Tuesday, December 8, 2015

The Learning Process and the broken feedback loop of Investing

There's an idea that's been jostling in my head for a while related to how we typically learn, and how investing simply doesn't fit our normal learning process.  

The basic idea is this:  It's difficult to learn what works in investing because the feedback loop is - or can be -  deceptively removed and jarringly out-of-sync with out normal learning methods.  Investing happens at a speed far slower than the speed of thought, and this poses problems for our learning process.  And to complicate matters further, results are noisy.  It is possible to be wrong and make money, and right and lose money.  And even then, the timing of an idea might make all the difference.

The key issue is this:  With most things, you get feedback within a reasonable amount of time that lets you know whether you are doing something properly or not.  You can then make adjustments, try again.  Incrementally you get better at the task.

For example:  Take shooting a basketball.  The first time you shoot a basketball you're probably small and uncoordinated, but have a general idea that tossing the ball in the direction of the hoop is the right thing to do.  When the ball misses (unless you're extremely lucky on your first try) you get immediate feedback that lets you know your error in any number of ways - direction, force, height, touch, etc.  So you get the ball again, and repeat, making adjustments.  Gradually you learn the actions that help improve your basketball shot - how to position your hands, elbow, flip the wrist, arc on the ball, timing the jump, etc.  It's all incremental - but the with the key point being that you get feedback that informs improvement on the next try, and the next try, and the next try.  In essence, shooting a basketball becomes a local optimization problem in a complex mechanical process.

Now in contrast, if we got feedback from shooting a basketball like we got feedback from investing investing, you'd take your first few shots, and then wait about 5 years with the balls in the air to see how you did.  Was it an airball, did you hit the rim, clunk of the backboard, string music?  Crucially, by the time you'd get feedback, you'd likely have forgotten what you were doing when you made those early shots - perhaps even forgetting why you took the shot in the first place.

To complicate matters with investing - with randomness being a strong component - it is entirely possible to in effect invest/throw a ball up in the air completely wrong and have it go in - on a somewhat regular basis.  Similarly, it is also possible to have the proper process and shoot an airball - on a somewhat regular basis.  So as I see it, the feedback process with investment is broken in ways that we typically don't encounter in life.  Or at minimum, the feedback loop is very loose in that you can be regularly rewarded for bad behavior and regularly punished for good behavior.  It's only with sufficient time does a better picture emerge, and as mentioned above - after so much time it's difficult to understand and be able to learn what is "working" and what is "not working" about the investment process given the confusingly reinforced feedback effects.

I guess I'm looking at 4 particular outcomes, and how they inform the learning process.

1. Right thinking, Profitable Result.  Ideally this is what we want.  It's shooting the ball properly, and having the ball go in the basket.

2. Right thinking, Unprofitable Result.  This type of outcome in investing happens all of the time.  Here I'm first reminded of Peter Schiff who awesomely called the housing bubble and financial crisis in 2008, but those who invested with him still lost from 40-70%.  But on a more pedestrian level, it's easy to think you understand what is going on (and largely be correct), but still lose money because of other factors that come into play and interact unpredictably or in ways that are unappreciated.  I currently have an investment in CF Industries, a nitrogen fertilizer company that I put in this category of a pretty simple story that I view largely as "right thinking" but "not-so-profitable" result.  The main input into nitrogen fertilizer is natural gas, and due to the fracking boom natural gas prices in the US are multi-year lows, making CF one of the low cost producers domestically and internationally.  That part has held up.  What hurts though, is that commodity prices are cratering, so things like corn that use alot of fertilizer, are seeing lower prices, and as a result farmers are spending less on fertilizer for the now less valuable crops.  Additionally, the company is going on an acquisition spree buying up capacity globally - something I was not anticipating that ups the risk level of the investment.  And gradually more capacity keeps coming on line even as prices drop, as new plants are being built by CF and competitors who weren't expecting price collapse when construction started years ago.

But ultimately what underlies these type of situations, is that it's entirely possible to have a good idea turn out badly - making it difficult to learn properly and distinguish between that good idea and a bad idea. 

3. Wrong thinking, Unprofitable Result. Ideally, this is what you like to see for proper learning.   Bad idea gets punished by the market.  This is that sub-prime mortgage lender I invested in prior to the 2008 crisis.  Yeah, I did that not understanding what garbage those loans would turn out to be.  I'm more careful with financial companies now, and largely stay away from them.

