Book: Non-Consensus Investing

Rupal Bhansali is chief investment officer and portfolio manager of Ariel's international and global equity strategies. In this capacity, she oversees global research effort and manages multi-billion dollar portfolios. She also co-manages the global concentrated strategy at Arial Investments.

In Non-Consensus Investing: Being Right When Everyone Else Is Wrong, Rupal makes a case for active investing when the world is favouring more of passive investing. In the book, she shares her perspective and her learnings. It is definitely a book worth reading at least once. For new investors, it is a must-read book.

Below are some of the sections and the most interesting statements, observations, learnings, and views of Rupal Bhansali. The words in Italics are my words to give additional clarity where required.

How My Passion Became My Profession

• This experience of thinking about both the long and short sides of the trade has become the signature element of my upside-down investment process: it focuses on what can go wrong (and how much the stock can go down), not just what can go right (and how much the stock can go up).
• Non-consensus investing is not simply doing the opposite of what everyone else is doing. It is deeper and broader and requires its practitioners to develop skills to recognize when widely held investment views are likely to be wrong.
• Non-consensus thinkers are not simply contrarians in a psychological or behavioural sense. They are analytical and independent thinkers who try to figure out what is misunderstood about the business and mispriced in the stock.
• Instead of trying to select companies, I look for reasons to reject them. By first and foremost looking for things to dislike and identifying what can go wrong, I proactively try to reduce the risk of being blindsided if adversity arises.
• The worst thing is being poor after you have been rich.
• Few people realize that investing is a paradox: to enhance returns one must reduce risks.
• Chapters 4 through 11 dissect the core principles of non-consensus investing, ranging from the need to stand alone to stand apart, to how misunderstanding quality can be the mother of all mistakes but also the mother lode of all opportunities.
• The concluding chapter 12 summarizes the core facets and tenets of non-consensus investing. Think of these principles as a north star, pointing you toward success.
• Keeping with the spirit of the contrarian theme that permeates this book, I often discuss what not to do and how not to do it.

“And” Not “Or” -- highlighting the different kinds of risk associated in investing.

• Who will buy the expensive stocks owned by passive investors when they want to sell? A wide divergence between what active investors are willing to pay (based on fundamentals) versus the price (bid up by flows) at which passives have valued their portfolios could set the stage for big markdowns, aka losses.
• Redemption risk. If everyone rushes to exit at the same time, how will passive easily liquidate its underlying assets into cash? Who will take the other side of the trade? Will a liquid asset class turn illiquid, causing passive managers to curtail redemptions?
• Liquidity risk. To avoid restricting redemptions, passive managers may have no choice but to dump stocks in a disorderly fashion, causing them to gap down, which I describe as the cost to exit positions.
• Front- running risk. In bull markets, nobody notices or complains about front running because it pushes prices up, creating the illusion of making money. On the way down, it can turn into a house of cards, as selling begets more selling by the front runners, paving the way for larger losses.
• Permanent- impairment- of- capital risk. Cheap beta (which is the promise of passive) is only desirable in bull markets. Passive cannot protect you against capital loss.
• Behavioural risk. Passive is not the negation of human neuroses or biases, but the aggregation of all neuroses and biases that exist in a market.
• Momentum risk. Lacking self- correcting mechanisms, indices can swing wildly from greed to fear as momentum cuts both ways. On the way up, it turbocharges returns; on the way down, it turns into a vicious downward spiral. Such roller coasters can be nerve-wracking, and investors may feel compelled to redeem instead of riding it out, exposing them to many of the risks described previously.
• Reflexivity risk. If you think that passive is unemotional, objective, and rational, think again. Going passive is itself an active decision. It is humans who make the decision to choose or quit passive, and they can be every bit as emotional and biased (which are accusations typically levelled against active managers).
• Market-inefficiency risk. Because passive does not care whether a market price reflects fair value or not (and therefore the efficiency of the market itself), all of society suffers.

Stocks or Bonds?

• You win or lose by chance, not a choice. In investing, you have the power to alter the odds, if you are willing to do the work. This means you win or lose by choice, not chance. This is a crucial distinction. If you play an active role in investing, you can influence the outcomes through skill. In speculating, you are reduced to a passive position where luck prevails, and skill does not matter.
• What exactly do those two words, “risk” and “reward,” mean? I think of risk as to the potential for permanent loss of money, and reward as the compounded rate of return over a full market cycle, typically ten years or more.
• This leads me to address a big question that should be on everyone’s mind: Should I invest in stocks or bonds? Which give better returns? Which have lower risk?
• Just as a brief illness builds your immune system, learn to think of volatility as a healthy interlude on the road to a stronger market eventually.
• If the fundamentals of the business have not materially changed and its intrinsic value— what the business is worth— is not impaired, a sinking stock price is an opportunity to gain even higher returns at a lower risk.
• Note, too, that the greater the discount to intrinsic value, the larger the margin of safety and the greater the reward. As the price falls, there is a bigger reward and lower risk.
• Conviction (aka confidence or hubris) will lead people to make a decision about a certain stock based on some sort of gut feeling— a whim, a hunch. But investing is not a confidence game; it is about being more correct, not being more confident.
• Free cash flows represent the surplus cash flows a company generates after: 1. Paying all expenses of the business 2. Reinvesting in the business to support ongoing operations or growth 3. Setting aside money to pay back long- term liabilities
• This is exactly what my investment approach strives to do. It tries to take advantage of both the volatility and the value- creation potential of equities and helps me choose well, to make higher returns without taking a higher risk.
• Then, as interest rates go up and risk appetite goes down, many borrowers may have difficulty repaying their debt. This is called a default risk.
• For sixty years, interest rates were range-bound between 2 and 5 per cent; then, in just over twenty years, they shot up to 15 per cent (see figure 3.2). The UK never regained its former glory.
• Most bonds, especially corporate bonds, are far less liquid than equities. If you need to sell them, you may not find a buyer right away, and you may have to offer significant discounts to their fair value to entice bids.
• You will only know their true value when you sell them. This takes us right back to the illiquidity risk. If you cannot liquidate, you cannot establish real value. Illiquidity risk exacerbates valuation risk.
• In November 2016, rating agency Fitch warned that a mismatch within open-ended bond funds offering daily liquidity while holding less liquid securities had increased to a record high. Fitch analyst Manuel Arrive cautioned, “Drawdowns resulting from fire sales in illiquid markets increasingly put fund capital at risk, as bond carry returns have become insufficient to offset volatility.” 2
• There’s one more type of risk, and it is a big one: Bonds can expose you to large losses but cannot offer large gains (unless you buy them in the secondary market at a huge discount to their face value).
• That is because a bond’s upside is capped at par. 3 Let’s say you hold a bond with a par value of $ 100. At any point before its maturation date, that same bond can fall in price to $ 70 or $ 60 or even lower.
• Bottom line: It is naive to think that bonds do not come with any risk. They just come with a different risk.
• Think of owning stocks of quality businesses akin to raising a child whose best days are still ahead of her. Sure, she may act up now and then, but you do not give up on a child just because of a few stumbles. Children, like stocks, may not offer joy every day, and on some days, they may bring pure nuisance and annoyance, but you would not decide not to have kids because some bad comes with the overwhelming good.

To Stand Apart, You Must Stand Alone

• That is, you must be right and prove others wrong. To achieve exceptional results, you must do something that makes you stand apart from the rest.
• To succeed, not only must you be right, you must prove everyone else wrong. That kind of asymmetry can be tough to understand, let alone accept, so let us take a deeper look.
• If research does not uncover anything original or differentiated, it is not value-added research but simply regurgitation, the investment equivalent of reinventing the wheel.
• Active investors who are unskilled in their research efforts are rightly facing an existential wake- up call: differentiate or die.
• This is what makes investing not simply different but asymmetric. You may not make any money for being correct if your correct views are consensus, but you will lose money for being incorrect. Figure 4.1 depicts this asymmetry:
• What I learned was that to find a treasure instead of a trap, an investor must first be a business analyst and then a financial analyst.
• Note that nobody in this gravy train questions whether their activity results in price discovery or price distortion. Is the stock trading above, at, or below its intrinsic value? Everyone blithely skips that part. Quant doesn’t calculate it (“ algorithms compute relative value not intrinsic value”), trend followers don’t care about it (“ don’t let facts get in the way of a good momentum story”), growth investors rationalize it (“ the high growth assumptions justify it”), and passive ignores it (“ theirs not to question why theirs but to do or die”).
• As the years rolled by and active managers continued to underperform in a strong upmarket, investors did what they often do— top ticked a trend (bought at the highs). In 1999– 2000, many clients withdrew money from their active managers and ploughed it into passive by investing in vehicles such as the QQQs (an ETF which mimicked the movements of the Nasdaq 100), which had doubled.
• A paper published in the Financial Analysts Journal in 2017 concludes that there is no evidence of underperformance among a group of funds with a high active share (those whose holdings differ substantially from their benchmark). Indeed, those who are also patient (withholding duration of more than two years) have outperformed, on average, by more than 2 per cent per year. Earlier studies showed similar results.
• The underperformers fell into two categories: closet indexers (benchmark huggers who called themselves active but were not) and pseudo active (those with a low active share between 60 and 80 per cent who pretended to be active but were not).
• When you look underneath the covers, there is a very compelling difference and argument in favour of truly active and against pseudo or closet active, not all active.

