Investing

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?

[Read more…] about Latticework of Mental Models: Pari-mutuel System

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.

[Read more…] about Latticework of Mental Models: Loser’s Game

“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).

[Read more…] about Latticework of Mental Models: The Two Systems of Thinking

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.

[Read more…] about Latticework of Mental Models: Checklist

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.

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.

[Read more…] about Latticework of Mental Models: Arbitrage