Book Review: Fooled By Randomness

My anti-library has grown (and is growing) at a substantial rate. I was fortunate to ignore my usual forced FIFO indexing system and pick up Taleb's first work as soon as it arrived on my doorstep. A few years ago I read  The Black Swan and related many of Taleb's thoughts. He is an individual and deeply reflective thinker. I finally got around to ordering Fooled By Randomness and was not disappointed. This truly is a seminal work. One, I believe, will lead to Taleb winning the Nobel Prize someday. It would be wise to review the notes from this work the next time hubris in thinking sets it. The highlights:

Nero's objective is not to maximize his profits, so much as it is to avoid having this entertaining machine called trading taken away from him. Blowing up would mean returning to the tedium of the university or the nontrading life. Every time his risks increase, he conjures up the tinge of the quiet hallway at the university, the long mornings at his desk spent in revising a paper, kept awake by bad coffee.

Trading forces someone to think hard. Those who merely work hard generally lose their focus and intellectual energy. In addition, they end up drowning in randomness; work ethics, Nero believes, draw people to focus on noise than the signal. 

"never ask a man if he is from Sparta: If he were, he would have let you know such an important fact - and if he were not, you could hurt his feelings"

One of the attractive aspects of my profession as a quantitative option trader is that I have close to 95% of my day free to think, read, and research (or "reflect" in the gym, on ski slopes, or, more effectively, on a park bench). I also had the privilege of frequently "working" from my well-equipped attic.

A mistake is not something to be determined after the fact, but in the light of the information until that point. A more vicious effect of such hindsight bias is that those who are very good at predicting the past will think of themselves good at predicting the future, and feel confident about their ability to do so. 

The argument in favor of "new things" and even more "new new things" goes as follows: Look at the dramatic changes that have been brought about by the arrival of new technologies, such as the automobile, the airplane, the telephone, and the PC. Middlebrow reference would lead one to believe that all new technologies and inventions would likewise revolutionize our lives. But the answer is not so obvious: Here we only see and count the winners, to the exclusion of the losers. 

Finally, I reckon that I am not immune to such an emotional defect. But I deal with it by having no access to information, except in rare circumstances. Again, I prefer to read poetry. If an event is important enough, it will find its way to my ears.

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the more information you have, the more you are confident about the outcome. Now the problem: By how much? 

So why do we consider the worst case that took place in our own past as the worst possible case? If the past, by bringing surprises, did not resemble the past previous to it, then why should our future resemble our current past? 

whenever I hear work ethics I interpret inefficient mediocrity 

The major problem with inference in general is that those whose profession is to derive conclusions from data often fall into the trap faster and more confidently than others. The more data we have, the more likely we are to drown in it.

As we are cut to live in very small communities, it is difficult to assess our situation outside of the narrowly defined geographic confines of our habitat - Here I will make note: I recently read an interview with Andreesen where he discussed the adaptability of ideas that are produced in silicon valley - tech entrepreneurs there are caught in a bubble where they have no idea what will work in the rest of the country. On the flip side of that, Schultz was enamored with Italian coffee shops and thought they could be very successful in his adopted hometown of Seattle (also FP) some place he knew very well. 

Aside from the misperception of one's performance, there is a social treadmill effect: You get rich, move to rich neighborhoods, then become poor again.

The mistake of ignoring survivorship bias is chronic, even among professionals. How? Because we are trained to take advantage of the information that is lying in front of our eyes, ignoring the information that we do not see.

Remember that nobody accepts randomness in his own success, only his failure

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The exact same task of looking for the survivor within the set of rules that can possibly work. I am fitting the rule on the data. This activity is called data snooping. The more I try, the more I am likely, by mere luck, to find a rule that worked on past data.

People overvalue their knowledge and underestimate the probability of their being wrong

A journalist is trained in methods to express himself rather than to plumb the depth of things - the selection process favors the most communicative, not necessarily the most knowledgeable.

The epiphany I had in my career in randomness came when I understood that I was not intelligent enough, nor strong enough, to even try to fight my emotions.

Dialectitian - someone who never committed himself to any of the premises from which he argued, or to any of the conclusions he drew from them.

There is no rational reason to keep a painting you would not buy at its current market rate - only an emotional investment. Many people get married to their ideas all the way to the grave. 

Certainly, the odds in games where the rules are clearly and explicitly defined are computable and the risks consequently measured. But not in the real world. For mother nature did not endow us with clear rules. The game is not a deck of card (we do not even know how many colors there are). But somehow people "measure" risks, particularly if they are paid for it. 

