The Unrepentant Recalcitrant

Lessons for an accidental entrepreneur

Archive for the tag “Capitalism”

Charlie Munger on Inverting: The Rose and it’s Thorn

Back in the last ice age, when I was an intern at my hospital, green both in experience and complexion (it was my first night on call…and I was, lets say a little nauseous with fear!), I asked my resident “ Are you sure you should be leaving me alone with sick people who might die?”

 

Yeah, confidence was my middle name as you can tell.

 

My resident gave me some of the best advice I have ever got.

 

“ Worry about whats going to kill them and take care of it urgently. Keep them alive at all costs. Everything else will take care of itself.”

 

Fear and good advice concentrated my mind like nothing else, and I learned to worry about “The Dreaded Downside” (in this case, death).

 

Fast forward to today and my behavior has been modeled this way:

 

1. Imagine a scenario that requires action.

2. Imagine what is the worst possible outcome(s) of this scenario.

3. Ask yourself how you can prevent/mitigate/evaluate and control such a situation.

4. Put plans in place for this.

5. Initiate said plans if the scenario materializes.

6. Watch how the alternative best case scenarios take care of themselves.

 

Its been an unpleasant surprise to me just how few people understand this concept.

 

People think rosy thoughts and don’t want to consider the thorns that come with the roses.

 

Big mistake!

 

Charlie Munger and Warren Buffet have spoken about this thought process when evaluating investments.

 

They call it “inversion”

 

Lets say you are looking at company A (or starting a company called A!)

 

Something about this has attracted you and you believe there is a reason to invest, right?

 

This is the “Rose”

 

What could happen to your thesis that would make this all come crumbling down?

 

These are the “Thorns”

 

Play out these scenarios. Understand their likelihood, understand how you would recognize them and take corrective action.

 

Once you have this information, you are better equipped to make decisions and more likely to get the desired outcome or to at least limit downside loss.

 

If they don’t materialize, and your thesis becomes correct, nothing more is required!

 

Munger does this each time when looking at an investment to fully understand his risk and whether the investment should be made.

 

Its the same for managers in companies and for entrepreneurs from a decisions perspective.

 

How do I know this works?

 

How successful are Munger’s stock picks?

 

I thought that would persuade you!

 

What I find most interesting in the preceding discussion is how universal and singular the truth is. 

 

It cuts across disciplines and scenarios and is always axiomatic*.

 

This is the universal thread that I attempt to point out in my blog. It’s all connected.

 

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*Axiom: That which does not require a demonstration of proof. Contrast with a “theorem” which has been proven or a “hypothesis” which awaits proof.

 

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Economic Principles are Slaves to Psychology, not Math

Pity the poor entrepreneur who embarks on a path of business education!

Whether its by way of starting a company, studying for a MBA, or even a million other paths, business education holds some surprises for us unwashed (read: unsophisticated) masses.

Two whole fields exist to dazzle you! Microeconomics and Macroeconomics. Its all exceedingly complicated and not for the faint of brain, you are told.

Some of the smartest people I have met have been economists by profession. Very bright, very quantitative and eager to explain the world of money.
There is however a 800 pound gorilla in the room.

And that is, that economists are almost without exception unable to describe economic reality.

Under most real world conditions, their models don’t work and their math fails them.

Why?

Let an ignorant doctor tell you the one thing he understands better than anything else.

Mathematical formulas are inadequate as models of human behavior.

Economics is at its heart, human behavior applied to a special situation.

Math cannot help you brother.

Don’t tie yourself up in contortions trying to force that economic model to give you testable hypotheses!

Instead, just watch how we behave as social animals and you will get a much better sense of what is happening and what will happen in the future.

Want to master economics and the nature of markets?

Watch “Animal Planet” and throw away your models!

Go to the zoo and say hello to those 800 pound gorillas! You will learn more about how markets behave watching them, than you will watching CNBC.

Trust me, I’m a biologist.

All Investing is value investing. The rest is speculation

Value Investing. Growth Investing. Momentum Investing. Trading. Real Estate. Precious Metals. Shorting.

A million different ways to lose your money (We should include failed startups to this now shouldn’t we? Heh Heh).

I am going to review some of the lessons I have learned about investing over several future posts but lets spend some time clarifying what we are talking about. Being exact is helpful in a situation where we are surrounded with many different voices in chaotic confusion.

