In Defense of Cash

There is a debate in the investment community about the merits of Schwab including a cash allocation in its new roboadvisor offering. Let us leave aside the merits of roboadvisors (short answer: they are great for some people, while terrible for others) and focus on the idea of an investor holding a steady cash allocation as a percentage of total investable assets. Betterfront and WealthFront, two of the early movers in the roboadvisor space, have piled on Schwab. The upstarts argue the cash allocation was merely a cynical ploy orchestrated by Schwab to generate higher revenues from client accounts. Schwab meanwhile argues this is merely a prudent allocation. So, is cash a good, or bad investment in a portfolio account? The answer to this debate holds implications not just for roboinvestors, but for all investors alike and sure enough, I think there is a conclusive answer (as the title suggests).

Here is Betterment’s argument against cash:

• “Cash has a significant chance of a negative real return over time due to inflation risk.”
• “Cash assets can present a conflict of interest when the investment manager is advising cash and then re-investing it for its own revenue.”
• “You never hold cash at Betterment, as we use fractional shares. That ensures every dollar—down to the penny—is fully invested in a diversified portfolio of stocks and bonds.”

The crux of these points are ancillary to the true debate. In fact, Betterment’s argument boils down to a marketing stance, more so than an investment argument. Cullen Roche at Pragmatic Capitalism nicely demonstrates how over the very long run, cash does in fact generate a nice, non-correlated return for portfolios; yet, this is merely the tip of the iceberg in defense of cash. I will do my best to round out the case here.

First, it’s important to note that Warren Buffett would strongly disagree with the roboadvisor assessment of cash. Alice Schroder offers the following take on Buffett’s perspective: “he thinks of cash differently than the conventional investors. This is one of the most important things I learned from him: the optionality of cash. He thinks of cash as a call option with no expiration date, an option on every asset class, with no strike price.” [emphasis added]. Here we have one of the foremost authorities on Warren Buffett labeling a cash allocation as amongst “the most important” elements of Buffett’s investment prowess. If cash is so important to Warren Buffett, who are these roboadvisors to say otherwise? 

While this point is merely an appeal to (quite the) authority, it might be worth exploring how and why this is not merely fallacious thinking. For that, we can turn to Claude Shannon, also known as “the father of information theory.” I first cited Shannon in my post explaining how the Kelly Criterion can be used to size positions. Unsurprisingly, this was not Shannon’s only investment insight. One of the more interesting conclusions Shannon came to about investing demonstrates how it is possible to “make money off of a random walk” with cash being the secret weapon. 

First let us look at the chart Betterment offered to support its case against cash, as it helps set the stage for why cash is so effective and what Betterment and WealthFront may be missing in building their story:

 Notice something about both lines? There is nothing jagged or wavelike to them. Have you ever observed a stock moving in such fashion? Has any actual historical performance visually appeared as smooth these two lines other than Madoff’s fund? Sure, this is standard operating procedure for presenting simulations of what forward performance could look like in an optimized portfolio, but this is only effective as a rough guide. Reality assuredly will be different, and while no one can guarantee the end return will be different (despite this likely being the case), we all can guarantee that the path in getting from the bottom left to the top right will be different. The fact is, the path of stock price movements have consequences for portfolio returns (human behavioral consequences aside--this alone could be its own extended blog post). There is considerable evidence behind the notion that in the short run, stock market movements are merely a random walk. This is another way of saying that stock price movements will be noisy and volatile, with up and down days scattered across time following no real, predictable patterns. In many respects, this is one of the more important philosophical underpinnings behind the existence of roboadvisors in the first place. It should then be no wonder that this fact has serious consequences for the benefits of cash as a strategic allocation.

The following is an explanation for how cash can effectively boosts returns from Fortune’s Formula by William Poundstone:

Shannon described a way to make money off a random walk. He asked the audience to consider a stock whose price jitters up and down randomly, with no overall upward or downward trend. Put half your capital into the stock and half into a “cash” account. Each day, the price of the stock changes. At noon each day, you “rebalance” the portfolio. That means you figure out what the whole portfolio (stock plus cash account) is presently worth, then shift assets from stock to cash account or vice versa in order to recover the original 50-50 proportion of stock and cash.

