More Ray Dalio Wisdom

Additional excerpts from Ray Dalio’s Principles. By presenting thoughts along similar veins by other investors, I do not wish to imply that Dalio’s thoughts are unoriginal. Instead, I am merely attempting to highlight psychological and behavioral commonalities between these investors. Random coincidence that these overlaps exist? Perhaps. But it’s much more fun to contemplate other contributing possibilities. Psychology, Process Over Outcome

“It isn't easy for me to be confident that my opinions are right. In the markets, you can do a huge amount of work and still be wrong. Bad opinions can be very costly. Most people come up with opinions and there’s no cost to them. Not so in the market. This is why I have learned to be cautious. No matter how hard I work, I really can’t be sure. The consensus is often wrong, so I have to be an independent thinker. To make any money, you have to be right when they’re wrong.”

Successful investing often requires the ability to straddle a very thin line between humility (“I could be wrong”) and hubris (“I am right, they are wrong”) – seemingly paradoxical dispositions. Howard Marks dedicated a whole chapter to this concept titled “Knowing What You Don’t Know.”

“I stress-tested my opinions by having the smartest people I could find challenge them so I could find out where I was wrong. I never cared much about others’ conclusions—only for the reasoning that led to these conclusions. That reasoning had to make sense to me. Through this process, I improved my chances of being right, and I learned a lot from a lot of great people. I remained wary about being overconfident, and I figured out how to effectively deal with my not knowing. I dealt with my not knowing by either continuing to gather information until I reached the point that I could be confident or by eliminating my exposure to the risks of not knowing. I wrestled with my realities, reflected on the consequences of my decisions, and learned and improved from this process.”

Asking others to torpedo your thesis and listening to their reasons helps avoid confirmation bias (seeking and retaining only information/facts that support your thesis while ignoring anything to the contrary). An example of this implementation in its extreme: as of 2010, Bruce Berkowitz of Fairholme didn’t employ analysts, and instead hired external experts to challenge his ideas and theses.

When To Buy

“I don’t make an inadvertent bet. I try to limit my bets to the limited number of things I am confident in.”

Charlie Munger once said the following: “…the one thing that all those winning betters in the whole history of people who’ve beaten the pari-mutuel system have is quite simple: they bet very seldom… the wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don’t. It’s just that simple.” Yes, he’s talking about horseracing, but same rules also apply to investing.

The Sugar Cookie

Many moons ago, we shared with you this matrix highlighting the importance of focusing on process over outcome.

In every investor’s lifetime, there will inevitably be one or more instances of “bad breaks” – when the investment process was solid, but the outcome was nonetheless bad. If that has ever happened to you, then you know what it feels like to be a sugar cookie.

What the heck is a sugar cookie? Here is the definition as explained by Naval Admiral William H. McRaven in a recent speech given at the University of Texas:

“Several times a week, the instructors would line up the class and do a uniform inspection.  It was exceptionally thorough. Your hat had to be perfectly starched, your uniform immaculately pressed and your belt buckle shiny and void of any smudges. But it seemed that no matter how much effort you put into starching your hat, or pressing your uniform or polishing your belt buckle--- it just wasn't good enough. The instructors would fine ‘something’ wrong.

For failing the uniform inspection, the student had to run, fully clothed into the surf zone and then, wet from head to toe, roll around on the beach until every part of your body was covered with sand. The effect was known as a ‘sugar cookie.’ You stayed in that uniform the rest of the day, cold, wet and sandy. There were many a student who just couldn't accept the fact that all their effort was in vain. That no matter how hard they tried to get the uniform right, it was unappreciated.

Those students didn't make it through training. Those students didn't understand the purpose of the drill.  You were never going to succeed.  You were never going to have a perfect uniform. Sometimes no matter how well you prepare or how well you perform you still end up as a sugar cookie. It's just the way life is sometimes. If you want to change the world get over being a sugar cookie and keep moving forward.”

Glancing Back At 2014

It’s that time of year – calendar year 2014 draws to an end. For one's trackrecord, there's particular emphasis on annual calendar year returns. Convention dictates that the annual return period fall between January 1st and December 31st, although there is no particular rhyme or reason behind this convention (e.g., why not April 1st to March 31st of the following year?).

For investors currently managing capital (especially those hoping to woo additional capital), we are subjected to the rules of the game – however arbitrary or nonsensical they may seem. Instead, let’s turn our attention to a more productive topic (something we can control) related to the calendar year convention…

2015 approaches – a new year, your oyster and blank slate – the possibilities are boundless! But before you say goodbye to 2014, will you glance back to examine, really breakdown, your 2014 returns? The exercise builds not only awareness, by forcing us to assess and admit our strengths or weaknesses and what we did well or poorly, it also reinforces a process over outcome approach to investing. How much of performance was due to luck? How much performance was due to process and skill? While not guaranteed to make us better investors, these are likely good questions to ask ourselves and perhaps even considerations to be worked into our investment processes throughout the next year.

For those needing ideas on how to evaluate your 2014 performance, below are excerpts from an article written by Mariko Gordon of Daruma Capital almost exact a year ago in December 2013:

“As the year ends, whether bull or bear market, the time of reckoning draws near. Now, mind you, scorekeeping happens all year round. But there's something about the nights getting longer and the coming winter solstice that creates an extra level of soul searching.

At Daruma, here are the things we ponder as we perform a post-mortem on the year's performance:

1. What percent of the stocks we owned over the last year and three years went up? And by how much compared to those that went down? It's easy to focus on the 'hit rate,' but if the pluses are small and the minuses are big, having a positive hit rate isn't going to do much good.
2. Did we add any value with adds and trims? Did we do a better job when we added or trimmed on the way up, or when we added or trimmed when the stock went down? Did we waste too much energy chasing squirrels when we should have focused on elephants? Activity does not always translate into returns.
3. How did the stocks that we sold do compared to the stocks we replaced them with or decided to keep? 'Out of sight, out of mind' means that we risk scoring ourselves only for what happened, and not for what could have been.
4. How did we spend our time? Since one team is responsible for two products, did we allocate our time properly between the two? And while we're at it, did we get the right balance of new ideas versus maintenance research? And did we have the right mix of tasks – calls with analysts versus field trips to companies, for example? It's easy to look at results without examining the success of the actions that led to those results.
5. How did we perform on an absolute and relative basis - in addition to the benchmark, sectors and industries - against the true investable universe? Not every stock in a small-cap benchmark in particular can be bought, as there are many teeny and illiquid banks and companies. Did we catch the best possible fish in our pond?”

Howard Marks’ Book: Chapter 17

Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 17 “The Most Important Thing Is…Investing Defensively” -- a rather apt topic given today's market environment. Psychology, Capital Preservation, Expected Return, Risk, Opportunity Cost

“What’s more important to you: scoring points or keeping your opponent from doing so? In investing, will you go for winners or try to avoid losers? (Or, perhaps more appropriately, how will you balance the two?) Great danger lies in acting without having considered these questions.

And by the way, there’s no right choice between offense and defense. Lots of possible routes can bring you to success, and your decision should be a function of your personality and leanings, the extent of your belief in your ability, and the peculiarities of the markets you work in and the clients you work for.”

“Like everything in investing, this isn’t a matter of black and white. The amount of risk you’ll bear is a function of the extent to which you choose to pursue return. The amount of safety you build into your portfolio should be based on how much potential return you’re willing to forego. There’s no right answer, just trade-offs…Because ensuring the ability to survive under adverse circumstances is incompatible with maximizing returns in the good times, investors must choose between the two.” 

Are capital preservation (defense, avoiding losers, etc.) & expected return (offense, going for winners, etc.) mutually exclusive concepts? Perhaps in the short-run, but in the long-run, they are two side of the same coin. Avoiding loss is essential to capital compounding over time. This is because the effects of compounding math are not symmetrical. A 50% loss in one period requires a 100% in a subsequent period just to break even! See our previous article titled: “Asymmetry Revisited” for more on the interplay between capital preservation and compounding.

Capital Preservation, Volatility, Diversification, Leverage

“But what’s defense? Rather than doing the right thing, the defensive investor’s main emphasis is on not doing the wrong thing.

Is there a difference between doing the right thing and avoiding doing the wrong thing? On the surface, they sound quite alike. But when you look deeper, there’s a big difference between the mind-set needed for one and the mind-set needed for the other, and a big difference in the tactics to which the two lead.

While defense may sound like little more than trying to avoid bad outcomes, it’s not as negative or non-aspirational as that. Defense actually can be seen as an attempt at higher returns, but more through the avoidance of minuses than through the inclusion of pluses, and more through consistent but perhaps moderate progress than through occasional flashes of brilliance.

There are two principal elements in investment defense. The first is the exclusion of losers from portfolios…and being less willing to bet on continued prosperity, and rosy forecasts and developments that may be uncertain. The second element is the avoidance of poor years and, especially, exposure to meltdown in crashes…this aspect of investment defense requires thoughtful portfolio diversification, limits on the overall riskiness borne, and a general tilt toward safety.

Concentration (the opposite of diversification) and leverage are two examples of offense. They’ll add to returns when they work but prove harmful when they don’t: again the potential for higher highs and lower lows from aggressive tactics. Use enough of them, however, and they can jeopardize your investment survival if things go awry. Defense, on the other hand, can increase your likelihood of being able to get through the tough times and survive long enough to enjoy the eventual payoff from smart investments.”

Psychology, Luck, Process Over Outcome

“The choice between offense and defense investing should be based on how much the investor believes is within his or her control…But investing is full of bad bounces and unanticipated developments…The workings of economies and markets are highly imprecise and variable, and the thinking and behavior of the other players constantly alter the environment…investment results are only partly within the investors’ control…The bottom line is that even highly skilled investors can be guilty of mis-hits, and the overaggressive shot can easily lose them the match.”

