“I’ll play any man . . . from any land – any game that he can name . . . for any amount that I can
count . . . (providing I like it).”
Puggy Pearson
Written on the side of Pearson’s mobile home, “The Roving Gambler”
Any Donkey Knows That
Earlier this year, we had the honor of hosting Legg Mason’s Bill Miller at our Security Analysis course at Columbia Business School. The students looked forward with great anticipation to Miller’s talk, especially given his 11 years of S&P-beating performance. Miller also embodies the
mental models approach to investing, with interests spanning philosophy, psychology, and complexity as well as investment building blocks like valuation, corporate governance, and competitive strategy.
A few minutes into his talk, Miller declared he had recently read a quotation that captured “all
you need to know about investing.” Whoa. From whom did this sage advice come, the students
wondered? It wasn’t Ben Graham. Or Peter Lynch. Not even Columbia’s hallowed progeny,
Warren Buffett. This pearl of investment wisdom came from Puggy Pearson. Wait, Puggy who?
Puggy Pearson grew up dirt-poor in northern Tennessee and only has an eighth-grade
education. (“That’s about equivalent to a third grade education today”, he quips). But Pearson is
one of the most successful, famous, and flamboyant gamblers ever. He won the World Series of
Poker in 1973, used to be one of the top ten pool players in the world, and once took a golf pro
for $7,000 on the links.
So what did Pearson say that so impressed Miller? “Ain’t only three things to gambling,”
Pearson remarked:
“Knowin’ the 60-40 end of a proposition, money management, and knowin’ yourself.”
For good measure, Pearson added, “Any donkey knows that.” 1
Pearson’s message may be colloquial, but that in no way undermines its power. We can
express the ideas more formally, and readily draw out critical investment concepts. Taken
together, Pearson’s points indeed provide a strong foundation for investment success.
Knowin’ the 60-40 End of a Proposition
The core of Pearson’s point is that investors should seek financial opportunities that have a
positive expected value. A positive expected value opportunity has an anticipated benefit that
exceeds the cost, including the opportunity cost of capital. Not all such financial opportunities
deliver positive returns, but, over time, a portfolio of them will.
So how should investors seek such opportunities? First off, investors must understand their
source of competitive advantage. Markets reflect the collective expectations of investors, and
embody more information than any individual can hope to have. An investor with a competitive
advantage knows something that the market doesn’t—based either on superior information or
on superior analysis of known information.
Michael J. Mauboussin
212-325-3108
michael.mauboussin@csfb.com
Kristen Bartholdson
212-325-2788
kristen.bartholdson@csfb.com
All Any Investor Needs to Know
An investor’s competitive advantage is limited to what Warren Buffett calls a “circle of competence.” Markets
are so competitive that an investor can only hope to gain deep understanding in a few domains. Just as
serious gamblers like Puggy Pearson stick to one game, so too must serious investors limit their sphere of
activity.
An investment is attractive if it trades below its expected value. Expected value, in turn, is a function of
potential value outcomes and the probability of each outcome coming to pass. Investing is fundamentally a
probabilistic exercise, and leading investors always think in probability terms.
In Pearson’s words:
“I believe in logics. Cut and dried. Two and two ain’t nothing in this world but four. But them suckers always
think it’s somethin’ different. I play percentages in everything.” 2
Investing is the constant search for asymmetric payoffs, where the upside opportunity exceeds the downside
risk. Ben Graham described margin of safety as buying an investment for less than what it is worth. The
larger the discount, the greater the margin of safety. That’s knowing the 60-40 end of a proposition.
Buffett, a master at understanding his core competence and identifying asymmetric payoffs, provided an
example of both in Berkshire Hathaway’s 1980 annual report. Discussing two of his largest investments, he
wrote:
“GEICO’s problems at that time [1976] put it in a position analogous to that of American Express in 1964
following the salad oil scandal. Both were one-of-a-kind companies, temporarily reeling from the effects of a
fiscal blow that did not destroy their exceptional underlying economics. The GEICO and American Express
situations, extraordinary business franchises with a localized excisable cancer (needing, to be sure, a skilled
surgeon), should be distinguished from the true ‘turnaround’ situation in which the managers expect—and
need—to pull off a corporate Pygmalion.”
Money Management
Once you’ve found a positive expected value investment, the next question is how much money you should
put behind it. Few money managers consider this issue in detail and often fall back on organizational or
institutional allocation guidelines. For example, portfolio managers often have a “standard” initial position in a
particular security without full consideration of the security’s relative attractiveness.
