Michael Mauboussin joined Barry Ritholtz on the Masters in Business podcast and I loved every minute of it. Mauboussin is great, and I’ve taken notes on some of his other conversations; Michael Mauboussin with Shane Parish and another with Michael Mauboussin and Ritholtz.
I saw a lot of tweets about this interview and someone said that what makes Mauboussin a good interviewee is that he understands things deeply and can speak clearly. I couldn’t agree more. If you want to skip ahead there were 7 parts to my notes.
- Know the pot and the payout.
- Incentives matter.
- The inside and outside views.
- Wonderful story telling machines.
- How should you invest?
- Hold my beer and watch this.
- Rising ducks on rising tides.
This post is a longer one. If you want to buy it for ease of reading on a Kindle or via the Kindle app, purchase it on Amazon. If you want to listen, get the podcast version. If you’re reading it here, let’s get started.
1/ Know the pot and the payout. (“Any damn fool can see.”) “If you’re a handicapper and you want to make money there are two things that are important. One is how fast the horse is going to run (the fundamentals). Second is the odds on the tote board. The way you make money isn’t picking a winner. The way you make money is picking mispriced odds. That idea really carries over to investing. I think as investors many of us blur those two things.”
Jeff deGraff puts it in poker terms “if the opportunity to stay in the pot is low enough and the reward is high enough, absolutely stay in. Even though there might be a very slim chance of pulling a straight, the chance to stay in makes an awful lot of sense.”
Charlie Munger is – of course – the most colorful conveyor of this idea:
“Any damn fool can see that a horse carrying a light weight with a wonderful win rate and a good post position etc., etc. is way more likely to win than a horse with a terrible record and extra weight and so on and so on. But if you look at the odds, the bad horse pays 100 to 1, whereas the good horse pays 3 to 2. Then it’s not clear which is statistically the best bet using the mathematics of Fermat and Pascal.”
Short seller Jim Chanos said he’s seen “seen far more stocks go to zero than infinity.” If you short a stock, you could theoretically, have uncapped losses. The sky’s the limit, but Chanos says this rarely happens.
Cliff Asness explained this to Tyler Cowen:
“I want to ask one of my two older kids (age 12)… ‘Does this (merger arbitrage) sound like a good idea to you?’…There’s about a 98 percent chance they say, ‘No. That sounds like a terrible idea to me, you can lose a lot, you can make a little. Who wants to do that?’ I’d be the proudest pop on Earth if either one of them kind of paused and said, ‘how often do both of those two things happen, Dad?’ Because, that’s the proper question.”
The point we want to get to is the “pause.” It’s not to “blur” the two things. We want to think through the idea. We want to ask why it’s a good bet to make.
Sometimes longshot bets are worth placing if the cost is low, and sometimes almost certain bets are worth placing even if the cost is high. Most things are somewhere in the middle.
Know the pot. How much you can win?
Know the odds. What’s the chance for each outcome?
Do the math.
Note that this gets harder the more people doing it. Mauboussin calls this the paradox of skill, “if the people who are less capable are walking away from the poker table, who’s left?” As my dad says, if you look around and can’t tell who the fool is, it’s you.
The paradox is that, “when activities have both skill and luck, as most things do in life, as skill increases luck becomes more important,” explained Mauboussin. Luck becomes more important because there are fewer fools at the poker table and the range of skills has narrowed.
Burton Malkiel used this to explain why it’s hard to be an active investor, “the problem is, as the market gets more and more professional, when people are better trained, when people have better sources of information…it’s then harder and harder to actually beat the market.”
Nate Silver said he stopped playing online poker because of exactly this. Stephen Jay Gould called it the “right wall” and explained how it works with distributions. Former Philadelphia 76ers General Manager Sam Hinkie put it this way in his farewell letter:
“Opportunities in a constrained environment winnow away with each person that agrees with you, though. It reminds me of when we first moved to Palo Alto. Within about a week of living there a voice kept telling me, “This is great. Great weather, 30 minutes to the ocean, 3 hours to ski, a vibrant city 30 miles away, and one of the world’s best research universities within walking distance. People should really move here.” Then I looked at real estate prices. I was right, yes, but this view was decidedly not a non-consensus view. My viewpoint as a Silicon Valley real estate dilettante, which took a whole week to form, had been priced in. Shocker.”