“Playing for offense – trying for winners through risk bearing – is a high octane activity. It might bring the gains you seek…or pronounced disappointment. And there’s something else to think about: the more challenging and potentially lucrative the waters you fish in, the more likely they are to have attracted skilled fishermen. Unless your skills render you fully competitive, you’re more likely to be prey than victor. Playing offense, bearing risk and operating in technically challenging fields mustn’t be attempted without the requisite competence.”

Psychology plays an integral role in successful investing. One must learn to distinguish between the impact of process (avoiding the mis-hits) vs. the outcome (sometimes uncontrollable), and to not be deterred by the occasional but inevitable “bad bounce.” Additionally, there’s the self-awareness and honesty requirement so that one can exercise discipline and remove oneself from the game if/when necessary.

Psychology, Trackrecord

“Investing is a testosterone-laden world where too many people think about how good they are and how much they’ll make if the swing for the fences and connect. Ask some investors of the ‘I know’ school to tell you what makes them good, and you’ll hear a lot abut home runs they’ve hit in the past the home runs-in-the-making that reside in their current portfolio. How many talk about consistency, or the fact that their worst year wasn’t too bad.”

“One of the most striking things I’ve noted over the last thirty-five years is how brief most outstanding investment careers are. Not as short as the careers of professional athletes, but shorter than they should be in a physically nondestructive vocation.

Where’d they go? Many disappeared because organizational flaws render their game plans unsustainable. And the rest are gone because they swung for the fences but struck out instead.

That brings up something that I consider a great paradox: I don’t think many investment managers’ careers end because they fail to hit home runs. Rather, they end up out of the game because they strike out too often – not because they don’t have enough winners, but because they have too many losers. And yet, lots of managers keep swinging for the fences.”

“Personally, I like caution in money managers. I believe that in many cases, the avoidance of losses and terrible years is more easily achievable than repeated greatness, and thus risk control is more likely to create a solid foundation for a superior long-term trackrecord.”

Related to the above, please see our previous articles on the concepts of “Toward vs. Away-From Motivation” and “Outer vs. Inner Scorecard.”

Howard Marks' Book: Chapter 16

Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 16 “The Most Important Thing Is…Appreciating the Role of Luck.” Luck, Capital Preservation

“We have to practice defensive investing, since many of the outcomes are likely to go against us. It’s more important to ensure survival under negative outcomes than it is to guarantee maximum returns under favorable ones.”

Luck, Process Over Outcome

“The investment world is not an orderly and logical place where the future can be predicted and specific actions always produce specific results. The truth is, much in investing is ruled by luck. Some may prefer to call it chance or randomness, and those words do sound more sophisticated than luck. But it comes down to the same thing: a great deal of the success of everything we do as investors will be heavily influenced by the roll of the dice.”

“Randomness (or luck) plays a huge part in life’s results, and outcomes that hinge on random events should be viewed as different from those that do not. Thus, when considering whether an investment record is likely to be repeated, it is essential to think about the role of randomness in the manager’s results, and whether the performance resulted from skill or simply being lucky.”

“Every once in a while, someone makes a risky bet on an improbable or uncertain outcome and ends up looking like a genius. But we should recognize that it happened because of luck and boldness, not skill…In the short run, a great deal of investment success can result from just being in the right place at the right time…the keys to profit are aggressiveness, timing and skill, and someone who has enough aggressiveness at the right time doesn’t need much skill.”

“…randomness contributes to (or wrecks) investment records to a degree that few people appreciate fully…We all know that when things go right, luck looks like skill. Coincidence looks like causality. A ‘lucky idiot’ looks like a skilled investor. Of course, knowing that randomness can have this effect doesn’t make it easy to distinguish between lucky investors and skillful investors.”

“Investors are right (and wrong) all the time for the ‘wrong reason’…The correctness of a decision can’t be judged from the outcome. Nevertheless, that’s how people assess it. A good decision is one that’s optimal at the time that it’s made, when the future is by definition unknown. Thus, correct decisions are often unsuccessful, and vice versa.”

“[Nassim] Taleb’s idea of ‘alternative histories’ – the other things that reasonably could have happened – is a fascinating concept, and one that is particularly relevant to investing.

Most people acknowledge the uncertainty that surrounds the future, but they feel that at least the past is known and fixed. After all, the past is history, absolute and unchanging. But Taleb points out that the things that happened are only a small subset of the things that could have happened. Thus, the fact that a stratagem or action worked – under the circumstances that unfolded – doesn’t necessarily prove the decision behind it was wise.

Maybe what ultimately made the decision a success was a completely unlikely event, something that was just at matter of luck. In that case that decision – as successful as it turned out to be – may have been unwise, and the many other histories that could have happened would have shown the error of the decision.”

“What is a good decision?…A good decision is one that a logical, intelligent and informed person would have made under the circumstance as they appeared at the time, before the outcome was known.”

“Even after the fact, it can be hard to be sure who made a good decision based on solid analysis but was penalized by a freak occurrence, and who benefited from taking a flier…past returns are easily assessed, making it easy to know who made the most profitable decision. It’s easy to confuse the two, but insightful investors must be highly conscious of the difference.

In the long run, there’s no reasonable alternative to believing that good decisions will lead to investor profits. In the short run, however, we must be stoic when they don’t.”

Luck, Historical Performance Analysis, Expected Return, Volatility

“Investment performance is what happens to a portfolio when events unfold. People pay great heed to the resulting performance, but the questions they should ask are: were the events that unfolded (and the other possibilities that didn’t unfold) truly within the ken of the portfolio manager? And what would the performance have been if other events had occurred instead? Those…are Taleb’s ‘alternative histories.’”

“…investors of the ‘I know’ school…feel it’s possible to know the future, they decide what it will look like, build portfolios designed to maximize returns under that one scenario, and largely disregard the other possibilities. The sub-optimizers of the ‘I don’t know’ school, on the other hand, put their emphasis on constructing portfolios that will do well in the scenarios they consider likely and not too poorly in the rest…

Because their approach is probabilistic, investors of the ‘I don’t know’ school understand that the outcome is largely up to the gods, and thus that the credit or blame accorded the investors – especially in the short run – should be appropriately limited.”

“Randomness alone can produce just about any outcome in the short run…market movements can easily swamp the skillfulness of the manager (or lack thereof).”

For further reading on luck and process over outcome: Howard Marks wrote an entire memo on the topic in Jan 2014 titled Getting Lucky. One of my favorite articles on this topic is from Michael Mauboussin & James Montier on Process Over Outcome. Michael Mauboussin recently wrote an entire book, The Success Equation, dedicated to untangling skill and luck. 

Waiting For The Next Train

Following up our recent article on selectivity standards in an upward moving market, below are some comforting words (and/or coping advice) from Mariko Gordon of Daruma Capital derived from her October 2013 Newsletter. “My ruminations on regret are of the bull market variety. Whereas bear markets make me regret owning every single stock in the portfolio, bull markets make me regret every stock we flirted with but didn't buy.

Why? Because it feels like everything we looked at and passed on is up way more than what we own or bought instead. And whether we passed for stupid, the-dog-ate-my-homework reasons or because we thought the price wasn't right, this is what happens in bull markets:

...the stock gets bought out at a ridiculous premium, or ...activist shareholders announce their position the day AFTER we shut the file for good, or ...the stock simply skyrockets, just out of spite.

As the markets rise, great ideas are harder and harder to find. Everything cheap has so much "hair" on it that it makes Chewbacca look as sparse as Kojak (look him up, youngster). Sorting through the "hair" that makes the stock cheap - and therefore unattractive to other investors - is not only time-consuming, it requires the investment equivalent of a hazmat suit.

On the other hand, if a new idea has a timely and compelling investment case, it will be anything but cheap. Even if other investors haven't discovered ALL of its charms, it will be 30% higher just because of the rising tide of the market. We then hesitate to pay up - because we all know what happens when the tide goes out.

Most days, therefore, you're faced with either loading down the portfolio with broken down junk that, while cheap, doesn't represent real value and will sink further or, chasing stocks that have gone parabolic, leading to multiple compression when the inevitable market melt-down happens.

In short, bull markets make you want to grab the nearest bottle of whiskey and listen to Edith Piaf songs until the market rolls over and dies.

Here is how I keep the hounds of bull-market frustration at bay:

• I work on what look to be great businesses, regardless of valuation, figuring that one day we may get our chance.
• I look to see which insiders are buying their stocks, because most of them are now selling faster than you can say hot potato.
• I look to see where there's a management change, because maybe the force will be strong with them, and a piece-of-junk of a business will start to deliver and the stock will levitate.

And, most important of all, every day, without fail, as sacred to me as a bedtime prayer, I think of the following advice: One morning, years ago, I scrambled down the subway steps, only to find the train leaving the station, a pissed off woman cursing up a storm and a homeless guy sitting on a bench. After watching the temper tantrum unfold for a minute, the guy finally said: "Lady, relax. Trains are like men. Another one will come along."

So whenever I think of Piaf songs and of the frustration of the hot stock that got away in this bull market, I remember that patience is needed to get over those heartbreaks. Because another new idea, like trains and men, will come along soon.”

Howard Marks' Book: Chapter 14

Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 14 “The Most Important Thing Is…Knowing What You Don't Know” Mistakes, Sizing, Diversification, Leverage, Opportunity Cost

“…the biggest problems tend to arise when investors forget about the difference between probability and outcome – that is, when they forget about the limits on foreknowledge:

• when they believe the shape of the probability distribution is knowable with certainty (and that they know it),
• when they assume the most likely outcome is the one that will happen,
• when they assume the expected result accurately represents the actual result, or
• perhaps most important, when they ignore the possibility of improbable outcomes.”