At the limit, you can decide whether to be (relatively) poor, but free of your time, or rich but as dependent as a slave.

Rereading those sections after a week away from them was incredibly enlightening (again). I just ordered Taleb's newest book and can't wait to jump my FIFO system again.

The Real Cost of Home Ownership

I have recently begun the process of purchasing a house for the purpose of living in myself. I have always publicly denounced the age-old wisdom that, "a home is your largest investment". Largest and worst I always say. I know this but there is some sense of Americana to home ownership and I'm getting sucked in. I've done extensive research and there are a myriad of articles pertaining to "Rent vs. Own". Most talk about the emotional satisfaction of owning embattled against the excessive secondary costs of owning the property. I could not find one that actually went into, well, the math.


A home is a horrible investment. More so, a mortgage is a terrible investment. The obtainer of a mortgage is paying interest to get principal. That's an astonishing fact, let me elaborate. When one obtains a mortgage, they are paying let's say 5% to get their payment back. To make matters even worse, the banks have stacked the chips against the obtainer. Mortgages are front loaded to pay interest off before principal. Let's look at a scenario:

Your wife fell in love with this beautiful 3 bedroom, 2 bathroom ranch that will be the perfect starter home for your (soon to be) family. You've punched some numbers and found your monthly payment on the $250,000 home will be comparable to your current rent payment: $1,100 at the market rate of 5% after your put 20% down ($50,000). You think, "Great! Home ownership here we come!"

So you're ready to do it! Then your agent tells you your closing costs will be $4,000, your insurance will be $750 a year and property tax will be about $2,500 a year. Bummer. But at the cost of owning a home and obtaining your largest investment, no big deal. You've done it! Closed on your first home.

Month one rolls around and you write your $1,100 check. Where does that money go? Well, $850 goes to interest (rounding) and $250 goes to principal. This is great. Instead of throwing away the $1,100 expense a month like you were with renting, you got $250 in equity back. And this goes on religiously for 30 years, each month you gain incrementally, a little more equity in your house. At the end of 30 years, you are free and your expense column looks somewhat like this:

So to obtain that $250,000 house, you ended up paying $613,011 (total payments + down payment + closing costs + taxes + insurance). Ouch. For real ouch this time. But what is your house worth? It must be worth much for than you bought it for, right? Well I don't have a crystal ball but it's some output of (population growth / new home builds) mixed with a bit of psychology and location preference. Robert Shiller famously documented that home prices from 1900-2000 increased by 0.2% a year over inflation (but no one believes that). So let's be fair and say your home increased in price by 2% annually (which may or may not be the rate of inflation). Now your home is worth $452,840. Awesome!!!

On the flipside, you have to live somewhere so instead you decided to rent through the 30 year period and invest the money from the downpayment, taxes, and insurance in an S&P 500 index fund. You were fortunate to gain the historical 10% per annum over the holding period!

Over the 30 year period, your landlord (wise in the field of purchasing power) also kept up with inflation, increasing your rent 2% per annum for the 30 years bringing your total payments to $537,491. Ouch. But what about that money you have been investing? You put $54,000 down at the start (downpayment and closing costs) and continued to contribute $270 per month (taxes and insurance)  Well, that little nest egg is now worth $1,457,228.

Seeing it on paper is almost surreal. The author will be the first to admit there are many assumptions in this example and a major difference between empiricism and reality (new roof, accelerated payments, renter's insurance, moving costs etc. etc.) that could skew the numbers a few points one way or another but the results provide a large margin of safety:

Owning - ($156,171)
Renting - $919,737

Over a $1,000,000 difference on that $250,000 house that your wife fell in love with. Incredible.

Book Review: The Most Important Thing

I've gotten away from a good habit recently: writing book reviews. I will try to go back and recap my

highlights from recent book readings starting with Howard Marks', "The Most Important Thing". I was initially rubbed the wrong way with Marks being a descendant of the University Of Chicago's oft incorrect EMH. I stuck with it and Marks does a good job explaining the baseline of semi-strong efficiency and then getting into personal interpretations of alpha. Overall, impressive work from a storied investor. While he doesn't ever come out and say it, his underlying investing rational is spot on: don't lose money. The thought-provoking highlights (all quotes):

Like opportunities to make money, the degree of risk present in a market derives from the behavior of the participants, not from securities, strategies, and institutions. Regardless of what's designed into market structures, risk will be low only if investors behave prudently.

