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I recently finished Michael Mauboussin’s new book entitled “Think Twice” which expands on many of the topics of “More Than You Know” but is geared a bit more towards a general audience and less directly at institutional investors. Mauboussin’s goals are not dissimilar from those of Alpha Theory. We both strive to help people appreciate the common and avoidable mistakes of the decision making process, although he explains the pitfalls much more eloquently than I.

Now I read a lot of books on Behavioral Finance and Neuroeconomics, so the studies he reference in “Think Twice” are old hat, but Mauboussin does a great job of teasing out new insights. Check out the first chapter for a taste of how Mauboussin takes an interesting subject – Big Brown in the Kentucky Derby, makes it relevant for decision making – odds were obviously incorrect because of emotional bias, and creates a repeatable way to enact it – every chapter has a summary of how to incorporate each lesson into your decision process.

Additionally, I ran across a recent interview with Mauboussin discussing “Think Twice” and it highlights a few of the key tenets of his new book. Take a look (video here) and if you liked “More Than You Know” you should definitely check out “Think Twice”.

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The other day, I was doing what I spend much of my days doing – talking to a portfolio manager about Alpha Theory. He told me that Alpha Theory makes terrific sense for firms that calculate price targets, but that he didn’t believe in price targets. When I asked him why, he responded that there is a lot of instinct that price targets do not capture and it is his instinct that makes him successful. I explained that instinct and price targets are not mutually exclusive because price targets are estimates. Instead of estimating whether to buy or sell (pure instinct), you’re estimating reward and risk (price targets). To drive the point home, I asked him, “What are the 5 best ideas in your portfolio? Are they your 5 biggest positions?” He did not know. Is there any more proof needed?

Using price targets is not about being precise; it is about being directionally accurate. Price targets define why you are making the decisions you are making and do not require that you strip away the instinct that may be a primary component of your abilities. In fact, it is quite the opposite.  Because price targets are part science and part art, instinct plays a critical and indispensable role. This is especially true if you use probability weighted price targets because the art-to-science ratio is even higher. If you are already good at estimating price targets and probabilities, you will create a far superior portfolio if you discipline yourself to write them down. If you are not good at estimating price targets, well … you probably would not be successful anyway.

The only way to justifiably choose against the use of price targets is to take the position that instinctual decision making is not detrimentally affected by cognitive biases.  Before taking this position and relying solely on your instinct, however, it is an enlightening exercise to review a list of Cognitive Biases and consider whether any of them affect your decision making. Believers in the instinct assume (implicitly or explicitly) that instinct reflects logic. This assumption is compellingly supported by the studies of people like Gerd Gigerenzer, Daniel Goldstein, and Malcolm Gladwell.  Unfortunately, however, these studies become much less compelling when they are applied to investing. In this area, there is much more support for non-instinct based decision making. Behavioral Finance and Neuroeconomics research shows how logic based decision process is critical in achieving successful long-term results (see the work of, for example, Amos Tversky, Daniel Kahneman, Michael Mauboussin, Ron Howard, Jason Zweig, James Montier, and Matthew Lieberman).

To illustrate why price targets are critical, ask yourself this simple question, “Why did you buy this stock?” Your answer is probably some version of “I believe I can sell it for a higher price down the road.” If your decision is only about that one stock, that’s a great answer and you can responsibly stop the analysis right there. If, however, you have many stocks to choose from and you have capital that must be efficiently allocated between too much risk and too little return, then you have to consider each asset’s impact on the overall portfolio. To responsibly measure this impact, you must quantify the potential reward and its probability as well as the risk you are taking on and its probability, the combination of which is a risk-adjusted return. Instinct can, and perhaps, should be a primary component of these estimates, but it cannot responsibly stand alone.  Repeatable success requires disciplined price targets that explain the fitness of a decision within your portfolio.

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“…we try to exert a Ted Williams kind of discipline. In his book The Science of Hitting, Ted explains that he carved the strike zone into 77 cells, each the size of a baseball. Swinging only at balls in his “best” cell, he knew, would allow him to bat .400; reaching for balls in his “worst” spot, the low outside corner of the strike zone, would reduce him to .230. In other words, waiting for the fat pitch would mean a trip to the Hall of Fame; swinging indiscriminately would mean a ticket to the minors.” Warren Buffett, 1997 Berkshire Hathaway Letter to Shareholders

I recently ran across an Investopedia article called “Think Like Warren Buffett” that reminds me of the foundation of Alpha Theory thinking.  The article analyzes 8 investment tenets that Warren Buffett employs (which are more fully discussed in Robert G. Hagstrom’s 1999 book “The Warren Buffett Portfolio“) and is worth a read.  Here’s a synopsis.

1. Think of Stocks as a Business – this is a way to force yourself to think less about the market’s influence and more about the cash flow generating potential of the “business.” You also redirect your attention towards aggregate value (enterprise value – including the capital structure of the business) and away from share price.

