Martin Kronicle访谈

Think Twice Interview May 4, 2010 MartinKronicle: Hi everybody. It’s Michael Martin from MartinKronicle.com. I’ve got a great show today. I think you’re going to enjoy quite a bit. Welcome Michael Mauboussin. How are you doing Michael?

Michael Mauboussin: Michael, I am great.

How are you doing?

MartinKronicle: I am Rock n Roll All Night, And Party Every Day [laughter] …If you want to know what my life is like.

Mauboussin: That’s good.

MartinKronicle: Now, I’ve read all your work, going back to the “Consilient Observer,” so I am a big fan. And, I appreciate you taking the time today. Now in the back of the book – this is a very important question, it has to be addressed right way – it says you live in Darien, Connecticut with your wife and five kids, the heart of New England. So the first thing I need to know is Yankees or Red Sox?

Mauboussin: See, I am not a big baseball fan…

MartinKronicle: Safe answer…!

Mauboussin: …so I stay in the fence pretty much. But I got to say that I am a fan of…I am sort of a money ball fan so I think that both…I think both of those guys have a lot of money. But I think I like what the Red Sox have done with Epstein over the last few years. But, I am on the fence.

MartinKronicle: Theo Epstein is a rock star for sure. I think this might be influenced by the fact that John Henry probably has money with you, but then, again, what do I know.

Mauboussin: [laughs] Not at all, yeah.

MartinKronicle: Yeah. So good. A mentor of mine Ed Seykota used to say – coming back to the title of your book – that: “Make sure that your intuition doesn’t become ‘into-wishing’.” Do you see that a lot in your field, in your experiences, both as a teacher, as a head strategist and as a money guy?

Mauboussin: Absolutely. The first thing I would say about intuition is that it does have a role in decision-making. But I think it’s been vastly over glorified, in particular in its role in markets and in business.

And the way I like to think about this is, well, using what psychologists call the two systems of the minds: system one and system two.

System one is your experiential system. It’s fast. It’s quick. It’s automatic and really difficult to control. System two is your analytical system: slow, purposeful, deliberate, but malleable. I think intuition works when you start off in an activity, say playing chess as a little kid. Every activity that you start, you’re in system two. So it’s the analytic side. You think of how each of the pieces move.

But if you do it enough times, over time, it slides into system one and things become very intuitive. So there is intuition in certain sectors, but the key is that it has to have two conditions: One is you need to be dealing with the system that’s stable, or if you want to use a fancier term, stationary statistically. And second it has to be a system that’s linear – so ‘a’ causes ‘b’ the way every single time. It can’t non-linear. So the question I pose back is, when we’re dealing with chessboards, is it stable and linear? Yeah, pretty much. But when we’re dealing with things like markets or business, is it stationary and non-linear? I think the answer to that is yes. So there you have to be very, very careful about using your intuition.

What’s I think crucial about this, and to your quote, is that I think people often confuse experience with expertise. The difference is: an expert has a model that is actually predictive. Can actually anticipate what’s going to happen in the future. People that have experience often think that they’re experts and they can predict, but that’s not always the case because you’re experience may or may not be any indicator about what’s going to happen in the future.

And you think about people, for example, in the equity markets, my world. You started doing this 20 years ago, 25 years ago, there’s

absolutely nothing in your experience that would have lead you to understand what happened over the last few years. So experience was not predictive in that case, and hence you have to be very careful about that. Yeah, I think that intuition works, but I think too many of us extend it at the boundaries and with some negative consequences.

MartinKronicle: I appreciate your feedback on that. I am always interested. I am a physically trained trader, having come from the hedge side very, very briefly, and then I moved to system development. So it’s all about Monte Carlo simulations and looking for expected outcomes in terms of trades, and we’re going to get to that for a minute. But also my foray into trading was learning how to be a tape reader. And I think that might be where intuition or a feel for the market could actually come into play. It’s a lost art on some level.

Do you have any experience with tape readers in terms of the old school way of trading?

Mauboussin: I don’t. I think that there is some value in being engaged. I mean especially when you’re trading, you have to be engaged. And, there probably is some sense in “feel the market,” and maybe the tape reading contributes to that.

That said, I think that…I don’t know if anybody has studied this systematically.

Maybe somebody has.

MartinKronicle: Yeah.

