In this episode of The Acquirer’s Podcast Tobias chats with Mark Simpson. He’s the author of Excellent Investing: How to Build a Winning Portfolio, and the manager of Danger Capital. During the interview Mark provided some great insights into:
- The Two Big Advantages For The Individual Investor
- Which Is The Right Investing Style For My Personality Type
- How To Avoid Investment Fads, Frauds And Failures
- Behavioral Biases And How To Overcome Them
- Common Investing Mistakes Based On My Personality Type
- Creating And Maintaining Optimal Portfolios
- The Dunning–Kruger Effect And How It Applies To Investing
- Rip Off The Band-Aid And Sell Those Losing Stocks
- Why Is ‘Grit’ Such An Important Trait For Investors
- What Inspired Excellent Investing: How to Build a Winning Portfolio?
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Full Transcript
Tobias Carlisle:
Alright, man. When you’re ready. Let’s get underway.
Mark Simpson:
Yeah, let’s do it.
Tobias Carlisle:
Hi, I’m Tobias Carlisle. This is the Acquirers Podcast. My special guest today is Mark Simpson. He’s the author of Excellent Investing How to Build a Winning Portfolio, and the manager of Danger Capital. It’s a great name. We’re going to talk to him right after this.
Speaker 3:
Tobias Carlisle is the founding principal of Acquirers Funds. For regulatory reasons, we will not discuss any of the Acquirers funds on this podcast. All opinions expressed by podcast participants are solely their own and do not reflect the opinions of Acquirers Funds or affiliates. For more information, visit acquirersfunds.com.
Tobias Carlisle:
Hi, Mark. How are you?
Mark Simpson:
Hi Toby. Great to be here. I’m good thanks.
Tobias Carlisle:
Danger Capital, great name. How’d you come up with that?
Mark Simpson:
Yeah. Well, let me just be clear. I don’t run outside capital, I only run my own portfolio. The Danger Capital is a tongue in cheek name mainly because it would generally be a terrible name for a hedge fund. Most funds like to call themselves things like lion rock, so that they’re solid, they’re never taking a risk with your money. Whereas, certainly in my world it’s the judicious taking of that risk and being exposed to the right risks that generate returns. So the Twitter handle Danger Capital’s a bit of a play on that.
What Inspired Excellent Investing: How to Build a Winning Portfolio?
Tobias Carlisle:
So what inspired you to write the book? I saw the Excellent Investing, I was a little bit wary when I saw the title because I like to read value investing books, but it’s very clearly it’s a value book and you’re a deep value guy. So what inspired you to write the book?
Mark Simpson:
Yeah, I’ve tried to write the book. Although I myself, a deep value investor, I tried to write the book from a perspective of things that are applicable to lots of different types of investors, and hopefully that comes through. And it’s not all deep value, but I guess it’s very hard to remove yourself from your lens of the world. The book itself is… I read a lot of obviously widely around investing and there’s a lot of books that are, how to choose your next great stock, but there’s very little discussion on the strategic aspect of portfolio management. This is something I’ve observed in various fields, including how some investors approach betting sites not on Gamstop UK with a similar mindset, focusing not just on individual picks but on building a balanced and resilient strategy. The process of building a portfolio, weighting the stocks in that portfolio, and avoiding investment mistakes, in my opinion, are almost equally important as being able to be a stock picker, and I felt that, yes.
Mark Simpson:
So a lot of investors were under-resourced in this area and the books that were out there were quite academic. So they either were very detailed and good, but very hard to apply or had no practical aspects for implementation or they pushed you towards passive investing. And for a lot of people, I think passive investing is a great thing if you don’t have the time or the inclination, but saying to stock pickers what you should give up and go into passive investing, the analogy I use is a little bit like one of your friends asking for relationship advice to improve their romantic relationship and you say, “Just break up, you’re terrible anyway, just break up.” And it’s just not the advice that people want or-
Tobias Carlisle:
There might be some incremental advice before that end stage.
Mark Simpson:
Yes. Yeah, there should be something and hopefully the book is that practical guide for people to build better portfolios and particularly to avoid common investment mistakes that people make.
Tobias Carlisle:
I like the way the book is laid out. You begin with strengths and then you move into weaknesses and then how to build an optimal portfolio. So let’s go through that. The first thing is talking about competitive advantages and you don’t mean that just in terms of finding competitive advantages in the companies that you’re looking at, you mean finding those competitive advantages in yourself so perhaps you’d like to discuss how you go about doing that.
Mark Simpson:
Yeah, I think again, there’s a lot that’s written about competitive advantage, finding moats in the market and they’re very important, being able to analyze a corporate moat is one of the key parts of successful investing, but many people forget to apply that process to themselves or to the managers they choose so they accept that a company without competitive advantage will in the long-term only earn it’s cost of capital, but they forget that, well actually your going to have the same thing, the stock market is a competitive market in the same way and unless you have an edge, at best, if you’re a good decision maker, match the market performance and at worst, you’re going to massively underperform.
The Two Big Advantages For The Individual Investor
Mark Simpson:
And I think there’s probably two advantages or probably only two advantages that individual investors like myself can have. They are smaller companies, the stuff that your average fund can’t invest in due to size and thinking longer term than the market and that doesn’t mean investor has to hold for the long-term, but they’ve got to be willing to do that. And I think there’s some structural reasons usually to do with bonus incentive and not being fired why fund managers can’t truly think long-term with their portfolios. And finally, I think there’s an advantage that all investors can have and that’s this so-called special situations. So you look for places where people are selling that are unrelated to the underlying value of the asset or the business. So spinoffs are the classic example of that.
Tobias Carlisle:
So individual investors short a little bit sometimes, everybody does. If you can value a company that’s just mis-priced in the market, whatever the reason is, I don’t think you’d have to worry too much about why you’re the one who found it, you just know that over the course of a year, if you find a company trading at say, $100 over the course of the year at trade, this is pretty common, they trade as low as $50 and as high as $150 and if you think it’s worth somewhere between 80 and 120, then you can buy it at 50 and maybe sell it at 150 or hold onto whatever the case may be.
Tobias Carlisle:
So I do think that individual investors can do this stuff for sure, but there’s no question at all that there are going to be some places where that’s easier and it’s certainly going to be in small and special situations as you point out. So that’s one of the bits of advice that you give, think small and then I interpret from that or you discuss shortly after that, think about value to why focus in those two areas beyond the returns that you can find there?
Mark Simpson:
Yeah. Well, I guess just the historic out-performance that value is shown as well as small caps. So both are a little bit controversial. The small cap effect as being widely criticized, but there’s a good paper from Cliff Asness called… Let me get this right, Size Matters If You Control Your Junk, that you’re probably aware of it. And his thing is you do have the size effect as long as you ignore the really scummy companies that promotes the bankrupt, some of the IPOs where there’re just the founders’ cashing in. If you just avoid those worst quality companies, the size effect comes back in and it’s more pronounced in value stocks as well or maybe the value of… That’s probably the wrong way around it. The value effect is more pronounced in smaller stocks as well. So if you do have the mindset to be a value investor, I think that small is the place to be. You still need to be able to analyze a company, but you’re still swimming with the flow rather than against it, in my opinion.
