I bought my first stock when I was in college. $1,000 invested in Novell. In those pre-Internet days, I watched the Nightly Business Report every evening to see how it performed. The stock rose, I took a healthy profit, and I thought I was a genius – until I bought my second stock.
Since then I’ve spent over a decade interviewing countless investment managers, hedge funds, private equity shops who spend all of their time researching securities and deals. Every single idea they espouse sounds compelling at the time. Just like I felt about Novell. But the good managers admit they are wrong almost as often as they are right. The trick is to make more money when you are right than when you are wrong.
The stock market is an auction. Whenever you buy a stock, there is someone on the other side of the trade who is just as convinced it is time to sell.
25 years ago the person on the other side of the trade was probably an individual, a retail investor. Now greater than 90% of trades are by institutions, firms which spend all of their time researching securities, who have dozens of analysts and access to reams of research. They build elaborate spreadsheets forecasting earnings and speak frequently with company management, customers and suppliers.
When I buy a stock the underlying assumption is I have an informational edge, that I know something about the company the institution on the other side of the trade doesn’t know. In fact, when I buy a stock I’m saying I know something the majority of market participants don’t know, which is why the stock is undervalued.
The fact is I don’t know more than the person on the other side of the trade. I have no informational edge when it comes to individual securities, and I would argue very few investors do.
I admit my ignorance up front so when there is a company that interests me, I buy stock options. I purchase just enough options that if they expire worthless, I’m willing to accept the 100% loss. But if I win, I win big.
When you invest in individual stocks and have no informational edge, it is no different than gambling. Consequently, you might as well structure the investment just like a bet. Double or nothing. That is the beauty of stock options.
Last week here in Idaho, Federal regulators charged our local version of Bernie Madoff, a man named Daren Palmer, with a “brazen Ponzi scheme”. Palmer allegedly promised investors 20%+ returns by investing in stock index futures. Instead, Palmer only invested $4.5 million and used the remaining $40 million to pay profits to early investors, build a $12 million home, pay off credit cards and buy snow mobiles. I know of people who lost the bulk of their net worth investing with Palmer, who apparently was a church going, family man.
About a decade ago, I met with a university client to discuss hedge funds. One board member, an older gentleman much wiser than me, said he would never recommend the university invest in hedge funds. When I asked why, he said he had a simple rule of thumb when it came to investing. “If I can’t explain it to someone, then I don’t invest.”
Many a fortune would have been saved if investors would follow that simple rule.
Several weeks ago, a doctor friend invited me to listen to a CEO who was doing a round of fund raising for an early stage venture. This doctor had invested $50,000 several years ago in this enterprise and wasn’t sure if he should invest more.
We met in the home of a different doctor to listen to the pitch. The scene can only be described as a Tupperware party for doctors, complete with chocolate brownies for refreshments. I was one of the only non-MDs in the room.
The CEO gave a PowerPoint presentation highlighting all of the wonderful things his company had been doing and would be doing, including making a lot more money than they were making now. I could see the doctors and their spouses get that glazed look one gets when they start imagining future riches.
I was one of the only attendees who asked tactful, but hard-nosed questions, such as if this is such a great company why is he raising money in the living room of some doctor in Idaho. The presentation ended with the distribution of USB drives containing key documents, such as the offering memorandum.
I’m convinced I was one of the few that read through the documents, and probably one of the few that didn’t invest. The supporting documents were alarming. The CEO needed to raise money in Idaho because venture capitalists wouldn’t go near this company. The doctors were keeping it afloat.
In this case, this wasn’t a Ponzi scheme because the sorry state of the company was fully disclosed. But for the doctors that invested it might as well have been a Ponzi scheme because they were violating that university board member’s simple rule of thumb. “If you can’t explain it to someone, then don’t invest.”
P.S.
Even if you can explain an investment to someone, there are some additional precautions. If the investment has the word hedge, leverage, shorting, arbitrage, derivatives, illiquid or any other fascinating jargon of high finance, then make sure the fund (and one should only make such an investment through a fund) is audited by a top-tier independent accounting firm and all valuations are verified by a top-tier independent administrator.
I met with a university client this past week with an endowment of several million dollars. Like most schools of its size, the college has a diversified portfolio of stocks, bonds, hedge funds, private equity, natural resources and real estate. And like most endowments, the returns in 2008 were horrible. Down about 26%.