Mauboussin: My sense is we tend hear the – like most things in life – we tend to hear the stories that come out to be favorable, and we don’t hear the stories that don’t come out to be favorable. So why I am absolutely convinced – and you know more than I do – that being a great trader involves being engaged, and there’s some element of that. I am open minded about it, but I just would be skeptical as to whether there is such a thing as a guy being a pure tape reader being able to generate like such returns.

MartinKronicle: OK.

Mauboussin: Just solely from that.

MartinKronicle: Fair enough. Paul Tudor Jones might disagree, but I don’t really know of everything that he uses. I know he was an Elliot Wave guy at one time, too.

Let’s get back to you. You and I are both in Michael Covel’s movie, “Broke: The New American Dream,” and I’ve watched it a few times, especially your stuff. Now in the movie and in the book you say – and I am kind of putting this together – that in a probabilistic environment you’re better served by focusing on the process not the outcome. And I say the outcome might be due to luck or skill. The public thinks: “If Mike Martin goes on TV and makes a call on Gold and and I get it right, it might be because I am expert. But I’d say in the short run, it’s probably much more random than that, and may it might be even more luck. Can you explain that for the listeners?

Mauboussin: Oh, yeah. I appreciate you bringing this up, and I think you’ve got a really important dose of honesty in all this.

The way I think about this personally is that there’s a continuum in life of some activities that are pure skill and some activities that are pure luck.

So, you and I run a running race or something, you know the faster guy is going to win. And there are other things – roulette wheels or something – that are going to be pure luck.

And almost everything else in life is some combination of these two.

I think what humans are really bad at is understanding where things lie along that continuum. And there are some activities that are mostly skill, where, again, you just do it a few times and skill will reveal itself. Other things that are mostly lucky.

And I think that we talk about markets often because the prices itself has a lot of information. Luck is also often a very, very important component. So this goes back to what you said at the outset, which is: Should I focus on my process or should I focus on my outcome? What we know is process is what

you can control, and that would be ultimately the skill component. And if you do it over and over the right way enough times, ultimately the outcomes will be to your liking.

However, there’s also the opposite which is true, which is hard for people to get their minds around, which is: you can have a bad process, a poor process, a faulty process, and enjoy positive outcomes, at least in the short

run. One story that comes to my mind is I was talking to Paul DePodesta, who is now an executive at the San Diego Padres, and he was talking about blackjack in Las Vegas. And he’s sitting next to a guy who has got a 17. So the dealers asking for hits and, of course, everybody knows, standard blackjack you sit on a 17. The guy asked for a hit. The dealer flips over 4, makes the guys hand, right, and the dealer sort of smiles and says, “Nice hit, sir?”

Well, you’re thinking nice hit if you’re the casino, right, because if that guy does that a hundred times, obviously the casino is going to take it the bulk of the time. But in that one particular instance: bad process, good outcome.

So that’s a thing I just try to emphasis over and over. And by the way, this is true for sports. It’s true for investing. It’s true for trading. If the process is the key thing that you focus on, and if you do it properly, over time the outcomes will ultimately take care of themselves.

In the short run, however, randomness just takes over, and even a good process may lead to bad outcomes. And if that’s the case: You pick yourself up. You dust yourself off. You make sure you have capital to trade the next day, and you go back at it.

MartinKronicle: That sounds like religion. The first thing that I say when someone says, “Well, why I should I give you money?” At least I used to say it, now I have a big allocator to help me out. I’d say, “Well, because in the heat of battle, I am going lose you less.”

[laughs]

Mauboussin: Exactly, exactly. And that’s a big part of it.

MartinKronicle: Then the next guy…Because when I smell smoke, my goto-guns response is: I have to assume that it’s at least a minimum three alarm fire.

And if I can keep your losses small, I’ll emotionally be able to keep my head in the game and recover from a drawdown, whether it’s a couple of percentage points or whatever. If you get down to 15-20%, now you’re just like every other manager and it takes you a lot longer to get back to break even.

In the book, you say “smart people make poor decisions because they have the same factory settings as the rest of us.” Malcolm Gladwell said: “Credentials are poor predictors of performance.” My take is that, emotionally speaking, smart people don’t like being wrong, because their self esteem is pretty invested in being smart.

They are used to getting A’s. They are used to being in the dean’s list. They are being, like you, a Georgetown and Hoya Saxa. I will give you $500 if you can tell me what Hoya Saxa means. Can you discuss this poor decision making process with respect to investors – and I say investors plurally – and their reliance on professional designations in choosing their asset manager or fiduciary?

