A Man’s Got To Know His Limitations

Lieutenant Briggs: You just killed three police officers, Harry. And the only reason why I’m not gonna kill you, is because I’m gonna prosecute you–with your own system. It’ll be my word against yours. Who’s gonna believe you? You’re a killer, Harry. A maniac.

[Briggs starts to drive away when the car blows up]

Harry Callahan: A man’s got to know his limitations.

That’s the end of the 1973 movie Magnum Force. Briggs, a vigilante cop, has an opportunity to shoot Harry Callahan dead. But Briggs is an egomaniac convinced of his own moral superiority. He opts for a clever revenge scheme instead. He flees in a car, which, unbeknowst to him, has a live bomb in the backseat.

A man’s got to know his limitations.

I was moved to reflect on this after a recent due diligence trip. In investing, outcomes are inherently uncertain. We never have perfect information when making investment decisions. We’re lucky to have “good” information in most cases. Even then, unexpected events have a nasty habit of blowing up our plans.

Investing is an exercise in probabilistic thinking. Outcomes do not necessarily reflect the quality of decisions (good investment decisions often result in bad outcomes and vice versa).

When investing, you’ve got to know your limitations.

If you’re a typical outside minority passive investor, you have minimal control over investment outcomes. Basically, the only variable you can control is your own behavior.

You need to be realistic about what you can and can’t know, and the kinds of things you should and shouldn’t expect to get right. The more you can expect to get a decision right, the more time you should spend on that area. Don’t waste time on things that aren’t knowable, or things subject to lots of random noise.

 

Things I Will Never Get Right

Forecasts for prices and other variables. (This would seem obvious but it never ceases to amaze me how much time and energy is wasted here)

Timing, in the sense of trying to buy the bottom tick or sell the top tick.

Macroeconomics.

Intrinsic value. (It’s not observable)

 

Things I Should Get Right More Than Half The Time

The general quality of a given management team.

The general quality of a given business.

Industry dynamics, competitive forces and secular trends.

The potential range of outcomes for a given investment.

 

Things I Should Get Right Most Of The Time

The handful of key variables that will make or break an investment.

How I’ll know if I’m wrong about any of the key variables that will make or break an investment.

Assessing the major “go-to-zero” risks: leverage, liquidity, concentration, technological obsolescence and fraud.

When to average down, when to hold and when to sell out of an investment, not based on price action but on the key drivers and risks.

How To Win

One of my favorite bits of life advice comes from Mark Cuban. A couple of years ago, Business Insider wrote a brief piece on his view that surprisingly few people are willing to put in the effort to gain a knowledge advantage in their fields. I remember it to this day, because it is consistent with much of my experience in the working world.

“I remember going into customer meetings or talking to people in the industry and tossing out tidbits about software or hardware,” he writes. “Features that worked, bugs in the software. All things I had read. I expected the ongoing response of: ‘Oh yeah, I read that too in such-and-such.’ That’s not what happened. They hadn’t read it then, and they still haven’t started reading it.”

Cuban says that despite a minimal background in computers, he was outperforming so-called experts in the field simply because he put time and effort in. It’s why, he writes, he still allocates a chunk of his day to reading whatever he can to gain an edge in the businesses he’s involved in.

“Most people won’t put in the time to get a knowledge advantage,” he writes.

Another quote that sticks in my head along these lines (I don’t recall exactly where I heard this, and it’s possible I’ve fused a couple different quotes together):

“If you aren’t passionate about what you’re doing, don’t ever make the mistake of competing with someone who is. You will lose every time.”

Mental Model: Time Dilation

Time dilation is a consequence of relativity in physics. Put simply: individuals moving at different speeds perceive time differently. The most extreme example of this would be someone moving at the speed of light versus a stationary observer. For the person traveling at the speed of light, time measured from the point of view of the stationary observer would appear to have stopped.

Crazy, right?

Take a moment and allow that to sink in. It is pretty wild to think about. It took me two passes through A Brief History of Time before I felt like I had a decent handle on the concept.

Below is a fun animation to help illustrate.

Nonsymmetric_velocity_time_dilation
Time dilation illustrated. The motion inside each “clock” represents the perceived passage of time from the blue clock’s perspective. Source: Wikipedia

In financial markets, we experience our own form of time dilation. A high frequency trader experiences time differently than Warren Buffett. Here the relative velocity we are concerned with isn’t physical motion, but rather the velocity of activity in a portfolio of financial assets. The more you trade, the slower time moves for you.

