Ask Eric!

[ERICOPOLY]

What I am really trying to do is to draw out your method of analysis in choosing or rejecting the idea. I was invested in MBIA but I was killed by the time decay on the LEAPS I held. I switched to BAC. Calonego has a good post warning about options which I should have read.

 

Can you point me out to this post?

 

Eric -> Have you had any large losses to date? or just simple small losses on rolling over options?

 

My portfolio has been down 50% off of peaks now a few times since 2008.  Most recently in 2011.  Actually, it was down 30% last summer off of the highs hit in March.

 

During those times I have sometimes booked large losses and moved the proceeds into something I liked better.

 

When I was really young I lost some money in the tech bust but that was before I found Buffett, before reading Graham's book, and essentially before I realized that one could estimate a value for a stock and then do buy/low sell/high relative to that value.  So I don't really count that loss  :D

 

[Aberhound]

Here is Calonego's post about options from about March 2010:

 

"Hugh,

 

I'm going to start at the beginning.

I know you know this stuff, but I don't want anyone thinking I have a flawed basis and make a flawed assumption.

 

So, you've found a company... you like the business and find that it's worth "X", but trading at "0.3X".

In my case, most of these instances are discovered in small, nano-cap companies. So really the only option is to attempt to buy enough common that it makes a dent on your net-worth when the thing triples to a fair intrinsic value. Rarely these companies may have a somewhat more complicated capital structure and you may be able to buy a really interesting convertible bond, quoted warrant, or do a PIPE with them on favorable terms, otherwise, just be in the market daily bidding the stock and you may get some.

 

In rare occurrences I've found small-to-mid capitalization companies (say $500mln-$5bln market caps, which generally have options) trading at a very favorable valuation. Historically FFH in '06 at $89 comes to mind, WEN before the Tim Horton's spinoff was discussed publicly (in the $20s); and recently Telefonica (TEF) and Transocean (RIG) may be in this ballpark (ideas I'm looking at).

 

So, the company has some options outstanding if it's large enough, and you think it's cheap. You must, as a favor to yourself, examine what's available. Morningstar.com is really good for this as it lays out what's out there on a security and the relevant info/data points, plus it's free.

 

In the calls, you could purchase a deep in the money call, giving up dividends,etc, but you would have less capital tied up (you save on the opportunity cost of this cash) and still participate in most of the favorable parts of being a shareholder in a public company.

If you purchase an out of the money call, you are speculating on the timing of the company trading up to your valuation or a catalyst playing out. In the event that a large company is really trading at 30% of what it's worth (based on really good analysis) this may not be a bad speculation for a small portion of a portfolio, the main unknown is the timing of the market and the individual company. The writer of the option is writing it based on the assumption that the company can go up or down, and almost in a equal probability, so you may do alright in time betting against that if your valuation is correct and you do this with small sums of money.

 

In the puts you can write something out of the money or near the money. As you point out, you have a sum of capital you will receive for writing the put (think of it as an insurance premium) in return you are telling the counter-party that you will be there for them to sell the security to in the event it goes below the strike price. I like to think of it as:

 

a) buy the company's shares for $25 (even though they are worth $75)

b) sell a Nov $20 put for say $2, locking in a purchase price of $18... less the time value of the $25 being invested in short-term bonds

 

If you were looking to buy a 20% position, the company is that cheap, selling the $20 put for $2 may be a viable choice for a portion of the position, it'll lock in a buy at $18 in the event it is exercised. However, as you rightly stated, you may give up on the upside from $25-$50, the move to intrinsic value, in the event the shares do not fall below $20, and at the right time, for the holder to exercise their option.

 

I like to think of it this way, if I'm going to buy shares in the company at $25 for 10% of my equity (at a 66% discount to my IV), I would likely buy more at a 75% discount, say 20% of my equity. This $17-18 cost is below a 75% discount and a great forced entry point if the shares get that low.

 

If you are considering doing this to make $2 every few months selling options, you are selling insurance policies. You better know what you are insuring and price accordingly (I have friends that do this very well).

If you are doing so thinking the shares will go higher and based on the volatility going down so the price declining (etc, etc), you are speculating...