Tobias Carlisle:
Small caps is one of those places where really does pay to be a stock picker rather than an index hugger for the reasons that you point out. I also think even though value has had a horror run and size has had a horror run to the point that I think now there’s a question whether the size effect actually exists or not, which the contrarian in me says, “Well, that’s probably a good place to be hunting right now.” You say that folks who think differently, what do you mean by that?
Mark Simpson:
Yeah. So what I said in instruction is that the process of thinking or finding opportunities where somebody else is selling and they don’t really care about the price they get. So that’s when you’re going to find your biggest inefficiencies. Joel Greenblatt’s spinoffs are the classic one where you get a small business unit that spun off from a larger company and then everybody says, “Oh, what’s this small amount of stock I’ve never heard of in my portfolio?” They treat it like a free bit of money. They’re like, “Oh, hey, I can, well, depending on the size guide for me or go on holiday, I’ll sell it.” And they view it as something that they’ve got for free and therefore doesn’t really have any value. Other examples I think you sometimes see this year-end, you get companies that nobody wants to hold the loser at the year-end and [crosstalk 00:11:15] yes. Within the UK it’s different.
Tobias Carlisle:
You got a fiscal year-end and a tax year-end are not the same.
Mark Simpson:
Yeah, so you get it.
Tobias Carlisle:
So this is a hoarding phenomenon. They just don’t want to show that they were holding it over the course of the year. Right.
Mark Simpson:
Yeah. And if you’re going to buy something you think is undervalued, you’ve just got an incentive to wait a couple of weeks and put it in your portfolio when it’s got a full year or a full quarter to recover and show that you’re the genius that picked the recovery stock and with low liquidity at Christmas time, new year as well, I think that the whole combination of the three, the tax, the liquidity and the reporting means you often get price insensitive sellers, which you can take advantage of.
Tobias Carlisle:
The spinoffs is interesting because everybody read that Greenblatt’s Yellow Book when that came out, whenever that was, but it’s been around for 20 years or something like that, maybe longer than that. Is that right? Something like that.
Mark Simpson:
99, I think.
Tobias Carlisle:
Is it 99? Well, almost a little bit over 20 years and then had a great decade for spins and everybody made a lot of money and value guys get to look really smart, buying the uglier part of the spin and holding that or watching where the managers go as Joel recommends. But then the last decade it’s been really rough for spinoffs, so they just haven’t worked very well. So I don’t know whether it’s just the book got too popular or there’s something junky about spins, I’m not really sure. What do you think about them?
Mark Simpson:
Yeah, I think there’s probably a couple of facts. One is just everybody knows about it, so I would certainly expect the speed that people adapt to this would change. So I think in Greenblatt’s book he said you wait six to nine months before buying in, you’re waiting for the smaller investors to get bored, see their brokerage statement and sell off. And these days most people are checking their portfolios daily or, yeah.
Tobias Carlisle:
That would be a little restraint. I check it about 100 times a day.
Mark Simpson:
Yes. I would definitely think that the effect you’re seeing is going to happen quicker just because information flows. People are used to the idea that spinoffs are there, I think as well, what Greenblatt says is you still have to do the valuation work, whereas maybe in the past spinoffs definitely, you could just buy every single one and you get some excess return by doing so I think, but he never really said that was the way to do it. He said, “Well, if you do good valuation work, this is the place to be.” And that’s maybe what people forget and some of the valuation stuff of the general market could be considered excessive in certain areas. So again, if they’re spinning off popular companies at high multiples, do you really know better than those managements or better than those teams? Probably not.
Tobias Carlisle:
And you talk about merge-arb or as I like to call it risk-arb because it sounds a lot sexier, you can be Danger Capital and get a little thing on your card that says that you’re a risk arbitrager, that’d be great to get into a pub and hand those out. That’s super sexy. Merge-arb, what are your thoughts there?
Mark Simpson:
So I think these things work, but they’re not very good places for your individual investor to be searching in. The same with things like convertible-arb or capital structure-arb, where you buy one structure of share and you short the convertible and the bonds or something like that. Usually they have the wrong type of exposure you’re looking for an investor. So if you win, you win small and you lose, you lose big. If that merger doesn’t go through, you lose 30 or 40%, whereas if it goes through, you make 5%. And hedge funds really like this because it’s uncorrelated to the rest of the market.
Mark Simpson:
So if you call them right, you get this small return every time and no correlation. And if you invest in 100 of them and you have the resources to do your research well, you’ll do quite well out of it. And also if you prepare to use leverage, but for the average investor or individual investor, you’re going to not have the time to do the right level of research to gauge whether it’s going to go through ahead or not and the risk reward just doesn’t look like the thing you want as a independent investor, which is, “Heads, I win several hundred percent and tails I lose 5%.”
Tobias Carlisle:
I don’t merge-arb as a strategy for home gamers. I think you just need to combine it with a value mindset where you think about what happens if this busts, I hold whatever I hold, I’m short one and long the other one, not even worried about the short, just hold the target long. But I also like to do it when, if the merger gets busted or there’s some problem with it and it trades really wide and you think the under-lying’s undervalued, which often they are, so you can buy them.
Tobias Carlisle:
Well, I’ve got an undervalued stock, which is probably going to work. And then there’s a chance that those returns get pulled forward and the deal goes through and you get a pretty material. That’s worked a few times for me where the professionals have picked them over pretty heavily and don’t think it’s going to work at all and because I don’t know what I’m doing, I’m going to put in one or two or 3% in something that I think is undervalued and then it went through. I’m getting paid for something that I didn’t really know how it was going to work.
Mark Simpson:
Yeah, I think if you’re willing to hold the underlying for the long-term, there’s chances you get competing bidders and more people come in as well. So it’s probably the going longer and also shorting the acquirer and taking on significant leverage to make a 5% return into a 50% return that’s going to hurt most individual investors so yeah. I’m not aversed to it, again, if I spot something that I think is under-priced, but it’s definitely on the riskier end.
Which Is The Right Investing Style For My Personality Type
Tobias Carlisle:
I had Michael Mauboussin on the show and he said it’s this received wisdom, I guess there was data in it too that mergers don’t work, they’re basically value destroying for the most part. And he said over the last decade that’s not actually been true. Mergers have tended to outperform, which just goes to show how hard this game can be. The next section that you talk about know yourself, I love this. So you talk about the different personality types so let’s talk about that. What are the different personality types?