Score Upset Victories

• However, I want to make it clear that investing is not about gambling or betting or playing games, but about conducting serious, differentiated research which uncovers information that proves both correct and non-consensus.
• Investing is a pari-mutuel endeavour, where you are betting against other people since every share you buy is being sold to you by someone else. Unlike gambling, where the odds of winning and losing are preset by the casino and no gambler’s bets can alter those predetermined odds, in investing, each investor’s decision alters the preexisting odds. And as the odds change, the payoffs change. Of course, investing is not a zero-sum game, but one in which everyone can win something. However, those who score upset victories win way more, and that makes all the difference because the goal of an active investor is to beat the market, not just match it.
• If the companies did not generate free cash flows, we were told to look at earnings. • If they did not make any earnings, we were redirected to revenues; earnings would come later. • If there wasn’t much in the way of revenues, we were told to look at eyeballs; it was all about user engagement. • If there weren’t enough eyeballs, we were redirected to the founder’s vision; the eyeballs would follow.
• The arguments boiled down to buying concepts instead of companies. It felt surreal because it was. Eventually, investors began to realize that the emperor had no clothes, and the Nasdaq (which was heavily weighted in TMT stocks) crashed, losing 78 per cent of its peak value. What took five years to make took less than three years to lose (most of it anyway). What is worse, many of the concept stocks in the Nasdaq went out of business, causing permanent losses. In investing, it is not what you make but what you keep that matters. Your checks will bounce if you write them based on what your portfolio used to be valued at its peak but is no longer worth that high- watermark.
• Incidentally, this speaks to the power of global research: when you cover fifty countries around the world, as I do, you see fifty times as much. So even when pundits such as Alan Greenspan and Ben Bernanke debunked the notion of a nationwide housing crisis, I took the opposite path, selling many of my financial stocks in 2006. Two years later, the financial crisis of 2008 sent markets into unprecedented turmoil. Many financial institutions went under or had to be rescued at taxpayer expense.
• They say you can tell the experts are wrong when they unanimously agree on something. In all the preceding examples, the crowds believed their investment theses to be foolproof bets resting on solid ground— until they were not. In my experience, at best, crowded trades won’t make you much money, but at worst you could end up losing a lot of it (if not initially then eventually). On the other hand, at its best, the lonely trade can often help you score big, but if it doesn’t work out, you won’t lose much money either. This asymmetric risk/ reward tips the scales in favour of lonely trades and against crowded trades. This is where correct fundamental research comes into the picture. If the correct research is also non-consensus, you have all the makings of an upset victory.
• The bottom line is that betting on the underdog can improve the odds of making a lot of money while betting on everyone’s favourite increases the odds of losing it. (A prerequisite is that your research on the underdog must be correct.)

Do No Harm

• You always lose money from a higher number but gain money from a lower number, which is why incurring heavy losses proves more damaging than missing some gains. Investors are better off researching potential for failure and avoiding losers than chasing success stories and picking the winners. The main reason to invest in equities is to compound capital, and losing money is the albatross.
• For one thing, risk comes in many forms: financial-leverage risk, corporate-governance risk, currency-devaluation risk, regulatory risks, low-barriers-to-entry risk, and on and on. For another, the risk is often hidden from plain sight or comes in a disguise, not revealing its true character or intensity until it is too late.
• There is ample statistical data on default rates to help you handicap future expected losses. You would be benefiting from underwriting experiences of the past. However, there is another, more sinister type of risk you should be on the lookout for, and it can be vastly different from risk experience. I’m talking about risk exposure.
• In bull markets, where the focus is on returns, there is a greater tendency to become complacent about risk. This is dangerous. At precisely the time when investors should be paying more attention to risk, they pay less.
• This feeds a self- fulfilling cycle of ignoring risks which multiply unabated and finally blow up in our faces (as we all confronted in 2008).
• It is not that regulators, central bankers, management teams, rating agencies, and money managers were not looking at risk reports on the banking sector. The problem is that they were looking at misleading metrics such as value at risk, or VAR. 2 The formula for calculating VAR relies on measuring volatility experienced, which was of little help in 2008 because the securities were often new and had limited trading history (data). Therefore, to understand risk exposure, investors needed to use judgment, not statistics. If they had, they would have realized that the facts, taken out of context, were misleading. They would have seen that during a persistent bull market with an upward trending bias, volatility was likely to be understated, and thus would give a skewed sense of risk exposure.
• I researched a whole range of risk factors and exposures in the banking sector and foresaw the high-risk exposures such as asset/ liability mismatch risk, maturity-mismatch risk, wholesale-funding risk, counterparty-risk, and so on, that had eluded many.
• For instance, I examined the corporate-governance incentives of CEOs and found that their compensation packages often incentivized them to expand their banks and maximize short- term returns rather than walk away from risky assets.
• Think of stock- price volatility as the minor heart- rate fluctuations that we routinely experience when we move from resting to walking to running. They are not significant, and you can usually ignore them. On the other hand, chronically high blood pressure, for which you may see no obvious outward signs of fluctuation, is a huge risk. You would find it absurd if your doctor measured your heart rate all day long and completely ignored measuring your blood pressure. But this is exactly the absurdity we indulge in when we focus on beta or volatility instead of risk. Unfortunately, because we cannot easily measure or visualize risk before it happens, while measures such as historical beta, volatility, or tracking error are precise and tangible, people fall into the trap of measuring something that does not matter because they can, not because they should. Measuring risk is right but not easy; measuring beta and volatility is easy but not right.
• Just as not all cholesterol is bad for you, not all deviations from the benchmark are bad.
• A well-meaning but equally damaging form of swapping risk comes from the recent obsession with owning stability at any cost and avoiding volatility at any cost.
• What is more worrisome is that instead of focusing on fundamental improvements in corporate strategy or execution, many activists now overwhelmingly focus on what they call “maximizing capital structure.” It’s nothing but a euphemism for leveraging up the balance sheet to fund share buybacks.
• Expensive share buybacks funded with “cheap” debt are nothing but a form of doubling down on risk.
• Many investors encourage companies to buy back their shares in bull markets only to cut those programs in bear markets when they should be doing the opposite.
• Long- term stock- price performance arises from value creation in the underlying business, not from tinkering with the capital structure via financial engineering.
• To add insult to injury, the companies and money managers who have the guts and grit to stay out of this fray find themselves in the unfortunate predicament of having to apologize for their conservative risk management. Cash has become a four-letter word, while debt is not. It has become fashionable to ridicule companies holding cash (which is nothing but a form of risk management) while taking on debt is encouraged.
• I am not for management teams hoarding excessive cash, and obviously deciding what level is excessive is a judgment call. But I would rather the board and long- term shareholders make that decision than short-term traders or fly-by-night activists.
• Debt is a double-edged sword; it can amp up your returns in the good times but wipe you out during the tough times. Such binary outcomes make a highly indebted company very speculative. My advice: avoid it.
• Acquisition risk is a special form of denial in which inferior risk management is indulged in the name of superior return management. Invariably, management teams and investors justify their expensive forays with arguments of faster growth and immediate profit accretion. The downside emerges much later, when accounting regulations force them to confess to their mistakes by impairing the value of the asset. Once again, focusing on short- term gain and ignoring long- term pain proves to be a losing investment strategy in the fullness of time. Overpaying for an asset in the name of the strategy is simply obfuscating the valuation risk.
• Another form of doubling up on risks comes when a company with operating leverage takes on financial leverage. That is a deadly cocktail in times of adversity. Many financially leveraged energy companies went bankrupt when oil prices crashed unexpectedly in 2014 because their bonds and shares plunged simultaneously as investors priced in both bond default and equity- dilution risk. At exactly the time that the company needed to raise money to get through the downturn, both equity and debt markets closed their doors because of this layering of risk upon risk.
• Risk is absolute, not just relative. A lot of small risks with low probabilities can add up to a gigantic fat- tail risk. Layering risk upon risk ensures multiple ways to lose, instead of multiple ways to win. Doubling up on risk means that a humdrum downturn can explode into a full-blown crisis. Do not put yourself in such a vulnerable position in the first place.
• Risk is omnipresent. There is no denying it or avoiding it. Your only choice is to find it and deal with it. Equity investors need to be especially vigilant about risks because they are the risk- bearers of first resort. Risk management is not an attempt to eliminate all risks (that is impossible) but to distinguish between those risks that are minor— in which case the equity is worth buying at a good price— or major, meaning you should steer clear at any price.
• If the risks in the business are outsize, unquantifiable, or of a binary/ speculative nature, stay away. Do not own the stock at any time or any price. This is an absolute standard, not mitigated by a low or falling price. Warren Buffett put it best in his 1996 annual letter to shareholders: “If you wouldn’t own the business for ten years, don’t even think of owning it for ten minutes.”
• In other words, when markets pay you to assume the risks of a high- quality business, you should bear them. When markets do not pay you, you can sit back and wait for a setback in the business or pullback in the share price. Let the opportunity come to you, and only engage when the risk/ reward balance becomes attractive. Thus, risk management is not only about risk reduction but also about return enhancement. You can take advantage of risk to generate returns if a stock is mispriced.
• Investors can reduce the risk of large losses by insisting on a large value spread between the price of a stock and its intrinsic value.
• Part of astute risk management is to not be afraid because excessive fear can cause you to miss out on opportunities. I call this risk an error of omission, and I too have fallen into this trap.
• In life, we don’t give up striving for success because some struggles or sacrifices come with it. We figure out how to manage and overcome them, so they do not overwhelm us. Similarly, in investing, you must not give up the pursuit of any return just because it comes with some risk. Instead, you learn to identify risk, manage it proactively and prudently, and insist on getting paid for it.
• They are just not in plain view or have not materialized yet. I refer to this out-of-sight-out-of-mind risk as a blind spot.
• Risk is a virus that can mutate unpredictably, not a bacterial cell that multiplies predictably. Your doctor would not confuse a bacterial infection with a viral one, and neither should you. Like a potentially deadly virus that keeps morphing, risk requires you to be constantly vigilant and stay a step ahead. This requires judgment, foresight, and multidimensional approaches, not reliance on rote checklists or static metrics. Managing risk is an ongoing process, not a one- and- done task.
• Remember that being risk aware does not mean you should be risk-averse.
• In his 1921 book, Risk, Uncertainty, and Profit, Frank Knight, an economist, formalized a distinction between the two. He understood that an ever-changing world brings new opportunities for businesses to make profits, but also means we have imperfect knowledge of future events. Risk, according to Knight, applies to situations in which we do not know the outcome but can accurately measure the odds. Uncertainty, on the other hand, applies to situations in which we cannot know all the necessary information to set accurate odds in the first place.
• If you do not know how to tune into risk, or do not want to, that’s fine. Outsource it. You do this in many aspects of your life, by finding the best doctor to avoid the risk of dying from some disease or the best lawyer to avoid the risk of losing a lawsuit. Apply the same logic in investing. Find the money managers or financial advisers who know how to manage the risks of your investment portfolio, not just its returns. As Peter Bernstein, the guru on risk management, rightly noted: “Risk is a choice, not a fate.”

