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Good Reading -- August 2012

Facts and Figures

  • The 100 largest U.S. corporate pensions have an aggregate funding deficit of $486bn, an increase of $186bn in the quarter ended June 30, 2012. And discount rates are still too high... (Source: Milliman Inc.).

  • Ford's pension plan has 80% of its assets in bonds.

  • In light of recent gasoline demand declines:< >Percent of 19 year-olds with a driver's license: 87.3% in 1983, 75.5% in 2008, 69.5% in 2010 (Source: U. Mich. Transp. Research Inst.) Annual miles driven by age peak at >15k for 30-39 year-olds; range from 13-15k for 20-29 and 40-60 year-olds; and plunge beyond age 60 (souce: Nat'l Household Transp. Survey)


  • Investment Principles & Checklists -- This is a collection of investing concepts, mostly organized into checklists, that I've been compiling for several years. First off, let me apologize for the sloppy formatting (and the mistakes and typos...see below for some irony). Things really get disjointed in the appendix, but hopefully there is enough structure (or you can ctrl + f) to find people/concepts of interest. I've tried to cite and attribute everything that came from a third party, but this needs work -- please let me know if you see any mistakes or omissions. Anything not clearly labeled is likely mine, although this isn't my working checklist. I do refer to it often and I have used it to create my own checklist, which I'll try to refine for distribution in coming months. In the meantime I thought I'd send this around after getting several requests for a collection checklists similar to the quotations compilation I sent around earlier.

  • "Earnings Quality: Evidence from the Field" -- The headlines are about the estimates of fudged earnings reports from public-company CFOs -- Jim Chanos has cited an even higher number from a different study for years -- but the whole paper is worth reading. Abstract: "...key findings include (i) high-quality earnings are sustainable and are backed by actual cash flows; they also reflect consistent reporting choices over time and avoid long-term estimates; (ii) about 50% of earnings quality is driven by innate factors; (iii) about 20% of firms manage earnings to misrepresent economic performance, and for such firms 10% of EPS is typically managed; (iv) CFOs believe that earnings manipulation is hard to unravel from the outside but suggest a number of red flags to identify managed earnings; and (v) CFOs disagree with the direction the FASB is headed on a number of issues including the sheer number of promulgated rules, the top-down approach to rule making, the curtailed reporting discretion, the de-emphasis of the matching principle, and the over-emphasis on fair value accounting."

  • "Does the Shiller-PE Work in Emerging Markets?" -- Another good academic paper. (Spoiler alert: the authors find a cyclically adjusted PE ratio to be a reasonably good long-term indicator of future stock market returns.) Thanks to Greenbackd for finding this, along with another paper ("Value Matters: Predictability of Stock Index Returns") that I meant to send around a while ago -- similar approach and results in developed markets.

  • "So You Want to Be the Next Warren Buffett? How's Your Writing?" -- Mark Sellers gave this speech several years ago at Harvard Business School. (See related material below.)


  • The Einstein of Money: The Life and Timeless Financial Wisdom of Benjamin Graham. -- This is an interesting new Ben Graham biography that reminded me a shorter version of The Snowball. There is a lot of in-depth biographical detail, including material that I don't remember reading anywhere else, combined with alternating chapters on several of Graham's specific investment tenets. Parts of it were oddly personal, and parts of the investing-related chapters fell a little short, but I still think this is a worthwhile read.

  • Great Summer Reading -- Bill Gates discusses some of the best books he's been reading.

  • Charlie Rose interviews Bills Gates -- Interesting thoughts on a range of topics: business (Apple, Microsoft, computing/software), philanthropy, India, and others. For even more Bill Gates, check out this great blog and a review of his eerily prescient thoughts on smartphones in his 1995 book The Road Ahead.

  • More great reading from a great blog.

  • Book recommendations in accounting -- A great reading list of accounting books from a great accounting blog (and no, those are not oxymorons).