Mauboussin: Yeah. First, are you serious about giving me $500 to tell you what Hoya Saxa means, because I should know the answer to that?

MartinKronicle: I know it, too. I looked it up on Wikipedia. But you guys have to figure it out and get your Greek and your Latin together.

Mauboussin: Exactly. Hey, this is an extraordinarily important question. And, to me, one of the best sources for discussing this is the work done by Phil Tetlock, who is psychologist at Cal, Berkley, and he wrote an absolutely awesome book a few years called Expert Political Judgment. And what I’d like to say is I think every citizen – and certainly every investor – but every citizen of our nation should understand the core findings from Tetlock’s book. I mean here’s what he did

basically. He went out and surveyed 300 experts. These are people typically Masters, PhD levels; dozen years of experience. He asked them to make specific predictions on the political and economical outcomes, and he talked about just shy of 30,000 predictions over about a 15 year period. So it’s a lot of experts, a lot of predictions, over a long period of time.

And what he found was their predictions, as you would expect, were horrible. And, in fact, almost simple algorithms, extrapolation algorithms did as well. Now also did something very rude. He kept track of these things and he confronted these experts with their outcomes; and they, just like the rest of us, exactly as you said, they had just a host of excuses as to why they got things wrong. “I almost got it right. Had this gone the other way, I would have been right,” and so forth.

Why I say that smart people come with the same software? Here’s the main thing. I mean, it’s that, when we’re faced with certain types of situations, all of us, our minds typically gravitate toward one way of thinking about it when there’s a better way to think about that. And that’s true even for so called highly educated people. So just because someone is an expert, by the way so called expert, you should be very, very…I don’t know. You should suspend any sort of beliefs. You should be very careful about relying on these people, especially getting in dealing with things that are probabilistic or messy.

Now, there are some areas where experts are going to be great. If your automobile needs repair or call the plumber or those kinds of things, experts are going to do a great job. But for the kinds of things that we’re dealing with, they can be extremely messy.

So that’s the big message, and I think it’s a big message for all of us is that: Be careful when you – circumspect is the word – be circumspect when you listen to people. And by the way, I want to mention of the things that Tetlock found that was…He found that these guys were bad predictors. But there are two things that were statistically significant and it’s worked. Number one was the more frequently mentioned in the media a pundit was, the worst his or her predictions.

MartinKronicle: Oh!

Mauboussin: So almost by definition, the people we see on TV or are quoted in the press are the worst predictors. And the second thing he found was that it didn’t matter so much what people’s political views were, their age or their gender, what mattered was their way of thinking. And he distinguished using Isaiah Berlin’s language between foxes and hedgehogs. Hedgehogs, we all know these people. These are the one big idea, everything in the world view fits into their big idea, and they periodically get their 15 minutes of fame, right. The foxes, in contrast, are those people that know little bit about a lot of different things. They tend to be equivocal. They tend to be down the middle of the road. They’re the ones that are saying, “One the hand, one the other hand.” And it turns out foxes are much better predictors than our hedgehogs.

So that’s the other thing to bear in mind. And by the way, I think those two things are related. TV, media – who do you want? You don’t want a guy saying, “On the one hand it could do this, on the other hand it could do that.” You want that someone who has a strong view on one side or the other. They tend to be hedgehogs, and they tend to again be on balance the worst predictors.

So these are things are all related. So, yeah, be circumspect about listening to experts in many, many domains. Even things like medicine, by the way, is another area where you should be very mindful of this.

MartinKronicle: First things first: When you wrote about situational awareness – “I walk into the wine store and there’s beautiful French crooning..,” – you showed us a statistic where it absolutely affected ones purchases, and French wines, I think, were sold in greater volume than German wines, for example. So with what you just said about professional designations and trying to rely on experts – experts who had an inverse relationship or their expertise was an inverse relationship with how many times they were mentioned in the media –

my question to you is this: Situationally, “Does having financial broadcast media on in the background of your trading day affect the number of transactions you put on, the types of trades that you might put on, along the lines of how you’re encouraged to buy more French wine if you’re hearing the French music?

Mauboussin: To me, that whole discussion of situational awareness is one of the most – in the sense, in the book – one of the most disconcerting, because it is I think demonstrably a very powerful influence and something that’s below our level of consciousness. And, we’re just not aware of that. And that study you mentioned, just to recap it very quickly: When they had two sets of wines, French and German, next to each other in the supermarket, roughly match for price and quality. They alternated playing French and German music over a couple of weeks. When they played French music, people bought French wine 77% of time. And, when they played German music, people bought German wine 73% of the time.

