Michael Lewis’s Princeton Commencement Speech

Keeping in yesterday’s theme of commencement speeches, readers may also find Michael Lewis’s speech worthwhile.

Lewis’s life experiences and research has led him to believe that luck plays a huge role in determining one’s success (or lack of success). Students graduating from Princeton are by most people’s standards extremely lucky. These individuals may feel a sense of entitlement, but they should not forget the role luck has had in their current success:

A few years ago, just a few blocks from my home, a pair of researchers in the Cal psychology department staged an experiment. They began by grabbing students, as lab rats. Then they broke the students into teams, segregated by sex. Three men, or three women, per team. Then they put these teams of three into a room, and arbitrarily assigned one of the three to act as leader. Then they gave them some complicated moral problem to solve: say what should be done about academic cheating, or how to regulate drinking on campus.

Exactly 30 minutes into the problem-solving the researchers interrupted each group. They entered the room bearing a plate of cookies. Four cookies. The team consisted of three people, but there were these four cookies. Every team member obviously got one cookie, but that left a fourth cookie, just sitting there. It should have been awkward. But it wasn’t. With incredible consistency the person arbitrarily appointed leader of the group grabbed the fourth cookie, and ate it. Not only ate it, but ate it with gusto: lips smacking, mouth open, drool at the corners of their mouths. In the end all that was left of the extra cookie were crumbs on the leader’s shirt.

This leader had performed no special task. He had no special virtue. He’d been chosen at random, 30 minutes earlier. His status was nothing but luck. But it still left him with the sense that the cookie should be his.

This experiment helps to explain Wall Street bonuses and CEO pay, and I’m sure lots of other human behavior. But it also is relevant to new graduates of Princeton University. In a general sort of way you have been appointed the leader of the group. Your appointment may not be entirely arbitrary. But you must sense its arbitrary aspect: you are the lucky few. Lucky in your parents, lucky in your country, lucky that a place like Princeton exists that can take in lucky people, introduce them to other lucky people, and increase their chances of becoming even luckier. Lucky that you live in the richest society the world has ever seen, in a time when no one actually expects you to sacrifice your interests to anything.

All of you have been faced with the extra cookie. All of you will be faced with many more of them. In time you will find it easy to assume that you deserve the extra cookie. For all I know, you may. But you’ll be happier, and the world will be better off, if you at least pretend that you don’t.

Never forget: In the nation’s service. In the service of all nations.

Michael Burry’s UCLA Economics Commencement Speech

Michael Burry is a former hedge fund manager that predicted the subprime mortgage bubble. Below is his commencement speech to the graduating class of UCLA’s economics department.

Michael Burry presents a glimpse of his investment philosophy: always asking questions. He’s a veracious seeker of knowledge which helps him challenge the status quo and recognize when the masses are wrong. Regarding traditional views of modern portfolio theory and finance, he states, “As it turns out, information is not perfect, volatility does not define risk, markets are not efficient, the individual is adaptable.”

Why Smart People Are Stupid

We all know humans suffer from cognitive biases that cloud our judgment and how we perceive the world. We also know that smarter people tend to have meta-cognition, or the ability to think about what we are thinking. Logically, we would expect that better thinkers would be more aware of when they are subject to these cognitive biases and be less susceptible to them.

One researcher decided to test this hypothesis:

The results were quite disturbing. For one thing, self-awareness was not particularly useful: as the scientists note, “people who were aware of their own biases were not better able to overcome them.” This finding wouldn’t surprise Kahneman, who admits in “Thinking, Fast and Slow” that his decades of groundbreaking research have failed to significantly improve his own mental performance. “My intuitive thinking is just as prone to overconfidence, extreme predictions, and the planning fallacy”—a tendency to underestimate how long it will take to complete a task—“as it was before I made a study of these issues,” he writes.

Perhaps our most dangerous bias is that we naturally assume that everyone else is more susceptible to thinking errors, a tendency known as the “bias blind spot.” This “meta-bias” is rooted in our ability to spot systematic mistakes in the decisions of others—we excel at noticing the flaws of friends—and inability to spot those same mistakes in ourselves. Although the bias blind spot itself isn’t a new concept, West’s latest paper demonstrates that it applies to every single bias under consideration, from anchoring to so-called “framing effects.” In each instance, we readily forgive our own minds but look harshly upon the minds of other people.