If you are doing this with the knowledge that your valuation is entirely correct and that if the shares fell that low you would love to have the option exercised on you, you may be doing this per what I think Warren did with KO a number of years ago. A second reason may be due to his requirement (personally and to the insurance regulators) to hold only a certain amount of float in equities. He may have been forced to write the puts based on a need to hold cash and short-term bonds, although there was a great opportunity to invest in KO. But my recollection is that the use was for the former reason.

In the event the shares do not decline and you are not forced upon more wonderfully undervalued securities, the profit will augment your returns somewhat, but much less so than having purchased more common.

 

In a combination, you can write a put and buy a call in a synthetic long position, but this stuff gets a little complicated. 

 

So the basis of the investment is entirely founded on valuation - caveat venditor - as Uccmal has said, you may get a margin call, as the common declines and if the value of the option spikes, plus you better be willing and able to buy the common that is put on you.

 

You better be right on your valuation. You can loose a lot of dough doing this if you are very wrong.

 

The original info you quoted is a little odd - I'm note sure what he meant with his reference to margin of safety, but I can tell you this much, it wasn't something Ben Graham intended when he coined the term."

[Uccmal]

You have enjoyed big returnsw on two of three of Berkowitz's big bets MBIA and BAC. Are you invested in Sears? How would you comment on the following points I picked up reading?

 

1. Berkowitz: The trick is to find permanent capital. Buffet did it with BRK. Lampert is doing it with Sears. I am limited to a 5% position in BAC in the mutual fund and if I could I would own a lot more. Real estate offers getting closer to full value. I like to invest in things which for half value which will rise to full value. Sears is selling and closing unprofitable stores leaving the profitable stores.

 

2. Lampert: Main points from my reading: Dramatically increasing online sales while selling loss making stores then liquidating inventory paying back debt and buying shares steadily.

 

3. ESL: Selling a big position steadily at and below current stock price.

 

4. American consumer: Middle class being squeezed but pent up demand building for many years. Eventually the fridge needs to be replaced. More people can now move because of the increase in home prices and sales allowing the step up or step down which often causes new appliances to be purchased. Numerous rentals acquired from banks many of which by funds which replace appliances all the same.

 

5. Short squeeze. Lampert intend to take it private so the run up for the last shares will create a spike if Lampert does a deal.

 

6. Possible Catalyst: There is always a possibility of a big deal unloading many similar type stores to other retailers of private equity fun expanding some successful idea followed soon afterwards by Lampert taking the company private. Private equity has good access to cheap capital and might want to acquire all the downtown properties for instance as a store of value while Lampert may want only the easy to drive to and park stores for pick up with most sales online.

 

7. Valuation: Not cheap in view of current losses but tax losses and real estate values not reflected on balance sheet. Perhaps the biggest value not in the balance sheet is mentioned by Berkowitz: Once the remaining stores are profitable and throwing off cash flow which Lampert reinvests the value rises substantially.

 

What I am really trying to do is to draw out your method of analysis in choosing or rejecting the idea. I was invested in MBIA but I was killed by the time decay on the LEAPS I held. I switched to BAC. Calonego has a good post warning about options which I should have read.

 

I haven't thought enough about Sears to comment.  I've been partial to BAC because there is a money maker if they just cut expenses -- and that looks to be on track.  I think MBI is the same (except not needing to cut).  But I feel like Sears is more of a mystery because I've been to  a couple of their stores.  And more recently I used their SearsPartsDirect website -- yikes!  I had to call their customer service and the woman on the phone couldn't even tell me what manufacturer made a given part number.  I mean, talk about incompetence.  But perhaps I extrapolate too much from that anecdote.

 

 

 

I mean, talk about incompetence.  But perhaps I extrapolate too much from that anecdote....

 

 

Uhm, no your not.  The whole company is incompetently run. 

[mrvlad0]

Calonego's original post on May 26, 2010, 10:48:45 AM:

 

http://www.cornerofberkshireandfairfax.ca/forum/general-discussion/a-question-about-selling-puts-versus-buying-the-stock/msg20087/#msg20087

 

Hugh,

 

I'm going to start at the beginning.

I know you know this stuff, but I don't want anyone thinking I have a flawed basis and make a flawed assumption.

 

So, you've found a company... you like the business and find that it's worth "X", but trading at "0.3X".

