Live By The Sword, Die By The Sword

Good management teams are first and foremost good storytellers. They’re shapers of reality. I don’t care whether you’re Warren Buffett, Elon Musk or Reed Hastings. If you are the Big Guy (or Big Gal) most of your job is storytelling. You spend most of your time telling stories to your stakeholders. Employees. Customers. Investors.

What’s truly amazing about Reed Hastings’s ability as a CEO/storyteller is how he’s managed to make Netflix’s free cash flow burn irrelevant. Here’s a screenshot directly from the company website:

NFLX_FCF_FAQ
Source: NFLX website

This is a company burning billions in cash a year, that is utterly dependent on the amity and goodwill of the capital markets (specifically, the high yield debt market) to support its continued existence.

And no one cares.

The reason no one cares is Reed Hastings is a great CEO/storyteller. He’s convinced the market it’s subscriber growth and not free cash flow that matters.

Well, yesterday NFLX (badly) missed expectations for subscriber growth. The result?

NFLX_180716_Price
Source: Google

Live by the sword, die by the sword, as the saying goes. This is the kind of reaction you get when you train the market on a certain narrative, and then that narrative is called into question. The market freaks out.

This is something short sellers understand deeply and intuitively. If you are a short seller who doesn’t understand this deeply and intuitively, you’re not going to last very long.

A short needs to understand the narrative driving a stock. The time to short a stock is when the narrative breaks. When a narrative breaks, investors start casting around, looking for a new narrative. If the CEO can’t get control of the narrative again, they might start to fixate on things like profitability and cash flows and leverage.

Of course, a good management team will have a new narrative ready to go to replace the old one. In NFLX’s case, they are talking about the limitations of their internal forecasting methods. Short selling is a hard life.

I literally have no opinion on NFLX’s subscriber growth numbers. But I do understand the narrative around them, and the purpose it serves.

Once you start looking for this stuff, you see it everywhere. Tesla is the best example, but it’s a more controversial stock than NFLX. The reason Elon Musk is coming apart at the seams is he’s losing control of TSLA’s narrative. That’s bad for TSLA, which is going to have to pay down or refi about $7 billion worth of debt in the next couple of years.

For these large cap cash incinerators, narrative is a matter of life and death.

Disclosure: No position in either NFLX or TSLA.

Our World In Meta-Games

Matryoshka_Russian_politicians
Source: Brandt Luke Zorn via Wikipedia

The world is a complicated place. A good way of attacking that complexity is to view the world as a nested series of games and meta-games.

Ben Hunt at Epsilon Theory wrote an excellent post about meta-games in financial markets a while back, specifically in the context of financial innovation. While I’m going to take a slightly different angle here, his illustration of how a meta-game works is useful as a jumping off point.

It involves the coyotes that “skirmish” with the residents of his town:

What’s the meta-game? It’s the game of games. It’s the larger social game where this little game of aggression and dominance with my wife played out. The meta-game for coyotes is how to stay alive in pockets of dense woods while surrounded by increasingly domesticated humans who are increasingly fearful of anything and everything that is actually untamed and natural. A strategy of Skirmish and scheming feints and counter-feints is something that coyotes are really good at. They will “win” every time they play this individual mini-game with domesticated dogs and domesticated humans shaking coffee cans half-filled with coins. But it is a suicidal strategy for the meta-game. As in literally suicidal. As in you will be killed by the animal control officer who HATES the idea of taking you out but is REQUIRED to do it because there’s an angry posse of families who just moved into town from the city and are AGHAST at the notion that they share these woods with creatures that actually have fangs and claws.

For simplicity’s sake, I’m going to write about four interrelated layers of “games” that influence financial markets. Imagine we are looking at a set of Russian nesting dolls, like the ones in the image at top, and we are working from the innermost layer out. Each successive layer is more expansive and subsumes all the preceding layers.

The layers/ games are:

1. The Security Selection Game

2. The Asset Allocation Game

3. The Economic Policy Game

4. The Socio-Political Power Game

Each of these games is connected to the others through various linkages and feedback loops.

Security Selection

This is the most straightforward, and, in many ways, the most banal of the games we play involving financial markets. It’s the game stock pickers play, and really the game anyone who is buying and selling assets based on price fluctuations or deviations from estimates of intrinsic value is playing. This is ultimately just an exercise in buying low and selling high, though you can dress it up any way you like.

While it often looks a lot like speculation and gambling, there is a real purpose to all this: price discovery and liquidity provision. The Security Selection Game greases the wheels of the market machine. However, it’s the least consequential of the games we will discuss in this post.