When everyone believes something is risky, their unwillingness to buy usually reduces its price to the point where it's not risky at all. Broadly negative opinion can make it the least risky thing, since all optimism has been driven out of its price.

When everyone believes something embodies no risk, they usually bid it up to the point where it's enormously risky.

Whatever few awards are presented for risk control, they're never given it out in good times. The reason is that risk is covert, invisible. Risk - the possibility of loss - is not observable. What is observable is loss, and loss generally happens only when risk collides with negative events. 

The worst loans are made at the best of times. This leads to capital destruction - that is, to investment of capital in projects where the cost of capital exceeds the return on capital.

When buying something has become comfortable again, its price will no longer be so low that it's a great bargain. Thus, a hugely profitable investment that doesn't begin with discomfort is usually an oxymoron. 

You tend to get better buys if you select from the list of things sellers are motivated to sell rather than start with a fixed notion as to what you want to own. An opportunist buys things because they're offered at bargain prices. There's nothing special about buying when prices aren't low. 

Mujo means cycles will rise and fall, things will come and go, and our environment will change in ways beyond our control. Thus we must recognize, accept, cope and respond. Isn't that the essence of investing? (Potential fund name)

The critical observation is that the [investor] pursues high returns, even in a low-return environment, and bears the consequences - increased risk - although often unknowingly. 

Investors are right (and wrong) all the time for the "wrong reason." Someone buys a stock because he or she expects a certain development; it doesn't occur; the market takes the stock up anyway; the investor looks good

I don't think many money manager's 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.

Investing defensively can cause you to miss out on things that are hot and get hotter, and it can leave you with your bat on your shoulder in trip after trip to the plate. You may hit fewer home runs than another investor...but you're also likely to have fewer strikeouts and fewer inning-ending double plays. 

In heady times, capital is devoted to innovative investments, many of which fail the test of time. Bullish investors focus on what might work, not what might go wrong. 

When investor psychology is at equilibrium and fear and greed are in balance, asset prices are likely to be fair relative to value. In that case there may be no compelling action, and its important to know that, too. When there's nothing particularly clever to do, the potential pitfall lies in insisting on being clever.

In good years in the market, it's good enough to be average. Everyone makes money in the good years, and I have yet to hear anyone explain convincingly why it's important to beat the market when the market does well. No, in the good years average is good enough. 


The Most Important Thing

Return on Invested Capital - A Multi-Silo Approach

I paraphrase Sanjay Bakshi when he says, being a great operator or a great capital allocator are rare skills; being both is almost unheard of. Return on Invested Capital is the most basic value of a business' success - how much money have you made as a percentage of how much money you invested. ROIC (and it's cousin ROE) is typically used to value public companies because it is easily calculable. With a base level of capital (or equity) what are the company's earnings? The use of debt can help leverage the ROIC by using someone else's money to increase your business assuming it is cash-flow positive.

The problem with the common understanding of ROIC is it's limitation to being used to evaluate within silos, not across them. Sadly, this is a tenant of most video games (and game theory) that is often not correctly applied to real life. Save up coins or dollars or credits and the more you have, the more you can trade in for a benefit producing advantage.

For years, I have listened to Buffett speak along the lines of, "if I had a million dollar portfolio, I could easily return 50% a year". The misinterpretation of this statement is that he is implying the necessitation of stock picking. The most recent Shareholder's Letter has been widely quoted due to Buffett's lesson on his commercial real estate in New York and his farm in Nebraska. An individual with a million dollar portfolio has an advantage because of the greater market mispricings in illiquid and/or psychologically misjudged investments on a localized level. That individual does still have greater opportunities than the billionaire investor in financial markets due to size but why even bother? If one found a gas station for sale that had a ten-year track record of 50% ROIC, there is no point to even do security analysis. You can't beat that.