In my case, most of these instances are discovered in small, nano-cap companies. So really the only option is to attempt to buy enough common that it makes a dent on your net-worth when the thing triples to a fair intrinsic value. Rarely these companies may have a somewhat more complicated capital structure and you may be able to buy a really interesting convertible bond, quoted warrant, or do a PIPE with them on favorable terms, otherwise, just be in the market daily bidding the stock and you may get some.

 

In rare occurrences I've found small-to-mid capitalization companies (say $500mln-$5bln market caps, which generally have options) trading at a very favorable valuation. Historically FFH in '06 at $89 comes to mind, WEN before the Tim Horton's spinoff was discussed publicly (in the $20s); and recently Telefonica (TEF) and Transocean (RIG) may be in this ballpark (ideas I'm looking at).

 

So, the company has some options outstanding if it's large enough, and you think it's cheap. You must, as a favor to yourself, examine what's available. Morningstar.com is really good for this as it lays out what's out there on a security and the relevant info/data points, plus it's free.

 

In the calls, you could purchase a deep in the money call, giving up dividends,etc, but you would have less capital tied up (you save on the opportunity cost of this cash) and still participate in most of the favorable parts of being a shareholder in a public company.

If you purchase an out of the money call, you are speculating on the timing of the company trading up to your valuation or a catalyst playing out. In the event that a large company is really trading at 30% of what it's worth (based on really good analysis) this may not be a bad speculation for a small portion of a portfolio, the main unknown is the timing of the market and the individual company. The writer of the option is writing it based on the assumption that the company can go up or down, and almost in a equal probability, so you may do alright in time betting against that if your valuation is correct and you do this with small sums of money.

 

In the puts you can write something out of the money or near the money. As you point out, you have a sum of capital you will receive for writing the put (think of it as an insurance premium) in return you are telling the counter-party that you will be there for them to sell the security to in the event it goes below the strike price. I like to think of it as:

 

a) buy the company's shares for $25 (even though they are worth $75)

b) sell a Nov $20 put for say $2, locking in a purchase price of $18... less the time value of the $25 being invested in short-term bonds

 

If you were looking to buy a 20% position, the company is that cheap, selling the $20 put for $2 may be a viable choice for a portion of the position, it'll lock in a buy at $18 in the event it is exercised. However, as you rightly stated, you may give up on the upside from $25-$50, the move to intrinsic value, in the event the shares do not fall below $20, and at the right time, for the holder to exercise their option.

 

I like to think of it this way, if I'm going to buy shares in the company at $25 for 10% of my equity (at a 66% discount to my IV), I would likely buy more at a 75% discount, say 20% of my equity. This $17-18 cost is below a 75% discount and a great forced entry point if the shares get that low.

 

If you are considering doing this to make $2 every few months selling options, you are selling insurance policies. You better know what you are insuring and price accordingly (I have friends that do this very well).

If you are doing so thinking the shares will go higher and based on the volatility going down so the price declining (etc, etc), you are speculating...

If you are doing this with the knowledge that your valuation is entirely correct and that if the shares fell that low you would love to have the option exercised on you, you may be doing this per what I think Warren did with KO a number of years ago. A second reason may be due to his requirement (personally and to the insurance regulators) to hold only a certain amount of float in equities. He may have been forced to write the puts based on a need to hold cash and short-term bonds, although there was a great opportunity to invest in KO. But my recollection is that the use was for the former reason.

In the event the shares do not decline and you are not forced upon more wonderfully undervalued securities, the profit will augment your returns somewhat, but much less so than having purchased more common.

 

In a combination, you can write a put and buy a call in a synthetic long position, but this stuff gets a little complicated. 

 

So the basis of the investment is entirely founded on valuation - caveat venditor - as Uccmal has said, you may get a margin call, as the common declines and if the value of the option spikes, plus you better be willing and able to buy the common that is put on you.

 

You better be right on your valuation. You can loose a lot of dough doing this if you are very wrong.

 

The original info you quoted is a little odd - I'm note sure what he meant with his reference to margin of safety, but I can tell you this much, it wasn't something Ben Graham intended when he coined the term.

[Liberty]

Hi Eric,

 

I love how you boil down your investment theses to a few important things and never lose track of those, even if you also keep track of the stream of details. It sounds easy, but in practice there's always the danger of drifting away from something important.

 

I know that over time you've been invested in FFH, ORH, BAC, AIG, MBI.

 

Are others missing from the list? If so and you want to share, can you write a few words on the reasons why you invested?

