“Fail Well”

A while ago I put up a post that may have gone a little off the deep end. It likened investing to a spiritual journey and drew heavily on the example of Bridgewater Associates.

Barry Ritholtz has a neat Bloomberg View piece up summarizing some takeaways from a recent interview with Bridgewater founder Ray Dalio. I love this thinking and it is why I keep an investing journal:

Throughout the book, and in a recent conversation we had, Dalio insists the key to his turnaround was revisiting failure and learning from it. He is enamored of the framework described in Joseph Campbell’s “The Hero with a Thousand Faces.” Campbell’s book examined the evolution of mythological figures, whose failure leads to discovering new wisdom that they use to achieve their goals. Dalio wanted his failures to have the same results, so he created a broad set of rules to do so:

  • View mistakes as opportunities to improve. He calls this “mistake-based learning.”
  • Own your errors. Never hide them, but bring them forward to create a learning opportunity. His advice is to “fail well.”
  • Pain + reflection = progress. The “pain of failure” should lead to reflection, from which your wisdom derives.
  • Track what you do; keep systemizing what you learn from your mistakes.
  • There are many more principles, but this gives you an idea of some of the basics.

Dalio does things that most ordinary people don’t do. Set aside for a minute his remarkable track record as an investor and note the following unusual business behavior: He writes down and reflects on everything he does. Then he systemizes it, eventually turning these into algorithms that his firm’s computer systems help backtest against earlier eras. The end result of this is a hybrid of human creativity and machine learning that produces results better than either could separately.

My Definition Of Wealth

I am not motivated by money.

That may sound strange coming from someone who works in investment research, and I certainly don’t mean to imply I don’t care about money at all. I have to make money to live a certain quality of life. Money will also allow me to achieve financial independence some day. So maybe I am motivated by money and I just define wealth differently than others.

For me, wealth is not an extravagant lifestyle, a huge mansion or fancy cars and clothes. Rather, wealth is financial security and independence. Wealth allows you to write and say what you want, when you want, and how you want.  Wealth is “fuck you” money.

While I try not to curse much on this blog (requiring a herculean effort at times), it’s important to me that bit of profanity be written out in full. To sanitize the statement is to diminish its power.

The link is to a post by J.L. Collins:

If memory serves, it comes from James Clavell. In his novel “Tai Pan” (highly recommended BTW) a young woman is on the quest to secure 10 million dollars. She calls it her “F-you money,” although the F-word is spelled out in the book. So you can look it up in case you’re wondering just what word it is. And 10m is far more than it takes, at least for me. More monk than minister.

I may not have known what it was called, but I knew what it was and why it is important. There are many things money can buy, but the most valuable of all is freedom. Freedom to do what you want and work for whom you respect.

Those who live paycheck to paycheck are slaves. Those who carry debt are slaves with even stouter shackles. Don’t think for the moment their masters don’t know it.

Much of what we believe about wealth we accept without critical thought. It does not help that we are inundated with messaging glorifying conspicuous consumption. What was the Fyre Festival but a monument to conspicuous consumption and personal vanity? What does it say about conspicuous consumption that the whole event ended up being a massive fraud?

Simply taking the time to examine our beliefs about money, wealth and power has the potential to redefine our worldview and change our lives. At a bare minimum we will better understand ourselves. We might also avoid being stranded on Caribbean islands without access to food and shelter.

Investing Like John Wooden

These days it is more or less common knowledge that our brains are not evolved for investment success. In fact, our brains are evolved to keep us from investment success. I don’t have anything profound to say on the science behind this. If you are interested in the science, I would recommend reading Thinking, Fast and Slow, by Daniel Kahneman.

Rather, I want to focus on how we can deal with our evolutionary disadvantages.

There is much investing literature insisting the solution to our cognitive and emotional biases is simply to think as dispassionately and analytically as possible. That sounds nice on paper. However, I don’t think it is realistic. I don’t believe it is possible to completely cut emotion out of the investment process. I would argue that if you think you have successfully removed emotion from your investment process what you have really succeeded in doing is deceiving yourself.

It is both healthier and more productive to openly acknowledge that investing is a difficult, emotional process. Better to channel your emotions toward productive ends than waste time and energy denying they exist.

