Risk and Return

I had failed stuff before, but not academic stuff. When I got to University, I was left dazed and confused on several occasions. Sometimes for time pressure reasons and the sheer volume of work to get through. I was made to fully realise the limits of my academic ability. My mantra getting through was, “This is not Rocket Science. You are not pushing the boundaries of human thought. Other people have done this before.” One idea that I found really problematic coming out of the maths of finance was the oversimplifying of risk to volatility. Volatility is quantifiable. It is how much the average observation, differs from the average of the observations. So, if you know the average, how far “on average” will one of the parts be away from that. It is appealing if you can count something. If you want to believe in a world where you can clearly say return simplifies down to a number, and risk simplifies to a number. Then you can adjust return for risk. Take the level of risk appropriate for your appetite, and you choose the option at that level with the highest reward. Now, that seems beautifully simple. It is just wrong. You don’t get paid for taking risk. You get paid for value added. You don’t get paid for complexity, you get paid for solving things. You don’t get paid for not failing. You get paid for getting to a solution.

 

Do Good Work

There is nothing more Free Market than failure. Bail-outs etc. are “third way” interventions where Government steps in. Particularly bad if they only step in when there is failure, and do not share in the up-side. A danger of basing your investment philosophy on a dance around what something is worth, rather than what it does, is that price and value can disconnect massively. It is particularly dangerous if you “bet” more than 100%, or are naked (have a position in something you do not own). You can trade anything with a pulse, the underlying thing does not matter as much as the person (legal or real) you are buying/selling from/to. You can leverage up a horrible asset to make great profits (until things go wrong). Investment is different. A basic principle of fundamental investing is that what you do matters. It is not gambling. It is capital allocation and problem solving. Shifting resources to where they are doing good work, and continuing to do good work over long periods of time. No one can force you to sell if the business is strong enough to carry on doing its work.

Panning for Gold

My oldest brother used to love (as a Medical Student) asking, “What do you call a Medical Student who gets 50% for their final exam?”. The answer is Doctor. It is only in the classroom setting where the false laboratory conditions allow us to weigh and measure everybody. You can even ask university level questions for 2 marks to separate the first and second place 12-year olds who are getting everything “at their level” right. In the real world, meritocracy is limited by the fact that no one cares how clever you are. It is not about you. They want their problem solved. If there is an over supply of problem solvers, you do not have to pay them very much. As more people can read, write, think, create, and exchange ideas, it gets harder to pretend the barrier to wealth is merit. The barriers are not skills and knowledge. The barriers are the containers. Rather than survival of the fittest, it is survival of the most flexible. What is the container in which you make money? Why can’t others make money in that way? What if that container no longer existed?

Dry Your Muffin Eyes

A standard question when talking about investments is “what return can I expect?”. Howard Marks warns us to never forget the 6-ft man who drowned in a river that was 5-ft deep, on average. When I stepped away from the corporate world to live off an Engine, I did it with open eyes and hope. A salary can secure the 5-ft, but an Engine invested in Equity feels every rock. One Equity Fund pot for my engine has ranged in calendar after-fee performance (since my Aug ’14 leap) from -20.9% to 28.8% with an average of 4.0%. Simply put, not enough and bumpy. In addition, my spending has overshot my ambitions, despite my self-proclaimed self-discipline. Like Climate Change, there comes a point where you realise things are not sustainable… even if you could delude yourself for a few more years. Reluctantly, I am having to re-engage with the constraints of money making. Very aware that I am doing this from a significantly more privileged position than most. As a good friend would say, “Dry your muffin eyes”.

Red Flag Perfection

Josh Waitzkin talks of 'Investing in Loss'. In investing, a perfect track record is a red flag. The world is complex, uncertain and ambiguous. Getting it right every time suggests you are neither learning nor, if for too long a period, honest. It isn't that we should celebrate mistakes or failure, but there is always more opportunity to learn and grow with regular small mistakes. It is like going to the gym and gradually building up the size of the weights through being a little sore, rather than suddenly picking up something way too heavy and putting your back out. If something is a guaranteed success with no pain, it isn't.

A solid red flag, signifying the ship’s intent to engage in combat

Too Far Down the line?