 

Thanks

 

 

[ERICOPOLY]

Hi Eric,

 

I love how you boil down your investment theses to a few important things and never lose track of those, even if you also keep track of the stream of details. It sounds easy, but in practice there's always the danger of drifting away from something important.

 

I know that over time you've been invested in FFH, ORH, BAC, AIG, MBI.

 

Are others missing from the list? If so and you want to share, can you write a few words on the reasons why you invested?

 

Thanks

 

I've bought more complicated things like HPQ that I lost a bit on.  And I held DELL which I sold to buy more BAC.  And on, and on, and on....

 

I have learned that I can only stick it out if I have some grasp on a highly predictable earnings future that presents me with a nearly certain massive earnings yield.  The trick is finding things really cheap that have highly predictable and stable/growing long term earnings.  Without taking big risks from competitively driven declines in those earnings.  I think that's why Buffett claims they don't come around very often. 

 

Every time I've lost money it has been because I didn't start off with a company with a highly certain future earnings stream that offered a gargantuan earnings yield.

[JBird]

Quoting from the article:

 

"First there's mathematics. Obviously, you've got to be able to handle numbers and quantities—basic arithmetic. And the great useful model, after compound interest, is the elementary math of permutations and combinations. And that was taught in my day in the sophomore year in high school. I suppose by now in great private schools, it's probably down to the eighth grade or so.

 

It's very simple algebra. It was all worked out in the course of about one year between Pascal and Fermat. They worked it out casually in a series of letters.

 

It's not that hard to learn. What is hard is to get so you use it routinely almost everyday of your life. The Fermat/Pascal system is dramatically consonant with the way that the world works. And it's fundamental truth. So you simply have to have the technique.

 

Many educational institutions—although not nearly enough—have realized this. At Harvard Business School, the great quantitative thing that bonds the first-year class together is what they call decision tree theory. All they do is take high school algebra and apply it to real life problems. And the students love it. They're amazed to find that high school algebra works in life....

 

By and large, as it works out, people can't naturally and automatically do this. If you understand elementary psychology, the reason they can't is really quite simple: The basic neural network of the brain is there through broad genetic and cultural evolution. And it's not Fermat/Pascal. It uses a very crude, shortcut-type of approximation. It's got elements of Fermat/Pascal in it. However, it's not good.

 

So you have to learn in a very usable way this very elementary math and use it routinely in life—just the way if you want to become a golfer, you can't use the natural swing that broad evolution gave you. You have to learn—to have a certain grip and swing in a different way to realize your full potential as a golfer.

 

If you don't get this elementary, but mildly unnatural, mathematics of elementary probability into your repertoire, then you go through a long life like a onelegged man in an asskicking contest. You're giving a huge advantage to everybody else.

 

One of the advantages of a fellow like Buffett, whom I've worked with all these years, is that he automatically thinks in terms of decision trees and the elementary math of permutations and combinations...."

 

I'm going to give you two quotes from Buffett, and then hope the correlation between what Charlie said and Buffett said is so clear that I don't have to explain very much.

 

"We have no particular bias when it comes to choosing from these categories; we just continuously search among them for the highest after-tax returns as measured by "mathematical expectation," limiting ourselves always to investment alternatives we think we understand. Our criteria have nothing to do with maximizing immediately reportable earnings; our goal, rather, is to maximize eventual net worth." Berkshire Annual Report 1989

 

“We are obviously following a policy regarding diversification which differs markedly from that of practically all public investment operations. Frankly, there is nothing I would like better than to have 50 different investment opportunities, all of which have a mathematical expectation (this term reflects the range of all possible relative performances, including negative ones, adjusted for the probability of each- no yawning, please) of achieving performance surpassing the Dow by, say, fifteen percentage points per annum. If the fifty individual expectations were not intercorelated (what happens to one is associated with what happens to the other) I could put 2% of our capital into each one and sit back with a very high degree of certainty that our overall results would be very close to such a fifteen percentage point advantage.

 

It doesn’t work that way.

 

We have to work extremely hard to find just a very few attractive investment situations. Such a situation by definition is one where my expectation (defined as above) of performance is at least ten percentage points per annum superior to the Dow. Among the few we do find, the expectations may vary substantially. The question always is, “How much do I put in number one (ranked by expectation of relative performance) and how much do I put in number eight?” This depends to a great degree on the wideness of the spread between the mathematical expectation of number one versus number eight. It also depends upon the probability that number one could turn in a really poor relative performance. Two securities could have equal mathematical expectations, but one might have a .05 chance of performance fifteen percentage points or more worse than the Dow, and the second might have only .01 chance of such performance. The wider range of expectation in the first case reduces the desirability of heavy concentration in it.

