January 7, 2016


My Most Recent Thoughts

Folding Aces

Imagine you are sitting at a poker table in a Las Vegas Casino.  It is a tournament that you have dreamed of playing in for years, and by some crazy stroke of luck you got in this year.  All the great famous poker players from TV are here playing.  You realize this is a once in a lifetime opportunity and you are just thrilled to take part.

The first hand gets dealt and you get Ace, Ace.  Pocket aces, the best possible starting hand.

The action goes around the table, fold, fold, fold, ….and then, All in.  Someone has just pushed all their chips into the pot.

You can’t believe your luck!  Some sucker decided to push all-in on the first hand and you are loaded with Aces!  The next three players quickly fold, and the action gets to you.  You're ready to put all your chips in and call - but then, you hesitate.

You're odds of winning with pocket Aces against one other player is somewhere between 70 and 80% - dominating odds.  The right move is to call and its not close.

But, this is the first hand.  If you lose here your dream comes to an end.  It's a very high probability of winning, but its not a certainty.  80% means you would lose that hand 1 time out of 5.  What do you do?

Most people here make the 'right' decision and call; and very likely, they would double their chip stack and be in a better position for the rest of the day.   But you are also taking a 20 - 30% chance of being the first one eliminated.  Everyone would understand - "I had Aces, I had to call."  But just because its excusable does not make it easy to spend the day watching from the sidelines.  'Bad beats' happen all the time - and not just in poker.

A few months ago I posted the following tweet about my investment process.

It got a lot more reaction than I expected, including some great questions so I thought it worthwhile to expand a bit on this premise.

Too often the investment world thinks in black and white.  Right and wrong.  You either did the work, read the research, crushed the Excel models, and came to the right assessment, or you screwed up.  It's what Annie Duke, who recently made the podcast rounds to promote her book Thinking in Bets, calls 'resulting'.  'Resulting' is where the outcome determines whether you made the right move.  Did the trade make money?  Then you were right and did a good job.  If it lost money, you did a lousy job.

What is the probability of being right?

Some investors can move beyond the world of right or wrong.  They understand that a lot can happen and you cannot know anything for certain.  This is why my favorite definition of risk is the one quoted by Howard Marks in his great book The Most Important Thing.

"Risk means more things can happen than will happen." - Elroy Dimson

Single minded people believe that things are bound to happen - that you could figure it out if you were just smart enough or had enough information.  Investors thinking probabilistically understand that nothing is certain.  There are only degrees of likelihood.

Nassim Nicholas Taleb sums it up even further in Fooled By Randomness -

“Probability is not a mere computation of odds on the dice or more complicated variants; it is the acceptance of the lack of certainty in our knowledge and the development of methods for dealing with our ignorance.”

The future is unknowable, and thinking otherwise is folly.  When people become certain that something will happen that is when they get into the most trouble.  Indeed it is one of the most consistent market inefficiencies in history - People will treat as certain something that has a very high probability of happening, and treat as impossible something that has a very low probability of happening.

What is the consequence of being wrong?

I've had this post (A Long Chat with Peter Bernstein) by Jason Zweig saved because I think it is so fundamental on how people should be approaching the investment process.  The late Peter Bernstein is one of my favorite financial writers (Against the Gods is a must read) and Jason Zweig is one of today's foremost investment commentators.  You should really read the entire thing (and read again if you already have) but for our purposes, Peter Bernstein goes through the biggest errors investors make.  The first one is 'extrapolation' (which is a topic that deserves it's own discussion ... another time perhaps), but the second one is  Thinking of probabilities without regard for the potential consequence.

Peter Bernstein on the most famous investor mistakes

To quote Mr. Bernstein:

Pascal’s Wager doesn’t mean that you have to be convinced beyond doubt that you are right. But you have to think about the consequences of what you’re doing and establish that you can survive them if you’re wrong. Consequences are more important than probabilities.

Even if you have a very strong probability of being right, if the consequence for being wrong is unbearable, you should not take the risk.