There are two parts to any investment; the horse/company/house/investment and what people think the horse/company/house/investment are worth. Ideally something is accidentally mispriced (Seth Klarman talked about this), but it doesn’t happen often.
Situations get even harder to figure out when the novices leave the table and the remaining skill level is high.
2/ Incentives matter. Mauboussin was once asked to suggest a better research process. He proposed the research team be split. One group works on one area, one on another. Then they come together at the end of the process and compare notes. “They kind of said ‘that’s a cool idea, see you later,’ it didn’t go very far.”
Mauboussin’s idea was probably good, but the people listening weren’t incentivized to try it.
Incentives are a powerful force. Charlie Munger says “what wins in human affairs are incentives.” He tells this story:
From all business, my favorite case on incentives is Federal Express. The heart and soul of their system—which creates the integrity of the product—is having all their airplanes come to one place in the middle of the night and shift all the packages from plane to plane. If there are delays, the whole operation can’t deliver a process full of integrity to Federal Express customers.
And it was always screwed up. They could never get it done on time. They tried everything: moral suasion, threats, you name it. And nothing worked.
Finally, somebody got the idea to pay all these people not so much an hour, but so much a shift—and when it is all done they can all go home.. Well, their problems cleared up overnight.
So getting the incentives right is a very, very important lesson. It was not obvious to Federal Express what the solution was. But maybe now, it will hereafter more often be obvious to you.
Mauboussin suggested the company split their research according to point #1.
- What’s the fundamentals of the business, the skill of the team, the cards in your hand, the quality and location of the house?
- What’s the stock price, the odds of the team, the chances with your cards, the housing market?
Answer these questions separately and then at the last moment bring them together to get an accurate picture of what’s happening. My guess is that the idea didn’t go very far because the managers had the wrong incentives. Their incentive was career preservation. One way we do this is erring to fail in normal ways rather than succeed in abnormal ones.
A profession that’s had this examined a lot is football, here’s coach Kevin Kelley.
Kelley doesn’t punt on fourth down. He’s been very successful, but recognizes the traditional incentive system.
I liked was this quote most ( 1:12).
That’s the impression. That’s the incentive. Don’t be a crazy nutjob. Especially when things are going well. What’s the incentive if you’re doing well? Don’t rock the boat.
Toward the end of the interview Mauboussin comes back to this point about sports. “This remains remarkably pervasive… they’re still doing things that don’t make a lot of sense…A lot of it is that people grew up with the sport. They can’t expand their view.”
I’d argue that the things they are doing do make sense in the system of incentives that exist in sports.
Sports aren’t completely about winning and losing. Sports are about reputations, attitudes, attendances, feelings and ego. If sports were all about winning and losing then things like prima donna soccer owners wouldn’t be a thing and Sam Hinkie would still have his job as GM of the 76ers.
In episodes #3 of Malcolm Gladwell’s Revisionist History podcast he looks at this very thing. Wilt Chamberlain refused to shoot his free throws underhand – EVEN THOUGH IT MADE HIM A BETTER SHOOTER!!! – because he didn’t like the way it looked. Sports isn’t always about winning.
When the Philadelphia 76ers fired Sam Hinkie, it was about more than basketball. Hinkie wasn’t trying to win in the traditional way. He could be bad, but not that bad. His system I guessed was good, but the incentives weren’t to win that way.
Hinkie’s situation reminded me of when Bill Belichick was the Cleveland Browns head coach. Neither guy was great with the media (think about their incentives when a coach doesn’t appear buddy-buddy). Belichick’s demise began when he cut quarterback Bernie Kosar. This is from The Education of a Coach.
“On Monday, November 8, they cut him, and they did it with a certain brutality, as Belichick spoke of Kosar’s diminished skills. For Cleveland the unthinkable had happened. He had cut their favorite son.”