2. Increase the Size of Your Investment – there are several great academic studies (Cohen, Polk, and Silli (2009) and Baks, Busse, and Green (2006) ) that point to the benefits of concentration. My personal observation is that it is very difficult to find good ideas, so when you find one, you should bet accordingly.

3. Reduce Portfolio Turnover – I’m not so convinced that I subscribe to this theory. Buffett has to be less active because he is moving in such large amounts and his moves are seen to have profound effect on a stock. If, like the rest of us, you have flexibility, then you should constantly ensure that position size is well-aligned with the risk-reward balance of each investment.  This means trading whenever there is an imbalance.

4. Develop Alternative Benchmarks – This is great for firms with multiple analysts. Measuring performance based on stock movement (especially in the short-term) is futile. Determining ways to measure based on value creation (book value growth, ROIC, etc.) will redirect the conversation away from ephemeral stock prices and towards more permanent value.

5. Learn to Think in Probabilities – Can we say this any louder, “LEARN TO THINK IN PROBABILITIES?”  If there is one overarching theme that we find with great investors it’s their tendency to approach investing with a probabilistic framework. It is not enough to say, “I’m pretty confident this stock is going to $40.” You must force yourself to describe how confident you are in probabilistic terms and, more importantly, describe what the risk (downside) is if you are wrong.

6. Recognize the Psychological Aspects of Investing – If we have learned anything over the past 40 years of Behavioral Finance / Neuroeconomic research, it is that humans are poorly designed to make financial decisions. Because of that we must protect ourselves from ourselves. We are our own worst enemies. In fact, Charlie Munger goes through many of these cognitive biases in his speech “Art of Stock Picking.” Review this list of cognitive biases and you’ll likely recognize many of them as errors you make in your daily investment process.

7. Ignore Market Forecasts – This reminds me of my previous post about Bill Ackman-Style Investing: Market and economic direction are multi-variable equations with thousands of inputs.  You can find two Nobel Laureate economists with well-defended theses for divergent directions of the US economy.  If they cannot figure it out, why should you try?  Mental capacity is a precious commodity and should be focused on reasonable prognostication, not on knowing the unknowable.

8. Wait for the Fat Pitch – Have you ever watched poker on TV?  They show one hour of poker that actually took 10 hours to play.  How is that possible?  It is simple: great poker players fold A LOT and there is no need to show folds on TV.  There is a 1 in 10 chance that a player’s hand will maintain positive expected return all the way to the river (last card dealt). A good poker player, therefore, will fold 9 out of 10 hands – which is exactly how you eliminate 9 out of 10 hours of poker coverage.  In investing, as in poker, you are constantly searching for positive expected return.  Of course, so is everyone else, and the more people that are looking for it, the harder it is to find.

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“A reasonable probability is the only certainty.” – Edgar Watson Howe

In Einstein’s Theory of Relativity, he postulates that space and time are relative to the person observing them. That a set of twins, one standing here on Earth and the other shot at the speed of light to the edge of the universe and back, will be significantly different in age when the twin returns to Earth, even though neither one of them noticed a difference in how time passed. In fact, if I take off on a cross country flight and my wife stays at home, I will be slightly younger than her when I arrive on the West Coast. In these examples, time and space are not continuums rather they are experiences. Careers are devoted to understanding Einstein’s theory, so we will not go into the science here, but understanding relativity is important for us as investors.

Knowledge itself is relative. I do not know if a company I’m invested in will beat earnings but the CFO surely does. In this case, uncertainty becomes relative and dependent on our differing levels of knowledge. If I, the investor, am assigning a probability of the company beating earnings, I will base it on my compiled knowledge of the company. As my knowledge changes, I will change my probability of success. The CFO will do the same thing, but his base of knowledge is different. This is described in statistical parlance as epistemic probability. Epistemic is the antagonist of aleatory probability (i.e. coin-flips) which is described by statisticians as an uncertainty due to randomness. No matter how much knowledge I gain, I will never know the outcome of a coin-flip, only the probability of its outcome.

Investing is not like coin-flips, blackjack, or poker in our ability to define aleatory probability. But that does not mean that we should give up on estimating an epistemic probability. In fact, it should be the foundation of our investment process. Gene Gigerenzer describes Degrees of Belief in his book “Calculated Risk”, “The point here is that investors can translate even onetime events into probabilities provided they satisfy the laws of probability – the exhaustive and exclusive set of alternatives adds up to one.  Also, investors can frequently update probabilities based on degrees of belief when new, relevant information becomes available.”

In investing, you are forced to invest with the knowledge you have today. There are no certainties and, as a result, we must accept that every investment thesis is based on a probability (degree of belief) of an outcome. For examples sake, let’s say that our degree of belief is 80%. This creates a vacuum that can only be filled by describing outcomes that make up the other 20%. In this vacuum, lies the elegance of probabilistic investing. It is an imperative calculation for every investment because it requires you to consider all the possibilities and it provides the flexibility to incorporate ever-changing research.

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“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

Why do you buy an asset? Because you believe that it is worth more than what you are paying for it.

