way NFLX accounts for the cost of content. NFLX spends real cashtoday to produce and license streaming content. However, on its income statement it amortizes that cost over a longer time period to (allegedly) better reflect the economics of that content. While the cash flow statement shows $1 of spend on content going out the door today, the income statement spreads that same $1 over about four years.
Who determines the amortization schedule? Why, management, of course.
Here is the relevant disclosure:
The table is a little hard to read so here is the text of the note again (emphasis mine):
On average, over 90% of a licensed or produced streaming content asset is expected to be amortized within four years after its month of first availability.
As of December 31, 2017, over 30% of the $14.7 billion unamortized cost is expected to be amortized within one year and 29%, 78% and over 80% of the $1.4 billion unamortized cost of the produced content that has been released is expected to be amortized within one year, three years and four years, respectively.
As it turns out, the NFLX of today is a massively capital intensive business. This wasn’t always the case. Back when NFLX distributed other people’s content it cash flowed quite nicely.
As a general rule I am suspicious of businesses that show growing GAAP income alongside large, negative operating cash flows (in NFLX’s case the cash burn actually gets larger over time–it is moving in the wrong direction). In these cases management’s judgement is driving the income statement. We have a special name for this in analyst land: “low earnings quality.”
So. Does the income statement or cash flow statement better reflect the economics of this business? This is hardly a trivial issue when you are buying a $138bn market cap company on 200x EV/EBIT. After all, it does you no good to add millions of subscribers if you have to burn up all your cash flow to retain them over time. Meanwhile you are funding that cash burn by taking on billions of dollars of debt:
The benefit of accruals for smoothing irrelevant volatility comes at a cost. Accrual accounting opens the door to opportunistic short-run income smoothing that can lead to future restatements and write-downs (e.g., Enron). Earnings quality can be improved when accruals smooth out value-irrelevant changes in cash flows, but earnings quality is reduced when accruals are used to hide value-relevant changes in cash flows. Distinguishing between these two types of accrual adjustments is critical to financial analysis. As we discuss in Chapter 3, an astute analyst cannot focus on earnings alone. To assess earnings quality, the analyst must evaluate the company’s cash flow statement and balance sheet in conjunction with the income statement.
Hence I have this niggling contrarian idea about NFLX. My niggling contrarian idea about NFLX is that the business valued at 200x EV/EBIT is an accounting illusion, and what NFLX will really be in the long run is a massive incinerator of cash. A massively levered incinerator of cash. In extremis: a potential zero.
This is not without precedent. The movie business, for example, is notorious for creative accounting.
Now maybe NFLX is cut from a different cloth than the bankrupt movie studios of yore. Maybe it has developed super sophisticated ways of allocating production capital so as only to back projects with a high probability of success and very long cash flow streams. Management sure doesn’t account for content that way in the financials. But hey, maybe they are just that rare conservative management team of a highly touted momentum stock.
Has it occurred to anyone buying (or hawking) NFLX stock on 200x EV/EBIT that if you spend like FOX and Time Warner on content, maybe your stock should be priced similarly? (e.g. FOXA: 14x EV/EBIT BUTWITH $3.4BN OF FREE CASH FLOW)
I am not writing this up as a research note or an investment recommendation. This is simply an exercise in healthy skepticism.
We all have our weird niche interests and obsessions. For instance, my quixotic obsession with tail hedging. Conventionally, that means protecting portfolios against “rare” events (the VIX doubling in a single day, for instance). I am interested in tail hedging in a less conventional sense. I am interested in actually making money off “rare” events. I use “rare” in scare quotes here because contrary to the what you might hear from boilerplate financial advice, “rare” events are surprisingly common in financial markets.
If you are interested in the philosophical and mathematical underpinnings of tail risk, you should read Taleb’s Fooled By Randomness and Lo’s Adpative Markets (review forthcoming soon). But if you prefer practical applications, check out the below table:
This is taken directly from the paper “A Comparison of Tail Risk Strategies in the US Market.” The intuition is simple: markets offer the highest expected returns when they are bombed out, when valuations are deeply discounted, when (to borrow a Buffettism) everyone is feaurful. A tail hedge not only provides excess returns in times of crisis that mitigate drawdown, but also a source of liquidity that can be redeployed into equity and/or fixed income securities at firesale prices.
