Dear Mr. Buffett_ What an Investor Learns 1,269 Miles From Wall Street - Janet M. Tavakoli [31]
The problem with that reasoning, as hedge fund after hedge fund has discovered, is that the market has uncertain outcomes and the probabilities are unknown in advance. In such circumstances, making riskier bets does not show superior decision-making ability, it just means the fund manager is happy to accept a lower margin of safety.
Even the hedge fund manager of “sound mind” can be wiped out on a series of bets that have a 50-50 chance of winning $4 billion versus losing $2 billion. John Maynard Keynes warned: “The market can stay irrational longer than you can stay solvent.”18 Warren Buffett is even more risk averse than the hedge fund manager of “sound mind.”Yet he is the best investor in the last century—perhaps in the history of mankind—disproving the theory of efficient markets, a pet theory of many business school professors. “You can occasionally find markets that are ridiculously inefficient,” Warren points out, or “…you can find them anywhere except at the finance departments of some leading business schools.”19
In his book Innumeracy, mathematician John Allen Paulos gives many examples showing human beings are not good at assessing probabilities without formal training.We like to explain random events after-the-fact as if we predicted the outcomes. Many hedge funds are successful simply because of lucky bets. If the bets randomly pay off and the fund has a great year, the lucky fund manager takes credit for being a genius.When Nassim Nicholas Taleb, a risk theorist, discusses Buffett’s success, he seems to damn it with faint praise: “I am not saying that Warren Buffett is not skilled; only that a large population of random investors will almost necessarily produce someone with his track records just by luck.”20 If Taleb needed an example of success due to random luck, he did not choose well; he could have chosen from any number of hedge funds instead. Taleb fails to mention conditional probabilities (in this context), and it is remiss to describe Warren’s success without bringing that up. Certainty is not possible, and luck is always a part of the equation, but Warren works hard to uncover a margin of safety whenever possible.
What is the probability of a successful investment, given that one has a sound methodology for analyzing a business? It is much better than the probability of success without the sound methodology, and the probability of disaster is very low. In contrast, a one-sided leveraged bet presents an altogether different conditional probability.What is the probability of a disaster, given that one has merely leveraged a market bet? If one is lucky one will do well, but if one is unlucky—or simply flat out wrong from not doing one’s homework—the probability of disaster is about 100 percent.
I sent Warren a client note in September 2006 in which I made a similar point after the Amaranth hedge fund imploded after losing its shirt on natural gas contracts.The hedge fund leveraged up a bet and the bet (on natural gas spreads) went against them. It was a classic Dead Man’s Curve trade: “The last thing I remember, Doc, the market started to swerve.”21 Unlike Warren Buffett, Amaranth had no margin of safety. Warren wrote back: “You both think and write well.”22 Since meeting Warren, I’ve found myself comparing every trade against value investing.
A man once asked the late Richard Feynman, a Nobel Prize- winning physicist, how he would design an anti-gravity machine.When