Last week, I also met with a friend who is retired. He is 72 and reliant on social security and an IRA to fund his living expenses. His financial advisor invested his IRA in three balanced mutual funds, which average 60% stocks and 40% bonds. The portfolio lost over 28% last year. It is now worth only $75,000.
Endowments annually spend 4% to 5% of their average market value (often calculated on a trailing 3 or 5 year basis). Their time horizon is infinite so in order to maintain the real value of their assets, they need to earn long-term rates of return that at least equal their spending rate plus inflation. Consequently, they structure portfolios with expected rates of return of 8% or greater. They are willing to withstand high volatility, even the rare negative 20%+ return because the money must last for generations. When returns are negative, the annual distribution from the endowment is cut. Reducing spending is an unpleasant task, but it can often be offset by new donations.
My friend’s money doesn’t have to last forever. Only 30 years or so. A year ago, he might have been spending 5% of the IRA market value, but after a 28% loss his spending rate will jump to close to 7%. Unfortunately, his spending is already bare bones. Dramatic cuts are not an option. The IRA will be depleted well before 30 years.
Why would a financial advisor invest my friend’s assets as if he were an endowment? Retirees can’t afford 20%+ losses. Their expenses aren’t as flexible as an endowment. There are no gifts to offset the lean years. Yet again and again, I see financial planners launch their clients into retirement with endowment like portfolios. They put 50% or 60% in stocks and pacify them with Monte Carlo simulations showing only a 10% probability of running out of money.
Guess what. Bear markets reek havoc on probabilities. After a 28% decline, the retirees’ risk of running out of money went from 10% to 30%.
When I speak to institutional investors, I’m often asked how my money is invested. The implication is I should be invested like their portfolios. Eating my own cooking. I tell them I’m not. I’m not an endowment. Nor are retirees. So financial planners should stop investing retiree assets like they are. Unfortunately, for many retirees it’s a little too late to learn that lesson.
When I was 10, I got my first job delivering the Hilltop News, a weekly neighborhood newspaper. I loved the smell of the news ink, the twang of a rubber band as it slipped onto a paper, and the lightness I felt at the end of my route when my delivery bag was empty. I kept that job for years until I passed it on to my younger sister, who passed it on to an even younger sibling. It never paid more than $30 a month, but it was enough to keep me supplied with candy, soda and baseball cards.
Yesterday, the Rocky Mountain News printed their last edition. It will not be the first major newspaper to close down this year. The recession is just hastening an ongoing trend of how consumers get the news. Still, not all newspapers will die. There will just be less of them.
Newspapers historically served three core readerships:
1. Readers seeking in-depth quality stories prepared with high journalistic standards and professional editing. This is the journalistic equivalent of fine dining.
2. Readers wanting local news - a digest of what happened and will be happening in their neighborhood or city. This is journalistic equivalent of local delicacies.
3. Readers just wanting to know the top stories, to get a pulse on what people are talking about. A summary. This is the journalistic equivalent of casual dining or fast food. Information snacking is the term Jeff Bezos uses.
The challenge newspapers face is most readers fall into this third category - the vast middle, and newspapers are an inferior platform for readers who just want a summary of the top stories. In an age of online video, blogs and 24 hour news channels, newspapers lack the immediacy and multimedia elements to satisfy information snackers, who can satiate their news fix for free.
The simple fact is there are not enough fine dining readers to support the number of existing newspapers. Satisfying fine dining readership is a niche market and those readers will gravitate toward the highest quality newspapers, the premier global dailies such as the New York Times, the Wall Street Journal, the Financial Times, the Washington Post, etc. Fine dining readers will pay for that content if the product is of the highest quality. Many of those readers will read the content online. I personally subscribe to three of those papers via my Kindle. I am willing to pay for good editing and journalism, because it is of value to me.
On the other end of the spectrum is local news. Unfortunately, local news by definition is a niche market. I want to know and recognize the people and events being written about in my local paper. I want stories I can’t get anywhere else. Local delicacies. What are my neighbors up to? If my local paper prints a story about a regional or national event, I skip it. I can get better coverage with my fine dining papers or more immediate coverage online for free. I recognize the journalism in my local paper isn’t Pulitzer Prize quality. There are typos, run-on sentences but I subscribe anyway because it is the only source for local news.