  • 'Deliberate Practice' -- I think the habit of going back, with the obvious benefit of hindsight, to study ideas that have worked (and failed) for other investors is extremely instructive. Last year I sent around some ideas for such "practice" from Ted Weschler's 13-F filings in his Peninsula days -- there are some great, fairly recent ideas in there (email me if you want the list in spreadsheet form). Two older ideas -- complete with copies of the now-ancient annual reports -- were just presented by some great blogs. See here for American Express in 1964/65, here for Coca-Cola in 1988,here for Dairy Queen in 1997, and here for Wal-Mart in 1981.

  • Interview with Jim Chanos -- A great interview on China and short-selling in general.

  • "Angola's Chinese-built Ghost Town" -- A bizarre derivative of the Chinese ghost-town phenomenon: a Chinese SOE building a massive speculative development in Angola on credit secured by oil.

  • "I'm the Fastest No in the West" -- A brief interview with Sam Zell about his investments and the advantage of speed.

  • "The Future of Manufacturing is in America, not China" -- These articles are stopping to pop with some regularity, and this is one of the better summaries of the concept. I don't buy parts of it, but it's worth considering.

  • "How Not to Invest in Myanmar" -- A brief Foreign Affairs article about a pretty amazing situation in a truly "frontier" market: Myanmar had more FDI last year than in the previous 20 combined; hotel room prices are up >8x in the past six months; and its currency was trading at 840 to the USD in June against six in April. And Burmese leaders already (and rightly) warning against "reckless optimism."

  • "Leon Cooperman on How to Succeed in Business (By Really Trying)" -- 14 rules to live by, according to the man himself.

  • "I Won't Hire People Who Use Poor Grammar. Here's Why." -- I highly recommend Lynne Truss's book, which I read years ago and still love. I'm not quite at the "zero tolerance" level -- typos and mistakes made in haste do happen -- but I'm always appalled at the number of people who repeatedly misuse "its" and "it's" or "your" and "you're." If you ever see me commit any such errors please feel free to blast away.

  • I also highly recommend an old speech by Mark Sellers titled, "So You Want To Be The Next Warren Buffett? How’s Your Writing?" (see attached). I agree that all the best investors (Graham, Buffett, Klarman) are also excellent writers and that there's probably a good reason for that. There are also a lot of other good lessons from this speech and from Sellers' own career (do a quick Google search or email for a compilation of files).


  • "The Oracle of Boston" -- A good profile of Seth Klarman and Baupost from The Economist.

  • "Waiting Game" -- Frank Partnoy of Fiasco fame is out with a new book about waiting in the context of decision making. From the article below: "...given the fast pace of modern life, most of us tend to react too quickly. We don’t, or can’t, take enough time to think about the increasingly complex timing challenges we face. Technology surrounds us, speeding us up. We overreact to its crush every day, both at work and at home. Yet good time managers are comfortable pausing for as long as necessary before they act, even in the face of the most pressing decisions. Some seem to slow down time...Life might be a race against time but it is enriched when we rise above our instincts and stop the clock to process and understand what we are doing and why. A wise decision requires reflection, and reflection requires a pause." (Emphasis mine)

  • Here is another article from the author on the same topic.

  • Optimizing the Investment Process: Michael Mauboussin's Strategies for Making Decisions Under Uncertainty" -- Summary of a recent presentation with a lot of good thoughts on Mauboussin's keys to success: focusing on process over outcome; finding favorable odds; and understanding the value of time.

  • "A Beekeeper's Perspective on Risk" -- I admit that this sounds like a stretch, and at points this analogy is taken right to the limit, but still I think this it is fairly interesting and useful. "[H]oneybee colonies...were structured for consistent long-term growth and the prevention of severe loss due to unpredictable environmental surprises. Bees are masters at risk management..The hive is only beholden to the long term."

The Oracle of Boston

A hedge-fund manager with a low profile and a big following

Jul 7th 2012 | Boston | from the print edition

HEDGE-FUND bosses rarely double as cult authors. But an out-of-print book by Seth Klarman, the boss of the Baupost Group, sells for as much as $2,499 on Amazon. A scanned version of “Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor” has been circulating around trading floors. One hedgie likens Mr Klarman's book to the movie “Casablanca”: it has become a classic.