“Investors who feel they know what the future holds will act assertively: making directional bets, concentrating positions, levering holdings, and counting on future growth – in other words, doing things that in the absence of foreknowledge would increase risk. On the other hand, those who feel they don’t know what the future holds will act quite differently: diversifying, hedging, levering less (or not at all), emphasizing value today over growth tomorrow, staying high in the capital structure, and generally girding for a variety of possible outcomes.”

“If you know the future, it’s silly to play defense. You should behave aggressively and target the greatest winners; there can be no loss to fear. Diversification is unnecessary, and maximum leverage can be employed. In fact, being unduly modest about what you know can result in opportunity costs (foregone profits). On the other hand…Mark Twain put it best: ‘It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.’”

A few months ago, we wrote about Michael Mauboussin’s discussion on utilizing the Kelly Formula for portfolio sizing decisions. The Kelly Formula is based upon an investor’s estimation of the probability and amount of payoff. However, if the estimation of probability and payoff amount is incorrect, the mistake will impact portfolio performance through position sizing. It’s a symmetrical relationship: if you are right, the larger position size will help performance; if you are wrong, the larger position size will hurt performance.

Marks’ words echo a similar message. They remind us that an investor’s perception of future risk/reward drives sizing, leverage, and a variety of other portfolio construction and management decisions. If that perception of future risk/reward is correct/incorrect, it will lead to a positive/negative impact on performance, because “tactical decisions like concentration, diversification, and leverage are symmetrical two-way swords.” In order to add value, or generate alpha, an investor must create asymmetry which comes from “superior personal skill.” One interpretation of superior personal skill is correct perception of future risk/reward (and structuring the portfolio accordingly).

Psychology

“Awareness of the limited extent of our foreknowledge is an essential component of my approach to investing.”

“Acknowledging the boundaries of what you can know – and working within those limits rather than venturing beyond – can give you a great advantage.”

“No one likes having to invest for the future under the assumption that the future is largely unknowable. On the other hand, if it is, we’d better face up to it and find other ways to cope…Whatever limitations are imposed on us in the investment world, it’s a heck of a lot better to acknowledge them and accommodate them than to deny them and forge ahead.”

Investors must embrace uncertainty and the possibility of unpredictable events. Acknowledgement of “the boundaries of what you can know” won’t make you immune from the possible dangers lurking in the unknown future, but at least you won’t be shocked psychologically if/when they occur.

Macro, Luck, Process Over Outcome

“…the future is unknowable. You can’t prove a negative, and that certainly includes this one. However, I have yet to meet anyone who consistently knows what lies ahead macro-wise. Of all the economists and strategists you follow, are any correct most of the time?”

“…if the forecasters were sometimes right – and right so dramatically – then why do I remain so negative on forecasts? Because the important thing in forecasting isn’t getting it right once. The important thing is getting it right consistently.”

“One way to get to be right sometimes is to always be bullish or always be bearish; if you hold a fixed view long enough, you may be right sooner or later. And if you’re always an outlier, you’re likely to eventually be applauded for an extremely unconventional forecast that correctly foresaw what no one else did. But that doesn’t mean your forecasts are regularly of any value…It’s possible to be right about the macro-future once in a while, but not on a regular basis. It doesn’t do any good to possess a survey of sixty-four forecasts that includes a few that are accurate; you have to know which ones they are. And if the accurate forecasts each six months are made by different economists, it’s hard to believe there’s much value in the collective forecasts.”

“Those who got 2007-2008 right probably did so at least in part because of a tendency toward negative views. As such, they probably stayed negative for 2009.”

Bill Lipschutz: Dealing With Mistakes

The following excerpts are derived from Jack Schwager’s interview with Bill Lipschutz in The New Market Wizards. Lipschutz helped build and ran Salomon’s currency desk for many years – here is a 2006 EuroMoney Article with additional background on Bill Lipschutz. There are number of worthwhile portfolio management tidbits here, mainly the relationship between making mistakes, portfolio sizing & exposure, and controlling one’s psychological reactions. Mistake, Liquidity, Psychology, Process Over Outcome

“Missing an opportunity is as bad as being on the wrong side of a trade…”

“…the one time since I first started trading that I was really scared…our position size at the time was larger than normal…the dollar started moving up in New York, and there was no liquidity. Very quickly it was up 1 percent, and I knew that I was in trouble [1% of $3 billion = $30 million loss]…It transpired in just eight minutes. All I wanted to do was to make it through to the Tokyo opening at 7pm for the liquidity…By the time Tokyo opened, the dollar was moving down, so I held off covering half the position as I had previously planned to do. The dollar kept collapsing, and I covered the position in Europe…The reason that I didn’t get out on the Tokyo opening was that it was the wrong trading decision...

…That was the first time it hit home that, in regards to trading, I was really very different from most people around me. Although I was frightened at the time, it wasn’t a fear of losing my job or concern about what other people would think of me. It was a fear that I had pushed the envelope too far – to a risk level that was unacceptable. There was never a question in my mind about what steps needed to be taken or how I should go about it. The decision process was not something that was cloudy or murky in my vision. My fear was related to my judgment being so incorrect – not in terms of market direction (you can get that wrong all the time), but in terms of drastically misjudging the liquidity. I had let myself get into a situation in which I had no control. That had never happened before.”

“Q: Let’s say that the dollar started to go up – that is, in favor of the direction of your trade – but the fundamentals that provided your original premise for the trade has changed. Do you still hold the position because the market is moving in your favor, or do you get out because your fundamental analysis has changed?

A: I would definitely get out. If my perception that the fundamentals have changed is not the market’s perception, then there’s something going on that I don’t understand. You don’t want to hold a position when you don’t understand what’s going on. That doesn’t make any sense.”

Liquidity is your friend when it comes to dealing with mistakes.

Mistakes, Psychology, Sizing, When To Buy, When To Sell, Exposure, Expected Return

“When you’re in a losing streak, your ability to properly assimilate and analyze information starts to become distorted because of the impairment of the confidence factor, which is a by-product of a losing streak. You have to work very hard to restore that confidence, and cutting back trading size helps achieve that goal.”

“Q: For argument’s sake, let’s say that the fundamentals ostensibly don’t change but the dollar starts going down. How would you decide that you’re wrong? What would prevent you from taking an open-ended loss?

A: …if the price action fails to confirm my expectations will I be hugely long? No, I’m going to be flat and buying a little bit on the dips. You have to trade at a size such that if you’re not exactly right in your timing, you won’t be blown out of your position. My approach is to build to a larger size as the market is going my way. I don’t put on a trade by saying, “My God, this is the level; the market is taking off right from here.” I am definitely a scale-in type of trader.

Q: Do you believe your scaling type of approach in entering and exiting positions is an essential element in your overall trading success?

A: I think it has enabled me to stay with long-term winners much longer than I’ve seen most traders stay with their positions. I don’t have a problem letting my profits run, which many traders do. You have to be able to let your profits run. I don’t think you can consistently be a winning trader if you’re banking on being right more than 50% of the time. You have to figure out how to make money being right only 20 to 30 percent of the time.”

Very interesting way to think about overall expected return of a portfolio – how to make profits if you are right only 20-30% of the time. This highlights the concept that in investing, it doesn’t matter how often you are right or wrong, what ultimately matters is how much you make when you are right and how much you lose when you are wrong.

Volatility, Exposure, Correlation

“…playing out scenarios is something that I do all the time. That is a process a fundamental trader goes through constantly. What if this happens? What if this doesn’t happen? How will the market respond? What level will the market move to…

…Generally speaking, I don’t think good traders make gut or snap decisions – certainly not traders who last very long. For myself, any trade idea must be well thought out and grounded in reason before I take the position. There are a host of reasons that preclude a trader from making a trade on a gut decision. For example, before I put on a trade, I always ask myself, ‘If this trade does wrong, how do I get out?’ That type of question becomes much more germane when you’re trading large position sizes. Another important consideration is the evaluation of the best way to express a trade idea. Since I usually tend not to put on a straight long or short position, I have to give a lot of thought as to what particular option combination will provide the most attractive return/risk profile, given my market expectations. All of these considerations, by definition, preclude gut decisions.”

Is not “playing out scenarios” within one’s mind a form of attempting to anticipate possible scenarios of expected volatility?

Trade structuring is an under-discussed topic. Many people buy or short things without understanding/considering the true exposure – standalone and/or when interacting with existing portfolio positions. In the words of Andy Redleaf of Whitebox, “The really bad place to be is where all too many investors find themselves much of the time, owning the wrong things by accident. They do want to own something in particular; often they want to own something quite sensible. They end up owning something else instead.”

Sizing, Psychology

“Q: Beside intelligence and extreme commitment, are there any other qualities that you believe are important to excel as a trader?”

A: Courage. It’s not enough to simply have the insight to see something apart from the rest of the crowd, you also need to have the courage to act on it and to stay with it. It’s very difficult to be different from the rest of the crowd the majority of the time, which by definition is what you’re doing if you’re a successful trader.”

Also true for fundamental investors.

Risk, Diversification, Exposure

“Q: How did the sudden demise of your personal account change you as a trader?

A: I probably became more risk-control oriented. I was never particularly risk averse…There are a lot of elements to risk control: Always know exactly where you stand. Don’t concentrate too much of your money on one big trade or group of highly correlated trades. Always understand the risk/reward of the trade as it now stands, not as it existed when you put the position on. Some people say, ‘I was only playing with the market’s money.’ That’s the most ridiculous thing I ever heard.”