Mark Simpson:
Yeah. So when I was writing this, one of my key thesis is, no strategy works consistently over short periods of time. Everybody at some point will face drawdowns, everybody will have a strategy that just doesn’t work and the reason is markets are adaptive. So if you had something that worked all the time, everybody realizes-
Tobias Carlisle:
It gets out of the way, it doesn’t work.
Mark Simpson:
It gets out of the way. So suddenly it doesn’t work. So it’s anything that works for the long-term works because it’s painful in some way. And that pain is, it doesn’t work for extended periods of time and the more you’re able to stick with your strategy through these weak times, the better long-term returns you’ll have. I’m sure there’s people out there who can read the market, they can jump ahead of the trends and do that, but you look at the data, most people have very poor market timing instincts. They capitulate at the bottom of the market and they go all in and leverage the top of the market or the top of the market for their particular strategy. So I think most people are better choosing a strategy that they can stick with over the long-term, and that’s going to be a lot easier if it fits their unique personality.
Tobias Carlisle:
Sorry. Keep going.
Mark Simpson:
And I was going to say one of the… I did quite a lot of reading around trying to look at academic research was into this personality style and there wasn’t a lot that I personally found particularly useful and particularly because it tended to use categories of types of investors I’ve never heard of or never heard anybody else use. Most people, if you ask them what type of investor they are, they say, “I’m a trend or a momentum investor, I’m a quality investor, I’m a growth investor, I’m a value investor.” And the reason is they’re the styles that worked over long periods of time.
Mark Simpson:
So what I wanted to do is look at using the big personality, there’s five different measures of personality… Let me get this right. Agreeableness, openness, conscientiousness. Oh, man, I can’t remember the other two, but the one that I think stands out most for investors is agreeableness or it’s opposite, which is disagreeableness and it’s essentially how willing are you to go with the flow of what everybody else is doing. Are you the person that if nobody else is laughing in the cinema, you don’t find the film funny or are you the person who is roaring in laughter and everybody else is looking at you going, “What on earth is this guy on?”
Tobias Carlisle:
Well that’s for the laugh track, right? Because I guess most people like to hear other people laughing. That’s your cue.
Mark Simpson:
Yeah, it’s right. People know that most people prefer to go with the flow and as an investor, if your SNU goes with the flow, you’re probably much better off being a momentum investor and just picking that trend and following that trend. And that’s agreeable, those are the people, agreeable, but if you’re an agreeable person trying to be a deep value investor, it’s also great with you everyday it’ll be difficult for you to go against this flow when you see the market going this way and you’re going the other way. I think with Warren Buffet, everybody says, “Okay, he transitioned from being a gray in value investor to being well, now the Warren Buffett quality investor that he is now because he reached the limits of what he could deploy capital into, he met Charlie Munger, he had this epiphany.” And when you read biographies like The Snowball, you see that actually Buffet, he isn’t a very disagreeable person.
Tobias Carlisle:
Interesting.
Mark Simpson:
He wants to be liked, he wants to be popular. He really struggles with the, “I go into this town, everybody hates me and I’m closing down their factory or sacking half their journalists.” It just doesn’t really fit, certainly my assessment of his personality from reading those books. So it does seem a very natural transition for him. You can imagine being the quality investor, the never sell the working with the management, the thinking long-term, building a team that agreeableness fits much better with his current strategy than it ever did with the Graham liquidate the business strategy.
Tobias Carlisle:
That’s interesting. That’s a good insight. I’ve never heard of that before, I thought about that, but there’s something in that. This is a digression that I saw when I was a university student, I went and watched American Psycho in the cinema. And I only went and watched it because the book had been banned in the state when I was growing up. It had been published and then the movie came out and ridiculous, but I thought that the reason it was banned was because it was such a violent, serial killer. That’s what I thought it was about, I didn’t know it was a dark comedy and I went into the cinema, it wasn’t very popular and it was in the middle of the day and there were maybe half a dozen other people in there. And halfway through the first scene, I realized that it was actually a comedy and started laughing really hard, which scared everybody else in cinema because here’s a guy laughing at a serial killer type movie. Anyway, I digress. One of the-
Mark Simpson:
It’s probably a sign you’re disagreeable.
Tobias Carlisle:
It’s probably why I’m a deep value investor.
Mark Simpson:
Why you’re a deep value investor.
Why Is ‘Grit’ Such An Important Trait For Investors
Tobias Carlisle:
I think I’m quite an agreeable deep value investor though. Maybe I got a transition at some stage to, “I can’t do it.” One of the interesting parts in the know yourself, so there’re two parts that I really like, you discuss grit. Let’s discuss grit. So what is grit and why is it important?
Mark Simpson:
So this is a term that psychologists have come up with to describe, I guess people are willing to stick with things despite adversity. And the classic or the class definition has two aspects. One is persistence, the ability to maintain it and the other one is interest and they claim certainly that it’s a better predictor of success than conscientiousness. So that’s the other one of the big five personality types that relates to usually… Conscientious people are usually highly successful people because they care about the details, they work hard, they are willing to put the hours in, they care about things, they care about success of things, but the claim is that grit is actually more predictive of success than conscientiousness because it tends to be domain specific as well.
Mark Simpson:
You can be gritty in one area and not gritty in another area because there’s this enjoyment aspect to it. So I guess my advice in the book is if you’re an investor, find a strategy that fits your personality, but also find what you enjoy about investing. So if you enjoy going and meeting management and gaining insight into businesses, you’re much more likely to persist and have grit during those periods of under-performance. Whereas if your strategy relies on meeting managements and you really don’t like it, you’re not likely to have that level of persistence. So it’s the two combined that make grit so powerful. It’s the persistence aspect, but also the enjoyment of the process that keeps people going.
Tobias Carlisle:
There’s a great Paul Graham essay where he talks about what he looks for in funds is this bus ticket collector. Have you heard this before?
Mark Simpson:
No, I don’t think so. Go for it.
Tobias Carlisle:
Basically the idea, is a bus ticket collector, maybe something like the UK version might be a trend spotter. It’s someone who just does something that ostensibly from the outside it looks really boring and nobody would do it, but these guys just do it because they really love it. And then if you can find some way to turn your little obsession that you would do anyway for free into a way to get paid enormous amounts of money, then it’s complete joy for you every moment that you’re doing it and it’s easy for you to persist through times when it doesn’t look like you’re going to get paid or there’s no chance of getting paid. I often think it’s like Joe Rogan with his podcast. He could easily be like a guy running a little radio, like a short wave CD radio station out in Malibu or something like that has an audience of like 100 people. But it just turns out that when you put your little CD radio show on the internet and call it a podcast, you wind up with millions and millions of followers. Again, a little bit off-track but the same idea. One of the things that… Sorry. Keep going.
Mark Simpson:
I’ve got to say it’s a little bit like in castles, intelligent fanatics. You want the intelligence but you like the… as well, can have real value for businesses and real value for investors if you can find them.
