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In General thoughts

May 24, 2019

6 Min read

7 comments

I recently tweeted the following

No one has a logical objection to saving and starting as early as possible in life. If you understand the power of compounding, you will not argue against this point.

The most common objection is against investing in index funds. A lot of people think its an admission of defeat if you go the route of index funds, especially when it so easy to do better than the market

Is it so easy to beat the index?

A lot of people look at the recent experience and conclude that beating the market will be easy going forward. In reaching this conclusion, they are ignoring some obvious points

Indian markets similar to global markets continue to get more transparent and hence more efficient. The more efficient a market, the harder it is to beat the index
At the height of the bull market in 2017, a lot of people thought anything less than a 40% CAGR was for losers. That expectation has a lot of arrogance built into it. If the overall market is going to deliver around 14-15% over a long period of time, then the only way an individual can achieve such high returns is by being a far superior investor. A few people may turnout to be exceptional. However, the ex-ante probability of that is usually low
Most investors ignore the aspect of luck. A lot of new investors started investing in the 2010-2013 period when small and mid cap valuations were at a decade low. We will get the same tailwind in the future.

We are already seeing the level of excess returns over the index compress in several markets such as the US due to rising competition. I think the same is happening in India. This is also called the red queen effect and we are seeing this in other competitive fields such as sports, business, marketing etc too.

Is it worth the effort?

Let’s assume that you work hard and do manage to beat the index. At this point, I would like to reference this post I wrote on the ROI of such an effort. Anyone who decides to become an active investor has to divert time from either full time work or from some other personal activities to make this extra return.

I have laid the math in the table below and you can play with the numbers in terms of your opportunity cost (salary, time with family or any other metric). There is no standard formulae to evaluate the ROI – this is something personal and only you can answer it. However, if you are in this only for the money, then a valid metric for comparison is your current hourly rate in terms of a full time job.

The question to answer is – When will the per hour wage from ‘active investing’ exceed the wage from doing a full time job?

A tough way to make easy money

As can be seen from the table above, the break even usually happens after 8-10 years of active investing. Even if you are great investor – compounding at 20%+ rate which very few investors or mutual funds achieve, the returns are back ended and come much later in life.

Now some folks will point to Rakesh Jhunjhunwala or warren Buffett or some such investor who have become famous and very rich through investing. This is the equivalent of someone pointing out one of the superstars in any field (cricket, Movies etc) and justifying their decision.

They are completely oblivious to the hidden evidence – for every Kohli, Aamir khan or any other hugely successful individual, there is large group of people who never made it big. The earnings per hour through active investing clearly show that making money via this route is not an easy way to get rich

Am I being a hypocrite?

One of the thoughts in your mind must be – This guy has been investing actively and is turning around and recommending others not do it. He is being a hypocrite as he wants to reduce his own competition.

I can assure you that the number of professional and individual investors getting attracted to market is very high and this post will make no difference to that. The rewards of success (or the allure) in this field is high enough to keep attracting new entrants.

As I have shared in the past, if I look back at the 20 years of my investing career, the economic (key word) ROI of the time spent on investing and writing this blog would be far less than a full time job. The only reason I have done this is because I have always loved the process and would do it even if I was not being paid for it (Which is true for this blog anyway).

Active investing is an irrational decision

If you agree with my argument that from an economic standpoint a career of investing actively in the market does not make sense, then saving early and investing via other instruments (mutual funds, ETF etc) is the way to go.

The above point does not mean that you don’t become financially literate. I think that is a must and should be made mandatory in schools. We should all have the minimum knowledge of personal finance to make sensible decisions. This would require only couple of hours a month. Once you have done that, you can use the rest of your time on other pursuits. That was the key point behind the above tweet

Unless you invest for a living (in financial services industry), I think investing directly in the market is not a rational decision. A lot of people do for the entertainment or bragging rights and in the end hurt themselves financially. People who are truly successful in it are those who love the process and don’t care only about the returns. If you are one of those folks, then welcome to my world and please ignore this post.

For others who are in it only for the money – find an area you truly love and get good at it. You will make a very good living at it and enjoy the process. The surplus income you make should then be invested in index funds. That’s what I am going to advise my kids.

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Weekend Thoughts

In General thoughts

February 21, 2019

3 Min read

I am have been mulling a few things over the last few weeks. Thought of sharing it with all of you. I may probably do this again in the future on other topics

Cut and run

In the last few months, we have seen stocks nose dive when the market learnt that, management was doing something unethical or working against the shareholders. The examples are quite well known and need not repeated.