And here’s the upsetting punch line: intelligence seems to make things worse. The scientists gave the students four measures of “cognitive sophistication.” As they report in the paper, all four of the measures showed positive correlations, “indicating that more cognitively sophisticated participants showed larger bias blind spots.” This trend held for many of the specific biases, indicating that smarter people (at least as measured by S.A.T. scores) and those more likely to engage in deliberation were slightly more vulnerable to common mental mistakes. Education also isn’t a savior; as Kahneman and Shane Frederick first noted many years ago, more than fifty per cent of students at Harvard, Princeton, and M.I.T. gave the incorrect answer to the bat-and-ball question.

Continue reading here.



Sharpe: The Arithmetic of Active Management

William Sharpe presents a logical argument that passive management is superior than active management. Since the average return of both passive and active investors must equal the market return, and the costs of active management are greater than passive management, he concludes:

Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement.

Read the full article here. It was written in 1991 but is still relevant today.

2012 Q2 Portfolio Review: +2.84% and +10.17%

My portfolio year-to-date returns as of the end of the second quarter are +2.84% for my individual account and +10.17% for my Roth IRA compared to +1.63% for the S&P 500.

I accidentally skipped doing this for the previous quarter and have been neglecting this blog in general for the past few months. At some point during the past few months, I decided to focus intensely on studying for Level 2 of the CFA exam which I wrote last weekend. Everything else, including this blog and managing my portfolio was secondary for quite some time. But now I can return to writing in my pathetic blog.

The orange line in the graph above represents my Roth IRA. The green line represents my individual account. Readers may not know that my individual account has essentially been passively managed for the entire existence of this pathetic blog and probably longer than that. In fact, I can’t remember the last time I made a trade in that account. The reason is that I still have a considerable amount of excess cash in my Roth IRA which I need to commit. Any trades (especially of a short-term nature) should first be made in my Roth IRA to take advantage of its tax benefits.

Overall, I’m still happy with my Roth IRA’s performance. I had a short position through TZA (a 3x levered short ETF that uses the Russell 2000 as its benchmark) for most of the year which I sold recently for a short profit. Unfortunately, I sold much too early, so I’ve been exposed to the recent market decline.

Given the passive nature of my individual account, I’m satisfied with its performance as well.

I normally don’t like talking about my positions publicly because I’m scared that announcing any positions will negatively affect my trading performance. So for now, I’ll only be able to discuss my trades retrospectively. Maybe I’ll change my stance on this position in the future. I’m willing to discuss my latest thoughts in private though.

On Facebook And Efficient Markets

On the days leading up to the Facebook IPO, Physicians Formula Holdings (ticker symbol FACE) increased 22 percent. Are markets efficient?

Read more discussion at /r/finance here.

Can Facebook Become The Biggest Company In The World?

I have never seen a sell-side analyst make a recommendation on a stock through a video like this. Is this the future of sell-side research? It feels a bit too polished for my tastes. I kept on waiting for some disclosure saying that they got paid to do this, but it never came.

That being said, I think the message is great. Neil Campling of Aviate Global LLP asks a simple question: Can Facebook become the biggest company in the world? It’s entirely possible that Facebook has crossed this critical threshold where the network effects within Facebook are so great that no other social networking site can flourish in the foreseeable future.

I mean, just take a look at Google+. One of the biggest and most successful internet companies has pretty blatantly been pushing its social network for almost a year now, and it still sucks. This is based on my non-scientific anecdotal interactions with Google+. Can anyone else do better?

Interested readers can also view a thirty minute presentation that Facebook has been showing at its roadshow presentations in preparation of its IPO here.

Krugman: Baby-Sitting The Economy

Nobel-prize winning economist Paul Krugman recently did an IAmA on Reddit. One user asked Krugman why a growth oriented approach led by monetary and fiscal stimulus to solving our economic and fiscal problems is the correct approach (as opposed to austerity).

