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Investing in The Unknowable: Red Flags and Opportunities

Investing in The Unknowable: Red Flags and Opportunities. July 3, 2011. THE FAT SEAGULL — The Current Salience of Behavioral Finance. Stock Market November 2008. 100%. Housing 2007. Panic. Euphoria. Psychological versus Value Pricing. 0%. 1. Low. High.

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Investing in The Unknowable: Red Flags and Opportunities

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  1. Investing in The Unknowable: Red Flags and Opportunities July 3, 2011

  2. THE FAT SEAGULL— The Current Salience of Behavioral Finance Stock Market November 2008 100% Housing 2007 Panic Euphoria Psychological versus Value Pricing 0% 1 Low High Price/Value Ratio Relative to History or Recent Norms Frequency Fat-Tailed Distribution Price/Value Ratio

  3. Mr. Market Powerful, Trickster, Readily Able to Change Shape Old rules do not apply, at least while Loki remains in his trickster mode: Mechanism: Investors respond to past market behavior. That transforms the nature of market behavior.

  4. Regulating Finance

  5. The MeltdownA Grey Swan Subtle warnings were there

  6. Lightning Bolt or Earthquake • Lightning bolt – Out of the blue, unforeseeable. • Earthquake – Pressure builds up in a fault line. Finally slips. Great damage done. • New paradigm – • Immense volatility • Interconnectedness among markets (psychological and real) • Negative sentiment seems to presage falling not rising market. • Individual stock selection may pay. • Critical questions: • Will momentum continue to be an explanatory factor? • Will small investors come back to equities? • Has volatility moved to a new level? • Can trust in major financial institutions be restored?– Reputational externalities.

  7. The Market Rolls Down Real Asset (Housing) Real Asset (Housing) Transparent Derivatives Opaque Derivatives Effective Rating Mechanisms Flawed Rating Mechanisms Reasonable Leverage Excessive Leverage Effective Government Bailout (Liquidity, Confidence) Impotent Government Bailout Rock Bottom Recovery

  8. European Markets Moved Down with Dow Jones DowJones Weekly Averages, Indexed Values* AEX DAX VIX** Jan 2007 Jan 2008 Oct 2008 * DowJones, AEX and DAX indexed to January 3rd, 2007 = 100, VIX not indexed ** CBOE Volatility Index Source: EuroNext, Yahoo! Finance, Ojobo Atukulu, Ronald Roosdorp, Christoph Schwerdtfeger API302-EE-2008-10-30

  9. Metaphor for Market Slide • At every table. Each person picks a number from 1 to 100. • If all numbers at a table are 50 or over, each person gets $10. • If any number at a table is under 50: • Any player 50 or over gets $2. • Any player under 50 gets $8.

  10. Red Flags Before the Meltdown • Transparency is not certain. You do not know earnings. You do not know risks. • Experts are fooled. You will be fooled. • Bubble in one market implies bubble in many markets. Bubbles are contagious. • Treating bubbles alike. Housing bubble worse than NASDAQ bubble. Much greater penetration to real economy. • Finance executives Keeping Up with the Joneses. • Failure to trace contagion of risks. RJZ recognizing subprime, missing AIG. • Financial termites.

  11. Red Flags After the Meltdown • Earthquake. Old wisdom may not apply. • People asking about the bottom. Statistically very unlikely to be picked. • Small losses of value – fundamentals matter. Large losses of value – Keynes beauty contest and the fun-house mirror. • You feel a need for a short-term investment.

  12. Gaining Reassurance Without Reason Quotations from the Great Depression Recovery?

  13. Quotations from the Great Depression http://www.doublestandards.org/depression1.html

  14. Quotations from the Great Depression http://www.doublestandards.org/depression1.html Hank Paulson, May 2008 to the Wall Street Journal: "I do believe that the worst is likely to be behind us."

  15. Probability Neglect Table 1. Willingness to Pay in Dollars for Elimination of Arsenic Risks Median Response Unemotional Emotional Probability description description 1/1,000,000 25 100 1/100,000 100 100 • Panic selling. • Pollyannish buying. • Making investment decisions, it is critical to distinguish between 1 chance in 10 and 1 in 100, though our brains are not wired to do so.