False Positives and Negatives

• Porter’s Five Forces: industry rivalry, threat of new entrants, threat of substitutes, bargaining power of suppliers, and the power of customers.
• its moat became irrelevant, and the company became marginalized in the marketplace.
• The question is not “What is their market share?” but “Why do they have that market share?” Not “What is the profit margin?” but “Why do they have that profit margin?” “Why” provides the missing link that goes past the symptom to the source.
• Business model is understanding the change in trend or technology that can impact the business.
• They repeated this mistake when they bought bank stocks as they were falling in 2008, using the same circular logic of cheapness. Historical financial numbers or naïve valuation metrics such as low price- to- book or price-to-earnings ratios will not tell you that the quality of the underlying business is about to deteriorate. Non-consensus investing is about buying quality when it goes on sale, not buying junk at clearance prices.
• Non-consensus investing is about buying quality when it goes on sale, not buying junk at clearance prices.
• Knowing how to correctly distinguish quality from junk is a prerequisite to generating higher returns with lower risk— which is a central aspiration of non-consensus investing.
• Familiar but flawed Real and reliable Indicators of low-quality Indicators of high-quality Competitive advantage Darwinian1 advantage Leading market share Growing market share Pricing power Price disrupter Captive customers Loyal customers Brand Value proposition Results Process Buzz model Business model Luck Skill Patents Know-how High tech Proprietary tech
• It is those who are most capable of adapting to their environments over time who gain the upper hand.
• While expanding market share is better than not, it is a means to an end, not an end in itself. The pursuit of market share should not come at the expense of developing a strategic advantage and pursuing long-run profits. Markets are dynamic, and winners and losers are continuously shifting.
• They mistook captive customers, who had nowhere else to go, for loyal customers. The moment those customers got a choice, they shifted their business en masse, exposing the business model for the low quality that it was. Captivity is not loyalty. High- quality businesses are those where customers willingly do business even if they could go elsewhere, because they are getting real value for their money.
• The worst offenders are those that rely excessively on their brands to do the heavy lifting of increasing revenues.
• Another red herring that keeps investors going in circles is looking at the quality of outcomes when they should be looking at the quality of the underlying decisions a company makes.
• Leverage in any form— operating or financial— is a source of risk to equity shareholders, and therefore highly leveraged companies fall squarely in the low- quality camp.
• The lesson here is that winning by default (being in the right place at the right time) is not the same as winning by design (strategically positioning yourself to win against the odds). Luck, in the form of tailwinds and externalities, may confer a fleeting victory to a company or industry but it will not stand the test of time.
• Did you know that some of the worst-performing stocks over the past several years, such as Xerox, IBM, and Canon, are some of the largest patent owners? In my experience, patents are overrated, know-how is underrated.
• Know-how is accumulated knowledge about a process or technique that is hard to decipher or reverse engineer. That means it can yield a competitive advantage for a long period of time.
• I was right about the facts but wrong about the conclusion. A petrochemical- manufacturing plant is indeed very sophisticated and complex. However, the technology and expertise to build and install the process- automation equipment in the manufacturing plant is owned by their suppliers, such as ABB, Siemens, and Emerson Electric, and they sell it to anyone who wants to buy it. There is nothing exclusive or proprietary about it. This explains why, despite being high- tech, petrochemical plants do not generate good returns on capital invested, which makes them low- quality businesses with poor value- creation prospects.
• This underscores the importance of distinguishing high tech from proprietary tech. They are not the same.
• In assessing quality, you must be vigilant about circular logic, in which you confuse cause and effect or conflate numbers with the narrative.
• A genuinely high- quality business is one that offers exclusive and enduring value propositions to consumers and generates a fair return to justify both the costs and risks of lawfully engaging and reinvesting in that business.

Ditch the Database, Embrace the Search Engine

• Research is not merely about knowing a lot; it is about understanding a lot and, more importantly, applying what you know. Unfortunately, from kindergarten through college, most people are spoon-fed questions that lead them to “right” answers. We need to rewire these bad forms of learning, because they give us a knack for accumulating knowledge, not applying it.
• Where has apathy or pessimism degenerated into neglect?
• Where is failure priced in, but success is not?
• You are better off researching failure. Two benefits: it will sharpen your antennae for what can go wrong; but also, if it has already gone wrong and your research tells you a reversal is at hand, you can score an upset victory.
• My unconventional view is that for the companies rooted in science and skilled in doing R& D, the industry’s challenges are also their opportunities.
• Where is the future better than the past?
• Where is secular growth hiding behind cyclical volatility?
• Disruptive business models or technologies can be fertile sources of upset victories, provided one knows how to conduct such research. It often takes deep domain expertise about the industry and years of training and practice to parse the reality from the hype, so be sure to stay within your circle of competence.
• Where are the setbacks that are due for a comeback?
• if a turnaround company belongs to a bad industry, its problems are likely to be more chronic than transient.
• Where are the second-order impacts being ignored?
• This instant payoff may feel gratifying, but it is chump change compared to the big payoffs that come from figuring out second-order impacts, where one change results in another change, like a domino effect. Focusing on second-order effects is like watching a stone thrown into a still pond; take your eyes off the stone and instead note where the ripples go. Let’s look at an example.
  Where are the “and” propositions?
  The leader will be working and exploring various aspects of the customer needs.
  Companies that deliver products with “and” propositions tend to succeed for a long time because what they do is exceedingly difficult to replicate.
  Two attributes— high quality and low cost.
• Non-consensus investors are always on the lookout for companies that make or deliver a product, service, or solution in such a compelling way that customers don’t even think of trying an alternative because none exists. Such companies epitomize high quality and exude the “and” proposition on a multitude of vectors:
• They possess exclusive and enduring Darwinian advantages.• They offer higher quality and lower cost, delivering unbeatable value propositions.• They generate surplus cash to reinvest in the business and distribute regular dividends to shareholders.• They succeed in the present and build momentum for the future.• They play good offence and defence.• They perform well in good times and hold up better in tough times.• They offer upside potential and provide downside protection.