To make this clear: Imagine you start with $1,000, $500 in stock and $500 in cash. Suppose the stock halves in price the first day. (It’s a really volatile stock.) This gives you a $750 portfolio with $250 in stock and $500 in cash. That is now lopsided in favor of cash. You rebalance by withdrawing $125 from the cash account to buy stock. This leaves you with a newly balanced mixed of $374 in stock and $375 cash. 

Now repeat. The next day, let’s say the stock doubles in price. The $375 in stock jumps to $750. With the #375 in the cash account, you have $1,125. This time, you sell some stock, ending up with $562.50 each in stock and cash.

Look at what Shannon’s scheme has achieved so far. After a dramatic plunge, the stock’s price is back to where it began. A buy-and-hold investor would have no profit at all. Shannon’s investor has made $125.

This scheme defies most investor’s instincts. Most people are happy to leave their money in a stock that goes up. Should the stock keep going up, they might put more of their free cash into the stock. In Shannon’s system, when a stock goes up, you sell some of it. You also keep pumping money into a stock that goes down.

Poundstone then offers a chart of Shannon’s performance in a 50/50 cash/stock portfolio rebalanced once per each unit of time:

It turns out the rebalanced portfolio beats the fully invested portfolio while also minimizing volatility. The example above is clearly a far more extreme version of the cash allocation and stock volatiltiy Schwab (or most investors) would take on in a real portfolio; however, even in more subtle form the effect is noticeable and real. Note how jagged, rather than smooth, these lines are. Jagged lumpiness is a reality we all must contend with in financial markets.

Long-term investors of all kinds need to acknowledge how hard it is to predict short-run movements in stocks. Even in a good value investing opportunity with an impending catalyst, one can never know with certainty which way a stock will move. We can rely on “asset classes” in the most general sense to earn a positive return over long enough timeframes, but we never can now in advance how long that long-run needs to be. Further, we must also acknowledge the unfortunate reality that it is possible for decades of stagnation on price appreciation even with a growing “intrinsic value”—we call this multiple compression. In such an environment (more so than in a trending environment), cash serves as imposed discipline: one systematically buys low and sells high when this kind of rebalancing is automatic.

Clearly rebalancing is part of the roboadvisors' strategy in switching between stocks and bonds when an allocation leaves a tolerance band; however, there are long stretches of time when stocks and bonds are correlated and meaningful periods of time where cash would offer not just a strong buffer against volatility, but an actual enhancer of return. Poundstone references how counterintuitive Shannon’s methodology appears. As counterintuitive as it may be, it is assuredly true and the benefits are both actual and behavioral. If you like better returns, with less volatility, then cash must be an important component of your portfolio.

Buffett, Soros and Uncle Sam

 I recently came across an interesting piece comparing the returns of Warren Buffett and George Soros (h/t @ReformedBroker). The post immediately caught my attention, for both Buffett and Soros are two of my favorite minds in investing.  I am oversimplifying greatly, but from Buffett, I learned much about the importance of patience, quality and management integrity, while from Soros, I learned the importance of identifying self-fulfilling cycles and reflexive processes in financial markets. While some like to contrast these two gentlemen as taking opposing views to markets, I think their approaches are not mutually exclusive.  In fact, combining the lessons from these two gentlemen has been a potent force in crafting my own, unique approach to investing.

In the piece comparing the relative performance of Buffett and Soros, the author includes the following chart:

The author then asks, if “George's track record is better but Warren is richer. Why?” while offering the following answer:

The snowball of POSITIVE compounding for longer. Both were born in August 1930 and Warren ran his hedge fund from 1957 but George didn't set up his until 1969. Warren was lucky to be in Omaha while Dzjchdzhe Shorash was in Budapest, more affected by WW2. Also Warren got into currency trading and philanthropy later. George's outperformance is due to stronger international diversification and because reflexivity is ignored. Value investing is copied more than reflexivity investing. The boom bust of Eurozone sovereign credits and subprime CDOs are quintessential examples of reflexivity. Crises are PREDICTABLE. And profitable if you have expertise.

