This is a special rushed edition of my usual post given today’s news. I planned to post this in two weeks, but it is more interesting today. I had already collected the quotations last weekend, but had not written the usual commentary. Since it is a rushed edition (I read the news less than an hour ago at 6AM), there is less commentary than usual, but most of the quotes are self-explanatory.
1. “I picked up Ed [Thorp’s] book in early 1966. I got in an automobile accident and had to go into the hospital and had time to practice the card-counting technique he discovered. And it worked! I had $200, so I headed out to Las Vegas. I turned my $200 into $10,000. I didn’t care about the money. I wanted to prove that you could beat the system. Then I thought about what I could do that takes the same skills. I realized it was investing.” “My early blackjack career taught me several things. The first is that if you apply yourself with a lot of hard work and mathematical prowess you can beat the system.” “Many of the same principles I learned from blackjack apply equally to equities as to bonds. First, spread your risk. Cards run hot and cold, so be prepared. Second, as far as possible know your risks. Quantify them, predict the consequences, and prepare how to react.” “It’s just like in blackjack. That puts the odds in your favor. If you don’t bet too much and if you stay at the table long enough, the odds are high that you are going to go home with some extra money in your pocket.” “Dice have no memory and, it’s said, the only way to win at roulette is to steal from the table. Blackjack is not chance. It is not an independent trial process; rather the cards played affect the odds on subsequent hands. So, situations emerge that give the player the advantage, situations where the house edge can be overcome. It requires discipline, dedication and skill, but it can be achieved. You learn to predict what the next card might be, whether it is likely to be high or low. You may be frequently wrong, but if on average you come out on top, you win in the long term. And I like winning.” Investing is like gambling, but it is not gambling. Knowing the difference between gambling and investing is important. Investing is a potentially net-present value positive activity (the likelihood of the net present value of the potential benefits minus the likelihood network present value of the potential loses, is positive) whereas gambling is not. Gambling is a form of present-moment consumption and the net present long-term value of the activity is negative.
2. “Gambling is viewed negatively because the average gambler is emotional, undisciplined and often desperate. A card counter has a method to assess and evaluate the probability of future events. This probability theory is based on mathematics. Cards dealt are cyclical challenges. The blackjack player, like the professional investor, tries to develop the skill to predict the cyclical challenge to ensure success over the long term. Our bets don’t always succeed, but we win often enough to come out well ahead.” As stated above, at a fundamental level, investing is just one form of making a bet. It’s essential, however, that the bet be made in a way that is investing (net present value positive) rather than gambling (net present value negative).
3. “I am not a quant. I don’t have a 150 IQ… put an amount of suspicion in the modelling of anything. The model could get broken by animal behavior.” “I am more of a subjective, seat-of-the-pants guy, although I appreciate the need for mathematical analysis and modelling. Unlike card games, human nature changes the rules of economics with the potential to punish anyone who relies too much on any one system, no matter how consistent it has been over time. I would say that human nature is a consistently inconsistent input into a model.” Gross does not believe that humans are perfectly informed rational agents or in the efficient market hypothesis. He believes in using multiple models.
4. “Big bets are crucial. You need to make them when you believe the odds are in your favor, but big bets can go spectacularly wrong. I always set aside 50 times my maximum bet to avoid significant loss through a bad streak. We apply the same principles at PIMCO with risk management being one of our highest priorities. We can and have lost bets, but we are well hedged and can stay in the game. …Ed’s basic thrust concerns the idea of gambler’s ruin, where you lose everything by over-betting. In the context of blackjack, you can never bet more than 2% of your stake without the possibility of eventually losing your entire pot. Here at Pimco, it doesn’t matter how much you have, whether it’s $200 or $1 trillion. You’ll see it throughout our portfolio. We don’t have more than 2% in any one credit. Professional blackjack is being played in this trading room from the standpoint of risk management, and that’s a big part of our success.” You will see below that he has made a different statement when it comes to stocks. Part of a Wall Street Journal Interview is explanatory:
5. Mr. Thorp: You have to make sure that you don’t over-bet. Suppose you have a 5% edge over your opponent when tossing a coin. The optimal thing to do, if you want to get rich, is to bet 5% of your wealth on each toss — but never more. If you bet much more you can be ruined, even if you have a favorable situation.
WSJ: Your key risk-management strategy is known as the Kelly Criterion. What is it?
Mr. Thorp: It’s a formula Bell Labs scientist John Kelly devised in the 1950s for maximizing the long-term growth rate of capital. It tells you how to allocate your money among the choices available, and how much to invest as your edge increases and the risk decreases. It also avoids the over-betting that can ruin an investor who otherwise has an edge.
Mr. Gross: Ed’s basic thrust concerns the idea of gambler’s ruin, where you lose everything by over-betting. In the context of blackjack, you can never bet more than 2% of your stake without the possibility of eventually losing your entire pot.
Here at Pimco, it doesn’t matter how much you have, whether it’s $200 or $1 trillion. You’ll see it throughout our portfolio. We don’t have more than 2% in any one credit. Professional blackjack is being played in this trading room from the standpoint of risk management, and that’s a big part of our success.
