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Alpha Theory Blog - News and Insights

« May 2010 | Main | July 2010 »

2 posts from June 2010

June 17, 2010

The Investor’s Serenity Prayer

"I must concede that my occupation, active money management, may be one of the best examples of the illusion of control in the professional world." – Michael Mauboussin.

If ten randomly selected people play Federer in tennis, they will, with a very high probability all lose. You would get the same outcome if ten people play Kasparov in Chess. If ten randomly selected people pick a portfolio of stocks against an expert, say Warren Buffett or Seth Klarman, there is a very high probability that at least one will beat the expert. If we change the number to 100 people playing against Federer, there is still a very high probability that all will lose. With 100 random investors, you are almost guaranteed that several of the average Joe portfolios will beat the experts.

Why do experts of one field dominate, while others could lose at anytime to a random player? The answer lies in the "random" part. Think of each sport as an equation where we select the three most important variables to determine the outcome and add a random variable. For example, a random variable in tennis would be Federer breaking up with his girlfriend right before the match. We'll say the equation for tennis is Serve + Backhand + Forehand + Random Variable = Tennis Winner. Now, add a subjective weighting of how important each variable is to success. For tennis I'll say, 30% Serve + 20% Backhand + 40% Forehand + 10% Random Variable = Tennis Winner, for Chess I'll say 60% Strategy + 10% Defense + 25% Board Memory + 5% Random Variable = Chess Winner. In investing, I'll go with 30% Stock Selection + 20% Position Sizing + 20% Risk Management + 30% Random Variable = Top Portfolio.

Why is the random variable so dominant in investing? It comes down to the uncertainty associated with stock selection. There are no 100% certainties and, quite honestly, very few 80% certainties either. So if I am presented with a bet where 50% of the time I make 100% and 50% of the time I lose 10%, I've been given a great opportunity to achieve a 45% expected return, however, I still may lose because the recognized possibility of failure can in fact occur.

To drive the point home, take an expert lottery player versus a novice lottery player, the equation of success has no variables except the random one (assuming the novice can fill out the lottery ticket): 100% Random Variable = Lottery Winner.

As investors, we must understand that a portion of our success or failure is out of our control. It reminds me of the serenity prayer:

God, grant me the serenity to accept the things I cannot change; Courage to change the things I can; And the wisdom to know the difference.

In the dynamic where outcomes do not effectively measure decisions you must be vigilant in evaluating your decision process and prune the inherent bias that comes from watching the daily profit and loss and associating every success with good decisions and every failure with poor decisions.

For some great writing on the topic, see "Think Twice" by Michael Mauboussin, Chapter 3 – The Expert Squeeze.

 

June 01, 2010

Assumptions on Assumptions – A good guess is not enough

I was working with a smart firm the other day and one of the partners was reticent to implement Alpha Theory. He believed  that it was flawed by forcing assumptions on top of assumptions. While I can understand this visceral response, the logic doesn't hold true in complicated decisions like asset selection and portfolio management. At the end of the day you are making an economic decision about an asset, whether to pay a certain amount of dollars. This means that your "assumptions" must be expressed in economic terms to balance the decision equation.

Assigning probability is the task that creates the most angst, but look at why it is important in three ways. One, if you can look at your portfolio and say that you have more confidence in one idea versus another idea, then you have expressed probability and you can simply classify positions as either High, Medium, or Low Conviction Level and those automatically translate into probabilities. Two, let's run through an example and say I offer you a bet to win $1 if Obama wins the 2012 election. Would you pay $.30 for that bet?, $.40?, $.50?, $.60?, $.70?. The highest amount you would be willing to pay is an expression of your subjective probability of Obama winning the 2012 election. Certainly this is subjective, but an effective expression of your assumptions is required to make effective decisions. Third, and lastly, psychologists have consistently proven that a weak model is better than strong heuristics. This blog references an article by Robyn Dawes that shows why we build some basic processes around complicated decisions (Robyn Dawes article).