Common Investing Mistakes Based On Personality Type
Tobias Carlisle:
Yeah. I love the other part where you go through each personality type or investment type and then you say, “These are the common mistakes that each one makes.” So I’d like to go through that. Let’s start with value investors. What are the common mistakes that value guys do or that personality type makes?
Mark Simpson:
So I think with value investors, because they tend to be disagreeable, it can quickly go into stubbornness so there tends to be, you need an overwhelming amount of evidence to say that you’re wrong. Which means that value investors tend to average down too much. So I am an average down investor, I don’t see the moment that I buy something the world should suddenly love it and it should start going up again. It’s likely to keep going down because I’m buying something that’s already hated so it’s as likely to get more hated than is to turn around, but yeah. So value investors can be a little bit slow to realize, “Oh, no actually something has changed.” And to switch and say, “I’m going to sell here.” So things like at cost position limits. So the idea that you limit not just how much of your portfolio you put into a stock, but how much you put in at cost, it is very important for value investors.
Tobias Carlisle:
So just to expand on that, that means, say you’ve got a 5% position at inception and then it halves and then you re-up to 5%, before you do that, at the start of that process you should say, “I’m prepared to lose no more than whatever it is, 7% 10% whatever it is in this particular position.” So you can’t just keep on doubling as it goes down.
Mark Simpson:
Yes. Yeah, because you can have a 10% portfolio limit and quickly lose, 10, 20, 30% of your portfolio on that one stock because you keep just putting more and more into it.
Tobias Carlisle:
John Hempton has a great discussion. John Hempton, the OIC hedge fund, he’s best known for shorts, but he’s long short. He has a great discussion on his blog about just that exact. There’s this tension between the Paul Tudor Jones, Losers Average Losers and the really good value investors have made a lot of money if they’re right about the value and it goes down, the opportunity does get better, but you have to have some risk limits because the first supposition or proposition there is that you’ve got to be right about the value and these things can go down and sideways for a lot longer than you can.
Mark Simpson:
Yeah, I think he talks about maybe Bill Miller in that and I talk about that in my book as well as ALCA value investor who beat the S&P after costs for 15 years in a row. When they do studies on is success chunks or is it not, it always used to be Bill Miller that they picked out as the proof that there was skill, until in 2000… Well, it was in the financial crisis basically, he lost investors all his cumulative return over those 15 years and he did it because he kept averaging down on things like Washington Mutual. Yeah. I can’t remember whether it was that, but it was all the stuff that was bailed out in the financial crisis and you think… Essentially he was bailed out and I think he’s had a bit of a resurgence in the last few years because obviously he is a guy who knows his stuff, but that process of averaging down on the same leveraged stocks, and I think this is what Hempton says as well is, “Don’t average down if it’s leveraged or if there’s obsolescence risk, like Kodak.”
Tobias Carlisle:
I’ve even lost money in the Washington Mutual stub that had a whole lot of net operating losses. I managed to lose money. I didn’t lose it beforehand, but I lost it in the stub. So it’s got everybody that thing, geez. What about momentum investors, where do they make mistakes?
Mark Simpson:
So I think the momentum investor that probably again, position size can come to haunt them because the stuff that’s doing well becomes their biggest positions. And you have this tendency to start to like the things that make you money. So they can get caught by… If you’re a pure momentum investor, if the momentum fades, you should be selling, but you see a lot of momentum investors, they’re like the product of the thing. So I’ve seen people… Do you get Fever Tree in the U S, do you know what that is?
Tobias Carlisle:
No. We may have it in the U S.
Mark Simpson:
It’s a premium tonic water-
Tobias Carlisle:
Oh, yes. Sorry. We do have-
Mark Simpson:
And it did really well because it got ahead of this premium-ization process or trend. So no longer people didn’t want their Schweppes or the whatever the brand is in the U S they started to ask for Fever Tree, pubs started to stock it, it became this trend and it did really well, but people also became, “Well, I’m also a Fever Tree drinker of the tonic water. I prefer for Fever Tree.” So they’re making all this money on the stock and it’s going up, but they’re also going, “Yeah and I go and buy Fever Tree and I tweet pictures of me drinking Fever Tree,” and I’m sure there’s good investors out there who got out, but the route is that momentum doesn’t last forever and it’s very hard if you’ve identified as, “I am the Fever Tree investor and drinker of the products and I met the management,” maybe and you bought into the whole environment, it’s very hard to then sell, whereas the day the momentum turns, it reminds investor, “You should be out and you should be moving on to the next thing that does have positive momentum.”
Tobias Carlisle:
Is that’s true for growth investors as well, is that the common mistake that growth investors make?
Mark Simpson:
Yeah. It’s harder to define a specific personality trait for growth investors. The thing that I found probably most instructive was Henrik Cronqvist I think is a Swedish academic, did some research on twins. So he looked at how likely are identical and non-identical twins or what factors did it cause people to prefer growth investing to value investing. And there was definitely a genetic aspect. So if identical twins were more likely to be the same type of investor than non-identical twins. So interestingly your genetics plays a part. But the other one was people who have higher disposable income, greater social, have better jobs or better careers outside of investing are more likely to be growth investors and people who have lived in times of economic boom are more likely to be growth investors.
Mark Simpson:
And the common factor I could come up with was they all create optimism so it gives you the optimistic thing and in the book I talk about the issues with being overly optimistic and they tend to be that you fall for frauds, fads and failures. So I think that’s probably the biggest mistake that growth investors make is they’re just too optimistic about the future and they particularly have this thing of they all gloss over red flags that say, “Well, this isn’t a particularly strongly finance company or this management have committed frauds before, or a number of other.” Or they buy into fads, which quickly reverse.
Behavioral Biases And How To Overcome Them
Tobias Carlisle:
It’s very difficult because Ian Cassel, who we were talking about before, he’s done some analysis on, and this is quite common looking at how to hold those multibagger compounders over years and years and years. You do have to endure many of these gigantic drawdowns. Amazon famously has a 90% drawdown early on so I’m sure almost nobody has held it from IPO to date because of things like that. But equally you have to have that ability to recognize when it’s maybe got too far ahead of its… I honestly don’t know how to do that balancing that’s why I don’t do that, that’s why I’m a deep value guy because it makes sense to me and I frankly just cannot figure out how they do it, but I think it’s a nice segue into the weaknesses part of the book where you’re discussing the behavioral biases. So let’s just start with overconfidence and what is that and how do we overcome it?
Mark Simpson:
So most of us are overconfident. We believe that we are better at things than we actually are. If you go into room for all the people and ask them, “Hands up if you’re a better than average driver in this room,” 80% of the hands would go up, I think on average. And it’s natural to think that, to be confident in what you do, particularly if you’re experienced and you have specific knowledge and experience. One of the classic studies is I think a psychologist got, and this is like in the 1950s, so it’s been known for a long time, is ask other psychologists to do personality assessments on patients. And he gave them and they started off with a bare minimum of information in their file and then added more and more information. And the more information didn’t add any real extra ability for them to assess personalities.