The reaction is swift and brutal. I have learnt this painful lesson personally in the past, on a few investments. In the first case – SSI tech, which occurred in early 2001, I kept holding the stock waiting for some miracle to happen. In the end, I lost around 90% of my investment in 2 years. The same occurred with Zylog in 2012-13, but as this was a tiny speculative position, the loss was very small.

We have been lucky to have avoided such a situation till date. However, it does not mean I am exempt from it. Inspite of my best efforts, I may end up trusting a management who could turn out to be a fraud.

To be clear, I don’t think we have any such position where I think the management is cheating us.

I want to make it clear that if such a situation were to occur and it becomes apparent that the management is either fudging the accounts or cheating the minority shareholders, i will not hesitate to exit even if it means a financial loss and me looking like a dumb fool.

I have learnt that exiting such a position and salvaging whatever you can is always the best option. Case in point: I sold zylog for a 30% loss at around 30-35/ share. It now sells for 0.8 (yes that’s not a typo)

Pick and choose

I am aware that some of you use the model portfolio as a starting point and pick and choose some positions out of it. I have no problems with it personally and you are free to make your decisions.

That said, I am would not do that if I were in your place. The reason has nothing to do with my ego or that I am some awesome investor whose every word is gospel.

The true reason is actually the opposite. Even the best of investors do not get more than 70% of their picks right (in our case its around 60-65%). This means that around 1 in 3 picks are wrong and will lose money.

When you pick and choose from the model portfolio, you are making an implicit bet that you have the skills to know which one of my three picks, will fail. I cannot judge that for anyone – that is for you to answer for yourself.

My own process acknowledges the above failure rate and hence most of the new positions start small and at a lower priority in the model portfolio. As the company/ management performs, I raise the position size (often after a long time). If on the other hand, I make a mistake, I simply take the loss and move on.

The key point in this process is that my focus is on the portfolio, which should do well and not on individual positions alone. Doing a pick & choose means, that you are ignoring the portfolio approach (or handling it yourself)

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Building an edge

In Advisory letter

January 19, 2019

5 Min read

In an earlier note, I wrote about the three factors which contribute to outperformance (doing better than an index). I expanded on the third factor in the most recent update.

Sources of outperformance
Superior performance versus the indices can usually be broken down into three buckets

Informational edge – An investor can outperform the market by having access to superior information such ground level data, ongoing inputs from management etc.

Analytical edge – This edge comes from having the same information, but analyzing it in a superior fashion via multiple mental models

Behavioral edge – This edge comes from being rational and long term oriented.

I personally think our edge can come mainly from the behavioral and analytical factors. The Indian markets had some level of informational edge, but this edge is eroding with wider availability of information and increasing levels of transparency.

We aim to have an analytical edge by digging deeper and thinking more thoroughly about each idea. Ultimately it, depends on my own IQ levels and mental wiring, which is unlikely to change despite my efforts.

The final edge – behavioral is the most sustainable and at the same the toughest one to maintain. This involves being rational about our decisions and maintaining a long term orientation. If you look at the annual turnover of mutual funds and other investors, most of them are short term oriented with a time horizon of less than one year. In a world of short term incentives, an ability to be patient and have a long term view can be a source of advantage.

An enormous advantage
We started the advisory in 2011. At the outset, we made a few decisions which has made our life simpler and saved us a lot of pain.

We will not tout the wins on social media, which are often due to luck and can easily get hit by a random event causing a loss for anyone trying to follow them. If it works well, the person taking the tip attributes it to their genius. If it fails, we are responsible. Considering that the best of investors don’t get it right more than 60-70% of the time, what is the upside other than an occasional ego trip?
We will focus on the investment process as that is the only repeatable aspect of investing over which we have some control. We cannot control the outcome.
We will focus on the long term as short-term results are prone to random events, but the noise cancels out over time
We will not indulge in making fun of other investors when we are doing well. It is stupid behavior and extremely petty. There are times when every investor goes through a bad patch – so what goes around comes around

Some of the behavior we see in the media, although loud, petty and promotional is not irrational. It allows the advisor/ fund manager to get visibility and increase their AUM. In the end, managing a fund is a business and one cannot live on high ideals alone.

The problem with this behavior is the type of investors you attract. If you talk about short term performance and multi-baggers, then you will attract people looking for quick gains and easy profits. The downside of having such investors, is that they get quickly disappointed when the inevitable downturn hits the market.

Looking for quick gains, such investors join at the top and manage to get quick losses.