The people of Cleveland doubted him. Doubted the football coach who is a defensive mastermind. The coach whose father was a long tenured assistant. The coach who won two Super Bowls with the Giants with Bill Parcells. The coach who no one outworked. Here’s what an early peer said.
“I think a lot of it came from the fact that he had not played big time football and because of that he felt he had to work twice as hard as anyone else to prove himself, to prove his bona fides…he was someone who was simply not going to be denied.”
That’s the guy who was fired a week after the team owner moved the franchise to Baltimore. That’s the guy who the fans changed “must go” for each home game after Kosar was canned.
The incentives in sports go beyond only winning.
Incentives matter and figuring out which incentives matter to which people is a powerful tool.
3/ The inside and outside view. Mauboussin uses the example of a kitchen remodel to explain the inside and outside view.
The inside view is what you know about the kitchen, the contractor, the job, and the situation. “Left to our own devices,” Mauboussin says, “that’s how we solve problems.”
Then we see our neighbor one day and he asks about the van in the driveway. We tell him about the remodel (already delayed, countertops) and he smirks. He knows that remodels take longer and cost more. He’s the outside view.
“Psychologists have found,” Mauboussin says, “that introducing the outside view almost invariably improves the quality of decisions.” The problem is that we loaf. It takes a mental effort to come up with the outside view and then compare it to what we were thinking. You need to figure out the range of outcomes for the kitchen remodel then where yours might fall in that range.
There’s a way to make this easier. Rules, numbers, and formulas.
“The virtue of basic rules for buying and selling are precisely because you take the emotion out,” Mauboussin says, “and you’re making fundamentals and expectations two separate things.” Emotions are the inside, rules and numbers are the outside. Remember, when dealing with people (you included), you will be dealing with emotions. Those can cloud the inside view even further.
Business is emotional. Andy Grove wrote, “People who have no emotional stake in a decision can see what needs to be done sooner.” That is, people who see more of the rules and numbers side. But you can’t just present the facts. You have to untangle them. “Confusion engulfs you,” Grove wrote. “In many instances, your personal identity is inseparable from your lifework.”
That’s the kind of emotional investment involved. That’s why, Mauboussin says you need rules. “I felt the frustration that comes when the things that worked for you in the past no longer do any good,” wrote Grove. Look at that not from the Intel executive angle but from the investor angle. You had a system that worked, it made you one of the best in the world, then it stopped. Is it permanent? Maybe a dip? A blip? It’s certainly how you define yourself.
It’s easy to write about the inside/outside view or to listen to Mauboussin talk about it. Application is much harder. The inside/outside view is a simple but not easy system. To do it well we need practice. Fortunately this starts the same way, it’s all about the base.
In situations without a big swing (Intel), we can look at the base rate. We can ask “What normally happens?” Remember coach Kelley? Want to guess the base rate for fourth down conversions of three yards or less? It’s one hundred ten out of two hundred twenty. That’s the NFL number. Start there. That’s the base rate, the outside view.
What if your team practices this skill and gets better than the base rate? What if the other team knows this and practices against it? Start with the base rate and move around from there.
Another reason to get the base rate/ the outside view/ the numbers and rules point of view because the people involved in a project tend to be more optimistic about its completion and success than people not involved (like the kitchen remodel). This happened to Daniel Kahneman. He was part of a team of people tasked with writing a new textbook. They began the work and in the beginning it was easy. He writes that the team had made good progress over the first year.
Soon they began to write about the planning fallacy (Chapter 23 of Thinking Fast and Slow ).
Well, thought Kahneman, let’s see what this looks like up close. He asked each team member to write down how much longer they thought the book would take to finish. The collective average was 2 years. Not bad, but Kahneman didn’t stop there. He writes:
“I turned to Seymour, our curriculum expert, and asked whether he could think of other teams similar to ours that had developed a curriculum from scratch… and Seymour said he could think of quite a few.”
Okay, so far so good.
