Value Investing and Ergodicity: A Framework for Long-Term Success

During their recent episode, Taylor, Carlisle, and Luca Dellanna discussed Value Investing and Ergodicity: A Framework for Long-Term Success, here’s an excerpt from the episode:

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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