During this week’s Value: After Hours podcast Taylor, Brewster, and Carlisle discuss a game that helps us to decide whether investing is more luck than skill. Here’s an excerpt from the interview:
Tobias Carlisle: So gents, other topics, what have we got?
Jake Taylor: Well one thing that came up during this weekend that was kind of a fun, call it a game, and I’ll see what you guys have to say about this, but here are the ground rules for it, and maybe if you’re… Try playing this game with your friends and see what they come up with and maybe we can crowdsource what’s a good answer to this because there were some very unsatisfying answers that we came up with.
Jake Taylor: So here are the rules, you’re allowed to pick any security long or short, I guess credit or equity, and so no derivatives, no options, but here’s your goal, you have one year and you have to get the lowest possible return that you can get, lose the most money. Ideally you go to zero. Okay?
Jake Taylor: Sounds like it would be easy, right? And this is why it’s interesting is that it’s really trying to get Michael Mauboussin’s idea about when you try to determine luck versus skill of something, if you can fail on purpose, then that means maybe there is some skill involved.
Jake Taylor: So you think of a roulette table, I could try to lose by putting all my money on one of the numbers, and I’m likely to lose but I could also win really big. So there’s the rules. What do you guys have? Bill, why don’t you start since you kind of already answered a little this weekend.
Bill Brewster: Yeah, I mean, I’d probably go to a levered minor or something like that, but you know with-
Tobias Carlisle: Long, long the levered minor.
Bill Brewster: Yeah that’s right. But with my luck, they end up getting a bid and I end up six X and then it’s like a Brewster’s Millions type problem. But we were talking about… I mean, I think the tough thing about this is that it also hits on the second order thinking, right? It’s easy to say, “Well, I just buy this piece of crap,” but that piece of crap is priced like a piece of crap. And if something changes, you’re going to have a lot of money that you got to blow in the next… Let’s say it takes six months, you only have six more months to lose it all.
Bill Brewster: I think what we were getting to is over the short-term there is a lot of luck in this game. What do you say Toby?
Tobias Carlisle: Yeah, the-
Jake Taylor: I would add that… I mean, it means also literally one year results are meaningless.
Bill Brewster: Yeah.
Jake Taylor: Completely meaningless.
Tobias Carlisle: The issue… So if you had… Just taking the roulette table example, you can’t have the win, but if you can play all day long, every day for a year, you can vaporize that money, right?
Bill Brewster: Yeah, that’s true.
Tobias Carlisle: You could grind all the way through it because the vague and the… you’re getting a return that’s less than one all the time.
Tobias Carlisle: I think I could… I don’t have to trade it, but I think that if I could trade it I could get you much closer to vaporizing that money. I’ve got a short string, I got things that I think are going to go down.
Tobias Carlisle: But it does illustrate one of the problems that Bill brought up then, that you do have to have… you’re looking for stuff that’s overvalued, or is mispriced anyway.
Jake Taylor: Yeah.
Tobias Carlisle: And that’s the problem with investing. A lot of stuff is pretty well priced, even the junkie stuff is pretty, it’s accurately priced. I’d be going through that list of short names and I’d be buying them long and buying one of them long and then I’d trade them more regularly. Because I think that although you got zero cost trading that, right? You can really set yourself on fire with that.
Jake Taylor: Yeah.
Tobias Carlisle: It’s hard, but I do think that investing is a game of skill and I do think you can lose over the course of a year, and I think that that’s some proof that there’s some skill in it. I think that there is an enormous component of luck though, which is what makes it so hard.
Bill Brewster: Well, there’s definitely… I mean, I think what we were talking about is like there is certainly skill over a five year time horizon. The one year, I think we were backing into almost our little version of-
Jake Taylor: Depends on those five years though.
Bill Brewster: Yeah.
Jake Taylor: Like let’s say 2009 to 2014, did you need a ton of skill to make money?
Bill Brewster: You needed guts. Right?
Tobias Carlisle: That’s true.
Bill Brewster: I mean, a lot of people were hiding.
Jake Taylor: Yeah, all right.
Tobias Carlisle: That’s very true.
Bill Brewster: Which I think that’s a learned habit, right? I think a lot of… I mean, certainly me back then. I mean I was an amateur back then. I was a lot more afraid than I think I’d be now.
Jake Taylor: Okay, how about then 2014 to 2019? That might be the better sample of-
Tobias Carlisle: That’s a hard one.
Bill Brewster: Yeah, yeah.
Jake Taylor: Was that luck or skill?
Bill Brewster: I guess we’ll see, right?
Jake Taylor: Yeah.
Tobias Carlisle: I think that that period is an interesting period because the value, I don’t want to say factor because factor’s price to book, but the guys who are like me who are buying more on yield, care less about growth, definitely have not performed very well through that period of time.
Tobias Carlisle: If you’re somebody who leans a little bit more heavily on growth, so if you’re trying to buy growth at a reasonable price, or that Buffett compound style, then I think it’s probably be quite good period for it. I think it’s… you’ve done quite well.
Bill Brewster: Yeah. Well I think what those guys probably did well in aggregate is realizing that the path of distributions was mispriced. I guess the tough thing about that is as that thesis gets proven out, the world gets priced in a rosier and rosier way, and eventually there’s not a lot of-
Jake Taylor: You start being-
Bill Brewster: There’s not a lot of people out-
Jake Taylor: You start being right for the wrong reasons now.
Tobias Carlisle: You’re saying that that was this fundamental change wrought by the internet where that marginal cost, that marginal sale was at zero cost, or virtually zero cost? That’s the software as a service, or anything distributed over the internet.
Bill Brewster: Yeah. I mean, I think what certainly I missed, I don’t know about the market or whatever, but is just how much margin inflection was on the horizon and how persistent that would be. And some people saw it. Then some people probably got lucky, right? But they’re not all lucky by any stretch. The question is going forward what’s the right bet? Because anyone can know what the history said.
Jake Taylor: So my answer to what I would try to do is I thought about how could I find one particular thing that might change that I would be very highly levered to. So for me, I got to thinking, “All right, I want to be long the most ultra-duration that I can get.” So I would short the Argentinian century bond. And it either is going to work spectacularly, or totally blow up in my face, but I’m basically making a huge interest rate bet as much as I can and hoping that that changes somehow.
Tobias Carlisle: If you’re a macro investor and you had… So let’s say you don’t put 100% of your position into this, right? Let’s say you put, I don’t know, some sense, like one or 3%, something like that, and then you build out a whole portfolio of these things, because that’s such a contrary bet, I’ll bet there’s almost nobody in the world who thinks that that’s a good trade, right? So it’s probably…
Jake Taylor: Well, what’s ironic is that actually I might also take the long, the Argentinian century bond as my bet. I think-
Tobias Carlisle: Well that’s what I-
Bill Brewster: [crosstalk 00:25:08] straddle. You’re just betting vol.
Tobias Carlisle: You’re betting on the move, yeah.
Bill Brewster: Yeah.
Jake Taylor: Either one of those has probably a decent chance of being such a crazy val that maybe it helps you [inaudible 00:25:21].
Tobias Carlisle: The thing you have to… The only way that you win on that though is if the val is too low, if the val’s already in those prices, then that catches you. That’s why it such a hard game. It’s the expectations game, right?
Bill Brewster: Well that’s where people get crushed in options, right? I’ll have friends that’ll be like, “Oh, I think this is going up.” And I’ll buy the calls and I just say to them, “If you don’t know what the term val crush is, you should stay as far away from options as humanly possible because there’s nothing worse than being right and losing your money.”
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