Team Management

“…John [Gutfreund of Salomon Brothers] could smell death at a hundred paces. He didn’t need to know what your position was to know…how it was going. He could tell the state of your equity by the amount of anxiety he saw in your face.”

Time Management

“By the way, when I talk about working hard, I meant commitment and focus; it has nothing to do with how many hours you spend in the office.”

Consequences of Contrarian Actions

Below are excerpts from a speech Bob Rodriguez of First Pacific Advisors gave in May 2009. Quite a few interesting lessons derived from his previous trials and tribulations in dealing with clients and redemptions during periods of contrarian actions and underperformance. Psychology

“I believe I have found success because I have been deeply aware of the need to balance the human emotions of greed and fear. In a word, DISCIPLINE…is a key attribute to becoming a successful investor. I stress that, without a strong set of fundamental rules or a core philosophy, they will be sailing a course through the treacherous investment seas without a compass or a rudder.”

AUM, Clients, Redemptions, Patience

“It seems as though it was a lifetime ago in 1986, when I had few assets under management, and the consultant to my largest account insisted that, if I wanted to continue the relationship, I had to pay to play. I was shocked, dismayed and speechless. Though this would probably have never become public, if I had agreed, how would I have ever lived with myself? By not agreeing, it meant that I would lose nearly 40% of my business. When I was fired shortly thereafter, this termination compromised my efforts in the raising of new money for nearly six years because I could not say why. Despite pain and humiliation, there was no price high enough for me to compromise my integrity. With the subsequent disclosure of improprieties at this municipal pension plan, the cloud of suspicion over me ultimately lifted. I not only survived, I prospered.”

“While technology and growth stock investing hysteria were running wild, we did not participate in this madness. Instead, we sold most of our technology stocks. Our ‘reward’ for this discipline was to watch FPA Capital Fund’s assets decline from over $700 million to just above $300 million, through net redemptions, while not losing any money for this period. We were willing to pay this price of asset outflow because we knew that, no matter what, our investment discipline would eventually be recognized. With our reputation intact, we then had a solid foundation on which we could rebuild our business. This cannot be said for many growth managers, or firms, who violated their clients’ trust.”

“Having the courage to be different comes at a steep price, but I believe it can result in deep satisfaction and personal reward. As an example, FPA Capital Fund has experienced heavy net redemptions since the beginning of 2007, totaling more than $700 million on a base of $2.1 billion. My strong conviction that an elevated level of liquidity was necessary, at one point reaching 45%, placed me at odds with many of our shareholders. I estimate that approximately 60% left because of this strategy…We have been penalized for taking precautionary measures leading up to and during a period of extraordinary risk. Though frustrating, in our hearts, we know that our long-term investment focus serves our clients well. I believe the words of John Maynard Keynes…‘Investment based on genuine long-term expectations is so difficult today as to be scarcely practicable,’ and ‘It is the long-term investor, he who most promotes the public interest, who will in practice come in for the most criticism wherever investment funds are managed by committees or boards or banks. For it is the essence of his behavior that he should be eccentric, unconventional, and rash in the eyes of average opinion.’”

“I believe superior long-term performance is a function of a manager’s willingness to accept periods of short-term underperformance. This requires the fortitude and willingness to allow one’s business to shrink while deploying an unpopular strategy.”

As I write this, the world’s smallest violin is playing in the background, yet it must be said: what about clients violating a fund’s trust by redeeming capital at inopportune times to chase performance elsewhere? The trust concept flows both ways.

There will be times in every fund manager’s career when doing what you believe is right will trigger negative consequences. The key is anticipation, preparation, and patience.

Historical Performance Analysis, Luck, Process Over Outcome, Mistakes

“Let’s be frank about last year’s performance, it was a terrible one for the market averages as well as for mutual fund active portfolio managers. It did not matter the style, asset class or geographic region. In a word, we stunk. We managers did not deliver the goods and we must explain why. In upcoming shareholder letters, will this failure be chalked up to bad luck, an inability to identify a changing governmental environment or to some other excuse? We owe our shareholders more than simple platitudes, if we expect to regain their confidence.”

“If they do not reflect upon what they have done wrong in this cycle and attempt to correct their errors, why should their investors expect a different outcome the next time?”

Examine your historical performance not only to provide an explanation to your clients, but also to yourself. For example, was there anything that you could have done to avoid the “stink”?

Rodriquez mentions “bad luck.” During this reflective process (which ideally should occur during times of good and bad performance) it’s important to understand whether the returns resulted due to luck or to skill. See Michael Mauboussin & James Montier’s commentary on Process Over Outcome & Luck.

Psychology, When To Sell, When To Buy

“Investors have long memories, especially when they lose money. As an example, prior to FPA’s acquisition of FPA Capital Fund in July 1984, the predecessor fund was a poster child for bad performance from the 1960s era. Each time the fund hit a $10 NAV, it would get a raft of redemptions since this was its original issue price and investors thought they were now finally even and just wanted out.”

Anchoring is a powerful psychological bias that can compel investors to buy and sell for the wrong reasons, as well as to allow those who recognize the phenomenon to take advantage of the bad decisions of others.

Is the opposite true: investors have short memories when they’re make money?

Mind of an Achiever

In the competitive world of investing, each of us should constantly be seeking out competitive advantages. Personally, I believe that a certain degree of competitive advantage can be found in the cross-pollination of different schools of investment thought. Many in the value school often deride trading strategies, but they cannot deny the existence of those who practice the trading style of investing and have generated fantastical trackrecords over time, even if the disbelievers cannot understand the basis of how they have done so.

The following excerpts derived from Jack Schwager’s interview with Charles Faulkner in The New Market Wizards relate to trading strategies, but I think many of the psychological and process-focused aspects are also applicable to fundamental investors.

Psychology, Portfolio Management

“Natural Learning Processes [NPL]…the study of human excellence…studies great achievers to pinpoint their mental programs – that is, to learn how great achievers use their brains to product results…The key was to identify…the essence of their skills – so it could be taught to others. In NPL we call that essence a model.”

“If one person can do it, anyone else can learn to do it…Excellence and achievement have a structure that can be copied. By modeling successful people, we can learn from the experience of those who have already succeeded. If we can learn to use our brains in the same way as the exceptionally talented person, we can possess the essence of that talent.”

This is the goal of Portfolio Management Jar: to study the rationale behind portfolio management decisions of great investors, and perhaps one day generate returns the way they do. Notice, there’s a distinction between observing the actions and decisions vs. analyzing the rationale behind those actions & decisions. The true treasure trove is the latter – the way they use their brains.

Process Over Outcome, Psychology, Portfolio Management

On characteristics of successful traders:

“Another important element is that they have a perceptual filter that they know well and that they use. By perceptual filter I mean a methodology, an approach, or a system to understanding market behavior…In our research, we found that the type of perceptual filter doesn’t really make much of a difference…all these methods appear to work, provided the person knows the perceptual filter thoroughly and follows it.”

“People need to have a perceptual filter that matches the way they think. The appropriate perceptual filter for a trader has more to do with how well it fits a trader’s mental strategy, his mode of thinking and decision making, than how well it accounts for market activity. When a person gets to know any perceptual filter deeply, it helps develop his or her intuition. There’s no substitution for experience.”

Interestingly, this is very applicable to portfolio management. Because the portfolio management process has so many inputs and differs depending on the person and situation, in order to master the art of portfolio management, investors need to figure out what works for them depending on “mental strategy, his mode of thinking and decision making.” It helps to observe and analyze the thought processes of the greats who came before you, but there’s “no substitute for experience.”

Process Over Outcome, Luck, Psychology

“…if a trader does very well in one period and only average in the next, he might feel like he failed. On the other hand, if the trader does very poorly in one period, but average in the next, he’ll probably feel like he’s doing dramatically better. In either case, the trader is very likely to attribute the change of results to his system…rather than to a natural statistical tendency. The failure to appreciate this concept will lead the trader to create an inaccurate mental map of his trading ability. For example, if the trader switches from one system to another when he’s doing particularly poorly, the odds are that he’ll do better at that point in time even if the new system is only of equal merit, or possibly even if it is inferior. Yet the trader will attribute his improvement to his new system…Incidentally, the same phenomenon also explains why so many people say they do better after they have gone to a motivational seminar. When are they going to go to a motivational seminar? When they’re feeling particularly low…statistically, on average, these people will do better in the period afterwards anyway – whether or not they attended the seminar. But since they did, they’ll attribute the change to the seminar.”

“Medical science researchers take the view that the placebo effect is something bad…However, Bandler and Grinder [founders of NPL] looked at it differently. They saw the placebo effect as a natural human ability – the ability of the brain to heal the rest of the body.”

Mistakes, Process Over Outcome, Psychology

Traders seem to place a lot of value on “emotional objectivity,” a term I found interesting since it’s definitely something that’s applicable to fundamental investors especially in situations involving mistakes.

“We’ve all been in trading situations where the market moved dramatically against our position. The question is: How unsettling or disconcerting was it? What happens when you’re in a similar situation a couple of weeks or even a couple months later? If you begin to experience some of the same unsettling feelings just thinking about it, you’ve conditioned yourself just like Pavlov’s dogs.”

“Manage of one’s emotional state is critical. The truly exceptional traders can stand up to anything. Instead of getting emotional when things don’t go their way, they remain clam and act in accordance with their approach. This state of mind may come naturally. Or some people may have ways of controlling or dissipating their emotions. In either case, they know they want to be emotionally detached from feelings regarding their positions.”

Is important question is how to un-condition oneself, to remain emotionally objective when mistakes have been made. Of course, since each of us is mentally programmed differently, the answer to this question likely differs from person to person.