“I asked him to think of these teams when they had made as much progress as we had. How long, from that point, did it take them to finish their textbook projects? He fell silent.”
“I never realized this before, (Seymour said), but in fact not all the teams at a stage comparable to ours ever did complete their task.”
In groups with comparable situations 40% failed to finish. Of those who finished, none did it in less than 7 years. But, wait! This group has Daniel freaking Kahneman, a man who would go on to win a Nobel Prize. Surely a brilliant star can lift a team. Kahneman asks about this:
“I grasped at a straw: ‘When you compare our skills and resources to those of the other groups, how good are we? How would you rank us in comparison with these teams?’ Seymour did not hesitate long this time. ‘We’re below average,’ he said, ‘but not by much.’”
No matter how great you are, the base rate is a good place to start. Especially because of an omnipresent villain, storytelling machines.
4/ Wonderful storytelling machines. “Once an event occurs, all of us effortlessly and naturally create a narrative to explain that outcome. Two things kick in, the first in hindsight bias. We start to believe we knew what was going to happen with a greater probability than we actually did…And the second thing that happens is creeping determinism, where you start to believe that what happened is the only thing that could have happened.”
What we need are counterfactual stories and the honesty to admit we were wrong. First we’ll look at the stories we tell, then about being wrong.
As football season is almost here, let’s continued that theme. Here’s a nice counterfactual from the NYT:
Here’s a thought exercise for you. Imagine that for decades no one ever thought of the punt. Teams knew nothing else than to run or pass on 4th down. And then one day it’s invented. Some guy comes up to a coach and says, “Kick the ball on every 4th down and the other team gets possession 37 yards further down the field.” The coach would think he was crazy: “Wait, you want me to give up one quarter of my opportunities for a first down on every series…just for 35 yards of field position? Do you realize how much that’s going to kill our chances of scoring?”
And that coach would be absolutely right. It’s funny how boxed in our thinking can be. Except for the most desperate of circumstances or with inches to go just outside of field-goal range, today’s N.F.L. coaches will choose to punt.
“Boxed in thinking” is another way to say that we stink when it comes to coming up with counterfactuals. That quote is from 2009, but the point is the counterfactual. We have a tendency, as Mauboussin puts it, “to believe that what happened is the only thing that could have happened.”
“Coincidence is logical,” said a great football/soccer player and coach Johan Cruyff.
In the book Why Everything You Know About Soccer is Wrong Chris Anderson and David Sally write “we remember, and place undue significance on, things that do happen while ignoring those that do that.” In soccer this is easy to see, goals.
A goal is salient. A defensive play is not. So what? “People discount causes that are absent (things that didn’t happen) and augment the importance of causes that are present (things that did happen),” the duo wrote.
Counterfactuals are a tricky creature. We tend to like them if they confirm our self-image but reject them if they tell us we may be wrong. Philip Tetlock found this in his research on predictions and concluded, “Experts were open to “I was almost right” scenarios but rejected “I was almost wrong” alternatives.”
That is, when presented a counterfactual, something else that could have happened after a small tweak, people wanted to believe it if it made them right but rejected it if it made them wrong.
A quick summary: We tend to overemphasize the things we see happen and deemphasize the entire range of other possible outcomes.
I haven’t read Klosterman’s book (yet), but the premise from the interviews he’s done is that we can’t predict what will be remembered from any certain time period. Popular music, for example, will be viewed differently in 100 years in the same way that we view music from 100 years ago. Klosterman explains:
“But for the most part, everything, whether it’s music, film, books, whatever the subject may be, culture seems to operate like this over time. You start with a huge field of potential candidates. There are many people who could be seen as really central to the existence of that art form. And then time plods along. And as time plods along, certain candidates drop by the wayside. They get lost or they disappear, or their relevance changes. And eventually you get down to only one artist remaining. And then, the significance of that artist is kind of amplified and exaggerated. And that person ends up becoming interchangeable with the art form. John Philip Sousa being this example–there were many people creating marches.”
