In their latest episode of the VALUE: After Hours Podcast, Tobias Carlisle, Jake Taylor, and Luca Dellanna discuss:
- Ergodicity in Action: A Story of Ski Racing and Investment
- Value Investing and Ergodicity: A Framework for Long-Term Success
- Understanding Reproducible Strategies in Investment
- Why Society Needs More ‘Elon Musks’ with Better Risk Management
- How Often Should You Check Your Investments?
- Why Maximizing Chances of Success Beats High Returns in Investing
- The Importance of Learning from Others’ Failures
- Why Risk Management is Like Car Brakes: Enabling Speed and Safety
- Why Betting Less Can Lead to Greater Investment Success
- The Importance of Analyzing Near Misses in Risk Management
- Why Fund Managers Need to Educate Clients with Stories
- Understanding Risk in Long-Term Games: Why Multiple Winners Matter
You can find out more about the VALUE: After Hours Podcast here – VALUE: After Hours Podcast. You can also listen to the podcast on your favorite podcast platforms here:
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Transcript
Tobias: This meeting is being livestreamed. That means it’s Value: After Hours. We’re back.
Jake: We’re back, baby.
Tobias: I’m Tobias Carlisle joined by my cohost, as always, Jake Taylor. Extra special call today. We’ve got a special guest, Luca Dellanna, author of Ergodicity-
Luca: Thank you so much for having me.
Tobias: [laughs] -and a brand-new book, Winning Long-Term Games. We’re going to talk about both of those in a moment. But where are you calling in from, Luca?
Luca: I’m calling from Italy, from Turin.
Tobias: Yeah. That sounds really nice. Is it summer in Italy right now?
Luca: Yeah, summer. Very hot, very long days. Nice time.
Tobias: And what’s Turin known for?
Luca: We’re known for automotives. So, Fiat was born here and then wine.
Tobias: Fiat?
Luca: Fiat, the car.
Tobias: Oh, Fiat.
Luca: Yeah, the automotive company. Then great wine, great food. Yeah. Not very touristic city. So, lovely to visit.
Tobias: The anchovies you were showing me before, are they local or are they imported?
Luca: So, actually, we don’t touch the sea, which is very weird. But we use these anchovies to make garlic sauce that tastes wonderful and smells horrible, but it’s the local specialty.
Jake: What’s the name of that sauce?
Luca: Bagna càuda.
Jake: I’ll never remember that. [laughs]
Luca: Yeah. So, here, you have the anchovies.
Tobias: There we go.
Jake: Beautiful.
Tobias: [crosstalk] the one’s I love. Luca, we’ve read Ergodicity a few years ago. JT and I have discussed it on the show a few times, because we’re huge fans of that idea. It’s an extremely difficult idea to articulate to people. I said to you when we met in Omaha, “How do you describe Ergodicity to someone?” And you said, “I don’t,” which I thought was a great answer. [chuckles]
Jake: Yeah. [laughs]
Tobias: Why don’t you explain it for the folks at home?
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Ergodicity in Action: A Story of Ski Racing and Investment
Luca: Yeah. So, the trick is to avoid defining it and make an example first. Because when people hear the story, they understand it immediately. And in the book, I’m talking about the story of my cousin, who was a great skier since very, very young age. He made it even to the World Championship for his age bracket. But then, sadly, one leg injury after the other, he had to quit professional skiing before he even turned 18.
From him, I’ve learned a lesson, that it is not the fastest skier who wins the race, but the fastest skier amongst those who make it to the finish line. [Tobias laughs] Here, I’m not making the banal point that survival matters for performance, but I’m showing that it matters more than performance, especially over the long-term. And so, I’m bringing this numerical example, which is a very quick riddle. It goes like this.
Imagine that my cousin is a very good skier. He participates in a ski championship consisting of 10 races. My cousin, excellent skier, he has a 20% chance of winning each race, but he also takes a lot of risks, so he has a 20% chance of breaking his leg in each race. The question is, how many races is he expected to win over a championship of 10 races? The naive answer is two races. Because we think 10 races, 20% chances of winning each, 10 times 20% makes 2. However, if you crunch the numbers, you get to only 0.71. This big difference between 2 and 0.71 is due to the fact that if my cousin breaks his leg in one race, not only he loses that race but also all the following ones, because he cannot participate to that.
So, this is the principle that irreversibility absorbs future gains. We see this in skiing, we see it investing. If you have $1,000 and you lose 50%, not only you lost $500 but you also lost all the future gains that those $500 could have produced. This principle that irreversibility absorbs future gains is the core of Ergodicity. In particular, we say that when a context is ergodic, there is non-irreversibility, we call it ergodic, and you can use averages. But in most of the real world, if not in all of the real world, losses are irreversible, which means that you cannot use averages, you cannot rely on averages, and these are contexts that we call non-ergodic.
Jake: Beautiful. That’s surprising. I think it’s probably one of the least appreciated concepts and yet most important to understand in the financial world.
Luca: Yeah, exactly. I think that it’s terrible that it has such a bad name. The name ergodicity is terrible to-
Jake: Yeah, the marketing team.
Luca: -understand. To market.
Jake: It’s getting fired for sure on that.
Luca: [laughs] Exactly. And then the problem is that everyone tries either to define it or to explain in mathematical terms, which is terrible idea, to get the idea understood. What I did in the book was that I had two constraints for myself. The first one, I won’t use any mathematics at all. And the second one, I will not define the concept until we get in the second– Oh, my God, what’s happening? until we get into the–
[laughter]Luca: Sorry. Until we get into the second half of the book. Yeah.