4. Wrong thinking, Profitable Result.  These are the "oops" situations where a stock goes up for unexpected reasons.  For instance, I almost invested in Yahoo a few years ago in the low-to-mid teens thinking they had a valuable franchise, and should be able to figure out how to monetize all the viewers they have.  The stock certainly rallied from that point to over $50/share, and is currently priced at $34.85.  However, the rally had little to do with turning things around, it was mostly due to Yahoo's ownership stake in Alibaba.  Here something totally unexpected drove investing outcomes.  It's like the ball slipping out of your hands, but still going in the hoop.

5.  Timing is Off.   OK, I'm adding a #5 here, because even if you get other things right, just having the timing off can ruin your returns also.   This idea falls in the vein of "being early is indistinguishable from being wrong."  Investing has a time component, and your investments can simply take too long to work out even if your idea is sound.  I currently have an overweight investment in energy/oil stocks, and it is increasingly looking like they are going to take much longer to work out than I had hoped.  Given marginal extraction costs and assuming global demand growth, I'm fairly confident that oil prices will eventually settle much higher than where they are presently, but the "when" is an important part of the overall consideration that helps determine whether an idea is profitable or not.  Opportunity costs.

So the thing I'm left wondering is how can the learning process with investing be improved.  Ideally, I'd be able to analyze a situation, make my choices, and push a button and see what happens in five years to know whether I'm right or wrong, and understand why.  Then repeat the process.  But that isn't possible.  Similarly, I can't go back in time 5 years ago and try to recreate that scenario, because I already know how the world has changed in that time, and what ultimately happened with stocks like AAPL and GOOG on the upside, and what has happened to Coal and Gold stocks on the downside.  And in any event, as Howard Marks points out, more things can happen than will happen, so even if you run the clock forward and get one outcome, if you were to repeat it again, you'd likely see something different happen.

In these types of situations where uncertainty levels are high, it is pointed out from multiple sources that adhering to and focusing on a proper process is critical.  (Focus on process, not the outcome - like a poker player who is happy if he gets chips in the pot when the odds are in his favor, even if he loses on the river).

A key issue in this case is to determine the proper process.  I can take the quant approach and focus on factors like value, momentum, quality, and size to improve my odds and apply a process to that approach.  That is one way to go, and I do that for much of my filtering process.  Essentially it's just a way of saying, "in the past, investments with these types of characteristics have tended to outperform in the past, so going forward I'll pick those types of investments in a systematic way."

However, if I'm trying to learn to select individual securities and learn about the selection process and the errors I make in that process, it seems a much more complicated effort to "learn" than is required by the quant approach.  Maybe I should be happy with a quantitative approach, but I'd also like to be able to successfully apply other qualitative factors in a way that is productive to the overall process.

For example, right now OUTR Outerwall is a company that has been on my radar and it just dropped 25% today to a share price of  $44.  Their business is mostly Redbox movie and game rentals from vending machines.  Despite being a business that is probably in long term decline, from a quantitative standpoint they look to have very high amounts of value and quality.  The business generates tons of free cashflow, and they're probably trading at less than 4X free cashflow currently, so if they just have a "little bit" of life left in the company they should pay back.   Digital streaming (or something similar) will eventually put them out of business, but the question is how much money will they make prior to then?  And will they not waste those profits trying to unsuccessfully grow?  To me it looks like they should earn alot more than their $44 share price over their remaining life, but I'd love to be able to "learn" from the current situation by being able to hit the fast forward button and look forward 5 yrs and see what happens in the interim.  What risks am I seeing right?  What risks am I missing?   I'm aware that I like contrarian plays like this, but buying stocks in strong downtrends is dangerous (and quantitatively not a good idea based on probabilities), but I can't help but be drawn to these type situations.  It just looks so cheap assuming it has some life left in it.

I guess in five years I'll check back and see what I can learn.

Thursday, November 5, 2015

Confirmation Bias

As background, I've been learning over the past year or two about behavioral biases that impact my perceptions, observations, and thinking about things.  The contexts apply widely, although the specific application is to try to be aware of biases in my thinking toward investment.

I wanted to talk a bit about confirmation bias after having some insight as to its usefulness today.

Confirmation bias is simply our tendency to see what we expect to see, interpret data in a way that confirms our preconceived model of the world.  The corollary is that we tend to discard/discount data or observations that don't fit what we expect to see.  Obviously in investing this can be dangerous - it means we're likely to interpret information about the market or an investment in a way that fits our preconceived ideas about that investment.  A bullish investor will tend to look for and "see" data to support his bullish thesis, and a bearish investor will tend to look for and "see" data to support a bearish thesis.