Imagine you face a wager with 90% odds of paying you $1 million with a 10% chance you have to pay $750,000.  That is an easy bet to take if you have the money.  But what if your net worth is only $200,000 and you have three kids that play travel soccer and are enrolled in private school?  You would face a 10% chance of losing your entire retirement savings, your house, any personal property of any value.  The statistician would say there is no question you should take this wager.  The estimated value is positive $875,000 (90% x $1m plus 10% x -750,000).  C'mon!  Take the bet!  It is the mathematically appropriate thing to do!

But can you afford to lose?  If the answer is no, walk away, avoid the possibility of ruin.  That is appropriate risk management.

Are you thinking about folding those aces yet?

Today's lessons

Tesla, that polarizing electric car company ;-), has been in the news a lot lately.  The stock has a very large, and very loud, group of short sellers (betting that the stock will go down).  The rationale is logically sound - the company cannot hit production targets, there is a huge amount of turnover among executives, they are burning cash at an alarming rate, not to mention the craziness of CEO Elon Musk.

However the risk of being in a short position was on full display in recent weeks.  Even if all the arguments of the short sellers are ultimately true, there are still things that can happen which make a short trade disastrous.  The following tweet was a case in point.

While this is tweet is now under investigation by the SEC (ultimately strengthening the short case), were he able to take the company private at $420, all the short positions would have locked in a loss.  It is a case of being right in theory but wrong on the outcome.

Even still, the stock has dropped down to around $300, and the short sellers believe it has much farther to go. But the cult following around this company and their enigmatic leader, mean that there is a meaningful chance that even with the difficulties the company faces, it could still continue to rise - defying logic or financial common sense.  It could simply rise on the faith and enthusiasm of its sycophantic followers.

I highlighted the risk of short selling most recently in this profile of Cornelius Vanderbilt's take-over of the Harlem and Hudson rail-lines.  The point being that when you own a stock (are long) the most you can lose is your investment.  When you are short, the stock could rise theoretically into infinity and cost you much more than your original investment.

Stocks that do not trade according to fundamental valuations are particularly dangerous. When the consequence of being wrong is unknown and potentially huge it is a dangerous risk to take.

Back to the Poker Game

First hand of your dream tournament.  The bet is to you for all your chips and you have the best possible hand.  You know your probability to win is very high, but your consequence of being wrong is to go home before you even get a chance to order a drink.

The poker players out there would say call.  It's the right move and poker is a game of exploiting statistical advantages.

Me?  Perhaps this reinforces why I would never be playing in a high stakes dream tournament, but I would probably fold them - face up just to let everyone know I was nuts.  The pain of hitting a bad beat and going home would be far worse than the benefit of doubling my chip stack.

But then again.... it would be a good story to tell.

Until next time......

"The word ‘risk’ derives from the early Italian risicare, which means ‘to dare’. In this sense, risk is a choice rather than a fate. The actions we dare to take, which depend on how free we are to make choices, are what the story of risk is all about.” -  Peter L. Bernstein


Feature photo credit: Poker Photos via Flickr.com

Continue Reading

The Best Stock Trade I Ever Made

I fell in love with the stock market when I was in college. I became president of my university’s investment club and also decided to start investing the small amount of money I had personally.

One stock I analyzed had a solid business with great numbers.  Its dividend was high but well covered by earnings and had been raised every year like clockwork for the previous 20. This stock would go into my portfolio as the rock and cash cow.

I bought it at $42 and six months later it was up to $47 - and churning out a 7–8% yield on top of that. I was ready to hold that stock for years.

Unfortunately, my priorities in college were not where they should have been and I wasn’t careful with cash. As I got to my last semester I needed to buy textbooks and didn’t have the funds. I ended up selling my stock, painfully.

The year was 2006 and the stock was New Century Financial, the second largest sub-prime mortgage lender in the country.  By early 2007 the company got into serious trouble and in April it filed for bankruptcy.  It was the first major casualty of the financial crisis.

The stock went to $0. I sold it a few months before to buy textbooks.

That was the greatest stock trade I ever made.

I learned some important lessons from this.

1)            The numbers are important, but they can’t predict the future

New Century Financial was the second largest sub-prime mortgage lender in the country.  (For more on the companies and CEO’s involved in the financial crisis check out the excellent book All the Devils are Here by Bethany McLean and Joe Nocera.)  Of course the numbers were great while the housing market was booming, but once house prices started declining, their business imploded. 