From Victim to Victor

• Flaw #1. Jumping to False Conclusions: The Availability Bias.
  Academic papers, interviews with key division heads in speciality trade publications, books written by former employees of companies I was researching, memoirs of former CEOs, case studies of analogous challenges faced in other industries, and so on.
• Flaw #2. Falling Victim to Vividness: The Recency Effect
• Flaw #3. Monday- Morning Quarterbacking: Hindsight Bias
  To give yourself a much- needed reality check down the road, take time to investigate before you invest, write down your investment theses and quantify your qualitative expectations in a spreadsheet. Then track how things are going in the business versus how you modelled it. This will enable you to separate out the luck from the skill. Most professional investors do this.
• Banking on Best-Case Scenarios: The Planning Fallacy
  We all know that when the stakes are high, we should not count on the best-case scenarios, but instead plan for the worst. Yet most of us hope for the best and tune out the rest.
  I had fallen for the planning fallacy. I had not considered the possibility that they would satisfy their growth envy through acquisitions, no matter how expensive or risky. I had assumed that because the management was also the largest shareholder, they would be excellent stewards of capital. But simply being aligned with shareholders is not enough for the best outcomes. Even well-intentioned, well-incentivized management teams can make mistakes in allocating capital. It was clear that I should have considered worst-case scenarios, not just planned on the best case.
• Overvaluing What You Possess, or Denial on Steroids: The Endowment Effect
  Complacency is not a good reason to continue owning overrated stocks well past their prime.
  “If I didn’t own the stock already, would I buy it today?” 1 This is known as zero-base thinking.
  Many hedge- fund managers guard against the endowment effect by forcing preset stop-loss limits on trades. They automatically sell the stock when the limit hits. The manager can then reassess whether to reinstate that position by buying it back. Some would regard this as suboptimal from the standpoint of transaction cost: it costs money to liquidate and reinstate a position. But the smart money considers it a small price to pay to guard against the larger cost of suffering from the endowment effect. In fact, because the benefits can outweigh the costs, in many hedge funds this is a standard risk-management policy.
  Cutting your losses ensures two salutary outcomes: you learn from your mistakes, and you spare your portfolio further damage from an investment that is headed south. The best way to figure out if one is wrong, rather than simply ahead of others in an investment call, is to compare how the underlying business is performing (as opposed to how the stock is performing) versus one’s expectations in the original investment thesis. If the business (not the stock) is tracking my expectations, I hold onto or even average down on my investment. However, if it is performing worse than my expectations, I force myself to rethink my thesis and apply the fix.
• Clinging to the Past and Being Slow to React to Change: Anchoring Bias
  Many companies generate high profits when times are good, not necessarily because the company itself is good. When the tailwinds turn to headwinds, the company flounders. The mind takes time to process this changed reality. Academics call this anchoring— the tendency to adjust prior estimates insufficiently when presented with new information. In simpler terms, it means human beings are slow to react to change and prefer to cling to a point of view even though it is no longer valid.
  To overcome this bias, it is best to appoint someone else to do clean- slate research so that original or contradictory points of view emerge. That person needs to be ruthless and relentless in looking for information that invalidates, refutes, upends, or discredits any or all beliefs about company X.
  This Emperor Has No Clothes: Relying on Intuition Over Data
  Listening to your gut instead of checking the facts is what academics describe as intuition bias: relying on intuition over data.
• Knowing Less Than You Think You Know: Overconfidence Bias
  In fact, you might call overconfidence the original sin of investing. Thinking we know more than we do, certain that we are right, works against having the humility— or the common sense— to know when our judgment is off.
  Human beings are prone to overestimating what they know and underestimating what they do not know. Confucius put it best when he described knowledge as knowing the extent of one’s ignorance. The worst part of this behavioural flaw is we do not know what we do not know. So we underestimate the uncertainties of the future and invest as if we knew all there is to know. Such blind faith leads us to bet the farm on investments that appear to have great promise because we ignore what can go wrong.
  The lesson learned is that investing comes with uncertainty. No matter how much you to try to handicap all outcomes, unexpected things happen. No amount of research would have uncovered this accident. Sometimes all you can do is reassess the risk/ reward of an investment as new facts emerge and then take appropriate action.
• Believing What You Believe Instead of Questioning It: Confirmation Bias
  However, in investing, we need to do the opposite. Figure out what does not add up, instead of what does. Actively look to invalidate rather than validate.
  Too many investors inadvertently set themselves up for confirmation bias by favouring companies that score well on a checklist of desired attributes.
  When you seek out information that does nothing more than confirm what you already “know” to be true, you have swapped confidence bias for confirmation bias.
  Here is a summary of the top five mental states a non-consensus investor would do well to cultivate: 1. Scepticism (poke holes, insist on triangulated validation) 2. Optimism (consider what can go right) 3. Pessimism (stress- test what can go wrong) 4. Pragmatism (don’t bet the farm on some hunch or belief) 5. Stoicism (be equanimous amid adversity or euphoria)
• Flaws Fixes 1. Availability bias Go outside the sandbox 2. Recency effect Think long term. 3. Hindsight bias Parse luck from skill. 4. Planning fallacy Play devil’s advocate. 5. Endowment effect Practice zero- base thinking. 6. Loss aversion Acknowledge reality and cut bait 7. Anchoring bias Adopt clean- slate thinking. 8. Intuition bias Collect and connect information. 9. Overconfidence bias Accept what you do not or cannot know. 10. Confirmation bias Look to invalidate, not validate.

Value Investing = Margin of Safety

• The first negotiation ploy (someone offered $ 125 in the past) appeals to “reversion- to- mean” investors who believe that if the stock traded at a higher price or multiple in the past, it will do so in the future.
• The second negotiation ploy (someone else was willing to pay $ 100) is designed to deceive you with the “greater fool theory,” or what I call “optical value.” Just because someone else was willing to pay a higher price does not mean you should.
• The third negotiation ploy (compared to $ 100, you can have it for $ 80) appeals to “relative value” investors. In relation to something else, it can be made to look cheap, so it appears to be a bargain even if it is not. You have seen plenty of “relative” value traps even if you didn’t know the name.
• The fourth negotiation ploy (if you want this, you must buy it right now) is to trick you into making a hasty decision without having all the necessary information. Investing before investigating is risky; you are playing the game blind and relying on luck rather than skill. Do not fall for this ruse.
• The fifth negotiation ploy (offering you more for less) appeals to “distressed value” investors.
• Value is driven by what you are getting, not just by what you are paying.
• In good times, people focus unduly on what can go right and ignore what can go wrong. In troubled times, people dwell unduly on what has gone wrong and overlook what can go right.
• Investors who were betting on Sony’s continued dominance paid the price. Over a decade, Sony went from being a growth stock to a “reversion to mean” value trap to succumbing to the “greater fool theory” to being perceived as “relative value” to finally being regarded as “distressed value.” Frankly, it never represented value but a value trap, as all these value frameworks are false ways to assess value.

Sizzle Fizzles, Patience Prospers

• Confusing luck with skill is endemic in investing because the short term and the long term often diverge and investors tend to confuse frequency and severity.
• “What Matters May Not Be Measured and What Is Measured May Not Matter.” (Albert Einstein)
• Worse still, frequent measurement of performance is not only futile, it actually proves counterproductive.
• The ideal scenario is a money manager who has built an investor base with common investment philosophy, time horizon, resolve, and tolerance for underperformance. Only then can a manager maintain the stable capital base required to see his contrarian philosophy through to a successful conclusion.
• This is about managing expectations rather than managing money.
• In his book Active Portfolio Management, published in 1995, Ronald Kahn demonstrated through a series of equations that it takes sixteen years’ worth of performance data to prove skill over luck with a high degree (95 per cent) of statistical confidence.
• I would also seek managers who have been baptized in the school of hard knocks and not given in or given up. It takes character and fortitude, not just calibre and intellect, to succeed in this profession.
• Often, strategies appear compelling because they are easy to explain and understand, not because they are sound or effective in practice. When launching a new product, it has become easy to impress investors with backtesting statistics that predict high-performance potential. That kind of statistical evidence can seem very convincing but be careful. It may be none other than fanciful data mining that fails in practice because implementation costs are too high, or the targeted inefficiency is so small that it is unlikely to produce any meaningful returns. Evaluating skills and capability has predictive power; looking at historical performance does not.
• Leverage turbocharges performance in a bull market but decimates it in a bear market.
• However, exactly when the opportunity to make money is highest, investor interest is lowest. An out-of-favour asset class, sector, geography, or stock offers rich pickings for those who are willing to be contrarian. 

North Star

• Conducting differentiated research to identify what is misunderstood and therefore mispriced by the consensus. 2. Taking advantage of excessive pessimism that focuses unduly on negative developments in the near term while ignoring what can go right in the long term. 3. Investing countercyclically to other people’s investment appetite when the sentiment swings from greed to fear or reverence to repulsion. 4. Looking at pockets of the market suffering from sheer neglect. 5. Arbitraging differing time horizons, taking advantage of people’s inability or unwillingness to think long term.
• Whenever investors pursue a fad or a fetish, there is usually money to be made by looking at the opposite end of the spectrum.

A Special Message from Me to You

• Everywhere, I encountered people, practices, and cultures that seemed vastly different from one another. But on reflection, what my travels really revealed is not how different we are, but how similar: the same aspirations, if not the same ideals; the same values, even if not the same religion; the same basic human needs, wants, emotions, and vulnerabilities, even if expressed in different forms.
• However, in most situations, in-depth analysis or painstaking rigour is simply overkilled.

Book: Man for all Market

Edward O. Thorp -- A Genius -- Professor, Mathematician, Inventor, & A Successful Investor

In his autobiography, A Man For All Markets, Thorp shares everything about his life, his achievements, his failures and most importantly he has deconstructed the way he thinks. And in the end, Thorp shares his views on how individuals should try to think.