For me, this means measuring success by the quality of your investment process and the consistency of its implementation–not the daily, weekly, monthly or even annual tape print. If you have a quality process and implement it consistently, and you strive for continuous improvement, you will do okay in the long run.

Think of this as the John Wooden approach to investing:

When Wooden arrived at UCLA for the 1948–1949 season, he inherited a little-known program that played in a cramped gym. He left it as a national powerhouse with 10 national championships—one of the most (if not the most) successful rebuilding projects in college basketball history. John Wooden ended his UCLA coaching career with a 620–147 overall record and a winning percentage of .808. These figures do not include his two-year record at Indiana State prior to taking over the duties at UCLA.

What’s more, Wooden openly shared his secret sauce:

John_Wooden_Success_Pyramid

Here are a couple of the ways I strive to channel emotion into process and not into a self-defeating obsession with outcomes:

  • I keep an investing journal where I document research, investment theses, thesis breaks, trades and post-mortems of exited investments. I will also write own my feelings and views of difficult situations or frustrating outcomes.
  • My emphasis is always on following my process. Making money on random gambles or “lottery ticket” type investments doesn’t count as success. My process does not revolve around “making money.” The goal of my process is to validate or disprove investment theses.
  • Thus, selling out of a bad investment is not failure. Exiting bad investments quickly allows me to redeploy that capital into better quality investments. Some of the worst investing mistakes (think Valeant) have been made by people being unwilling to admit they are wrong.

For a process-oriented investor, much of what passes for “investing” seems silly–like poker players on a tilt or dogs chasing cars.

The Pursuit of Truth

Bridgewater Associates has a reputation for being something of a cult. I do not have direct experience with Bridgewater or its founder Ray Dalio other than reading some of their research and thought pieces. So I’m not really qualified to weigh in on the cult aspect. What I do appreciate about Bridgewater’s culture is that it is fanatically process-oriented, to the point of resembling a spiritual quest. Check out these snips:

Principles
Source: Website for Ray Dalio’s Principles
Bridgewater_What_We_Do
Source: Bridgewater Website

Now, this post is not meant as Bridgewater commercial. Bridgewater is simply a real-life example of firm that seeks to understand Truth, and has reaped the benefits of the process. If you understand the Truth of how the world operates, making money using that knowledge is trivial.

This might seem like a banal observation. I promise it is not. In my view a majority of investment organizations have it backward. They are focused on outcomes. The Truth of what caused those outcomes is irrelevant. It is easier from a business perspective to simply rationalize things in ways that appeal to clients. It is clients who pay the bills, after all.

The result is that investing becomes an endless performance chase. This is the finance equivalent of Buddhist samsara. It is an endless cycle of birth, suffering and death.

By now you might think I am off the deep end. Yet I am not the first person to connect practical issues in asset management to broader philosophical concepts. Patrick O’Shaughnessy has written an excellent post covering related subject matter, “Two Star Managers and the Wheel of Fortune.” In it he shares this Taoist story:

There is a Taoist story of an old farmer who had worked his crops for many years. One day his horse ran away. Upon hearing the news, his neighbors came to visit.

“Such bad luck,” they said sympathetically.

“We’ll see,” the farmer replied.

The next morning the horse returned, bringing with it three other wild horses.

“How wonderful,” the neighbors exclaimed.

“We’ll see,” replied the old man.

The following day, his son tried to ride one of the untamed horses, was thrown, and broke his leg. The neighbors again came to offer their sympathy on his misfortune.

“We’ll see,” answered the farmer.

The day after, military officials came to the village to draft young men into the army. Seeing that the son’s leg was broken, they passed him by. The neighbors congratulated the farmer on how well things had turned out.

“We’ll see” said the farmer.

As I was writing this I read an excellent piece by Morgan Housel discussing the impact of lived experience on investors’ views of financial markets and investment strategy. It includes this chart:

Morgan_Housel_Investor_Experience_Chart
Source: Collaborative Fund Blog

Here is a bridge from the Taoist story to our lived experience as investors. It illustrates how something as simple as the year we were born can have a dramatic impact on our lived experiences, and by implication our worldview. If we only ever filter the world and the markets through the lens of our personal experiences (and biases), we will see things as we would like to see them rather than how they truly are.