If you are looking at projections for a stock, you have to ask yourself – what could make this story blow up?  I looked at the numbers and just expected the trend to continue. 

The number one error investors make is to extrapolate trends indefinitely into the future.


2)            Sometimes you are better lucky than good.  Acknowledge it and learn from it.

My investment would have been wiped out if I didn’t need the cash.  I got lucky and dodged a bullet.  When analyzing how a trade worked or did not, you should not focus on the result, but on the process.


3)            If a trade looks like a slam-dunk, the radar needs to go up.

My analysis of New Century Financial made it look like a no-brainer.  Anyone who has done a discounted cash flow model knows that high dividends, high growth, and high return of equity will make a stock look like it’s worth a ton.  That may be the case, but it depends on those numbers continuing on into the future.  You need to be skeptical when the analysis looks too good.


Just because I got lucky, it doesn’t mean I can’t learn something.  The close calls can still give you valuable experience, with the added benefit of less bruises.

Until next time….

“Don’t confuse luck with skill when judging others, and especially when judging yourself” – Carl Ichan



Photo Credit - Luis Villa Del Campo via flickr.com

Continue Reading

Vanderbilt and the Greatest Corner Never Told

“He was to finance what Shakespeare was to poetry and Michelangelo to art.”

Financier and Statesman Russell Sage said these words of Cornelius Vanderbilt after the Commodore laid his enemies low with a brilliant double corner of Harlem and Hudson Rail stocks.  The ploy not only made him a small fortune, but also control of the only two rail lines offering service to Manhattan Island.  The historian John Steele Gordon described it as such “…Cornelius Vanderbilt played Hannibal at Wall Street’s battle of Canae.  His double envelopment of the bears netted him and his allies $3 million and was recognized immediately as a masterpiece of financial manipulation.”

Despite the fact that this is arguably the greatest coup in Wall Street history, it isn’t widely reported in popular history.  Here is the story along with a couple of lessons we can take with us a century and a half later.


The Man

“Vanderbilt, then, combined in himself the new and the old social traits at once.  Something of a sea-dog and a pioneer, endowed with physical courage and high energy as well as craftiness, he was the Self-Made Man, for whom the earlier, ruder frontier America was the native habitat.” – Matthew Josephson, Robber Barons

Vanderbilt got his start in business as a teenager, working as a ferry-boat captain.  He quickly gained a reputation as a slick operator and a ruthless business competitor and started making a fortune. He was constantly hustling, constantly working and competing.  As T.J. Stiles reports in his biography The First Tycoon, the New York Times thought Vanderbilt was a destructive force for business as someone who “competed for competition’s sake.”  Even his leisure time was taken up with such things as drag racing chariots down the streets of New York and other dangerous, competitive pursuits

He was already the country’s wealthiest man (or close to) by the time he decided to switch his energies towards rail in the 1850’s.  John Rockefeller, Andrew Carnegie, Jay Gould, and JP Morgan were all young men just getting started in the world at this time.  Vanderbilt’s tough reputation was only enhanced by the fact that he was involved in one of the first deadly rail accidents.  Every single passenger aboard that railcar died except him.  He was not deterred and continued to acquire rail properties, expanding his venture.  In the early 1860’s, he set his sights on a couple lines in New York City.

The Play

The Harlem and the Hudson were both poorly run, lightly traveled rail lines that were not thought of as highly valuable.  Vanderbilt saw that these lines were the only rails allowed to come directly onto Manhattan island.  Sensing an opportunity, he started to accumulate shares in Harlem.

At the same time Vanderbilt was buying, there was a large contingent of players who were selling the shares short.  That is, they were borrowing shares, and selling, with the hope to buy them back at a lower price, netting the difference.  This group of sellers (bears, in Wall Street parlance) included members of the New York City council as well as members of the board of directors for Harlem rail!  One of those board members was long-time Vanderbilt rival, Daniel Drew.