Sure some of these factors certainly played a role in Buffett’s wealth relative to Soros, though this is largely misleading and the most crucial point is ignored entirely. Simply put, these return figures are not presented on an apples to apples basis.  Buffett’s returns are presented using the growth in Berkshire Hathaway’s book value, while Soros’ returns are presented using his hedge funds’ returns.  In this comparison, the author is therefore comparing Buffett’s after-tax returns, with Soros’ pre-tax returns. (There is a second key point missed that many Buffett followers will pick up on: book value does not reflect the true realizable value of many Berkshire assets, and therefore, is understated relative to the intrinsic value of the company. While important, my intent here is to focus simply on the tax consequences so beyond this mention, I will skip digging into the consequences of this reality).

We can re-plot the relative returns of Soros and Buffett in order to more closely portray what the comparative returns would look like on an after-tax basis.  For the purposes of this comparison, I assumed that each year, 20% of Soros’ returns would be paid out in taxes.  This is obviously a simplification, and not intended to be historically accurate, as everyone has their own unique tax profile, and long and short-term trades have different consequences.  I am merely cherry-picking a number that if anything, is probably favorable to Soros in light of the following factors: 1) capital gains tax rates were higher than today’s 15% during much of the time period covered in this analysis; 2) we know that Soros profited in capital markets subject to hybrid tax rates between long and short-term capital gains (like commodity and foreign exchange markets); and, 3) from Soros’ own journal in Alchemy of Finance (which I strongly recommend reading), we know that he engaged in many short-term, speculative trades that would be subject to ordinary income tax rates.

There is a second simplification I’ve made for the purposes of this comparison in assuming that returns were earned on a straight-line basis, rather than calculating each individual’s returns per year, adjusting for taxes and plotting those out.  Again, the purpose here is to demonstrate the impact of taxes on returns, and not to be perfectly precise with who is better than whom.  

As we can see below, the end result looks quite different when compared on an after-tax basis:

Plotted this way, Buffett’s compounded annual growth rate (CAGR) remains 21.4%, while Soros’ is 21.0%.  Now some might argue that an investor in Berkshire would still have to pay taxes on his or her investment, and this is true, but the clear intent in the article cited was to compare the performance track-record of each investor as stated by the author, and as evidenced by the author’s focus on the CAGR of Berkshire’s book value, rather than the performance of the stock itself. 

One of the biggest problems with performance generally speaking is how reporting systemically does not take into account tax consequences, yet there can be huge differences between two strategies with identical “returns.”  In reality, it’s only after-tax returns that matter.  Buffett’s partner, Charlie Munger offered the following important point on targeting after-tax, rather than pre-tax returns (from Munger's "On the Art of Stock Picking"):

Another very simple effect I very seldom see discussed either by investment managers or anybody else is the effect of taxes. If you're going to buy something which compounds for 30 years at 15% per annum and you pay one 35% tax at the very end, the way that works out is that after taxes, you keep 13.3% per annum. In contrast, if you bought the same investment, but had to pay taxes every year of 35% out of the 15% that you earned, then your return would be 15% minus 35% of 15% or only 9.75% per year compounded. So the difference there is over 3.5%.And what 3.5% does to the numbers over long holding periods like 30 years is truly eye-opening. If you sit back for long, long stretches in great companies, you can get a huge edge from nothing but the way that income taxes work.

I am a fan and student of Mr. Buffett and Mr. Soros and have no bone to pick in this race, though it should be clear to all that both men’s returns are about as good as they get over such a long time-frame.  To summarize, there are two key points here that I want to emphasize.  For individual investors, it’s extremely important to plan your investments in such a way as to maximize after-tax, not pre-tax returns.  Don’t be fooled simply by the appreciation in your portfolio.  Think about what portion of your gains you are paying to Uncle Sam (taxes) come April 15th each year.  For those who work with investment managers or invest via funds, when looking at performance reports, it’s extremely important to think about what the after-tax returns of a strategy look like.