What’s remarkable, again, is when people were checking out, after researchers then approached them and said, “Hey, did the music playing…did that have any influence on your purchase decision?” And nine out 10 say, “No.” OK. So big numbers, but just people are not aware of that. So we say “hey, I’ve got the TV on, ” and someone’s talking about…talking about gold or oil prices or what have you, and non stop, is it possible that that would not affect you? I think it’s conceivable, but it’s very, very unlikely. It’s just very unlikely because you’re enveloped in this basic environment where people are talking about one thing or another.

To me, in the sense that you see many of the best traders and many of the best investors, this is kind of a funny thing. In life you like to be emotionally connected to other people. You want to be able to relate to them. You want to emphatic. But in investing, in the sense, it’s that emotional detachments that’s so essential.

That you are able to not get swept by other people, and you can think independently. And I think that’s the big challenge that a lot of us face, is that when we have those influences, like the TV, it’s almost impossible for us to not – at least in someway – for it to not affect our behaviors.

MartinKronicle: So you probably remember, I think it’s probably six months.

Jon Stewart took on Jim Cramer and really blasted him. Again, I only saw clips of it on Hulu or whatever it is that I am watching.

And in your book you mentioned the pundits being entertainment and not educating or not being educators. Do you think Jon Stewart, without choosing a side, that he might have been holding Cramer a lot more accountable and not seeing him as an entertainer? In other words, giving him a back-handed compliment? [laughs]

Mauboussin: This is a really interesting question. I think Cramer is highly entertaining. I actually think his intentions are all good. I truly think he really does want to help people. But I think as viewer…One thing is just that the undertone of all this is just to make this explicit about our discussions about experts.

The fact of the matter is, as human beings, we love it when tell us what’s going to happen.

We love to have someone say, “This is your future,” right.

MartinKronicle: Yeah.

Mauboussin: It’s a deeply satisfying sensation, and, when someone does with authority, all the better. So someone like Cramer is, to me, clearly an entertainer. But I think that many people view him as an educator and are quick to take the advice that he gives.

Just as you did, I watched that probably on YouTube. But I think the challenge is, when you are in the position like Cramer is it comes with an enormous amount of responsibility.

Those distinctions between entertainer and educator become very difficult to manage.

I think that’s one of the challenges he’s faced. That fact of the matter is, for most individual investors, probably most of the viewers of that show, are best off building a diversified portfolio, using low cost funds and just getting on with their lives. Right. If they want to play around, with some side money, that’s fine.

But, I think that’s an important issue that

Stewart raised. Obviously, what he’s doing is finding conflicts between Cramer saying one thing one day and something different the next

day. But it’s a challenging issue.

There’s a lot of responsibility, being a very public figure like that with those kinds of discussions.

MartinKronicle: Yeah, for the record. I’ve said it once before, but I’ll say it again because people kind of see me as somewhat opinionated. I think Cramer’s heart’s in the right place, I think he wants to be an educator. I think he was a tremendous law student. He went to Harvard Law, if some of you don’t know that. I thought his book was pretty good: Confessions of a Wall Street Addict, was very humble. But, I think he might be better suited, working next to you at Columbia Business School. But, he wouldn’t have the reach that he does on CNBC.

Mauboussin: Right.

MartinKronicle: Let’s get back now to being an expert stock picker. You also mention Surowiecki’s The Wisdom of Crowds. I tend to like books that have crowds in the title: Extraordinary Popular Delusions and the Madness of Crowds, “Wisdom of Crowds.”

But are the crowds really that mad?

Wouldn’t it be better for me to go to my Twitter feed and put it out there like, “Where do you think the Comex Gold is going to settle, by expiration” than to rely on George Milling-Stanley or George Soros or Jim Rogers for that matter.

Mauboussin: Yeah. That’s a great question.

There are a couple of things that come to my mind immediately on this. The first is you make this distinction between the wisdom of crowds and the madness of crowds, and I think that that’s a very important thing to think through carefully. I think what Surowiecki did in his book. He was good about, was specifying conditions under which crowds are smart. I’m going to rephrase what he says, but to me there are three conditions that are really important. First is diversity. So, we need to have diverse underlying agents and investors in our world.

Second is a properly functioning aggregation mechanism: some way to bring that information together. That of course would be an exchange. Then, your voice and my voice can both be heard. If you have more money than me, yours will be heard at a greater level.