Asset Allocation

Asset Allocation is the game individuals, institutions and their financial advisors play as they endeavor to preserve and grow wealth over time. People often confuse the Security Selection Game with the Asset Allocation Game. Index funds and ETFs haven’t helped this confusion, since they are more or less securitizations of broad asset classes.

At its core, the Asset Allocation Game is about matching assets and liabilities. This is true whether you are an individual investor or a pension plan or an endowment. Personally, I think individual investors would be better served if they were taught to understand how saving and investing converts their human capital to financial capital, and how financial capital is then allocated to fund future liabilities (retirement, charitable bequests, etc). Unfortunately, no one has the patience for this.

The Asset Allocation Game is incredibly influential because it drives relative valuations across asset classes. As in Ben Hunt’s coyote example, you can simultaneously win at Security Selection and lose at Asset Allocation. For example, you can be overly concentrated in the “best” stock in a sector that crashes, blowing up the asset side of your balance sheet and leaving you with a large underfunded liability.

I sometimes meet people who claim they don’t think about asset allocation at all. They just pick stocks or invest in a couple of private businesses or rental properties or whatever. To which I say: show me a portfolio, or a breakout of your net worth, and I’ll show you an asset allocation.

Like it or not, we’re all playing the Asset Allocation Game.

Economic Policy

The Economic Policy Game is played by politicians, bureaucrats, business leaders and anyone else with sociopolitical power. The goal of the Economic Policy Game is to engineer what they deem to be favorable economic outcomes. Importantly, these may or may not be “optimal” outcomes for a society as a whole.

If you are lucky, the people in power will do their best to think about optimal outcomes for society as a whole. Plenty of people would disagree with me, but I think generally the United States has been run this way. If you are unlucky, however, you’ll get people in power who are preoccupied with unproductive (yet lucrative) pursuits like looting the economy (see China, Russia, Venezuela).

The Economic Policy Game shapes the starting conditions for the Asset Allocation Game. For example, if central banks hold short-term interest rates near or below zero, that impacts everyone’s risk preferences. What we saw all over the world post-financial crisis was a “reach for yield.” Everyone with liabilities to fund had to invest in progressively riskier assets to earn any kind of return. Cash moved to corporate bonds; corporate bonds moved to high yield; high yield moved to public equity; public equity moved to private equity and venture capital. Turtles all the way down.

A more extreme example would be a country like Zimbabwe. Under Robert Mugabe the folks playing the Economic Policy Game triggered hyperinflation. In a highly inflationary environment, Asset Allocators favor real assets (preferably ones difficult for the state to confiscate). Think gold, Bitcoins and hard commodities.

This is no different than Darwin’s finches evolving in response to their environment.

Do you suppose massive, cash-incinerating companies like Uber and Tesla can somehow exist independent of their environment? No. In fact, they are products of their environment. Where would Tesla and Uber be without all kinds of long duration capital sloshing around in the retirement accounts and pension funds and sovereign wealth funds and Softbank Vision Funds of the world, desperate to eke out a couple hundred basis points of alpha?

Insolvent is where Uber and Tesla would be.

In general, western Economic Policy players want to promote asset price inflation while limiting other forms of inflation. There are both good and selfish reasons for this. The best and simultaneously most selfish reason is that, to a point, these conditions support social, political and economic stability.

However, the compound interest math also means this strategy favors capital over labor. This can create friction in society over real or perceived inequality (it doesn’t really matter which–perception is reality in the end). We’re seeing this now with the rise of populism in the developed world.

The Sociopolitical Power Game

Only the winners of the Sociopolitical Power Game get to play the Economic Policy Game. In that sense it is the most important game of all. If you are American, and naïve, you might think this is about winning elections. Sure, that is part of the game. But it’s only the tip of the proverbial iceberg.

Winning this game is really hinges on creating and controlling the narratives that shape individuals’ opinions and identities. If you are lucky as a society, the winners will create narratives that resemble empirical reality, which will lead to “progress.” But narratives aren’t required to even faintly resemble reality to be effective (it took me a long time to understand and come to grips with this).

You could not find a more perfect example of this than President Donald Trump. People who insist on “fact checking” him entirely miss the point. Donald Trump and his political base are impervious to facts, precisely because Trump is a master of creating and controlling narratives.

