Blog on Value Investing | Safal Niveshak

Latticework of Mental Models: Winner’s Curse

Consider this thought experiment –

A friend of yours is the Chairman of the Acme Oil Company. He occasionally calls with a problem and asks your advice. This time the problem is about bidding in an auction. It seems another oil company has gone into bankruptcy and is forced to sell off some of the land it has acquired for future oil exploration. There is one plot Acme is interested. Until recently, it was expected that only three firms would bid for the plot, and Acme intended to bid $10 million. Now they have learned that seven more firms are bidding, bringing the total to ten. The question is, should Acme increase or decrease its bid? What advice would you give?

Do you advise bidding more or less?

If you’re like me and seeing this case study for the first time you’d probably go with a higher bid. After all, there are additional bidders, and if you don’t bid more you won’t get this land. Isn’t it?

Latticework of Mental Models: Pari-mutuel System

You don’t win by predicting the future; you win by getting the odds right. You can be right about the future and still not make any money. ~ Will Bonner

The way to win in stock market, according to Charlie Munger, is to work, work, work, work and hope to have a few insights.

Now, the question is – how many insights do you need in your investing lifetime?

Not many, as Munger says…

…you don’t need many in a lifetime. If you look at Berkshire Hathaway and all of its accumulated billions, the top ten insights account for most of it. And that’s with a very brilliant man—Warren’s a lot more able than I am and very disciplined—devoting his lifetime to it. I don’t mean to say that he’s only had ten insights. I’m just saying, that most of the money came from ten insights.

So you can get very remarkable investment results if you think more like a winning pari-mutuel player. Just think of it as a heavy odds against game full of craziness with an occasional mispriced something or other. And you’re probably not going to be smart enough to find thousands in a lifetime. And when you get a few, you really load up. It’s just that simple.

Munger uses horse racing’s Pari-mutuel betting system as one of his mental models to make sense of stock market investing. He is asking us to think like a Pari-mutuel player and look for the mispriced bets.

So what’s a Pari-mutuel system and how does one find a mispriced bet in such a system?

An Investor’s Best Friend

In one of his most dramatic investment outlooks yet, Bill Gross wrote in May 2015 about fears of his looming death –

Having turned the corner on my 70th year, like prize winning author Julian Barnes, I have a sense of an ending. Death frightens me and causes what Barnes calls great unrest, but for me it is not death but the dying that does so . . .

What I fear most is the dying . . . the suffering that . . .will accompany most of us along that downward sloping glide path filled with cancer, stroke, and associated surgeries which make life less bearable than it was a day, a month, a decade before.

He then went on to relate this to the coming death of the investment super-cycle the world over.

Latticework of Mental Models: Loser’s Game

In the hope of executing an impressive smash, I again sent the ball flying away from the table. Losing yet another game of table tennis to Navin, a good friend and a colleague in my previous job. It was probably 50th consecutive loss since I started playing TT with Navin.

“It isn’t that I am an extraordinary player,” explained Navin, “I just focus on returning the ball back on your side. Your unforced errors are just too many so you continue to lose.”

The idea of unforced error didn’t make much sense to me at that time. And the streak of losses continued for another few months until our employer decided to remove the TT facility from the office. They reasoned that some employees were spending more time on TT table than their workstation. I wonder who those employees were. 😉

It took another few years for the idea of ‘unforced errors’ to sink in properly. It happened when I learned about a concept called – Loser’s Game.

Admission Open: Safal Niveshak Academy of Stock Market Failure

“We learn wisdom from failure much more than from success. We often discover what will do, by finding out what will not do; and probably he who never made a mistake never made a discovery.” ~ Samuel Smiles

“Fools say that they learn by experience. I prefer to profit by others experience.” ~ Otto von Bismarck

If, like me…

You hold a PhD or post-graduation in making mistakes in the stock market – as an investor / trader / speculator
Some of your teachers in the stock market have had the following surnames – Mr. Blunder, Ms. Mistake, Mr. Error, Ms. Fault, Sir Omission, Mr. Hit and Miss, Ms. Oversight, Mr. Slip, Ms. Trip, Mr. Stumble, Ms. Mess, Mr. Misfortune, Mr. Downfall, Mr. Bite the Dust, and Mr. Lose Your Shirt.

…I welcome you to join the Safal Niveshak Academy of Stock Market Failure.

The idea of this Academy is to bring together all those who have attained graduation or PhD in making mistakes in the stock market (and I am one of those), so that…

We learn vicariously from the stock market mistakes others have indulged in and we haven’t (as yet)
We confess the blunders we have committed so that others may know what they must avoid

Latticework of Mental Models: The Two Systems of Thinking

“What’s 2 + 2?”

You can’t help but think of the answer instantly. Your mind throws the number “4” on your thought screen. It’s actually impossible to not think of the answer here, unless you haven’t learnt to count to ten.

The answer is almost like a reflex. It was an instance of fast thinking. In fact, you don’t even need to consciously think about it. It just happens to you. This is the result of what scientists call reflexive brain.

Now if I ask you, “What’s 38 multiplied by 27?”

For most of you, except if you’re a math wizard, your brain goes blank. It doesn’t give you any instant answer. You’ll have to take a pause and calculate the answer with some efforts, and if you’re like me you won’t be able to do it without pen and paper. Here you have to involve a part of your brain which is known as the reflective brain. You experience a slow mode of thinking as you proceed through a sequence of steps to solve this multiplication problem.

Reflexive brain is quick and it tends to jump to conclusion. Reflective brain is much slower, requires effort, it’s logical and, as we’ll see later, less prone to error.