Mark Simpson:
It’s very complex to judge somebody’s personality or neurosis or whatever from the information. So I think it started off at around 26% and they thought they’d got about maybe 30% right. At the end of the process when they’d been given all the information, their personality assessments had not improved in the accuracy at all, but they thought they were 50% confident in what they’d done. So all the extra information they’d done, and I think this is a real problem for investors because we tend to think, “Okay, the more research I do, the higher conviction I can have in that position. The more times I’ve met the management, I can go to 20 or 30% rather than my normal 10%.” And you add all this information and in reality, your judgment about the stock has not got any better, you’ve just become more and more confident in your own assessment and then something that was completely in their field. Take BP and the Macondo Well disaster, how many people foresaw a single well blow out was going to cost them $62 billion in fines and compensation?
Tobias Carlisle:
Is that what it came to finally?
Mark Simpson:
Yeah, that was the final figure.
Tobias Carlisle:
I had no idea it got as high as that, wow.
Mark Simpson:
If it wasn’t a super major, it would’ve put the company under basically any other company apart from Exxon or Shell, probably would’ve gone under for that level of damage.
Tobias Carlisle:
I was investing through that period and I remember that it’s sold off very sharply and Whitney Tilson went on television and said, “It’s overdone that they won’t be as big as this.” And I thought that’s probably right. Everybody does overestimate the scale of the crisis in the moment, but I had no idea that the final bill was 62 billion, maybe everybody panicked appropriately.
Mark Simpson:
Yes. Yeah. Except I guess the company did alright and survived and made the returns back. So even though it costs that much money, you look at long-term chart and it hasn’t really caused the damage you expect, but that is 62 billion that’s gone out of shareholders’ pockets and they’ve…
Tobias Carlisle:
In quantitative value we discussed two studies that are similar to the one that you discussed there. One is on horse race predictions and another one is on college football. So they asked some college students about college football, if they knew anything about it all and they said that they did. And then they had say 100 pieces of information and they randomized those pieces of information and they gave them 10 blocks of 10 bits of information about the games and so you got the first bit and you made your prediction on who was going to win and then you got the second bit and then you made a new prediction, but the person sitting to the left and right of you might get different information even though by the end, you all had the same information and people made different predictions and I think that the conclusion was that we anchor too much on the first bit of information that we get.
Tobias Carlisle:
So your decision was made on the first block and then everything after that was just you collecting for your, “I am right,” file to show that the decision was correct. So we don’t update our priors enough. And you talk a little bit about Bayesian probability in the book. I don’t know if it’s in this context, but that was the question I was going to ask you about the value investors. Is that a good approach for value investors, do you think to take some Bayesian approach where if your instinct is to get stuck into something and to dollar cost average down into it? In the case where you’re wrong, you’re finding this new information, you’ve got some probability, here’s your new bit of information, now you update it with your prior to have some process so if you get enough of these, eventually you’ve got some statistical reason for selling out of something.
Mark Simpson:
Yeah, I think it’s good if you can actually quantify those things. I think if you can do that, that’s great, but I think for the vast majority of investors that’s probably too complex a process to apply or certainly to actually apply the formula. I think with the Bayesian approach is these two factors that you really need to be aware of. The first is base rates matter. So if you are going to invest in IPOs, then knowing that the average IPO under-performs in the following 12 months, it is an important base rate and if you bought two successful IPOs and they did really well, your tendency is to forget the base rate that well actually most management IPO at the top.
Mark Simpson:
They’re the most knowledgeable people and they’re the most willing sellers. And there is exceptions to that. I think you get IPOs where management don’t take any money out and all the money goes back into the company to grow, but the average, particularly private equity salaries and things like that, they’re the knowledgeable investor and you’re the patsy usually in those situations.
Tobias Carlisle:
They do a big recapitalization and pay themselves a big fat dividend, load the company up with debt and then IPO. That’s the one you got to be careful with.
Mark Simpson:
Yeah. And then it goes bust by two years later and they buy [crosstalk 00:47:36] a few years later.
Tobias Carlisle:
Yeah, that’s a great trick.
Mark Simpson:
And then false positives, the other one is the idea that if you have an idea of what the… You have some signal that says this is a good buy, it doesn’t just matter how often that signals that it’s a good buy and it is a good buy, it also matters that the times it signals and it isn’t a good buy and having an idea of the false positive rates as well as the base rates gives you the… It’s very important in medicine and diagnostic tests, having a high false positive rate for something like Coronavirus really isn’t a good test because if you test thousands and thousands of people, you’re going to get a lot of false positives and thus will dwarf the real cases of Coronavirus and now you’ve got thousands and thousands of people in isolation or in hospital who don’t have the Coronavirus and taking up beds for people who are genuinely sick. So in medicine, false positives are a real challenge particularly when you get big screening of lots of people.
Rip Off The Band-Aid And Sell Those Losing Stocks
Tobias Carlisle:
What’s loss aversion?
Mark Simpson:
So loss aversion is a case where we just don’t like to take losses. And you see this in people’s portfolios, usually by a long tail of small positions that people just aren’t willing to sell. And everybody is lots of us. I don’t think there’s anybody out there who’s truly calibrated to not mind taking a loss. And the strategies that people use to deal with this, in the book I suggest that everybody should have a lower portfolio limit. So everybody should just say, “If this drops below, say 1% of my portfolio, I’m just going to sell.” And I’ve applied this to my own portfolio and it’s really hard. Other people have stopped losses, so they say, “Well, okay, if something drops 20%, I sell out,” and that’s a stop loss. So I don’t think that usually works very well for value investors.
Tobias Carlisle:
It’s statistically not well supported on an individual stock name and I don’t think it works for value investors too. I agree.
Mark Simpson:
So for some people, this is never an issue because they buy something, it goes down 20%, they sell, it’s gone, but for me as a value investor I either average down or in an ideal world, I either sell, I should be selling or averaging down, but what you find is you get these positions that you go, “Oh, I’m not confident enough really to put any fresh capital in, but Oh, I also don’t want to sell it.” And it’s a classic sign of, “I’m loss averse. I don’t want to take a definite loss.”
Mark Simpson:
And we tend to roll the dice. We like to say, “Rather than taking definite loss, I’ll roll the dice and hope something works out.” But of course, if something’s 0.2, 0.3% of my portfolio, it could double, it’s daily noise so why am I still holding this? Why am I spending my time and my energy to actually do this? And I either say, “This really is my best idea and I’m going to buy more or this is loss aversion, I’m just going to sell and cut it out.”