With all these inside interests betting on the price of Harlem to go down, there had to be something going on.  Sure enough, a franchise bill that authorized Harlem to lay a double track was suddenly rescinded.  The price dropped suddenly on the news and all the short sellers expected to clean up and declare victory – except that Mr. Vanderbilt was still on the other side, buying everything that was being sold.  Not only did the stock stop going down, but it started to rise quickly.

Now for those that do not know, shorting a stock can be a dangerous business.  When you buy a stock (go long) you only have your investment to lose.  If you pay $100 for a stock, it can only go to $0, thereby wiping out your investment.  However, if you borrow a stock and sell it short, there is technically no limit to high it could go before you must buy it back to cover your borrowing.  If you borrow shares and sell them at $100 and the price goes to $200, you have lost your entire investment.  But if the price goes to $300 or $400, you would be on the hook for more multiple times your initial position.

Now imagine one person owns the entire supply of stock.  If you sold it short at $100, and now you have to buy it back to cover your position, what price does the owner set?  This is the danger of being caught short when someone has ‘cornered’ the market.  As John Brooks explains in his classic “Once in Golconda:

“Since a successful cornerer may theoretically set an infinite price, any finite one is a theoretically a bargain.”

This is what happened to the short sellers of Harlem stock.  Vanderbilt and his allies had purchased the entire supply and had them at their mercy.  In order to escape complete ruin, the city council gave back Harlem’s franchise which now Vanderbilt owned outright.

Already, this was one of the most successful corners of a market in history and made the Commodore a ton of money in the process.  However, this was just the beginning.

Watching this epic battle unfold, some Wall Street speculators decided to attack the neighboring Hudson rail line.  This group thought that Vanderbilt must be short of cash (after all that buying) and attention, and so went heavily short hoping to drive the price down and make themselves a tidy profit.  What they did not know, was that Vanderbilt was already one step ahead and actually perpetuated the rumor that he was short on cash by weakly buying Hudson shares using futures.  This was a common strategy for buyers short on cash because it was merely a promise to buy at a later date.  The intermediaries Vanderbilt used were actually part of the short-selling group, who would gladly accept the options from the Commodore and then turned around and sold the stock into the market.

Little did the bears know, they were selling this stock to allies of Vanderbilt, who far from being short on cash, still had plenty of powder left.  When, finally, he demanded delivery of the stock he purchased, the sellers had to go into the market to buy it back and found no sellers except Vanderbilt himself.  Mercifully, instead of raising the price to infinity, Vanderbilt let the short-sellers off relatively easy.  They weren’t ruined, merely badly burned.

Within the span of a couple months, Cornelius Vanderbilt acquired full control of the only two railways with access to Manhattan and made a substantial fortune in the process.

Daniel Drew, still stung from his losses in the failed Harlem short, decided he wanted one more crack.  He convinced a few law makers in the state capitol of Albany to revoke the franchise for Harlem, overriding the city council.  If they revoked the license and shorted Harlem stock, they could make a bit of money as well.  This turned out to be a fateful mistake.

From The Great Game:

“Drew’s scheme was, of course, a carbon copy of what cost the members of the city council so dearly the previous spring.  One is at a loss to explain how they could have been tempted. ‘The statesmen at Albany,’ E.C. Stedman, a veteran of Wall Street in the 1860’s, wrote at the turn of the century, ‘in the spring of 1864, were well aware of the misfortune into which the statesmen at New York had plunged themselves, less than a year before, by their bear campaign against this stock.  Yet they rushed fatuously into a similar attempt, as if Vanderbilt has proved an easy victim.’”

Interestingly, the timing on this second attempt to ‘bear raid’ Harlem stock was in favor of the shorts.  The price went from $140 down to $101.  The greed of speculators who always hope to make more money was on full display here.  Instead of covering at a net profit of almost $40 per share, the shorts tried to press their advantage.  “They held on, hoping to see it drop to $50”

Despite really not being very liquid this time around, the Commodore was still not easily defeated.  He rallied his allies and raised cash to buy up the last remaining supply of the stock.  The price rose to $109, then to $125, and by the end of April was all the way to $224.  Feeling less charitable than the last time, Vanderbilt was asked by his brokers where to set the price.  “Asked what to do, he bellowed, ‘Put it to a thousand!’”

