Monday, June 6, 2016

Winning by Losing

Evernote: Observations from the Star

Observations from the Star

“You don’t learn to hold your own in the world by standing on guard, but by attacking and getting well hammered yourself. - George Bernard Shaw”

Pat asked the question, ‘are you going to play?’ and Peter responding with ‘I’m too smart for that’. In a vacuum; his answer is totally correct. Life is a game of avoiding mistakes. However, there are some games where there is a price to sit at the table; a price to learn the game; a price it takes to be good at the game.

Would an intern refuse a zero salary intern position at a prestigious firm because it is measured financially as a net negative outcome?
What about the unreturned losses of the psychology of reciprocation?

Gambling, if you choose to participate is about loss-minimisation - you are learning the first skill of value investing. There are some bets you are going to make that go wrong - how will you deal with it? Deciding to cut your loss versus when to press your bet. You have to learn to both cut and press to survive in this game of elites. The second lesson is the gambler’s fallacy which is based on Martingale is doubling your bets when you expect a streak to end. Learning this fallacy while attempting it and losing big in gambling amounts but minuscule in investment amounts can actually equip investors for the market psychology that will creep in when you see a stock going straight to zero. Answering whether the value stock is worth holding and going down with the ship; or whether it is actually a prudent move to be adding to the losing position is probably one of the most critically debated risk management topics amongst traders vs investors. Traders pledge to cut losses early, value investors pledge to bet big and keep adding when losses are occurring (assuming your analysis is correct). The biggest moment in my investing education was when I realised, that investing is the superior style; and has the billionaires to prove it.

The biggest paradox of value investing is that as a price gets cheaper one of two things are happening:
1. You are losing money and becoming more wrong (and the market is being more correct) - this is the efficient market hypothesis.
2. You are getting better odds of payoff (the market is over or under reacting) and the divergent view that you hold will be profitable.

In the case of 1/ you must sell your holdings and minimise your losses. In the case of 2/ you must add to your losing position and capitalise on the fact that you will eventually be correct. People think dealing with these scenarios is as simple as having a pre-calculated spreadsheet with a DCF or EPV value. Most of the value in investing is lost; simply because fund managers are unable to utilise zigging when others are zagging. There are times when momentum works, and there are times when value works. Is it possible to jump investment styles during trend changes? Research indicates it is unlikely; sticking to a value style will mean you under perform at times, and those are the times when you should be increasing allocation to this style.

Learning that in gambling you will never have the edge is correct. Losing consistently and seeing your own psychology to losses and how you deal with them is the purpose of a learning based approach to gambling; risk management in institutional terms. Can you walk away after committing your initial outlay? Can you bet the full, committed amount for the night? Are you able to press the winning streak, despite the irrationality; why even gamble if you aren’t gambling to win big?

The tale of Amazon almost two decades without a profit - yet it became one of the greatest value creators to investors in the last decade. A stock that many value investors have shunned as ‘overpriced’. The reasoning lies squarely with those who refuse to take negative EV propositons without seeing the long run implications and value of long run market dominance that began with loss making short run transactions.

“One gains by losing and loses by gaining”
Dao of Capital