 

The above may make the whole operation sound very precise. It isn’t.” - Buffett Partnership Letter 1966

 

As you may have noticed during the Berkshire meeting this year, Buffett more than once asked Charlie a question about the probability of a future event. Buffett's mind is automatically thinking about the future in terms of real-probabilities, and he's navigating it by making choices based on mathematical expectation.

 

 

 

[biaggio]

Quoting from the article:

 

"First there's mathematics. Obviously, you've got to be able to handle numbers and quantities—basic arithmetic. And the great useful model, after compound interest, is the elementary math of permutations and combinations. And that was taught in my day in the sophomore year in high school. I suppose by now in great private schools, it's probably down to the eighth grade or so.

 

It's very simple algebra. It was all worked out in the course of about one year between Pascal and Fermat. They worked it out casually in a series of letters.

 

It's not that hard to learn. What is hard is to get so you use it routinely almost everyday of your life. The Fermat/Pascal system is dramatically consonant with the way that the world works. And it's fundamental truth. So you simply have to have the technique.

 

Many educational institutions—although not nearly enough—have realized this. At Harvard Business School, the great quantitative thing that bonds the first-year class together is what they call decision tree theory. All they do is take high school algebra and apply it to real life problems. And the students love it. They're amazed to find that high school algebra works in life....

 

By and large, as it works out, people can't naturally and automatically do this. If you understand elementary psychology, the reason they can't is really quite simple: The basic neural network of the brain is there through broad genetic and cultural evolution. And it's not Fermat/Pascal. It uses a very crude, shortcut-type of approximation. It's got elements of Fermat/Pascal in it. However, it's not good.

 

So you have to learn in a very usable way this very elementary math and use it routinely in life—just the way if you want to become a golfer, you can't use the natural swing that broad evolution gave you. You have to learn—to have a certain grip and swing in a different way to realize your full potential as a golfer.

 

If you don't get this elementary, but mildly unnatural, mathematics of elementary probability into your repertoire, then you go through a long life like a onelegged man in an asskicking contest. You're giving a huge advantage to everybody else.

 

One of the advantages of a fellow like Buffett, whom I've worked with all these years, is that he automatically thinks in terms of decision trees and the elementary math of permutations and combinations...."

 

I'm going to give you two quotes from Buffett, and then hope the correlation between what Charlie said and Buffett said is so clear that I don't have to explain very much.

 

"We have no particular bias when it comes to choosing from these categories; we just continuously search among them for the highest after-tax returns as measured by "mathematical expectation," limiting ourselves always to investment alternatives we think we understand. Our criteria have nothing to do with maximizing immediately reportable earnings; our goal, rather, is to maximize eventual net worth." Berkshire Annual Report 1989

 

“We are obviously following a policy regarding diversification which differs markedly from that of practically all public investment operations. Frankly, there is nothing I would like better than to have 50 different investment opportunities, all of which have a mathematical expectation (this term reflects the range of all possible relative performances, including negative ones, adjusted for the probability of each- no yawning, please) of achieving performance surpassing the Dow by, say, fifteen percentage points per annum. If the fifty individual expectations were not intercorelated (what happens to one is associated with what happens to the other) I could put 2% of our capital into each one and sit back with a very high degree of certainty that our overall results would be very close to such a fifteen percentage point advantage.

 

It doesn’t work that way.

 

We have to work extremely hard to find just a very few attractive investment situations. Such a situation by definition is one where my expectation (defined as above) of performance is at least ten percentage points per annum superior to the Dow. Among the few we do find, the expectations may vary substantially. The question always is, “How much do I put in number one (ranked by expectation of relative performance) and how much do I put in number eight?” This depends to a great degree on the wideness of the spread between the mathematical expectation of number one versus number eight. It also depends upon the probability that number one could turn in a really poor relative performance. Two securities could have equal mathematical expectations, but one might have a .05 chance of performance fifteen percentage points or more worse than the Dow, and the second might have only .01 chance of such performance. The wider range of expectation in the first case reduces the desirability of heavy concentration in it.