Psychology, Capital Preservation, Risk

“There are two different types of motivation…either toward what we want or away from what we don’t want. For example, consider how people respond to waking up in the morning…The person who wouldn’t get up until he saw images like his boss yelling at him has an ‘Away From’ motivational direction. His motivation is to get away from pain, discomfort, and negative consequences…He moves away from what he doesn’t want. The person who can’t wait to get out of bed has a ‘Toward’ motivational direction. He moves toward pleasure, rewards, goals…he moves toward what he wants. People can have both types of motivation…but most people specialize in one or the other. They are very different ways to getting motivated, and both are useful in different situations.”

“People who move toward goals are greatly valued in our society…However, the Away From direction of motivation has gotten a bad rap…The Toward motivation may be enshrined in success magazines, but the less appreciated Away From motivation individuals can also be very successful…Many outstanding traders reveal an Away From motivation when they talk about ‘protecting themselves’ or ‘playing a great defense.’ They’re only willing to take so much pain in the market before they get out. As Paul Tudor Jones said in your interview, ‘I have a short-term horizon for pain.’”

“Very often they come in with a developed Toward motivation – toward success, toward money – that’s why they got into the markets in the first place. However, those that are primarily Toward motivated must spend the time and energy to develop the Away From motivation required for proper money management. In my studies of traders I’ve found that it’s nearly impossible to be a really successful trader without the motivation to get away from excessive risk.”

Some people are more genetically inclined to focus on capital preservation. Some people are less genetically inclined to control “risk.”

Montier & Mauboussin: Process Over Outcome

James Montier’s Value Investing: Tools and Techniques for Intelligent Investment is a book I often recommend to others - Montier does a wonderful job of pulling together a range of topics related value investing. Below are excerpts from Chapter 16 titled “Process not Outcomes: Gambling, Sport and Investment.” Montier derived much of the content below (story & matrix) from Michael Mauboussin's book More Than You Know - Chapter 1. Process Over Outcome, Mistakes, Psychology, Luck

“We have no control over outcomes, but we can control the process. Of course, outcomes matter, but by focusing our attention on process we maximize our chances of good outcomes.”

“Psychologists have long documented a tendency known as outcome bias. That is the habit of judging a decision differently depending upon its outcome.”

“Paul DePodesta of the San Diego Padres and Moneyball fame relates the following story on playing blackjack:

'On one particular hand the player was dealt 17 with his first two cards. The dealer was set to deal the next set of cards and passed right over the player until he stopped her, saying: ‘Dealer, I want to hit!’ She paused, almost feeling sorry for him, and said, ‘Sir, are you sure?’ He said yes, and the dealer dealt the card. Sure enough, it was a four.

The place went crazy, high fives all around, everybody hootin’ and hollerin’, and you know what the dealer said? The dealer looked at the player, and with total sincerity, said: ‘Nice hit.’ I thought, ‘Nice hit? Maybe it was a nice hit for the casino, but it was a horrible hit for the player! The decision isn’t justified just because it worked…’

The fact of the matter is that all casino games have a winning process – the odds are stacked in the favour of the house. That doesn’t mean they win every single hand or every roll of the dice, but they do win more often than not. Don’t misunderstand me – the casino is absolutely concerned about outcomes. However, their approach to securing a good outcome is a laser like focus on process…

Here’s the rub: it’s incredibly difficult to look in the mirror after a victory, any victory, and admit that you were lucky. If you fail to make that admission, however, the bad process will continue and the good outcome that occurred once will elude you in the future. Quite frankly, this is one of the things that makes Billy Beane as good as he is. He’s quick to notice good luck embedded in a good outcome, and he refuses to pat himself on the back for it…'

To me the similarities with investment are blindingly obvious. We are an industry that is obsessed with outcomes over which we have no direct control. However, we can and do control the process by which we invest. This is what we should focus upon. The management of return is impossible, the management of risk is illusory, but process is the one thing that we can exert influence over.”

“Outcomes are highly unstable in our world because they involve an integral of time. Effectively, it is perfectly possible to be ‘right’ over a five-year view and ‘wrong’ on a six-month view, and vice versa...During periods of poor performance, the pressure always builds to change your process. However, a sound process can generate poor results, just as a bad process can generate good results.”

The Importance of Knowing Thyself

Readers know that I’m a fan of Mariko Gordon of Daruma Capital. Below is an excerpt from her recent March 2013 Letter. Although she is referring specifically to equities, I think her comments are applicable to all portfolio assets. Lao Tzu wrote that “He who knows others is wise; he who knows himself is enlightened.” This letter perfectly showcases why I’m a fan of Gordon. She is already a successful investor running a successful investment management firm. Yet she never stops searching for incremental knowledge – of herself, her results, her surrounding environment – striving for improvement. She is aware of the competitive nature of this business, and how she fits into that landscape. There are no illusions here…or at least that’s the goal. All that we are, as it pertains to investing (and sometimes even personal tendencies), is stripped bare and evaluated for the good and the unpleasant. The willingness to withstand such scrutiny, and reexamination year after year, is the mark of great investors.

Mistakes, Process Over Outcome, Psychology, When To Sell, When To Buy

“The investment case must be made in a completely detached way. A stock doesn't care whether you own it or not, or whether you had a good or bad "relationship" with it during the course of your ownership. A stock is not your friend. It doesn't give a crap about you, and you should reciprocate that indifference.

All of my investment process mistakes (as opposed to all my bad outcomes - this is an important distinction, as one can have bad outcomes despite a good process) have always come from a place of emotion. Every single one, whether it was a purchase or a sale.

By contrast, my best decisions in fraught times have been when I have accessed that place of flow and clarity by being entirely detached emotionally. It turns out that for someone who tends to be very expressive and prone to hyperbolic language, I can be quite cold blooded and calculating when I need to be, for the good of the portfolio.”

Buffett Partnership Letters: 1968 & 1969

During 1969, the Partnership transitioned into Berkshire Hathaway. Therefore this concludes our series on portfolio management and the Buffett Partnership Letters. Please see our previous articles in this series. Control, Hurdle Rate, Compounding, When To Sell

“…controlled companies (which represent slightly over one-third of net assets at the beginning of the year)…we cannot make the same sort of money out of permanent ownership of controlled businesses that can be made from buying and re-selling such businesses, or from skilled investment in marketable securities. Nevertheless, they offer a pleasant long term form of activity (when conducted in conjunction with high grade, able people) at satisfactory rates of return.”

“Particularly outstanding performances were turned in by Associated Cotton Shops, a subsidiary of DRC run by Ben Rosner, and National Indemnity Company, a subsidiary of B-H run by jack Ringwalt. Both of these companies earned about 20% on capital employed in their businesses.”

We’ve previously written that portfolio capital compounding can be achieved in multiple ways:

• “Compounding can be achieved by the portfolio manager / investor when making investments, which then (hopefully) appreciates in value, and the repetition of this cycle through the reinvestment of principal and gains. However, this process is limited by time, resources, availability of new ideas to reinvest capital, etc.”

• Compounding can be achieved by operating entities owned in the portfolio by “reinvesting past earnings back into the same business (or perhaps new business lines). In this respect, the operating business has an advantage over the financial investor, who must constantly search for new opportunities.”

In the quotes above, Buffett was referring to the latter method.

Toward the end of the Partnership, Buffett struggled with the continuous churn & reinvestment process as prices in the marketplace rose and rendered good capital reinvestment opportunities difficult to find. Enter the attractiveness of leaving capital with operating entities (in which he had a controlling stake) that can generate profits (compound) & reinvestment capital, at “satisfactory rates of return,” without Buffett having to watch too closely (provided he found “high grade, able people” to oversee these control investments).

Buffett seemed agnostic between the two as long as the control situations produced “satisfactory rates of return.” As always, the devil lies in the details: what is a “satisfactory rate of return”? Was this figure Buffett’s mental hurdle rate?

Nevertheless, this serves as an useful reminder to investors today that the process of buying and selling assets is not the only way to compound and generate portfolio returns. In fact, sometimes it’s better to hold on to an asset, especially when good reinvestment opportunities are rare.

Process Over Outcome

“It is possible for an old, over-weight ball player, whose legs and batting eye are gone, to tag a fast ball on the nose for a pinch-hit home run, but you don’t change your line-up because of it.”

AUM, Sizing

“…our $100 million of assets further eliminates a large portion of this seemingly barren investment world, since commitments of less than about $3 million cannot have a real impact on our overall performance, and this virtually rules out companies with less than about $100 million of common stock at market value…”

Returning Capital

For those searching for language related to returning capital, the letter dated May 29^th, 1969 is a must read.

Wisdom from Peter Lynch

Previously, we summarized an interview with Michael F. Price & an interview with David E. Shaw from Peter J. Tanous’ book Investment Gurus. Below are highlight from yet another fantastic interview, this time with Peter Lynch, the legendary investor who ran Fidelity's Magellan Fund from 1977-1990, compounding at ~30% annually during that period.

When To Buy, Volatility, Catalyst

On technical buy indicators, expected volatility, and catalysts:

“I have traditionally liked a certain formation. It’s what I call the electrocardiogram of a rock. The goes from, say, 50 to 8. It has an incredible crater. Then it goes sideways for a few years between 8 and 11. That’s why I call it the EKG of a rock. It’s never changing. Now you know if something goes right with this company, the stock is going north. In reality, it’s probably just going to go sideways forever. So if you’re right it goes north and if you’re wrong it goes sideways. These stocks make for a nice research list…stocks that have bottomed out...

...When it’s going from 50 to 8, it looks cheap at 15; it looks cheap at 12. So you want the knife to stick in the wood. When it stops vibrating, then you can pick it up. That’s how I see it on a purely technical basis…why the stock is on your research list, not on your buy list. You investigate and you find that of these ten stories, this one has something going on. They’re getting rid of a losing division, one of their competitors is going under, or something else.”

