Below are excerpts (Part 3 of 4) from Thirty Years: Reflections on the Ten Attributes of Great Investors by Michael Mauboussin.
Portfolio Management, Sizing, Psychology
“Position sizing and portfolio construction still do not get the attention they warrant.”
Preach!
“Puggy Pearson was a cigar-chomping gambling legend who won the World Series of Poker and was one of the world’s best pool players. When asked about his success, Pearson said, ‘Ain’t only three things to gambling: Knowin’ the 60-40 end of a proposition, money management, and knowin’ yourself.’ Great investors take to heart all three of Pearson’s points, but money management is the one that gets the least attention in the discourse on investment practice…”
“…success in investing has two parts: finding edge and fully taking advantage of it through proper position sizing. Almost all investment firms focus on edge, while position sizing generally gets much less attention. Proper portfolio construction requires specifying a goal (maximize sum for one period or parlayed bets), identifying an opportunity set (lots of small edge or lumpy but large edge), and considering constraints (liquidity, drawdowns, leverage). Answers to these questions suggest an appropriate policy regarding position sizing and portfolio construction.
The most common approaches are based on mean-variance (maximize return for a given level of risk) and the Kelly Criterion (maximize a portfolio’s geometric mean return). Which approach makes most sense for you depends a great deal on how you answer the questions about goals, opportunities, and constraints. But the broad point is that most investors do a poor job with position sizing and great investors are more effective at it.”
“Astute investors understand that finding edge and betting on it appropriately are both essential to long term success.”
“Handicappers talk of ‘action bets’ and ‘prime bets.’ Action bets are small bets that serve to keep the handicapper engaged and sharp. The stakes are low but the handicapper gets feedback to help his bigger bets. Prime bets are the big bets. If action bets are the warm up, prime bets are the main event. In order to gain repetition, the investor should think about everything relevant in probability terms and sharpen his or her ability to do so.”
Here’s a previous article in which Charlie Munger discusses the similarities between investors & gamblers.
Expected Return, Process Over Outcome
“To be a successful investor, you have to be comfortable with numbers. There are rarely complicated calculations but a feel for figures, percentages, and probabilities is essential.”
“Investing is an activity where you must constantly consider the probabilities of various outcomes. This requires a certain mindset. To begin, you must constantly seek an edge, where the price for an asset misrepresents either the probabilities or the outcomes. Successful operators in all probabilistic fields dwell on finding edge, from the general managers of sports franchises to professional bettors.
When probability plays a large role in outcomes, it makes sense to focus on the process of making decisions rather than the outcome alone. The reason is that a particular outcome may not be indicative of the quality of the decision. Good decisions sometimes result in bad outcomes and bad decisions lead to good outcomes. Over the long haul, however, good decisions portend favorable outcomes even if you will be wrong from time to time. Time horizon and sample size are also vital considerations. Learning to focus on process and accept the periodic and inevitable bad outcomes is crucial.
Great investors recognize another uncomfortable reality about probability: the frequency of correctness does not really matter (batting average), what matters is how much money you make when you are right versus how much money you lose when you are wrong (slugging percentage). This concept is very difficult to put into operation because of loss aversion, the idea that we suffer losses roughly twice as much as we enjoy comparably sized gains. In other words, we like to be right a lot more than to be wrong. But if the goal is grow the value of a portfolio, slugging percentage is what matters.
There are three ways of coming up with probabilities. The first is subjective probability, a figure that corresponds with a state of knowledge or belief. For instance, you might assign a subjective probability to the likelihood that two countries go to war. Second is propensity, which is generally based on physical properties of the system. For example, you would estimate the probability of a die coming up four in a single roll as one out of six based on the fact that the die is a perfect cube and the toss is without bias. The final approach is frequency, which considers the outcomes of a proper reference class given the situation under deliberation.”
“Subjective probabilities, which require frequent updating, can also be very useful. But there are realms where attaching probabilities to outcomes can be treacherous. Here, both the probabilities and outcomes are largely unknowable. This is the territory of ‘black swans,’ outcomes that are ‘outside the realm of expectations,’ have a large impact, and are explained after the fact. If you are going to participate in this area, the goal here is to gain exposure to positive black swans.
Warren Buffett, chairman and chief executive officer of Berkshire Hathaway, summed up this attribute well: ‘Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That is what we’re trying to do. It’s imperfect, but that’s what it’s all about.’”
Intrinsic Value, Expected Return
“Fundamentals capture a sense of a company’s future financial performance. Value drivers including sales growth, operating profit margins, investment needs, and return on investment shape fundamentals. Expectations reflect the financial performance implied by the stock price. Making money in markets requires having a point of view that is different than what the current price suggests. Michael Steinhardt called this a ‘variant perception.’ Most investors fail to distinguish between fundamentals and expectations…great investors are adept at translating between expectations and fundamentals, and keep them separate in decision making.”
“It is interesting to consider what about investing is mutable and what is immutable. The truth is that much is mutable. The average half-life of a public company is about a decade, which means that the investable universe is in flux. Conditions are always shifting because of unknowns including technological change, consumer preferences, and competition. But one concept that is close to immutable for an investor is that the present value of future free cash flow determines the value of a financial asset. This is true for stocks, bonds, and real estate. Valuation is challenging for equity investors because each driver of value—cash flows, timing, and risk—are based on expectations whereas two of the three drivers are contractual for bond investors.”
“I recall going to an equity research morning call and hearing the utility industry analyst suggest the slow-growing companies under his coverage deserved price-earnings (P/E) multiples in the high teens and the tobacco industry analyst imply that his fast-growing companies should trade at P/E’s in the mid-teens. How does that make sense? I was dropped into a world of rules-of-thumb, old wives’ tales, and intuitions…multiples are not valuation but a shorthand for the valuation process. No thoughtful investor ever forgets that. Shorthands are useful because they save you time, but they also come with blind spots.”