This may blind us to opportunity. It may also blind us to risk. Even thinking of “opportunity” and “risk” as discrete concepts can be reductive and limiting. Typically where there is risk there is also opportunity, and vice versa. This is especially true of investments that are out of favor or misunderstood. To this day, skilled structured credit investors are making good money off toxic mortgage-backed securities originated prior to the financial crisis. Since they have deep, objective knowledge of the securities and the market, they are able to see past the label of “toxic” to the underlying value.

If you can understand the Truth, making money is trivial.

#ContrarianProblems

I am generally a contrarian by nature.

To illustrate:

  • I am skeptical of home ownership as wealth creating endeavor.
  • I do not like reading “popular” books or seeing “popular” movies for the sake of being able to have conversations about them.
  • In my view at least 50% of the episodes of Game of Thrones are time-wasting filler.
  • I am generally not that into big events that draw crowds (sports victory parades, Coachella, Burning Man or Fyre Festival–but there are exceptions).

Perhaps unsurprisingly this permeates my investment philosophy. Things I like right now include a Russian natural gas company, a Brazilian aerospace company and sub-Saharan African bank holding company (I have a North African/Middle Eastern bank on my watch list, too, if the valuation ever comes down to earth). This is not a recipe for outperformance. It is not investment advice. It is just who I am as an investor.

Being a contrarian investor is great. You have good company in people like Seth Klarman and Howard Marks. On the other hand, being a contrarian in the investment business is not nearly so pleasant.

Contrarian ideas are often hard to sell and investment committees are engineered to arrive at consensus decisions. Consensus decisions are generally good for business. Consensus decisions will not deliver top quartile performance but they will not deliver bottom quartile performance, either. You can have a very nice business and never deliver top quartile performance. But woe betide you if you end up in the bottom quartile. It may well be the end of your business.

I sometimes hear about firms that designate “devil’s advocates” on committees. The devil’s advocate’s job is to argue against every single investment thesis. She is not allowed to argue in favor, or to moderate her argument. She is a dedicated short and everyone knows it in advance. This is a neat solution to the problem of encouraging a contrarian viewpoint in a high pressure group setting (contrarians can often grate on their fellow committee members). But does it make any difference?

What percent of ideas get blown up because of the devil’s advocate? Or is the whole thing just an exercise in box-checking dreamed up to please consultants? I suspect in most cases it’s the latter.

Edward Hess summarizes the issue quite nicely in an article titled “Why Is Innovation So Hard?”:

Most organizational environments won’t help us overcome our fear of failure and build our innovative thinking skills. That’s because most organizations exist to produce predictable, reliable, standardized results. In those environments, mistakes and failures are bad. That is a problem. To innovate, you must simultaneously tolerate mistakes and insist on operational excellence. Many businesses struggle with implementing that dual mentality.

Here we can learn from exemplar companies like IDEO, Pixar, Intuit INTU -1.84%, W.L. Gore & Associates, and Bridgewater Associates. In those organizations, mistakes and failures are redefined as “learning opportunities.” IDEO takes it even further, characterizing failure as good because it helps people develop the humility that is necessary for empathy—a critical skill in user-centric innovation.

But in many workplaces, people do not “feel safe enough to dare.” They don’t necessarily feel that they can speak with candor up and down the organization. Can you tell your boss the truth?  Innovation occurs best in an “idea meritocracy,” a culture where the best evidence-based ideas win. There can’t be two sets of rules—everyone’s ideas must be subject to the same rigorous scrutiny. As Ray Dalio, the founder of Bridgewater Associates, one of the largest hedge funds in the world, so bluntly said, “We all are dumb shits.” That’s why everyone at his company is engaged in a radically transparent “search for truth,” which involves candid feedback and a deliberate effort to “get above yourself,” to get past the emotional defenses that inhibit our thinking.

In other words, organizational incentives are skewed toward rewarding preservation of the status quo. If The Golden Rule is “He who hath the gold, maketh the rules,” surely immediate the corollary is “He who f***eth with The Golden Goose shall meet with a pointy reckoning.”

#ContrarianProblems.