An asset is something that puts money in your pocket either today or in the future. Today it might be cash in your pocket, and in the future it may be the result of an investment, a gamble or a speculation.

Value Investing (or Investing) is the act of acquiring an asset for less than what its worth. Once the asset reaches the point where it is valued at what it is worth (or more), we have made a profit. Agreed?

Speculation is the act of (well speculation, I guess!) an informed (yes, informed…maybe incorrect but informed) betting on the movement in the price of an asset or a presumed asset. If the speculation is correct, a profit is made, and if not, a loss is suffered.

Gambling is the act of largely (not uniquely, no) uninformed speculation that most often results in losses for the gambler and winnings for the counter-party. The counter-party may be a speculator or an investor.

Now lets be theoretical for just a second and invoke math (or maths, if you are British). The only guarantee of profit in the above scenarios comes from buying an asset for less than its worth, i.e. value investing. Its more complicated than that but lets start with the numbers.

When you speculate, you position a bet to take into account certain unperceived or less perceived visions of a future wherein the asset you purchase will sell for more than you paid for it, regardless of whether it is worth what you paid or what the next person pays you for it (Greater fool theory).

That last bit is important. Its important because it underlies the idea of “margin of safety”. The concept of margin of safety says that you have purchased an asset for so much less than it is worth, that even in the likelihood that the greater fool theory did not apply, you would either minimize your losses or make a profit when the asset is fully valued.

A value investor lives or dies by his margin of safety.

A speculator is less concerned by it.

A gambler does not even know it exists.

Every situation where you buy an asset for less than its worth is therefore an example of value investing (stocks in 2009, real estate in 2010, Europe for the longest time etc).

Every time you don’t do that but you believe something good will happen to you, (i.e. currency trading, buying and selling gold, real estate in 2007, European debt over the past few years etc), you are speculating. There is nothing wrong with it, but its good to know what you are doing very clearly isn’t it?

The difference then between these two methods of generating wealth is therefore predicated on whether there is a difference between the price of an asset and its intrinsic value. That in turn is predicated on the estimation of value, the most important item in our arsenal.

Let me be very clear on this so there is no doubt where I stand. If you are unable to ascertain the value of an asset, you are a speculator and if you don’t even know that there may be an intrinsic value that you are missing, you are a gambler and one that will lose to the house every single time.

Every single time.

You have no business investing/speculating/gambling if you are unable to ascertain value.

Am I clear?

Would you perform surgery on yourself without going to medical school?

Exactly. (sigh..I can see the gamblers in the audience going..Hmm.. Why not give it a try?)

If you insist on doing this without the fundamental knowledge of valuation, I have some news for you. You have a name on Wall Street.

Sucker. Muppet (if the counter party is Goldman Sachs).

Warren Buffet says and I paraphrase “Every game has a sucker. If you don’t know who that sucker is, its you. Sucker”

I know the wider world thinks buying and selling stocks and “playing” the market is easy. Dead Wrong.

The market makes its money off of you.

Ok, lets summarize what I said so far.

The least risk (or most sure way) to generate positive returns is by investing and specifically by buying an asset for less than it is worth.

Speculation done well is an art that is beautiful to behold. Some of the richest people in the world are successful speculators. However, its extraordinarily difficult to do and to do it consistently over time is a rare feat. When you see the best at their game, its sometimes difficult to tell whether they speculated or whether they are very savvy value investors.

Most speculators are lousy and should be reclassified as gamblers.

Its more risky and much more stressful.

I don’t need to say anymore about gambling, do I?

Whats next?

In future posts I will discuss the concepts of valuation, its pitfalls and what you must learn in order to perform a reasonably good valuation.

We will then go over the principles of value investing (There are only three principles, my wide eyed acolytes, so don’t worry!!).

Among these posts in the future, I will discuss why these principles can and should be generalized to entrepreneurship and perhaps even to the Right Thinking principles I have been discussing so far.

Flood me with your comments, but please only positive ones.

I have a fragile ego.

Milton Friedman on “GREED”

I’m not a fan of economists in general but a couple like Friedman were some of the greatest minds in our history.

Agree with him or not, Friedman is compelling with his arguments and logic.

Think about what he says and try to come up with a logical (and not emotional) rebuttal. Its actually not easy.

What this does for me, and I’m no unvarnished capitalist, is demonstrate how the real world functions (and not how I would like it to function!)

Great Stuff!

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