Pascal’s Wager – For Richer, For Poorer

My Grandmother's Lottery

My grandmother, on being told by a friend that if they won the lottery they wouldn’t know what to do with the money, was affronted: “Don't be stupid”, she said, “I’d spend half going down one side of Main Street and the other half going up the other side”. Unfortunately, in the real world, we need to keep an eye on the both sides of the equation – is it worth taking the chance of becoming rich if the downside means being poor?

Blaise Pascal, in another context, tried to answer this question five hundred years ago. Admittedly, in a sign of our changing times, he was less concerned about his terrestrial wealth than his immortal soul. Nonetheless, his argument – forever encapsulated as “Pascal’s Wager” – can just as effectively be applied to the arguments for and against a balanced investment approach.

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Markowitz’s Portfolio Theory and the Efficient Frontier

Managing Risk

You’d have thought that the management of risk in respect of stockmarket investment would have a long and reputable history. After all, the very idea of a share is all about allowing individuals to spread their capital and risks across multiple, partial investments.

This is not so, stockmarket risk management only really started with Harry Markowitz’s seminal paper Portfolio Selection in 1952. Typically the industry then ignored his ideas for twenty years before belatedly getting around to using them for, well, everything. And then some, leading eventually to the invention of the index tracker.

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Gaming the System

Bankers and Politicians

Using the rules of any system for personal gain is, in the parlance, “Gaming the System”. We’ve seen a lot of this recently. Not only have a variety of financial executives and employees absconded with bonuses for profits that turned out to be illusory but here in the UK the whole political system has been rocked by revelations of the extent to which our elected politicians have been using their expenses system as a personal cash machine.

Charlie Munger states that the people who design easily gameable systems belong in the lowest circle of hell. However, the reason why this happens is rooted very deeply in human psychology and causes all sorts of effects that are bad for us as societies. Those people who invent mechanisms that prevent systems being gamed do us all a favour, and this matters hugely to investors.

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The Psychology of Scams

Gullible Brits, Smart Scammers

The UK’s Office of Fair Trading (OFT), an arm of government concerned with stopping consumers being ripped off, has just published a study into The Psychology of Scams looking at why 3.2 million adult Brits manage to lose £3.5 billon ($5.4 billion) to scammers each year. The fact that they’re looking into the psychological reasons that the victims throw their money away, with a view to stopping them from doing so, suggests an enlightened view in the British civil service that hadn’t been previously noticeable.

Some of the results are really interesting. It seems you’re more likely to fall victim to a scam if you think about it or, if you’ve previous knowledge in the area that the scam’s targeting, you’re likely to suffer from overconfidence in your ability to detect a problem. So are we all potential victims?

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The End of the Age of Retirement

Bismarck’s Pension Policy

In 1889 Otto von Bismarck’s German government introduced the first old age pension scheme providing retirement benefits to people over 70, later reduced to 65. The aim of this wasn’t to provide a deserved holiday for old folks at the end of their lives but to ensure a safety net for those made incapable of working by the disabilities of extreme age. At the time the average Prussian lived to 45.

Since then, while lifespans have increased and the likelihood of illness in early retirement has declined, the retirement age hasn’t changed. In the developed world, where the most generous pension entitlements are offered, bitter demographic reality will soon see the end of the Age of Retirement: the idea that people stopped work and had a holiday before they died will one day seem like a curious feature of our peculiar times.

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Correlation is not Causality (and is often Spurious)

Portfolio Theory

Correlation’s a powerful tool in stockmarket investment, because it allows investors to identify assets whose price tends not to move in the same direction at the same time. The branch of the Efficient Market Hypothesis labelled “Portfolio Theory” shows that by selecting groups of uncorrelated stocks it’s possible to create portfolios with lower levels of volatility than the individual stocks themselves.

The same is true of different asset classes – you can create a portfolio of these to provide a defence against any particular asset suffering a nasty fall. This has usually proven to be really useful, right up to the point it was actually needed.

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Copper at Morewellham Quay

Victorian Copper

As you gaze around the tiny Devon hamlet of Morwellham Quay, fifteen miles up the River Tamar, deep in an area of outstanding natural beauty, it’s hard to imagine you’re standing at the gateway to the biggest copper mine in Queen Victoria's far flung empire. By 1850 Morwellham Quay was a more important port than Liverpool yet within a few decades the port was subsiding into ruin, from which it’s only now re-emerging as an industrial archaeology site and post-industrial tourist attraction.

Once this leafy backwater was a blasted and desolate wilderness – the pollution generated by the multiple mines along the Tamar turning what is now a green, leafy beauty spot into a Hell on Earth. All because of the most precious base metal of them all, copper.