Below are two charts for AAPL, one for the last trading day and one for a trailing 1-year period. All the price action depicted in the first chart is imperceptible on the second.

AAPL_1_Day
Source: Google
AAPL_1_Year
Source: Google

This idea of time dilation presents significant challenges for investment organizations.

The first challenge is the friction it creates between stated investment horizons and performance measurement. It is tough to manage money to a three or five-year horizon if your investors are measuring performance monthly. With that kind of mismatch, stuff that wouldn’t seem significant over three or five years starts to look significant (in a way, it is). And so you are tempted to “do stuff” to keep your investors happy.

While you should be focused on the “signal” from annual reports, you get bogged down in the “noise” of quarterly fluctuations in earnings. Or, god forbid, daily and weekly newsflow. Unless you are a proper trader, nothing good ever comes of focusing attention on daily and weekly newsflow.

Also, since people pay money for investment management, it is easy for them to mistake large volumes of activity for productive activity. Yet, just because you “do a lot of stuff” doesn’t mean your results will be any better. In fact, plenty of empirical evidence argues the opposite. The more “stuff” you do, the worse your results will be.

Here is an example of market time dilation from Professor Sanjay Bakshi. Years ago he executed a “very cool” arbitrage trade involving Bosch stock for a triple digit IRR. That’s an objectively fantastic result. And yet, Prof Bakshi readily admits to missing the forest for the trees. Why? He was operating on a different time horizon.

bakshi_bosch
Source: Professor Sanjay Bakshi

You can judge whether someone truly has a long term mindset based on how he feels about being “taken out” of a stock in a merger or buyout. Long-term thinkers don’t like to be taken out of their positions! They would rather compound capital at 20% annually for 30 years than have a 100% return in a single year.

They all explain this the same way: there aren’t that many businesses capable of compounding value at 20% annually for 30 years. When you find one you should own it in size. Selling it should be physically painful. Only phony long term thinkers are happy about getting taken out of good businesses.

Now, that’s certainly not the only way to make money in the markets. The trick isn’t so much finding “the best way” to make money as it is genuinely aligning your process with your time horizon. This is not a trivial thing. Particularly if you manage other people’s money.

Clear Thinking: Why Many Great Investors Are Also Great Writers

Morgan Housel observes:

Communicating and allocating capital are miles apart. Completely different topics. But look around, and the two are constantly paired.

Warren Buffett is a great writer. Paul Graham is a great writer. John Bogle is a great writer. Howard Marks is a great writer. Josh Brown is a great writer. Brent Beshore, Seth Klarman, Joel Greenblat, Ben Graham – the list goes on.

None of this is a coincidence. These aren’t just great investors who happen to be good communicators; their ability to communicate well helped make them great investors.

The post focuses on the importance of clear and effective client communication. However, I would argue that great investors often make for great writers because great investing and great writing both require clarity of thought. Parsimony is a beautiful thing.

In writing, the ultimate example of this is Hemingway’s “six word novel.” Here it is in its entirety:

For sale: baby shoes, never worn

Those six words evoke an entire lifetime of experiences and emotions. You could write a thousand page novel about the death of a child and you would struggle to make the impact of the six word Hemingway story. Why? The six word story contains only the most important parts. Your thousand page novel is going to contain all kinds of extraneous crap. And that extraneous crap dilutes the emotional impact of the most important parts.

Likewise in investing, you need clarity of thought to identify the key drivers of a situation. Most great investments hinge on two or three key drivers. Everything else is noise. You get lost in the noise at your peril. In Margin of Safety, Seth Klarman tells the story of an analyst who (badly) missed the forest for the trees on Clorox:

David Dreman recounts, “the story of an analyst so knowledgeable about Clorox that ‘he could recite bleach shares by brand in every small town in the Southwest and tell you the production levels of Clorox’s line number 2, plant number 3.’ But somehow, when the company began to develop massive problems, he missed the signs… .” The stock fell from a high of 53 to 11.

The analyst knew a lot of crap about Clorox. But he wasn’t thinking clearly. All that extraneous crap he knew about Clorox blinded him to what really mattered. So knowing all that crap about Clorox was irrelevant to the outcome.