So newspapers will serve two niche markets - the subset of citizens who value reading and professional journalism and the subset of citizens who want local tidbits. Newspapers were staffed to serve the mass market. Now they must serve niches. Consolidation and closings are inevitable, but journalism is not dead. It serves a critical purpose in democratic societies. There will just be a lot fewer newspapers.
“So, first of all, let me assert my firm belief that the only thing we have to fear is fear itself—nameless, unreasoning, unjustified terror which paralyzes needed efforts to convert retreat into advance.
In such a spirit on my part and on yours we face our common difficulties. They concern, thank God, only material things. Values have shrunken to fantastic levels; taxes have risen; our ability to pay has fallen; government of all kinds is faced by serious curtailment of income; the means of exchange are frozen in the currents of trade; the withered leaves of industrial enterprise lie on every side; farmers find no markets for their produce; the savings of many years in thousands of families are gone.
Yet our distress comes from no failure of substance. We are stricken by no plague of locusts. Compared with the perils which our forefathers conquered because they believed and were not afraid, we have still much to be thankful for. Nature still offers her bounty and human efforts have multiplied it. Plenty is at our doorstep, but a generous use of it languishes in the very sight of the supply. Primarily this is because the rulers of the exchange of mankind’s goods have failed, through their own stubbornness and their own incompetence, have admitted their failure, and abdicated. Practices of the unscrupulous money changers stand indicted in the court of public opinion, rejected by the hearts and minds of men.
True they have tried, but their efforts have been cast in the pattern of an outworn tradition. Faced by failure of credit they have proposed only the lending of more money. Stripped of the lure of profit by which to induce our people to follow their false leadership, they have resorted to exhortations, pleading tearfully for restored confidence.
Happiness lies not in the mere possession of money; it lies in the joy of achievement, in the thrill of creative effort. The joy and moral stimulation of work no longer must be forgotten in the mad chase of evanescent profits. These dark days will be worth all they cost us if they teach us that our true destiny is not to be ministered unto but to minister to ourselves and to our fellow men.” - Franklin D. Roosevelt, Inaugural Address, March 4, 1933
It is sobering to see how closely today’s market crisis parallels the Great Depression. Certainly there are differences and our mechanisms to deal with the crisis are greatly expanded, yet the root of the market collapse happening before our very eyes is fear.
And what is fear?
Fear is a lack of trust. Banks do not lend to each other or to their clients because they do not trust they will be repaid. Investors do not provide capital because they are distrustful it will be returned. Our global, interconnected marketplace is based on trust and that trust is being severely tested.
Participants hoard their capital like squirrels as if preparing for an economic winter.
When capital is hidden away in the 21st century equivalent of the proverbial mattress: government bonds, then businesses do not expand.
When businesses do not expand, then jobs are lost, economies contract and suffering increases.
When distrust is rampant, people are only willing to create and transact commerce with those they know.
They turn to their tribe. In past times, your tribe would have been members of your family and local community.
Today we have the social tools to connect with people across vast distances. The breakdown in trust does not have to mean turning only to those close at hand.
We must build and create and trust with those we have met on social networks such as Twitter, Facebook, Linked-In, Ning and others.
Trust is rebuilt one relationship at a time. We are fortunate the technology is in place to rebuild those relationships not in an insular, local fashion but globally.
Return to your tribe until you can trust again, but please make sure your tribe is global.
When I was eleven, my family and I piled into a white Ford Maverick for a road trip to Niagara Falls. I had never been there and didn’t know what to expect. We parked far from the falls – as my Dad was not one to pay for parking. Even from that distance, I heard the distant roar and saw the towering mist clouds. When we reached the edge, the site of four million cubic feet of water plunging 167 feet filled me with awe.
Yet, it was the view upstream from the falls that had the most lasting impact. We walked a path that ran along the Niagara River. Next to us the river raced and churned faster than any water I had ever seen. There was no fence. Only three feet of unobstructed space kept me from being swept down river and over the falls to a certain death. The river seemed to call out to me, daring me to jump. Inviting me to taste of its seductive power and test my skinny frame against its convulsive waves. I moved to the far side of the path, shaken. Death had never seemed so close, and I wanted no part of it.