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Fairy Tales for Investors

Storytelling and Stocks

Once upon a time there was a wonderful company with a magic formula which kept on growing forever and ever. Or so we’d like to believe.

The world we live in is saturated with stories for good reason – they're the prism through which we make sense of our lives. Stories, however, aren’t necessarily real and the ones we're told about stocks are as likely to be fiction as fact. Understanding the difference is critical if investors aren’t going to spend their lives as the stockpicking equivalent of Alice in Wonderland.

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Overconfidence and Over Optimism

Behavioural Biases (1): Overconfidence and Over Optimism

Most of us are way too confident about our ability to foresee the future and overwhelmingly too optimistic in our forecasts. This finding holds across all disciplines, for both professionals and non-professionals with the exceptions of weather forecasters and horse handicappers.

To add the problems it also turns out that the executives running the companies we invest in so hopefully suffer from the same problems. Overconfident, over optimistic investors investing in companies run by overconfident, over optimistic executives. What could possibly go wrong?

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Investing Like Berkshire Hathaway

Running the Quality Check

So how do we explain The Buffet Munger Paradox? It’s perfectly clear that the gentlemen in question don’t have a problem, but how does Buffett’s demented focus tie in with Munger’s breathtaking scope?

The answer’s simple, of course. Munger’s mental models are the framework upon which Buffett’s ideas are arrayed. Munger’s the quality check on Buffett’s biggest adventures.

Great Businesses at Good Prices

Buffett often says: We prefer to buy great businesses at fair prices than good businesses at low prices. This wasn’t always the case – indeed most of the Buffett Partnership’s investments were often in very poor businesses trading at exceptionally cheap prices – classic Ben Graham type heavy discount to net asset plays. Buffett’s change of focus was coincident with the start of the second phase of his career, as he started to build the web of businesses that led to the Berkshire Hathaway consortium he presides over today.

It seems highly unlikely that Buffett’s investing style changed entirely of its own accord. Warren Buffett is, and always has been, very much his own man but the influence of Munger’s broad based approach can be seen across all of Berkshire’s long term investments both partially and wholly owned.

Earnings not Capital

What Berkshire do is simple to analyse, largely because both Buffett and Munger tell everyone. Yet almost no one can do what they do. They’re contrarians on a grand scale, but their focus is on long term investment because they don’t view companies as pools of capital, to be traded. Berkshire is not, in general, investing for short-term capital gain.

What Berkshire does, and the Buffett Partnership never did, is treat companies as long-term earnings streams. In this model the capital doesn’t matter, because Berkshire never intends to flip its investments. However, to make this model work the companies that Berkshire invests in need to have a bunch of very specific qualities – it’s not enough to buy an average company at a low price because that will never generate the long-term earnings needed to make their model work.

The Four Point Investor’s Checklist

Buffett told us this back in the 2007 Letter to Berkshire Hathaway shareholders:

Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag. We like to buy the whole business or, if management is our partner, at least 80%. When control-type purchases of quality aren’t available, though, we are also happy to simply buy small portions of great businesses by way of stockmarket purchases.

Understand that statement and you’ve found the heart of the Buffett Munger paradox. These four qualities are all that Berkshire needs to make its long term earnings stream model work:

a) A business we understand. Don’t confuse this with the nuts and bolts of the businesses they own – this is about understanding the financials and business models. That’s where they add value – they’re managers of capital, not operating companies.

b) Favourable long-term economics. It’s all about the moat. It’s about finding businesses that have a sustainable business advantage that can’t be easily overcome by competitors.

c) Able and trustworthy management. Obvious, one hopes. Not so easy to do for private investors.

d) A sensible price tag. Sensible, not necessarily cheap but one that will provide good returns to shareholders if held over a long enough period.

Buying companies with these characteristics allows Berkshire to invest in companies whose earnings – profits – will reliably increase at an above inflation level over many, many years. Which means that it can ignore short-term issues and focus purely on making sure that the other piece are in place.

Analysing Buffett and Synthesising Munger

It’s easy to see that Buffett’s ruthless pursuit of a financial margin of error ties in beautifully with Munger’s broad based synthesis of ideas to cross-check investment proposals. It’s not just that the businesses need to be good, it’s that they need to offer sustainable long-term business advantages and checking that requires a wide range of mental models, because a single one isn’t going to do the job under all circumstances.

Consider the different types of business and circumstances that Berkshire’s invested in. Wells Fargo was originally bought during the Savings & Loan crisis in the 1990’s. Buffett’s analysis was the margin of safety was sufficient to protect Wells against the worst of the downturn (it was, barely). However, it’s the broader analysis that identified the bank’s management and processes as offering long-term competitive advantages. Buffett bought more of Wells Fargo last year, of course. American Express was another crisis investment, Washington Post was bought at a huge discount to net assets and Coca Cola bought opportunistically at moments of peak investment fear.