Elsewhere, Charlie Munger has commented on how important clarity of thought is at Berkshire Hathaway:

Our ideas are so simple. People keep asking us for mysteries, but all we have are the most elementary ideas.

I have this pet theory that you should be able to go through a portfolio and summarize every single investment thesis (as a falsifiable statement, of course!) in just a couple of lines. If there are things you can’t do that for, you probably shouldn’t own them.

“The Last, Best Order”

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.

A Mental Model For Politics

Politics is the process by which tribal groups negotiate the distribution of power and resources in a society. A tribal group may identify strongly with a particular philosophy. However, conflating politics with philosophy (“values”) is a muddy way of viewing the underlying drivers of political conflict. It took me a long time (about 15 years) to realize this.

I now realize there are two dimensions to tribal politics:

  • The competitive dimension (the political process itself). This is essentially a strategy game. Because it is a strategy game, effective political operatives (Lee Atwater) needn’t actually concern themselves with “correct” policy or philosophy. Their role is simply to “win”–that is, secure power and resources for the tribal group they serve.
  • The philosophical dimension (the inner lives of tribal group members). This is the process by which tribal group members construct their identities, bond with one another and develop a shared vision of how power and resources should be allocated across society. Tribal group members may or may not develop their identities through a rigorous process of reasoning from first principles. That depends largely on the mental complexity of each individual.

Thus, mental complexity is a key input to this model:

  • Socialized minds simply adopt an identity consistent with their surroundings.
  • Self-authoring minds go a step further and build their own identity.
  • Self-transforming minds go a step even further and work to develop a meta-understanding of tribal group dynamics, in order to integrate that into a more “complete” mental model of how the world works.

To make that more concrete:

  • The socialized mind says: “Everyone in my town and my workplace supports Political Party A. Political Party A is the place to be. I am A.”
  • The self-authoring mind says: “I identify with aspects of Political Party A, but also Political Party B. Furthermore, I believe in X, Y and Z based on my education, life experience and vision for what I want to achieve in life. I combine these inputs to formulate my own identity, views and goals. I am a C.”
  • The self-transforming mind says: “I am a C, but it is possible (in fact likely) that my views as a C are incomplete, inaccurate, or oversimplified. I must leave room to modify these views over time. Over the years I will likely transform from a C to a D, to an E, and so on as I constantly integrate new learnings into my mental model of the world.”

Morgan Housel provides a good example of how a self-transforming mind views tribal politics:

Everyone belongs to a tribe and underestimates how influential that tribe is on their thinking. There is little correlation between climate change denial and scientific literacy. But there is a strong correlation between climate change denial and political affiliation. That’s an extreme example, but everyone has views persuaded by identity over pure analysis. There’s four parts to this:

  • Tribes are everywhere: Countries, states, parties, companies, industries, departments, investment styles, economic philosophies, religions, families, schools, majors, credentials, Twitter communities.
  • People are drawn to tribes because there’s comfort in knowing others understand your background and goals.
  • Tribes reduce the ability to challenge ideas or diversify your views because no one wants to lose support of the tribe.
  • Tribes are as self-interested as people, encouraging ideas and narratives that promote their survival. But they’re exponentially more influential than any single person. So tribes are very effective at promoting views that aren’t analytical or rational, and people loyal to their tribes are very poor at realizing it.

Psychologist Geoffrey Cohen once showed Democratic voters supported Republican proposals when they were attributed to fellow Democrats more than they supported Democratic proposals attributed to Republicans (and the opposite for Republican voters). This kind of stuff happens everywhere, in every field, if you look for it.