Assume you can buy two different assets for $20 dollars. Stock #1 is worth $35 and Stock #2 is worth $30, which one would you buy more of?

Of course, Stock #1 with a value of $35, because it is worth more. Unfortunately in investing, assets have risk. So, unless there is a 100% probability of the stock going from $20 to $35, you have to compare its upside potential to its downside risk to better understand how much return you are being paid for the risk you are taking on.

Assume we calculate the downside using net cash per share. Stock #1 has more upside to $35 but only $5 in net cash per share ($15 of upside and $15 of downside) and Stock #2 has a lower upside of $30 but more net cash at $15 per share ($10 of upside and $5 of downside). Now, which one would you take a bigger position in?

More than likely you would have a greater exposure to Stock #2 because it has a better risk-reward. But this still misses a critical component of the analysis, conviction level. What if I’m extremely confident, say 80%, in Stock #1 achieving $35. For Stock #2, it is a coin-flip whether it will reach $30 or fall to $15. If I multiply each stocks’ Upside times the Probability of Upside and add it to the Downside times the Probability of Downside, I get a Risk-Adjusted Value of $29 for Stock #1 and $22.50 for Stock #2. The Risk-Adjusted Value is truly representative of the full qualities of this asset and should be the basis from which portfolio level decisions are made.

If you were to invest in Stock #1 10 times, you would make $15 eight times and lose $15 twice for a total gain of $90. If you were to invest in Stock #2 10 times, you would win $10 five times and lose $5 five times for a total gain of $25. Now, which asset would receive greater exposure?

Every investment decision should be framed by Risk-Adjusted Return. This allows an investor to properly size positions and quickly adjust exposure as the underlying price of the asset changes and as new fundamental information is received. Although the concept seems simple, it is rarely implemented. To see how Alpha Theory puts this concept into practice, view our demo (www.AlphaTheory.com/demo).

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I was discussing portfolio management strategy with a client who runs a long/short equity hedge fund. In his former life, he worked for a large Fund of Funds where he evaluated long/short equity mangers. In that role, he frequently referenced an article on Risk Management by Ed Seykota. He had increasingly become frustrated with traditional manager measurement techniques like VaR, Sharpe Ratio, alpha, etc. He found the article’s concepts to be central to evaluating the portfolio management prowess of fund managers.

Fortunately for us, the tenets of Ed Seykota’s article are embodied by the Alpha Theory Portfolio Management Platform:

1. Risk is the possibility of loss (not volatility).
2. Hunch-centric betting is certainly popular and likely accounts for an enormous proportion of actual real world betting.
3. Despite almost universal agreement that a system offers clear advantages over hunches, very few risk managers actually have a definition of their own risk management systems that is clear enough to allow a computer to back-test it.
4. To maximize returns, position sizing should be based on a measurement of potential profit, potential loss, and probability of each.
5. Kelly may be sub-optimal for portfolio management because of the diversification effect.
6. Diversification relies on the average security having a profitable expected value.
7. In times of stress, investors and managers access their primal gut feelings (when they should go back to discipline).
8. In actual practice, the most important psychological consideration is the ability to stick to the system. To achieve this, it is important (1) to fully understand the system rules, (2) to know how the system behaves and (3) to have clear and supportive agreements between all parties that support sticking to the system.
9. Profits and losses do not likely alternate with smooth regularity; they appear, typically, as winning and losing streaks. When the entire investor-manager team realizes this as natural, it is more likely to stay the course during drawdowns, and also to stay appropriately modest during winning streaks.

To see the full article, Risk Management by Ed Seykota. To view how Alpha Theory help create a investment process discipline, visit www.AlphaTheory.com.

Tags: Ed Seykota, Risk Management

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“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

I have read several articles, like this one from Securities Industry News, over the past month discussing the coming trends of transparency. The article explains, “Several hedge funds and their administrators are adopting enhanced systems aimed at fulfilling expected compliance requirements for more transparency and meeting heightened demands from investors to communicate portfolio information quicker and with more granular detail. The idea is to allow managers quicker screen-based views into their own trading and money management processes.” So effectively what we are saying is that if we had daily information we would have caught the overt risk or fraud that we could not catch with quarterly data. Sure, if you are now getting position level detail where you had veiled aggregate data before, you can isolate risk.  But, it seems that the positions themselves are only a portion of transparency.

True transparency, for the investor and the fund manager, comes from ensuring that you understand why you chose the assets that reside in your portfolio and how you determined their position size. This level of transparency is not something that reporting alone can expose because, for an overwhelming majority of firms, that critical information sits in the portfolio manger’s head and disparate Excel, Word, and email files. Transparency requires understanding more than “I have a position.”  It involves, “why I have a position.” Firms must adopt strategies to help codify their investment process and better explain to themselves (so that they can explain to investors) why they are making the decisions that they make. Alpha Theory has developed a framework, that embodies the best practices of great money managers, to provide “True Transparency” into every portfolio decision a fund manager makes.

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Tags: Consilient Investing, Michael Mauboussin, More Than You Know

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