Rivers that race over waterfalls are powerful but chaotic. There is only one way to harness that power to create electricity. Focus. Because the water pressure is too great to harvest all of a river’s force, a small part of the river is channeled into a conduit that sends the liquid plummeting through water turbines. The rushing water rotates the turbines hundreds of times per minute, creating the necessary force to generate electricity.
Living on the leading edge of the present involves taking advantage of new ideas and new opportunities as they present themselves. But this stream of ideas/opportunities needs to be channeled by our strategic focus to have optimal impact, just as a conduit channels the river current that turns water turbines to create electricity on the Niagara River.
In previous posts, I stated intuition means pattern recognition, and higher strategic elevations provide more data to recognize patterns. Just as a skydiver is better able to see road connections and waterways from 10,000 feet above the surface than while rushing headlong into an oak tree, we can better discern the pattern and direction of events from higher strategic ground.
But not too high of a strategic elevation. Nor too low.
If our strategic elevation is too high, we end up floating in clouds of generalities and our intuition fails us because there is too much data to recognize patterns. It’s like trying to harness an entire river for electricity. The water pressure (i.e. the flow of ideas) is too great.
Strategic statements such as, “Our business strategy is to make money. We will do so by being entrepreneurial” or “This year I will focus on being better” are too generic. They are rudderless, providing no direction as to which plot of fertile ground we should search for ideas to try.
Likewise, if we set our strategy too close to the tactical trenches, we are likely to get sidelined by unexpected events. A good clue that a strategic intent is too narrowly focused is its length. The longer it takes to explain, the more likely it is too specific.
What is the optimal strategic elevation?
Sufficiently high to place strategic stakes in the ground that bring some order to the tactical chaos below. In other words, we have to set the metes and bounds of our playing field, our area of focus. We have to channel the river of ideas into a strategic conduit.
Strategy means making choices. Not only choosing what activities to pursue, but even more importantly choosing what not to do. It means deciding what won’t change. What principles will we adhere to no matter what the circumstances. We can’t do everything. There are too many ideas, to much popping corn to catch. We have to focus on what we can be the best at the world at. Our intuition will help us know what that is.
A skydiver jumps from a plane and marvels at the patchwork of fields and forests below. From 10,000 feet above the earth’s surface, the jumper sees how the roads connect and where the rivers and creeks drain. Subtle changes in shading outline the hills and valleys. The diver flips, turns and rolls by manipulating her body shape, doing everything a bird can do except one – climb back up.
Instead, the skydiver plummets at 120 miles per hour until she deploys her chute at 3,000 feet, slowing the descent. The view is narrower with the ground approaching. The fields and forest directly below become clearer with the diver able to make out individual trees and the planted rows, but she can no longer discern the broad patterns of roads and rivers.
With the drop zone in site, the jumper directs the chute with hand toggles attached to steering lines. The video below captures the final descent.
There is no better way to illustrate intuition works best from higher strategic elevations than a skydiver crashing into a tree.
Intuition means pattern recognition. Patterns can’t be discerned when you are rushing headlong into an oak. There is only one data point and there is precious little time to react to it.
Higher elevations provide more data points for pattern recognition. Just as a skydiver is better able to see road connections and drainage patterns from 10,000 feet above the surface than from 500 feet, we can better discern the pattern and direction of events from higher strategic ground. In other words, focus on the big picture rather than minute detail.
Jeff Bezos, CEO of Amazon, illustrated this concept in an October 2007 Harvard Business Review interview. At Amazon, one of the questions they constantly ask is what is not going to change over the next 5 to 10 years. They then design their activities around the broad patterns they identify in answering that question rather than more transitory items, such as who their customers will be or what technologies will be available. In Amazon’s case, what they believe won’t change is customer demand for large selection, low prices and fast delivery. Perhaps that seems too simplistic, but the brilliance comes from what they do with that information.
They plant seeds.
Having determined what they believe will not change over the next decade, they are free to conduct experiments in areas that will improve the items that won’t change.
Bezos said, “We are willing to plant seeds and wait a long time for them to turn into trees. We may not know that it’s going to turn into an oak, but at least we know it can turn out to be big. I think you need to make sure with the things you choose that you are able to say, ‘If we can get this to work, it will be big’”
What won’t change?