It should be obvious by now why most political debates among individuals go nowhere:

  • Most individuals debating politics do not clearly distinguish between the strategy game dimension and the philosophical dimension. This is important. A genuine philosophical debate is a complex and mentally taxing endeavor requiring concentration and a high level of openness. The goal of a philosophical debate is to pursue Truth, not to “win.” What we call political “debate” is almost always strategy and tactics masquerading as philosophy.
  • Socialized minds are simply not capable of engaging in genuine philosophical debate. They do not possess the requisite level of mental complexity (though they certainly can develop it). You will never change a socialized mind with evidence and argument. You need look no further than the comments section of a website for evidence of this.
  • Self-authoring minds are more than capable of engaging in lively philosophical debate. However, they tend to grasp their mental models rather tightly (after all, these are intelligent, highly motivated individuals we are talking about). This can be perceived as either stubborn, obnoxious or even courageous, depending on the observer. As mentioned above, genuine philosophical debate is exhausting. Most people do not want to put the energy into engaging in genuine philosophical debate. Don’t waste your time trying to debate political philosophy with people who aren’t interested in working hard at the process!
  • From a distance, self-transforming minds can seem devoid of logical consistency. This is especially true from the perspective of a socialized mind, for which maintaining an identity consistent with the tribal group is of paramount importance. This is because self-transforming minds are explicitly aware not only of the need to develop mental models, but of the need to adjust them. This can make it difficult for them to relate to the more static worldviews of self-authoring and socialized minds (and vice versa). Others may view a self-transforming mind as an untrustworthy waffler.

To conclude, here is a little checklist for thinking about politics:

  • Be explicit about the dimension you are analyzing:
    • Strategic Dimension?
    • Philosophical Dimension?
  • When analyzing the strategic dimension, do not conflate “values” with strategy and tactics. This will allow you to reason more clearly.
  • If you are analyzing the philosophical dimension, account for mental complexity.
  • If you are involved in a political discussion, try to understand the level of mental complexity the other part(ies) are operating at. This will lead to richer, more fulfilling conversations. On the other end of the spectrum, it will clue you in on when it might make sense to simply disengage.
  • If you want to do deep, truthful, political analysis, you need to integrate both the strategic and philosophical dimensions.

First Principles

I have three great posts I would like to share. All deal with the subject of mental models and reasoning from first principles:

“Speculation In A Truth Chamber” (Philosophical Economics)

First, the idea behind the exercise is not for you to literally walk through it, in full detail, every time you are confronted with a question that you want to think more truthfully about. Rather, the idea is simply for you to use it to get a sense of what it feels like to be genuinely truthful about something, to genuinely try to describe something correctly, as it is, without pretenses or ulterior motivations. If you know what that state of mind feels like, if you are familiar with it, then you will be able to stop and return yourself to it as needed in your trading and investment deliberations and in your everyday life, without having to actually step through the details of the scenario.

Second, the exercise is intended to be used in situations where you actually want to get yourself to think more truthfully about a topic and where you would stand to actually benefit from doing so. Crucially, that situation does not describe all situations in life, or even most situations. There are many situations in life where extreme truthfulness can be counterproductive, creating unnecessary problems both for you and for others.

Third, all that the exercise can tell you is what you believe the most likely answer to a question is, along with your level of confidence in that belief. It cannot tell you whether you are actually correct in having that belief. You might believe that the answer to a question is X when it’s in fact Y; you might have a lot of confidence in your belief when you should only have a little. Your understanding of the subject matter could be mistaken. You could lack the needed familiarity or experience with it to have a reliable opinion. Your judgment could be distorted by cognitive biases. These are always possibilities, and the exercise cannot protect you from them. However, what it can do is make you more careful and humble as a thinker, more open to looking inward and assessing the strength and reliability of your evidence and your reasoning processes, more willing to update your priors in the face of new information–all of which will increase your odds of getting things right.

Thinking From First Principles” (Safal Niveshak)

Practicing first principles thinking is not as easy as explaining it. As Musk said, it’s mentally taxing. Thinking from first principles is devilishly hard to practice.

The first part, i.e., deconstruction, demands asking intelligent questions and having a deep understanding of the fundamental principles from various fields. And that’s why building a latticework of mental models is so important. These mental models are the fundamental principles, the big ideas, from different fields of human knowledge.

The best way to achieve wisdom, said Charlie Munger, “is to learn the big ideas that underlie reality.”

The second step is the recombination of the pieces which were identified in the first step. This is again a skill which can only be developed by deliberate practice. Any idea as an isolated piece of information doesn’t stay in the human brain for long. To be sticky, it needs to be connected with other ideas. A latticework is essentially a grid of ideas connected to each other. These connections are the glue which holds those ideas together.