 

The above may make the whole operation sound very precise. It isn’t.” - Buffett Partnership Letter 1966

 

As you may have noticed during the Berkshire meeting this year, Buffett more than once asked Charlie a question about the probability of a future event. Buffett's mind is automatically thinking about the future in terms of real-probabilities, and he's navigating it by making choices based on mathematical expectation.

 

Thanks for posting this. Very good. If you have any other pearls from Buffett Partnership Letters, please feel free to post. Very much appreciated. Personally I have copied + saved above to have as a reference to read again later.

[biaggio]

to follow up Birdman, or Eric if you use similar approach-would you be able to give example or tell me if what I wrote below is more or less the idea

 

I did a quick look at FFH (which is my top holding):

-taking todays price of $420. BV of $378

-using 3 possible scenarios + the probability of each + then calculation of expected value (outcome x probability)

- I assume that it is possible that FFH will grow at least as fast as the base rate for the market=7% 

-I thinks it reasonable that it could grow at 15% per year on average over next 5 years. Give it the same chance as growing the same as the market (45% each).

-Assume a worst case 50% decrease in value-I maybe overestimating the down side( with all the hedges, improved underwriting), with probability as 5%

 

 

Possible outcomes                            Probability                    Value

or scenerios

15% growth in BV x5y                        .45                            $340                   

BV of $756 in 5 years

 

7% growth x 5

to $529 in 5 years                          .45                            $238

 

0 growth in 5 years                      0.05                            $19

to $378

 

50%  decrease                              .05                            $9             

to $189

 

Expected Value=$606 in 5 years + 2%/y dividend=~10%/y

 

I know what Munger says about using exact math for this type of purpose, but is this the general idea of what Buffett/Munger  meant, not as an exact measurement but just a a general educated guestimate? Assuming that you would expect market to return 7% per year, + you want to do 10% more that that= then FFH at $420 would not be an attractive buy at this price.

 

If this is reasonable it confirms my feeling that I would not want to add FFh at this price

 

[ERICOPOLY]

I had to throw FFH overboard in order to pick up MBI.  That was a short holding period!

 

I'm not a kind lifeboat captain.  Beautiful women first... then we'll see what room is left for others.

[JBird]

Biaggio

 

I think you understand the concept quite well. In my own application, I often use a bit broader range of possible outcomes, say 6-8.

 

If you get into the habit of using this model all the time, you can be sure you'll have an mental edge over practically everyone.

[constructive]

I had to throw FFH overboard in order to pick up MBI.  That was a short holding period!

 

I'm not a kind lifeboat captain.  Beautiful women first... then we'll see what room is left for others.

 

But to be specific, they're the steerage passengers and the storm has left them a bit worse for wear. Once they get out of the elements and put some makeup on, other captains might appreciate them a bit more.

[Kiltacular]

As you may have noticed during the Berkshire meeting this year, Buffett more than once asked Charlie a question about the probability of a future event. Buffett's mind is automatically thinking about the future in terms of real-probabilities, and he's navigating it by making choices based on mathematical expectation.

 

Here's what's interesting to me when one tries to talk this way with others.  First, you have to find a "partner" that thinks this way too. And, I've found that to be very difficult.

 

I regularly talk to a lot of people that are objectively "smart"...people that went to Harvard, Princeton, Stanford, Yale, MIT, etc. -- and many of them went to graduate programs at those institutions (see, it already sound like I'm pumping up my credentials... I'M NOT).

 

Anyway, what has happened to me -- INVARIABLY -- when I start talking to people about probabilities that include negative outcomes is that they HEAR expectations.

 

Try it.  Talk to someone you know to be "smart" -- talk to a bunch of them if you can stomach it.  Ask them what they think they probability of a nuclear terrorist attack is on a major city in the United States (for example). 

 

If you can find someone that doesn't respond, at 'best', with: "You really think that WILL happen", talk further.  Don't hold your breath.

 

No matter how much people believe they might want to think this way -- in terms of probabilities, there are a large number of possible events -- invariably negative outcomes -- that even the mere mention of which your conversational partner will deem as your "expectation" if the possible outcome you're discussing is "negative".