Disclosure: Long shares of BRK.B in my own and client accounts.

Keynes Applied To Investing Today

Recently, both Bloomberg and the Wall Street Journal ran pieces that highlighting the investment successes of John Maynard Keynes.  Both emphasize how little Keynes actually applied his economic theory to investment; instead, focusing on how Keynes operated in a very Warren Buffett-like manner.  Keynes focused on valuation, applying probablistic analysis in order to decipher his risk/reward.  It's enlightening to learn about Keynes' role as an active participant in markets, but these articles seem to be saying that while Keynes is the father of macroeconomic theory, he was not a macroinvestor, but rather a micro investor.  In black and white terms, this is true; however, it is Keynes' superior understand if the macro landscape that I think led him to this conclusion and this chart of his performance as both a macro and micro investor should serve as a warning to many of the macrotourists out there today (Chart from Jason Zweig's article: Keynes: One Mean Money Manager):

In fact, from a reading of The General Theory, it becomes clear that Keynes' deep understanding of the role of behavioral economics, credit cycles, and the marginal efficiency of capital on investment played a crucial role in his realization that company-specific investments based on valuation made the most sense.  Keynes' description of the stock market as a beauty contest should strike any reader of Benjamin Graham as akin to the Mr. Market analogy.  Clearly Keynes recognized the connection between the emotional fluctuations of market temperment and its role in leading to over and undervaluation on the micro level.

Here I have pulled together 12 separate passages from Keynes that in my opinion are very relevant for today's economy.  Many of these help highlight how his understanding of macroeconomics ultimately led to the conclusion that a valuation-focused investment strategy is superior, while others provide key insights to investors of all types on how and why things are shaping up as is today in the broader economy.  One theme clear throughout is Keynes' understanding that a capitalist democracy inevitably requires certain bargains between capital and labor in order to survive, but that regardless, it is necessary for long-term investors to maintain an opportunity to profit.  Further, Keynes' disdsain for speculators in contrast to investors is clear throughout, and this is an area which I think requires more discussion today.

1. “It is certain that the world will not much longer tolerate the unemployment which, apart from brief intervals of excitement, is associated…with present-day capitalistic individualism.  But it may be possible by a right analysis of the problem to cure the disease whilst preserving efficiency and freedom.”

2. “There are valuable human activities which require the motive of money-making and the environment of private wealth-ownership for their full fruition….It is better that a man should tyrannise over his bank balance than over his fellow-citizens; and whilst the former is sometimes denounced as being but a means to the latter, sometimes at least it is an alternative…The task of transmuting human nature must not be confused with the task of managing it.  Though in the ideal commonwealth men may have been taught or inspired or bred to take no interest in the stakes, it may still be wise and prudent statesmanship to allow the game to be played, subject to rules and limitations, as long as the average man, or even a significant section of the community, is in fact strongly addicted to the money-making passion.”

3. “Changing views about the future are capable of influencing the quantity of employment and not merely its direction.”

4. “A collapse in the price of equities, which has had disastrous reactions on the marginal efficiency of capital, may have been due to the weakening either of speculative confidence or of the state of credit.  But whereas the weakening of either is enough to cause a collapse, recovery requires the revival of both.  For whilst the weakening of credit is sufficient to bring about a collapse, its strengthening, though a necessary condition of recovery, is not a sufficient condition.”

5. “But the daily revaluations of the Stock Exchange, though they are primarily made to facilitate transfers of old investments between one individual and another, inevitably exert a decisive influence on the rate of current investment.  For there is no sense in building up a new enterprise at a cost greater than that at which a similar existing enterprise can be purchased; whilst there is an inducement to spend on a new project what may seem an extravagant sum, if it can be floated off on the Stock Exchange at an immediate profit.  Thus certain classes of investment are governed by the average expectation of those who deal on the Stock Exchange as revealed in the price of shares, rather than by the genuine expectations of the professional entrepreneur.”