The first rule of money management is to “live to see another day.” Say you see a 50-1 event priced as if it’s
100-1. That is an attractive opportunity, but you surely wouldn’t bet your net worth on it. Two types of
investments are worth looking out for. The first is a positive expected value investment with a high probability
of loss. A portfolio of these investments is attractive, but betting too much on any single idea is poor money
management.
The second is the one with a high probability of gain but significant downside risk. These investments are
luring even though they have a negative expected value. Eventually, time assures that investors seeking
these opportunities do poorly (witness Long Term Capital Management).
A related concept in money management is that it is not the frequency of correctness that matters, but the
magnitude. 3 Behavioral finance emphasizes that humans like to be right. Many positive expected value
investments have a high frequency of a small downside and a low frequency of large upside. Such
investment opportunities may be systematically mispriced, reflecting inherent human bias.
Another rule of money management is the larger the margin of safety, the more you should invest. More
attractive investments should receive a greater percentage of the funds.4 While most portfolio managers
have legitimate constraints on how much they can invest in any single idea, too frequently their asset
allocation does not distinguish sufficiently for the relative attractiveness of various stocks.
Here again, Buffett serves as an example. After he identified American Express as an attractive investment
in 1964, he put about 40% of Buffett Partnership Ltd.’s capital into the stock—the largest investment the
partnership ever made.
Knowin’ Yourself
Pearson stresses that of the three keys to success “that third thing is the hardest part.” Knowing yourself
means understanding how you’re likely to behave under various circumstances. “The first thing a gambler has to do is make friends with himself,” Pearson says, “A lot of people go through the world thinking they’re
somebody else.” A. Alvarez, author of Poker: Bets, Bluffs, and Bad Beats, continues, “Making friends with
yourself means being able to recognize your own weaknesses—impulsiveness, impatience, greed, fear. But
the greatest enemy of all is ego.” 5
Over the past couple of decades, behavioral finance researchers have developed a clearer understanding of
the psychological traps investors fall in. The best way for you to avoid these traps is to become aware of them,
the forms they take, and which you are most likely to fall into. Here are five common pitfalls:6
Overconfidence. Researchers have found that people consistently overrate their abilities, knowledge,
and skill—especially in areas outside of their expertise. Investors must seek and weigh quality
feedback and stay within their circle of competence.
Anchoring and adjusting. In considering a decision, we often give disproportionate weight to the first
information we receive, hence anchoring our subsequent thoughts. You can mitigate this risk by
seeking information from a variety of sources and viewing various perspectives.
Improper framing. The decisions of investors are affected by how a problem, or set of circumstances,
is presented. Even the same problem framed in different, and objectively equal, ways can cause
people to make different choices. Framing, too, plays a central role in assessing probabilities.
• Irrational escalation of a commitment. Investors tend to make choices that justify past decisions, even
when circumstances change. To avoid this trap, investors should only consider future costs and
benefits.
Confirmation trap. Investors tend to seek out information that supports their existing point of view while
avoiding information that contradicts their opinion. Psychologist Thane Pittman’s slip of tongue sums it
up: “I’ll see it when I believe it.”
You should also understand how you tend to react under stress.7 People with different personality profiles
behave in dissimilar ways when stressed. Here again, self-awareness and some basic techniques to offset
suboptimal behavior go a long way. Pearson declares, “A gambler’s ace is his ability to think clearly under
stress. That’s very important, because, you see, fear is the basis of all mankind . . . .That’s life. Everything’s
mental in life.” 8
N.B.: CREDIT SUISSE FIRST BOSTON CORPORATION may have, within the last three years, served as a manager or co-manager of a
public offering of securities for or makes a primary market in issues of any or all of the companies mentioned.
_____________________________
1 David Spanier, Easy Money: Inside the Gambler’s Mind (New York: Penguin, 1987).
2 A. Alvarez, Poker: Bets, Bluffs, and Bad Beats (San Francisco: Chronicle Books, 2001), 52.
3 Michael J. Mauboussin and Kristen Bartholdson, “The Babe Ruth Effect: Frequency versus Magnitude” The Consilient
Observer, Credit Suisse First Boston Equity Research, January 29, 2002.
4Michael J. Mauboussin and Alexander Schay, “Ruminations on Risk: Beta versus Margin of Safety” Credit Suisse First
Boston Equity Research, August 3, 2001, 7.
5 Alvarez, 50.
6 Alfred Rappaport and Michael J. Mauboussin, “Pitfalls to Avoid” www.expectationsinvesting.com. See http://www.expectationsinvesting.com/pdf/pitfalls.pdf
7Michael J. Mauboussin and Kristen Bartholdson, “Stress and Short-termism: Linking Stress to Suboptimal Portfolio
Management” The Consilient Observer, Credit Suisse First Boston Equity Research, May 7, 2002.
8 Alvarez, 52.
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