When To Buy

“You could have bought Wal-Mart ten years after it went public…it was a twenty-year-old company. This was not a startup…You could have bought Wal-Mart and made 30 times your money. If you bought it the day it went public you would have made 500 times your money. But you could have made 30 times your money ten years after it went public.”

Many value investors experience difficulty buying assets when prices are moving upward. At those moments, perhaps it’s important to remember to see the forest (ultimate risk-reward) through the trees (an upward moving price).

Expected Return, Fat Tail

“There may be only a few times a decade when you make a lot of money. How many times in your lifetime are you going to make five times on your money?”

I hear chatter about “lotto ticket” and “asymmetric risk-reward” ideas all the time. A friend recently joked that he would rather buy actual lotto tickets than the lotto-ticket-ideas because with the former he actually stands a chance of hitting the jackpot.

Apparently, Peter Lynch sort of agrees with my friend. Markets are generally efficient enough that asymmetric risk-reward opportunities rarely occur. The tricky part is discerning between the real deal vs. imitations conjured from misjudgment or wishful thinking analysis.

Diversification, Correlation

“If you buy ten emerging growth funds and all these companies have small sales and are very volatile companies, buying ten of those is not diversification.”

The correlation between assets, not the number of assets, ultimately determines the level of diversification within a portfolio.

Clients

“One out of every hundred Americans was in my fund…For many of these people, $5,000 is half their assets other than their house. And there are people you meet who say we sent our kids to college, or we paid off the mortgage. What I’m saying is that it’s very rewarding to have a fund where you really made a difference in a lot of people’s lives.”

How refreshing. Those who work in the investment management world sometimes forget for whom they toil (beyond numero uno). A job well done could potentially make large positive impacts on the lives of others.

Team Management

On how he’s spending his time after stepping down from managing the Magellan Fund:

“…I work with young analysts. We bring in six new ones a year and I work with them one-on-one.”

Process Over Outcome

On whether Peter Lynch would have pursued an investment career had he lost money in his first stock purchase:

“Well, I guess if I’d lost money over and over again then maybe I would have gone into another field.”

Only in the long-run is outcome indicative of skill.

Mandate

“…I was always upset by the fact that they called Magellan a growth fund. I think that is a mistake. If you pigeonhole somebody and all they can buy are the best available growth companies, what happens if all the grow companies are overpriced? You end up buying the least overpriced ones.”

Howard Marks' Book: Chapter 10

Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 10 “The Most Important Thing Is…Combating Negative Influences” Mistakes, Portfolio Management, Psychology

“Why do mistakes occur? Because investing is an action undertaken by human beings, most of whom are at the mercy of their psyches and emotions. Many people possess the intellect needed to analyze data, but far fewer are able to look more deeply into things and withstand the powerful influence of psychology. To say this another way, many people will reach similar cognitive conclusions from their analysis, but what they do with those conclusions varies all over the lot because psychology influences them differently. The biggest investing errors come not from factors that are informational or analytical, but from those that are psychological.”

Marks’ comments perfectly describe why portfolio management is so difficult. The portfolio management decisions that occur after idea diligence & analysis are more art than science – intangible, manifesting differently for each person depending on his/her mental makeup. This also makes it particularly susceptible to the infiltration of psychological behavioral biases.

This underlies my assertion that merely having good ideas is not enough. In order to differentiate from the competition and to drive superior performance, investors also need to focus on portfolio management, and face the associated (and uniquely tailored) psychological obstacles.

Mistakes, Psychology

“The desire for more, the fear of missing out, the tendency to compare against others, the influence of the crowd and the dream of the sure thing – these factors are near universal. Thus they have a profound collective impact on most investors and most markets. The result is mistakes, and those mistakes are frequent, widespread and recurring.”

Howard Marks provides a few psychological factors that lead to mistakes: 

1. Greed – “Money may not be everyone’s goal for its own sake, but it is everyone’s unit of account…Greed is an extremely powerful force. It’s strong enough to overcome common sense, risk aversion, prudence, caution, logic, memory of painful past lessons, resolve, trepidation and all the other elements that might otherwise keep investors out of trouble.” 

2. Fear – “The counterpart of greed…the term doesn’t mean logical, sensible risk aversion. Rather, fear – like greed – connotes excess…more like panic. Fear is overdone concern that prevents investors from taking constructive action when they should.” 

3. Willing Suspension of Disbelief – “…people’s tendency to dismiss logic, history, and time-honored norms…Charlie Munger gave me a great quotation…from Demosthenes: ‘Nothing is easier than self-deceit. For what each man wishes, that he also believes to be true’…the process of investing requires a strong dose of disbelief…Inadequate skepticism contributes to investment losses.” I wonder, is denial then just a more extreme form of confirmation bias? 

4. Conformity/Herding Behavior – “…even when the herd’s view is clearly cockeyed…Time and time again, the combination of pressure to conform and the desire to get rich causes people to drop their independence and skepticism, overcome their innate risk aversion and believe things that don’t make sense.” 

5. Envy – “However negative the force of greed might be…the impact is even strong when they compare themselves to others…People who might be perfectly happy with their lot in isolation become miserable when they see others do better. In the world of investing, most people find it terribly hard to sit by and watch while others make more money than they do.” 

6. Ego – To a certain extent this is self-explanatory, but I will further explore this topic in another article in relation to Buffett’s concept of the “inner” vs. “outer-scorecard.” 

7. Capitulation – “…a regular feature of investor behavior late in cycles. Investors hold on to their conviction as long as they can, but when the economic and psychological pressure become irresistible, they surrender and jump on the bandwagon.” 

Psychology, When To Buy, When To Sell

“What, in the end, are investors to do about these psychological urges that push them toward doing foolish things? Learn to see them for what they are; that’s the first step toward gaining the courage to resist. And be realistic. Investors who believe they’re immune to the forces describes in this chapter do so at their own peril…Believe me, it’s hard to resist buying at the top (and harder still to sell) when everyone else is buying…it’s also hard to resist selling (and very though to buy) when the opposite is true at the bottom and holding or buying appears to entail the risk of total loss.”

Mistakes

“In general, people who go into the investment business are intelligent, educated, informed and numerate. They master the nuances of business and economics and understand complex theories. Many are able to reach reasonable confusion about value and prospects. But then psychology and crowd influences move in…The tendency toward self-doubt combines with news of other people’s successes to form a powerful force that makes investors do the wrong thing, and it gains additional strength as these trends go on longer.”

“Inefficiencies – mispricings, and misperceptions, mistakes that other people make – provide potential opportunities for superior performance. Exploiting them is, in fact, the only road to consistent outperformance. To distinguish yourself from others, you need to be on the right side of those mistakes.”

Investing is a selfish zero-sum game. Mistakes, on the part of some, must occur in order for others to generate profits. Mistakes of others = your opportunity 

Luck, Process Over Outcome

During the Tech Bubble,“Tech stock investors were lauded by the media for their brilliance. The ones least restrained by experience and skepticism – and thus making the most money – were often in their thirties, even their twenties. Never was it pointed out that they might be beneficiaries of an irrational market rather than incredible astuteness.”

Howard Marks' Book: Chapter 7

Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 7 “The Most Important Thing Is…Recognizing Risk” Risk, Capital Preservation, Compounding

“…Warren Buffett, Peter Lynch, Bill Miller and Julian Robertson. In general their records are remarkable because of their decades of consistency and absence of disasters, not just their high returns.”

“How do you enjoy the full gain in up markets while simultaneously being positioned to achieve superior performance in down markets? By capturing the up-market gain while bearing below-market risk…no mean feat.”

“The road to long-term investment success runs through risk control more than through aggressiveness. Over a full career, most investors’ results will be determined more by how many losers they have, and how bad they are, than by the greatness of their winners.”

The resilient yet participatory portfolio (this term was stolen from a very smart man named Ted Lucas at Lattice Strategies in San Francisco) – a rare creature not easily found. We know it exists because a legendary few, such as those listed above, have found it before. How to find it for ourselves remains the ever perplexing question.

Our regular Readers know that we’re obsessed with the complementary relationship between capital preservation and compounding. For more on this, be sure to check out commentary from Stanley Druckenmiller and Warren Buffett – yes, two very different investors.

Conservatism, Hedging

“Since usually there are more good years in the markets than bad years, and since it takes bad years for the value of risk control to become evident in reduced losses, the cost of risk control – in the form of return foregone – can seem excessive. In good years in the market, risk-conscious investors must content themselves with the knowledge that they benefited from its presence in the portfolio, even though it wasn’t needed…the fruits…come only in the form of losses that don’t happen.”

People talk a lot about mitigating risk in the form of hedging. But what about remaining conservatively positioned (such as having more cash) and incurring the cost of lower portfolio returns? Isn’t the “return foregone” in this case akin to hedging premium?

Conservatism, Fat Tail

“It’s easy to say that they should have made more conservative assumptions. But how conservative? You can’t run a business on the basis of worst-case assumptions. You won’t be able to do anything. And anyway, a ‘worst-case assumption’ is really a misnomer; there’s no such thing, short of a total loss…once you grant that such a decline can happen – for the first time – what extent should you prepare for? Two percent? Ten? Fifty?”

“Even if we realize that unusual, unlikely things can happen, in order to act we make reasoned decisions and knowingly accept that risk when well paid to do so. Once in a while, a ‘black swan’ will materialize. But if in the future we always said, ‘We can’t do such-and-such, because the outcome could be worse than we’ve ever seen before,” we’d be frozen in inaction.

