Tag: Benjamin Graham

Avoiding Stupidity is Easier than Seeking Brilliance

Avoiding Stupidity

Simon Ramo, a scientist and statistician, wrote a fascinating little book that few people have bothered to read: Extraordinary Tennis Ordinary Players.

The book isn't fascinating because I love tennis. I don't. In the book Ramo identifies the crucial difference between a Winner's Game and a Loser's Game.

Ramo believed that tennis could be subdivided into two games: the professionals and the rest of us.

Players in both games play by the same rules and scoring. They play on the same court. Sometimes they share the same equipment. In short the basic elements of the game are the same. Sometimes amateurs believe they are professionals but professionals never believe they are amateurs. But the games are fundamentally different, which is Ramo's key insight.

Professionals win points whereas amateurs lose them. Think about professional games. Each player, nearly equal in skill, plays a nearly perfect game rallying back and forth until one player hits the ball just beyond the reach of his opponent. This is about positioning, control, spin. It's a game of inches and sometimes centimeters.

Avoiding Stupidity is Easier than Seeking Brilliance

In his 1975 essay, The Loser's Game, Charles Ellis calls professional tennis a “Winner's Game.” While there is some degree of skill and luck involved, the game is generally determined by the actions of the winner.

Amateur tennis is an entirely different game. Not in how it is played but in how it's won. Long and powerful rallies are generally a thing of the past. Mistakes are frequent. Balls are constantly hit into nets or out of bounds. Double faults are nearly as common as faults.

The amateur duffer seldom beats his opponent, but he beats himself all the time. The victor in this game of tennis gets a higher score than the opponent, but he gets that higher score because his opponent is losing even more points.

***
Two Games

Ramo found this out because he gave up trying to keep track of conventional scores — “Love,” “Fifteen All,” etc. Instead he simply looked at points won versus points lost.

In expert tennis, about 80 per cent of the points are won; in amateur tennis, about 80 per cent of the points are lost. In other words, professional tennis is a Winner’s Game – the final outcome is determined by the activities of the winner – and amateur tennis is a Loser’s Game – the final outcome is determined by the activities of the loser. The two games are, in their fundamental characteristic, not at all the same. They are opposites.

After discovering that there are, in effect, two different games and realizing that a generic strategy will not work for both games he devised a clever strategy by which ordinary players can win by losing less and letting the opponent defeat themselves.

… if you choose to win at tennis – as opposed to having a good time – the strategy for winning is to avoid mistakes. The way to avoid mistakes is to be conservative and keep the ball in play, letting the other fellow have plenty of room in which to blunder his way to defeat, because he, being an amateur will play a losing game and not know it.

If you're an amateur your focus should be on avoiding stupidity.

***
An Investor Bets on Someone Else’s Game

This brings to memory something about Warren Buffett and Ben Graham. Buffett used to convene a group of people called the “Buffett Group.” At one such meeting Benjamin Graham, Warren Buffett's mentor and teacher, gave them all a quiz. I spent hours searching for this reference, which comes from Benjamin Graham on Value Investing: Lessons from the Dean of Wall Street.

“He gave us a quiz,” Buffett said, “A true-false quiz. And there were all these guys who were very smart. He told us ahead of time that half were true and half were false. There were 20 questions. Most of us got less than 10 right. If we’d marked every one true or every one false, we would have gotten 10 right.”

Graham made up the deceptively simple historical puzzler himself, Buffett explained. “It was to illustrate a point, that the smart fellow kind of rigs the game. It was 1968, when all this phoney accounting was going on. You’d think you could profit from it by riding along on the coattails, but (the quiz) was to illustrate that if you tried to play the other guy’s game, it was not easy to do.

“Roy Tolles got the highest score, I remember that,” Buffett chuckled. “We had a great time. We decided to keep doing it.”

***
Avoiding Stupidity

The point, if I have one, is that most of us are amateurs but we refuse to believe it.

This is a problem because we're often playing the game of the professionals. What we should do in this case, when we're the amateur, is play not to lose.