It’s hard to think of what else could have happened. In the late 1800’s Sousa was one of many marching music composers, but we tend to remember only him. Why? If you asked someone 100 years ago, would they come up with this outcome?
I tried to consider counterfactuals in my book, 28 Lessons from Start-ups That Failed. The question was, what contributes to a start-up failure?
Remember the movie The Social Network. Watch that and you could think there is a recipe for a successful start-up. Good idea (social networks), test case (Harvard campus), roll out, smart people, tweak the product, hoodies. But what if other companies do those same things? Will they succeed? How do you tease out who succeeds and who doesn’t? Coming up with counterfactuals helps you see the world in truer terms.
Now, about being wrong.
On some level we all know we are wrong. Mauboussin references Kathryn Schulz and she has a great TED talk about being wrong. After a funny story to start, she says;
“We get it in the abstract…but when it comes down to me, right now…suddenly all this abstract appreciation of fallibility goes out the window and I can’t think of anything I’m wrong about.”
How great is that? Of course I’m wrong about some things, but what? Just like the counterfactuals, it’s hard to come up with things that aren’t there. To create a story from scratch. This blog is probably wrong about a lot of things, but I can’t tell you what any are.
Schulz thinks we’ve messed up culturally about the feeling of wrongness. We wrongly emphasis wrongness in school. “So by the time you are nine years old, you’ve already learned that people who get stuff wrong are lazy irresponsible dimwits. Second of all, the way to succeed in life is never to make any mistakes.”
We equate wrong with bad. Being wrong means lower grades in school. It means isolation from one group. It means being that kind of kid. These expectations creep into the teacher’s lounge and they creep into our lives. “We learn these really bad lessons really well,” Schulz says.
But being wrong is rational. “What’s it mean to be rational?” asks Mauboussin, “That your beliefs map accurately to the world. That’s a real challenge because the world is constantly changing and requires you to change your own views.”
If the facts change, you need to change your mind. You were wrong, now you’re right.
How do we do this? Two ideas come to mind; be comfortable in the wrongness but don’t stay there.
Part of the reason that Anson Dorrance succeeded as a soccer coach is that he trains his teams to be comfortable in uncomfortable situations. Running late? Not a problem, his teams are late all the time. Tired? Not a problem, his team conditions ruthlessly. Fifty fifty ball in the box? Not a problem, that’s his favorite drill and they run it all the time.
If you can weave comfort with wrongness into your decision-making process you’ll panic less and have fewer knee jerk reactions. Seth Klarman spoke about how culture matters here. If someone makes a mistake, don’t yell at them, Klarman said. That’ll incentivize them to just not tell you the next time. In Schulz’s terms, don’t equate wrong with bad.
The second thing you need to do is not stay there. As Ritholtz likes to say, “you can be wrong but you can’t stay wrong.” Know the feeling of being wrong, that’s it’s not the end of the world, and move on. To put it differently, succeed by adapting.
We saw how Steve Callahan did this when he was lost at sea. Callahan didn’t have enough food, so he focused his efforts on catching more food. When he needed water, he switched his focus to that. He succeeded by adapting.
The history of Coca-Cola is one of adaptation too. Coke began as a patent medicine, all sizzle no steak. Then it was a pick me up beverage, both steak and sizzle. When people thought there might be too much pick me up (was it the caffeine, the sugar, or the cocaine derivative?) it was a refreshing beverage. Then it was an American beverage and so on. Coke has evolved, in name and formula because the times they are a changin. Coke succeeded by adapting.
Charlie Munger said about the Berkshire Hathaway success, “It is remarkable how much long-term advantage [we] have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.” Berkshire succeeded by adapting. They’ve been wrong but haven’t stayed wrong.
But it won’t be easy.
“In life consistency is valued as a good thing.” Mauboussin says, “If you’re changing your view you’re called a flip flopper. In investing, if you’re doing the right thing, that’s what you need to do.”
Andy Grove explained this beautifully in his book Only the Paranoid Survive. His thesis was that at strategic inflection points (SIPs), a business has to be open to change. This is what Intel did. They had to shift from memory chips to microprocessors.