For the fund manager, there is no downside. If the market keeps going up, they get to make their fees. If the market drops and they lose a few investors, which is part of the normal business cycle. They just need to wait for the next bull market for a new crop of performance chasers.

Both me and Kedar don’t want to play this game. We are not running this advisory for the good of mankind, but do not like this behavior. In addition, we are in a financial position, where we do not depend on the fees we earn to put food on the table.

Why am I sharing this now after so many years?

The reason for sharing is that a person cannot be rational and make decisions for the long term if that results in career risk. Try telling your family that you took a 5-year view which cost you your job. It is never going to happen.

We have taken this element of risk out of the equation for us. As I mentioned earlier – we do not depend on the advisory to put food on our table. In addition, our own money is invested in the same way as the model portfolio. Put the two together and you will realize that we are willing and able to think long term with a focus on risk reduction.

I think this is a very important edge for us compared to most fund managers. We can safely ignore short term fads (such as the bull market in small and mid-caps last year) and panics and rationally manage the portfolio. This allows us to take bets which are unpopular and hold on to them.

In an age of huge computing power and easily available information, one is unlikely to get a durable analytical or information edge over other investors. However, the third edge – behavioral which is durable and cannot be competed away, is available to us due to the reasons I have shared.

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The Journey matters

January 2, 2019

4 Min read

Following is from my recent annual update to subscribers

The journey matters

I wrote about bitcoin in the 2017 update and compared it with small caps and midcaps. Since then bitcoin is down 75%, midcaps are down 16% and small caps are down around 30% on average.

A lot of investors believe they have a lot of tolerance for risk. I can tell you from personal experience, that most of us over-estimate our tolerance to risk, me included. There is a lot of difference between intellectually thinking of a 30% loss versus experiencing a real 30% loss in your portfolio.

For a check, think of how you felt during September when the market and individual portfolios dropped around 20%. These drops have gotten worse emotionally in the recent past due to social media and the speed with which rumors and panic spread. The same 20% drop causes far more anguish now than the past when such noise was minimal. In such a climate, it is critical to insulate yourself from the noise. If you don’t do that, it is likely you will panic at the bottom and make an irrational decision.

One way to insulate yourself from this noise is to know your own risk tolerance. If you think, you can bear a 30% loss on your portfolio – ensure that your equity allocation as percentage of your net worth does not exceed 50%. This will ensure that the net impact on your portfolio will not exceed 15%. In effect, ensure that the actual loss of your net worth is less than half your estimate of risk tolerance. This is a sort of margin of safety on your own behavior in case you have over-estimated your ability to withstand financial pain.

Know thyself

You will find a lot of charts on how companies like amazon have given 25%+ CAGR with 60-70% drops along the way. These charts show the 100X returns a hypothetical investor would have made in the last 15 years of holding this stock.

I can tell you that such hypothetical investors are very very rare and even if they hold this stock, it would be a small percentage of their portfolio. There is an infinitely small number of investors who can buy and hold such volatile companies as a large percentage of their portfolio. Try imagining your entire net worth going down by 80% and still holding on to it.

I am definitely not one of those brave investors. I have a much higher tolerance for volatility and risk than an average person, but I am not a risk savant – an outlier in terms of my tolerance. I have developed a level of risk tolerance over time but have always tried to remain within my limits. I see no reason for testing those limits as I don’t want to be miserable even if I get ‘richer’ over time.

There are no defined limits for risk tolerance. Every individual has to answer it for himself/herself. You will have to do same. One of the best test I have found is the sleep and worry test. If some positions or the overall equity allocation is causing you to worry and lose sleep, then it means that you are nearing your risk tolerance. At that point it makes sense to drop the position or reduce allocation before hitting the limit (and panicking at the wrong point).

I started worrying in late 2017 and hence reduced the equity allocation in the model portfolio. This allowed me to sleep better in 2018.

Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.

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Missing the forest for the trees

November 23, 2018

4 Min read

1 comment

I wrote the following note to subscribers, in context of a specific position. I have made edits and additions to the original note for this post.

I have a different set of expectations from this position. The management of the company is quite conservative (rightfully so) and as a result has always grown at a measured pace without taking on too much debt. As a result, the profit growth has never been too high, but at the same time the company has always been profitable even in the worst of the times.

Due to this cautious approach, we cannot expect this position to be a multi-bagger any time soon.

Although a lot of subscriber still look at individual positions, I prefer to zoom out and look at the aggregate portfolio level. We are not in multi-bagger business where me and kedar will run around touting our wins on social media.