The user also requested that Krugman explain like the user was five years old. In response, Krugman mentioned an article he wrote in 1998 which uses a baby-sitting co-op as a representation of a nation’s economy. The article is worth reading:

The Sweeneys tell the story of–you guessed it–a baby-sitting co-op, one to which they belonged in the early 1970s. Such co-ops are quite common: A group of people (in this case about 150 young couples with congressional connections) agrees to baby-sit for one another, obviating the need for cash payments to adolescents. It’s a mutually beneficial arrangement: A couple that already has children around may find that watching another couple’s kids for an evening is not that much of an additional burden, certainly compared with the benefit of receiving the same service some other evening. But there must be a system for making sure each couple does its fair share.

The Capitol Hill co-op adopted one fairly natural solution. It issued scrip–pieces of paper equivalent to one hour of baby-sitting time. Baby sitters would receive the appropriate number of coupons directly from the baby sittees. This made the system self-enforcing: Over time, each couple would automatically do as much baby-sitting as it received in return. As long as the people were reliable–and these young professionals certainly were–what could go wrong?

Well, it turned out that there was a small technical problem. Think about the coupon holdings of a typical couple. During periods when it had few occasions to go out, a couple would probably try to build up a reserve–then run that reserve down when the occasions arose. There would be an averaging out of these demands. One couple would be going out when another was staying at home. But since many couples would be holding reserves of coupons at any given time, the co-op needed to have a fairly large amount of scrip in circulation.

Now what happened in the Sweeneys’ co-op was that, for complicated reasons involving the collection and use of dues (paid in scrip), the number of coupons in circulation became quite low. As a result, most couples were anxious to add to their reserves by baby-sitting, reluctant to run them down by going out. But one couple’s decision to go out was another’s chance to baby-sit; so it became difficult to earn coupons. Knowing this, couples became even more reluctant to use their reserves except on special occasions, reducing baby-sitting opportunities still further.

In short, the co-op had fallen into a recession.

Since most of the co-op’s members were lawyers, it was difficult to convince them the problem was monetary. They tried to legislate recovery–passing a rule requiring each couple to go out at least twice a month. But eventually the economists prevailed. More coupons were issued, couples became more willing to go out, opportunities to baby-sit multiplied, and everyone was happy. Eventually, of course, the co-op issued too much scrip, leading to different problems …

If you think this is a silly story, a waste of your time, shame on you. What the Capitol Hill Baby-Sitting Co-op experienced was a real recession. Its story tells you more about what economic slumps are and why they happen than you will get from reading 500 pages of William Greider and a year’s worth of Wall Street Journal editorials. And if you are willing to really wrap your mind around the co-op’s story, to play with it and draw out its implications, it will change the way you think about the world.

Continue reading here. And read Krugman’s IAmA here.


The Lure Of Active Management

CFA Program Curriculum, Level II, Derivatives and Portfolio Management:

Consider the results of the following two different investment strategies:

  1. An investor who put $1,000 in 30-day commercial paper on January 1, 1927, and rolled over all proceeds into 30-day paper (or into 30-day T-bills after they were introduced) would have ended on December 31, 1978, fifty-two years later, with $3,600.
  2. An investor who put $1,000 in the NYSE index on January 1, 1927, and reinvested all dividends in that portfolio would have ended on December 31, 1978, with $67,500.

Suppose we defined perfect market timing as the ability to tell (with certainty) at the beginning of each month whether the NYSE portfolio will outperform the 30-day paper portfolio. Accordingly, at the beginning of each month, the market timer shifts all funds into either cash equivalents (30-day paper) or equities (the NYSE portfolio), whichever is predicted to do better. Beginning with $1,000 on the same date, how would the perfect timer have ended up 52 years later?

This is how Nobel Laureate Robert Merton began a seminar with finance professors 25 years ago. As he collected responses, the boldest guess was a few million dollars. The correct answer: $5.36 billion.


Burger King’s Upcoming IPO

Burger King is returning to the public markets. The following presentation makes a compelling case for a Burger King turnaround. Also provides valuable insight on the metrics and fundamental analysis that private equity firms care about.

Justice is Best Served Flame Broiled

The original document can be found here.