This was a point Charlie Munger, the billionaire business partner of Warren Buffett, made a long time ago.

In a letter to Wesco Shareholders, where he was at the time Chairman (and found in the excellent Damn Right!: Behind the Scenes with Berkshire Hathaway Billionaire Charlie Munger), Munger writes:

Wesco continues to try more to profit from always remembering the obvious than from grasping the esoteric. … It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent. There must be some wisdom in the folk saying, `It's the strong swimmers who drown.'

And there is so much wisdom embedded in that quote that I've attached it to my wall.

The Timeless Parable of Mr. Market

“In the short run, the market is a voting machine
but in the long run it is a weighting machine.”
— Ben Graham

***

There is no one better to explain the concept of Mr. Market than Warren Buffett, who has used to to make billions of dollars and remain calm when all around him were losing their heads.

In the 1987 letter to Berkshire Hathaway shareholders, Buffett unfolds the concept for us.

Ben Graham, my friend and teacher, long ago described the mental attitude toward market fluctuations that I believe to be most conducive to investment success. He said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.

Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market's quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him.

Mr. Market has another endearing characteristic: He doesn't mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic-depressive his behavior, the better for you.

But, like Cinderella at the ball, you must heed one warning or everything will turn into pumpkins and mice: Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren't certain that you understand and can value your business far better than Mr. Market, you don't belong in the game. As they say in poker, “If you've been in the game 30 minutes and you don't know who the patsy is, you're the patsy.”

Ben's Mr. Market allegory may seem out-of-date in today's investment world, in which most professionals and academicians talk of efficient markets, dynamic hedging and betas. Their interest in such matters is understandable, since techniques shrouded in mystery clearly have value to the purveyor of investment advice. After all, what witch doctor has ever achieved fame and fortune by simply advising “Take two aspirins”?

The value of market esoterica to the consumer of investment advice is a different story. In my opinion, investment success will not be produced by arcane formulae, computer programs or signals flashed by the price behavior of stocks and markets. Rather an investor will succeed by coupling good business judgment with an ability to insulate his thoughts and behavior from the super-contagious emotions that swirl about the marketplace. In my own efforts to stay insulated, I have found it highly useful to keep Ben's Mr. Market concept firmly in mind.

Following Ben's teachings, Charlie and I let our marketable equities tell us by their operating results – not by their daily, or even yearly, price quotations – whether our investments are successful. The market may ignore business success for a while, but eventually will confirm it. As Ben said: “In the short run, the market is a voting machine but in the long run it is a weighing machine.” The speed at which a business's success is recognized, furthermore, is not that important as long as the company's intrinsic value is increasing at a satisfactory rate. In fact, delayed recognition can be an advantage: It may give us the chance to buy more of a good thing at a bargain price.

Of course this concept can be applied outside of stock markets as well.

Mr. Market is a Farnam Street Mental Model.

How Good Gamblers Think

Warren Buffett

From The Signal And The Noise:

Successful gamblers – and successful forecasters of any kind – do not think of the future in terms of no-lose best, unimpeachable theories, and infinitely precise measurements. These are the illusions of the sucker, the sirens of his over-confidence. Successful gamblers, instead, think of the future as speckles of probability, flickering upward and downward like a stock market ticker to every new jolt of information. When their estimates of these probabilities diverge by a sufficient margin from the odds on offer, they may place a bet.

This sounds an awful lot like how Warren Buffett, Charlie Munger, and Benjamin Graham think about investing.

In his 1987 letter to shareholders, Warren Buffett explains Graham's concept of Mr. Market:

Ben Graham, my friend and teacher, long ago described the mental attitude toward market fluctuations that I believe to be most conducive to investment success. He said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.

Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market's quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him.

Mr. Market has another endearing characteristic: He doesn't mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic-depressive his behavior, the better for you.

But, like Cinderella at the ball, you must heed one warning or everything will turn into pumpkins and mice: Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren't certain that you understand and can value your business far better than Mr. Market, you don't belong in the game. As they say in poker, “If you've been in the game 30 minutes and you don't know who the patsy is, you're the patsy.”