Tobias Carlisle:
Do you know, that’s funny. I’d never heard that idea before of a lower position limit, but about two weeks ago, Jake Taylor on our other podcast that I do with those two guys, he mentioned the same idea. I think it’s a really good idea. I don’t know if there’s any statistical support for it, but it’s a good one. Good behaviorally.
Mark Simpson:
Yes. Yeah. I think I know where Jake got that idea from.
Tobias Carlisle:
Where did he get it? Did it come from the book? There you go. Congrats.
Mark Simpson:
Because I went on his podcast and it’s one of the things-
Tobias Carlisle:
Ah, there we go. That’s great. That’s why you got to be careful man because ideas come back at you from lots of different angles even though there’s only one source. I was just like, “I’ve heard that idea twice. It must be good one.”
Mark Simpson:
I can now quote that, I’ve heard it on your podcast, on Jake’s podcast so therefore…
Tobias Carlisle:
Optimism bias. What’s that?
Mark Simpson:
So I think this is a more general case of overconfidence. So overconfidence is I am too optimistic about my own abilities and the things that I can control, whereas optimism bias is we just tend to be overly optimistic about everything. We think that the product of a company will be bigger than this, we’ll underestimate the amount of time it will take to develop and the amount of money it will take to market and it’s for good reason. If you’re an optimist, your typically more successful, more attractive, there’s lots of biological and-
Tobias Carlisle:
It’s pushed humanity forward for hundreds of thousands of years.
Mark Simpson:
Yeah. The guys who weren’t willing to leave their caves because they were scared. So the only people who aren’t overconfident are the clinically depressed. You don’t want to trade that off.
Tobias Carlisle:
They’re clearly assessing their risks.
Mark Simpson:
Yes.
Tobias Carlisle:
We should listen to them more.
Mark Simpson:
Yeah. So probably if you want a risk manager, get a clinically depressed risk manager too.
Tobias Carlisle:
Yeah, you got to be careful with the flamboyant risk managers.
Mark Simpson:
Yeah.
The Dunning–Kruger Effect And How It Applies To Investing
Tobias Carlisle:
I had a thought when you were talking before about the overconfidence bias, I don’t know if you have any discussion of Dunning-Kruger in the book, but the Dunning-Kruger… Do you have a discussion in there? What’s Dunning-Kruger? Let’s talk about Dunning-Kruger.
Mark Simpson:
I briefly mentioned it, I think because… So Dunning-Kruger is this idea that the skills required to assess competency are the same as the skills of competency themselves. So the truly incompetent are doubly cursed because they’re both truly incompetent and unable to see their own incompetence. So it’s why you get the guy in the office who everybody thinks is terrible, but he thinks he’s the best performer, the highest guy, everybody loves him. So it can be quite annoying in a work context, but as a portfolio context, it really is that thing, and I think I talk about it in relation to some of these behavioral biases. My theory is that you’re much better off making rules for your portfolio like a maximum portfolio or a minimum portfolio limit, then you are leaving it to your discretion. And the reason is Daniel Kahneman, who won the Nobel prize for all of his research in this area, they asked him “Has it improved your decision making?” And he said, “No, it’s just made me better at spotting the mistakes in other people.”
Tobias Carlisle:
That’s funny. I think that Dunning-Kruger also impacts in us that when you learn a new skill initially you think, “Well this is quite easy.” And then a little bit later you think, “No, this is insurmountably hard and I’m terrible at it and there’s no hope.” And then you gradually get better. So you’re just overcoming that part where you don’t know how bad you are, then you do know how bad you are and then you start getting better.
Mark Simpson:
Yeah. I think that probably mirrors a lot of people’s investing journeys because I’ve got a mathematical background. So when I first started investing, I could do the discount cash flows, I could do that stuff. So I do discount cash flows for things and then of course, something from that field that I haven’t seen at all would completely wipe out, the company and you look back at the files you created, these complex models and you’re just like, “What was I thinking?”
Mark Simpson:
I missed the wood for the trees and it’s that effect that you go through this investing of, “Oh, hey, I can do it. I can read Ben Graham and analyze a balance sheet or do a discount cash flow.” And then you go through the process of, “Oh, no it’s not enough to be good. I have to be better than everybody else. I need an edge.” And then you go through the process of making all these mistakes and trying to overcome those by trying harder and as I found, it just doesn’t work. You need the rule, you need the…
Tobias Carlisle:
Yeah. I couldn’t agree more. I agree with all of that. And I think that I’m like Daniel Kahneman I suffer probably more so to all of those things than everybody else and so it helps to have the rules there. And I was just thinking before about the loss aversion. I’m thinking of a particular stock in my portfolio that I’m dreading selling, but I know that I’m going to have to rebalance it out at some stage. I don’t want to mention it because I don’t want to give it too much more heat. There’s…
Mark Simpson:
Just do it. Rip the bandaid off.
How To Avoid Investment Fads, Frauds And Failures
Tobias Carlisle:
Oh, yeah. It’s out of my hands. So I’ve already handed that over to the system, so I don’t have it. I don’t get to make that decision anymore, thank God. I’d hold it. That’s my instinct, it’s to hold it. In the optimism bias context, you talk about fads, frauds and failures. So let’s talk about, how do you avoid fads?
Mark Simpson:
This might be controversial, but I don’t think you should necessarily avoid fads. Fads can be very profitable on the way up. They can be quite hard to spot, but I think there’s a couple of clues. The first one is single product companies. So I think I used the example of Crocs.
Tobias Carlisle:
That’s what I was thinking of, they’re coming back.
Mark Simpson:
Yeah. They come back in and it’s like, you think-
Tobias Carlisle:
They were a knit at one stage. You could’ve got them as a knit.
Mark Simpson:
Oh, really?
Tobias Carlisle:
Yeah.
Mark Simpson:
But when you’ve got one product you are massively exposed to these trends and also your advertising isn’t as effective. Whereas if you take a luxury goods company, you advertise Burberry and they could sell shoes or they could sell ties, anything that fits that brand, can sell well and the advertising adds value. Whereas Crocs, it’s like you either want a pair of Crocs or you don’t. And for a long time people wanted them for a long time people don’t-
Tobias Carlisle:
We feel very strongly about them both ways. That’s right.
Mark Simpson:
Yeah. I picked that because people have an emotional reaction to what they like.
Tobias Carlisle:
I have been to the UK a few times. The last time I was there, Burberry had a problem where the chavs, there was like this… Just explain to everybody what a chav is and what the problem was.
Mark Simpson:
So I guess the classic definition of a chav would be yes, somebody who is from a relatively poor background who probably has money to spend on quality goods.
Tobias Carlisle:
Very delicately done, you’ve diffused that bomb very well.