Why are Wall Street traders such avid readers of Mr Klarman? Baupost, which manages $25 billion, is the ninth-largest hedge fund in the world. Since 2007 its assets have more than tripled, as other funds have wobbled. Baupost has had only two negative years (in 1998 and 2008) since it launched in 1982, and is among the five most successful funds in terms of lifetime returns (see chart), a particularly striking record given its risk aversion. Long closed to new investors, Baupost counts elite endowments like those of Yale, Harvard and Stanford among its clients.

Soft-spoken and based in Boston, a safe distance from the Wall Street mêlée, Mr Klarman keeps a low profile and rarely speaks at industry shindigs. He is probably the most successful long-term performer in the hedge-fund industry who has managed to stay out of the spotlight.

Mr Klarman is a devotee of “value investing”, a discipline forged by Benjamin Graham (see article) and popularised by Warren Buffett, which involves buying stocks at a discount to their intrinsic value. He will look beyond equities for bargains—a good example is Lehman Brothers, which at the end of last year was Baupost's largest distressed-debt position. But in every investment he insists on a “margin of safety”, the buffer between what investors pay for the stock and what they think it is worth, so they are protected against unforeseen events or miscalculations.

Mr Klarman first became an acolyte of value investing when he worked at Mutual Shares, a value-investing mutual fund, as an intern and again after he finished Harvard Business School. One of his former Harvard professors then recruited him to run a family office for him and three other families, with an investment pot of $27m (Baupost is an acronym for these families' surnames). Although the fund is significantly larger today, Mr Klarman still runs Baupost like a family office. He is extremely risk averse; his primary goal is not stellar returns but preservation of capital.

In other ways, too, Baupost is not a typical hedge fund. It uses no leverage, which is partly why Mr Klarman is not famous for one stunningly profitable trade, like George Soros's bet against sterling or John Paulson's against the housing bubble. Baupost has few short positions and often holds its positions for years, rather than days or months. Mr Klarman is patient and confident enough to do nothing. He currently has around 30%—and has been known to have as much as 50%—of his portfolio in cash. In 2008 Baupost was one of the few firms that had the scale and the available capital to buy up lots of assets from distressed sellers. “The ability to be one-stop shopping for an urgent seller is very advantageous,” he says.

Given Baupost's allure, it could easily make a killing on fees. But Mr Klarman eschews the generous “2 and 20” compensation structure typical of most hedge funds, which take 2% of capital as a management fee and 20% of gains. Instead, old investors pay “1 and 20”, and newer ones (he has let them in twice, in the early 2000s and 2008) no more than “1.5% and 20”.

That is not the only way Mr Klarman has positioned Baupost in contrast to other funds. He thinks one of investors' greatest mistakes is chasing short-term performance and obsessively comparing returns with those of competitors and with benchmarks. In the year to April, Baupost was up by around 2%, trailing the S&P 500 (which was up by 11.9%) and the average hedge fund (4.4%). He is probably the only hedge-fund manager ever to tell investors that he does not want to be their best-performing fund in a given year, as he did in a recent letter. He has deliberately maintained a sticky investor base composed almost entirely of endowments, foundations and families, which understand his investment philosophy and will not redeem after a few negative quarters.

Some have nonetheless expressed concern about Baupost becoming a behemoth. The bigger a hedge fund, the more its investments become restricted to bigger companies and the harder it is to generate profits. Returns could flag. “He's pretty damn big. That doesn't excite me,” says the chief investment officer of a large American endowment with money in Baupost. Mr Klarman himself says he remains “convinced that unlimited size is a bad idea.” Two-thirds of the firm's approximately $17.6 billion in growth over the past five years comes from compounded profits, as opposed to new money coming in. In 2010 Baupost returned 5% of investors' capital, because he did not think there were enough ways to put it to work.

