Attractive investment games
David Swensen Guest Lecture (Yale University, 2011) - In this 2011 lecture David Swenson, the long-time Chief Investment Officer (CIO) of Yale University Endowment, provides a good summary of his book Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment. The book discusses asset-allocation topics including the characteristics of asset-classes where investors should take ‘active’ versus ‘passive’ allocations. These asset-classes have three attributes: (i) high variance between top-decile and bottom-decile returns; (ii) persistency in winners; (iii) returns benefit from skill. Swensen argues the key is identifying asset-classes where skill matters and picking top-quartile performers. The Mauboussin paper (below) further expands on this idea.
Alpha and the Paradox of Skill (Credit Suisse, 2013) - Michael Mauboussin’s essay beautifully explains why in investing absolute skill is not sufficient to generate excess returns, because stock prices reflect the wisdom of crowds, what matters is skill relative to the competition. This leads to the counter-intuitive conclusion that one of the biggest determinants of investment success is not the quality of the analysis, but choosing the right markets in which to play. The best investors recognize their core skill set and where it can best be leveraged.
Why Indexing Works (SSRN, 2015) - ‘Active’ investing is an implicit decision of superiority where the investment manager believes his genius, intuition, and experience can outperform a rules-based investing strategy based on passive exposure to representative subset of the asset class. By definition then an ‘active’ strategy which can generate excess returns must systematically exploit weaknesses in this rule-based approach. This paper explains ‘positive skewness’: the majority of index performance typically comes from just a few securities. To outperform an active manager identify signals in advance that reasonably identify these few key securities or consistently avoid underperforming securities in the index.
Doing good research
Yen Liow / Aravt Global (Graham & Doddsville, CBS) - Former Ziff Brothers investor Yen Liow discusses his investment process around ‘compounders’: high ROE long-term investments. Given the sophistication of the competition, a high-quality research process is table-stakes for success.
Jesse Livermore: The Search for the Truth with the Anonymous Master (Invest Like the Best, 2019) - In this podcast Patrick O’Shaughnessy interviews pseudonym investor ‘Jesse Livermore’. Livermore’s rigorous background in STEM informs his views of the pedagogy of inference. The conversation nicely structures ideas I’ve long understood but hadn’t clearly differentiated: intuition, analysis, data-analysis, and identifies when each approach is most appropriate. These ideas intersect well-known concepts from Daniel Kahnemann (intuition) and Phil Tetlock (analysis). There is a nice written summary of this podcast here.
Skating Where the Puck Was: The Correlation Game in a Flat World (William Bernstein, 2012) - A neurologist turned investor, Bernstein approaches many investing problems from first principles and in the process unpacks concepts of risk awareness that many stock pickers seldom consider. Most investors start in some narrow corner of asset markets (which naturally is deemed most attractive) then one day discover that their success was not divinely ordained, but the lucky happenstance of reasonable skill, right place, and right time. Understanding evolving opportunities requires a broader perspective. This piece showcases the reflexive properties of the Yale Endowment Portfolio and how its popularity diminished many of its original advantages. The best investors, invest across regimes, which requires some understanding of the complex interplay between the market’s participants and the opportunities that creates.
The Dog and the Frisbee (Andrew Haldane, Bank of England, 2012) - The ideas in this speech draw extensively on the work of Gerd Gigerenzer. If the financial world seems to be on an accelerating treadmill of more data, more algorithms, and belief in the reducible certainty of a financial model, this essay argues otherwise. For complex physics problem of calculating the precise trajectory of a frisbee, sometimes a simple heuristic works best: run in the same direction while keeping your eye on the disc. Sometimes the fact that an investor is buying a stock for 5x p/e is more important than the story we tell ourselves about why we did so.
Investing in the Unknown and Unknowable (Zeckhauser, 2006) - The best investors understand that success requires a deep understanding of concepts of pari-mutuel betting: forecast accuracy + mispriced opportunity. In this paper, Harvard professor Richard Zeckhauser describes how investors might succeed when investing in situations with unknown probability distributions — Unknown and the Unknowable (UU) events — provided other participants are similarly ignorant. A good primer on first-principles thinking of betting amidst uncertainty.
Scale: The Universal Laws of Growth, Innovation, Sustainability, and the Pace of Life in Organisms, Cities, Economies, and Companies (Geoffrey West, 2018) - I’ve always thought companies are similar to biological organisms, they evolve over-time, and this topic seems especially relevant today. Business existing online are not limited by the same form-fits-function requirements which exist in the physical world, providing a freedom of adaptation not limited by traditional constraints. This book discusses the limits of scaling laws from physics first-principles, as applied to organisms, cities and economies. Many online businesses seem to run up against similar ‘invisible asymptotes’ of scale.
The Checklist (Atul Gawande, New Yorker 2007) - Medicine has long dealt with complexity and uncertainty. For instance, every unexplained death in a hospital is subject to an all-staff Mortality and Morbidity (M&M) review. Investors deal with a similar quantum of problem and require rigorous tools for learning, feedback, and review. In this essay, which pre-dated his now famous book, Atul Gawande explains why checklists are important for complex tasks with severe risks.
The Reluctant Mr Darwin (David Quammen, 2007) - The story of how Charles Darwin discovered his ground-breaking theory of natural selection. Most amazing — Darwin sat on his idea of natural selection for almost 20-years from the completion of his voyage on the HMS Beagle. Only the impending publication of the same idea by Alfred Russell Wallace motivated the rush to publication. This book answers two important questions: 1) what note-taking practices might allow one to slowly iterate on an idea; 2) what were the precursor ideas to the ground-breaking ideas of evolution. If these research practices worked for one of the most complex ideas in the modern world, they are more than sufficient for improved investment thought.
Richard Hamming: You and Your Research (1986) - Physicist Richard Hamming, who worked at Bell Labs and Los Alamos, gives a talk to physics Phd’s on successful multi-disciplinary research. His central idea is innovative ideas come from the cross-pollination of different disciplines (not extreme specialization) and researchers should foster an open-minded approach to chance interactions with others. This intersects with the earlier pieces on choosing attractive investment games.
Black Hole Apocalypse (PBS Nova, 2019) - We now live in an Abstracted World where when we peer into our smartphones, we are offered products & services untethered from the frictional realities of the physical world. Ideas spread faster, distribution costs go to zero, delivery can be instantaneous, and proximity is not defined by kilometers, but network-hops between websites. Physicists have long struggled to understand the complex interplay between forces which exist in different planes, or dimensions, from gravity to space-time. If the physical and abstracted worlds are subject to different economic scaling laws, what forces might characterize the interactions between these planes?
On Grand Strategy (John Lewis Gaddis, 2018) - Many investors crave consistency: we are either value or growth, investors or traders. Yet the most talented investors are often chimeras who exist between disciplines, open-minded and flexible. F. Scott Fitzgerald said: “The test of a first-rate intelligence is the ability to hold two opposed ideas in mind at the same time and still retain the ability to function.” Through historical allegory, Gaddis illuminates the advantages of differential levels of perspective: the Fox and the Hedgehog (Isaiah Berlin), micro- and macro-perspectives (Tolstoy / War and Peace), and political goals driven by idealism versus pragmatism (Abraham Lincoln / Slavery).