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« Michael Lewis / David Einhorn article in NY Times | Main | Bringing Down the House - What Blackjack can teach us about investing. »

January 18, 2009

The Good Investor's Mentality - Do you have it?

This quick test will tell you if you have the mentality of the world's greatest investors:

1)       A blackjack player has 19, takes a hit and gets a 2 for 21.  Is the decision to take a hit a:

a.        Good decision

b.        Bad decision

2)       You buy a house for $1 million that subsequently declines in value to $500,000.  Someone offers you $800,000 for the house.  Do you:

a.        Take the deal

b.        Pass

3)       Two stocks trading at $30 have the same potential upside to $50 and downside to $20, but you have greater confidence in the upside being achieved for Stock One.  Assuming all else equal you would:

a.        Have a greater exposure to Stock One

b.        Have equal exposure to both assets

4)       You should let winners run:

a.        True

b.        False

5)       The five best ideas in your portfolio from a risk-reward standpoint should be your five largest positions:

a.        True

b.        False

6)       The best measure of risk for an asset is:

a.        Downside potential

b.        Volatility

Answers:  1 – b, 2 – a, 3 – a, 4 – b, 5 – a, 6 – a.


    1)       b – Bad decision. A blackjack player with 19 has a higher expected return staying than hitting no matter what the dealer is showing. To maximize the long-term expected return of their play they should always stand on 19. (“Any individual decision can be badly thought through, and yet be successful, or exceedingly well thought through, but be unsuccessful, because the recognized possibility of failure in fact occurs. But over time, more thoughtful decision-making will lead to better overall results, and more thoughtful decision-making can be encouraged by evaluating decisions on how well they were made rather than on outcome. “– Robert Rubin, former Treasury Secretary)

    2)       a – Take the deal. The decrease in value from $1 million to $500,000 is a sunk cost. The question should always be, "if I were investing in this asset forthe first time today, what would I do?" In this situation you would take the deal because you could turn around and buy another house of similar properties for around $500,000 and collect $300,000 in profit. (“What you already have invested in the pot doesn’t matter.” – Doyle Brunson, ten time World Series of Poker Champion / “Never stay in a poker game hoping to get even.” – Doyle Brunson, ten time World Series of Poker Champion)

    3)       a – Have a greater exposure in Stock One. The true value of an asset is a combination of the potential upside, potential downside and the probability of each. If one asset has a higher probability of upside then it has a higher risk-adjusted return and should merit a great exposure in the portfolio.  (“People don’t need extraordinary insight or intelligence.  What they need most is the character to adopt simple rules and stick to them.” – Benjamin Graham, father of Value Investing / “The main reason investors struggle with how to react to bad news is that they really haven’t figured out why they own the stocks they own.” – Bill Nygren, Oakmark Fund)

    4)       b – False. As a "winner runs" its position size increases, the potential upside decreases, and the potential downside increases. This equals greater exposure to a lower expected return asset.  (“We as a firm are always going to buy too soon and sell too soon.  And I’m very at peace with that.” –Seth Klarman , Baupost Group / When asked how he had become so rich?  He replied, “I sold too early.” – JP Morgan, famous financier / “The riskiest moment is when you’re right.  That’s when you’re in the most trouble, because you tend to overstay the good decisions.” – Peter Bernstein, legendary investor)

    5)       a – True. There is no better way to maximize long-term portfolio expected return than to ensure that the best risk-adjusted return assets are the largest positions in the portfolio. See the Alpha Theory™Monte Carlo simulation that shows Expected Return based position sizing is 40% better than the next best method for creating long-term returns.  (“We construct portfolios the way theory says one should, which is different from the way many, if not most, construct their portfolios.  We do it on a risk-adjusted rate of return.” – Bill Miller, legendary investor)

    6)       a – Downside potential. What is a better measure of risk? How much something moves or how much you can lose? Downside potential is a fundamental manager's gauge of risk and reflects their analysis of an asset. Volatility is simply a proxy for downside potential and is based on a log normal distribution of the market. See the Alpha Theory™ Differentiation from Portfolio Optimization for more details.  (“risk is not volatility” – Mario Gabelli, GAMCO Funds, Bloomberg TV Interview – December 3rd, 2008 / “They’re looking for lower volatility, and they are paying a very heavy price for lower volatility: They’re losing performance.” –George Soros , Quantum Fund)

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