Mark Simpson:
But they’re probably not as discerning or they don’t have the background that somebody who has always purchased luxury goods has. So it tends to be an insult really. It’s something used for somebody who wears a certain style of clothing. And this is the issue Burberry had was they had a very unique check pattern that defined their clothes and then people of this demographic started wearing it. So then people of their more classic demographic stopped wearing it, but I think because they weren’t a single product company, they were okay because they still had the brand, they just had to lose the check pattern on everything. It was the check pattern that stood as being… You can think maybe Canada Goose might be an example of a fad that has now maybe become too popular that now people love to hate it rather than actually love it. This represents people who are showy and have, however much it is $500 to spend on a winter jacket that they’re everywhere in the city. Sorry.
Tobias Carlisle:
I think they’re seven or 800. I’ve been short Canada Goose goes for a few quarters now and full disclosure, so I’m 100% in agreement.
Mark Simpson:
There’s the deep value investor who’s never going to spend $800 on a jacket.
Tobias Carlisle:
I can’t do it either. And I lived in California, so there’s no need, but I still see them around, which just makes no sense at all.
Mark Simpson:
Yeah. Which is because people are using them as a status symbol and once people turn against that status symbol, the fads quickly ends, in my opinion. I guess we’ll see whether your short is successful in that.
Benford’s Law
Tobias Carlisle:
It’s working, but I’m always nervous about the shorts, they can always blow up in your face. In the discussion on frauds, you talk about Benford’s law. Just one of my favorite ways of identifying something that are a bit weird and I think you could’ve applied it to the DNC primary over here. That doesn’t even concern me, but I looked at the results just eyeballing the results and I thought that’s a really weird distribution and I bet if I applied Benford’s law to that I would find that someone had filled those results. But what is it?
Mark Simpson:
Oh, really. Yeah, so Benford’s law is this chap called Benford found that any series of numbers produced by a natural process tend to follow a certain distribution. So the number one is the most common digit followed by two going down through the numerals. So if you do a science experiment or you produce a set of accounts that are made up of lots of small accounting entries over the year, the numbers that are produced should follow Benford’s law so one should be the most common number and going down. So if you’ve made up a set of accounts, so this is not your earnings manipulation, but guys who just completely made up the numbers and people tend to think that certain numbers are more random than others, like three and a seven. And I know they’re not, but I still have this feeling that-
Tobias Carlisle:
Well, it’s because they’re not numbers. So even numbers don’t feel random and they’re not the one or the 10, which are both the ends of the distribution. It’s not five because that’s the middle so that only leaves you with threes and sevens.
Mark Simpson:
Yeah. And it’s like if you ask somebody to pick a random number between 100, people pick 37 or 73 because they feel I’m left right.
Tobias Carlisle:
It’s the most random number.
Mark Simpson:
They’re the most random numbers because they’re prime numbers.
Tobias Carlisle:
Do you think that they know that they’re prime, off the top of their head?
Mark Simpson:
Well, yeah. Maybe they just feel it, but there’s definitely that aspect. And the other aspect that people don’t like when making up accounts is they don’t like to put a zero on the end. Feels too precise. It feels like if you made exact numbers, you are trying to show that you’ve made the exact numbers so therefore people are going to say, “Well, you just made up that number.” So they under-use the zero as a trailing digit. It’s a second level thinking thing that catches people out as well.
Tobias Carlisle:
And in terms of identifying failures, what do you recommend there?
Mark Simpson:
So for me it’s pretty much balance sheet strength. So all the evidence of this stuff is found on the balance sheet. So the classic one is just to look at the current ratio or the quick ratio. There’s a guy called Paul Allen who’s a accounting professor and wrote a book called Choose Stocks Wisely, again, a deep value guy. And he takes an adjusted current ratio. So he takes all the current assets apart from cash and says, “I’m going to take 0.8 of those.” He’s giving us fire sale or-
Tobias Carlisle:
It’s the grand discounted net current in asset value approach.
Mark Simpson:
Yeah, except he’s using it for just testing of balance sheet strength rather than yeah. His theory is you want a company that’s strongly capitalized in the short-term that they can survive the turnaround and the effect of… So I think that’s a classic one. You then go into the more metrics that people have produced. I think the Altman Z is the classic one and that’s been updated. I think Black-Scholes-Merton fame treated the equity as an option on the assets or something like that and he came up with a formula as well. And… like Olson and then Campbell… I’m going to get this wrong. Hillshire and… or something like that. I think produced the latest one and they all either have a threshold and the easiest thing is you get these from a data provider, whatever you use to screen your stocks or whatever, you use those. What did you use in quantitative value, was it Olson?
Tobias Carlisle:
We used a few. What we found was interesting at a universe level, excluding the 5% that are the worst on Olson’s, Altman and I think we might’ve used some earnings manipulation type measures as well. So we used to stress earnings manipulations, statistical fraud and I still do this because I do think this is a good approach. If you exclude those stocks from the universe, you get a couple of percent of better performance out of the entire universe.
Tobias Carlisle:
The funny thing is that if you’re already a value guy and you’re looking for these cash rich balance sheets and strong earnings, you don’t really find yourself excluding very many companies from that list because you’re already looking for those better quality things, but I still do it as a step just in case something slides through into there. And the other thing I always look for is just a divergence between the reported earnings and the cash flow. The accrual that builds over time is a pretty good indicator that there’s some shenanigans because you don’t really necessarily, you rarely find earnings manipulation or fraud in a company that’s going really well because they don’t need to do it. So all that stuff turns up in distress.
Mark Simpson:
Yeah. Interesting you say that though. The Beneish… There’s certain factors that yeah… So he splits into two. He looks at what type of companies are likely to be earnings manipulators and then he looks at, well what are the signs of earnings manipulation? So obviously the signs of the earnings manipulations are the increasing accruals, some of those other balance sheet entries, but the things that the type of companies actually tend to be the fast growing ones because and there’s an interesting theory on this from a guy called Dan Davies who wrote a book called Lying for Money, which is about the types of frauds you get.
Mark Simpson:
And his theory is if you’ve got a fraud, you’ve got almost two sets of books. You’ve got the real set of books and you’ve got the fake set of books and both have to grow. So you’ve got two things that are compounding so anything that grows unusually rapidly, you have to investigate. So it can be the distressed companies that have an incentive and obviously are going to miss banking covenants or declining gross margin and things like that are all I think declining gross margin is one of the Beniesh tests as well. Those things are in there, but interestingly, rapid growth is one of the signs.
Tobias Carlisle:
Yeah. That is interesting. That’s funny that John Hempton pointed this out to me a long time ago, that one of the things that you look for is an unusually large asset that just shouldn’t be there. So Parmalat which was the milk company that went under, they had $1 billion in cash. So they said in this bank, and the auditor sent the junior audit employee to the bank to get the letter. The bank said, “Yeah, they’ve got the billion dollars here,” but the bank was it on the fraud too, which just shows how hard it is to prove. The reason they asked was because they were missing some debt payments of why they have $1 billion here and you’re paying your debt over here.
