Investment vs gambling, and our strategy- On investment (29)
Investment vs gambling
Investment vs gambling, people are used to treat the two as totally distinctive. However, they are all about putting money at first, projecting the future, and hoping for the best. We believe the seemly different, ‘disgraceful’ gambling and the ‘noble’ investment are in the same coordinates of PAY BACK and CERTAINTY, though at different positions.
When the certainty is high, it is more like a conventional value investment, otherwise it is more like a gambling.
As a value investor, our overall strategy is to put more weight on where certainty is high and pay back is also high. We should forget about those opportunities which pay back is ordinary and certainty is not high enough. This probably stands for majority of the opportunities as the mediocre are much more common than otherwise. Therefore, we have to abandon those targets as they are too difficult to understand as lower certainty and their returns are simply too low to justify the trouble.
When payback is satisfactory, but certainty is low, we should bet smartly and agility with eyes open, using Bayesian inference and recalibrating constantly. Finally, when the payback is average the only reason that we should get involved is that its certainty is high enough that we might live with the fact that its return is low as long as it’s an easy investment.
When CERTAINTY is high?
BEDROCK believes CERTAINTY equals to ‘robust to any risks and disturbs’, that said, robust is the key for CERTAINTY. To achieve a successful investment, you have to be robust from many impacts or disturbances, especially from fundamental, valuation and mental.
Fundamental Robust
Monopoly and cooperative oligopolies;
Resilient business with Nondurable and Indispensable products that non-related to overall market;
Companies with capable, hoest managers;
Stay away from faddish or fast-changing businesses;
Stay away from Commoditized businesses;
Companies without a lot of debt;
Valuation Robust
Undervalued, at least a valuation does not need too many projections into the future, otherwise the roomfor error would be limited;
Mentality Robust
Do invest patiently and rationally;
Do invest in what you know; (the copycats and pure luck can win sometimes but far from robust)
A quick check for mental certainty
As Warren Buffett and other value investors always put it : “if you cannot live with your investment down 40-50%, you should never get involved in” and “if you are not comfortable with the market isn’t open tomorrow, next month, or even forever, then you should not invest”.
And also, as Joel Tillinghast in ‘Big money thinks small’ commented: if you always agitate about “what happens next?”, you are probably gambling or speculating on something you are not certain of.
These are all easy practices to test whether you feel certain with your investment and whether you are in a mentally robust status.
When PAY BACK might be high?
As same as CERTAINTY, we believe PAY BACK can also come from fundamental, valuation, and speculation sides.
Fundamental
Industries under structural changes, just as internet, cloud, smart phone, etc. The final winner would payback huge;
Fast growing demand, both from structural and cyclical;
Limited supply which might drive up selling price;
Operation enhancement due to better management, decreasing cost, etc.;
Leverage can also increase shareholder’s benefits when things go well;
Valuation
Re-valuation can massively change an investment payback, especially when in a bubble;
Speculation
Speculate on how other investors would react and try to front run;
Sometimes CERTAINTY and PAY BACK are reinforce each other, but many times they contradict with each other.
Some examples that the time they buttress each other：
Generally, when a company has a strong and solid fundamental it is more likely in a competition free position which would generate higher, long term pay back consequently;
When an investment has rock solid valuation, it can be very profitable once the market starts to rerate;
And a more robust mindset with reliable fundamental would eventually receive a great result, as most of other investors move clueless as herds.
Some examples that the time they contradict each other：
The more volatile the industry the less certainty it has, though it might generate short term opportunities;
The higher the leverage the less room for error, though it magnifies the return;
Gamblers are more likely to achieve quickest return in a bubble time, however, speculating about how long the animal spirits can continue is never an easy task let alone certainty.
In short, certainty can achieve higher return over long period of time, however short-term luck is never about certainty.
Kelly Criterion for asset allocation and money management
Even if we have some sense about an investment’s certainty and pay back, we might still be baffled about how much weight we should put in a portfolio? We may have some rough idea that the one with highest pay back and highest certainty should be rewarded with highest weight, but how much is the optimal size? Can we quantify rather than purely subjective feelings? BEDROCK believes that we can borrow some ideas from the quandamental techniques, especially the famed Kelly Criterion, though probably not strictly and with some tweaks.
The Kelly Criterion is a mathematical formula that helps investors and gamblers calculate what percentage of their money they should allocate to each investment or bet. It shares the same idea ofour ‘Payback vs Certainty’ principle.
The Kelly Criterion strategy has been known to be popular among big investors including Berkshire Hathaway’s Warren Buffet and Charlie Munger, along with legendary bond trader Bill Gross.
Kelly Criterion believes the optimum weight under certain win/loss ratio and probability can be calculated as follow:
In practice, when dealing with more mathematical related problems as blackjack, Kelly criterion would be agreater use. However, in investment, the problem of finding the exact number of probability (certainty) andreturn ratio (payback) would almost be a mission impossible. Nevertheless, Kelly criterion still shares a greatway of how to deal with the possible payback and certainty and helps us to quantify how much risk andposition we should take each time.
Myopia and Bayesian Inference
As the well-known saying “the only thing constant is change”, we still need to have open eyes and minds wheninvesting even the target seemingly monopolizes the market, for example they may face anti-trust punishmentor a more futuristic power to upheaval the current industry.