6. “There is no clear evidence from experience that the investment policy which is socially advantageous coincides with that which is most profitable….human nature desires quick results, there is a peculiar zest in making money quickly, and remoter gains are discounted by the average man at a very high rate….Furthermore, an investor who proposes to ignore near-term market fluctuations needs greater resources for safety and must not operate on so large a scale, if at all, with borrowed money….Finally it is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks.”

7. “The explanation of the time-element in the trade cycle, of the fact that an interval of time of a particular order of magnitude must usually elapse before recovery begins, is to be sought in the influences which govern the recovery of the marginal efficiency of capital.”

8. “As the organisation of investment markets improves, the risk of the predominance of speculation does, however, increase.  In one of the greatest investment markets in the world, namely, New York, the influence of speculation…is enormous.  Even outside the field of finance, Americans are apt to be unduly interested in discovering what average opinion believes average opinion to be; and this national weakness finds its nemesis in the stock market….Speculators may do no harm as bubbles on a steady stream of enterprise.  But the position is serious when enterprise becomes the bubble on a whirlpool of speculation.”

9. “Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive a activities depend on spontaneous optimism rather than on a mathematical expectation, whether moral or hedonistic or economic.  Most probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits–of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.”

10. “It is curious how common sense, wriggling for an escape from absurd conclusions, has been apt to reach a preference for wholly “wasteful” forms of loan expenditure rather than for partly wasteful forms, which, because they are not wholly wasteful, tend to be judged on strict “business” principles.  For example, unemployment relief financed by loans is more readily accepted than the financing of improvements at a charge below the current rate of interest; whilst the form of digging holes in the ground known as gold-mining, which not only adds nothing whatever to the real wealth of the world but involves the disutility of labour, is the most acceptable of all solutions.”

11. “The later stages of the boom are characterised by optimistic expectations as to the future yield of capital-goods sufficiently strong to offset their growing abundance and their rising costs of production and, probably, a rise in the rate of interest also.  It is of the nature of organised investment markets, under the influence of purchasers largely ignorant of what they are buying and of speculators who are more concerned with forecasting the next shift of market sentiment than with a reasonable estimate of the future yields of capital-assets, that, when disillusion falls upon an over-optimistic and over-bought market, it should fall with sudden and even catastrophic force.  Moreover, the dismay and uncertainty as to the future which accompanies a collapse in the marginal efficiency of capital naturally precipitates a sharp increase in liquidity preference.”

12.  “Later on, a decline in the rate of interest will be a great aid to recovery and, probably, a necessary condition of it…. But, in fact…it is not so easy to revive the marginal efficiency of capital, determined, as it is, by the uncontrollable and disobedient psychology of the business world.  It is the return of confidence, to speak in ordinary language, which is so insusceptible to control in an economy of individualistic capitalism.  This is the aspect of the slump which bankers and business men have been right in emphasising, and which the economists who have put their faith in a “purely monetary” remedy have underestimated.”

How did Ed Thorp Win in Blackjack and the Stock Market?

My earlier post laid out some important lessons on behavioral economics learned from Santa Fe Institute’s conference on Risk: the Human Factor.  The specific lecture that first caught my eye when I saw the roster was Edward Thorp’s discussion on the Kelly Capital Growth Criterion for Risk Control.  I had read the book Fortune’s Formula and was fascinated by one of the core concepts of the book: the Kelly Criterion for capital appreciation. Over time, I have incorporated Kelly into my position-sizing criteria, and was deeply interested in learning from the first man who deployed Kelly in investing.  It's been mentioned that both Warren Buffett and Charlie Munger discussed Kelly with Thorp and used it in their own investment process.  Thus, I felt it necessary to give this particular lecture more attention.

In its simplest form, the Kelly Criterion is stated as follows:

The optimal Kelly wager = (p*(b+1)—1) / b where p is the probability (% chance of an event happening) and b is the odds received upon winning ($b per every $1 wagered).

It was Ed Thorp who first applied the Kelly Criterion in blackjack and then in the stock market.  The following is what I learned from his presentation at SFI. 