  16. Opportunities in the UnknowableDavid Ricardo Battle of Waterloo Four days before the battle. He understood “dismal forebodings.” • Not a military analyst BAD • No basis to compute the odds BAD BUT • Knew that the competition was thin. GOOD • The seller was eager. GOOD • The pounds if he won would be worth much more than the pounds if he lost. VERY GOOD The financing was 36 million pounds. Ricardo took a substantial share. Malthus bailed out on 5,000 pounds. Ricardo made more than $50 million by today’s standards, and that does not allow for the increased value of the pound.

  17. Risk, Uncertainty and Ignorance Escalating Challenges to Effective Investing • Overall goal: Select assets that will do well when future states of the world become known. • Probabilities known: RISK. Merely an portfolio optimization problem. CAPM • Probabilities unknown: UNCERTAINTY. Big payoff to person who estimates probabilities the best. Warren Buffett’s approach. • Real world of investing ratchets the level of non-knowledge into still another dimension. Even the IDENTITY and NATURE of POSSIBLE FUTURE STATES are UNKNOWN. • The WORLD OF IGNORANCE. One can’t sensibly assign probabilities to the unknown states of the world. • Risk – Modern finance theory triumphs. • Uncertainty – Modern finance theory hits the wall. • Ignorance – Unknown and unknowable (UU) – Need new skills. Standard investors steer clear. Greatest profits available.

  18. Opportunities in the Meltdown • Prices out of line between stocks. Brookfield Infrastructure Properties. Closed-end funds, conglomerates. Toyota Industries (Marty Whitman) – selling just over $20…$22 of Toyota Motors stock, $8-9 other portfolio companies, $2 in earnings Gazprom, down 67% this year…Other international oils down modestly. • Tax strategies. Sell losers. Capitalize on highly volatile assets for tax losses. • Go to the source. If you really know the details on a stock you are much better off than usual. • Capitalize on the weakness of others. Buffett and the need for reassurance. Provision of capital for nearly completed deals.

  19. Dreary and Positive Conclusions • Dreary 1. Unknown and unknowable situations are widespread. (As unknowable today as 1997 Asian meltdown, 9/11 attacks, NASDAQ soar and swoon at turn of century, subprime crisis, 2008 meltdown) Aggregate versus idiosyncratic unknowables. Idiosyncratic: Will Vietnam let me sell my insurance product on a widespread basis? Will my friends’ new software product capture significant market share? LAND OF BIG PAYOFF. • Dreary 2. Most investors, even professionals, trained to deal with world where states and probabilities are known, have little idea of how to deal with the unknowable. They recognize its presence, but they steer clear. • Positive 1. Unknowable situations have been and will be associated with remarkably powerful investment returns. Will have losses, and will be blameworthy after the fact. But the net results will be strongly positive. LEAVE THIS LECTURE IF BLAME AVERSION IS A PRIME CONCERN.

  20. Three-Prong Test for Big Positive Expected Value Bets • UU underlying features. • Complementary capabilities are required to undertake them. (Hence limited competition.) • Unlikely that party on the other side of the transaction is better informed. No Edge to Other Side Unknowable Complementary Capabilities Not common, but not rare. Will not scale up like NYSE stock. Top-flight investors are always on the lookout. Warren Buffett trolls for them.

  21. Complementary Skills Few of us have capability to be: • Real estate developer • Venture capitalist • High tech pioneer Unusual judgment • Buffett – But also gets investments that you and I would not, savvy, reputation, discounted price • Successful investors explain their success … others can’t follow. Seem like nice guys.

  22. Sidecar Investments • Pulled along by a powerful motorcycle Confidence in driver’s integrity and motorcycle capabilities • Price lower due to limited competition • Premier sidecar investment Berkshire Hathaway Buffett paid $100,000 with no options

  23. Conclusions and Implications • Mr. Market will always continue to change his behavior. • The most important probabilities will always be ambiguous. • The world is essentially unknowable, at least for big opportunities. • Money management is always a first priority. • Individual investments: • Consider your knowledge relative to seller. • Seek sidecar investments. • With investing, as in any commercial activity, competition is the enemy. • The greatest opportunities exist when unknowables abound. • When others sit, it is your time to act.

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