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Tobias: One of the things I found most interesting when we were talking in Omaha was that you said is you’re a mechanical engineer by training, and your background is in manufacturing and production, and not really anything at all to do with finance. How do these ideas apply in a manufacturing context?
Jake: Is this a manufacturing podcast now, Toby? I didn’t know.
Tobias: It is now.
[laughter]Luca: No. Actually, you don’t really hear the word ergodicity in manufacturing other than for some very, very specific physical processes. The good thing about having worked a lot in operations and manufacturing is that you really understand a lot of things about the real world and about risk. There especially no one really cares about the formulas or everything, because you get immediate, actual feedback. Yeah, and that helped me a lot about– I almost never use mathematics to think about risks, and you always think about it from much more of a real-world perspective.
Tobias: You had an endorsement on ergodicity from Nassim Taleb. How did you get in contact with Taleb?
Luca: No, I did not.
Tobias: Oh, you did not?
Luca: No. So, he endorsed the idea many times, saying that the idea is extremely important. Actually, I learned about the idea from him, and then I started reading about it, and then I’ve seen there was nothing practical and simple talking about it. And so, that’s why I wrote the book, because I was reading it. That’s fantastic, but it took me so much to understand, because everyone was talking about it in a mathematical way. And so, I will write about it, yeah, a book.
Tobias: Well, I found it interesting that Taleb writes about it some– He’s writing about from the short side. He’s imagining that there’s a point in time where the event comes to fruition, and then he profits when the market goes down just by the nature of the strategy that he runs. But I think you think about it from the other side, you’re thinking about how to survive those events. I think that’s what Winning-Long-Term-Games is a little bit more about. Do you want to talk about Winning-Long-Term-Games a little bit?
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Why Risk Management is Like Car Brakes: Enabling Speed and Safety
Luca: Yeah. So, Taleb here is a great example, because his fund, Universa– Spitznagel, they have this, they gained a reputation because of their tail risk hedging, which is making money when things go terrible. But actually, their funds are long and they actually are not bearish on the market. They’re just, “We protect ourselves from the worst possible case, so that we can take more risk and profit more.” That’s the concept that risk management is like car brakes.
In cars, the brakes are not to go slow, but they are to enable going fast. The person who puts brakes on their car, they don’t do it because they want to go slow. They do it so that they can go fast without crashing. The same applies to risk management, the same applies to ergodicity. You understand it not because you want to survive, Of course, because of that. But because you want to gain as much as possible without sacrificing the risk of survival.
The book, Winning-Long-Term-Games, which is the title of my most recent book, is about the same thing. So, during the first couple of chapters, I’m explaining how adopting a long-term focus gives you more chances of winning. I make this example to understand, which is imagine that the devil comes to you and he asks you to pay $1 million, and you don’t have that million today. You’re not a millionaire. You’re a normal person. And the devil asks you to pay $1 million, otherwise he will kill you and your family. He asks you to pay it by tomorrow. You only have terrible options. What do you do? You sell your kidney, you take whatever you have, and you go to the casino and you bet it on 36, the roulette, terrible options.
Jake: Zero-day expiry. Just kidding. [laughs]
Luca: Yeah, exactly. Now imagine that the devil gives you two years. Now your options are better. They’re still not great, but you have better options. Maybe you work super hard on a startup or something like that. Now imagine that the devil gives you 20 years to come up with the million. Now you have great options, and maybe you don’t even need to sacrifice your life and maybe the pressure even makes your life better. You work very hard, but you work still a good job, a good conditions. You are quite safe. If you choose the right job, you can become a millionaire in 20 years and so on.
So, the principle is that by enlarging your time horizon, you get better options. So, people always tell me, “Luca, playing the long-term games means delaying gratification.” That’s the opposite. By playing long-term games, you can enable gratification right now, because if I am here for my job for the next 20 years, I can have good relationships, I don’t feel the pressure to sell very hard today, which may lead to me working super long hours or lying to people or feeling stressed and it enables me to enjoy life and so on.
So, long-term games is not delaying gratification. It is just delaying comparison. Because the moment that you take actions which are optimal for a five-year time horizon, for a 20-year time horizon, what happens is that you start seeing people with a short-term time horizon, that today they seem like they’re growing faster. You need to resist the temptation, because they grow faster today, but they will very soon hit a plateau and they will not be able to grow faster.
I see it all the time on my job with managers, for example. You get long-term managers who spend time training their people, and you get short-term managers who never train their people, because every week, there is something more urgent to do. What happens is that if you measure their production over one-month, short-term managers get more done, because they don’t waste time on anything else than production. However, those managers, they are unable to grow up above a certain time, they produce more this month, but that’s the maximum that they can produce.
Whereas conversely, the long-term managers, they produce a bit less today because they train their people, but that enables them to grow much more. I see this in investing. investors with a longer-term horizon, they will have lower one-year results, but larger 5 and 10 years result.
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Understanding Reproducible Strategies in Investment
Jake: So, my segment this week, Toby, is asking Luca questions about the book. So, maybe I’ll keep going in this thread. How does this relate then to the reproducible strategies then? Because I think that’s a big part of it. I think we often look at one single person and how they do, and then we’re like, “Oh, that’s how I should do to be successful.” But is that actually a reproducible strategy?