Our focus is to achieve above average returns at the portfolio level with lower risk over the long run, to achieve our financial goals.

Mania of the multi-baggers

The last three years have been all about multi-baggers.

The Media is usually fixated on multi-baggers and short term price changes as that grabs attention (which is their sole focus). Unfortunately, a lot of investment advisories and so called gurus are the in same boat. It is not too difficult to see the reason – you need to make big claims to grab attention and clients.

Touting a low risk, steady compounder which doubles every four years is not going to win too many fans and subscribers/investors. As a result, the focus of the industry is to talk about high returns and multi-baggers in the portfolio, ignoring the risk completely.

On this count, I will not blame the media and financial industry alone for selling dreams to the general public. A vast majority of investors (if you can call them that) are searching for shortcuts to become rich quickly. Media and a lot of professionals are merely satisfying that demand.

One cannot run a business on high principles alone.

Missing the forest for the trees

In selling, what is being demanded, the financial industry ends up ignoring several other key factors which drive returns over the long run.

The key point in investing is how well are you doing at the portfolio level and if the return is commensurate with the risk. The individual wins and losses are a driving factor but not the only criteria. Overall risk driven by position size and diversification plays an equally important role. I find these aspects of investing missing in most discussions.

If you agree with the above point, then you should also consider the lower risk, moderate return ideas. In the past, I have not allocated as much as I should have to these kind of ideas as they do not have the dazzle and fireworks. However, I have slowly changed my thought process on it.

A part of the portfolio should be allocated to such low key, solid performers which act as a ballast to the portfolio and deliver decent returns over the long run (with much lower stress). This is now becoming apparent where some of the past multi-baggers have left investors holding the bag.

Confusing the means (multi-bagger picks) with the end (achieving financial goals via equity investing) had led to investors achieving neither.

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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.

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Dont worry, there will be pain

October 6, 2018

2 Min read

A comment made to subscribers when adding to the portfolio:

I am not calling out the bottom of the market or anything of the sort by making the above transactions. As I have repeated often in the past, no one other than liars and self-delusional people can predict what the market will do in the short term.

The best approach always is to look at each individual company closely and evaluate how it will do in the next 3-5 years including under stressful macro conditions.

As we add to the model portfolio, a few positions will not work out – that is a given. The key is to ensure that we do well on an aggregate basis and the returns are above average over time. This approach has worked for me over the last 20 years and I think is still the best approach to follow.

Although we are analyzing as rationally as possible and making a tough decision to start adding to the portfolio, it will be painful to watch the portfolio drop almost on a daily basis. After all these years in the stock market, it is equally painful for me. The key is to focus on the long-term prospects of the companies and their intrinsic value and not react to emotions which will lead you to the wrong decisions.

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Blood on the streets

In Finance and Banking

September 26, 2018

10 Min read

I sent out this note to the subscribers over the weekend. Reproduced below with edits

I am not going to talk about risk again. I have been speaking about it for the last 12-18 months. The time to prepare for the storm was when the skies were clear. We have a full storm now.

We started reducing some of the fully valued positions last year and raised our cash levels to almost 30% of the portfolio. We were at 29.1% of the portfolio in cash at the start of the year. We now have 33.3% of the portfolio in cash as of last week. In effect, we have shuffled between the existing positions, but have not changed the net cash position much since the start of the year.

There is no grand strategy or deep macro reasoning behind all of this. We have been exiting some of the positions which seemed overvalued and started positions in a few others with good long-term prospects. As I have shared in the past, I don’t invest based on macro factors such as interest rate changes, currency or inflation rate. I also ignore short term panics and euphoria in the market other than making decisions at a company level based on the valuations in each case.

My preferred approach is look at the long-term prospects of a company and invest in those cases where the we can make above average returns in the long run. In all these cases, the objective is to make multiples of the invested amount.

Why am I repeating this again? I am making this point because I have no plans to play the current panic for some quick gains. There are a lot of investors and traders who can jump in during intraday lows and make a good gain out of it. There are a handful who can even do this on a consistent basis.

I am not one of those. I know my temperament. I have a tendency to buy and hold to the point of overstaying in a position. In some of these cases, it would have been better to have exited earlier. However, on average I have found that, being patient and holding on has worked out better in the long run.

If you agree with my philosophy, then you will understand the reason why I have not reacted much in the last few months to the noise in the market. As always, I continue to analyze the current and new positions and will make buy or sell decisions slowly over time. I see no reason to speed up the decision making process unless the current events change the thesis for the existing or new positions.