What if you were to discover that everything you ever thought was true wasn't? Is there any one thing that could completely shatter your world view? If there is, and you actually found this out... Would you just pretend it wasn't true, and carry on living out your life?

A fair amount of our lives is spent creating more and more vested interests. If you spend years and years becoming an oil specialist and then just as you finish your training, someone discovers a way to make energy from water, and all your training becomes obsolete... what do you do?

If you spend your entire life basing everything you do on predictive models based on ridiculously complicated hard core stochastic mathematics, and then after reading 'the black swan', and doing some thinking, decide that you have wasted your time... what do you do?

If you are a minister in the church, and you stop believing in God... what do you do?

It is one thing to say that you would like the curtain to be pulled away, and discover the truth... but what happens if that truth is not something you REALLY want to know.

Being prepared to accept that you may be wrong about something is one thing. Being prepared to change is another.

And even another is being prepared to forgive yourself regularly for having been wrong in the past, even grossly wrong.

But...

I think we should be less forgiving about our future selves.

Do something about it.

Creative Destruction & Infallible Ships

After reading Fen's comment on `Creative Destruction' I purposefully held back on responding until Stu did.

Fen:

If left to right itself a year ago ,the sub prime problem would have swallowed most financial institutions in the US. Lehmans!!

stu:

You talk about the peculiar belief that we could build something infallible, but in the next paragraph you imply that if we intervened we could stop these bad things from happening.

Of the two scenarios (intervention/non-intervention), intervention seems to me to be a much clearer example of us believing we can make something infallible.

I find the image of the Titanic a useful one. But for different reasons. If the titanic had been save by an intervention... say, a chance passing ship, perhaps another 20 titanics would have been built. Maybe... and this is not a nice thing to think of, the tragedy of the failure saved us. Unsafe ships sink, people re look at the model and build something that works. That is where I think Capitalism is at its best.

Perhaps the lesson here is that we shouldn't be building titanics.

As for the systemic risk of the Financial system, I can't comment. Despite 8 years of studying Finance and Economics, I can't claim to understand how the financial system works. Banks are opaque beasts at best.

This ogre of systemic risk I feel is perhaps an excuse used to justify intervention. Intervention that keeps the Titanic afloat.

Long enough for more titanics to be built and more people to die?

I don't think this crisis is an example of failed Capitalism. I do think it is an example that there isn't any obvious answer as to how to intervene when periods of destruction happen.

Creative Destruction

I think we are living in a particularly interesting time. This is where capitalism shows its true value in my opinion. I say this at a time when this value is being discounted by the opposite actions of very interventionist governments.

The value is that of creative destruction. The best ideas continue to survive. People are still earning some money, maybe less, but some. People are tightening their belts but the world is carrying on. They will still spend their money on what you are doing IF it is the best use of their money.

To a large degree... having to fight means the best ideas and most efficient users of resources will be those that survive. In a centrally planned economy, things don't fail... on the outside. In fact, things that fail actually attract resources like a black hole.

That being said, while this creative destruction is probably good at `taking out the trash'. I am sure some great ideas (for the future) will not work right now because of the harsh environment, and I am sure that this process is a painful one for lots of people.

But... how do you improve if you aren't allowed to fail?

Fail = Succeed

Just started reading the Black Swan, sequel to Fooled by Randomness, by Nassim Taleb.

He makes a point I had heard before and which I think is very valid.

People often argue that Capitalism Works because it allows for the right incentives... but Capitalism works more because it allows things to fail. Seth Godin talks about the power of small companies, and maybe that is the biggest lesson from the mess that is happening now. All these huge companies are failing, but they are so big that it sends off tidal waves of repercussions.

I don't claim to be an expert on Ford and GM, but something strikes me as not working if two companies that make cars that no one wants because other people are making better cars, get propped up.

They need propping up because SO many workers will lose their jobs in such a short space of time. But, people lose their jobs all the time, they figure out a way to make do, learn a new skill and move on.

Thing is, if you are entrenched in a behemoth of a company and the entire city revolves around a particular Industry, multi-skilling and moving on is really tough.

But... if things aren't allowed to fail, then we don't carry on trying to find better ways to do things.

I don't know what the answer is... how do you create an environment where people can fail, and businesses can fail, without everything else collapsing. Then they can get back up, and make something even better.

If you remove failure, you remove progress.