The final is incentives, which are rewards for being right and penalties for being wrong. Our world is obviously monetary. So, the smarter people get more money and the less smart people lose their money. So, when one or more of those conditions are violated, you get the madness of crowds.

By far the most likely to be violated is diversity. So, rather than each of us thinking independently, we all start to think in a coordinated fashion that leads to extremes. So, that leads to the second question, if you’re thinking about how: “Hey, I’m thinking about December Comex Gold, where will it settle at expiration? How will I go at that?”

So, to me, the best answer for that is where it’s actually trading at the market today. Right. So, the market itself is the wisdom of crowds if it’s operating effectively. That’s going to be probably the best indicator of that. There’s been a temptation, I think, by a number of different parties to what I call the meta-wisdom of crowds.

Which is, like I said, just going out on your Twitter feed and asking people, “Hey, where will gold settle? Or, where will Apple’s stock be six months from now?” I’m just not persuaded by that meta-wisdom of crowds, in other words. Wisdom of crowds on top of wisdom of crowds can buy you a lot. There’s been some evidence on both sides of that, but, to me, I’d just be skeptical about that.

So, to me, the more fundamental way to look at that is to look at the asset price itself and say, “Hey, what has to happen for that asset price to make sense?” Then go from there.

Rather than saying I’m going to go back to more experts or meta-wisdom of crowds kind of idea, if that makes sense.

MartinKronicle: No. It makes sense to me.

The question that comes up for me, then, is two-fold. One, do you feel that the price then contains the best reflection of all the participants at any given time? I know that with Covel and his marketing machine, he’s going to say that the price tells you everything: all you have to do is follow the price. If you do break-outs or moving average crossovers and put on your protective stops, you don’t really have to know the fundamentals until afterwards. As long as you get in on the trend, it doesn’t really matter the why; it’s the how. Is that your thinking, in terms of…

Mauboussin: Yeah, that’s not how we know, so I think that the first thing is that there are many ways to invest successfully. And I guess the trend followers have their own sets of rules. You know clearly what we do, we’re money-managers; predominately long money-managers. We’re looking for, specifically, discrepancies between what we believe is, well, I would call it expectations and fundamentals. Expectations are what financial performance is baked into a particular stock price. Fundamentals are what we think is going to happen. You know, we just had the Kentucky Derby last weekend.

So, this is a good time to bring up that type of metaphor. That the tote board, the odds and the expectations that would be the asset price. The speed of the horse based on the horse’s past record and trainer and jockey and so forth would be the fundamentals. I could tell you which horse is going to win every single race in America. That doesn’t make you money;

what makes you money is mispricing between the tote board and the speed of the horse. To me, that is the key thing that we dwell on.

Now, I definitely understand Michael’s point, I understand the trend followers point. It’s that there may be ways to simply look at price and not worry about those fundamentals.

But at some point, somebody’s got to be thinking about fundamentals.

So, I think he’s looking at, in a sense, the next order process of what those fundamentalists are doing back and forth. Yes. We’d look at the fundamentals versus expectation gap, but I can see where he’s coming from on that, in terms of pure price.

MartinKronicle: So, let’s talk about bet sizing, for example. You mentioned Michael Lewis before, and he’s written one of my favorite books, but also one of my least favorite books. I actually threw “Liar’s Poker” out of a 12-story window, but I loved “Money Ball.” So, go figure.

[laughter]

MartinKronicle: In the book, he talks about how in a five-game baseball series the worst team is going to beat the best team 15 % of the time. Now, in the game of accuracy, the neophytes might be sitting down saying, “Well, God, I’d never bet the worst team in those scenarios, because 15 % hit ratio is beyond failure. That’s several degrees below failure”. But, if we were sitting together, and we said, well when that 15 % rings true, you’re going to win 10 times your bet size. Explain to folks in lay person language as best you can, the difference between an accurate system and one that has positive expectation.

Mauboussin: Exactly. Such a crucial idea, and the sooner you learn about this when you’re young, the better off you’re going to be in life. I can go right back to my racehorse metaphor, because I think that’s a very, very good way to explain this. Right?

So, you mentioned this 15 % of the time.

Right. So, you think those are the odds that that are going to occur. You can translate those into specific odds. If the payouts reflect specifically those odds, that’s not very interesting. In other words, it can only happen one-out-of-six times, roughly. And you’ll make good money. But if it’s deficient in that regards, it’s not very interesting.