Luca: Yeah, exactly. I always make the example of the casino croupier, who is the only person at the gambling tables with a money-making strategy. Everyone else who goes to the casino, on average, they lose money. However, every night, the casino croupier sees at least one player getting way richer than him. But he must resist the temptation to switch from his good money-making strategy to the money losing strategy of the players. And the same applies to investing.
Jake: Or, maybe you could talk Luca about hindsight gerrymandering then also, that’s related.
Luca: Yeah. So, I just finished the topic of reproducibility. So, the idea is of course, you don’t want to imitate bad strategies, you only want to imitate good strategies. But of the good strategies, you should ask yourself, which are reproducible and which are not reproducible and don’t limit the reproducible ones. Reproducible means if you use it, good things will happen to you, which is not the case, for example, of playing the roulette. Yeah, I talk about hindsight, the hindsight of gerrymandering. It’s the reason why, even though we understand this concept, we still play non-reproducible strategies.
It works like this. let’s imagine that me, you and Tobias, we go at the casino tonight and we all play roulette, but each with a different strategy. I always put money on the red. Jake, you always put money on odd numbers. And Tobias, you always put money on the last number that won. Let’s imagine, for example, I lose money, and Tobias loses money and Jake makes money.
Jake: Now we’re talking.
Luca: Now, there is the lesson that we should get. The lesson that reason teaches us is that going to the casino is a terrible idea for investing. But what happens is that a lot of us, instead, we think going to the casino is a terrible idea unless you use Jake’s strategy of playing always on the odd numbers. Now, in this example, it’s obvious that it’s not like this, because we all know that the roulette at the casino is a pure luck.
But now, let’s make the same example about stocks. Let’s imagine we all invest in stocks and I pick Korean stocks, and Jake picks stocks with a [unintelligible [00:17:36] below 30 years old and Tobias picks, I don’t know, stocks with high diversity in the board. Then we discovered at this time, the one who made the most money is Tobias. It’s very easy to think that the reason he may to think there is a big alpha in investing into stocks with a very diverse board.
The question is always, how much of our strategy is based on bottom-up thinking, like first principles thinking, and how much is based on hindsight? It is not a rule, because sometimes with hindsight, you get a very good rule which makes sense from first principles, you discover something, but in general, you want to heavily discount strategies which are fully based on hindsight, and they do not have a history of reproducing over a long time.
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Jake: One thing you had was– Oh, sorry. Go ahead, TC.
Tobias: No, you go because I’m going to do a shoutout [crosstalk]
Jake: Do you want to just get that over with?
Tobias: Yeah, let me do that. Let me do that first– [crosstalk]
Jake: I can see you’re a little antsy.
[laughter]Tobias: Santo Domingo. So, Luca, we always give a shoutout to everybody who puts their location into the chat. Santo Domingo, Dominican Republic. Danny Beltran, how are you? Gothenburg, Sweden. That’s a good one. Toronto. Miami. Savonlinna, Finland. Valparaiso. How are you, Mac? Porto de Mós, Leiria Portugal. Sounds good. Lewes Delaware. Tomball, Texas. Toronto. Riyadh, Saudi Arabia. What’s up? Nashville, Tennessee. Wildwood Crest, New Jersey. Lewes, Delaware. Brandon. Bethany Beach. Melbourne. Got some early stuff for you. Camas. Saskatchewan. Edinburgh.
Jake: Sounded out.
Tobias: [laughs] Yeah. Well, you tell me how to say. Edinburgh. Scotland. Jupiter, Mendocino. What’s up? Thanks, everybody, for joining us. Back to you, JT.
Jake: Okay.
Tobias: And Turin.
Jake: Ah, Turin as well.
Luca: [laughs] Thank you.
Tobias: Los Angeles and Sacramento.
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Why Maximizing Chances of Success Beats High Returns in Investing
Jake: So, I think one of the things I really liked also was that you talked about there’s three different ways to optimize for your long-term objective. The number one being maximizing the best-case scenario. So, that would be like the top end, like, “I just want to be the wealthiest person in the world,” maybe that’s your– Then there’s the second. Achieve your objective as quickly or efficiently as possible. So, that’s like getting there the fastest. And then the third one, which is maximizing your chances of achieving your goal. So, it’s giving you the best odds. What do you think that that means then for investing?
Luca: Yeah. So, just a clarification. I’m not advocating for the first two. I’m just saying that there are three possibilities of you of optimizing a goal. I am strongly for the third one, which is optimizing your chances of success. That’s because, for investing, we very often try to optimize our average returns. But that’s hard to do up to a certain point, because there are some very basic things that you can do that brings you from average to a bit better than average. But then the more you try to gain over that, the more the strategy becomes worse, in the sense that you need to take more risk for a lower additional return.
Instead, what I suggest is to always optimize first the chances that you are successful in 100% of the cases. Only on top of that, you try to optimize your returns. Let me make an example to explain this, because it’s always better to talk with examples. I had a conversation some time ago with someone who manages wealth for some wealthy people. One of his clients was a software developer who had most of his wealth invested in stock options in the company that he works for. He was very reticent to diversify. His argument was, because my company has a very, very good chance of becoming one of the next big things, and I don’t know any other way in which I could invest my money that has a better expected average return.
The problem with this thinking is that this thinking, maybe he’s correct that it maximizes his average expected wealth. However, it leaves a big hole. The hole is that maybe his company only has a 50% chance of becoming the next Google or the next Facebook. The question is, what happens to the other 50% of cases? Is he wealthy enough, so that he’s still a multimillionaire, or does he lose most of his wealth? If the answer is, he loses most of his wealth, I don’t really care about what’s the average expected wealth. What I care about is that there is a 50% or a 20% chance in which he’s unhappy.