 

This stuff is easy on paper.  I like talking about it.  Most people would rather talk about ANYTHING else.  I think the main reason that Buffett and Munger have been such a successful partnership is that they both automatically think this way.  It is rare to find anyone that really wants to talk about very negative outcomes much less even consider them.

 

I think Bruce Berkowitz has discovered this.  All his partners abandoned him when the tide turned.  He is always talking about "killing" his ideas.  He thinks like Buffett and Munger.  But, most people, including his partners, don't.  Hence, his recent comment that he's tried for a long time to change people -- without success -- and now just uses them for their good traits and shuns them for their negative attributes.

[Liberty]

Great post, Kiltacular. Very true.

[ERICOPOLY]

I had to throw FFH overboard in order to pick up MBI.  That was a short holding period!

 

I'm not a kind lifeboat captain.  Beautiful women first... then we'll see what room is left for others.

 

But to be specific, they're the steerage passengers and the storm has left them a bit worse for wear. Once they get out of the elements and put some makeup on, other captains might appreciate them a bit more.

 

I want to bring them back into my boat again.  Probably soon.

[SharperDingaan]

Biaggio: Think a 3 factor model  ;)

 

P(specific scenario) x P(market drop) x Projected Value. You should also use P(FX change) as a 4th factor, if you're considering out-of-country investments. A 10% adverse change in FX rates can really screw up your day.

 

 

 

[rkbabang]

As you may have noticed during the Berkshire meeting this year, Buffett more than once asked Charlie a question about the probability of a future event. Buffett's mind is automatically thinking about the future in terms of real-probabilities, and he's navigating it by making choices based on mathematical expectation.

 

Here's what's interesting to me when one tries to talk this way with others.  First, you have to find a "partner" that thinks this way too. And, I've found that to be very difficult.

 

I regularly talk to a lot of people that are objectively "smart"...people that went to Harvard, Princeton, Stanford, Yale, MIT, etc. -- and many of them went to graduate programs at those institutions (see, it already sound like I'm pumping up my credentials... I'M NOT).

 

Anyway, what has happened to me -- INVARIABLY -- when I start talking to people about probabilities that include negative outcomes is that they HEAR expectations.

 

Try it.  Talk to someone you know to be "smart" -- talk to a bunch of them if you can stomach it.  Ask them what they think they probability of a nuclear terrorist attack is on a major city in the United States (for example). 

 

If you can find someone that doesn't respond, at 'best', with: "You really think that WILL happen", talk further.  Don't hold your breath.

 

No matter how much people believe they might want to think this way -- in terms of probabilities, there are a large number of possible events -- invariably negative outcomes -- that even the mere mention of which your conversational partner will deem as your "expectation" if the possible outcome you're discussing is "negative".

 

This stuff is easy on paper.  I like talking about it.  Most people would rather talk about ANYTHING else.  I think the main reason that Buffett and Munger have been such a successful partnership is that they both automatically think this way.  It is rare to find anyone that really wants to talk about very negative outcomes much less even consider them.

 

I think Bruce Berkowitz has discovered this.  All his partners abandoned him when the tide turned.  He is always talking about "killing" his ideas.  He thinks like Buffett and Munger.  But, most people, including his partners, don't.  Hence, his recent comment that he's tried for a long time to change people -- without success -- and now just uses them for their good traits and shuns them for their negative attributes.

 

I think this way as well, but I never put a specific number to the probability, more of a range. There is no scientific way to assign probabilities to possible future real world events. Therefore you can not say that there is a 1.45654% chance of losing a city to a nuclear explosion in the next 10 years, but you can say "There is a small, but real chance" of such a thing happening and give it a probability of, say, <3%.  In the end though that is just your opinion at worst, educated guess at best. It could be that the person who asks "do you really think that will happen" is assigning it such a low probability that it is almost zero, but maybe I'm just giving people the benefit of the doubt here.  I have a bad habit of overestimating the intelligence of other people.  I've got a policy of smart until proven stupid.

 

[muscleman]

I've explained this before but I'll say it again -- this is not my net worth growth, it's the growth in my RothIRA:

 

During 2003,2004,2005, my net worth went up a lot (from investing/speculation) but my RothIRA declined those years.  So in those first 5 years the RothIRA lagged the net worth gains.  Then, since 2008, my RothIRA has grown more than my taxable account (but I live out of that account and can't go as aggressive, plus it lags with taxes).

 

This looks like Fidelity. But you said you use IB as your broker?