What is interesting is somehow it’s a 15 % probability, but it’s getting priced as if it’s a 5 % probability or a 1 % probability. In which case the payoffs will vastly exceed. Now, the thing is, by the way as traders, you guys tend to be much better than many people in my world, like boring old stock people. But, the key to understanding this is that if you can

find enough of these types of situations. Right. Because, more times than not, like you said, five out of six times, you’re going to lose on this bet, right? So, if you can find enough of these situations and put those trades on and build a portfolio of them, the payoffs from those things will vastly exceed.

In other words, you’ll lose money majority of the time, but the money you make will make up for how much you lost when you lost. So, this is an idea we go back to a lot in our own organization. This is the difference between frequency and magnitude. By the way, I first read about that, or sort of solidified in my mind, through Nassim Taleb’s book…

MartinKronicle: Yeah. I was going to bring him up, but go ahead.

Mauboussin: …”Fooled by Randomness.”

Yeah. So, the idea would be, the story, I don’t know if it’s a apocryphal. But, Taleb tells the story of sitting around a room sort of shooting the breeze with his colleague traders about the stock market. A guy turns to him and he says, “Taleb, what do you think the market’s going to do next week?” He said, “I think it’s going to go up.” Then, another trader yells across, “Hey, but you’re short on your trading book.

In other words, you bet that the bet is going to go down. So, how do you reconcile this”. And he said his belief was there’s a 70 % chance the market would be up 1 % and a 30 % chance it would be down 10 percent.

So, the probability is the market would be up. But, the expected value net in that instance is negative. That’s a very easy thing to translate over to the world of stocks. So, for example, a growth stock, a stock that everybody loves, it’s priced for success. Let’s say they’re going to report earnings tomorrow. A 70 % chance they match or exceed expectations, the stock would go up a little bit, 1 % lets say, but there’s a 30% chance they disappoint. The stock goes down 10 %.

That’s a great probability, but a very poor expected value. You can flip that and say… Let’s say the downtrodden stock that everybody hates… A 70 % chance that more bad news comes out. It only goes down 1 %.

Most of that’s already reflected in the price, but a 30 % chance that they do better, or there’s a restructuring announcement, or what have you, and that stock goes up 10 %. A bad probability bet, but an excellent expected value bet. So, the keys is for that people who are investing or trading is to always think about, as you said, the term expectation. What is the expected value of that particular bet, that trade. That is the guiding principle, that you want to put on positive expectation bets.

They’re not always high probability bets. They always have to be high expectation bets.

MartinKronicle: Yeah, I pretty much live for expectation. It’s interesting, that you bring up Taleb. Speaking of Fat Tony, I’ve read “Black Swan” and “Fooled by Randomness.” For me, those books were so pithy I had to take them a chapter at a time.

He’s definitely a unique personality, Taleb is, to say it nicely. I’d like to have a glass of French wine with him, with some German music playing, actually, to see his reaction.

Let’s go back to this 15 % of the time racket. Taleb’s approach to running money is to play the fat tails, as they’re called. Not to get inside baseball, but he’s actually playing for trades that are 1 %, or 1/2 of a percent accurate, really. He’s looking for those really asymmetric payoffs.

I think the other thing to consider for the new trader out there who’s listening to Mauboussin and myself, is that you have to have a very special emotional constitution that can take being wrong almost all of the time, because that’s what Taleb does. He’s wrong most of the time, but when he’s right, he’s right sickly.

Mauboussin: Right, and you think about how that works. You take $100, and what he often did… What he did historically is that he would take the money and buy deep out of the money. Puts and calls, just for the point. Deep on the money, so you’re spending a little bit of money. You’re drawing down just a little bit, little bit, and then, as you said, episodically it goes… Tails are mispriced, so you get these huge increases. It’s down, down, down, down a little, and then up a lot. Down, down, down, down, up. Again, the vast majority of the time you’re drawing down. It’s a small percent, but

you’re drawing down. I talked to him and asked him about this. To me, I think he believes that many of the clients that he dealt with were very uncomfortable with that, because more times than not, their monthly statements will be showing them down a little

bit. That’s something that, as humans, we like to be right. We like to be right more than we’re not right, and so that was a very uncomfortable approach for many people. So, that definitely takes an unusual psychological makeup to be able to do that.

MartinKronicle: You’re effectively selling people on systematic attrition of capital, saying, “Hey, our business is erosion of the beach!”