The question is, instead, what do you do if you want to maximize the number of parallel worlds in which you’re happy? The answer is, you take a part of your stock in the company and you diversify it, even if it has a lower expected return, because you will lower the expected return, but you increase the number of chances that you have of being happy. This, I think it’s a very important mindset switch.
For me, it’s not being conservative. It’s actually being aggressive. You’re just being aggressive on another dimension. You’re being aggressive on maximizing the chances of success. Then it doesn’t mean that you play it overly safe, because you only want to diversify up to the point in which you achieve 100% or 99% chances of being happy. Anything above that is maybe overkill, and then it means you can take– Once you get to this 99%, you can start thinking about how to maximize return. But try to get to that 99% chances first.
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Why Betting Less Can Lead to Greater Investment Success
Tobias: Luca, are you familiar with any bet sizing theory like Kelly theory, the Kelly Criterion? Have you ever encountered that?
Luca: Yeah. So, Kelly Criterion, which– Well, I imagine that most listeners are familiar with. But if you’re not familiar, let’s call it an algorithm that helps you decide how much to bet on a given bet on a stock, on a project, something like that. It’s interesting, because in a world in which you know all the information and so you can put all the right variables inside the formula, Kelly is optimal. This criterion is optimal. But in the real world, there is uncertainty on the values that you give to the variables that you put in the formula. Because of that uncertainty, Kelly will do bad things for you. I think it was Harry Crane who said something along the lines also, “Kelly will lose you the most money the moment where it looks like you have the best bet.”
Tobias: Yeah.
Luca: Or, something along those lines. I think that’s something very important that investors need to know about it. Harry Crane wrote a beautiful article, which I think that you can google it if you write something like Kelly Criterion or St. Petersburg’s paradox in the same query. But basically, it tells you that you should– that because of the uncertainty, you should discount the bets a lot. So, if Kelly tells you to bet $100, you should only bet $20, because that way you can afford to make more bets, which has two benefits.
One is that, if you lose money, you want to lose that much money, and it’s easier to get back on track. But perhaps more importantly, it makes it so that if you discover that the value you thought the variables have were actually wrong, like you made some wrong assumption, you discover it. It’s cheap to make the discovery, because you lose little money to discover that. Whereas if you bet with what Kelly will suggest you, you almost get bankrupt by the time you discover that you didn’t have the good information that you thought you had.
Jake: It’s probably, especially true when the data is non-stationary, like the real-world. Like, roll of the dice is never– It’s always going to be come up with one through six. But in the real world, you’re looking backwards and to plug in your assessment of what the odds are of winning or losing, and that is not necessarily a continuous data set that is always going to represent the future.
Luca: Yeah, exactly. This principle about betting less because of uncertainty is another idea of why it’s so important of playing long-term games. Because if you have a long-term focus, you can afford to make smaller bets. It will take you a bit more time to get rich, but it will be safer and you’re more likely to get rich. Whereas if you are pressed because you want to get rich as fast as possible, you will oversize your bets and you will increase your chances of getting something wrong and getting a loss that is hard to recover from.
Tobias: I think it was you who had written something about ergodicity and Kelley Criterion. Just pointing out, I think that if everybody imagines that if you apply Kelly, Kelly’s trying to find that log optimal wealth over a period of whatever it is, and it’s used in series rather than parallel, which is most of the time in the real world, you’ve got multiple bets on at the same time. I think that you make the point that you can have one winner who accumulates all of the wealth. The average wealth-
Jake: Looks pretty good.
Tobias: -looks good across the group. Every other player can have less or below average.
Luca: Yeah, exactly. In the winning long-term, I make this example with around simulation, I have 100 people, let’s call them Alice, who use an aggressive strategy and 100 people, let’s call Bob, who use a more conservative strategy. Here, I’m not using Kelly Criterions, but I think that the result would be the same if Alice’s use the aggressive Kelly Criterion and Bob uses the conservative version.
What happens if you run this simulation and you look what happens after some years? You notice a very interesting thing, that the richest person is always an Alice, because they are the most aggressive. So, survivorship bias means that there will be at least one Alice who gets most things right and ends up super rich.
If you make one of those terrible rankings, such as the top 10 wealthiest persons, people, they will all be Alice’s. However, if you look at the average wealth, the average Bob is way richer than the average Alice, which means that for you, while you are one person and you do not care about what happens at the population level, you should get Bob strategy. That’s so much better for you. But it’s very hard to take a Bob strategy when you look at the winner. All the winners, they look like Alice’s. But if you use Alice’s strategy, the chances is that you will end up much worse than if you have Bob.
Tobias: I love that.
Luca: This is such an important concept to understand.
Tobias: That’s an amazing illustration of an incredibly subtle point. Yeah, I love that.
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Why Society Needs More ‘Elon Musks’ with Better Risk Management
Jake: I wondered if reading biographies might have some problematic nature to it, because biographies are all Alice’s. No one’s reading Bob’s biography. So, you’re looking for lessons and you’re reading about Alice, and maybe that’s [chuckles] not a reproducible strategy.
Tobias: Yeah.
