Sunday, July 21, 2013

Important Lessons From Michael Mauboussin About Investing

The below 6 observations come from Tren Griffin's post, A Dozen Things I’ve Learned From Michael Mauboussin About Investing.The observations are rarely discussed but are a very important concepts to grasp to be a long-term successful investing. Those familiar with Austrian economics will recognize that the observations are similar to Austrian views about methodology and entrepreneurship.  The comments also dovetail quite nicely with some commentary I have had in recent days in the EPJ Daily Alert regarding mispriced risk, especially mispriced risk in the tail end of possible financial outcomes:
1.      “The only certainty is that there is no certainty… With uncertainty, the underlying distribution of outcomes is undefined, while with risk we know what that distribution looks like. Corporate undulation is uncertain; roulette is risky…” There is no single number which can be used to predict the future price of an investment because the future is not only risky (like roulette) but uncertain (unknown unknowns). There are known future states for which probability is unknown and future states that are unknown for which probability is not computable.

 2.      “Success in a probabilistic field requires weighing probabilities and outcomes—that is, an expected value mindset.” The best that an investor can hope for is to identify a range of possible outcomes/scenarios. “Expected” value is the weighted-average value for a distribution of those possible outcomes (multiply the probability of each possible outcome by its respective present value and sum those numbers). Since only a few outcomes can realistically be identified by an investor, skill is involved in choosing those possible future outcomes. This is where business judgment becomes particularly critical. That skill is important in this process does not means that luck is not a huge factor in outcomes.

3.      “Perhaps the single greatest error in the investment business is a failure to distinguish between the knowledge of a company’s fundamentals and the expectations implied by the market price.”  It is the gap between expected value and market price which should drive decision making. If you have views which reflect the consensus of the crowd you are unlikely to outperform a market since a market by definition reflects the consensus view. Being different is necessary but not sufficient for investing success since you must also be right. To be contrarian for its own sake is for suckers. What you are looking for is a bet that has been mispriced by the crowd.  Mauboussin quotes Seth Klarman: “Successful investing is the marriage of a calculator and a contrarian streak.”

4.      “It’s unlikely you will gain insight if your inputs are identical to everyone else’s.”  Since a big source of mispricing is a lack of crowd diversity it makes sense that a lack of diversity in terms of where you generate your inputs can potentially give you an advantage as an investor.

8.  “Increasingly, professionals are forced to confront decisions related to complex systems, which are by their very nature nonlinear…Complex adaptive systems effectively obscure cause and effect.  You can’t make predictions in any but the broadest and vaguest terms.”… “complexity doesn’t lend itself to tidy mathematics in the way that some traditional, linear financial models do.” The life of an investor would be far simpler if one could assume that people behaved as physics would predict in the case of an electron.  Mauboussin writes: “Security returns are not normally distributed, but exhibit high kurtosis and fat tails.” Extreme events are inevitable and not thinking in terms of both negative and positive Black Swans is a very bad idea.

9.  “When you see something occur in a complex adaptive system, your mind is going to create a narrative to explain what happened—even though cause and effect are not comprehensible in that kind of system.”  People love stories and great story tellers can earn a huge premium in financial markets as promoters.  Getting rich as a promoter is very different than getting rich as an investor.

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