Nobody really knows exactly what is going to happen

Despite my forecasts, I don’t know exactly what’s going to happen. And, neither does anyone else.

When I make forecasts about the future, they are mere probabilities–usually what I consider to be the highest probability outcome.

But, a probability is not the same as certainty.

In fact, a low probability event, like 9/11, can potentially blow all high probability outcomes out of the water!

It’s important to acknowledge what I don’t know, and the degree of uncertainty in any situation.

When I make investments, I don’t know with certainty the outcome. In fact, the best I can do is assign probabilities to several outcomes and then take action based on such assessments.

But, investing is fraught with uncertainty. The economy is too complex for any one person to know exactly what will happen.

The way to make money over time is to formulate probabilities and outcomes with enough accuracy to get things generally right. That’s all it takes, but it’s not easy.

The economy appears to be entering a recession. I think that is a high probability at this point, but that doesn’t mean it’s certain.

I think that if we enter a recession, there is a high probability the stock market will end up down much further than it is now. Once again, my high probability assessment–not certainty.

I acknowledge that I don’t know what will happen, and have invested accordingly. My goal is to make good returns regardless of whether or not we enter a recession. I’ve picked investments that I have assessed to be good for the long run. That’s the best anyone can do.

Those who just guess and bet big don’t remain in the game for long, unless they get blind lucky.

Stick to long term thinking, prepare for the worst and hope for the best, invest so that you’ll do well regardless of short term outcomes, and you’ll do just fine.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

My latest client letter is available

For those of you interested, my latest client letter just came out today.

In it, I discuss client account performance, my projections for the market over the next 6 years and my opinion on the economy, Part III of my assembling portfolios segment dealing with investment probabilities, an investment spotlight on Microsoft, a segment on why the subprime mortgage market impacted equity markets, and my section on admirable business people covering Benjamin Graham–the father of value investing.

If you get a chance to read it, please tell me what you think and what could be improved.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

“Reasoning correctly from erroneous premises”

The quote above is from John Locke, but I found it second hand from Nassim Taleb’s The Black Swan. Supposedly, it’s Locke’s definition of a madman.

In my opinion, this quote accurately describes the state of the art in academic finance and economics.

Although it may be hard to believe, the Nobel prize has been given out repeatedly to very smart people who are exemplars of the above quote.

As a result, the field of finance, economics and investing is populated with folks who seem to unquestioningly follow such teachings.

That’s why most people are over-diversified and think risk equals volatility. The result is that most investors are under-protected from low probability, high impact, negative events and over-protected from low probability, high impact, positive events.

When a couple of Nobel laureates who exemplify the quote above followed their own advice, they lost almost all of their investors’ money and nearly caused a temporary collapse in the world’s financial system (if you think I’m exaggerating, read When Genius Failed by Roger Lowenstein).

Despite this paradigm shifting result, most market participants go right on assuming that erroneous premises can be followed with rigorously correct reasoning (and lots of higher math and Greek symbols).

Which reminds me of an apt definition of insanity: “doing the same thing over and over again and expecting different results” (Albert Einstein).

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Black Swan

I have another excellent book to recommend: Nassim Taleb’s Black Swan (Taleb also wrote another favorite: Fooled by Randomness)

The book deals with a subject I’m always thinking about, the impact of improbable events. Taleb is an trader who seems to have made a career out of betting that improbable events may happen more frequently than most people predict, so he knows of what he speaks.

Taleb describes two countries, Mediocristan and Extremistan, which have very different characteristics. In Mediocristan, everything follows a bell shaped curve and is relatively easy to predict. He gives the example of the income of dentists, which tend to fall around an average and not vary too far from it. In Extremistan, however, things don’t follow a bell shaped curve and are almost impossible to predict. He gives the example of authors whose incomes are either extremely high (for very few) or extremely low (for the vast majority).

The reason he highlights this difference is a lot of people, especially academics in economics and finance, tend to assume that we live in Mediocristan even though we live in a world that resembles both Mediocristan and Extremistan. The height of people and the income of dentists are bell shaped, financial markets and the income of authors are not. The problem is that highly improbable events can easily overwhelm the highly probable events that most people focus on.

His point is important to acknowledge, because if you are measuring the height of people, bell shaped curves are great. But, if you are operating in financial markets, using bell shaped curves can be very dangerous (just ask the Nobel prize winners who worked with Long Term Capital Management).

I’m finding the book a pleasure to read because the subject matter is fascinating and relevant, and because I really enjoy his style of writing, which is laced with stories, examples and no punches pulled. Sometimes, he seems to be a bit arrogant in his way of describing things, but I’m usually more amused than offended by this.

I highly recommend the book to anyone operating in Extremistan for a living.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

What separates good investors from great investors

Michael Mauboussin, from Legg Mason, recently released a great article about the difference between good and great investors.