Ben Hunt, who writes extensively about narrative on Epsilon Theory, calls this “controlling his cartoon.” As long as there are people who find Trump’s narratives attractive, he will have their support. Facts are irrelevant. They bought the cartoon. (“I just like him,” people say)

It’s the same with Anti-Vaxxers. Scientific evidence doesn’t mean a thing to Anti-Vaxxers. If they cared even the slightest bit about scientific evidence, they wouldn’t exist in the first place!

I’m picking on Trump here because he is a particularly prominent example. The same can be said of any politician or influential figure. Barack Obama. Angela Merkel. JFK. MLK. I think MLK in particular is one of the more underrated strategists of the modern era.

Here is Sean McElwee, creator of #AbolishICE, commenting to the FT on effectively crafting and propagating narratives:

“You make maximalist demands that are rooted in a clear moral vision and you continue to make those demands until those demands are met,” said Mr McElwee. “This is an issue where activists have done a very good job of moving the discussion of what has to be done on immigration to the left very quickly.”

If you want to get very good at the Sociopolitical Power Game, you have to be willing to manipulate others at the expense of the Truth. It comes with the territory. Very often the Truth is not politically expedient, because our world is full of unpleasant tradeoffs, and people would prefer not to think about them.

I have been picking on the left a lot lately so I’ll pick on free market fundamentalists here instead. In general it is not a good idea to highlight certain features of the capitalist system to the voting public. Creative destruction, for example. In Truth, creative destruction is vital to economic growth. It ensures capital and labor are reallocated from dying enterprises to flourishing enterprises. Creative destruction performs the same function wildfires perform in nature. Good luck explaining that to the voters whose changing industries and obsolete jobs have been destroyed.

Because of all this, many people who are very good at the Sociopolitical Power Game are not actually “the face” of political movements. These are political operatives like Roger Stone and Lee Atwater, and they are more influential than you might think.

The Most Important Thing

There is a popular movement these days to get back to Enlightenment principles and the pursuit of philosophical Truth. I’m sympathetic to that movement. But I’m not sure it really helps you understand the world as it is.

In the world as it is, people don’t make decisions based on Truth with a capital T. In general, people make decisions based on: 1) how they self-identify; and 2) what will benefit them personally. Rationalization takes care of the rest.

When have you heard an unemployed manufacturing worker say, “yeah, it’s a bummer to be out of a job but in the long run the aggregate gains from trade will outweigh losses like my job”?

In the world as it is, people operate much more like players on competing “teams.” They want their team (a.k.a tribe) to win. They are not particularly concerned with reaching stable equilibria across a number of games.

And that tribal competition game is probably the most important meta-game of all.

Book Review: Every Shot Must Have A Purpose

every_shot_must_have_a_purposeGolf is a weird game. Playing well is actually fairly demanding physically (assuming you are walking). It requires core strength and good hand-eye coordination. But what makes golf truly weird is the mental dimension. Sure, all sports have a mental dimension. But golf is especially mental. If your head is not right, you will play terribly.

Every Shot Must Have A Purpose, by Pia Nilsson and Lynn Marriott, is described early on as “a life philosophy, not merely a golf instruction book.” It is therefore relevant for anyone engaged in any complex and mentally demanding endeavor (read: investing). Given the nature of this blog, I’m going to focus on the broader relevance of the ideas in the book.

Summary

There are a handful  of Big Ideas in this book:

  • Focus on process, not outcome
  • Learn to bring yourself from heightened emotional states back to neutral
  • Trust your swing. It is your signature.

All of this is relevant for investors. Even the part about trusting your swing. I’ll take them in reverse order.

Trust Your Swing

On trusting your swing, Nilsson and Marriott write:

If you can hit the shots you want under pressure, your swing is working. What is important is to make up your mind what swing you believe in, and to have the discipline not to abandon that belief because of a bad round or two. To be in “search-and-scan” mode never works over time. Find your swing, trust it, and stay committed to it.

For the investor, your “swing” is your investing discipline. It is the value creation mechanism(s) that will compound the value of your capital over time.

Classical Ben Graham value investing is a swing form. Munger and Buffett-style value investing is a swing form. Momentum investing is a swing form. All of these swing forms “work” because they are fundamentally sound in terms of economic principles and investor behavior. Just like the golf swing “works” because it is grounded in the laws of physics.

What does not work very well is trying to time different styles to chase “what’s working” at a given point in time. This is the equivalent of trying to rebuild your golf swing from scratch after every round where you score poorly. Both are a recipe for poor future performance.

Bring Yourself Back To Neutral

It is fun to take a pitching wedge from 90 yards out and land a perfect strike six feet from the pin. When you hit a shot like that, you literally get high. But when you chunk a five iron thirty-five yards from a perfect lie in the middle of the fairway, you crash.