Luca: Yeah, exactly. One question that I always get after the Alice and Bob example is, “Luca, but Elon Musk uses an Alice strategy?” And I’m like, “Yes.” And then they say– Without taking anything from his skills and hard work, because obviously he’s extremely skilled and extremely hard work. And then the people, they tell me, “Luca, but Elon Musk is good for society, and we need more people like Elon Musk.” Absolutely. Why are there so few people like Elon Musk? Because they are bad at managing risks. They were 10% better at managing risk, we would have more Elon Musks, not fewer. I think this is extremely important concept for people to grasp.
Jake: Yeah. What do you think about that, Luca, from a societal standpoint? Same thing with biology, where there’s an optimization, sometimes at the genetic level, individual level, but then there can also be group selection level. Do you think that same thing holds true for Alice and Bob strategies, where we need people out on the front edge, on the bleeding edge crashing to make progress, or is that not a good setup of the problem?
Luca: We need people taking risks. We do not need them crashing. [Tobias laughs] It’s like saying, “Luca, should I drive fast, or should I drive slow?” They are not on the opposite side. Of course, you should drive fast. But within driving faster, there is driving recklessly and driving fast but sustainably. We want people to drive fast and sustainably. We do not want to drive recklessly, because driving faster than fast becomes counterproductive.
This is, again, the thing. We need more Elon Musks. We need people that take the kind of risk that Elon Musk takes that are not reckless, and we need them to stop at the point of recklessness and do not do over the recklessness, so that their risky bets are more likely to succeed. So, yes, we want people like Elon Musk starting companies, taking risks, but we want them to do it with that modicum of risk management which enables the risky bets to succeed. That’s what we want them to.
Jake: Not committing securities fraud or things like that?
Luca: Yeah.
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The Importance of Analyzing Near Misses in Risk Management
Tobias: How does an individual apply that idea? How do they know when they’re taking too much risk?
Luca: Yeah. So, Jake earlier mentioned biography–
Jake: After you hit the wall.
[laughter]Tobias: That’s right.
Jake: Yeah. [laughs]
Tobias: [crosstalk] edges.
Luca: Yeah, that’s the thing. You need to know before you crash. How do you know before you crash? The best option is to look at how other people crashed and ask yourself if you are committing the same mistake. So, best thing you can do right now is to ask yourself, if there are other people with the same goal as yours who failed and how they failed, why they failed, and to make sure that you’re not committing the same mistake.
Now, the problem with this is that people usually think, but the people who fail are dumb and I am smart, so I will succeed. So, the question is, you should ask yourself, what people smart like you with the same goal as yours nevertheless failed? What happened to them, and how can you prevent making the same mistake? That’s an extremely valuable exercise to do.
Tobias: Sorry, keep going. Keep going.
Luca: No. Then the second exercise, which I suggest in the book, is looking at near misses. You probably heard about this survey that they did in the US. 93% of US drivers think that they are a better driver than average, which is an obvious statistical impossibility. But why? The reason is because if you drive slow, you will think that you are a good driver because you drive slow. If you drive fast, you will think that you are a good driver because you drive fast, unless you already crashed. But that’s unlikely.
If you drive fast, you take risks and you are almost about to crash, and then you make an emergency braking and you avoid the crash, will you learn that you were driving too fast, or will you learn that you have good reflexes and therefore, [Tobias laughs] you are a good driver?
Jake: Really skillful.
Luca: You will learn that you have good reflexes, and therefore, you are a good driver. So, what you need to do is to get into this mindset of interpreting near misses, near misses when you almost had an incident or a loss but avoided it. You need to interpret them not as evidence that you are good or that you are lucky, but as an evidence that you are taking a level of risk, which is excessive for the long-term. This is extremely important.
Tobias: Buffett and Munger have made this– The three ways that you can go bankrupt I guess in business– But the three ways you go bankrupt are ladies, liquor and leverage. I think that the ladies in the liquor are the less– It’s always leverage, which is the equivalent of driving too fast in the car, right?
Luca: Yeah, exactly. But don’t also forget ladies or like your spouse or familiar situations in general, the same also for investors of both sexes, because the good thing about asking yourself the question not, how can my investments fail, but how did other investors fail, is that suddenly you discover that maybe you will fail because of some investment choice. But also maybe you will fail because of an unstable family situation, which either you have a bad divorce, or maybe it puts you some pressure or some stress that degrades your decision making. So, very important to have a holistic approach to risk management.
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How Often Should You Check Your Investments?
Jake: Yeah. Luca, one of the things that you mentioned earlier was about evaluation periods and how much that can impact, then how you optimize. What do you think is the right periodicity to check on your investments, let’s say?
Luca: So, first, let me talk about what’s the right time horizon. This is a pet peeve of mine, because I hear a lot of people like “My time horizon is 5 years. My time horizon is 7 years. My time horizon is 10 years.” And I’m like, “Whoa, do you have some health problem [Jake laughs] and the doctor only gave you 10 years?”
Tobias: The devil.
Luca: Because if you are healthy and you-
Tobias: A million bucks in 10 years.
Luca: tend to live for another 50 years, your time horizon should be 50 years, not 10 years. Why does it matter? Because imagine that you are taking a risk that has a 0.5% chance of happening each year. If your time horizon is 10 years, that means that you have a 95% chance of getting away with it. Now, I’m simplifying a bit. People might say, “Fine.” If you have a 50 years’ time horizon, that risk is too big for you.
