Sunday, December 18, 2011

Diary: Taleb

I'm just reading through a PDF written by Taleb. Mind-blowing stuff. I really ought to read from this guy.

He recounts the story of Thales, a philosopher. His mercantilist friends jibed him as to how he was poor, an how philosophy was useless in practise. Tired of this accusation, Thales did something remarkable. During winter, he had looked at the stars, and determined that there would be a prosperous summer. So he made a down payment on the use of every olive press for that season. Sure enough, there was a bumper crop, there was a big demand for olive presses, and he realised large sums of money letting out the presses on his own terms. All hail the genius. Aristotle clearly stated that it was Thales' superior knowledge that led to his fortune.

According to Taleb, though: this is the wrong lesson. The basic premise is this: things are inherently unpredictable. "It is, rather, the skilled expression and exploitation of ignorance, not knowledge".
Thales put himself in a position to take advantage of his lack of knowledge —and the secret property of convexity effects. The key to the message of this book is that he did not need to understand too much the messages from the stars. Simply, he had, an option, “the right but not the obligation”, which hebought cheap: there was no need to be right on average —so long as you pay a low price that allows you to have greater upside than downside. His payoff was so large that it could have afforded him to be wrong very, very often and still make a bundle in the long run.
This stuff is getting my head spinning. Geoff Gannon has written an article on net-nets recently. It got me to thinking that it is entirely possible that net-nets exploit this effect.

My shares in PIC (Pace) sprung to mind wrt Taleb's writings. During the year, it has been affected by a delayed customer order, Japanese Tsunami, and flooding in Thailand. This has of course sent the stock reeling, driving it down to a PER of 4. These event were unpredictable, and renders analyst forecasting meaningless.

So, the real takeaway would appear that it's not that the analysts are stupid, but that they're trying to predict the inherently unpredictable, and hence are doomed to failure.

The good news is that making above-normal returns in the market is not a doomed exercise due to unpredictability. You need to look for the "cheap options with large upside and low downside". Actually, Greenblatt already alludes to this in his preference for value investing: "it gives you  asymmetric returns". Perhaps what value investors do is to distill their investment choices further, and see how they can fit in more with the Taleb model.

Talking of philosophers ... I was reading a blog the other day that was talking about "Philosopher Kings". The theory is that since philosophers are the best thinkers, they would make the best kings. The author said that if you look at the kind of politics that are played in university philosophy departments, you would soon realise that this idea has no merit.

Happy investing, all.

1 comment:

Mark Carter said...

OK, I found a followup for what I was looking for ...

In the book "Just One Thing", there is a chapter "Signposts in the Fog" by Andy Kessler.

He has a section called "You can't make money standing in the sunshine". He goes on to say "Formulas rarely have an input for risk. Even if they did, it’s an unquantifiable number."

"The problem with Widgets ‘R’ Us, the stock anyway, is that it’s
out in the open, right out there in the sunshine. Everybody can seeit. Everybody agrees on its prospects. Whoop-dee-doo. The weather’s gonna change.I’d rather be out in the fog where nobody knows nothin’. Then,if I’m good, I can peer out into the fog and spot some yellow rocksto show the way to a higher level. Once I get to the signpost, it’squite clear, and my stocks based on getting to that signpost will beproperly valued; so I slog on looking for the next signpost."

It seems that he has grasped the whole idea of optionality intuitively.