I find confirmation bias a difficult tendency to overcome.  Here's an online test that gives an example:

In the above, I read alot into test shown above - and was largely seeing what I was expecting to see - rather than seeing what was really there.  I can't help having a tendency to see things that I expect to see.

Now, to bring this around to today - my question is why is confirmation bias such a strong tendency?  Well, my answer is that I think confirmation bias is highly useful in many circumstances, and I'll describe a situation from today.

I've been doing some work under my house, putting in some supports underneath a shower pan.  Now my crawlspace is tight, and I am a big guy, and I liken it somewhat to going through birth everytime I go under the house and try to squeeze myself back out.  Squeezing in the tiny door, squeezing under flexible vent tubes, squeezing under plumbing pipes, etc.  The basic idea is that it is very tight down there, not alot of room to move or even look around.  Plus, there's not a lot of light, so I'm somewhat sensory deprived.

So I squeeze myself in under the shower, twist onto my back and am looking up at the shower pan.  In a bag I've drug bunch of tools and supplies in there with me.  tape measure, pencil, paper, gloves, maybe a few other things .  So I'm on my back looking up at the shower pan, concrete blocks pinning me in pretty tightly on both sides and the drain pipe kindof pinning me from the top.  One of my little Harbor Freight LED lights starts to flicker on and off (this is the light I'm referring to - I like it) so I'm thinking I better get my backup flashlight handy.  (I later took an extension cord and lamp down there, but initially I was just using a small battery powered light to see what was going on.)  I'm really not able to move my head enough to see what I'm looking for in the bag that I brought along, so I'm basically going by feel at this point.

For whatever reason, as I am reaching in for my little flashlight and feeling around and having difficulty finding it, I started thinking about confirmation bias and how useful it can be in a situation like that.  I kid you not, I was laying there under the house in the dark thinking about the usefulness of confirmation bias.  I knew I was looking for a small tubular metal LED flashlight, so I blindly reached down toward the bag (it's down near my knees) and started feeling for things.  I wasn't concerned about taking in other information about the worn leather texture of my gloves, or the ridges on my screwdriver, or a wrinkled up piece of paper, or the handles on the bag that kept getting in my way.  I was just digging around in there with single purpose of finding that other flashlight in case my other light went out - because I really didn't want to try to squeeze out of there in the dark (although that would've been a good story).  In this case, I was looking solely for information that confirmed that I had found the flashlight that I was looking for.  I ignored everything else.  Pure confirmation bias.  And I think it can be a useful bias in many of life's situations.

So why are we wired for confirmation bias?  I think it's because it's useful in many situations.  It reduces the complexity of a problem considerably and helps us focus on what we're looking for.   Now clearly, where this gets us into trouble is when this bias causes us to miss important details, or to see things that aren't there.  My screwdriver sortof felt like the flashlight, so for a moment I thought it was the flashlight.  Similarly, if I would've reached down and grabbed a possum by the tail it probably would've taken me a moment to figure out what was going on because I wasn't in a mental state to digest that bit of information.

Let me turn this into a specific line of thought on investments.  I have an overweight position in several energy stocks currently, and I expect the price of oil to recover - but it is taking longer than I expected.  So naturally, I try to realize I tend to view the world through the lens of an expectation of oil price recovery.  I look for stories that tend to validate this type of thinking - indicating US crude production is dropping, rig counts are declining, that international demand might pick up if global economies start growing more, that budgets of many oil producing countries are strapped so OPEC has incentives to increase prices, that instability in various regions could produce supply disruptions, price is below marginal cost of production, etc.   There are so many reasons for me to think that oil prices will recover.

But I also try to realize that I tend to discount or downplay the reasons that oil prices might have a more protracted downturn, because that doesn't fit my prior expectations of a price recovery.  Maybe the fracking technology is so good now that costs are fundamentally lower perpetually.  (While US fracking is a small part of the global production, it is a large part of the recent growth, so on the margin the boom in US fracking is impacting global supplies disproportionately.)  Maybe excess supply will be persistent.  Maybe this is the mother of all market share wars, and Saudi Arabia is trying to run US fracking capacity out of business?  There are lots of reasons that the price of oil could stay low for a longer time than I expect.