Experiencing wild emotional swings is not a recipe for consistent golf.

Likewise in investing, you get high when a stock doubles in three months. You crash when a name halves on some seemingly random exogenous event.

How many times have you hit your tee shot into the trees and then, in a fit of anger, tried to do too much with your second shot and ended up making a triple bogey? The disappointment with the drive leads you to attempt to erase the poor shot with one swing. And we all know how that works out. More often than not, a gamble is greeted with a ball clunking off a tree or remaining in the rough.

The frustrating thing is that on many of those occasions, when you looked back at the round you wondered why you didn’t just pitch back to the fairway and settle for a bogey–or maybe a one-putt par. Anger opens the door to a variety of mistakes: bad decisions, hesitant swings, rushed tempo, and even not seeing the line to the target clearly.

Consistent performance starts internally, with how you regulate your emotions. The goal isn’t to become a robot impervious to emotion. I don’t think such a thing is possible. And even if it is, it’s certainly not healthy. The goal is that whether you hit a good shot or a bad shot (whether an investment is a winner or a loser) you are able to bring yourself back to a neutral state of focus, where your attention is on executing the shot in front of you.

Focus On Process, Not Outcome

One of the reasons golfers–professionals as well as recreational players–can’t take their games from the range to the course is that, in the current practice culture, they are two different experiences. Just as we try to unify the mental with the mechanical aspects of the game, we also must try to erase the line between practice and playing. We want to teach you to play when you practice and practice when you play. In the end, it all has to be about executing golf shots with total commitment when it matters most. To do this you have to learn that playing needs to be a process focus and not score focus.

It’s not that different in investing. Particularly in situations where you have to make a buy/sell/hold decision under pressure. Thinking about the score (returns) doesn’t do any good here. If anything, you’ll fall victim to the disposition effect.

Who Should Read This Book

Anyone trying to improve her golf game should read this book. Investors and other professionals who golf (regardless of skill level–I think I am a 25 handicap) can also benefit from applying these concepts to areas outside the game. I would not recommend the book to non-golfers, as it’s hard to relate if you haven’t struggled through learning the game or fought through some difficult rounds.

Betting Dark Side

In craps the best bet on the table (other than Odds) is Don’t Pass. The house edge is just a teensy bit narrower there than on the Pass Line. But no one really bets that way. And when people do, they are quiet about it, because they are betting for everyone else at the table to lose. That’s not the way you endear yourself to a bunch of degenerates at the casino. Betting Don’t Pass is also called betting “dark side.”

Personally, I have no interest in betting dark side in craps. The edge is pretty small to have to endure swarthy drunks shooting you sideways glances all night. But when it comes to investing I am plenty interested in opportunities to bet dark side.

In fact, sometimes I play a mental little game with myself called: What’s A Seemingly Obvious Trend Or Theme I Can Get On The Other Side Of?

For example right now everyone in the US is whining about how there are no cheap stocks. You know where stocks are cheap?

Russia.

In Russia you’ve got stuff on single digit earnings multiples paying 6% dividend yields. And it’s not even distressed stuff for the most part. Research Affiliates has got a phenomenal little asset allocation tool you can use for free. See those two red dots on the upper right in the double-digit return zone? That’s Russian and Turkish equities. (In case you are wondering, US large cap equity plots at about 40 bps of annualized real return)

RAFI_Cap_Markets201806
Source: Research Affiliates; Returns pictured are estimated real returns

Yeah. I know. Everyone hates Russia. You can probably rattle off at least five reasons why Russia is an absolute no-go off the top of your head. But I will happily bet dark side on Russian equity. I won’t bet the farm, but I’ll take meaningful exposure. The reason is I am getting paid pretty well to take Russian equity risk.

Risk assets are a pretty crappy deal here in the US. (40 bps real per year over the next decade, remember?) Here everyone’s convinced themselves stocks don’t go down anymore so they are willing to pay up. I guess some day that will be put to the test. We’ll see.

In the meantime, what other trends can we get on the other side of?

ESG might create opportunities. If you haven’t heard of ESG it stands for Environmental, Social and Governance. Big asset managers have become obsessed with ESG because it’s an opportunity to gather assets from millennials and women at a time when index funds and quants are hoovering up all the flows.

This is literally what the big asset managers tell allocators in presentations now: “millenials and women are going to inherit all the assets and they want to be invested in line with their values. Here are all our ESG products. Also here is marketing collateral to help you have ‘the ESG talk’ with your clients.”