Below are some of the sections and the most interesting statements, observations, learnings, views of Thorp. The words in Italics are my words to give additional clarity where required.

Preface

• I found a resource that made all the difference: I learned how to think.
• I do all of these, but I also think using models. A model is a simplified version of reality, like a street map that shows you how to travel from one part of a city to another or the vision of gas as a swarm of tiny elastic balls ceaselessly bouncing against one another.
• Because of circumstances, I was largely self- taught and that led me to think differently.
• First, rather than subscribing to widely accepted views— such as you can’t beat the casinos— I checked for myself. Second, since I tested theories by inventing new experiments, I formed the habit of taking the result of pure thought— such as a formula for valuing warrants— and using it profitably. Third, when I set a worthwhile goal for myself, I made a realistic plan and persisted until I succeeded. Fourth, I strove to be consistently rational, not just in a specialized area of science, but in dealing with all aspects of the world. I also learned the value of withholding judgement until I could make a decision based on evidence.

Foreword

• True success is exiting some rat race to modulate one’s activities for peace of mind. Thorp certainly learned a lesson: The most stressful job he ever had was running the math department of the University of California, Irvine. You can detect that the man is in control of his life. This explains why he looked younger the second time I saw him, in 2016, than he did the first time, in 2005.

Chapter 1: LOVING TO LEARN

• From the beginning, I loved learning through experimentation and exploration of how my world worked.
• The books helped establish lifelong values of fair play, a level playing field for everyone, and treating others as I myself wish to be treated.
• The Great Depression’s twelve years of persistent widespread unemployment, peaking at 25 percent, were suddenly ended by the greatest government jobs program ever, World War II.

Chapter 2: SCIENCE IS MY PLAYGROUND

• Read through the list of 60 great novels, mostly American literature, by authors such as Thomas Wolfe, John Steinbeck, Theodore Dreiser, John Dos Passos, Upton Sinclair, Sinclair Lewis, Ernest Hemingway, and F. Scott Fitzgerald.
• Among foreign authors were Dostoyevski and Stendhal.
• I punctuated by hours of reading with body surfing and with thoughts about who I was and where I was going

Chapter 3: PHYSICS AND MATHEMATICS

• If you do this, what do you want to happen? and If you do this, what do you think will happen?
• Understanding and dealing correctly with the trade- off between risk and return is a fundamental, but poorly understood, challenge faced by all gamblers and investors.

Chapter 4: LAS VEGAS

• I also believed then, as I do now after more than fifty years as a money manager, that the surest way to get rich is to play only those gambling games or make those investments where I have an edge.

Chapter 5: CONQUERING BLACKJACK

• It is also common in science for the time to be right for a discovery, in which case it is made independently by two or more researchers at nearly the same time.
• Famous examples include calculus by Newton and Leibniz, and the theory of evolution by Darwin and Wallace.
• Proceedings of the National Academy of Sciences,
• On the other hand, students of plane geometry learn a simple method for bisecting an angle this way. A small change in the problem, from dividing an angle into two equal parts, to splitting it into three equal parts, transforms an easy problem into an impossible one.

Chapter 6: THE DAY OF THE LAMB

• In the abstract, life is a mixture of chance and choice. Chance can be thought of as the cards you are dealt in life. Choice is how you play them.
• Claude asked me at dinner if I thought anything would ever top this in my life. My thoughts then were much like I expected his to have been: that acknowledgment, applause, and honor are welcome and add zest to life but they are not ends to be pursued. I felt then, as I do now, that what matters is what you do and how you do it, the quality of the time you spend, and the people you share it with.
• This plan, of betting only at a level at which I was emotionally comfortable and not advancing until I was ready, enabled me to play my system with a calm and disciplined accuracy. This lesson from the blackjack tables would prove invaluable throughout my investment lifetime as the stakes grew ever larger.
• For the second time, the Ten- Count System had shown moderately heavy losses mixed with “lucky” streaks of the most dazzling brilliance. I learned later that this was a characteristic of a random series of favorable bets. And I would see it again and again in real life in both the gambling and the investment worlds.

Chapter 7: CARD COUNTING FOR EVERYONE

• He studied the theory of card shuffling, and the popular press widely reported his conclusion that seven fairly thorough shuffles was enough for practical purposes to randomize any deck of cards.

Chapter 9: A COMPUTER THAT PREDICTS ROULETTE

• In 1998 a New York Times Science Times article said that mathematicians had discovered how networks might “make a big world small” using the equivalent of the famous person idea, and attributed the concept of six degrees of separation to a sociologist in 1967. Yet all this was known to Claude Shannon in 1960.

Chapter 10: AN EDGE AT OTHER GAMBLING GAMES

• I am often asked what it takes to be a successful card counter. I’ve found that an academic understanding is not enough. You need to think quickly, be disciplined enough to follow the system, and have a suitable temperament, including the ability to switch your mind into the here and now and stay focused on the cards, the people, and your surroundings.

Chapter 11: WALL STREET: THE GREATEST CASINO ON EARTH

• I read stock market classics like Graham and Dodd’s Security Analysis, Edwards and Magee’s work on technical analysis, and scores of other books and periodicals ranging from fundamental to technical, theoretical to practical, and simple to abstruse.
• Behavioral finance theorists, who have in recent decades begun to analyze the psychological errors in thinking that persistently bedevil most investors, call this anchoring (of yourself to a price that has meaning to you but not to the market).
• Like my first mistake, this error was in the way I thought about the problem of when to sell, choosing an irrelevant criterion— the price I paid— rather than focusing on economic fundamentals like whether cash or alternative investments would serve better.
• Lesson: Do not assume that what investors call momentum, a long streak of either rising or falling prices, will continue unless you can make a sound case that it will.
• I also learned from my losing silver investment that when the interests of the salesmen and promoters differ from those of the client, the client had better look out for himself. This is the well- known agency problem in economics, where the interest of the agents or managers don’t coincide with those of the principals, or owners.

Chapter 12: BRIDGE WITH BUFFETT

• Afterward, when I was thinking about Buffett, his favorite game— bridge— and the nontransitive dice, I wondered whether bidding systems at bridge might be like those dice. Could it be that no matter which bidding system you use, there will always be another system that beats it, so there’s no best system? If so, the inventors of new “better” bidding systems could be chasing their tails forever, only to have their systems beaten by still newer systems, which in turn might then lose to old previously discarded systems.

Chapter 13: GOING INTO PARTNERSHIP

• Unknown to Einstein, his equations describing the Brownian motion of pollen particles were essentially the same as the equations that Bachelier had used for his thesis five years earlier to describe a very different phenomenon, the ceaseless, irregular motion of stock prices. Bachelier employed the equations to deduce the “fair” prices for options on the underlying stocks.
• Bachelier’s paper appeared in 1964 in The Random Character of Stock Market Prices, edited by Paul Cootner and published by the MIT Press.
• Bachelier had assumed that changes in stock prices followed a bell-shaped curve, known as a normal or Gaussian distribution.
• Moreover, PNP made money every month in its first six years except for one in early 1974, when it declined less than 1 percent. From the peak on January 11, 1973, to the bottom on October 3, 1974, the drop in the stock market was a savage 48.2 percent, the worst since the Great Depression. Even Warren Buffett said then that it was a good thing for his partners he’d closed down when he had.
• Perverse incentive by giving everyone a single pool of paid leave days that accumulated based on the number of hours worked and covered paid holidays, vacations, days off, and illness. Employees could use this time in any of these ways, subject only to the limitation that time off not interfere with essential job responsibilities.
• In fifty-five and a half years of marriage I don’t ever remember her bragging. The closest she came was when I would admire the way she matched the hues of her outfits or furnished our household with a designer’s eye. She would look at me and matter- of- factly explain, “I have a good eye for color.”
• Initially, I transferred to UCI’s Graduate School of Management, where I enjoyed teaching courses in mathematical finance. But I found factionalism and backstabbing as bad there as it had been in the Math Department.

Chapter 14: FRONT-RUNNING THE QUANTITATIVE REVOLUTION

• We analyzed and incorporated tail risk, and considered extreme questions such as, “What if the market fell 25 percent in one day?” More than a decade later it did exactly that and our portfolio was barely affected.
• The next big test of PNP’s investment approach came soon afterwards. From 1979 through 1982 there were extreme distortions in the markets.

Chapter 15: RISE . . .

• The prototype was Value Line, an investment service that launched a program in 1965 using information such as surprise earnings announcements, price- to- earnings ratios, and momentum to rank stocks into groups from I (best) to V (worst).
• stock is said to have positive momentum if its price has recently been trending strongly up, and negative momentum if strongly down.
• other data were marketed by CRSP, the University of Chicago’s Center for Research in Security Prices.
• The Compustat database provided historical balance sheet and income information.
• When the historical patterns persisted as prices unfolded into the future, we created a trading system called MIDAS (multiple indicator diversified asset system) and used it to run a separate long/ short hedge fund (long the “good” stocks, short the “bad” ones). The power of MIDAS was that it applied to the entire multitrillion-dollar stock market, with the possibility of investing very large sums.

