The beauty and embarrassment of writing is that your past essays can be easily unearthed and brought to the present. I have been writing since 2004 and have penned more than 1,000 essays. Many of them should remain six feet deep in the dust of history, but I’ll unearth a few that I believe are worth revisiting and will provide additional comments at the end of each essay.
December 2, 2006
“Any time you make a bet with the best of it, where the odds are in your favour, you have earned something on that bet, whether you actually win or lose the bet. By the same token, when you make a bet with the worst of it, where the odds are not in your favour, you have lost something, whether you actually win or lose the bet.” – David Sklansky, The Theory of Poker
Over a lifetime, active investors will make hundreds, often thousands of investment decisions. Not all of those decisions will work out for the better. Some will lose and some will make us money. As humans we tend to focus on the outcome of the decision rather than on the process.
On a behavioral level, this makes sense. The outcome is binary to us – good or bad, we can observe with ease. But the process is more complex and is often hidden from us.
One of two things (sometimes a bit of both) can unite great investors: process and randomness (luck). Unfortunately, there is not much we can learn from randomness, as it has no predictive power. But the process we should study and learn from. To be a successful investor, all you need is a successful process and the ability (or mental strength) to stick to it.
Several years ago, I was on a business trip. I had some time to kill so I went to a casino to play blackjack. Aware that the odds were stacked against me, I set a $40 limit on how much I was willing to lose in the game.
I figured a couple hours of entertainment, plus the free drinks provided by the casino, were worth it. I was never a big gambler (as I never won much). However, several days before the trip I had picked up a book on blackjack on the deep discount rack in a local bookstore. All the dos and don’ts from the book were still fresh in my head. I figured if I played my cards right I would minimize the house advantage from 2-3 per cent to 0.5 per cent.
Wanting to get as much mileage out of my $40 as possible, I found a table with the smallest minimum bet requirement. My thinking was that the smaller the hands I played, the more time it would take for the casino’s advantage to catch up with me and take my money.
I joined a table that was dominated by a rowdy, half-drunken blue-collar worker who told me several times that it was his payday (literally: he was holding a stack of $100 bills in his hand) and that he was winning. I played by the book. But it did not matter. Luck was not on my side and my $40 was thinning with every hand.
Meanwhile, the rowdy guy was making every wrong move. He would ask for an extra card when he had a hard 18 while the dealer showed 6. The next card he drew would be a 3, giving him 21. Then the dealer would get a 10 and then a 2 (on top of the 6 that already showed), leaving him with 18. The rowdy guy barely paid attention to the cards. He was more interested in saying “hit me”.
Every “right” decision I made turned into a losing bet, while every “wrong” decision he made turned into a winner. His stack of chips was growing while mine was dwindling. His loud behaviour and consistent winnings attracted several observers. Some were making comments such as: “This guy is good.” Nobody paid attention to me – I was not loud and I was losing.
The rowdy guy had no process in place. He was just making half-drunken bets that had statistical improbabilities of success. And he was winning, at least for a while. I was armed with statistics, making every bet to maximize my chances of winning (actually, to minimize my losses – the odds were still against me) but I was on the losing side of the game.
After a couple of hours, and of consuming more of the “free” alcohol, my rowdy companion was increasing the size of his bets with every successful hand. The law of large numbers caught up with him. He gave up his winnings and his pay cheque as well – two weeks of hard work rightly went into the casino’s coffers.
I was down to a couple of dollars at one point. But then my luck changed and I won the bulk of my money back. In the end I lost only $10. This was a successful deal. I’d had a couple beers, spent a couple of hours gambling and learned a valuable gambling/investing lesson about the value of the process.
What is the lesson? Spend more time focusing on the process than on the end results. If it was not for randomness, every decision we made would be right or wrong based solely on the outcome. If that were the case, the process could be judged solely on the end result.
But randomness is constantly present in investing (as it is in gambling). Though we are drawn to judge our own decisions, and those of others, on their outcomes, that is dangerous. Randomness may teach us the wrong lessons.
My thoughts today: I wrote this article for The Financial Times, a British newspaper. This is why the spelling of some of the words looks a bit different. I wrote it in (liberated from England) English, at least the English I know; it was translated into British by the FT. As George Bernard Shaw said, “Americans and British are one people separated by a common language.”
When I was writing this article, I did not realize that I’d be spending a good chunk of my investment career surrounded by “rowdy drunks.” There is a good reason Stoic philosophy clicked with me so well, especially its fundamental concept of dichotomy of control: We can only control our values, our thoughts, our actions. Everything else is not up to us – the weather, your spouse’s mood, construction on your way to work, and yes, how Mr. Market chooses to price your stocks on a daily basis.
Thus, I choose to spend my time focusing on tinkering with and improving my investment process, knowing that in the long-term this is what is going to matter.
In this casino story, my gambling lasted just a few hours and I had only a tiny bit of my own money at stake. In the stock market, the craziness can often last for years and there is enormous external pressure for investors to change and to start emulating the behavior of the “rowdy drunks.” Also, the stakes are a lot higher.
Here is how I deal with it. I keep going back to the proverbial drawing board – I ground myself in what I can control: our research and analysis. We analyze and reanalyze the stocks we own and the ones gobbled up by the rowdy drunks (the flavor of the month). We build discounted cash flow models – estimate their fair value, model earnings five, ten years out, and compute expected rates of return.
Here is an example.
My daughter Hannah was interning at IMA during the summer. She had just graduated from high school, and my wife thought it would be a good idea for her to see what I do. I swear, it was not my idea, though I welcomed it with a melting heart). As a final assignment that summer, I had Hannah research a company that she could understand. Its sales were growing at a very fast pace and it was trading at a nosebleed valuation.
Hannah (with my help) built a model for this company. We assumed that its past success would continue a decade into the future without slowing down or taking a break (we were literally growing revenues 30-50% for ten years). Even at this low-probability rate of growth, Hannah got bubkes for the expected return. All the excitement was already priced into the stock. This was an eye-opening experience for Hannah. The stock may double or triple from this point – insanity has no upper bounds – but the odds of success were clearly stacked against this investment. If you keep buying these types of investments, just as if you keep making statistically improbable bets, what you do in the short term is completely random but in the long term the odds are stacked deeply against you.
Key takeaways
- Value investing success depends more on your process than on short-term outcomes, much like how statistical probability ultimately beats random luck at the blackjack table.
- The dichotomy of control is fundamental to value investing – focus on what you can control (research, analysis, and decision-making) rather than what you cannot (market pricing and short-term movements).
- In value investing, there’s enormous external pressure to abandon your process and chase market trends, especially when “rowdy drunks” (trend-followers) appear to be winning in the short term.
- Grounding yourself in fundamental analysis – building models, calculating fair values, and computing expected returns – forms the bedrock of a sustainable value investing approach.
- The odds of success in value investing, as demonstrated through the DCF model exercise, favor those who understand that excitement and growth expectations are often already priced into popular stocks.
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