So, that’s why you should always use the upper pay time horizon, which, unless you have something very specific, such as you think that you will use the investment because you want to buy a house for your children or something like that. But unless these cases, your time horizon should almost match your life expectancy, a bit less, a bit more for different reasons, but that’s the idea. It shouldn’t be 5 years or 10 years if you are of our age, first thing.
Now back to your question of what’s the right time to check your investments? Well, I think it was Taleb who got something along the lines recently of, “If you need to check your investments every day or every week, it means that you are taking risks you cannot afford,” like risks that are excessive, which I think is a good way to think about it. Then, of course, a lot of the answer depends on things, such as, are you managing your clients or not? What kind of investments are you invested in? Well, different types of investments, they require different frequencies and so on.
Jake: What if I’ve checked five times since we’ve been talking?
Tobias: [laughs]
Luca: Again, it depends what we’re talking about. If you’re checking a stock which is giving earnings tonight or something like that, then maybe there is a good reason for doing that. If you’re checking it with no particular reason, then it’s a bad reason. It’s a bit like the difference between eating and overeating. The reason why so many people put extra weight and they find it hard to lose weight is because they don’t make the difference between eating and overeating.
Eating is healthy. It’s good. Overeating is detrimental. That applies to a lot of addictions. Like, there are addictions such as cigarettes, in which arguably every cigarette is bad. But there are addictions such as to food, to checking your phone and to checking your investments, in which it’s not so binary. Doing it up to a certain point is good and doing it more than that is bad. What’s that point? It depends. It’s as if you ask me, like “What’s the right amount to eat for you?” It depends. The best thing is that you observe your own body. You observe whether you’re putting weight, you observe how you’re feeling while you eat and these kind of things.
Same thing. What’s the optimal amount of checking your phone? I don’t know, it depends what you’re checking it for. It depends if you are playing video games, if you’re checking Twitter. If you’re using Twitter, it depends if you’re using it productively or if you’re scrolling. It depends. But the moment you realize that it’s like this, eating and overeating, consumption and overconsumption, you will immediately understand what’s the right amount for you. Immediately, no, it will take a bit of iteration, but you will get that.
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The Importance of Learning from Others’ Failures
Tobias: Is that a useful approach to risk management being able to iterate going from testing ideas? Do you like that approach?
Luca: Well, it depends. You need to do it in a way which is safe, so in a way that again you don’t iterate risk management driving a car, because if you crashed, too bad. Also, I don’t like iteration that much with investing, because the idea for iteration is that it’s only valid in the measure that the conditions in which you are testing persist in the future, which is true if you’re iterating over manufacturing process, it’s much less true if you’re iterating over investing. Especially because investing you have things which, how good a strategy depends, not only in the strategy, but also on whether other people are using it and the strategies–
So, it’s a bit more complex than that. So, that’s why I don’t really like iterating as the way, or at least the way in which you rely. I think that there was someone– I cannot remember which was on Twitter. Maybe it was [unintelligible [00:43:45] Crivello, maybe he had tweeted. But it was something like, “Experience is a good way to learn, but only idiots would rely on experience alone.” The reason is because if you rely on experience alone, either you’re too slow or either your risk of getting burned while you learn.
Tobias: Yeah.
Luca: And so, it shouldn’t be your main vector for learning and for taking decisions. The experience of others, yes, definitely learn from others.
Tobias: Yeah. Well, what’s the best way of doing that? What’s the best approach? If you approach something that you don’t know anything about, how do you learn?
Luca: Well, one of the first things is that I ask myself two questions. One is, how did people succeed? What did they do? And number two, that’s a good question to ask, but in no way it’s sufficient. The reason it’s sufficient is because we also need to ask you the second half, which is of the people who are as smart as me and who employed the same winning strategies as the winner. There will be some that failed, and I need to absolutely understand what caused them to fail. Until I understand that, I will have blind spots, and I need to understand that. Yeah.
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Tobias: What you got, JT?
Jake: I don’t know if you wanted to shift a little more personal gears and just talk about how your break was and visiting Australia. Any takeaways, bring homes?
Tobias: Yeah.
Luca: Any failures that we can learn from.
Jake: Yeah. Is everything upside down there? Is that true?
Tobias: [laughs] Well, it’s cold. It’s winter.
Luca: Oh, yeah.
Tobias: Still warm enough to go to the beach. Water was nice and warm. So, I’m as fat and sunburned as that I’ve been as if I’d gone to any other time. [Jake laughs] I think it’s interesting. One of the things we were talking about before we came on, it’s interesting, the fashion is slightly different. I think it’s clearly, it’s informed by Instagram. There’s a lot of Instagram fashion, but it is still, like its own unique little. All the girls are in the tan and earth color yoga pants. So, it was a good trip. I can’t complain, really. [laughs]
I think more interesting though, there was some huge news last week. I’m sure you guys caught that, “Value had this giant day” on Thursday where it was up like 4% while the market was down a couple of percent. I’m hoping that that indicates some huge reversal in the fortunes for value and for smalls. What do you think, JT? Did your portfolio look a little bit perkier towards the end of last week?
Jake: I sent you the Morningstar Style Box picture [Tobias laughs] just to send proof of life to you. Yeah, I don’t know, it’s interesting. Why do any of these things happen? I really have no idea. It could just be people are rotating out of things that have been working, and they decided that big tech has had its run, and now the herd wants to go somewhere else. That happens. It might even be related somewhat to your observations in Australia, where there’s this memetic herd like behavior that happens there, where a few leading fashionistas, I guess– [crosstalk]
Tobias: One side of the butt to the other side of the butt.