Hedge funds are notoriously monotheistic and usually suffer if the founder leaves. Mr Klarman, who is 55, has already started working with his team on succession planning. Last year he promoted someone to serve alongside him as manager of the portfolio. Mr Klarman has also hired coaches to work with him and some of his team on devising strategy and maintaining the firm's culture.

In 2011 Baupost opened a London office, its first outside Boston in its 30-year history, to buy assets as European banks deleverage. That has happened more slowly than expected. Mr Klarman has been critical of governments propping up markets through stimulus and keeping interest rates low, all of which has perverted markets. But this is the type of environment where bargains will eventually surface. “Whatever investment success we achieve will take place against a troubled backdrop,” he wrote in January. Last year “felt like we were playing a great hand of cards in the basement of a condemned building filled with explosives during an earthquake.” He did not get where he is now by being an optimist.

Waiting game

By Frank Partnoy

Watching the world’s best tennis players at Wimbledon over the next fortnight can help us make better decisions

During the two weeks of play that begin on Monday, professional tennis players at Wimbledon will return thousands of first serves. Many of those returns will be entertaining. Some will be remarkable. But all will give spectators an opportunity to improve on the personal and professional decisions we make in all aspects of our lives: by helping us learn to manage delay.

Watch Novak Djokovic. His advantage over the other professionals at Wimbledon won’t be his agility or stamina or even his sense of humour. Instead, as scientists who study superfast athletes have found, the key to Djokovic’s success will be his ability to wait just a few milliseconds longer than his opponents before hitting the ball. That tiny delay is why most players won’t have a chance against him. Djokovic wins because he can procrastinate – at the speed of light.

During superfast reactions, the best-performing experts in sport, and in life, instinctively know when to pause, if only for a split-second. The same is true over longer periods: some of us are better at understanding when to take a few extra seconds to deliver the punchline of a joke, or when we should wait a full hour before making a judgment about another person. Part of this skill is gut instinct, and part of it is analytical. We get some of it from trial and error or by watching experts, but we also can learn from observing toddlers and even animals. There is both an art and a science to managing delay.

In 2008, when the financial crisis hit, I wanted to get to the heart of why our leading bankers, regulators and others were so short-sighted and wreaked such havoc on our economy: why were their decisions so wrong, their expectations of the future so catastrophically off the mark? I also wanted to figure out, for selfish reasons, whether my own tendency to procrastinate (the only light fixture in my bedroom closet has been broken for five years) was really such a bad thing.

Here is what I learnt from interviewing more than 100 experts in different fields and working through several hundred recent studies and experiments: given the fast pace of modern life, most of us tend to react too quickly. We don’t, or can’t, take enough time to think about the increasingly complex timing challenges we face. Technology surrounds us, speeding us up. We overreact to its crush every day, both at work and at home.

Yet good time managers are comfortable pausing for as long as necessary before they act, even in the face of the most pressing decisions. Some seem to slow down time. For the best decision-makers, as for the best tennis players, time is more flexible than a metronome or atomic clock.

. . .

A tennis court, baseline to baseline, is 78ft long. First serves are launched at well over 100mph. Some volleys come even faster. That means a player returning a shot has just 400 to 500 milliseconds from when the ball leaves their opponent’s racket until it hits his or her own. Just half a second.

Hitting a tennis ball at this speed is a paradoxical act. On one hand, it is a largely unconscious physical reaction. It has to be, given the speed of the ball. There is not enough time to consider spin or angle. Conscious contemplation takes at least half a second, so anyone who even tries to think about how to return a shot will end up helplessly watching the ball fly by.

On the other hand, tennis involves a range of sophisticated and creative responses. Ideally, a player should react to both the placement and trajectory of an incoming ball. The position and movement of an opponent are also crucial. Great tennis returners respond to the information cascade of an incoming ball as if they had taken time to process it consciously, even though we know that is not possible.

Professional tennis players are no faster than we are at pure visual reaction time. Imagine that you and Novak Djokovic are playing a video game. We can measure visual reaction time by having both of you simply press a button when you first see the ball leave an opponent’s racket. Both of you would take about 200 milliseconds. Most people are about that fast, and no one is much faster.