Fortunately for the shorts, (and their brokerage houses, who also would have been decimated at that price), Vanderbilt relented and settled at $285.

“The second Harlem corner was over and there would not be another.  Indeed, for a full generation on Wall Street, the phrase, ‘short of Harlem’, meant much the same thing as ‘up the creek’”

The Lessons

Obviously, the stock market is a very different entity today than it was 150 years ago.  Electronic trading, stronger regulation, mark-to-market, all make bear-raids and corners a much rarer occurrence today than they were then.  People, however, have not changed.  Fear and greed still very much drive the market.

  1. Know your risks

Before you enter into any investment, you need to know the upside and the downside.  Trying   to short a stock may present a good chance for gain, but the downside is technically unlimited.  The upside, meanwhile, is capped at 100%.  The stock can only drop to $0.00.  Even when you have inside information (now very much illegal to act on material, non-public information), there is risk that things do not play out as you hope.  The city council members in this story knew they were going to revoke the street car license for the Harlem line, but they still got wiped out because they failed to properly assess all their risks – specifically on the next point -

  1. Know your opponent

When you enter into a trade, you have to remember that if you are buying, that means someone is selling.  There is a counterparty to every transaction that happens.  Those city council members under-estimated the pockets and the resolve of the Commodore, to their detriment.  If you think a trade is a slam-dunk, try to find out who is on the other side.  Why would someone bet in the other direction?  If the opposition is strong enough, even if you are right on your thesis, you may be better off to take a pass.

  1. Know when to take a profit

If the state legislators in the second Harlem corner would have booked their gains when the price fell from $140 down to $101 they would have been able to chalk up a good win with a nice gain.  However, they did not know when to stop.  When you are long, it can often pay to keep your winners running, because your upside is not capped.  On the short-side though, every day you do not cover is another day your position could be crushed.  Making a successful trade is so hard because you have to be right twice.  You have to be right on when to buy and also when to sell.

History can be a valuable teacher.  For those interested in finance and markets, there is much that can be learned from past events.  The best place to start is probably from the book where the bulk of this story comes from.  The Great Game: the Emergence of Wall Street as a World Power 1653 – 2000 by John Steele Gordon.  Vanderbilt’s corner of Harlem and Hudson are but one chapter of a book filled with fascinating episodes of market history.  Each has its cast of impressive characters winning and losing fortunes, and all have valuable insights which can be gleaned from them.

Vanderbilt did finally get bested in market manipulation years later in the much more famous ‘Erie War’ over the Erie rail line.  Daniel Drew finally got some bit of revenge as he was, per usual, on the opposite side of the Commodore’s.  The victory, however, belonged squarely with Drew’s tentative ally, Jay Gould, known as the ‘Dark Genius of Wall Street’.  Gould was one of the only people who could match Vanderbilt in stubbornness and the willingness to do whatever it took to win a battle.

Until next time……

“I don’t care half so much about making money as I do about making my point, and coming out ahead” – Cornelius Vanderbilt



Continue Reading

Most Men Should Take Social Security Benefits ASAP

When should you take social security benefits?

It is one of the most common questions people ask me when they are getting ready to retire.  There have been innumerable posts written about when you should take benefits. None of the ones I saw seemed very robust.  So, I decided I needed to hit the Excel spreadsheets and crunch some numbers.

For those who are not familiar, I will offer the basics.  First of all, the calculation of the benefit is beyond the scope of this writing.  However, a formula is used to come up with a ‘Primary Insurance Amount’ which becomes your benefit at ‘full retirement age’.  ‘Full Retirement Age’ “FRA” is considered 67 for anyone born after 1960.  You are allowed to start taking benefits as soon as age 62, but in exchange for taking your benefits early, you need to take a reduced amount.  You are also allowed to delay taking benefits until the age of 70.  By doing so you will receive a larger amount.  Below is the table that shows the amount of benefit you receive at each age:

Figure 1: Percentage of full benefit received at each age (for those born after 1960)

If you start taking benefits at the age of 62 you will only get 70% of your fully calculated benefit.  If you wait until 70, you will receive 124% of the benefit, but you have waited 8 years for that privilege.

