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