This bring us to the events around the NBFC space.

An obscure term – ALM
There is an obscure or rarely discussed term – asset liability management in the case of all NBFCs. This is a critical part of managing the operations of a financial institution but is rarely discussed as it works smoothly most of the time.

What is ALM?
I will not get technical on this and will try to simplify the explanation as much as I can. Any financial institution borrows money to lend it onwards to its customers. This borrowing is done via commercial paper, Bank borrowings, Mutual funds, Bonds etc. These instruments have varying durations between a few days to years.

On the asset side, the lending instruments also have varying durations depending on the nature of the loan and the time left on it. At one end of the spectrum are gold loans with a duration of 2-3 months and at the other end are the long dated loans such as infrastructure loans with a duration of 5-15 years (as in case of ILFS which is in the center of the current storm).

If you layout all the borrowings on a graph with amount on the y – axis and duration on X axis, you will get the liability profile of the company. A similar curve can be generated for the assets too. A well managed ALM operation tries to match these two profiles as close as possible. This makes intuitive sense. You want the short term assets to be funded by short term borrowings and vice a versa

I have pasted below the ALM chart as an example below. As you can see the ALM profiles are reasonably matched.

ALM mismatch and funding issues
As a financial institution has a mix of long and short-term debt, it has to renew its debt on a regular basis. This means that if the company cannot renew its debt, it has no way of repaying it via the cash flow from assets, especially if the assets are long dated in nature.

Let’s look at the case of ILFS
The company has a short term borrowing of around 25000 Crs out of total borrowing of 91000 Crs. This means that the company has renew to this borrowing on a regular basis.
The company does not break out the asset side duration, but if you look at the balance sheet almost 80% of the assets are long dated in the form of infrastructure assets and receivable claims etc.

This kind of a balance sheet works till the financial institution can refinance its debt on a regular basis. In the case of ILFS, they have been facing cash flow issues and losses due to various projects being stuck at different stages of completion with claims pending with the government. At the same time, the short term debt and interest has to be paid when it comes due.

In the recent months, the company started facing liquidity issues and has not been able to make payment on its interest obligations as it cannot liquidate its assets quickly to make these payment (keep in mind the nature of assets such as roads and bridges which cannot be sold quickly).

As the company defaulted in the last few weeks, the debt held by mutual funds and other lenders had to be marked down. This has led to a cascade effect where these funds have had to liquidate other instruments to meet their liquidity requirements.

This is a classic run on the bank. ILFS may not have a solvency issue (I don’t have an insight on that) but has a liquidity issues which is now spilling over to the wider market. These liquidity issues mean that all other financial institutions, especially NBFCs which are funded via a mix of short and long-term debt could face a similar risk if the situation escalates.

The parallel with Lehman
There is a fear that this is similar to the Lehman crisis from 2008. There are similarities, but it is not identical. In the Lehman crisis, the company had leveraged up to around 100:1 and funded the derivative assets with short term funding.

When the housing market collapsed, the company had to write down its assets and as it was so highly leveraged, its net worth vaporized in an instant. As Lehman was bankrupt, the counterparties refused to extend credit and hence the liquidity dried up. The only way to save Lehman was to recapitalize it.

In the case of most financial institutions in India, we do not have an asset side problem and hence they don’t have a solvency issue. What we are seeing is a liquidity concern and hence if the government steps in and provides liquidity, the situation could normalize.

Position risks
Let’s review the risk at the individual company level now in terms of ALM and liquidity levels

Portfolio risk
Let’s look at the portfolio level risk. For starters, I have kept position size at 5-7% (at cost) and the sector level cap at around 15-20%. This is to ensure that we reduce the risk from an implosion in a company or sector at any point of time.

This however does not eliminate some risks completely. I have focused on the company level and portfolio risks but cannot eliminate the second or third order effects. For example, the recent drop has been due to the problems at IL&FS, but as the liquidity concerns spread, it has started impacting the overall markets now. We saw midcap and small caps drop as a result of the fear last week.

There is a lot of commentary around what will happen. A lot of commentators feel that the market has over-reacted and we will back to normal soon. Anytime, I hear people prognosticate about the market, I am reminded of a simple fact – No one cannot predict what will happen next. If someone can, they will not share it with you as they will use that insight to make money in the market.

The reality of the situation is that we do have a serious situation with IL&FS which is a SIFI (systematically important financial institution). In simple words it means, that the company is so large that if it goes down, there will be a domino effect which will affect the entire financial sector.