The question then becomes, what is the optimal age to start receiving benefits?

When I looked this online most of the sites I came across try to find the age at which you will ‘break even’.  That is, when does it pay to wait?  Imagine your FRA benefit is $24,000 per year.  At age 62 you can start taking $16,800 (70% of FRA benefit) and at age 70 you can take $29,760 (124% of FRA benefit).  By the time you start taking $29,760 you would have already collected $134,400 if you would have started taking the benefit at 62.  Your break-even age then is 80 years old.

Figure 2: Straight dollar cash flow tracking shows breakeven at age 80.

The analysis these sites take is that if you think you have a good chance of living past the age of 80, it makes sense to wait to age 70 to take your benefits.  Seems pretty straight forward but there is something not quite right.

Most of the time in finance, a series of cash flows will be compared based on a discounted present value method.  That is, each of the cash flows will be discounted by the opportunity cost of those funds.  No analysis of Social Security benefits I came across attempts to use that analysis.  They use straight dollar figures.

While many advisors will argue that the cost of living adjustment (COLA) cancels out the inflation effect, that still doesn’t consider that you can invest those funds for some amount above the level of inflation.  Let me explain:

First of all, if you take the cash at 62 and invest it in an account that earns 5% you will have more than 151,200 at age 70.  You would actually have $185,246 as your $16,800 per year also earned an additional 5%.  This would push back your break-even age to 90!

-          But Keith!  This money usually gets spent, not invested!

That could be true; however, if you are 62 and decide not to take social security benefits you do need to pull money from somewhere.  The likely source that people would draw from would be retirement savings where money is currently invested!  This is why I think putting a small discount rate on these cash-flows makes sense.  Even if you are spending the funds, there is an opportunity cost that should be accounted for.

I also do not like the idea of setting a break-even age and trying to make a decision based on whether or not you think you will live longer than that long.  What if instead we adjusted each of the cash flows based on the probability of surviving to each subsequent age.  In this way we value the cash you receive at age 65 much higher than the cash you receive at age 100.  The odds of a man living to 100 is less than 1%, so it only makes sense to discount its value to someone who is age 62.

So, to summarize, here is how I ran my analysis.

1)      I assume a $2,000 per month benefit at FRA

2)      I used a conservative 3% discount rate for each cash flow to capture the opportunity cost of those funds

3)      I probability-adjusted all of the cash flows by the odds of surviving to each subsequent year using the mortality tables published on the SSA.gov website.

4)      I assume COLA adjustment of the benefits cancels out any inflation adjustment

What did the analysis tell us?

It turns out that for men, your most likely better off by taking your benefit ASAP.  The probability-adjusted present value is the highest by taking your benefit starting at age 62.  This would be reinforced for single men, since single men have a lower life-expectancy than married men.

Figure 3: Probability-adjusting the cash flows for men and discounting by 3% make it look more advantageous to take benefits early

Women, on the other hand, due to their longevity, do see some benefit in waiting.  The highest present-value in this analysis occurs at age 66.  Those women who have a history of longevity in the family can even benefit by waiting past 66 to 67 or even 70.

Figure 4: Women's probability-adjusted discounted PV is higher than men’s due to longer expected lives

The trick comes with married couples.  I will probably run a follow up to this piece with some of those numbers, but as with all of these scenarios, NONE of this should be construed as financial advice.  Seriously, talk to your advisor before making any decisions, though if he tries to tell you to wait until 70 to start taking your benefits, just ask why.

In closing, here are the main points to consider about social security benefits.

1)      It has been said that most people take their benefit as soon as they are eligible.  I agree that many make this decision with imperfect information, but I would submit that for many, it is a perfectly rational one.

2)      Advisors often say that “by waiting to take benefits, you can get 8% more.  It’s hard to find an investment that makes 8%” – This is completely illogical.  This statement totally disregards the fact that you are giving up the cash-flows from earlier years, whether those are spent on movies, race-cars, or lottery tickets, there is a cost to getting that extra 8%.  One should not compare waiting for a higher annual cash-flow with an investment return.