[ERICOPOLY]

I've explained this before but I'll say it again -- this is not my net worth growth, it's the growth in my RothIRA:

 

During 2003,2004,2005, my net worth went up a lot (from investing/speculation) but my RothIRA declined those years.  So in those first 5 years the RothIRA lagged the net worth gains.  Then, since 2008, my RothIRA has grown more than my taxable account (but I live out of that account and can't go as aggressive, plus it lags with taxes).

 

This looks like Fidelity. But you said you use IB as your broker?

 

My taxable account is with IB, my RothIRA is at Fidelity.

[One World Trader]

Hello Eric!

 

I'm pretty much new. To all of this. I have read many a book and I am curious, but I'm also confused. To be true to the thread subject, I shall ask..What do you do for those gains? Calls/Puts in combination with stock? I'll try reading this again, however much of the terms are new though I'm catching up. What's your strategy for the new kids on the block? Thanks in advance!

 

 

[ERICOPOLY]

Hello Eric!

 

I'm pretty much new. To all of this. I have read many a book and I am curious, but I'm also confused. To be true to the thread subject, I shall ask..What do you do for those gains? Calls/Puts in combination with stock? I'll try reading this again, however much of the terms are new though I'm catching up. What's your strategy for the new kids on the block? Thanks in advance!

 

I'm not skilled at valuing companies, but I understand the importance of it.  I see nothing more than buy/low sell/high when somebody pulls out the buzz words "Value Investing" -- the prices are high and low relative to an intrinsic value (it is already implicitly understood in the phrase "buy low, sell high").  So my strategy has been to follow investors who know how to value companies, and then pick over investments looking for something I like (this usually equates to a very straightforward pitch, or else I just wouldn't understand it enough to like it).

 

My returns were enhanced with options for non-recourse leverage, but I don't go around looking for things I can leverage.  There were times when I felt the risk/reward was so good that I used options for non-recourse leverage.

[One World Trader]

Thanks! I would go so far as to agree that BAC is one of those! Heck, I was just in a bank a few days ago and their advertised 15 month cd was .25 percent! That must mean something!

[JBird]

Your performance since 2008 has been perfectly ridiculous. I'd like to ask a question and I'm hoping for just a rough estimate at best: Given your various investment decisions since 2008, what was the range of possible outcomes for performance? What were the probabilities of each performance?

 

Ie. Probability of 75% annualized was 60%, probability of 30% annualized was 35%, and probability of 5% annualized was 5%.

 

I just wonder if in your mind there was a reasonable possibility your decisions could have had a dramatically different outcome.

[ERICOPOLY]

Your performance since 2008 has been perfectly ridiculous. I'd like to ask a question and I'm hoping for just a rough estimate at best: Given your various investment decisions since 2008, what was the range of possible outcomes for performance? What were the probabilities of each performance?

 

Ie. Probability of 75% annualized was 60%, probability of 30% annualized was 35%, and probability of 5% annualized was 5%.

 

I just wonder if in your mind there was a reasonable possibility your decisions could have had a dramatically different outcome.

 

I thought if I'd make 12% or 15% annualized I'd be doing extremely well.  I never tried to wonder what the chances or making 30% annualized were, because I never thought I could do it.  Never did I spend a minute thinking I would make 50%, or 75%.

 

I spent a good portion of today wondering if 12% were possible going forward.  I just don't have confidence that I've got anything special going on.  I go about my days like that, and then something comes along that I get really excited about -- but then I tend to believe it will be the last such investment I'll ever come across, so I make it worthwhile because I'll have to live on that bounty for the next 50 years.

 

I have no belief that I can continue to do any such results.  It's just been a strange string of once-in-a-lifetime investments that I never saw coming until they were upon me.  There is no reason to believe there will ever be another one.  They have to be simple enough for me to understand -- and that's a tough hurdle because I don't have much circle of competence.  So this means that I only have the very simple propositions to choose from -- but maybe that's an advantage after all.

[ERICOPOLY]

I also don't believe assigning probabilities would be as effective as it's promise.  On what information would I come up with numbers like 30% chance of X, or 5% chance of Z?  My biases would surely screw it all up.  Some people maybe could make use of the technique, but not me.

 

I am a lot less scientific -- after considering a range of outcomes, it's more like I go with what my gut tells me will be the most likely outcome by a country mile.