So in the end, recognition of confirmation bias has me tempering my bets in energy.  I am overweight the sector, but I easily could've been more if I wouldn't have thought in terms of probabilities like Howard Marks discusses.   As he explains, more things can happen than will happen, and we have to position ourselves appropriately.  This goes somewhat against the Buffett/Munger principle of making big concentrated bets, but then again, I'm not a Buffett or a Munger.  (I'm no Howard Marks either, but you know what I'm saying).

By the way, to guard against confirmation bias, Charlie Munger advises to invert the question - and ask what kind of information should I be looking for if my thesis is wrong.  So Munger's question would likely be more along the lines of "What type of evidence should I be looking for to confirm that the price of oil is going to stay depressed for an extended period?"   This approach takes advantage of confirmation bias by refocusing us on the inverse of our expectation.

Tuesday, October 6, 2015

A guy I'd recommend for floor leveling

I've been having some work done on my house, and if you're in the Middle Tennessee area and have floor leveling needs - like fixing sags in your floor by putting in supplemental supports - I wanted to recommend Bruce Little.  He's done two jobs for me over the years, is a class act, and is somebody you can tell loves the process of leveling floors and cares about doing a top notch job.  He even makes some of his own heavy duty equipment.

Additionally, I wanted to add that he recently returned a call from me while he was on vacation.  Again, the last job he did for me was probably 8-9 months ago, and he returned a call from me while on his vacation.

Anyhow, it's often difficult to find referrals for people you can trust to do good work on your home, but I just wanted to recommend Bruce Little.  In his day job he works for Powerlift and you can find him by searching his name and powerlift (or just contact powerlift and they'll put you through to him), but he does small jobs on the side in his free time that are too small for powerlift to mess with.

search tags:  Bruce Little, floor leveling, BC Leveling, Tennessee, Middle Tennessee, Nashville

Monday, January 26, 2015

Bacteria that live off of electricity

I hadn't heard of this finding of microbes that link together in chains and live off of the electrical differential/potential as electrons flow across the circuit created.

Here's the article:  Have we found alien life?

quote: “It is kind of like science fiction,” he says. To a biologist, finding life that chugs along without a molecular energy source such as carbohydrates is about as unlikely as seeing passengers flying through the air without an airplane.

Here's a couple of related videos:


Saturday, January 10, 2015

Bowhead whales live up to 200 years

Here's an interesting article on longevity research and a genetic study of bowhead whales.  The whales can live up to 2000 year.  

quote: The team found that the whales have genes related to DNA repair, as well as those regulating how cells proliferate, that differ from those found in humans.

Thursday, January 8, 2015

Horizontal drilling

Ever wonder exactly how the horizontal drilling and fracking process works?  Here's a pretty cool video that shows what's going on.  It's amazing to me that this can technically be done.


and a story from Foreign Affairs arguing that oil shale and natural gas boom that we've seen in the past decade or so could've only happened in the US due largely to individual land rights, legal system, and an economic structure that can support a large number of small independent operators.


The article concludes that despite large stores of natural gas in other parts of the world, it will likely be difficult to recreate the U.S. success globally.

Sunday, January 4, 2015

Public ownership of sports franchises

I've wondered why cities are willing to spend huge sums of money on stadiums and arenas, but don't just go ahead and buy the sports franchise itself? 

Here's a Vice article discussing this

"And then there were those who wondered: for $183 million, wouldn't it have been cheaper for D.C. to skip the stadium and just buy the team?"

Saturday, January 3, 2015

S&P500 and international exposure

I was thinking about asset allocation today - specifically: "what is international exposure?"

In particular, how much international exposure is built into the S&P500, or should we have explicit international exposure?  

Well, with some quick googling it seems the S&P 500 companies have anywhere from 33% to 50% of revenues coming from outside the U.S.  On the low end , this article mentions research showing that 33% of the revenue from S&P500 companies is derived outside of the US.  Here's another article that says 50% of S&P500 revenue comes from foreign sources.    This story from 2011 puts the figure at 47%.  I'm not sure why the wide range, but we're probably safe saying many of the big American companies have significant international exposure - anywhere from 33% to 50% in aggregate. 

So do I need an explicit international index in my portfolio?  After seeing this I'm less concerned about needing that, especially if I have a large S&P500 exposure or invest in US large cap companies.  In particular, I would want to make sure I don't inadvertently over-weight international by calling the S&P500 "domestic" exposure when it's probably close to a 50/50 split of domestic/international exposure already.