[The Weekend Bulletin] #97: Shanon's Demon, Paradox Of Change, Investment Patterns,...
...Losing Money Being a Contrarian, Fast vs Slow Risk, Internal vs External Benchmarks, etc.
A digest of some interesting reading material from around the world-wide-web. Your weekly dose of multi-disciplinary reading.
Section 1: Investing Wisdom
Here is an interesting exercise: Imagine we have a stock that is extremely volatile. Each day, the stock either *doubles* or *halves* in value. There's a 50/50 chance of either outcome, and there's no way to predict it in advance. Like a series of independent coin tosses -- one per day. The question is: Is there a way to consistently make money from this "double or halve each day" stock over the long term? That is, can we turn the stock's *random walk* into a compounding machine that works in our favor? Arithmetically, the expected return would be 25% ((-50%+100%)/2). However, that is not the actual return that you will realise. This is called the "Shannon's Demon" problem; this thread explains it and also provides the right investment strategy in this case (which might be a very practical approach for investors seeking lower downside volatility).
Chasing a trend / investing in momentum works, until it stops working suddenly. The other side isn't prettier either. Betting against a trend, i.e. being a contrarian, is fashionable, but not always profitable. This article explains.
There is a certain advantage that experience accords - the ability to identify patterns. This ability to connect dots, to group things, makes the task of selection easier. Here are 15 patterns that will help you identify profitable investments - this one is worth bookmarking.
This article explains that our understanding of risk is incomplete. It posits that there are two types of rIsks - fast and slow, and paying attention to one over other can lead to suboptimal decisions - in investing and in life. Which risk are you more focused on?
In a similar vein to the above, there are two ways in which you can measure performance/achievement. Your choice of the measure has a very large impact on your life and happiness. This is probably the most under-rated lesson in personal finance that this article explains. The following just stayed with me:
"I recently had dinner with a financial advisor who has a client that gets angry when hearing about portfolio returns or benchmarks. None of that matters to the client; All he cares about is whether he has enough money to keep traveling with his wife. That’s his sole benchmark.
“Everyone else can stress out about outperforming each other,” he says. “I just like Europe.”
I am not a fan of macro-economics and usually avoid sharing on the subject. However, given the raging debate about inflation these days, I felt that this article was worth sharing. It makes a point that I see missing in most debates about inflation - whether it is transitory or whether it is here to stay. It looks at the problem from the lens of incentives and makes for an educating read.
Section 2: Mental Models & Behavioral Biases
Change is the only constant. We all know and understand this. However, often when we try to bring about change, we fail miserably. This is particularly true when it comes to changing habits. The Behaviour Change Paradox explains why this is so, and how you can overcome it.
Section 3: Personal Development
Continuing from the above article, once you understand how to tackle change, the next step is to ensure that the change sticks - consistency, in other words. Here again, one realises that there is a mental roadblock that prevents us from continuing to so something new over a long period of time - anybody who has tried to quit smoking, or start writing a journal knows this very well. This article provides a framework to make new habits stick.
Section 4: Blast From The Past
Revisiting articles from a past issue for the benefits of refreshing memory and spaced repetition, as well as for a fresh perspective. Below are articles from #25:
A classmate of John F. Kennedy at Harvard, intelligence officer during World War II, researcher at the Federal Reserve Bank, economics professor, money manager, pioneer in investment analysis, historian, expert on risk and author. No I am not referring to a group of investors, but a single investor whose thoughts are as interesting as his profile. A long and dated interview of Peter Bernstein by Jason Zweig is worth reading several times.
One of Warren Buffet's many famous quotes is: 'Predicting rain doesn't count, building an arc does'. My own version of that quote is 'predicting rain doesn't count, carrying an umbrella does'. What they mean is that ideas are worthless without execution. And I thought that these quotes captured the idea so beautifully, until I read this article. While not as short as the quotes above, but in less than ten sentences it is the most impactful explanation ever. Don't skip reading this.
Section 5: Readworthy Passage
Let's read together a random, but read-worthy, passage from a randomly picked book.
The competitive strategy literature focuses largely on prescriptions for management action. But investors can use the same strategic tools, albeit in a different way.
Management’s objective is to create value by investing at above the cost of capital. Indeed, sustainable value creation is the signature of competitive advantage. And since a company’s competitive advantage hinges squarely on the quality and execution of its strategies, competitive strategy analysis is vital to planning and decision making.
Investors play a very different game. They generate superior returns when they correctly anticipate revisions in market expectations for a company’s performance. Investors do not earn superior rates of return on stocks that are priced to fully reflect future performance—even for the best value-creating companies—which is why great companies are not necessarily great stocks. Investors use competitive strategy analysis as a means to foresee expectations revisions.
- From EXPECTATIONS INVESTING by Alfred Rappaport and Michael Mauboussin
A recent quarterly earnings call reminded me of this quote that I had I read in an annual report first:
Top line is vanity, Bottom line is sanity, Cash in bank is reality
(on a lighter note, most new businesses are getting a price to vanity multiple these days).
Unless you attend to the past, learn clearly from it, your past will just rename itself as your future. Actually, there is no future; it is just the past returning to you in another name, and that's the punishment you get for not learning from the past, for not remembering the past.
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That's it for this weekend folks.
Have a wonderful week ahead!!
- Tejas Gutka
[Oct 30, 2021]