6. “Do you really like a particular stock? Put 10% or so of your portfolio on it. Make the idea count … Good [investment] ideas should not be diversified away into meaningless oblivion.” This is what Charlie Munger calls “focus investing.” What Bill Gross is recommending here for a stock, is very different from how he diversifies in bonds as explained above.
7. I learned in 1966 with blackjack, where although odds were many times in my favor, if you took too much leverage and had too much debt, then the house of cards will come tumbling down.” “[Minsky was] a relatively unknown economist whose work helped us save billions. His Financial Instability Hypothesis influenced PIMCO’s Paul McCulley resulting in us developing a strategic plan to avoid the subprime meltdown well ahead of time. Minsky argued that Wall Street encourages businesses and individuals to take on too much risk, creating ruinous boom-and-bust cycles. Sounds familiar, wouldn’t you say?” As Charlie Munger has said: “Three things ruin people: Drugs, liquor and leverage.” Leverage magnifies not just the upside but the downside. If things go wrong having a loan that can be called by a lender dos snot allow you to let your hand play out.
8. “The longer and longer you keep at it in this business the more and more time you have to expose your Achilles heel – wherever and whatever that might be.” Black Swans happen. People stop getting lucky. Stuff happens.
9. “It’s sort of like a teeter-totter; when interest rates go down, prices go up.” “All of us, even the old guys like Buffett, Soros, Fuss, yeah – me too, have cut our teeth during perhaps a most advantageous period of time, the most attractive epoch, that an investor could experience. Perhaps it was the epoch that made the man as opposed to the man that made the epoch.” That publications like the Wall Street Journal need to repeat in virtually every article about bonds that interest rates and bond prices move in different directions is a clue that this market is less well understood. Bond investors have been surfing a trend toward lower interest rates for some time. Load up on bonds and even leverage up as well and you can look like a genius until you don’t.
10. “An effective zero percent interest rate, as a price for hiding in a foxhole, is prohibitive.” “Central banks and policymakers are acting like barbers. They haircut your investments. Negative real interest rates, inflation, currency devaluation, capital controls and outright default are the barber’s scissors.” “In a rising interest rate environment over time, a portfolio manager might rely less on maturity ‘horses’ and depend more on the ‘machine guns and flamethrowers’ associated with credit, volatility, curve and currency.” There are many types of risk and uncertainty that someone like Bill Gross manages that are not just interest rate risk. Each is potentially a source of profit or loss.
11.“PIMCO’s foundation is one that attempts to analyze what we call the secular outlook, which means, for us, the next three to five years.“ “Secular analysis …examines geopolitical, social and demographic trends to anticipate what may occur. Cyclical trends affect the market over the shorter term, such as new producer price index figures or changes in the federal funds rate. Taken together they tell us where to invest our clients’ money – domestically or internationally, more interest rate risk or less, high quality or high yield. This approach improves our ability to consistently add value over the long term. “Successful money management over long periods of time rests on two, somewhat disparate, foundations. The first is “a secular outlook…. forces one to think long term and to avoid the destructive bile arising from the emotional whipsaws of fear and greed. Such emotions can convince any investor or management firm to do exactly the wrong thing during “irrational” periods in the market. The second foundation is what might be called the “structural” composition of portfolio management, and whether the reader agrees or disagrees with the secular thesis, I would argue that those who fail to recognize the structural elements of the investment equation will leave far more chips on the table for other, more astute investors to scoop up than they could ever imagine. A portfolio’s structure is akin to its genetic makeup: It is how it is constructed without regard to short-term strategic decisions. Structure incorporates principles that are longer than secular, principles that are nearly paramount and should be able to deliver alpha during years when the manager’s magic touch—to use a basketball metaphor—seems to have disappeared or when there’s simply a time-out on the court, with secular investment opportunities few and far between. Duration, curve, credit, volatility, and other less obvious tilts to a portfolio’s steady state status are what I mean when I speak of a portfolio’s inherent structure, although some tilts are more volatile than others and, therefore, produce less risk-adjusted alpha.” “Financial structure [is] almost guaranteed to generate a positive return on capital.” “Closer to portfolio managers is the structure of Warren Buffett’s Berkshire Hathaway, which depends on “float” (about which he frequently writes and talks). This structure, combined with his bottom-up, secular stock picks, has produced one of the world’s great fortunes and investment success stories.” “In addition to their profit-generating elements, these structures share the common element of longevity, near permanence. They span time periods beyond the secular segments of three to five years, which define typical forecasting periods, and secular stretches of inflation/disinflation that have endured for several decades. An investment’s structural magic, then, comes from its ‘Methuselahian’ ability to persist.” This immediately above is the best summary of Bill Gross’ investing thesis I can find. Cyclical, secular and structural are all key concepts for Bill Gross. He has an investing thesis/methodology that is not easy to execute on. Cliff Asness essentially said this week in an interview that he would not want to make his living making macro economic predictions. I agree with Asness.
12. “We are on the edge of uncertainty. It is almost like Columbus is sailing to the New World, all the time wondering whether the earth is flat and whether the Santa Maria would fall over the edge at any minute. That is the biggest amount of uncertainty – which is enormous – and is reflected in the violent changes in financial markets.” As Nassim Taleb likes to say, we are increasingly living in Extremistan. Be careful out there.
- A Dozen Things I’ve Learned from Henry Ellenbogen
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