Jake: Yeah, wear those particular brand of pants, and then everybody thinks they’re cool, and they want to be like the cool people and then they copy. I think the same thing happens in markets as well. The cool pants to wear for the last six months have been AI related things. So, maybe everybody’s like, “Yeah, maybe this crappy energy company is not so bad after all,” and they rotate over.
Tobias: Luca, are you familiar with value investing, Benjamin Graham, Warren Buffett [crosstalk] pressure risk.
Luca: Yeah, [crosstalk]
Jake: Tobias Carlisle, [Luca laughs] third in the series.
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Value Investing and Ergodicity: A Framework for Long-Term Success
Tobias: I think one of the things that value guys do, and probably the reason that Jake and I are so attracted to the idea of ergodicity, is that value really does consider that proposition as the first thing that– That’s the first thing that value investors will think about. Warren Buffett’s got this funny thing where he says, “There are only two rules to investment. The first rule is don’t lose money, and the second rule is refer to rule number one.” So, there’s really only one rule to investment, which is don’t lose money. But he doesn’t mean, clearly, you get mark to market, your stock price can go down. But ultimately what you’re doing is you’re looking at things where there’s some justifiable reason for making each investment.
The justification is often that the downside is you have a pretty good idea what the downside is, it’s factored in. The upside is unknowable, but it takes care of itself. You contrast that with some of the more growthy stocks, and the problem that they have is that they’re looking so far out into the future that there’s an enormous amount of risk in there, there’s an enormous amount of execution risk. They’ve almost made that bargain with the devil, where they have to come up with a million dollars in a very short period of time, and they have to take additional risk to get there. So, I wonder if you’ve ever considered those.
I’m working on a book. Mine is more value based. But considering the ideas of Ergodicity, before I even knew what that was, before I knew that term, I understood the idea. I would say that value investors have also considered that idea of Winning-Long-Term-Games. It’s a frame rather than how to win long-term games. It’s just realizing that you are playing a long-term game, and that alters your behavior. Is that a fair assessment? Do you think that the frame of realizing that you’re going to be repeating this game over and over again, repeating this race over and over again, is one of the more important steps that you make?
Luca: Yeah. Well, both books, Ergodicity and Winning-Long-Term-Games resonated extremely well with the value investing crowd. I think that the reason resonated is because many of those investors, they already knew the principles. Maybe they didn’t have a name, but intuitively, they knew the principle. But the problem is that the difficulty as a value investor is not understanding the value proposition.
It’s, one, being able to explain it to others, because you need to explain why you haven’t grown as fast as others today, for example. And two, you need also to have the argument to explain it to yourself. Not only to understand it, but to increase and to develop the conviction that your strategy is actually the better one, even if someone else made more money today. Because the biggest risk you have as a value investor, it’s not much what you can lose with your strategy, but it’s that you gave up your strategy because you feel like you’re falling behind and you switch to a worse strategy. And so, that’s very important.
The reason why people love the books, Ergodicity and Winning-Long-Term-Games is because it contains all these stories and examples that help justify what they know, but they didn’t have a vocabulary or stories to explain it to others, so that they can explain it to others and they feel understood. Because they feel understood, they don’t get the temptation to switch, or at least they feel less pressure from people who don’t have the same conviction to switch to another strategy. I think that’s extremely valuable.
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Why Fund Managers Need to Educate Clients with Stories
Jake: I think probably one of the issues is you can have all the conviction in the world as the manager. But if you’re investor base in a professional context, it doesn’t necessarily have the same conviction, then it doesn’t really matter. Like, even if you’re the ski racer who went slower, but you only get to participate in three of the races because the capital gets pulled because you were too slow, you didn’t win any of the races, the optimal then, strategy, actually is to be the dangerous racer because at least you got a shot of maybe having one of those good outcomes.
Then let’s say you crash, in the professional context, it’s like, “Okay, well, you have to go get a regular job now.” So, from a career optimization standpoint from you as a young manager, it’s reasonable to expect them to go take a lot of risk, actually. So, how do you get people all on the same page then to– I guess maybe besides just reading your book, which might be why it’s so popular. Maybe they’re all buying copies for their clients, is what the real-
[laughter]Jake: -the real answer is. But are there any other ways to help people get onto the same time horizons, which I think is where the real breakdown is? What is the time horizon that we’re operating on together?
Luca: Yeah. So, this is the most common question I get, all the time I get invited by some funds to talk to their clients to pass this knowledge.
Jake: Here’s why I fund XYZ is underperforming and it’s okay. Don’t leave.
Tobias: [laughs]
Luca: No. My idea is that if you’re a fund manager, there are two things you should do. One, is to educate your clients. Educate them not with numbers. They don’t have an emotional impact. Not with reasoning, because the decision to invest at the end would be an emotional one, but with stories. Stories such as the story of my cousin, the skier, or stories such as some of the others are using the book or some of the others that you have yourself from your own experience. But use stories to educate about this principle. One, about ergodicity. And two about this idea of Alice and Bob’s. This very important idea that you look at the winners and they are all Alice’s, but the best strategy for you is Bob. That is very important concept. This is the first thing to do. Educate.
That said, educate will only walk up to a certain point. You will convince some people, you will not convince others. So, the other thing probably you should do is that you cannot fully implement everything I mentioned to a 100%. Let’s say that zero is Alice’s strategy, 100 is Bob strategy. You probably cannot go to 100 to Bob, even if it’s the best strategy because you will lose too many clients, possibly. However, the answer is not to stay Alice at zero. You can make some steps. Maybe you go to 20. If you go to 20, you will already have decreased your risk and volatility a lot without sacrificing too much of the upside potential. I think that this is the right way to approach it.