What will change?
What is the rate of change?
These are questions intuition can help answer. They can produce insights into what may happen and help decipher trends and determine which are likely to continue. They can point to the areas where we should experiment, where we should plant seeds.
On the continuum of life, there are those who are stuck in the past. They live looking through a rear-view mirror, smiling at their successes and fretting about what might have been.
Others plant themselves firmly in the mediocre present where their days are predictable and the surprises few.
Others are mavericks, hurling themselves into the future with bold plans, taking care to burn their ships to prevent retreat.
99% of mavericks fail. They go down in flames, tripped up by some nasty surprise they didn’t foresee when viewing the future through the lens of the present.
The 1% of mavericks who succeed receive extraordinary acclaim. They are heralded as visionaries. The press gushes over their wealth and beauty, creating lists to rank these heroes by riches, influence and prestige. Successful mavericks sell books by the millions, explaining step by step how everyone can repeat their success. Failed mavericks never get book deals.
Mavericks are needed. The innovations spawned by their risk taking help create the future. Mavericks are indeed visionary. The question is how clear was their vision beforehand.
Mavericks, like everyone else, are near-sighted. Their vision is fuzzy. The 1% of mavericks who cross the finish line and are crowned with laurels and wealth rarely acknowledge they were at times stumbling in the dark. Success always appears inevitable to those who are successful. When looking backwards in time, the beaten path the maverick sees that led to his or her success looks straight and true. The lucky breaks and near disasters are hidden from sight. That’s not to imply that mavericks’ success is all due to luck and randomness. Only that there is a happy dance between skill and serendipity.
I applaud mavericks. I admire them. I just don’t like the odds. That is why I’d rather live on the leading edge of the present. Not stuck in the past, or muddling in the boring middle, nor blazing the maverick’s trail to glory or disaster. I’d rather be a step or two behind the maverick.
How do you live on the leading edge of the present? That’s what this blog is about, but here is a summary of steps covered in earlier posts.
Try the ideas and products successful mavericks produce. I’ve mentioned before these ideas are legion, as numerous as popping corn.
Don’t burn your ship when trying these new ideas, rather scale the experiment based on its risk. As the personal cost of being wrong about an idea or decision increases along with the uncertainty of success, the size of the bet should be reduced.
Measure the results of the experiment, paying particular attention to the unexpected, to the surprises both good and bad.
Step back and put the results in context. Look for patterns. What does your intuition say about the results?
Experiment some more, be a piece-meal engineer, a tinkerer. Take incremental steps to edge you closer to the future.
These are of course just steps. What are needed are more examples. A topic of many future posts.
At the beginning of a chess game, White has twenty possible moves and Black has twenty ways to respond – for a total of 400 possible positions after the opening turns. After two moves for each player there are close to two hundred thousand possible chess positions and after five moves the possible number of positions is over a trillion. In fact, there are more possible chess positions than there are atoms in the universe, according to estimates made by mathematicians.
Yet, if a chess grandmaster is given a brief look at a chessboard with 25 pieces arranged as they might be midway through a game, he can place all 25 pieces on a clean board exactly as they were configured during his brief encounter. A novice on average can only place six of the 25 pieces in their original spots.
At first it might appear chess grandmasters have superior memories, but if the 25 pieces are scattered randomly on the board, the chess masters perform no better than a novice, repositioning only six pieces correctly.
Kurt Matzler, Frank Bailom and Todd A. Mooradiun discussed this contradiction in an article published in the MIT Sloan Management Review entitled Intuitive Decision Making. They contend grandmasters see a pattern behind potential configurations of a game. One estimate is a professional player can recognize more than 50,000 configurations, but if the pieces are positioned in a way that doesn’t make sense according to the rules of the game, the chess masters are unable to recognize a pattern and their results are no better than a novice.
The authors define intuitive decision making as the ability to recognize patterns at lightening speed, often unconsciously. This intuition or pattern recognition involves a process where knowledge, experience and emotions are linked.
I mentioned in my last post that while we can’t escape viewing the future through the lense of the present, there are circumstances where we can get insight into what may happen. On the leading edge of the present – the thin line that separates the now from the future – intuition, or pattern recognition, can assist in deciphering current trends. Our intuition can help us develop a better than average assessment of which trends are likely to continue, at least until they get disrupted by some unexpected event.