Mauboussin: Exactly, although with the periodic dumping of the sand, right?

MartinKronicle: Right, exactly.

Mauboussin: It’s emotional… This goes back to, and you’ve looked at this before. I’m just making this explicit, as well. I think that’s why trading from my understanding, is so difficult to do. You read about these trading guys, and they’ll say 70 % of the trades that they put on lose money, but as you pointed out before, you can limit that loss. Thirty percent of the trades make money, and just a very small fraction of those positive trades carry almost all of the freight, in terms of returns. I think most people feel like, “Hey, you’re going to go into work, and 70 % of the time you’re going to be wrong, wrong, wrong?” That’s a very difficult way to go through life, but if you can deal with it emotionally, and understand the mathematics of it, that’s a great way to make a living.

MartinKronicle: I think for me, and I might as well answer this, because I have, as Immanuel Kant would say, “a posteriori”

knowledge here. That is, I take refuge in stick the discipline that I have, and sticking to my system, and knowing that even if I’ve lost five or six in a row, I have the discipline to put on the sixth trade, despite how I might feel about having five small losers. I don’t look at it… That goes to your point on following the process, not the outcome. I’m powerless over the outcome.

Mauboussin: But, I would say that’s a tribute to you. I think that some people… Some of us are better at it than others. It is not easy for everybody for everybody to do, so that’s a tribute to you, and that’s why you’re good at what you do. But, I think that’s not easy for many people.

MartinKronicle: Well, I appreciate that. I want to talk about the anti-hot hand, as it relates to basketball. You said 70 %, which is a foreshadowing here. When I look at basketball statistics, I saw that Scottie Pippen and another Bull were inducted into the Hall of Fame. Noticeably absent was Dennis Rodman, who I think, if he wasn’t on the team, there wouldn’t be a Scottie or Michael, because he came down with the boards on both sides of the court. But, that’s just me.

Michael Jordan, if I read the statistic correctly, shot about 50 % from the floor, but everyone knows him as this great winner, where he would rise to the level of the game and get the job done. But when you look back at his statistics, he never shot 80 % consistently from the floor. It was right within two percentage points, career wise, of 50 %, which… It doesn’t sound that great. It means you’re failing half the time. Going to the anti-hot hand, if Shaquille O’Neal, regardless of who he was playing for, got an offensive board underneath the basket, he would come up and slam it down for a 100 % probability of a two point thing. Now, they came up with something you may of heard of called “Hack-a-Shaq.” The strategy was when Shaq gets the ball, you smash him in the face, or you hit him hard, basically, and you induce the foul. The strategy was that he was only 70 % from the free throw line. So, in your language, in an easy to say… I think you probably see where I’m going with this.

Can you explain to the folks why Hack-A- Shaq was a bona fide strategy when he was 70 % from the line?

Mauboussin: Sure. By the way, I was actually… It so happens that I was looking at these statistics last week. An NBA player that has a 60 % field goal percentage over their

career, that’s as good as… The best guys are in the 60 % range from the field over their career. That tends to be big guys, right? So, it’s guys like Shaq and Wilt Chamberlain, and Bill Russell, those kinds of guys, because they’re down by the basket, as you pointed

out. They’re doing a lot of lay-ups, and nowadays it’s a lot of dunks.

By the way, Michael Jordan… 50 %, that’s a really good ratio. A lot of guards are in the high 40s, so he was obviously a pretty good shooter. LeBron’s numbers recently have been extraordinary. I think you were being very generous when you said Shaq was 70% from the free throw line. I think that number’s actually quite a bit lower than that. So, the actual decision as a coach is exactly what you pointed out, which is you just work out the math, right? If he gets the ball down low… Let’s say, if it’s a particular situation, he may have a 70 or 80 % chance or making that, making two points, so it’s an expectation of 1.5 or 1.6 expected points. If you put him on the foul line, he’s about a 50 % foul line shooter. Just do the math. What’s the probability of him making two in a row? It’s .5 times .5, so .25, times 2, right? So, that’s .5, right?

So, the math, going back to our expectations, the expectation’s much, much better that you should foul him, let him go to the line, and take his chances there than letting him do a 70 or 80 % shot from down low. I don’t know… I doubt many basketball coaches are pulling out their calculator and doing the math that way, but that’s precisely the justification for it. I think, in this case, they observed enough, and their history guided them toward the right solution. That’s it, but on the flip side, of course, if the guy’s a great free throw shooter, the best in the league over time, and around 90 %. These little guys you don’t want to foul, because there’s a really good chance, there’s a 80 % chance or 90 % chance that they’ll make two in a row, and that’s probably… For an average guard, that’s almost twice as high or more. Close to twice as high as they’d do from the field.