Why We Believe What We Believe

Most people do not reason from first principles when developing their political views. Rather, they develop a set of views based on their life experiences and retrofit facts and narratives to conform with that worldview (myself included). How else do you explain something like the backfire effect?

David McRaney of You Are Not So Smart writes:

Geoffrey Munro at the University of California and Peter Ditto at Kent State University concocted a series of fake scientific studies in 1997. One set of studies said homosexuality was probably a mental illness. The other set suggested homosexuality was normal and natural. They then separated subjects into two groups; one group said they believed homosexuality was a mental illness and one did not. Each group then read the fake studies full of pretend facts and figures suggesting their worldview was wrong. On either side of the issue, after reading studies which did not support their beliefs, most people didn’t report an epiphany, a realization they’ve been wrong all these years. Instead, they said the issue was something science couldn’t understand. When asked about other topics later on, like spanking or astrology, these same people said they no longer trusted research to determine the truth. Rather than shed their belief and face facts, they rejected science altogether.

In my view most people are “conditioned” to a set of political beliefs over time. The conditioning happens through the interaction of individual effort and experience and external stimuli. The process is path dependent.

If I am an entrepreneur, and I labor diligently for years to build my business and become wealthy and successful, I am conditioned to believe market systems work and are fair in allocating resources. I am more likely to support light regulation and promote individual accountability.

Likewise if I grow up in a community where financial institutions operate with predatory business models, I am conditioned to believe market systems are broken, and that a wealthy few (say, 1% of the population) manipulate markets to strip assets and wealth from communities like mine. I am more likely to support tight regulation and institutional accountability.

These are overly simplistic examples but I find them instructive. For someone like me who believes most individuals act based on incentive structures and not based on rational analysis, this is a powerful idea. It is consistent with the historical institutionalist approach to history, but on an individual level.

From Wikipedia:

A related crux of historical institutionalism is that temporal sequences matter: outcomes depend upon the timing of exogenous factors (such as inter-state competition or economic crisis) in relation to particular institutional configurations (such as the level of bureaucratic professionalism or degree of state autonomy from class forces).[6] For example, Theda Skocpol suggests that the democratic outcome of the English Civil War was a result of the fact that the comparatively weak English Crown lacked the military capacity to fight the landed upper-class. In contrast, the rise of rapid industrialization and fascism in Prussia when faced with international security threats was because the Prussian state was a “highly bureaucratic and centralized agrarian state” composed by “men closely ties to landed notables”.[7] Thomas Ertman, in his account of state building in medieval and early modern Europe, argues that variations in the type of regime built in Europe during this period can be traced to one macro-international factor and two historical institutional factors. At the macro-structural level, the “timing of the onset of sustained geopolitical competition” created an atmosphere of insecurity that appeared best addressed by consolidating state power. The timing of the onset of competition is critical for Ertman’s explanation. States that faced competitive pressures early had to consolidate through patrimonial structures, since the development of modern bureaucratic techniques had not yet arrived. States faced with competitive pressures later could on the other hand, could take advantage of advancements in training and knowledge to promote a more technical oriented civil service.[8][9]

The obvious takeaway from all of this is shouting at people about politics, either in person or on social media, is a complete waste of time and energy. Beyond that, however, this provides an objective framework for understanding why people believe certain things and why people behave in certain ways. This is of critical importance to investors, who must account for higher order, non-linear effects when making decisions.

Barring an “impact investing” mandate, an investor must set her political beliefs aside when making decisions. Rather the investor must focus on the beliefs of others. It is the beliefs of others that impact the economic and market environment.

Just Say No To News

If you have ever owned an individual stock–especially a large cap stock with a lot of coverage–one thing you probably learned very quickly is to tune out day-to-day newsflow. For example, the largest cap individual stock I currently own in my portfolio is Gazprom. Hundreds, if not thousands, of news stories are published daily either about the company itself, or about energy industry or geopolitical events that could impact the stock.

Here are sample headlines from a quick Google news search:

Gazprom Eyes Brazil’s Natural Gas Opportunities

Gazprom—the LNG pivot?

EU says wants Russia’s Gazprom to sweeten antitrust concessions

Russia’s Gazprom Neft ‘holds its nose’ at global oil output cut

Kiev allowed to arrest Gazprom’s property: there is nothing but gas

Russian Parliament to Consider Tax Preferences for Gazprom

You get the idea.