3)      A bird in the hand is worth two in the bush – No one knows what the future holds.  Whether you are worried about the solvency of the social security trust (it just went cash flow negative, like, last week), or acknowledging that we cannot know how much time we are blessed on this planet, there should be a premium placed on cash flows received sooner.

When I teach my finance class I talk about how a business should approach valuing cash-flows on three levels.

1)      More cash is better than less cash

2)      Cash today is better than cash tomorrow

3)      More certain cash is better than less certain cash

It seems funny that we do not apply these same tenants when we are analyzing cash for our personal use.  Instead of suggesting that most people are making a mistake by taking social security benefits early, we should acknowledge that this is a very rational decision to make.

Let me know what you think.  I’m curious what other advisors are doing, and I happen to love getting better by getting corrected.

Until Next Time….

“While money can’t buy happiness, it certainly let you choose your own form of misery.” – Groucho Marx



Feature photo credit: taxcredits.net via flickr.com

Continue Reading

How to Win at Investing

The Key to Winning is to Play the Right Game

Imagine you decide, in an effort to improve your overall health and wellness, that it is time to start running.  You go out on some training runs and then decide to join a local 5k.  You run this first race in 30 minutes flat.  How do you decide if that is good or not?  Did that meet your expectations?  How did you place according to your age group?  What if you go out to the next race and your time is 31 minutes?  Is that good?  Maybe that second race included a lot more hills and the average time of all runners was 33 minutes.  How does that change the perception of how you did?

In investing, most people attribute winning to whether or not you beat ‘the market’.  If ‘the market’ returned 10%, a 12% gain is considered a win, and an 8% gain is considered a loss.  But what does ‘the market’ consist of?

The returns of ‘the market’ can be thought of as just the average return of all the market participants.  This includes the largest hedge funds, the ‘mom and pop’ investors in retirement, university endowments, and pension plans.  Each of these groups have different goals and objectives for their investment portfolios.  These billions of dollars buying and selling stocks and bonds is what determines the market returns.  So, if the market return is the average of all of them, the ones who perform better than the market must be equal in magnitude to those that underperform.

A great podcast I listen to with some regularity is Invest Like the Best hosted by Patrick O’Shaughnessy.  Patrick is the CEO of O’Shaughnessy Asset Management and an astute market observer.  One thing he likes to say is that he sometimes wishes he called the podcast “This is who you are up against” because he interviews some of the smartest people in the world of investing.  And, if you are trying to beat the market, but the market consists of these super-geniuses, how does the average investor think they will get an edge?  This is the poker table analogy.

A Crazy Game of Poker

If 10 people sit around a poker table, the worst players will essentially subsidize the really good players.  In order for someone to win, someone has to lose.  The average players can break even and trade a few chips amongst themselves and have a good time.  The ‘market’ in the case of the poker table is measured as the net gain in chips at the poker table.  Since no one is creating chips and none are getting added to the table, the market performance is flat, or 0.00%.  So, if anyone is going to gain chips, they need to be taking from other people at the table.

If you wanted to make money at poker and you saw some of the best poker players in the world, Daniel Negranu, Phil Ivey, and Annie Duke, sitting at a table, you would likely go look for another table.  It would be very hard for you to win that game.

This analogy is used often in investing.  The really great investors like Warren Buffett, Ray Dalio, and David Tepper, do better at the expense of the suckers at the table - the ‘mom and pop’ investors who don’t know any better.

What Game are You Really Playing?

Let’s go back to the running analogy.  It is a lot less clear what one considers winning in running.  My first race, I made it across the finish line without dying – that was a win in my book.  Just like in the investing world, each of the runners lined up at the starting line have different goals and objectives for the race.  The crazy thin and wiry guys and gals at the front may, in fact, be looking to beat everyone else.  Some people at the back of the pack are just looking to get a decent workout in.  Some runners may want to win their age division, and others want to set a new PR.  Winning represents different things to each of them.

In investing it should work the same way.  The reality is that most people shouldn’t worry about beating the market.  Instead, winning in investing should be dependent on your personal and financial goals.  Are your odds of retiring with the lifestyle you want greater today than they were yesterday?  If so, the movement of the market (and thereby, the other market participants) shouldn’t worry you at all.