So, hypothetically, you make 2% at the portfolio level off a small-ish tail hedge and reinvest it into equities at firesale prices. Over the subsequent months and years maybe that amount doubles, triples or quadruples.
Sounds great, right? What’s the catch?
The catch is the cost of the hedge and the resulting drag on returns:
If you are interested in a detailed exploration of the strategies in the table, you will have to read the linked paper. However, at a high level the intuition is straightforward. When you are tail hedging you are essentially buying insurance. The person selling you the insurance wants to earn a premium for doing so.
The most common arguments against tail hedging are:
(1) there is no reason to hedge tail risk because in the long run equity markets always go up;
(2) the cost of the insurance is not offset by excess returns over time;
(3) there are better ways of mitigating tail risk.
I do not find Argument #1 compelling at all. All the data used to support this argument is subject to path dependency and survivorship bias. This is particularly true in the context of the US market, which is has been the best performing equity market in history. People tend not to respond well to my counterarguments because they imply an uncertain view of the future and they would rather extrapolate from the past (clients don’t like to face up to the uncertainty inherent in markets). People also have a difficult time with skewed payoffs–that is, understanding why a strategy with a 99% probability of a $1 loss and a 1% probability of a $100 gain is a good bet in the long run.
I do find Argument #3 compelling. AQR has a good paper on this that reaches similar conclusions to the Alternative Investment Analyst Review piece. However, AQR’s paper is focused on defensive applications of tail hedging strategies, whereas my interest is in playing offense. In full fairness, AQR addresses that in the paper:
We acknowledge that some investors might buy insurance for reasons other than reducing tail risk. For example, insurance can provide a cash buffer in times of market distress, potentially allowing investors to take advantage of fire-sales and other market dislocations. However, depending on the magnitude and frequency of the dislocations (and the manager’s ability to identify them), this opportunistic approach still might not make up for the negative expected returns from buying insurance. Other investors might occasionally have a tactical view that insurance is conditionally cheap. However, this is simply market timing in another form, and this decision should be made (and sized) in the context of other tactical views in the portfolio.
I have mixed views of Argument #2, mainly due to the issues of path dependency and survivorship bias noted above. If future equity returns look like the past 30 years or so, there is certainly no reason for long-term investors to tail hedge (assuming they have the wherewithal to stay invested in volatile markets). If the world becomes a more volatile and uncertain place over the next couple decades, investors may feel differently.
I have conducted some small experiments with real dollars over time. Most recently, I set up a long volatility trade using the VIXY ETF and ZIV ETN. It performed well during the February volatility spike, but was something of a blunt instrument (I have since closed out the position).
More recently I have been looking at Meb Faber’s TAIL ETF, which purchases a ladder of out-of-the-money put options on the S&P 500. Below is a rough scenario analysis I conducted to assess performance drag vs. crisis performance, as well as some historical monthly performance data for TAIL for context (the ETF has a short track record).
A couple takeaways:
This exposure has to be managed actively. When volatility spiked in early February 2018 the correct move would have been to trim the position on the back of the ~10% up move.
There is a consideration in play for me that is not in play for many retail investors, and that is that my compensation and career prospects are highly correlated to financial markets. For people with “bond-like” compensation (teachers, doctors) there is less benefit to spending portfolio dollars on a tail hedge from a pure risk management POV.
The real downside to putting on a position like this is not getting 18% annualized over a decade if the market returns 20% annualized. The real downside is getting an annualized 3% if the market returns 5%.
Billionaire Doomsday Prepping As Extreme Tail Hedging
Fear of disaster is healthy if it spurs action to prevent it. But élite survivalism is not a step toward prevention; it is an act of withdrawal. Philanthropy in America is still three times as large, as a share of G.D.P., as philanthropy in the next closest country, the United Kingdom. But it is now accompanied by a gesture of surrender, a quiet disinvestment by some of America’s most successful and powerful people. Faced with evidence of frailty in the American project, in the institutions and norms from which they have benefited, some are permitting themselves to imagine failure. It is a gilded despair.