Thorp had figured out a strategy for counting cards, but was left wondering how to optimally manage his wager (in investing parlance, we’d call this position sizing).  The goal was a betting approach which would allow for the strategy to be deployed over a long period of time, for a maximized payout.  With the card counting strategy, Thorp in essence was creating a biased coin (a coin toss is your prototypical 50/50 wager, however in a biased coin, the odds are skewed to one side).  This question was approached from a position of how does one deal with risk, rationally?  Finding such a rational risk management strategy was very important, because even with a great strategy in the casino, it was all too easy to go broke before ever attaining successful results.  In other words, if the bets were too big, you would go broke fast, and if the bets were too small you simply would not optimize the payout.

Thorp was introduced to the Kelly formula by his colleague Claude Shannon at MIT.  Shannon was one of the sharpest minds at Bell Labs prior to his stint at MIT and is perhaps best known for his role in discovering/creating/inventing information theory.  While Shannon was at Bell Labs, he worked with a man named John Kelly who wrote a paper called “New Interpretation of Information Rate.”  This paper sought a solution to the problem of a horse racing gambler who receives tips over a noisy phone line.  The gambler can’t quite figure out with complete precision what is said over the fuzzy line; however, he knows enough to make an informed guess, thus imperfectly rigging the odds in his favor. 

What John Kelly did was figure out a way that such a gambler could bet to maximize the exponential rate of the growth of capital.  Kelly observed that in a coin toss, the bet should be equal to one’s edge, and further, as you increase your amount of capital, the rate of growth inevitably declines.

Shannon showed this paper to Thorp presented with a similar problem in blackjack, and Thorp then identified several key features of Kelly (g=growth below):

1. If G>0 then the fortune tends towards infinity.
2. If G<0 then the fortune tends towards 0.
3. If g=0 then Xn oscillates wildly.
4. If another strategy is “essentially different’ then the ratio of Kelly to the different strategy tends towards infinity.
5. Kelly is the single quickest path to an aggregate goal.

This chart illustrates the points:

The peak in the middle is the Kelly point, where the optimized wager is situated.  The area to the right of the peak, where the tail heads straight down is in the zone of over-betting, and interestingly, the area to the left of the Kelly peak corresponds directly to the efficient frontier. 

Betting at the Kelly peak yields substantial drawdowns and wild upswings, and as a result is quite volatile on its path to capital appreciation.  Therefore, in essence, the efficient frontier is a path towards making Kelly wagers, while trading some portion of return for lower variance.  As Thorp observed, if you cut your Kelly wager in half, then you can get 3/4s the growth with far less volatility. 

Thorp told the tale of his early endeavors in casinos, and how the casinos scoffed at the notion that he could beat them.  One of the most interesting parts to me was how he felt emotionally despite having confidence in his mathematical edge. Specifically, Thorp felt that the impact of losses placed a heavy psychological burden on his morale, while gains did not have an equal and opposite boost to his psyche.  Further, he said that he found himself stashing some chips in his pocket so as to avoid letting the casino see them (despite the casino having an idea of how many he had outstanding) and possibly as a way to prevent over-betting.  This is somewhat irrational behavior amidst the quest for rational risk management

As the book Bringing Down the House and the movie 21 memorialized, we all know how well Kelly worked in the gambling context.  But how about when it comes to investing?  In 1974, Thorp started a hedge fund called Princeton/Newport Partners, and deployed the Kelly Criterion on a series of non-correlated wagers. To do this, he used warrants and derivatives in situations where they had deviated from the underlying security’s value.  Each wager was an independent wager, and all other exposures, like betas, currencies and interest rates were hedged to market neutrality. 

Princeton/Newport earned 15.8% annualized over its lifetime, with a 4.3% standard deviation, while the market earned 10.1% annualized with a 17.3% standard deviation (both numbers adjusted for dividends).  The returns were great on an absolute basis, but phenomenal on a risk-adjusted basis.  Over its 230 months of operation, money was made in 227 months, and lost in only 3.  All along, one of Thorp’s primary concerns had been what would happen to performance in an extreme event, yet in the 1987 Crash performance continued apace. 