That means virtually anyone who can see a distance of 78ft can react visually to any tennis serve or shot in plenty of time. As even the slowest video gamer can attest, if all you have to do is “see” and then press a button to swing — if you don’t even have to get off the sofa — anyone could return a professional-speed serve.

In real tennis, the difficulty arises in the second stage of the service return. The remaining period of, say, 300 milliseconds is the time players have to react physically – to adjust themselves to what they know about the ball’s flight and then try to hit it how and where they’d like.

Having just 300 milliseconds to hit a ball is a serious problem for most of us. Amateurs cannot move to the correct spot and produce a swing with accuracy or power in 300 milliseconds. Most of us can barely adjust our rackets by a few inches. Many solid professionals cannot do much more.

Even Djokovic does not successfully return every shot. But for most returns, he has plenty of time. He is so skilled and practised that he can produce near-instantaneous muscle contractions to move his body and execute a swing in perhaps 100 milliseconds. For him, the physical part of hitting the ball is almost as easy as pressing a button.

Djokovic’s physical speed frees up time for him to prepare during the phase tennis coaches call “ball identification”. This is when he absorbs the crush of data generated after the ball leaves his opponent’s racket. He splits up the time available during a return shot; because he is so fast, he has extra time to gather and process information. Finally, at the last possible instant, he commits to his choice and swings. He can sandwich a lot of preparing between seeing and hitting.

Because Djokovic needs less time to hit, he has more time to gather and process information. He sees, prepares and, finally, only after he has processed as much information as possible, he hits. His preconscious time management and his extraordinary ability to delay enable him to stretch out a split-second and pack in a sequence of interpretation and action that would take most of us much longer.

. . .

In recent years, scientists have made great progress in comprehending our reactions and decisions. Psychologists have suggested we have two systems of thinking, one intuitive and one analytical, both of which can lead us to make serious cognitive mistakes. Behavioural economists have said our responses to incentives are often irrational and skewed, sometimes predictably so. Neuroscientists have taken pictures of our brains to show which parts react to different stimuli.

Yet we still don’t understand the role time and delay play in our decisions and why we continue to make all kinds of timing errors, reacting too fast or too slow. Delay alone can turn a good decision into a bad one, or vice versa. Much recent research about decisions helps us understand what we should do or how we should do it but it says little about when.

Sometimes we should trust our gut and respond instantly. But other times we should postpone our actions and decisions. Sometimes we should rely on our quick intuition. Other times we should plan and analyse.

How do the above insights about sport matter to those of us who cannot compete with professional athletes? The decision-making framework that elite athletes use is precisely the same framework we should use for all kinds of non-sport decisions at slower speeds. The superfast athlete’s approach of first observing, second processing and third acting – at the last possible moment – also works well for our personal and business decisions.

Similar approaches are followed by top military strategists, surgeons, paramedics, crisis managers and acting coaches. Delay also helps in our personal decisions. For example, although we are taught to apologise right away, studies show that delayed apologies are usually more effective. If you accidentally spill a drink on someone at a party, you should say sorry immediately. But for more serious, intentional wrongs – infidelity or lying about a colleague – a quick apology is a mistake. Instead, you need to give the aggrieved person a chance to understand what happened and respond. The best apologies are fully informed and come at the last possible moment.

Likewise, we are often better off delaying our judgments about people as long as possible. We tend to overreact based on gender, race and attractiveness. That is why the international dating network, It’s Just Lunch, will not permit clients to see photos before a date. Irene LaCota, the company’s president, told me: “The two most important elements of a relationship are chemistry and compatibility, and a photo won’t help you with either.”

Most of us also make investment decisions too quickly. Instead, we should emulate Warren Buffett. When asked how long he will delay before buying a stock, he responds, “Indefinitely.” Buffett likens buying stocks to hitting a baseball – except without the strikes. “I call investing the greatest business in the world because you never have to swing,” he says. “You stand at the plate, the pitcher throws you General Motors at 47. US Steel at 39 ... All day you wait for the pitch you like; then when the fielders are asleep, you step up and hit it.”

