[The Weekend Bulletin] #64: Quantitive Techniques - Kelly Criterion/Magic Formula, Three Laws of Human Behaviour,
+ Three Elements of Investment Horizon, Feynman Technique, Slowing Down, and more.
A digest of some interesting reading material from around the world-wide-web. Your weekly dose of multi-disciplinary reading.
Hey All!!
I am back after a short break and have a small game that I'd want you'll to play before you get to reading the articles in this issue.
Playing the game will help you make sense of some of the articles better. Therefore, I encourage you to play the game before moving ahead. It's a fun ten minute activity.
Click here to start the game.
Section 1: Investing Wisdom
If you played the above game, you'd notice that the questionnaire at the end inquired about a concept called Kelly Criterion. It was a formula that was discovered by John Kelly, a Bell Labs researcher, in 1956. Ed Thorp used the formula to make substantial winnings in the game of Blackjack (so much so that casinos had to change the rules of Blackjack) and later in the financial markets. A group of MIT students used Thorp's techniques (from his book 'Beat the Dealer') to win millions from Vegas, a story that culminated in to a book, and eventually, the movie '21'. A number of concentrated investors, including Charlie Munger, have been said to intuitively use this formula in their investment process (although there is no explicit mention of it).
This article provides a good overview of the formula and how it can be applied to investing. While the formula works better for trading (it works over a large number of bets), it can also be applied to long term investing, as the article explains.
Here is another article that will help you better understand the formula, its application, as well as its shortcomings. In fact, this article is part of a series of article on portfolio construction and position sizing which are worth their weight in gold. I am yet to come across a more nuanced breakdown of the portfolio construction process than this one.
Having read these articles and understood the concept, you can try to play the game again and see if it helps improve your results.
Taking the discussion of quantitative techniques further is this summary of a 2005 talk by Joel Greenblatt where he discusses his simple 'magic formula' for investing in high quality value stocks (compounding capital at 20-30% over decades). The talk also cover's the investment process - a different version of the magic formula - that Greenblatt uses for his personal investments.
Corrections like the one witnessed this Friday (leading indices were down 3-4% in a day) as well as the Covid sell-off of last year serve as a healthy reminder of the volatile nature of markets. Not only do they test an investors grit and confidence, they are also a good test of an investor's actual investment horizon. It is very easy to be a long term investor when the going is good, however, an investor's behaviour during these extraordinary times are the true reflection of their personality. Taking this concept further, this article highlights the three elements that together make up our true investment horizon. Investors would do well to consider each factor carefully for a smooth and rewarding investment journey.
Section 2: Mental Models & Behavioral Biases
Drawing parallels from Newton's Three Laws of Motion, this article chalks out Three Laws of Human Behaviour. Similar to Newton's simplification of scientific theories in to three straightforwards assertions, the three laws of human behaviour help summarise our mental pitfalls very well. Further, just as Newton's laws formed the foundation for a number of scientific theories, the three laws of human behaviour set the context for a number of our behavioural patterns.
Section 3: Personal Development
"Slow down everyone
You’re moving too fast
Frames can’t catch you when
You’re moving like that"
Jack Johnson wrote those lyrics in reference to Bruce Lee who was asked to slow down his punching during a shoot as a 24 frames-per-second camera could not capture his movements. In 2001, the Dean of Harvard College, Harry R. Lewis, sent the exact same advice in a letter to the incoming students - Slow Down. While the letter was meant for students, we can all draw some inspiration from it. Here are 13 such inspiring life-lessons from it (If you have kids who are entering college, it may be worthwhile sharing the original letter with them). Below is one of my favourite lessons:
Empty time is not a vacuum to be filled: it is the thing that enables the other things on your mind to be creatively rearranged, like the empty square in the 4 × 4 puzzle which makes it possible to move the other 15 pieces around.
One of the ways in which you can slow down is by learning to prioritize your time. Here, the Eisenhower Matrix can be a very handy tool as it can help you focus on the right tasks, and delegate the rest, thereby adding some empty time on you calendar. This twitter thread has all that you need to know about the Eisenhower Matrix.
There was a time when I used hate the idea of marketing/selling. A close friend (and mentor) would always tell me that everything you do in life is eventually selling. I didn't understand it then, but over the years I have come to appreciate that fact. While I still don't enjoy making presentations, I have made my peace with them (and they with me by not being as bad as they used to be). You can love 'em, or you can hate 'em, but you cannot escape 'em presentations. And this succinct little note can help them being less dreadful if you are someone like I once was.
Quotable Quotes
Charlie Munger on the relationship between quality and price:
"The investment game always involves considering both quality and price, and the trick is to get more quality than you pay for in price. It’s just that simple.”
[P.S. If it interests you, here is the transcript from Charlie Munger's recent Daily Journal Meeting]
Adam Grant: "If knowledge is power, knowing what we don't know is wisdom".
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That's it for this weekend folks.
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Have a wonderful week ahead!!
- Tejas Gutka
[Feb 27, 2021]