Myopia as we are, BEDROCK believes that we can learn from the spirit of Bayesian theorem. Bayesiantheorem is right now widely used in machine learning and is also coherent with human being’s very basic logicof learning things, thus its idea should certainly be put in use in investment. The Bayesian theorem is expressed as follow:
In mathematics, the certainty is high means Pr (A|B) ≈ Pr (A), which Pr (B|A)/Pr (B) ≈ 1, therefore Pr (A) wesay is solid enough for impacts.
As for some disrupting, massively changing industries, the impact of input B might be so consequential thatwould change our whole investment story. In this case, we have to be on alert of newly surfaced impacts andconstantly change our estimates of the future.
The more volatile the probability can change under new inputs the lesser reliable of our prediction is. And oncethe impacts multiply, the complexity would go exponential, and our projection would become a pure guessingwork. That’s why for most of time, try to predict how the macro and overall market would perform is a purely guessing work and with poor win rate.
Understand human shortcomings
People are by nature avarice but at the same time tend to panic when sensing risk, therefore we tend tobecome crazy when in a bubble but become frightened in a more distressed value position.
The problem of investing in low certainty area is that we might not be that sure its future would still be greatagain when fundamental changes or purely from our panic due to lack of visibility. Even the great Omahaoracle Warren Buffett did not take advantage of market crash in 2020 March due to lack of visibility of how thefuture would look like under a virus raging environment.
In a market, when everybody is panic, only the certainty from fundamental and valuation would become astrong bracing for its price, and thus we would be comfortable enough to go against the freightened trends.
Only the robust fundamental and solid valuation can provide strut when knife falling:
And we all have capacity restrained
Even if you haven’t read Daniel Kahneman’s “Thinking, Fast and Slow”, you will notice that we all havecapacity limit both mentally and physically.
The investment which is uncertain means things can go sour if we do not keep an eye on, thus it can be veryphysically exhausting as we try to keep news updated and also a mentally ordeal as we are facing constanttest on whether we made a mistake. Especially when managing a portfolio that you have to deal with manyuncertain, volatile investments at the same time, life could be miserable.
The poker games and investment
Even though been disparaged by some investors, poker games actually share more common with investments than many believe. In total there are four player styles:
Tight-Aggressive (TAG) – This player type which makes up the majority of the winning player pool. They wait for strong hands and bet and raise them hard, punishing other players who play weaker styles.
Loose-Aggressive (LAG) – successful loose aggressive players are few and far between. They play lots of hands and play them very aggressively. It is a tough style to play but also a tough style to combat!
Tight-Passive (Nit/Rock) – this player type does not play very many hands and when they do the play them by calling and checking frequently. These players lose their money slowly but surely.
Loose-Passive (Fish) – these player types just don’t like to fold. Loose passive players play lots of hands – sometimes over 50% of the hands they are dealt. They are the complete opposite of tight-aggressive. This player type is the biggest loser and where the big winners make their money.
Understandably, many successful investors are also from Tight-Aggressive type, as Warren Buffett, DavidEinhorn, etc. And they are also well-known poker lovers.
The nightmare for value investing?
Of course, if possible, investors should go heavy in 1st quartile – the up-right area just as Tight-Aggressive poker player do. However, the problem for value investing or tight-aggressive players is there might not bemany opportunities for them. That dilemma can come from many ways: plethora of liquidity is one source ofthis problem that drives the valuation up and certainty down. A recent example is that the Fed and theTreasury are going all out to bail out the economy by backstopping the financial system and by helicoptermoney, and therefore there is no golden time for Buffet to buy really cheap – margin of safety— stocks thistime than last time in 2008.
It’s like in a poker game where someone constantly raise at the very beginning when the certainty is lowest,pushing the tight players out. The tight players have to adapt to the situation, otherwise the strike rate wouldbe simply too low to gain any profits or easily perceived by others the time you have the wining cards.
The way out
The way to deal with the impasse, BEDROCK believes, is a must concession that back to two inferior but also optimal options:
Only looking for the high certainty: The way many old school value investors choose is lowering theexpected return and keep focus on the high certainty investments. Unless the market drives the expectedreturn to a level of too low to endure, this way of investing is fine, at least it is energy saving for managers.
If not, try to go for higher pay back: The other way out is focusing on the other side of the matrix: betting bigon possibly high return stocks. This sounds counter intuitive to the conventional value investment, though thespirit is the same. If you have to invest anything uncertain in nature, try to go for those with possibly higherreturns, not those with mediocre returns as 10-20%. An achievable 5-10X return could well justify your hardwork to understand and follow the story and also the risk and uncertainty taking. At the end of the day, youmight find out that it is more reasonable to manage a few possible ten baggers rather than to deal with manymore mediocre choices.
Focusing on the 5%
In conclusion, BEDROCK’s strategy is to focus on the very best 5% opportunities. If an investment ‘s return isboth certain, at least we believe so, and high, then we will go big for it. Otherwise we would either go for thoseof certainty though lower return or go for the 5-10X opportunities though might be less certain.
BEDROCK believes the focusing strategy is for a longer, more interesting, energy saving, and hopefully fruitfulway of investment.
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