Financial securities, like stocks and bonds, should be viewed as tools to reach financial goals.  Some tools add capital appreciation, some provide income, and others act as counterweights to help smooth results (diversification).  The performance of a broad-based market index should not determine whether or not the assembled tools perform the task they are assigned.

Now I know what some of the investment folks out there will say.

“Keith, we all know about adjusting the allocation of investments depending on someone’s risk profile, but don’t you still measure how the stocks do against the stock market, and how the bonds do against the bond market?  This talk of not caring about beating the market sounds like a cop-out!”

To which I reply,

“Of course, I look at performance against a market index for client portfolios all the time.  But guess what – they don’t always beat the market, and I am perfectly fine with that.  I am saying that performance against the market index should not be the determinant of winning or losing.”

Maximizing the probability of meeting financial goals should be the primary indicator of success for most people.  This requires a keen awareness of risk and being able to asses what could happen to your investments.  If avoiding certain risks means that your return is less than the market, you should be ok with that.  In fact, chasing market beating returns is what gets many people into trouble.

Keys to Winning the Game

How should one go about winning the investment game?

  1. Identify what it is you are trying to accomplish with a given pool of assets.
  2. Assemble an appropriate set of tools (growth stocks, income stocks, bonds, etc…) to best achieve that goal.
  3. Mark progress towards that goal including the probability of success and the probability of failure. This includes a keen understanding of risk of loss.
  4. Realize that assembling the right tools to best achieve your goal may mean that your performance differs from that of a market benchmark.

This is the part where you say “Keith, that’s a real great theory you have there but what is the practical application.”

And then, before I go any further I feel compelled to reiterate the disclaimer (Nothing in this post should be construed as financial advice.  Before making an investment in any financial security, please consult your financial advisor.  If that person happens to me, I look forward to hearing from you.  Nothing in this post is design to treat, cure, or prevent any diseases….wait, I’m getting off track…)

Practically Speaking

The longer your time horizon, the more money you should have allocated to higher risk growth stocks.  For shorter time horizons you should be using less risky and more income generating securities.

Remember that instead of trying to beat the market, it often makes sense to just be the market in the form of investing in low cost passive index funds.  These funds just give you the average return of all the market participants listed above and do so at a very low cost.  Most people lose the investment game because they blow themselves up in search of higher returns.

When looking at risk, just remember that the stock market went down 50%, from top to bottom, during the financial crisis.  You can use that as a very quick rule of thumb to stress test your portfolio.  If 80% of your portfolio is in stocks, and those stocks can decline by 50%, your portfolio would take a hit of 40%.  Would your financial goals still be on track after that?  If you are 30 and starting to save for retirement, the answer is probably yes.  If you are 60 and looking at retiring soon, the answer will likely be no.  This is the difference between winning and losing.

Looking for advice is a great strategy if you are not willing or able to manage investments on your own.  A great financial advisor will help you identify your goals and make sure your investments are on track to meet them.  Just remember that paying over 1% of the assets to be managed is too high.  Paying commissions to advisors is a terrible arrangement.  Finally, make sure that the advisor is willing to act as a fiduciary (they are willing to hold themselves legally responsible to act in your best interest).

In Closing

While I love Patrick O’Shaugnessy’s work and his podcast, the “this is who you’re up against” message is not applicable to most investors, (I do still highly recommend people tune in.)  You can still achieve success no matter what algorithms and models the next generation of super-investors are using.  The world of investing is much more like a 5k than a game of poker.  You should not worry about what other investors are doing.  You should care about your own results and focus on achieving your goals.

A friend of mine holds a handful of large, well-known stocks that pay good dividends.  He says he doesn’t look at the price fluctuation except for when that price goes down.  If they pay the same dollar amount of dividends that means their dividend yields go higher so he may buy more.  All he is interested in is the income stream.  Do you think he cares what the market does?  He is winning if the income keeps rolling in and supports his growing book collection.

When it comes to investing winning is different for everyone.  As long as you set a clear goal, you can win the game of investing no matter what anyone else is doing.

Until next time….

“Winning is like shaving - you do it every day or you wind up looking like a bum.” Jack Kemp

and of course "Winning, duh." Charlie Sheen

Continue Reading