While intuition is not as good as having a crystal ball to predict the future, it is better than flying blind.
As I mention previously, John Elfreth Watkins Jr.’s predictions of the year 2000 were mostly wrong, but a number of his predictions were surprisingly prescient, particularly in regards to communication. He wrote “persons and things of all kind would be brought within focus of cameras connected electrically with screens at opposite ends of circuits, thousands of mile at a span.” He also mentioned, “Wireless telephones…will span the world.” Perhaps communications was an area where Watkins had more knowledge and experience, allowing him to better recognize patterns that led to his correct predictions.
I’ll explore in an upcoming post how intuition works better in some situations more than others.
Imagine a world where strawberries are as big as apples and peas as large as beets. In this imaginary world, mosquitoes, flies and roaches have been exterminated, while horses are nearly extinct. Only a few high breed horses are kept by the rich for racing, hunting and recreation. It is a land where packages are delivered through a network of pneumatic tubes and the letters C, X and Q have been eliminated from the everyday English alphabet in order to simplify it.
These were some of the predictions by John Elfreth Watkins, Jr. in a Ladies Home Journal article published in the year 1900 entitled, “What May Happen in the Next Hundred Years.”
The illustrations in this post are predictions made that same year on souvenir cards produced for the Paris Exposition. They depict what life would be like in the year 2000 (I originally found these on Paleo-Future: A Look into the Future that Never Was. They come from tvhistory.tv).
Most of the predictions were wrong, although a few were correct.
The incorrect ones exemplify why it is so difficult to predict what is going to happen. Our predictions are fuzzy like seeing a giraffe in the distance. We leave out important details and place too much emphasis on the details we imagine. The reason we put so much weight on the accuracy of those imagined details is they are heavily influenced by our present attitudes, feelings and knowledge. We view the future through the lense of the present.
Take Watkin’s prediction that horses would become nearly extinct, for example. It is illustrated below, showing the horse was expected to be so rare it would be put on display as a curiosity.
In the year 1900, automobiles were not widespread, having begun commercial production only ten years earlier. Still, the automobile had sufficient momentum that a forecaster could conceivably project they would replace the horse. What is interesting is how turn of the century attitudes toward thrift and utility influenced that prediction, not to mention the stink a surging horse population was causing for cities.
If the car was expected to replace the horse, then the horse would no longer be needed for farming and transportation. So why continue to raise and feed horses if they have no utility. And if there are no horses, then there is no horse manure and the attendant flies. In 1890, the Times of London estimated by 1950 the city would be buried in 9 feet of horse manure. One estimate is three billion flies hatched per day in U.S. cities in 1900 with horse manure being the preferred fly breeding ground. The stench, the muck and the flies caused by horses was overwhelming. (Here is an interesting article by Eric Morris on the topic).
So the logical forecast for the future based on a late 19th century frame of reference is the horse would become nearly extinct, and it would be a welcome development. What was unseen is the car and other technological breakthroughs would lead to increased efficiencies, greater wealth and more free time, greatly expanding the demand for recreational horse use, not only for the rich, but for farmers, ranchers and many others. The U.S. horse population did drop from an estimated 19 million in 1900 to approximately 9.5 million today. Worldwide horse population today is estimated to be 58 million, far from being extinct.
The turn of the century frame of reference influenced Watkin’s other predictions. Many were agrarian in nature, mirroring the predominant but changing culture back then. Predictions of transportation advances were focused on trains, ships and cars, the modes of transportation experiencing the greatest expansion at the time while the only reference to man flying was air-ships (zeppelins), which were not expected to be competitive with ground transportation for passenger and freight traffic.
What gets left out of all predictions is the unpredictable - the unexpected events, the surprises. It is these surprises that have the greatest impact on the future. They are the game changers that can swamp the incremental improvements and current trends. Since most forecasts are simply extrapolations of current trends, it’s understandable most predictions are wrong because they are torpedoed by disruptive events and surprise technological breakthroughs.
If we can’t escape viewing the future through the lense of the present, are there any circumstances where we can get insight as to what may happen. Yes there are, and I’ll address them in my next post.