I could spend a lot of time tracking Gazprom news. I could probably write an entire blog just about Gazprom (I am not sure it would endear me to the Russian security services). I would never want for material. But it probably wouldn’t improve my investment results much. It might even hurt my results.

Most of this daily news is just noise. It is exacerbated by the fact that Gazprom is majority owned by the Russian government — pro-Russian and anti-Russian news outlets have every incentive to put out biased coverage. If you immerse yourself in the noise, it is easy to lose track of business fundamentals. You start wondering whether you should buy or sell based on commentary from some journalist (who may or may not be able to read a balance sheet). You will be tempted to sell on every price move, either to avoid a loss or lock in a gain.

The problem is the news cycle moves very, very fast. Business cycles move slowly. The ratio of noise (meaningless information) to useful information in the news cycle is quite high. In the business cycle that ratio is lower. As a long-term fundamental investor you want to think in terms of business cycles as they are more aligned with your investment horizon.

Furthermore, when it comes to things like currency risk and geopolitical risk there is nothing about monitoring news that will give you any more control over the situation.  Either the stock has properly priced the graft, administrative inefficiency, currency risk and geopolitical risk embedded in the business or it hasn’t. You deal with that up front, with the margin of safety you demand at purchase. There is no point getting worked up over day-to-day newsflow. It is not constructive.

So it is with almost all types of news. Especially political news.

We are in the midst of a particularly vicious political cycle in the US. In my view this is a cyclical phenomenon. (Bridgewater did a nice little piece on populism a while back–I don’t believe it’s a coincidence that the last time populism had this much momentum in Western countries was in the decade following The Great Depression) Anyway, the forces that shape the political climate of a given era are much larger than you or me. Much like the geopolitical risks facing Gazprom, the political environment is beyond our control.

A majority of the news we consume is meaningless noise. I am looking at the title of a news story on my phone as I write this: “Woody Harrelson’s Dinner With Trump Was So Bad He Had To Smoke A Joint.” Now if I hate Donald Trump I am laughing at this story. If I am a Trump supporter it is fake news or liberal propaganda and I am angry. I will go to Breitbart and read something uplifting about glib liberal cucks. Vice versa for “Mark Zuckerberg and liberals seek to weaken bail system that keeps us safe.”

Again, this is meaningless noise. But worse than that it is noise that gets people emotionally charged up. That is what most political news does. Indeed it is designed that way–all the better for the clicks and social shares (not to mention Facebook’s margins).

In general I try to keep my political news consumption to minimal levels. I will read the top political stories in the Financial Times. I will also read a brief set of bullets I receive each business day from another investment professional. The bullets are non-partisan and succinctly summarize major developments and strategic considerations for each political party.

Beyond that I am careful about my political news consumption. The reason? Much of it is written to drive an emotional response and precious little of it actually matters. In his book Fooled By Randomness, Nassim Taleb observes:

We just saw how the scientifically hideous George Will and his colleagues can twist arguments to sound right without being right. But there is a more general impact by information providers in biasing the representation of the world one gets from the delivered information. It is a fact our brain tends to go for superficial clues when it comes to risk and probability, these clues being largely determined by what emotions they elicit or the ease with which they come to mind […]

In that sense the description coming from journalism is certainly not just an unrealistic representation of the world but rather the one that can fool you the most by grabbing your attention via your emotional apparatus–the cheapest to deliver sensation.

If the major cable news networks and their legion of apoplectic commentators winked out of existence tomorrow, what would really go missing from your life? (Ditto the HuffPosts, Daily Beasts and Breitbarts) Would this impede your ability to earn a living? Would it diminish your relationships with family, friends and professional colleagues? Would it negatively impact your physical and psychological well-being?

My guess is no.

In fact, if surveys conducted prior to the 2016 election are anything to go by, I suspect most individuals and their relationships would be all the healthier minus the incessant yammering of the pundit class.

So my humble suggestion is that you give the news cycle–particularly the political news cycle–the Gazprom treatment. Ignore it. Or at least ignore it a majority of the time. I suspect you will find it makes very little difference in your life. To the extent it makes any difference at all, it will probably be a positive.