I have a dramatically different reading: billionaire doomsday prepping is just an extreme form of tail hedging.
If you have a net worth of $1 billion, why not spend even $10 million of your net worth on a hedging strategy for the total collapse of civilization? This amounts to a 1% exposure. It’s a pretty good risk/reward tradeoff, if you ask me–especially if you are estimating your max downside as being drawn and quartered by some kind of Proletarian Justice Tribunal. Obviously, a financial hedge is not going to work here. You are going to need things like guns and butter. And some kind of bunker.
I am sure not all ultra-wealthy doomsday preppers look at it this way. But I am comfortable speaking for a majority. Even that New Yorker piece contains the following observation (they buried the lede, IMO):
Yishan Wong, an early Facebook employee, was the C.E.O. of Reddit from 2012 to 2014. He, too, had eye surgery for survival purposes, eliminating his dependence, as he put it, “on a nonsustainable external aid for perfect vision.” In an e-mail, Wong told me, “Most people just assume improbable events don’t happen, but technical people tend to view risk very mathematically.” He continued, “The tech preppers do not necessarily think a collapse is likely. They consider it a remote event, but one with a very severe downside, so, given how much money they have, spending a fraction of their net worth to hedge against this . . . is a logical thing to do.”
So the annual Berkshire letter is out and Buffett could not resist taking another swipe at Wall Street over his bet with Protégé Partners. I am not going to re-hash the letter or the bet here. (Incidentally, I highly recommend giving this annotated version a read) Rather, I want to draw your attention to one particular bit no one ever seems to talk about:
Am I the only person on the internet who believe this was a completely insane way to build a portfolio?Obviously, in the aggregate, the best investors can hope to do is match the market return, less fees (they can of course do considerably worse). It cannot be otherwise. There is nothing especially profound about the observation that it makes no sense to try and replicate the broad market with scores of active managers.
Fama and French demonstrated long ago that the aggregate portfolio of all investment managers more or less resembles the market cap weighted portfolio (read: an index fund, but with higher fees). Behold:
The high management fees and expenses of active funds lower their returns. If we measure fund returns before fees and expenses – in other words, if we add back each fund’s expense ratio – the α estimate for the aggregate fund portfolio rises to 0.13% per year, which is only 0.40 standard errors from zero. Thus, even before expenses, the overall portfolio of active mutual funds shows no evidence that active managers can enhance returns. After costs, fund investors in aggregate simply lose the fees and expenses imposed on them.
Adding insult to injury, the aggregate portfolio of active mutual funds looks a lot like the cap-weighted stock market portfolio. When we use the three-factor model to explain the monthly percent returns of the aggregate fund portfolio for 1984-2006, we get,
RPt – Rft = -0.07 + 0.96(RMt – Rft) + 0.07SMBt – 0.03HMLt + eit,where RPt is the return (net of costs) on the aggregate mutual fund portfolio for month t, Rft is the riskfree rate of interest (the one-month T-bill return for month t), RMt is the cap-weighted NYSE-Amex-Nasdaq market return, and SMBt and HMLtare the size and value/growth returns of the three-factor model.
The regression says that the aggregate mutual fund portfolio has almost full exposure to the market portfolio (a 0.96 dose, which is close to 1.0), but almost no exposure to the size and value/growth returns (0.07 and -0.03, which are close to zero). Moreover, the market alone captures 99% of the variance of month-by-month aggregate fund returns.
In short, the combined portfolio of all active mutual funds is close to the cap-weighted market portfolio, but with a return weighed down by the high fees and expenses of actively managed funds.
Therefore, in my view, Protégé’s failure was first and foremost a failure of portfolio construction. It’s totally fair to fault Protégé for this, just as it’s fair to fault many investors for buying into a collective delusion around hedge funds as magical assets* in the mid-2000s. To the extent Warren is underscoring that point, I wholeheartedly agree with him.
Beyond that, I don’t know the outcome of this best offers much insight into investment manager selection or the merits of investing actively. (See my Truth About Investing post for more on that subject) Warren Buffett did not get to be a billionaire buying index funds. Neither did Jim Simons. Or David Tepper. Or Seth Klarman.