Chapter 17: PERIOD OF ADJUSTMENT

• What the hagglers and the traders do reminds me of the behavioral psychology distinction between two extremes on a continuum of types: satisficers and maximizers. When a maximizer goes shopping, looks for a handyman, buys gas, or plans a trip, he searches for the best (maximum) possible deal. Time and effort don’t matter much. Missing the very best deal leads to regret and stress. On the other hand, the satisficer, so-called because he is satisfied with a result that is close to the best, factors in the costs of searching and decision making, as well as the risk of losing a near- optimal opportunity and perhaps never finding anything as good again.

Chapter 18: SWINDLES AND HAZARDS

• In the early 1980s, a decade before coming across Madoff, I learned of a remarkable investment manager. This foreign exchange trader was racking up returns of 1 percent, 2 percent, 3 percent, and even 4 percent a month. He seemed never to lose. I asked George Shows, an associate in my Newport Beach office, to make an onsite visit to J. David Dominelli in nearby La Jolla. George came back with the amazing track record and “advertising” literature but could find no evidence of any actual trading activity. Our requests for audited financial statements, proof of assets, and proof of trades were smoothly deflected. I suspected a Ponzi scheme, and we didn’t invest. Two years later Dominelli’s scam collapsed in 1984, wiping out $ 200 million and defrauding one thousand investors, including many of the social, political, and financial elite of the San Diego area.
• On HFT -- Some securities industry spokesmen argue that harvesting this wealth from investors somehow makes the markets more efficient and that “markets need liquidity.” Nobel Prize-winning economist Paul Krugman disagrees sharply, arguing that high- frequency trading is simply a way of taking wealth from ordinary investors, serves no useful purpose, and wastes national wealth because the resources consumed create no social good.
• On Silly Reporters & Headlines -- Offering explanations for insignificant price changes is a recurrent event in financial reporting. The reporters often don’t know whether a fluctuation is statistically common or rare. Then again, people tend to make the error of seeing patterns or explanations when there aren’t any, as we’ve seen from the history of gambling systems, the plethora of worthless pattern- based trading methods, and much of story-based investing.

Chapter 19: BUYING LOW, SELLING HIGH

• Market professionals describe stocks with large trading volume as “liquid”; they have the advantage of being easier to trade without moving the price up or down as much in the process. The latest prices from the exchanges flow into our computers and are compared at once with the current fair value according to our model. When the actual price differs enough from the fair price, we buy the underpriced and short the overpriced. To control risk, we limit the dollar value we hold in the stock of any one company. Our caution and our risk- control measures seem to work. Our daily, weekly, and monthly results are “positively skewed,” meaning that we have substantially more large winning days, weeks, and months than losing ones, and the gainers tend to be bigger than the losers.
• Scanning the computer screen, I see the day’s interesting positions, including the biggest gainers and the biggest losers. I can see quickly if any winners or losers seem unusually large. Everything looks normal. I walk down the hall to Steve Mizusawa’s office, where he is watching his Bloomberg terminal, checking for news that might have a big impact on one of the stocks we trade. When he finds events such as the unexpected announcement of a merger, takeover, spin-off, or reorganization, he tells the computer to put the stock on the restricted list: Don’t initiate a new position and close out what we have.
• Why is statistical arbitrage so-called? Arbitrage originally meant a pair of offsetting positions that lock in a sure profit. An example might be selling gold in London at $ 300 an ounce while at the same time buying it at $ 290 in New York for a $ 10 gain. If the total cost to finance the deal and to insure and deliver the New York gold to London were $ 5, it would leave a $ 5 sure profit. That’s an arbitrage in its original usage.
• For instance, in what is called merger arbitrage, company A trading at $ 100 a share may offer to buy company B, trading at $ 70 a share, by exchanging one share of company A for each share of company B.
• The market reacts instantly and company A’s shares drop to, say, $ 88 while company B’s shares jump to $ 83. Merger arbitrageurs now step in, buying a share of B at $ 83 and selling short a share of A at $ 88. If the deal closes in three months, the arbitrageur will make $ 5 on an $ 83 investment or 6 percent. But the deal is not certain until it gets regulatory and shareholder approval, so there is a risk of loss should the negotiations fail and the prices of A and B reverse. If the stocks of A and B returned to their preannouncement prices, the arbitrageur would lose $ 12 = $ 100 − $ 88 on his short sale of A and $ 13 = $ 83 − $ 70 on his purchase of B, for a total loss of $ 25 per $ 83 invested, or 30 percent. The arbitrageur won’t take this lopsided risk unless he believes the chance of failure to be small.
• The idea of the project was to study how the historical returns of securities were related to various characteristics, or indicators. Among the scores of fundamental and technical measures we considered were the ratio of earnings per share to price per share, known as the earnings yield, the liquidation or “book” value of the company compared with its market price, and the total market value of the company (its “size”). 
• The room also had its own safety system. In case of fire, the air was automatically replaced by noncombustible halogen gas within eighty seconds. Once this happened the room had too little oxygen for fire to burn or for people to breathe. We practiced how to get out in time and to trigger the halogen manually, if necessary.
• The Computing Power of PNP Partners -- Our facility was high- tech in the mid- 1980s, but with the enormous increase in computer miniaturization, speed, and cheapness, now even cellphones store many gigabytes. The room was chilled to a constant sixty degrees Fahrenheit by its own cooling system and had sealed doors and dust filters to keep the air clean. 
• To control risk further, I replaced Bamberger’s segregation into industry groups by a statistical procedure called factor analysis. Factors are common tendencies shared by several, many, or all companies. The most important is called the market factor, which measures the tendency of each stock price to move up and down with the market. 
• The daily returns on any stock can be expressed as a part that follows the market plus what’s left over, the so-called residual. Financial theorists and practitioners have identified a large number of such factors that help explain changes in securities prices.
• Some, like participation in a specified industry group or sector (say, oil or finance) mainly affect subgroups of stocks. Other factors, such as the market itself, the levels of short- term and long- term interest rates, and inflation, affect nearly all stocks.
• The portfolio is already market-neutral by constraining the relation between the long and short portfolios so that the tendency of the long side to follow the market is offset by an equal but opposite effect on the short side.
• Of course, there is a trade-off: The reduction in risk is accompanied by limiting the choice of possible portfolios. Only those that are market- neutral, inflation- neutral, oil- price- neutral, et cetera, are now allowed, and so the attempt to reduce risk also tends to reduce return.
• We called the new method STAR, for “STatistical ARbitrage.”
• One reason is that buying undervalued securities tends to raise the price, reducing or eliminating the mispricing, and selling short overpriced securities tends to lower the price, once again shrinking the mispricing. Thus, opportunities for beating the market are limited in size by how trading them affects market prices.

Chapter 22: HEDGING YOUR BETS

• If you have an area of expertise, look for funds that your knowledge can help you evaluate. Hedge fund data services typically list more than a thousand or so funds from the several thousand that currently exist. These services, along with Internet sources like Wikipedia, classify hedge funds by asset types. Another way to sort is by methodology, such as: fundamental, using economic data as opposed to technical, using just price and volume data; or quantitative (using computers and algorithms) compared with non-quantitative; or bottom-up (analyzing individual companies) versus top- down (focusing on broader economic variables). Other important characteristics are the fund’s expected returns, risks, and how the payoffs correlate with those from other asset classes. For instance, the returns from funds that exploit trends in the prices of commodity futures often are not correlated significantly with the market. This can make them useful in reducing the fluctuations in the value of your overall portfolio. There are equity long- only funds, short- only funds, and long/ short funds. Market-neutral funds (like PNP and Ridgeline) attempt to have returns uncorrelated with the market.
• Improperly charging expenses to the partnership is another way that the limited partners get less than they should. The list of issues goes on, the point being that hedge fund investors don’t have much protection and that the most important single thing to check before investing is the honesty, ethics, and character of the operators.

Chapter 23: HOW RICH IS RICH?

• Read up the article -- “Budget Basics: 25 Things You Can Do to Trim Yours Today”
• If you’re uncertain, put in a low value for what you own and a high value for what you owe, leading to a conservative value for what you’re worth.
• Later you will want to make a more accurate balance sheet, which I do about once a year. The difference in balance sheet net worth from one year to the next shows the change in your total wealth after income, expenses, gains and losses.
• In the asset section, for each item list the amount of cash you feel sure it would sell for in a reasonably short time. That car you bought new a year ago for $ 45,000 might have a replacement cost of $ 39,000 now, but you might be able to sell it for only $ 35,000. Put down $ 35,000. Recent sales of houses comparable with yours might range from $ 925,000 to $ 950,000, but after all sales and closing costs, you might net only $ 875,000. Put down $ 875,000. What you owe on the mortgage will be deducted in the liabilities section.
• A. Income, taxable and nontaxable: 1. Earned income such as wages and salaries. 2. Unearned income such as interest and dividends. 3. Realized capital gains and losses. 4. Royalties, honoraria, all other taxable receipts. 5. Tax- free interest, such as municipal bonds. 
• B. Nontaxable gains and losses: 1. Appreciation or depreciation of property such as real estate, art, and autos. 2. Unrealized capital gains or losses in securities. C. Expenses (all money paid out for “costs”— that is, not saved): 1. Living expenses, consumption. 2. Income taxes. 3. Gifts. 4. Any other money earned but not saved.
• As the folly of paying unnecessary taxes dawned on investors, the dividend rate paid by companies in the last part of the twentieth-century dwindled and stock prices soared, shifting returns away from income and toward capital gains.
• Category C is everything you spend or consume that doesn’t contribute to your wealth. Think of your wealth at the start of the year as liquid partly filling a huge measuring cup. The balance sheet tells you how much is there. During the year categories, A and B tell how much you add and category C tells you how much you takeout. The difference, A + B − C, is how much you added or subtracted during the year.