Thorp spent a little bit of time talking about the team from Long Term Capital Management and described their strategy as the anti-Kelly.  The problem with LTCM, per Thorp, was that the LTCM crew “thought Kelly made no sense.”  The LTCM strategy was based on mean reversion, not capital growth, and most importantly, while Kelly was able to generate returns using no leverage, LTCM was “levering up substantially in order to pick up nickels in front of a bulldozer.”

Towards the end of his talk, Thorp told the story of a young Duke student who read his book called Beat the Dealer, about how to deploy Kelly and make money in the casino.  This young Duke student then ventured out to Las Vegas and made a substantial amount of money.  He then read Thorp’s book Beat the Market and went to UC-Irvine, where he used the Kelly formula in convertible debt to again make good money. Ultimately this young built the world’s largest bond fund—Pacific Investment Management Company (PIMCO).  This man was none other than Bill Gross and Thorp drew the important connection between Gross’ risk management as a money manager and his days in the casino.

During the Q&A, Bill Miller, of Legg Mason fame, asked Thorp an interesting two part question: is it more difficult to get an edge in today’s market? And Did LTCM not know tail risk and/or realize the correlations of their bets?  Thorp said that today the market is no more or less difficult than in year’s past.  As for LTCM, Thorp argued that their largest mistake was in failing to recognize that history was not a good boundary (plus the history LTCM looked at was only post-Depression, not age-old) and that without leverage, LTCM did not have a real edge. This is key—LTCM was merely a strategy to deploy leverage, not one to get an edge in the market.

I had the opportunity to ask Thorp a question and I wanted to focus on the emotional element he referenced from the casino days.  My question was:  upon recognizing the force of emotion upon himself, how did he manage to overcome his human emotional impediments and place complete conviction in his formula and strategy?  His answer was a direct reference to Daniel Kahneman’s Thinking, Fast and Slow, whereby he used his system 2, the slow thinking system, in order to force himself to follow the rules outlined by his formulas and process.  Emotion was a human reaction, but there was no room to afford it the opportunity to hinder the powerful force that is mathematics.

Links for Thought -- February 10th

Warren Buffett: Why Stocks Beat Gold and Bonds (CNN Money) -- Warren Buffett gives a preview from this year's shareholder letter and explains why the long-run returns from equities will exceed those of stocks and Gold. As always with Mr. Buffett, the reasoning is presented in a clear and simple manner and the timing is impeccable considering the Gold vs. everything else discussion in the media this past year.

Credit Suisse Global Investment Returns Yearbook 2012 (Credit Suisse)-- This is an outstanding presentation from Credit Suisse that covers 112 years of market history as it pertains to inflation vs. deflation, currency investing/hedging, and panic vs. euphoria sentiment in markets.  

@Google Presents Daniel Kahneman (YouTube) -- In this gem, one of the fathers of Behavioral Economics and author of Thinking, Fast and Slow (a must read) discusses how and why our brain succumbs to cognitive biases, and what we as humans can do to adequately recognize and adapt to this reality. He does so by distinguishing between System 1, our "automatic" thought mechanism in the brain, and System 2, our "deliberate" one.

The Housing Bottom is Here (Calculated Risk) -- Calculated Risk, a site which rose to prominence for its early and frequent calls of a bubble in housing, dating back to 2005, this past week declared that the bottom in housing will come at some point in 2012. This is a big call for a site that is known for sharp analysis. Further, it's notable that this call comes just a few months after the rent vs. ownership cost gap in housing reached equilibrium for the first time since the late 1990s.

Bernanke-Led Economy Proving Critics Clueless About Federal Reserve Policy (Bloomberg) -- Fed Chairman Ben Bernanke gets some props from Bloomberg for masterfully navigating a challenging economic landscape.  Those who have followed me before this blog was born know that I have been a proponent of Bernanke's and as such, I'm happy to see a mainstream publication take some shots at the wrongness of conventional wisdom as it pertains to Fed policy.