And Charlie Munger's take:

The model I like—to sort of simplify the notion of what goes on in a market for common stocks—is the pari-mutuel system at the racetrack. If you stop to think about it, a pari-mutuel system is a market. Everybody goes there and bets and the odds change based on what's bet. That's what happens in the stock market.

Any damn fool can see that a horse carrying a light weight with a wonderful win rate and a good post position etc., etc. is way more likely to win than a horse with a terrible record and extra weight and so on and so on. But if you look at the odds, the bad horse pays 100 to 1, whereas the good horse pays 3 to 2. Then it's not clear which is statistically the best bet using the mathematics of Fermat and Pascal. The prices have changed in such a way that it's very hard to beat the system.

And then the track is taking 17% off the top. So not only do you have to outwit all the other betters, but you've got to outwit them by such a big margin that on average, you can afford to take 17% of your gross bets off the top and give it to the house before the rest of your money can be put to work.

Given those mathematics, is it possible to beat the horses only using one's intelligence? Intelligence should give some edge, because lots of people who don't know anything go out and bet lucky numbers and so forth. Therefore, somebody who really thinks about nothing but horse performance and is shrewd and mathematical could have a very considerable edge, in the absence of the frictional cost caused by the house take.

Unfortunately, what a shrewd horseplayer's edge does in most cases is to reduce his average loss over a season of betting from the 17% that he would lose if he got the average result to maybe 10%. However, there are actually a few people who can beat the game after paying the full 17%.

I used to play poker when I was young with a guy who made a substantial living doing nothing but bet harness races…. Now, harness racing is a relatively inefficient market. You don't have the depth of intelligence betting on harness races that you do on regular races. What my poker pal would do was to think about harness races as his main profession. And he would bet only occasionally when he saw some mispriced bet available. And by doing that, after paying the full handle to the house—which I presume was around 17%—he made a substantial living.

You have to say that's rare. However, the market was not perfectly efficient. And if it weren't for that big 17% handle, lots of people would regularly be beating lots of other people at the horse races. It's efficient, yes. But it's not perfectly efficient. And with enough shrewdness and fanaticism, some people will get better results than others.

The stock market is the same way—except that the house handle is so much lower. If you take transaction costs—the spread between the bid and the ask plus the commissions—and if you don't trade too actively, you're talking about fairly low transaction costs. So that with enough fanaticism and enough discipline, some of the shrewd people are going to get way better results than average in the nature of things.

It is not a bit easy. And, of course, 50% will end up in the bottom half and 70% will end up in the bottom 70%. But some people will have an advantage. And in a fairly low transaction cost operation, they will get better than average results in stock picking.

How do you get to be one of those who is a winner—in a relative sense—instead of a loser?

Here again, look at the pari-mutuel system. I had dinner last night by absolute accident with the president of Santa Anita. He says that there are two or three betters who have a credit arrangement with them, now that they have off-track betting, who are actually beating the house. They're sending money out net after the full handle—a lot of it to Las Vegas, by the way—to people who are actually winning slightly, net, after paying the full handle. They're that shrewd about something with as much unpredictability as horse racing.

And the one thing that all those winning betters in the whole history of people who've beaten the pari-mutuel system have is quite simple. They bet very seldom.

It's not given to human beings to have such talent that they can just know everything about everything all the time. But it is given to human beings who work hard at it—who look and sift the world for a mispriced be—that they can occasionally find one.

And the wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don't. It's just that simple.

That is a very simple concept. And to me it's obviously right—based on experience not only from the pari-mutuel system, but everywhere else.

And yet, in investment management, practically nobody operates that way. We operate that way—I'm talking about Buffett and Munger. And we're not alone in the world. But a huge majority of people have some other crazy construct in their heads. And instead of waiting for a near cinch and loading up, they apparently ascribe to the theory that if they work a little harder or hire more business school students, they'll come to know everything about everything all the time.

Silver concludes, “Finding patterns is easy in any kind of data-rich environment; that's what mediocre gamblers do. The key is in determining whether the patterns represent signal or noise.”