Someone please sit down with Jim Simons or David Tepper or Seth Klarman or Howard Marks or any of the dozens of hedge fund managers who have trounced the S&P 500 over the past couple of decades and lecture them about the aggregate performance of active management. I would love to hear how it goes.
* When I write about magical asset classes I am referring to any asset class or strategy people believe is inherently superior to others. In the mid-2000s investors clearly believed they could generate outperformance just by “being in” hedge funds. There are lots of reasons why aggregate performance has declined since then. First and foremost, hedge funds became victims of their own success as the space attracted large amounts of investor capital and many hundreds of talented money managers. Now that hedge funds are out of favor, the magical asset classes of today are private equity and venture capital. Also,hedge funds are not an asset class. They are a type of fund structure, just like closed end funds and mutual funds are types of fund structures. Similarly, you can argue that private equity isn’t a unique asset class so much as a levered investment in illiquid small caps and micro caps.
(See Part I for the background on this post. As usual, none of this should be treated as financial advice as it does not take your personal circumstances into account. If you want advice, talk to a professional advisor. Trust me, there are plenty of highly competent, ethical professionals out there who are excited to help you achieve your goals.)
After sharing the original post with some savvy friends, subsequent discussion stirred up some additional ideas for questions and answers. So here are some additions to our little Socratic dialogue.
So back to this active versus passive investing thing. It sounds like you are pro passive?
If I absolutely have to take a position, I would say most people are probably better off investing passively. Unless they happen to be really good at investing actively, of course.
Ugh. There you go again. But how can I figure out if I’m good at investing actively?
We can look at your returns 20 or better yet 30 years from now. That will give us a pretty good idea.
Double ugh. How can I know BEFORE I start making active bets? If I start down this path and it turns out I suck I may lose a lot of money.
You can’t know ahead of time. Don’t waste your time trying to “know” things that are fundamentally unknowable.
There are certain skills and psychological traits that may make you a better active investor than someone else. For example, skilled poker players typically make for good active investors. They intuitively understand expected value, probabilistic thinking and mental models for decision making under uncertainty. They understand the interplay between luck and skill in determining outcomes. Psychologically, they know how to handle a “bad beat” (or several) without blowing up. They are used to making calculated bets, and therefore also have an intuitive understanding of risk management.
If you are a good portfolio manager (you’ve got “poker skills”), you don’t have to be a great financial analyst to do well. The reason for that is that randomness plays a huge role in the markets (as it does in life). Thus it is more important in the markets to optimize decisions under uncertainty than it is to be “right” analytically. You still need to have an above average understanding of accounting, capital markets and basic principles of economic value creation to avoid making stupid, otherwise obvious mistakes. These things are easier to learn than “poker skills,” if you are willing to put in the time and effort.
Ultimately, if making decisions under uncertainty makes you queasy, I suspect you will have a difficult time investing actively.
That seems complicated and unhelpful.
Then invest passively. Or find someone you trust and respect to develop an active investing program suited to your goals (whether that is picking managers or individual stocks).
Okay. Let me try this another way. What I have really been asking this whole time is this: what is The Best Thing To Do?
There is no Best Thing To Do. There is only The Best Thing For You To Do.
So what does YOUR portfolio look like, big shot?
Approximately 70% of my investable net worth (ex-cash) is invested in actively managed strategies that should earn something like broad market returns over time. If I am lucky maybe a little extra. If I am unlucky maybe a little less. The remaining 30% is invested in a concentrated portfolio of individual securities with the goal of generating extraordinary capital appreciation over a multi-decade time horizon.
How do you know these managers will perform well over time?
I don’t. Honestly, just try to put money with folks doing sensible things who I think will be good stewards of my capital over a multi-decade time horizon, and who I believe charge reasonable fees for managing my money. That frees me up to do the work I want to do on individual securities, which will potentially compound value at a much higher rate over time.
Why this 70/30 split? Why not just go all in on the stuff that you think will go up the most?
Because if 30 years from now it turns out I really sucked at this I will not have laid waste to my net worth or my family’s financial security.