So where does your gas station investment leave you? After your first year, you have a 50% return (since you are such a good operator) that you must now allocate in order to obtain maximum IRR. For generalization sake, you have three options at this point:

1. Invest in something with a higher ROIC
2. Invest in something with equal ROIC
3. Invest in something with lower ROIC

While this may seem like a mundane answer to the question, the application in real life is very important to consider. Consider the scenario:

1. Invest in a better opportunity with a higher ROIC. On paper this sounds like a no-brainer but in actuality, you may find this hard to accomplish. The 50% I chose as base case was from an actual listing I was reviewing. Anything above 1 would certainly be a no-brainer (and possible when there is blood in the streets). 
2. Invest in an opportunity with the same ROIC. Naturally, your thought process would lead to more gas stations, which could increase your ROIC if efficiencies are obtained. Or invest in similar mispricing scenarios available to the smaller investor. 
3. Invest in opportunities with lower ROIC. Unfortunately, this is what the vast majority of people do. After experiencing high levels of ROIC, they protect their earnings by placing them in "safer" scenarios, which are often deemed safer by access to liquidity. This is mind numbing. You have an initial investment that with some degree of certainty, you can predict will return another 50% ROIC next year yet you decrease your IRR by investing in "safer" alternatives rather than trying to match or increase ROIC. 

Clearly, the elephant in the room is absolute return compared to ROIC. If you can get more money to your bottom line, than you should. Or should you? Should you ignore absolute return (possibly decreasing IRR for the short term), to maintain a high level of ROIC in the long run. By any reasonable argument, you should do the latter. This is the problem with size. As you get bigger, investments that maintain a high ROIC become more difficult. But there is a major difference between size of a Fortune 100 company and an individual investor. An individual investor, by definition, will never be too big for the investing universe to maintain his ROIC whereas one of the 100 largest companies in America (or the world) has almost reached the apex. Surely there will be physical limitations to the abilities of the individual investor (there can only be so many yogurt stores in one city) but reaching a point of fulfilling affluence should be easily obtainable without size limitations.

Sadly, Robert Kiyosaki's Cash Flow comes to mind but there is an important example to be made. In the game, you can invest in many different asset classes from securities to major developments. In the game, as in real life, there is a restriction on C, not on R. You only have so much capital to invest. Each step up you make in investable capital, more asset classes become available to you. For the very small investor, common stocks are probably the best opportunity for a good ROIC. As the investor grows, asset classes are unlocked. If you are able to invest in the gas station around the corner with a ten-year ROIC of 50% or a common stock with a ten-year ROIC of 50%, which is the better move? While there are many factors that could effect an individual's appetite for risk such as liquidity or capital appreciation, I would argue that circle of competence outweighs all others combined. You inherently know way more about the economics of your neighborhood than you do of a common share of a large corporation. Its a no brainer. By keeping your money that far within your circle of competence, you are able to eliminate risks inherit with public markets and the corporate governance of a public company. 

Insanity of Investment - LNKD

While I am quick to bash Facebook, Groupon, and Tesla today I will take on another of their ridiculously priced brethren, LinkedIn. LinkedIn is currently trading at a P/E of 860. 860. This is not a case of, "oh, they had a bad quarter" or "once they monetize, the earnings growth will be astronomical". This is a case of pure irrational exuberance.

Since it's IPO in 2011 where it reached, on day one, near $130 (closed around $94 for fairness sake), LNKD has returned 46% (100%) to investors. This, in the midst of one of the greatest market turnarounds in history, the SP has returned 43%. So LNKD has about matched the market return in three years (depending on how precise your market timing is). Where is the growth? Who actually is making money?

Where is the money? The money all went to the founders, angels, VCs, and investment banks in the IPO. The instant burst of liquidity (to a barely profitable company) allowed all of them to cash out for massive multiples over what the actual business is worth. Today, none of the founding five members own a reportable stake. Why anyone pays ridiculous multiples for a business that doesn't make any money is beyond comprehension.

So who is left holding the bill? The current shareholders of course. Mostly through mutual funds, which may or may not be choosing to own the stock. Many surely own it as a reflection of their "strategy", which mimics some indexable formula (Growth Stocks, Mid-Cap, Technology etc.). In order for LNKD to return to a market matching valuation (~19xE), earnings would have to increase 45x over. Immediately. Not in 5 or 10 years or a DCF would need to be applied compounding the growth astronomically bigger. How can an established company with market penetration and a monetization strategy possibly increase sales by that factor?

The growth is already in the price. It was from day one when the founders took the company public. Sure, the stock has increased since then but the economics of the business can't possibly continue the madness. When will LNKD in revert back to the mean? I have no idea but a due date lingers for this rocket ship.

Letter to Eddie Lampert (SHLD)

Edward S. Lampert

CEO and Chairman

Sears Holding Co.

What is the plan?

We, as shareholders of SHLD, are closing in on a decade since the merger of Sears and K-Mart in 2005. Over the last decade, we have watched both Sears and Kmart continue to fall from market leading positions and lose ground to traditional and online retailers alike. So I ask the question, what is the plan?