Yeah, maybe for your clients, going 100 is too much, but probably you can go 20, and probably your clients will appreciate that and actually will get you more clients because they can see that you took steps towards that, and maybe they’re willing to say, “Okay, I’m willing up to give up 20. I’m not willing up to give 100.” So, you need to look for these weak spots.
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Understanding Risk in Long-Term Games: Why Multiple Winners Matter
Tobias: Is the secret to winning long-term games, being your cousin and thinking about the entire season of ski events rather than trying to win each individual event?
Luca: Well, for winning long-term games, competitive skiing is a bad example. Why? Because there is a limited number of winners, either you are the number one in the world or you are not. That means that if you define happiness as being number one, there is no way that you can get to 100% chances of getting happy. Because to be number one, you need to take some level of risk, and take some level of recklessness, which means that you need to accept a certain level of chances of ending up like my cousin.
Thankfully, investing is not like skiing. Investing, you can have infinite winners. Or, maybe not infinite winners, but if you grow your wealth very fast, you are a winner. It doesn’t really matter if you are number one or number two. You just want to grow your wealth very fast and more than, let’s say, 90% of the population, so that you increase your relative wealth. Good news, if that’s your objective, there is a very large possible number of winners, which means that you do not have to take reckless risks.
Tobias: Yeah, that’s a good frame. In games where there is only one winner, you’re going to find out that the winner will be an Alice, but you don’t know which of the Alice’s it will be. But in a different kind of games, where you’re just trying to maximize your happiness, or whatever the case may be, the Bob’s strategy is better because it enhances– [crosstalk]
Luca: Yeah, exactly. The very important thing is choose a game in which Bob can be a winner. Because if only Alice is going to be a winner, you cannot guarantee that Alice would be a winner. [crosstalk] The other important thing is that skill is never sufficient to guarantee a winning. Never.
Imagine that your objective is the least apparently luck dependent one. You want to become chess world champion. You think perfect, I choose chess. Chess is pure skill, 0% luck. So, if I work hard enough and if I am smart enough myself, I can win. True? False. Why? Because there can be only one winner. If there is another person who works as hard as you and is as smart as you, then it becomes a coin toss, or even life.
So, again, you shouldn’t do the mistake of thinking, “I am smart, therefore I can do it. Or, I am hardworking, therefore I can do it.” The most important thing, the most important consideration is how many winners there can be, and play a game or defend the game that you’re playing in a way that there can be multiple winners.
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Jake: In our last little bit of time, well, Luca, we just happened to run into each other in London a couple weeks ago at the Nudgestock, which is Rory Sutherland’s little event that he puts on. Aside from the really fun conversation that we had to have with Rory at the end of it, any other takeaways from that conference that you enjoyed or thought worth sharing?
Luca: Well, I wouldn’t call it a small event. It was big and nice. Thinking about specific takeaways. Well, I think that one way in which you can think about winning long-term games was that actually, it was my second time at Nudgestock. I’ve been a few years ago as a speaker.
An interesting thing is if you go to a conference and you think you will attend it only once in your life, you will necessarily play a short-term game. Why? Because you want to get the most out of the conference, and you want to get the most out of each encounter you do. That leads you to do things which are not necessarily good. One, you will feel stressed and you will not enjoy the conference. Two, maybe you will have a promise, you will be very pushy if you’re trying to get them to hire you or whatnot. Bad things.
If instead you think that you will come back to the comfort and it becomes an iterated game, then you can play long-term games and everything would be nicer. You will enjoy the event more. You will enjoy talking with the other participants more, because you will not be in a selling mode, but you will just be building a relationship. Even if you are selling, because if you are playing iterated games, selling is not anymore as getting the most out of you can in this conversation, but it’s about making the next conversation better, which is a complete switch in mindset. And that enables you to do more things.
I think that the key takeaway is that most people, they play short-term games because they think that if they get the most out of each day, they will also get the most out of the year. But this is false. Because to get the most out of the year, some of the days, you need to take some actions that have no immediate payoff, but bring a payoff in the long-term.
Yeah. And so, that’s just something that I was thinking about the conference and noticing that I was very relaxed. Because I know that probably I will come back another year and so on, I was able to really enjoy it and to build relationships in a way that I wouldn’t have been able to do if I thought that I need to get the most out of it.
Tobias: That’s a great sentiment. Luca, if folks want to follow along with what you’re doing or get in contact with you, how do they go about doing that?
Luca: Yeah. So, the best way is either to follow me on Twitter. My name is @dellannaluca, D-E-L-L-A-N-N-A-L-U-C-A. Or, on my website, which is luca-dellanna.com with double L and double N. I am also LinkedIn, but I don’t really use that much, so don’t expect too much if you only follow me there.
Tobias: And Luca has two books are Ergodicity, which is excellent and Winning-Long-Term-Games is the brand new one.
Jake: He’s got eight other ones too, Toby. But those two are especially useful for investing.
Tobias: There you go.
Luca: Yeah. You can get them anywhere on Amazon or another bookstores.
Tobias: Well, thanks, Luca. Thanks, JT. Folks, thanks again–
Jake: Thanks, Luca.
Tobias: We’ll be back next week. Same time, same place. See you then.
Luca: Thank you so much.
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