Daniel Kahneman, a nobel laureate who is also known as the founding father of modern behavioural economics, in his book Thinking Fast and Slow, has termed these two modes of thinking as System 1 (reflexive) and System 2 (reflective).

Latticework of Mental Models: Active Reading

The summer season is here and irrespective of the fluctuations in the market temperature, the real mercury is rising everyday. In this sweltering heat, one of the things that brings an instant smile on my face is when I think about how I spent my summer holidays when I was a kid.

This thought sends me down the memory lanes of all those good old days when I played with friends all day, watched favourite cartoon programs on TV, and forgot all about school and homework.

My summer holidays were jam packed with activities like playing carrom, card games, checkers, chess, monopoly, cricket, and most of all – reading comics. I loved reading comic books. By the time I reached 8th standard, I had amassed a collection of more than 300 comic books. I even ran a small library which unfortunately had to be closed down after 10 days of operation.

The lesson learnt – kids like borrowing comics but don’t like returning them. 🙂

Anyways, when I look back at my childhood days, I realize that reading comics was one of the most pleasurable activity. I am sure many of you can relate to me.

When I entered college, those 30 page comic books were replaced by 500 page novels. But one thing remained unchanged about my reading habit. Most of my reading was for pleasure. Except of course college text books which I passionately disliked. For that matter, whenever I read anything which had a potential to challenge my cognitive resources, I forgot most of it by next evening. That explains my belief about studying for exams just a day before.

However, as I started working, my interest increased in the area of personal development, investing and personal finance, I found myself picking business and investing related books every now and then. But my years of poor reading habits – reading only for pleasure – had become a serious roadblock to derive any meaningful benefit out of these new kind of books.

Latticework of Mental Models: Checklist

Few months back, I was visiting a friend in the hospital. He was getting discharged after a minor surgery. While helping him pack his stuff I casually flipped through his discharge summary papers. Most of the medical jargon in the file didn’t make much sense to me but one particular thing caught my attention.

Under details of surgery, the last line read – “Mops/instrument counts were correct”. The first thought that came to mind was – are these guys so concerned about their instruments (and even cotton mops) that they count it after the operation? Many of those instruments are anyway disposable and can’t be used again. So what’s the big deal about counting them?

Later I came to know that counting all the instruments and mops is part of their protocol. It’s to make sure that they haven’t left any items inside the body of the person being operated. It was an important step in their written ‘list of things to check’. Made sense.

Hundred of people die every day because of unavoidable blunders (like leaving an instrument inside the patient’s body) by surgeons.

In US alone the number of deaths following surgery is 75,000 per year which is more than the number of road accident fatalities. And these are the cases which are avoidable because they emanate from human errors. The failure rate is disproportionately high and can’t be ignored.

But medicine has become a field of extreme complexity. And not just medicine but many other fields have grown so far beyond the usual kind that avoiding daily mistakes is proving impossible even for our most super-specialized.

So how do you approach this problem? This is the question that intrigued Dr. Atul Gawande, professor of medical surgery in Harvard Medical School, and his quest to find the solution ended at a totally unrelated place. The aviation industry.

Ask Vishal

“He who has a why to live for can bear almost any how.” ~ Friedrich Nietzsche

If there is one big lesson I have learned in my life on how to get better at something (anything), it is that of asking questions…and a lot of them.

Now, asking questions does not come naturally to me. All my school and college life, I rarely asked questions for the fear of looking like a fool for the next five minutes.

But I have learned it the hard way – through failures, missed opportunities, and (almost) a broken heart – that he who asks a question is a fool for five minutes, but he who does not ask a question remains a fool forever.

Anyways, now my life revolves around answering questions – and a lot of them that come in daily from Safal Niveshak tribe members. Questions related to investing, personal finance, career, and life.

[Read more…] about Ask Vishal

Latticework of Mental Models: Arbitrage

In 1954, a temporary shortage of cocoa in US caused its price to increase from 5 cents to 60 cents per pound, a whopping 12 times.

As a result, Rockwood & Co., a brooklyn based chocolate products company, found itself in a sweet spot. They were sitting on 13 million pounds of excess inventory of cocoa which instantaneously became a huge asset because of cocoa price increase.

So selling the inventory to make a handsome profit was a no-brainer except that there was just one catch to it. Rockwood & Co. followed LIFO (last in first out) inventory valuation which would have created a 50% tax liability on profits from sale of inventory.

Young Warren Buffett — Buffett in his early 20s

So to avoid this tax, they came up with an ingenious way to exploit the temporary opportunity. They extended a share buyback offer which allowed the shareholder to tender a share in exchange for 80 pounds of cocoa. This maneuver, according to 1954 tax code, was perfectly legal and didn’t invite heavy tax liability.

This caught the attention of a 24 year old investment analyst who was working in New York for Graham Newman Corp. It was obvious to him that one could buy Rockwood shares for $34, sell them back to the company for 80 pounds of cocoa beans (worth $36), and then sell the cocoa beans making an instant profit of $2. Considering the transaction could be done in less than a week, it worked out to a sky-high annualized return.

“For several weeks I busily bought share, sold beans, and made periodic stops at Schroeder Trust to exchange stock certificates for warehouse receipts.”, recounts Warren Buffett, the protagonist in the story above, “The profits were good and my only expense was subway tickets.”

What Buffett did is called an Arbitrage. It’s a process of identifying market inefficiencies. The classic idea is that of buying an item in one place and selling it in another. In the very early days the word applied only to the simultaneous purchase and sale of securities or foreign exchange in two different markets.