In other words, when we watch Wimbledon, we will see tennis returners do on the court what we should do in life: manage delay. The biggest difference is that they are teaching us this valuable lesson so quickly that they do not even have time to think.

. . .

If the financial crisis has taught us one lesson, it is that gut reactions are fraught with peril. Last month, the Lehman Brothers bankruptcy examiner released its trove of documents, confirming the bad decisions made by the firm’s leaders resemble the bad decisions many of us make in our personal and professional lives. We are biased. We overreact. We don’t understand when we are experts or novices. We don’t manage time; instead, time manages us.

Like the managers of failing European banks or the flip-flopping executives at JPMorgan (whose leader, Jamie Dimon, in April abruptly dismissed rumours about derivatives losses as a “tempest in a teapot”, only to admit weeks later that the bank lost $2bn on those trades), the senior leaders at Lehman didn’t stop to think about consequences. Nor did the regulators. Instead, under intense time pressure, these people favoured their gut instincts.

One of the most surprising aspects of Lehman’s collapse was that the firm’s leaders had tried so hard to understand the problems associated with their own decision-making. In autumn 2005, Lehman’s senior managers hired a group of experts to teach four dozen top executives how to make better decisions. Max H Bazerman, a chaired professor at Harvard Business School, reviewed cutting-edge decision research. Mahzarin Banaji, a Harvard psychologist, administered custom-designed tests to help the executives understand their biases. Malcolm Gladwell, who had just published Blink, a bestseller about the “first two seconds” of our reactions, gave the capstone lecture.

These managers sat for a cutting-edge course on the timing of decisions. Then, they rushed back to their offices and made some of the worst decisions in the history of financial markets. Three years later, their firm was gone.

If Lehman had lived until today, its decision-making course would look radically different. The core message of recent research is the opposite of the one Lehman’s executives learnt in 2005: the longer we can wait, the better. And once we have a sense of how long a decision should take, we generally should delay the moment of decision until the last possible instant. If we have an hour, we should wait 59 minutes before responding. If we have a year, we should wait 364 days. Even if we have just half a second, we should wait as long as we possibly can. As the matches at Wimbledon will illustrate, even milliseconds matter.

Thinking about the role of delay is a profound and fundamental part of being human. Questions about delay are existential: the amount of time we take to reflect on decisions will define who we are. Is our mission simply to be another animal, responding to whatever stimulations we encounter? Or are we here for something more?

Life might be a race against time but it is enriched when we rise above our instincts and stop the clock to process and understand what we are doing and why. A wise decision requires reflection, and reflection requires a pause.

If we are limited to just one word of wisdom about decision-making for children born a hundred years from now, people who will have all our advantages and limitations as human beings but will need to navigate an unimaginably faster-paced world than the one we confront now, there is no doubt what that word should be.


‘Wait: The useful art of procrastination’ will be published by Profile Books on July 5

Optimizing the Investment Process: Michael Mauboussin’s Strategies for Making Decisions under Uncertainty

Ed Bace, CFA

Decision making under conditions of uncertainty cuts to the heart of the investment process. At the recent CFA Society of the UK Annual Conference in London, Michael Mauboussin, chief investment officer at Legg Mason Capital Management, reviewed some best practices, including paying attention to process versus outcome, having the odds in one’s favor, and understanding the role of time.

Building on what he teaches at Columbia Business School, Mauboussin laid out his “T” theory, which postulates that the best decision makers have more in common with each other than they do with average participants, whether the context is investing or playing poker. “Average” players may lack a disciplined and economic process and fail to recognize that even excellent processes sometimes yield bad results. Mauboussin also contended that the investment community today is driven by financial incentives and is focused on outcomes to the detriment of process, a sentiment that was echoed by the audience of investment professionals in a post-lecture poll.