Myself, like I’m sure many other shareholders, bought into SHLD because of a belief that you, very personally, would right this ship. It was very clear for any shareholder to see that there was value to be unlocked through real estate or the brands. That is why we joined the cause. We, as shareholders, believed that you would do what was in the shareholders’ best interest.  We had faith in you. We have faith in the entity that you and Bruce control a majority stake in. What do we have to show for it?

The business is in a state of chaos. I have a Kmart and Sears within 5 minutes of my house. I have never been to either of them (in 8 years). The most recent shareholder’s letter verges on insulting due to your lack of understanding of branding and consumer behavior. The failure to invest in capital expenditures for the brick and mortar stores has forced customers to the likes of Wal-Mart and Target. If your customers don’t want to go anywhere near your physical locations, why on earth would they shop with you online given the proliferation of superior online retailers? Certainly Kmart and Sears brick and mortar stores still have markets that are captive and verge on monopolistic and therefore are able to convert customers to Shop Your Way customers but this can’t possibly be the strategic plan for the whole company, can it?

You posted on your blog at the beginning of the year about transformative companies. For ten years, SHLD has been lost in the shuffle as all of its competitors transform around it. Building an integrated online and physical platform is not transformative; it’s the norm. If you want this company to be transformative, make it disruptive. Change. Do something.

Everyday the value of the real estate portfolio becomes less valuable. The proliferation of empty commercial real estate (mall real estate especially) in America signals the exact transformative change you outline in your letter. There are hundreds of stores not making money, why are we behind the curve in making a real transformation and closing all of them immediately?

Mr. Chairman and CEO, what is the plan? The last ten years have seen remarkable opportunity costs go down the drain. How do we add value to shareholders over the next ten?

Thank You,

Jason M. Nista

Configural Processing - How big is too big to understand?

How much information is too much to process? How big can an organization get before it would be impossible for a CEO to understand the intricacies and domino effects of each decision? My take is that it doesn't have to get that big. I define configural processing as the process of evaluating, weighing, and understanding interwoven effects of the parts of a whole. A complicated definition for sure so let's take a look at three examples that are relatable:

Example 1: Citigroup. Citigroup is the classic definition of too big to fail. Their business units that number in the hundreds are so interwoven in the global economic picture that unwinding them could prove fatal to the whole system. How could one person (CEO) or even a group of people (Board or Office of the CEO/Chair) possibly understand the relationship and intricacies of all of those units? If you are evaluating 100 units that compromise of a total of $1T in assets, how can you make an expert decision in all of them? It's impossible. Further, it would be impossible for a securities analyst to possibly try to value the company, the 10K isn't required to go into enough detail to intimately understand each unit. I proposed that Citi is a case of the parts being worth more than the whole - if it were broken up, each autonomous business would be better off. Case in point being the sub-prime crisis where some divisions were continuing to underwrite subprime mortgage while the trading desks couldn't unload them fast enough.

Example 2: Coca-Cola. On the exact flip side of the equation I propose KO. Produce, bottle, and distribute a proprietary liquid. Now this seems like a business that a human being could wrap their head around. Is it that simple? No. A CEO would still have to be experienced in bottling, distributing, exchange rates, branding etc. but all along one product line. Reading through a KO 10k, its written in real english, terms and values that an average human being and certainly an analyst can understand. Evaluating and making an investment decision with some degree of certainty, I propose is much easier with KO.

Example 3: Berkshire Hathaway. The king of kings for all things investing. Not only do Charlie and Warren only invest in businesses they understand such as KO (the author has no comment on WFC common), they leave the management in place of the companies they acquire fully. They expect each business to operate with autonomy, holding each accountable for their performance, not allowing businesses to become intertwined or share resources. They've created possibly the greatest business in the world by acquiring Example 2 type businesses and not allowing management to destroy themselves by getting too large.

So what can be taken away from this analysis? Its naive to assume with any degree of certainty that you can place a reasonable value on a business as complex as an investment bank. I suspect that many analysts that cover such companies as C (whose earnings forecasts are perpetually wrong anyhow) have so many variables to consider that they can't possibly make a reasonable prediction aside from looking at previous results and guessing macro climates. Even if they are correct, are the theorems that made them correct proven out or is it by chance? Stick to your circle of competence. Be humble on what you understand. Ignore popular opinion.