Grove/Intel faced a SIP just when they were most profitable in memory chips. There was so much money it was hard to tell they were wrong. They were. This is also part of Clayton Christensen’s disruption theory. Grove explains it best with just the title of his book ONLY THE PARANOID SURVIVE. If you carve out a niche, people will come for you.
Sometimes numbers will tell you that it’s time to change. That you’ve been telling the wrong story. Intell saw the price of Japanese chips and knew the story was about to change. Coca-Cola saw Pepsi’s market share and knew the story was about to change. Google saw Yahoo’s search numbers and knew the story was about to change. Sometimes numbers will tell you, sometimes it has to be people.
That person is a Devil’s Advocate. Anson Dorrance, Marc Andreessen and Ben Horowitz, and Bob Seawright all suggest you have someone push back on your ideas. Stanley McChrystal talked about it in war games. It’s part of being a genius.
We are wonderful storytelling machines. The problem is that we tend to create narratives that only look at the most visible actions and miss things that mattered but are harder to see.
5/ So how should you invest? Index funds.
Mauboussin says this is the way to go for most people, and I agree. Why should you? Let’s apply our four big idea so far.
- The stock price (odds) is easy to find out but the quality of the business (fundamentals) is much harder. You may use an iPhone Mr. Lynch but is Apple a good business?
- Incentives are often misaligned and not always financial. How does your broker make money? What’s the incentive for the person giving you advice?
- The inside and outside views are hard to balance, especially for people emotionally involved. It’s one thing to say you’re ready for a drop, another thing to ride one out.
- How good are you at coming up with counterfactuals? How good are you at storytelling? Most people excel at the latter but require the former to pick the right stocks.
James Osborne had a nice post in August 2016 about “Spicing things ups.” Osborne is good about taking the planned, rational, organized, act-don’t-knee-jerk-react path. But even he is sometimes tempted.
“Some days this is just so excruciatingly boring I can barely stand it. I never get to do anything new. I never find some exciting stock or fund to buy. I never get to tell a great story over beers about the great trade I made in my account that week. I don’t have a new painstakingly crafted white paper to defend some exotic currency trade I just put on.”
Listen to Jason Zweig’s advice and get comfortable telling people “I don’t know and I don’t care,” when they try to talk about the stock market.
6/ Hold my beer, and watch this. Mauboussin recalls Dan Gilbert’s book Stumbling on Happiness and says, “mentally healthy people are mildly cognitively delusional.”
We sometimes smirk at these people, but we need these people. To paraphrase Nassim Taleb, the failures of the individual make success for the group.
- At the individual level we don’t want to overestimate our own abilities.
- At the collective level we want people who overestimate their own abilities.
Zoom in and we in we see it this way. Burton Malkiel explained:
“You ask a group of 200 students, are you a better driver or a worse driver than all the other students in the room, and 90% of them say they are better than average. It’s like Lake Wobegon, we’re all better than average.”
“The iron rule of life is that only 20% of the people can be in the top fifth,” said Charlie Munger. Individually we need to see this. But as a whole, we don’t want everyone to see this.
Look at Phil Knight. Knight had to believe he was better than average to create Nike. We need many “Knights” to believe they are better than average because some unpredictable amount will get lucky and we all will be better for it. We benefit from the risks people like Dan Coyle take in writing books, David Chang take in opening restaurants, and Alex Blumberg take in starting podcasts.
7/ M R Ducks. “People massively underestimate the role of their organization in their own success. They think they’re the one carrying the weight when in fact it’s everything that’s going on around them.” Mauboussin recommended Chasing Stars as a book that looks at this. We call this ducks on rising tides and we’ve seen it a few places.
We hijacked the idea of ducks on a rising tide from the early Warren Buffett letters. Buffett wrote to shareholders that they should know if the returns were due to a rising tide or him “flapping his wings.”
That’s probably enough for now. Thanks for reading, I’m @mikedariano on Twitter.
Notes: I used the funky fraction 110/220 so you couldn’t peek ahead and immediately see the answer.