So where do we go from here?

Well, for starters I am thinking a trillion dollars rotates into stuff that screens well on ESG. If this persists long enough and to a significant enough degree the stuff that doesn’t screen well on ESG is going to get hammered. With any luck it will get kicked out of indices and analysts will drop coverage and the bid-offer spreads will blow out.

Like Russian equities, the oil companies and the natural gas companies and the miners and the basic chemical companies and the capital intensive heavy manufacturers will trade on single digit earnings multiples with 6% dividend yields. All because they don’t score well on the asset gatherers’ screens.

So yeah, I think I’ll bet dark side when it comes to ESG, too.

For the record, I don’t have anything against ESG in principle. I am actually a big fan of  an extreme form of ESG, called impact investing, where you allocate capital with low return hurdles (like 0% real) to achieve a specific social objective. Maybe to fund development in a low income community in your city. Micro-lending is an example of this, and I think it’s a better model than philanthropy in many cases. But that’s a topic for another day.

This post is about how people’s emotional reactions to the securities they own create bargains. Here betting dark side is betting on something kind of icky. “Ick” is an emotional reaction. When people react emotionally to stuff, it has the potential to get mispriced. “Ick” is a feeling that encourages indiscriminate selling.

That’s where the Don’t Pass bet comes back into play. It’s one of the better bets in the casino, and it’s massively underutilized. Why?

Because it makes people feel icky.

“To the moon!”

From The McKinsey Global Private Markets Review 2018 (subtitle: “The rise and rise of private markets”):

McKinsey_PE_Rocket_Ship
Source: McKinsey

Your eyes do not deceive you. That is literally a rocket ship with stabilizer fins made of dollar bills, blasting off into the stratosphere. I like to imagine it’s headed off to join the crypto people and their lambos on the moon.

A few highlights from the introduction:

“Private asset managers raised a record sum of nearly $750 billion globally, extending the cycle that began eight years ago.”

“Within this tide of capital, one trend stands out: the surge of megafunds (of more than $5 billion), especially in the United States, and particularly in buyouts.”

“What was interesting in 2017, however, was how an already powerful trend accelerated, with raises for all buyout megafunds up over 90 percent year on year.”

“Investors’ motives for allocating to private markets remain the same, more or less: the potential for alpha, and for consistency at scale.”

This is what you see when an asset class gets frothy. And private equity is an asset class I have had my eye on for a while now. As I have written before, and as McKinsey says somewhat obliquely in their report, institutional investors have come to view private equity as a magical asset class.

We have seen this movie before. It happened with hedge funds in the early 2000s (spoiler alert: it ends with capital flooding into the space and diminished future returns). There are no magical assets. People ought to know better by now. I guess the allure is too powerful. Particularly for return-starved pension systems.

Anyway, when this thing turns there are going to be knock-on effects in a couple of other areas: namely high yield debt and leveraged loans. The gears of the private equity machine are greased with high yield debt. These days there is a strong bid for crappy paper. Especially crappy paper with floating rates.

The yield on the S&P/LSTA US Leveraged Loan 100 Index is something like 5%. Meanwhile, 2-year Treasuries yield 2.5%. And loan covenants suck, which means when defaults inevitably tick up recoveries are going to suck. Buyers are so fixated on interest rate risk they’re overlooking the credit component. You can keep your 250 bps of spread, thanks. Doesn’t seem like a great risk/reward proposition to me.

If I were a big institution, I would be swimming damn hard upstream against consensus on private equity.

If I were a financial advisor, I would steer clear of floating rate paper, rather than reach for a bit of yield so I can tell my clients they’re insulated from interest rate risk.

If I were a distressed debt investor I would make damn sure I had access to liquidity for when these deals start to explode (indeed, many distressed funds are out seeking commitments for exactly this purpose).

The institutional investors will screw it up, because they’re organizationally incapable of swimming upstream. Most of the financial advisors will screw it up, too, because they don’t really understand what they own in a bank loan fund and they tend to fixate on past performance data, which isn’t as relevant to the current environment. The distressed debt guys and gals will make a bunch of money for a few years picking through the shattered ruins of these deals. That, I admit, warms my heart. The distressed folks have had a rough go of it lately.

This whole dynamic is a great example of how investor psychology drives market cycles. To play off that tired old hockey analogy: investors don’t skate to where the puck is going, they skate toward the player who last handled the puck.

Here the puck is going to stressed/distressed debt.

It is most definitely not going to the moon.

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.

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.