So in most things, you can’t prepare for the worst case. It should suffice to be prepared for once-in-a-generation events. But a generation isn’t forever, and there will be times when that standard is exceeded. What do you do about that? I’ve mused in the past about how much one should devote to preparing for the unlikely disaster. Among other things, the events of 2007-2008 prove there’s no easy answer.”

Risk, Making Mistakes, Process Over Outcome

“High absolute return is much more recognizable and titillating than superior risk-adjusted performance. That’s why it’s high-returning investors who get their pictures in the papers. Since it’s hard to gauge risk and risk-adjusted performance (even after the fact), and since the importance of managing risk is widely underappreciated, investors rarely gain recognition for having done a great job in this regard. That’s especially true in good times.”

“Risk – the possibility of loss – is not observable. What is observable is loss, and generally happens only when risk collides with negative events…loss is what happens when risk meets adversity. Risk is the potential for loss if things go wrong. As long as things go well, loss does not arise. Risk gives rise to loss only when negative events occur in the environment.”

“…the absence of loss does not necessarily mean the portfolio was safely constructed…A good builder is able to avoid construction flaws, while a poor builder incorporates construction flaws. When there are no earthquakes, you can’t tell the difference…That’s what’s behind Warren Buffett’s observation that other than when the tide goes out, we can’t tell which swimmers are clothed and which are naked.”

Good risk management = implementing prevention measures.

Once planted, the seeds of risk can remain dormant for years. Whether or not they sprout into loss depends on the environment and its conditions.

In other words, mistakes that result in losses are often made long before losses occur. Although loss was not the ultimate outcome does not mean mistakes were not made.

Buffett Partnership Letters: 1965 Part 2

Continuation of our series on portfolio management and the Buffett Partnership Letters, please see our previous articles for more details. Trackrecord, Compounding, Duration, Special Situations, Time Management

“A disadvantage of this business is that it does not possess momentum to any significant degree. If General Motors accounts for 54% of domestic new car registrations in 1965, it is a pretty safe bet that they are going to come fairly close to that figure in 1966 due to owner loyalties, deal capabilities, productivity capacity, consumer image, etc. Not so for BPL. We start from scratch each year with everything valued at market when the gun goes off…The success of past methods and ideas does not transfer forward to future ones.”

Investing, compounding, and trackrecord creation is a perpetual intellectual treadmill – “We start from scratch each year with everything valued at market when the gun goes off,” and the “success of past methods and ideas” contribute only slightly to future returns.

In 1965-1966, a large portion of Buffett’s portfolio still consisted of generally undervalued minority stakes and special situation workouts.

Though not often highlighted, duration risk is a very real annoyance for the minority equity investor, especially in rising markets. Takeout mergers may increase short-term IRR, but they can decrease overall cash on cash returns. Mergers also result in cash distributions for which minority investors must find additional redeployment options in a more expensive market environment.

Special situations investors have to run even harder on the intellectual treadmill since their portfolios contain a natural ladder of duration as the special situations resolve and “workout.”

All this activity is subject to the 24 hours per day time constraint. How does one maximize portfolio compounding given these obstacles?

I suspect it was mental debates like these that drove Buffett, in later years, to seek out the continuous compounding investments such as Coca Cola, Wells Fargo, etc., to which he could outsource the task of compounding portfolio equity.

Here’s the basic rationale behind the term “outsourced compounding” extracted from an article I wrote a few months ago:

"Compounding can be achieved by the portfolio manager / investor when making investments, which then (hopefully) appreciates in value, and the repetition of this cycle through the reinvestment of principal and gains. However, this process is limited by time, resources, availability of new ideas to reinvest capital, etc.

Operating business achieve compounding by reinvesting past earnings back into the same business (or perhaps new business lines). In this respect, the operating business has an advantage over the financial investor, who must constantly search for new opportunities.

Tom Russo of Gardner Russo & Gardner, quoted above in a November 2011 edition of Value Investor Insight (many thanks to Rafael Astruc of Garrison Securities for tipping PMJar on this), highlights an important and useful shortcut for portfolio managers – why not outsource part of the burden of compounding to the operating businesses in one’s portfolio? (Price dependent, of course.)"

Expected Return, Volatility, Historical Performance Analysis, Process Over Outcome

“…our results, relative to the Dow and other common-stock-form media usually will be better in declining markets and may well have a difficult time just matching such media in very strong markets. With the latter point in mind it might be imagined that we struggled during the first four months of the half to stay even with the Dow and then opened up our margin as it declined in May and June. Just the opposite occurred. We actually achieved a wide margin during the upswing and then fell at a rate fully equal to the Dow during the market decline.

I don’t mention this because I am proud of such performance – on the contrary. I would prefer it if we had achieved our gain in the hypothesized manner. Rather, I mention it for two reasons: (1) you are always entitled to know when I am wrong as well as right; and (2) it demonstrates that although we deal with probabilities and expectations, the actual results can deviate substantially from such expectations, particularly on a short-term basis.”

Buffett wanted to correctly anticipate not only the expected return, but also the expected volatility of his portfolio. He was not “proud” when the return pattern of the portfolio vs. his index (Dow) did not occur according to his prediction (even though he still beat the index by a wide 9.6% margin during the first 6 months of the year) – “I would prefer it if we had achieved our gain in the hypothesized manner.”

This demonstrates that Buffett was not singularly focused on outcome, but process as well. He wanted to understand why the unexpected (albeit good) outcome occurred despite a process that should have led to something different.

Also, notice that the good outcome did not provide any sense of comfort and lead Buffett to ignore the anomaly in expected volatility. Over the years, I’ve noticed that many investors only dissect downside return anomalies and completely ignore upside return anomalies. Buffett’s actions here show that it’s important to understand both directionally because a rouge variable that causes unexpected upside patterns could just as easily reverse course and lead to unexpected poor results.

Lastly, I want to point out that the key to understanding sources of portfolio return and volatility requires the dissection of historical performance returns. For more on this, check out our discussion on the 1964 letter Part 3.

Mauboussin on Portfolio Management

Michael Mauboussin, author & former Chief Investment Strategist at Legg Mason, recently joined Consuelo Mack for an interview on WealthTrack (one of my favorite resources for interesting conversations with interesting people; the transcripts are economically priced at $4.99 per episode). Their conversation touched upon a number of relevant portfolio management topics. For those of you with more time, I highly recommend listening/watching/reading the episode in its entirety. Luck, Process Over Outcome, Portfolio Management, Psychology

“MAUBOUSSIN: …luck is very important, especially for short-term results...everyone’s gotten better, and as everyone’s gotten better, skills become more uniform. There’s less variance or difference between the best and the worst. So even if luck plays the same role, lesser variance in skill means batting averages come down…So I call it the paradox of skill, because it says more skill actually leads to more luck in results…

MACK: So what are the kind of skills that we look at that would differentiate an investor from the pack, from the rest of the Street?

MAUBOUSSIN: …when you get to worlds that are probabilistic like money management where what you do, you don’t really know what the outcome is going to be, then it becomes a process and, to me, successful investing has three components to the process. The first would be analytical, and analytical to me means finding stocks for less than what they’re worth, or in the jargon means getting an investment edge, and second and related to that is putting them into the portfolio at the proper weight. So it’s not just finding good investment ideas, but it’s how you build a portfolio with those investment ideas. And by the way, a lot of people in the financial community focus on buying attractive stocks, but the structure is actually really important as well…the portfolio positioning, I think there’s room for improvement there.”           

When dealing with probabilistic predictions, such as in investing, one must focus on process, not outcome. (For more on this, be sure to check out Howard Marks’ discussion on “many futures are possible, but only one future occurs.”)

As our Readers know, PMJar seeks to emphasize the importance of portfolio management within the investment process. We are glad to see validation of this view from a premier investor such as Michael Mauboussin – that successful investing requires “not just finding good investment ideas, but how you build a portfolio with those investment ideas.”

One other corollary from the quote above – investing is a zero sum game. In order to make profits, you need to be better than the “average” market participant. But over time, ripe investment profits have lured the brightest talent from all corners of world professions and consequently, the “average” intelligence of investors has increased. This means that the qualifications necessary to reach “average” status has inconveniently increased as well.

Here’s an exercise in self-awareness: where do you fit in – below, at, or above average – versus other fellow investors?

Luck, Process Over Outcome, Sizing, Psychology

“MAUBOUSSIN: This is such an interesting question, because if you look into the future and say to people, “Hey, future outcomes are a combination of skill and luck,” everybody gets that. Right? Everybody sort of understands that’s the case, but when looking at past results, we have a much more difficult time, and I think the answer to this comes from actually neuroscience. Brain scientists have determined that there’s part of your left hemisphere in your brain which they call the interpreter, and the interpreter’s job is when it sees an effect, it makes up a cause and, by the way, the interpreter doesn’t know about skill and luck, so if it sees an effect that’s good, let’s say good results, it says, “Hey, that must be because of skill,” and then your mind puts the whole issue to rest. It just sets it aside. So we have a natural sort of module in our brain that associates good results with skill. We know it’s not always the case for the future, but once it’s done, our minds want to think about it that way.

MACK: Therefore, do we repeat, when we’ve had a success that we attribute to our skill, do we constantly repeat those same moves in order to get the same result?

MAUBOUSSIN: I think it kind of gets to one of the biggest mistakes you see in the world of investing…this is a pattern we’ve seen not only with individuals but also institutions: buying what’s hot and inversely often getting rid of what’s cold, and that ultimately is very poor for investor results. It’s about a percentage point per year reduction in long-term results for individual investors because of this effect of buying high and selling low.

…one would be over confidence. We tend to be very over confident in our own capabilities. You can show this with simple little tests, and the way that tends to show up in investing is people, when they’re projecting out into the future, they’re much more confident about the range of outcomes, so they make a very narrow range of outcomes rather than a much broader range of outcomes. So there would be one example, over confidence, and its manifestation...