Mark Simpson:
Yeah. That was a classic in one of the examples given in the book of a UK company called Globo, is that they claimed they had 100 million euros of cash and 50 million euros of debt and they were trying to raise U S dominated bond at 10% yield or something like that. And it was clear there was something going on there. Yeah.
Tobias Carlisle:
It’s funny as we’re talking about this, Musk has said on the last earnings call that they don’t need any capital and they’ve just raised 2 billion or they said they’re about to raise $2 billion in capital.
Mark Simpson:
Well, with the price, he’s stupid if he isn’t… Well, I’m going to be careful what I say here, but if you’re going to keep the game going, then you need capital and you’ve got to raise it when-
Creating And Maintaining Optimal Portfolios
Tobias Carlisle:
They’re also potentially perfectly innocent excuses too, like when the stock price is high, I’m going to raise capital. If I was running a business, that’s what I’d be doing. When the stock price is low, I’m going to buy back stock. We’re coming right up on time, but I just want to discuss just really quickly optimal portfolios creating and maintaining. I know that’s a big chunk of the book, but just give us a flavor of what’s in there.
Mark Simpson:
Yeah. There’s obviously how you weight stocks in your portfolio is one of the big questions that most advanced investors face. And I’m going to be slightly controversial because I know we’re thinking equal weight. Is that right?
Tobias Carlisle:
I do for ease, but yeah, it can go.
Mark Simpson:
So I have an issue with equal weight investing is. I think it’s fine if you hold 100, 200 stocks, you’re a bit more of a quantity investor with a little bit of additional checks and things like that because you’re not really saying… Or if you buy 50 stocks with discounts, tangible book, you can’t really say that this company on 0.3 is better than this company on 0.4. In those situations I get that probably equal weighting is better, but people who have 20, 30, 40 stock portfolios, when you’re equal weighting, you’re so sure about what is in that portfolio, you’ve looked at the universe of stocks and you’ve said, “These 20 are in and these however many thousands are out, but I have no idea which of these 20s is any better or worse than the others.”
Tobias Carlisle:
So you advocate for Kelly in that scenario or some loose Kelly?
Mark Simpson:
Yeah. If you can apply some additional weighting, you will do better. If you can say, “Okay, this is a better idea.” And the other one is that people often forget and the idea of Kelly is that you’re weighting proportion to your edge divided by your odds and the more upside you have, the higher position you hold. And I think a lot of investors naturally think that way. What they often forget is the higher risk this stock is, the less you should hold. So I favor using the two functions together and I don’t think, unless you’re a conceive hedge fund, you probably shouldn’t be using the actual formula to guide your position.
Tobias Carlisle:
Kelly’s the outer limit of how much you should put into a position in anything under that fractional Kelly is perfectly fine.
Mark Simpson:
And knowing that you’re overconfident as well means that you’re much more likely to over-bet, which gives you significant risk of wipe out with Kelly. So what I advocate is people put them, have large positions which are in stocks that they consider low risk and high reward or high upside. And these are the Dhandho investors, this is Mohnish Pabrai’s idea that you pick the high reward, low risk stocks. Where I differ from Pabrai is and he spends a lot of time in cash, if I remember correctly, because he can’t find these stocks. Whereas I advocate, yes, you can own a company that’s high risk and high reward, but you only have a small amount of your portfolio in that position and that’s what Kelly says.
Tobias Carlisle:
It’s also true to Kelly.
Mark Simpson:
Yeah. Kelly doesn’t say don’t invest in these things and I know Pabrai uses Kelly in that, but he sticks at that and then he equal-weights within his portfolio, which again says he’s so certain that these 10 stocks are in and so uncertain that anything that drops off is not in. I think for most investors, this will be a way that adds value, is easy to implement and should increase your risk adjusted returns if you have the ability to assess risk and potential return.
Tobias Carlisle:
I think it’s a pretty well accepted marker that an investor has skill that their own portfolio outperforms the equal weight version of the portfolio. So Carl Icahn famously has a portfolio that outperforms the equal weight version of his own portfolio. The counter argument because I feel like I should defend myself a little bit.
Mark Simpson:
Yeah, go for it.
Tobias Carlisle:
If your universe is 1,500 stocks and you’re holding 30 long, you’re already down to like 0.2% of the universe and so then at that level… I know this is Joel Greenblatt’s saying it, he just says it’s very hard to distinguish sometimes between those stocks, he may have some false precision in there and there’s a great rejoinder. Ed Thorp went to a Value Investing Congress in Pasadena and heard Pabrai giving a talk and said, “Everybody at this conference is now a value investor and they’re all using Kelly.” Ed Thorp wrote this mathematical proof showing why you shouldn’t use Kelly or why you should be…
Tobias Carlisle:
Sorry, I take that back. He’s not saying don’t use Kelly, he’s saying basically size down your positions if you’re using Kelly. And he says it doesn’t account for black swans. And the other thing that Kelly does, it’s used in series when you’re playing blackjack rather than in parallel where you have all of the positions in so you could potentially have a position that should be 51% of your portfolio and if you have two positions at the same time, it would be 51% and both go to zero, that would violate Kelly’s never risk ruin dictum.
Tobias Carlisle:
So he says if you’re being honest about the construction of that portfolio, you find every positive expectation bet in the universe, which might include gilts, it might include treasuries, and if you look at them all and you size them all down appropriately so that nothing in the portfolio risks ruin, then that should be the sizing that you should adopt in your own portfolio and so I think if you do that, it still falls out. I found it’s computationally difficult to do, but you can go through this process and you can see that the position sizes tend to be a lot smaller than everybody expects and it falls out around even for a pretty high conviction position around three or 4%, which is how I run my portfolio. Anyway. That’s the way I get it.
Mark Simpson:
Yeah, I would say that my caution there is, I’m combining this with portfolio limits that reflect that people are overconfident and those black swan things. So again, even the things I think are very low risk and very high reward, in my own portfolio, I’m limiting to maybe say 10%. I’m not going and I think that-
Tobias Carlisle:
That’s not a perfect style 40% of the portfolio.
Mark Simpson:
I think I give the example in the book that I think even Buffet was overconfident. I think with the Dempster Mill where he had maybe 30% of his portfolio, he later said hiring Harry Bottle, the manager that turned it round, that changed the course of his life and I don’t really want to be in a position where any one investment decision changes the course of my life at least for the worst.
Tobias Carlisle:
Yeah. That’s a great sentiment to end on. Mark, if folks are looking for a way to get in contact with you, how do they do that?
Mark Simpson:
Yeah. So I’m on Twitter @DangerCapital, or people can email me, mark@excellentinvesting.org.
Tobias Carlisle:
And the name of the book is Excellent Investing: How to Build a Winning Portfolio. That’s the book that Mark very kindly sent through to me and I enjoyed it a great deal. Thoroughly recommend it. Mark Simpson, thank you very much.
Mark Simpson:
Thanks, Toby.
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