As this is a private company, we have not seen any action from the government on it. However, we are now at a point where the contagion has started spreading and sooner or later there will be a bailout (government will have to back the company). If this happens soon, then fall out will be contained. However, if the government delays taking action due to political compulsion, then we have lots of turbulence ahead.

The first order impact would be in the financial services sector, but it will spread to all the other stocks as we are already seeing now.

Action plan
I don’t have to give false hope to anyone. The reality is that no one knows yet how this situation will evolve. If the government steps in quickly, further panic will be avoided. If, however, we do not see a firm action, then we need to ready for some tough times.

As I have shared in the past, I do not manage the portfolio with an eye on reducing the short term swings in the portfolio. I am always concerned with the long term intrinsic value of the companies we hold. In sharing the above analysis, I have tried to evaluate the impact of a liquidity squeeze on some of our holdings in the long run. Inspite of the logical analysis here, it does not mean that our other positions will not be affected if panic spreads in the market.

This is similar to the analysis I shared after the demonetization even in Nov 2016, when our portfolio dropped by more than 10% in a few weeks. The risk at that time was much more wide spread and was mainly on the asset side of the business (loans going bad). This time around a liquidity crunch will not have a direct impact on the asset side and is more of an issue from the liability side of the balance sheet.

If you are invested the same as the model portfolio, then you should not try to average down if you already have an allocation which matches with the recommended percentage. If however, you have not purchased any particular stock, then you should buy slowly over time keeping in mind the recommended percentage.

Although I don’t react to the day to day movements in the market, I do have an eye on it. I will update all of you if there is any change in my views. For now, we have to be prepared for some tough times
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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.

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Evaluating management: Bayesian reasoning and fallacy of obviousness

August 1, 2018

4 Min read

When I invest in companies, I don’t vouch for or give a character certificate to management. I look at the past and current behavior and then try to arrive at a judgement. In majority of the cases, past behavior is a good indicator, but we do get surprises from time to time.

If new developments make me change my view, I will not try to defend my past decision which was made on a different set of facts. The key is to rationality is to evaluate new facts appropriately and move on from there. As John Maynard Keynes said a long time ago – when facts change, I change my mind. What do you do sir?

Let’s move to the point of how to evaluate management quality in light of poor behavior? For starter, there is no formulae which will give the answer. The best analogy to judge management quality comes from the court system in passing verdict on defendants. A defendant is assumed innocent till proven guilty.

I personally try to look at management with a neutral view when I start analyzing a company. They are neither good nor bad. This is a very important point. I have seen majority of investors start with a presumption of a good or bad management and then collect evidence to prove it. It is very easy to make an assumption and gather enough evidence to prove your point.

The fallacy of obviousness

See this wonderful article which makes the same point. I would highly recommend reading this article. Some excerpts –

So, given the problem of too much evidence – again, think of all the things that are evident in the gorilla clip – humans try to hone in on what might be relevant for answering particular questions. We attend to what might be meaningful and useful

However, computers and algorithms – even the most sophisticated ones – cannot address the fallacy of obviousness. Put differently, they can never know what might be relevant. Some of the early proponents of AI recognised this limitation (for example, the computer scientists John McCarthy and Patrick Hayes in their 1969 paper, which discusses ‘representation’ and the frame problem).

In short, as Albert Einstein put it in 1926: ‘Whether you can observe a thing or not depends on the theory which you use. It is the theory which decides what can be observed.’ The same applies whether we are talking about chest-thumping gorillas or efforts to probe the very nature of reality

Equal priors

The key is to start without an assumption (50-50 probability for both scenarios or equal priors) and look at the meaningful (and not trivial) evidence to come to a conclusion. Once you have done that, your conclusion should not be set in stone, but treated as a hypothesis which can change based on new evidence.

If the management continues to behave well, your confidence is increased. If you start seeing negative behavior, your confidence goes down and at some point (which cannot be mathematically defined), you may lose faith in the management and exit the position.

The above approach is fancifully also called Bayesian reasoning.

One should think probabilistically when evaluating management and not consider these issues as black or white. That’s the essence of Bayesian reasoning.

The central point of this approach is to look at new evidence in light of your prior conclusion and change it in proportion to the evidence. In some case, the new episode may be a small one and will cause you to reduce your level of confidence a bit. In other cases, either the episode or series of episodes will be so awful, that you will be forced to change your mind completely.

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Cash and portfolio rotation

July 21, 2018

2 Min read