...try to weave into your process tools and techniques to manage and mitigate them. I don’t think you can ever fully eradicate them, but just be aware of them and learning about them. So for example, in the over confidence, you can start to use tools to better calibrate the future, for example, using past data or making sure you’re pushing out your ranges appropriately. So there are, in every case, some tools to help you manage that."

An interesting observation on our brain’s inability to distinguish between luck vs. skill in a historical context, which explains our natural tendency to chase performance return trends.

In addition to projecting a narrow range of outcomes, overconfidence is deadly in another way – overconfidence in sizing. For example, after hitting a couple winners (mostly due to luck), an investor says “Hey, I’m really good at this. I really should have made those previous investments bigger bets. Next time.” And so, the overconfident investor sizes up the next few investments. But luck fails to appear, and the damage hurts far more because these bets were sized greater.

But worry not, salvation does exist. If investors are able to identify and become aware of their behavioral biases, they can work to control and counter the associated negative effect.

Macro

CONSUELO MACK: What’s interesting is we’ve just come through a period where we’ve heard over and over again that macro matters...I’ve had a lot of value investors come on who have very good long-term track records, saying, ‘You know what? I didn’t used to pay attention to the macro. Now I really have to pay attention. It really matters.’

MICHAEL MAUBOUSSIN: The first thing I would say about this, is this is an area of prediction that’s been very well studied, and my favorite scientist on this is a psychologist named Phil Tetlock at University of Pennsylvania who did an exhaustive study of predictions in social, political, and economic outcomes, and what he found, I think, beyond a shadow of a doubt is that experts are very poor at predicting the future. So while I know people are worries about getting whipsawed by macro events, the evidence that anybody can anticipate exactly what’s going to happen next is very, very weak. So that’s the first thing, is just to be very reserved about your belief in your ability to anticipate what’s going to happen next…Obviously, you want to be mindful of macro. I don’t want to say you be dismissive of it. I would say macro aware, but in some ways macro agnostic.”

Risk Free Rate, Equity Risk Premium

“The most interesting anomaly that I see continues to be what is high equity risk premium. So in plain words, you think of a risk-free rate of return. In the United States, a 10-year Treasury note is a good proxy for that…about a 1.8% yield. An equity risk premium is the return above and beyond that you would expect for taking on additional risk on equities. Now, over the long haul, that equity risk premium has been about three or four percent, something like that, and today, by most reckoning, it’s a lot closer to six percent. It’s very, very high.”

Historically (depending on time period examined), equity risk premium is normally 3-4%, versus ~6% today. But does this mean that today’s equity risk premium is abnormally high? Or was the historical equity risk premium just abnormally low?

What is the qualitative explanation behind the figure for the “normal” equity risk premium? Must it hold true into perpetuity?

Buffett Partnership Letters: 1964 Part 3

Continuation of our series on portfolio management and the Buffett Partnership Letters, please see our previous articles for more details. Historical Performance Analysis, Process Over Outcome, Psychology

“…the workouts (along with controls) saved the day in 1962, and if we had been light in this category that year, our final results would have been much poorer, although still quite respectable considering market conditions during the year…In 1963 we had one sensational workout which greatly influenced results, and generals gave a good account of themselves, resulting in a banner year. If workouts had been normal, (say, more like 1962) we would have looked much poorer compared to the Dow…Finally, in 1964 workouts were a big drag on performance.”

There is a chart in the January 18, 1965 partnership letter, in which Buffett breaks down the performance of Generals vs. Workouts for 1962-1964, and discusses the return attribution of each category in different market environments.

Most investors conduct some form of historical performance review, on a quarterly or annual basis. It’s an important exercise for a variety of reasons:

• To better understand your sources of historical return – performance analysis forces you to examine the relationship between your process vs. the outcome. Was the outcome as expected? If not, do changes need to be made to the process?
• To help you and your team become more self-aware – what you do well, badly, and perhaps reveal patterns of behavioral strength and weakness (here's an article about an interesting firm that offers this analysis)
• Team Compensation
• Highlight necessary adjustment to the portfolio and business
• Etc.

The investment management world spends a lot of time scrutinizing the operations of other businesses. Shouldn’t we apply the same magnifying glass to our own?

Sizing, Catalyst, Hedging, Activism, Control

“What we really like to see in situations like the three mentioned above is a condition where the company is making substantial progress in terms of improving earnings, increasing asset values, etc., but where the market price of the stock is doing very little while we continue to acquire it…Such activity should usually result in either appreciation of market prices from external factors or the acquisition by us of a controlling position in a business at a bargain price. Either alternative suits me.”

“Many times…we have the desirable ‘two strings to our box’ situation where we should either achieve appreciation of market prices from external factors or from the acquisition of control positions in a business at a bargain price. While the former happens in the overwhelming majority of cases, the latter represents an insurance policy most investment operations don’t have.”

Buffett discusses the phenomenon known as the “two strings” on his bow which allowed for heavy concentration in a few positions. The potential to (eventually) acquire a controlling stake in the underlying company served has an “insurance policy” via the creation of a catalyst after asserting control. (Some may argue that activism is applicable here as well. However, we tread cautiously on this train of thought because activism by no means entails a 100% success rate.)

It’s important to understand that control is not an option available to all investors. Therefore, when sizing positions, one should reconsider the exact emulation of Buffett’s enthusiastic buying as price continues to decline, and concentrated approach.

Interestingly, if a controlling stake in a company serves as an insurance policy (as Buffett describes it), is ‘control’ a type of portfolio hedge?

Activism, Control

“We have continued to enlarge the positions in the three companies described in our 1964 midyear report where we are the largest stockholders…It is unlikely that we will ever take a really active part in policy-making in any of these three companies…”

Control ≠ Activism

Conservatism

“To too many people conventionality is indistinguishable from conservatism. In my view, this represents erroneous thinking. Neither a conventional or an unconventional approach, per se, is conservative.”

“Truly conservative actions arise from intelligent hypotheses, correct facts and sound reasoning. These qualities may lead to conventional acts, but there have been many times when they have led to unorthodoxy. In some corner of the world they are probably still holding regular meetings of the Flat Earth Society.”

“We derive no comfort because important people, vocal people, or great numbers of people agree with us. Nor do we derive comfort if they don’t. A public opinion poll is no substitute for thought. When we really sit back with a smile on our face is when we run into a situation we can understand, where the facts are ascertainable and clear, and the course of action obvious. In that case – whether conventional or unconventional – whether others agree or disagree – we feel we are progressing in a conservative manner.”

Lisa Rapuano Interview Highlights - Part 2

Part 2 of highlights from an insightful interview with Lisa Rapuano, who worked with Bill Miller for many years, and currently runs Lane Five Capital Management. The interview touches upon a number of relevant portfolio management topics. Rapuano has obviously spent hours reflecting and contemplating these topics. A worthwhile read!

Fee Structure

“…I launched my fund [November 2006] with an innovative fee structure – wait three years and then charge only on the positive return over the market…three-year lock up…given the changes in the marketplace we simply did not think a three-year lock-up was a tenable proposition under any circumstances. So…we had to abandon our three-year free structure as well…What I was extraordinary surprised by however, was how little this mattered to many potential investors. There is an institutional imperative that has evolved in hedge funds that is very similar to that which has evolved in long-only funds. Being different, no matter how right it may be, doesn’t help.”

Given my family office background, the fee structure topic has come up frequently especially as it relates to fundraising. One would think that fee discounts should garner more investor interest. Unfortunately, my advice is the same as Rapuano’s: “being different, no matter how right it may be, doesn’t help.”

The average retail investor is usually not sophisticated enough to care about the difference between 1% (management fee) & 15% (incentive fee) versus 2% & 20%. The average institutional investor is merely going through the motions of checking boxes with a “cover your behind” mentality before presenting to committee. So with the exception of sophisticated investors (fewer in number than the unsophisticated), the fee discount really doesn’t make much difference.

In fact, it could potentially hurt fundraising because it begs the additional question: why are you different? With only 60 minutes or so per meeting, it’s likely best to not waste time having to answer this additional question.

Shorting, Team Management, Exposure

“On the short side, we only short for alpha – we do not use shorts to control exposure explicitly or to hedge or control monthly volatility…This model has been chosen very specifically to suit the skills of me and my team. We think being able to short makes us better analysts, it keeps us more honest.”

“We also like the flexibility to hold a lot of cash or be a bit more short when we think there are no great values lying around…we think eliminating the pressure to stay low-exposure (and to therefore often put on very poor shorts) is a good match for our style…”

Rapuano highlights a very important distinction: shorting for alpha vs. shorting to control exposure. I would add a third category: shorting to justify the incentive fee.

Also, it’s an interesting idea to build an investment process that works with the behavioral tendencies of the investment team. I guess the flip-side is to recruit for talent that fits a specific type of investment process.

Making Mistakes, Process Over Outcome

“Then there are the mistake where you just misjudged the situation in your analysis…I thought something was low probability but then it happens…we analyze these types of mistakes, but it’s not a focus on what happened, but simply to make sure we did all the work we could have been expected to do, our judgments were based on sound analysis, and well, sometimes you’re just wrong. There are other mistakes, however, that you can try to eliminate, or at least not repeat.”

“For me, my worst ones have been when I strayed from either my core values or my process. So, when we’ve done something as a ‘trade’ (it just seemed too easy) and not subjected it to the rigors of the process it usually doesn’t work out.”

Mistakes are not just situations when the outcomes are bad (i.e., ideas don’t work out). Do we make a mistake each time we stray from our investment process?