In their partnership Warren Buffett is very much the senior partner, with effectively a controlling stake in Berkshire. Some of the company’s more risky investments look very much as though Buffett pulled the trigger – Salomon Brothers and GEICO, for instance. Typically the company escaped with a decent return because of Buffett’s relentless focus on margin of safety, but it’s sometimes been a close run thing.

Share Price is Not .. So .. Important

Let’s return to the 2007 shareholder letter:

I should emphasize that we do not measure the progress of our investments by what their market prices do during any given year. Rather, we evaluate their performance by the two methods we apply to the businesses we own. The first test is improvement in earnings, with our making due allowance for industry conditions. The second test, more subjective, is whether their “moats” – a metaphor for the superiorities they possess that make life difficult for their competitors – have widened during the year.

Share price is not important, sustainable earnings are. In a market environment such as we have today that ought to be writ large through every investor’s heart. Buffet even tells us how to go about looking for the good companies:

To sum up, think of three types of “savings accounts.” The great one pays an extraordinarily high interest rate that will rise as the years pass. The good one pays an attractive rate of interest that will be earned also on deposits that are added. Finally, the gruesome account both pays an inadequate interest rate and requires you to keep adding money at those disappointing returns.

By “adding money” here Buffett means that the managers of your company have to keep re-investing your earnings at an increasing rate to stay still, rather having you shovelling new money at the business. Ironically “gruesome” was exactly the type of business that the original textiles based Berkshire Hathaway was. It’s interesting that they kept it going despite its poor return on capital until it could no longer maintain even a pretence of profitability: there’s more to Buffett and Munger than money, there’s humanity too.

Savers or Speculators?

So to be successful ultimately you only need to avoid the last kind of business as long as you don’t let share prices jerk you into buying and selling all the time. The last word, as ever, should go to Buffett himself (from the 1999 shareholder’s letter):

If you expect to be a net saver during the next 5 years, should you hope for a higher or lower stock market during that period?”Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall.”This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.

Hallelujah to that.


 


Related Posts: The Buffet-Munger Paradox, Is Intrinsic Value Real?

Contrarianism

Don’t Drive The Wrong Way Up One-Way Streets

We often hear that it pays an investor to be contrarian but, in reality, what does that mean? Running against the herd is, in the real world, usually a desperately stupid thing to do – driving the wrong way up one way streets or wagering blindly against the odds on horseracing are not strategies that should recommend themselves to any even half-way rational person.

So if contrarianism doesn’t simply mean doing the opposite of what everyone else does but is, somehow, the key to successful investing, what is it? What’s the magic formula that tells us when we should and when we shouldn’t bet against the markets?

Beware, Faulty EMH Ahoy

Contrarianism is, in itself, an assumption that the Efficient Markets Hypothesis (EMH) doesn’t work. In reality most investors implicitly accept this, even while the majority of our academic institutions continue to operate as though it’s a natural law. It’s like teaching our kids that Creationism is correct while the professors work on gene therapy.

Just because EMH is faulty, though, doesn’t mean it’s easy to exploit it. Firstly markets do behave normally (in both statistical and common parlance) most of the time. Inefficiencies are either arbitraged away or are fundamentally difficult to exploit for smaller retail investors. In such times there isn’t much money to be made being contrary at a gross market level. Quite the opposite.

Secondly, when markets do go badly awry it’s usually because of some kind of crisis, the outcome of which isn’t easily predictable. These are the points at which expectations become divorced from fundamentals because it’s very difficult to know what the latter are. The trick, if you’re a contrarian, is to pick these points and then set yourself a sufficient margin of safety as markets overreact.

The Wisdom of Crowds

That markets do overreact tells us something interesting about the nature of humans: it suggests that somehow collective human rationality is being overcome by group effects. It also runs contrary to one of the fundamental tenets of EMH – that humans are not rational but because they act independently their irrationality cancels out.

Well, it’s perfectly obvious – given that markets do exhibit inefficiencies, and sometimes for quite a long time – that this assumption must be flawed. The question is why is it flawed and how does this help us become better, contrarian, investors?

This assumption of irrationality being cancelled out underpins the concept of the Wisdom of Crowds, so smartly summarised by James Surowiecki in his eponymous book. The phenomenon was first noted by Frederick Galton back at the beginning of the twentieth century and essentially suggests that as long as people act independently of each other the sum of their guesses can produce a better result than any individual guess – aka the EMH.