If the new knowledge doesn’t find any connection or relevance to the old knowledge, it will soon be forgotten. New ideas can’t just be “stored” like files in a cabinet. They have to connect with what’s already there like pieces of a jigsaw puzzle. As you become better in finding connections between seemingly disconnected ideas, your recombination-muscle becomes stronger. Someone with a strong recombination-muscle will find it easy to practice the second step of first principles thinking.

“Playing Socratic Solitaire” (Fundoo Professor)

I am going to play a game based on ideas derived from Socrates and Charlie Munger. We will start with “Socratic Questioning” which is described as

disciplined questioning that can be used to pursue thought in many directions and for many purposes, including: to explore complex ideas, to get to the truth of things, to open up issues and problems, to uncover assumptions, to analyze concepts, to distinguish what we know from what we don’t know, to follow out logical implications of thought, or to control the discussion.

Socratic Questioning relates to “Socratic Method,” which is:

a form of inquiry and debate between individuals with opposing viewpoints based on asking and answering questions to stimulate critical thinking and to illuminate ideas.

Charlie Munger started using these two Socratic devices in a variation he called Socratic Solitaire, because, instead of a dialogue with someone else, his method involves solitary play.

Munger used to display Socratic Solitaire at shareholder meetings of Wesco Corporation. He would start by asking a series of questions. Then he would answer them himself. Back and forth. Question and Answer. He would do this for a while. And he would enthral the audience by displaying the breadth and the depth of his multidisciplinary mind.

I am going to play this game. Or at least, I am going to try. Watch me play.

If you are seriously interested in finance and investing, there is nothing more important to your development than accumulating a robust inventory of mental models. What mental models and reasoning from first principles allow you to do is see through to the true drivers of a situation, where it is often easy to get bogged down in unimportant details.

For example, if you are viewing a business through the lens of discounted cash flow valuation, here are the drivers of intrinsic value:

  • Operating margin
  • Asset turnover
  • Maintenance capex needs
  • Growth capex/reinvestment opportunities
  • Discount rate

Operating margin and asset turnover are quantitative measures reflecting the strength of your competitive advantage and, perhaps more importantly, the source of your competitive advantage.

Maintenance capex tells you how much cash the business needs to spend to keep running.

Growth capex/reinvestment opportunities give you an idea of growth potential over time.

When you combine operating margins and asset turnover (technically NOPAT x Sales/Invested Capital) you get a figure for return on capital. Return on capital is an excellent quantitative proxy for management’s skill allocating capital. Thus, it is also an excellent proxy for quality of management (though it is certainly not a be-all, end-all measure). When you combine return on capital with reinvestment opportunities you get an idea of what sustainable growth in operating income might look like.

There are lots of ways to handle the discount rate. Over time I have come to prefer an implied IRR method, where you simply “solve for” the discount rate that sets your cash flow model equal to the current stock price. You can then compare this to your hurdle rate for new investments.

DCF is one of the most important models in finance because it works with any investment that produces (or is expected to produce) cash flows in the future. At the end of the day, even an exercise as complicated as valuing a mortgage-backed security is just a variation on discounting cash flows.

All great mental models have two defining characteristics:

(1) They are robust. That is, they are applicable to a broad set of opportunities.

(2) They are parsimonious. That is, that is they demonstrate “economy of explanation.”

In my humble opinion, the most important mental models you need to understand in investing are:

  • Time Value of Money/Discounted Cash Flows
  • Capital Structure
  • Expected Value/Probabilistic Thinking
  • Optionality
  • Convexity/Linear Vs. Non-Linear Rates Of Change (e.g. compounding)
  • Investor Psychology

Conceptually that is really what it all boils down to (though the permutations are endless–for instance, a mortgage can be viewed as the combination of discounted cash flows and a call option). Now, you could of course write dozens of volumes on the nuances and applications of each of these models. That is part of what makes them robust. They are adaptable to an almost inconceivable range of circumstances.

This is something I don’t think most candidates in the CFA Program think about (they are too preoccupied with passing the exams!). The curriculum is designed to comprehensively introduce you to the most robust mental models in finance, and then to test your ability to apply those models to specific cases. Level I tests whether you understand the basic “tools” you have available to you; Level II tests more advanced uses of those tools (in exhausting detail, one might add); Level III tests your ability to apply all your tools to “real world” situations.

Maybe some day I will write up how I think about these super important mental models. In the meantime, enjoy the above linked posts!