Best Practices for Investment Decision Making

Mauboussin believes the main difference between good and great investors comes down to temperament and focus. Good processes and good outcomes deliver deserved success, just as bad processes and bad outcomes are a form of poetic justice. Conversely, bad processes that yield good outcomes are just dumb luck. Investors often confuse the two. Successful poker players and renowned economists agree that better decision making comes from evaluating decisions on how well they were made rather than on outcomes.

Asset prices clearly reflect expectations, which successful investors must understand (this is analogous to a gambler having odds in his favor). Mauboussin argued that the greatest failure in the investment business is not distinguishing between fundamentals and expectations as implied by price. As an insightful track bookie might put it, there is no such thing as “liking” a horse, only “an attractive discrepancy between the horse’s chances and his price,” a concept echoed by successful asset managers.

Mauboussin added that time plays a critical role here: The short term cannot distinguish between good and bad processes — a quality process has a long-term focus (a lot longer than that of most investors). He cited Michael Lewis’s observation inMoneyball that, over a season, luck among baseball teams evens out and skill shines through. In the short term, however, skill can be overwhelmed by chance. Famous card gambler Amarillo Slim didn’t care about the results of one game. He focused on decisions, not results: “Do the right thing enough times and the results will take care of themselves.” A quantitative example of “time arbitrage” shows that in 20 coin tosses, 30% come up heads, whereas in 100 tosses, the result is 50% heads.

Expected Value: Probabilities and Outcomes

Applying this to the practice of investing, Mauboussin focuses on setting probabilities and considering outcomes. As Warren Buffett knows well, expected value is the weighted average value for a distribution of possible outcomes. The investor’s goal of achieving net gain from probabilities of gain and loss is an imperfect process.

So, how should we set probabilities? There is the Bayesian approach (subjective, satisfying probability laws), propensity (reflecting system properties — e.g., rolling a die), and frequencies (using a large sample of an appropriate reference class). The latter is favored by the finance community, Mauboussin said. The problem with this approach was articulated by Bradford Cornell: If the data are nonstationary (which in all likelihood they are), the results of the sample (e.g., P/E) are typically not meaningful.

One way to think about outcomes is to look at a frequency distribution (for example, daily returns of the S&P 500 Index from 1978 to 2011). These data show at least five six-sigma events in the course of a single recent year, where theory would predict one six-sigma event every 4 million years!

Another simple example suffices to show that a good probability could result in a bad expected value: 70% probability of a 1% gain could well result in a negative return if there is a 30% probability of a 10% loss.

Why Are Most of Us Suboptimal?

Mauboussin stated that investors, like most of the general population, inevitably encounter pitfalls based on human behavior. As an example, overconfidence results in too narrow an outcome range, and the confirmation trap compels us to seek confirming information and dismiss or discount that which disconfirms. One interesting experiment he cited utilized brain-damaged patients, whose emotions had been suppressed as a result. The experiment found that in contrast to normal participants, these patients did best wagering a $20 stake over 20 rounds and played more rounds, especially after suffering a loss. Solomon Asch’s study of social conformity showed that, under pressure from peers, one-third of individuals conformed to the majority in giving a patently wrong answer. As also shown by researcher Greg Berns, this is a distortion of perception rather than of judgment or action.

Legg Mason’s CIO believes investing is probabilistic and that expected value is the right way to think about security prices. Investors encounter many pitfalls in objectively assessing probabilities and outcomes. He concluded that unless we practice mental discipline, we will lose in the long term to those who can. Indicative of this behavior are the excesses that markets periodically experience. Mauboussin’s forthcoming book, The Success Equation, strives to untangle skill and luck in business, sports, and investing.

A Beekeeper's Perspective on Risk

by Michael O'Malley

A decade ago, I embarked on a new hobby — one that many more people have taken up in the meantime. I became a beekeeper. At the same time, I became a bee observer. Like Sherlock Holmes (in His Last Bow), I spent many pensive nights and laborious days watching the little working gangs.

What I didn't expect was to learn lessons about organizational strategy and behavior that would inform my work as a human capital consultant. Professionally, I help large businesses manage risk by focusing on how their recruiting, compensation, training, and other systems encourage people to behave. What I came to recognize was that beehives were organizations that naturally got things right. The honeybee colonies I was cultivating were structured for consistent long-term growth and the prevention of severe loss due to unpredictable environmental surprises. Bees are masters at risk management.