Chapter 24: COMPOUND GROWTH: THE EIGHTH WONDER OF THE WORLD

• “the rule of 72” It says: If money grows at a percentage R in each period then, with all gains reinvested, it will double in 72/ R periods.
• I apply this to the trade-offs among health, wealth, and time. You can trade time and health to accumulate more wealth. Why health? You may be stressed, lose sleep, have a poor diet, or skip exercise. If you are like me and want better health, you can invest time and money on medical care, diagnostic and preventive measures, and exercise and fitness. For decades I have spent six to eight hours a week running, hiking, walking, playing tennis, and working out in a gym. I think of each hour spent on fitness as one day less that I’ll spend in a hospital. Or you can trade money for time by working less and buying goods and services that save time. Hire household help, a personal assistant, and pay other people to do things you don’t want to do. Thousand- dollar- an- hour New York professionals who pay $ 50 an hour for a car and driver so they can work while they commute understand clearly the monetary value of their time.
• To get an idea of what your time is worth, take a moment now to think about how much you work and the income you get from your effort. Once you know your hourly rate you can identify situations where buying back some of your time is a bargain and other situations where you want to be selling more of your time. As you get used to thinking this way, I predict that you will often be surprised at how much you can gain.
• Think of the single worker who spends two hours commuting forty miles from hot and smoggy Riverside, California, to a $ 25- an- hour job in balmy Newport Beach. If the worker moves from his $ 1,200- a- month apartment in Riverside to a comparable $ 2,500- a- month apartment in Newport Beach, his rent increases by $ 1,300 a month but he avoids forty hours of commuting. If his time is worth $ 25 per hour he would save $ 1,000 ($ 25 × 40) each month. Add to that the cost of driving his car an extra sixteen hundred miles. If his economical car costs him 50 cents a mile or $ 800 a month to operate, living in Newport Beach and saving forty hours’ driving time each month makes him $ 500 better off ($ 1,000 + $ 800 − $ 1,300). In effect he earned just $ 12.50 per hour during his commute. Does our worker figure this out? I suspect he does not, because the extra $ 1,300 a month in rent he would pay in Newport Beach is a clearly visible cost that is painfully and regularly inflicted, whereas the cost of his car is less evident and can be put out of mind.
• Spend an average of forty or more hours a week watching television (playing online games, watching movies, snapchat, twitter, etc). Those who do have plenty of “junk time,” which they can use instead for an exercise or fitness program. Five hours a week for this can add five years of healthy life.

Chapter 26: CAN YOU BEAT THE MARKET? SHOULD YOU TRY?

• In 2007-08: In some cases we could even buy SPACs holding US Treasuries at annualized rates of return to us of 10 to 12 per cent, cashing out in a few months. This was at a time when short- term rates on US Treasuries had fallen to approximately zero! For those who still believe that the market always prices securities properly, here’s a profit opportunity that arose because investors couldn’t even do arithmetic.

Chapter 27: ASSET ALLOCATION AND WEALTH MANAGEMENT

• Major Asset Classes and Subdivisions 
  EQUITIES Common Stock Preferred Stock Warrants and Convertibles Private Equity 
  INTEREST RATE SECURITIES Bonds US Government Corporate Municipal Convertibles Cash US Treasury Bills Savings Accounts Certificates of Deposit Mortgage- Backed Securities 
  REAL ESTATE Residential Commercial
  COMMODITIES Agricultural Industrial Currencies Precious metals
  COLLECTIBLES (Art, gems, coins, autos, etc.)
  MISCELLANEOUS (MARKETABLE) PERSONAL PROPERTY Motor vehicles, planes, boats, jewelry, etc.
• Investors who chase returns, buying asset classes on the way up and selling on the way down, have had poor historical results. The tech bubble that ended in 2000, the inflation in real estate prices that peaked in 2006, and the sharp drop in equity prices in 2008– 09 were especially costly for them. On the other hand, the buy- low/ sell- high investors, whom you might think of as “contrarian” or “value” investors, have tended to outperform by switching some funds between asset classes.
• On Real Estates -- For many it is a large part of their wealth. How good an investment has it been? In 1952, one of my uncles and his wife paid $ 12,000 for a small one- story wood- and- stucco home in the working- class community of Torrance, California. In 2006, he sold his house near the peak of the real estate bubble, which was especially extreme in California. Despite the deterioration of his neighborhood into a borderline gang area, and the advanced age of his house, he netted about $ 480,000 after taxes and commissions. His investment multiplied forty times in fifty- four years, for a compound annual return of 7 percent. Also, his expenses of a few percent a year in property taxes and maintenance were less than what he would have paid to rent a similar property.
• To cut taxes, start with a tracking basket and, each time a stock drops, say, 10 percent, sell the loser and reinvest the proceeds in another stock or stocks chosen so the new basket continues to track well. If you want only short- term losses, which is usually best, sell within a year of purchase. I advise anyone considering doing this in a serious way to study it first with simulations using historical databases.
• The lack of liquidity in hedge funds and in real estate would prove costly for investors in the 2008– 09 recession.
• Because you can’t get out in time when trouble is coming, the excess returns you expect from illiquid investments may be offset by the economic impact of unforeseen future events.
• The lesson of leverage is this: Assume that the worst imaginable outcome will occur and ask whether you can tolerate it. If the answer is no, then reduce your borrowing.
• In his fascinating history of the topic, Fortune’s Formula, William Poundstone points out that for a favorable bet that pays odds of $ A for a bet of $ 1, the optimal Kelly bet is the percent of your capital equal to your edge, divided by the odds, A.
• Kelly’s criterion is not limited to two- value payoffs but applies generally to any gambling or investing situation in which the probabilities are known or can be estimated.
• (1) The investor or bettor generally avoids total loss;
  (2) the bigger the edge, the larger the bet;
  (3) the smaller the risk, the larger the bet.
• (1) The Kelly Criterion may lead to wide swings in the total wealth, so most users choose to bet some lesser fraction, typically one- half Kelly or less;
  (2) for investors with short time horizons or who are averse to risk, other approaches may be better;
  (3) an exact application of Kelly requires exact probabilities of payoffs such as those in most casino games; to the extent these are uncertain, which is generally the case in the investment world, the Kelly bet should be based on a conservative estimate of the outcome.
• Investing heavily in extremely favorable situations is characteristic of a Kelly bettor.

Chapter 28: GIVING BACK

• We wanted at least 90 percent of the amount we gave to be spent directly on our target purpose, rather than on fundraising and administration. You can check this percentage for any nonprofit organization from its annual financial statements by looking at the ratio of money spent on the target to the amount of money spent overall.
• Vivian and I were indebted to the University of California system for giving us a quality education that we could not have afforded otherwise. It was also where we met. We enjoyed saying thank you.