Counterintuitive this may be, but it seems to be broadly correct. The key is that the individuals must genuinely be acting independently. Dependencies may be hidden – so, for instance, asking an indigenous population for their views on immigration won’t yield an independent result in a blind vote because voters will already have shared views based on a whole variety of social factors.

(Although, interestingly, research suggests that the type of immigrants you’ll be against will depend on your own economic self-interest.)

Complex Emergent Systems

In stockmarkets, of course, we don’t have a blind vote. The prices of shares indicate the current state of investor belief and we often find examples where shares have been marked up or down to an extent that doesn’t seem to make sense unless there’s some inside knowledge at work or investors are being driven by group effects.

The shape of these behaviours is similar to the type of outcomes seen in a class of systems known as complex adaptive systems. In these the outcomes – the behaviours – are “emergent” and arise out of the interactions between the various agents acting within the system. The agents in the stockmarket are, of course, the humans and the interactions are all of those numerous information flows between us. Everything from tipsheets to bulletin boards to analyst recommendations and even share prices themselves.

Emergent systems are brutally complex – you can’t understand them by the classic process of reductionism, breaking everything down into its constituent parts. Ask any human what’s happening in the markets and they’ll basically have no idea (although virtually every investor will have an opinion) yet the overall market behaviour emerges from the interactions between the human investors.

Contrarianism and Timing

If you accept that modelling stockmarkets based on complex adaptive systems seems to make sense then the next step is to figure out when it pays to be a contrarian. Clearly most of the time markets – at the gross level – are fairly efficient. Yet sometimes they’re not – the output of the adaptive system goes awry. So what’s happening?

It’s the idea that underpins the Wisdom of Crowds that’s being violated – investors stop behaving independently and irrationally and start behaving dependently and irrationally. It’s not the irrationality that’s the problem, but the interdependence. Can this happen? You’d better believe it.

Social psychology is full of examples showing individuals aligning their responses with the group even when the group’s view is clearly wrong going back to the Asch conformity experiments in the 1950’s. We have a powerful inclination to want to be part of a group – for good evolutionary reasons since being part of a group, no matter how stupid, misguided and irrational, provides us better protection than being correct, lonely and likely to be eaten by the next hungry carnivore that happens along.

Peak Fear and Greed

Unfortunately being contrarian at the market level is awfully difficult. When these periodic breakdowns in market efficiency occur the group effects will be at their maximum. You’re looking at moments of peak greed and fear, the very points at which herd behaviour is the most rational for socially organised creatures in a dangerous environment.

A second problem, which dogs the professional investment industry in particular but which is also an issue for individual investors, is that contrarianism, even when correct, takes time to work. Rationality doesn’t reassert itself overnight and markets can, as Keynes is famously misquoted as saying, “stay irrational longer than investors can stay solvent”.

The fund management industry faces real issues with this. Fund managers have a short-term need to generate fees, which mitigates against taking a longer term approach to generate better fund returns. They’re also incentivised to be successful in the short-term, with both bonuses and their jobs on the line. In such an environment it’s hard to see how fund managers can be contrarian.

For individual investors the problem is being able to divorce themselves from the social group effects sufficiently to be able to take advantage of market breaks. It’s also all too easy to get sucked into the idea that going against the market is good for its own sake. It’s not, it’s dangerous. A stock may be cheap because it’s fallen a long way, but it may not be – a stock that’s fallen 99% can still fall another 100%.

Go Long Term, Contrarian or Not

Deciding when markets are being irrational is, in part, a judgement call and in part down to detailed analysis. Even when markets are in their normal, nearly rational mode, longer term contrarian investing opportunities will arise with specific companies, usually smaller ones. This is the normal warp and weft of value investing which you don’t get right without proper fundamental analysis and a judgement about a margin of safety.

The alternative to contrarianism is, of course, to simply ignore short-term oscillations in the market and to invest through thick and thin. Regular drip feeding into passive funds will, in fact, capture some outperformance due to the larger stakes bought while markets are unduly pessimistic – although this advantage will partially be removed by also buying at overly optimistic times. Still, it’s a simple strategy if you don’t want to risk your mortal sole on being contrarian.


Related Posts: Don’t Give Index Trackers The Bird, Alpha and Beta: Beware Gift Bearing Greeks, Darwin’s Stockmarkets, Is Intrinsic Value Real?

Seven Psychological Quirks That Destroy Investment Returns

Posted over on www.monevator.com with thanks to The Investor. I recommend having a good browse around.

I’ll soon be starting a more detailed investigation into behavioural biases in dealing with a negative sum market, starting with: Behavioural Biases (1): Overconfidence and Over Optimism


Related Posts: Newton’s Financial Crisis