Take, for example, their approach toward the "too-big-to-fail" risk our financial sector famously took on. Honeybees have a failsafe preventive for that. It's: "Don't get too big." Hives grow through successive divestures or spin-offs: They swarm. When a colony gets too large, it becomes operationally unwieldy and grossly inefficient and the hive splits. Eventually, risk is spread across many hives and revenue sources in contrast to relying on one big, vulnerable "super-hive" for sustenance.

Here's another lesson by analogy: No queen bee is under pressure for quarterly pollen and nectar targets. The hive is only beholden to the long term. Indeed, beehives appear to underperform at times because they could collect more. But they are not designed to maximize current returns; they are designed to prevent cycles of feast and famine (a death sentence in the natural world). They concentrate their foraging on the most lucrative patches but keep an exploratory force in the field that will ensure future revenue sources when the current ones run dry. This exploratory force (call it an R&D expenditure) increases as conditions worsen.

Distributed decision-making is another honeybee strategy for mitigating risk. Individual bees make decisions based on local cues and information, making the beehive perhaps the original empowered organization. In contrast to stodgy centralized systems, bees are able to make high-quality, relatively quick choices through distributed authority because the colony has mechanisms in place that reinforce sound judgments and execution. The competence of the individuals, for example, is assured by a disciplined career development program. By the time bees are sent into the field, they are prepared—and, even then, novice foragers are frequently accompanied by veterans who show them how to efficiently and productively move among, and work, the flowers. Knowledge management is also essential. Bees have a great communication system by which the good incoming information is always overwhelming the bad and is on constant display for the bees to see. Thus, individual workers have access to an accurate, up-to-date depiction of the real world.

Risk is also tempered by diversity in a beehive. When making big decisions, bees use a process that is similar to the Delphi technique: They assemble multiple viable options that they present to other bees to vote on independently and iteratively until a quorum is reached. As the Marquis de Condorcet showed (in the collective wisdom proof), good, unbiased decisions are made if a solution space is well sampled and the final judgment is determined by independent decision-makers. One of the attributes that determines the range of options that bees ultimately consider is genetic diversity. The greater the diversity in the bees' DNA, the more sensitive they are to different conditions and circumstances, and the more options the hive is able to gather. More diverse hives are better at everything and more productive than less diverse ones.

Finally, bees choose the mistakes they will make, and are careful to make the right ones. The future is as unknowable for them as it is for us. A share of failure is inevitable. Sometimes, however, if you know you might be wrong, you can decide how to be wrong. For example, it is energy- and resource-costly for bees to build comb, and they don't want to manufacture it if they aren't going to use it. At the same time, they don't want to under-build and miss a life-saving opportunity to store honey. To strike the right balance between these potential errors, honeybees use a sliding rule (with respect to empty comb cells) that guides them toward the least bad mistake: "We will only over-build if conditions are good and nectar is flowing and we will only under-build if times are tough and nectar influx is marginal." These errors are better than the alternatives. The bees consider the worst that can happen no matter how improbable and protect themselves against that eventuality.

Should we try to build these features more fully into human organizations? No analogy is perfect, but the logic is hard to argue with. Honeybees have institutionalized procedures that prevent catastrophic loss, and their record of accomplishment is stunning: more than 100 million years of productivity and growth. Note, too, that no one needs to regulate the hives to keep them from taking on irresponsible risk—behaviors like these keep them self-regulating.

Companies differ enough from hives that we'll probably never be able to do without regulation. But managing for practical scale, long-term success, distributed decision-making, diversity, and least-worst outcomes may be the best hope for keeping organizations healthy. It is the wrong impulse to put a damper on all the risk-taking that produces value. By adopting the kinds of features that keep bees venturing productively, but never gambling catastrophically, businesses might avoid heavy-handed regulation, and everyone will be better served.

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