Chapter 29: FINANCIAL CRISES: LESSONS NOT LEARNED

• But the key to the disaster that followed was easy money and leverage. Investors could buy stocks on as little as 10 percent margin, meaning that they could put up only 10 percent of the purchase price and borrow the other 90 percent. It sounds eerily familiar because it is. The 2008 collapse in housing prices had the same cause: unlimited unsound loans to create highly leveraged borrowers.
• Brooksley Born wanted to regulate the derivatives that would later be a major cause of disaster, the PBS program Frontline detailed how she was blocked in 1998 by the triumvirate of Federal Reserve chairman Alan Greenspan, US Treasury Secretary Robert Rubin, and Deputy US Treasury Secretary Lawrence Summers, all of whom would later advise government on the 2008–09 bailout. Nassim Taleb asked why, after a driver crashes his school bus, killing and injuring his passengers, he should be put in charge of another bus and asked to set up new safety rules.
• 2004, five major investment banks persuaded the US Securities and Exchange Commission to increase their allowable leverage. Previously, they could borrow $ 11 for every $ 1 of net worth. This meant they only had $ 1 out of every $ 12, or 8.33 percent, as a cushion against disaster. Under its chairman Christopher Cox, the SEC allowed Goldman Sachs, Morgan Stanley, Merrill Lynch, Bear Stearns, and Lehman Brothers to expand their leverage to something like 33:1, rivalling the levels that doomed the ill- fated hedge fund Long-Term Capital Management just six years earlier. With, say, $ 33 in assets and $ 32 of liabilities for each $ 1 of net worth, a decline of a little over 3 percent in assets would wipe out their equity. Once this happened and a bank was known to be technically insolvent, creditors would demand payment while they could still get it, triggering a classic run on the bank, just as in the 1930s.
• Programs like the Works Progress Administration (WPA) and the Civilian Conservation Corps (CCC), which I remember from my childhood, built roads, bridges, and public works during the 1930s, and the improvement in our infrastructure benefited us all for decades.
• How can we prevent future financial crises driven by the systemic and scarcely regulated use of extreme leverage?
• Institutions that are “too big to fail,” and have a significant risk of doing so should be broken into pieces that are small enough to fail without jeopardizing the financial system.
• Canada did not see any massive meltdown in 2008. The difference was that Canada had strict standards for mortgages and tighter limits on bank leverage and risk.
• We privatize profit and socialize risk.
• Compared with one of their average workers, CEOs in 1965 took home 24 times as much but “four decades later the ratio was 411 to 1.”
• Another indication of increasing economic inequality is the share of national income captured by the top one- hundredth of 1 percent of all earners. In 1929 they captured 10 percent of national income. This fell to about 5 percent during the Great Depression, gradually rising again beginning in the 1980s. In the last few years the share of national income claimed by these 12,500 households broke its 1929 record of 10 percent and continues to increase. These executives claim that their compensation inspires them to be the creative engines of capitalist society, benefiting all of us. The crisis of 2008 is one of our rewards.
• Studies done both before and after the 2008–09 recession showed that the larger the percentage of corporate profit paid to the top five executives, the poorer the earnings and the stock performance of the company.
• However, as Moshe Adler, in his article “Overthrowing the Overpaid,” points out, economists David Ricardo and Adam Smith, writing more than two hundred years ago, “concluded that what a person earns is determined not by what that person has produced but by that person’s bargaining power. Why? Because production is typically carried out by teams . . . and the contribution of each member cannot be separated from that of the rest.”
• The company rules are deliberately designed to make it difficult or impossible for independent shareholders to nominate directors or place issues on the ballot. Instead, corporations — their legal existence already being permitted and regulated by the state— should be required to conduct democratic elections following the usual voting rules in our American democracy. Moreover, any block of shareholders that together holds some specified percentage of the shares should have the unrestricted right to nominate directors and to put issues on the ballot, including the replacement of board members and top executives.
• Management may, for instance, own A shares with ten votes each and the public may own B shares with one vote each. How would you like to live in a country where any “insider” could cast ten votes and any “outsider” got only one? Abolish this and make it one share, one vote.
• Institutions that hold shares in custody for their owners can cast proxy votes for those shareholders who decline to vote. These proxies usually perpetuate current management and ratify its decisions. Change this so that the only votes that count are those cast directly by the shareholder; so- called proxy votes would not count. These two measures— democratic elections and shareholder rights to put issues to a vote— would allow the owners of the company, namely, the shareholders, to exert control over the compensation of top executives, their so-called agents, and would, in my opinion, be far more effective and accurate than direct government regulation.
• As the philosopher George Santayana famously warned, “Those who cannot remember the past are condemned to repeat it.”

Chapter 30: THOUGHTS

• Education has made all the difference for me. Mathematics taught me to reason logically
• Physics, chemistry, astronomy, and biology revealed wonders of the world and showed me how to build models and theories to describe and to predict. This paid off for me in both gambling and investing.
• One of the major public policy issues today is the trade- off between the costs and the benefits of certain procedures. Some choices are stark. Is it better to spend $ 500,000 to save the life of someone with super-drug-resistant tuberculosis or to use the same amount to save fifty lives by delivering fifty thousand doses of flu vaccine at $ 10 each to schoolchildren? Statistical thinking can help us with choices like these.
• I believe that simple probability and statistics should be taught in grades kindergarten through twelve and that analyzing games of chance such as coin matching, dice, and roulette is one way we can learn enough to think through such issues. Understanding why casinos usually win might help us avoid gambling and teach us to limit our losses to their entertainment value.
• Gambling now is largely a socially corrosive tax on ignorance, draining money from those who cannot afford the losses.
• Most of what I’ve learned from gambling also is true for investing. People mostly don’t understand risk, reward, and uncertainty.
• This well- known strategy, called laddering, generally pays off because longer-term US bonds, with more price fluctuation, before they mature, generally yield more. Five- year bonds have beaten thirty- day T- bills by about 1.8 per cent annually over the last eighty- three years.
• One of my great pleasures from the study of investing, finance and economics is the discovery of insights about people and society. The physical sciences have rules such as the law of gravitation that generally holds true in the world as we know it. But human beings and the way they interact aren’t covered by broad, unchanging theories and may never be. Instead I’ve come across more limited concepts that tie things together and serve as shortcuts to understanding.
• Productivity would be maximized as though guided by an “invisible hand.” The notion is of limited use, because most markets are not as Smith assumed. Take computer chips: 99.8 percent of them, worldwide, are made by just two US companies, and the smaller one is fighting to survive.
• “The tragedy of the commons,” as explained in 1968 by Garrett Hardin. Example of the tragedy of the commons -- On a global scale, we have the example of pollution. Individual humans have freely burned fossil fuels and greatly increased the amount of greenhouse gases such as CO2, leading to a continuing rise in the earth’s temperature over the last century. The tiny particles also emitted have caused lung diseases and deaths. But each polluter gains more individually from his own actions than he loses, so he has no direct pressure to change.
• “Externalities.” In the arcane jargon so beloved by the economic priesthood, an externality is a cost or benefit for society that results from private economic activity. The externality is negative in the case of air pollution. The “fair” solution then becomes obvious: Estimate the damage and tax it by that amount. Externalities also can be positive.
• Berkshire Hathaway’s Charlie Munger presents his list of such thinking tools in the engaging Poor Charlie’s Almanack: The Wit and Wisdom of Charles T. Munger. This multidisciplinary collection of insights includes a favourite of mine for understanding deals and relationships, namely, “Look for the incentives,” which is closely related to finding “Cui bono?” or “Who gains?” Cui bono instantly explains why seven thousand US gun dealers, lining the border with Mexico from Tijuana to Corpus Christi, are allowed freely to provide nearly all the military- level arms used by the Mexican drug cartels.
• More insights come from a much bigger idea of fundamental importance for all investors, the recognition that the group I call the politically connected rich are the dominant economic and political power in the United States. This is a key concept for understanding what happens in our society and why it happens. They are the ones who buy politicians, using campaign contributions, career opportunities, investment profits, and more. As owners of wealth who also control power, they run the country and will continue to do so. We saw how they used the government to bail them out of the financial crisis of 2008– 09. The power in this group resides mostly in those who are in the upper 0.01 per cent of wealth holders, currently worth $ 125 million or more.
• Another theme for dealing with public policy issues is to simplify rules, regulations, and laws.
• The hardest part, more often than not, is passing laws to implement it. This has become harder, as the political clash between the parties in the United States has become extreme. Politics once called the art of the possible, is becoming the art of the impossible. Gridlock between uncompromising factions was one cause of the fall of the Roman Empire.
• History, arguably, has had just two great superpowers, the Roman Empire after the defeat of Carthage, and the United States after the fall of the Soviet Union. Of great importance for long- term investors is whether the US will be the dominant world power in the twenty-first century, or whether we have peaked, dissipating our strength in costly foreign wars, financial mismanagement, and domestic strife. The first scenario could lead to another century of equities returning 7 per cent a year after inflation. The other outcome could be far less pleasant. I reassure the pessimists by noting that we’re still rich, still innovating, and besides, Rome wasn’t destroyed in a day. Nations that were once among the most powerful, such as Britain, France, Italy, Spain, the Netherlands, and Portugal, are still among the most developed and civilized of countries. To the optimists, I mention the obvious: endless deficits, massive wastage of lives and wealth in wars, political subsidies (pork, bailouts, corporate welfare, paying the able-bodied not to work), and destructive partisanship in all three branches of government. Meanwhile, the rise of China is transforming the geopolitical and economic landscape.
• The ten campuses of the University of California, once among the finest public systems of higher education in the world, raised tuition to $ 12,000 a year by 2015. When I was a student in 1949 it was $ 70, which is like $ 700 today, adjusting for inflation. A good education was available to any qualified student. The university’s graduates went on to lead the technological revolution, but by 2014 the state contributed only about 10 per cent of the total cost of all campus operations. If the UC system doubled tuition and fees it could drop state support altogether and go private! Since out- of- state and foreign students are charged three times the tuition paid by California residents, individual deans and administrators are raising more money by replacing the latter by the former. Meanwhile gifted foreign students, many of them Chinese, receive advanced degrees in the United States and return home, rather than struggle for postdoctoral funding and permission to become residents. Talented American- born scientists and engineers are joining them in a reverse brain drain. Economists have found that one factor has explained a nation’s future economic growth and prosperity more than any other: its output of scientists and engineers. To starve education is to eat our seed corn. No tax today, no technology tomorrow.

Epilogue

• Life is like reading a novel or running a marathon. It’s not so much about reaching a goal but rather about the journey itself and the experiences along the way. As Benjamin Franklin famously said, “Time is the stuff life is made of,” and how you spend it makes all the difference.