The first issue he highlights is that great investors avoid being destroyed by high impact, rare events. For example, many value investors avoided investing in dot-com stocks during the late 90’s and looked liked fools until the market tanked between 2000-2002. Great investors aren’t great because they can predict such events, but because they have learned to avoid them.

The second issue he highlights is that great investors have the right temperament. By this, he means they don’t get sucked into the psychological traps that most people get sucked into.

For example, most people feel the pain of losses (loss aversion) so much more than the pleasure from gains that they make bad choices. What if I offered you a game where you had a 95% (19 out of 20) chance of losing $5 and a 5% (1 out of 20) chance of making $100, would you play? Would you play if you could play it an unlimited number of times? Most people wouldn’t play this game because they would feel the pain of losing more than the benefit of gaining, even though they would make money with no effort as long as they kept playing the game. Great investors understand this math and would play.

Great investors also understand the difference between probability and impact. In the example above, you have a high probability of losing, but when you win it has a very high positive impact. Most people over-emphasize the probability and under-emphasize the impact. Great investors understand the difference and play accordingly.

Great investors also grasp the randomness of any game they play. Short term results in the stock market are so random that someone with little skill can get wonderful returns over short periods of time (like a day, month, year or even 3 years). Only over the long term can you see who has skill. Great investors get this and judge their investing options over the appropriate time horizon.

Mauboussin concludes his article by pointing out that high impact, rare events, loss aversion, probability and impact, and randomness requires great investors to focus on 3 things: process versus results, a constant search for favorable odds while recognizing risks, and an understanding of the role of time.

Investors who follow this advice and can act on it have the potential of being great instead of merely good or even bad investors.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

A bird in the hand is worth two in the bush

I listened to an interesting lecture last week on behavioral finance by Mier Statman. He presented an interesting question that really has me thinking.

Behavioral finance is a specialized field that studies how people make human choices when it comes to financial issues. You see, economists have theorized a “rational man” that makes choices based on pure reason, without any real emotion. Most economists use this “rational man” to figure out how the economy works. Unfortunately, for the economists, real people just don’t act that way.

The example Mier Statman gave, offhandedly, in his lecture was this: if you were given the choice between $1 million guaranteed or a 50% chance for $3 million, which would you choose?

According to economic theory, “rational man” would calculated the expected value of the two options and pick the larger one. Or, 100% chance of $1 million is less than 50% chance of $3 million (or an expected value of $1.5 million), so you should choose the second option.

Usually, I scoff at such examples because I almost always pick the “rational man” option, and pity the poor mortals who can’t aspire to be “rational man.” But, in this case, I quickly chose the guaranteed $1 million. “You mean, I’m mortal!” I seemed to think.

Even after thinking about it a bit, I still would chose the guaranteed $1 million. Why? Because $1 million would really make a big difference in my life, and I wouldn’t want a 50% chance of ending up with nothing.

After thinking about it a bit, I realized that the scale of the reward madea big difference for me. Give me the same bet on a 100% chance of $100 or a 50% chance of $300, and I’d happily take the 50% chance at $300. Same goes for 100% chance of $1,000 versus a 50% of $3,000. For me, I’d still rather a 50% chance at $30,000 over a 100% at $10,000. Around $100,000 is where I start to waffle, though.

I think I’d take the guaranteed $100,000 over a 50% chance at $300,000. Why? Because, once again, $100,000 would make a big difference in my life right now, and I’d much rather have a bird in the hand ($100,000) than 2 in the bush (a 50% chance of $300,000).

Where’s your break point? $30, $300, $3,000, $30,000, $300,000, $3,000,000? At what point would you chose the guaranteed 1 over the 50% 3?

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

In An Uncertain World

I have another book recommendation to make: Robert Rubin’s In An Uncertain World.

Rubin was Bill Clinton’s Secretary of Treasury from 1995 to 1999. The reason why I really like the book has little to do with politics, and everything to do with investing.

Rubin worked on Wall Street at Goldman Sachs long before he became Treasury Secretary. While there, he learned the fundamental principles of investing, and put them to work doing risk arbitrage for Goldman.

He does an excellent job spelling out how he thinks in terms of probabilities, and how this thinking is equally applicable in investing, politics, and life. If you can consider the potential outcomes in a situation, and you can apply reasonable probabilities to each, it allows you to make good decision in any facet of your life.

The principles of probabilistic thinking in investing are simple, but the judgment and analysis required are hard. If you know a security has a 25% chance of going to zero, a 25% change of being flat, a 25% chance of going up 20%, and a 25% chance of going up 100%, then it’s easy to figure out whether it’s a good investment or not. The math of probability is easy, figuring out what the probabilities and outcomes will be is hard.

But, Rubin does a great job of describing this way of thinking. He even gives concrete examples to make it clear both in investing and in politics.

I must admit, it’s an enjoyable read, too. I don’t agree with everything he has to say, but you can’t help finishing the book and thinking that Rubin is a thoughtful, well meaning person. I highly recommend the book to anyone.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.