MartinKronicle: Now, with that in mind, that’s the strategy. The thing there would be to manage your losses, so you wouldn’t have someone like LeBron or Kobe go making the foul, because you want them on the floor. You have to use an expendable player who you don’t mind fouling out of the game. So, you manage your losses.

Two more things, and then we’ll say goodbye here. I don’t want to take up all of your time, but I really appreciate this. I think the layperson, as well as the expert, is going to get a lot of what you’ve been talking about so far. Let’s talk about falsification. We’re not built to falsify stuff. We buy Research in Motion. We buy Google. We buy BP or Goldman Sachs on the big draw down that they’re going through right now, and we’re looking for verification. That’s how we’re built. In the book, you discuss how falsification or contrarian style thinking might actually be better for a person who is an investor or a trader. Can you elaborate on that?

Mauboussin: Yes, we talked about this idea of the black swan. And I think now almost everybody associates the black swan with these fat-tails, these extreme events that are unexpected. But of course the black swan has got a philosophical tradition that is exactly to this point. And it goes back to Karl Popper, the philosopher.

MartinKronicle: Right.

Mauboussin: And Popper’s point was, this is a key thing. Everybody looks for verification.

It’s going to be your natural way of doing things. Popper’s point is, let’s say your thesis is all swans are white. Well seeing 1,000, 100, or 10,000 white swans doesn’t prove that case is true, although it may give you some evidence for that. But seeing one black swan proves that it’s not true. So the quickest way to test a theory is to look for falsification, and that’s where this idea of the black swan comes from.

So, to your point, we all have models in our mind, theories of how the world works. And once you’ve developed a theory of how the world works, you immediately go out and you start looking for confirming evidence. In fact, psychologists very specifically call this the confirmation bias, which says once you’ve

made a decision you tend to seek confirming evidence and disavow or disregard dis-confirming information. So you basically blow it off. The best thinkers in the world, I think, are people that, and it’s very, very difficult, by the way, emotionally, are people who very specifically seek falsification. So that if they have an idea, a belief, a theory, a thesis, they seek to prove it wrong versus to validate it. By the way one of the greatest thinkers is in this regard was, who was famous for this, is Charles Darwin, who developed his theory 150 years ago, and in his notebooks, constantly was questioning himself, constantly judging whether his theories were valid or not by looking for falsification.

So that’s the thing. I’ll give you one trivial example of how we try to use this is that, often when analysts are interviewing with management teams, for example, they ask all sorts of leading questions to try to verify their own points of view or confirm their own thesis. What I tell our analysts to do or suggest they do is ask the questions in the exact opposite way. So whatever you believe, ask the question in the opposite way, and listen to how they react. You might get a very different point of view that way.

So this is a very important discipline. It’s very hard because it means that if you’re wrong you have to change your point of view, but it’s absolutely essential to good thinking and being adaptable, adaptive thinking.

MartinKronicle: Well that says it a lot more clearly than I would presume. I’ve been lucky enough to go to school. I went to Columbia, where you teach, and I was able to meet a lot of folks from a lot of different walks of life, both economically, politically, class and culture. And I said to myself as I’m looking at things fundamentally, “How would so and so from Beirut look at this?

How would so and so from Cameroon look at this? How would so and so from Kalamazoo, Michigan look at this?” And then try to say “Well, I don’t have all the answers, which of these might have more magnitude?” And I don’t know that it helps

me. What it does is it helps me get out of my own way, my own kind of myopic thinking.

And that opens up my world literally and figuratively.

Mauboussin: Well Mike I think that goes back to what we were talking about with diversity. And that’s interesting because there have been these studies of how individuals think. And they go back to this idea of these foxes, people that are willing to consider different points of view. And often what most of us do is we’re kind of mentally lazy; once we topic comes up, we think about it and we kind of like our way of thinking about it and we sort of shut off all alternatives. So for you to sit there and take on a problem and say “Let me think about this as other people might think about this, ” in a sense you’re injecting diversity into your own thought process and that allows your mind to probably come to or settle on better ways of thinking about it than the person who just says, “Here’s my point of view, nothing else really matters.” By the way, it takes some energy, as you know.

MartinKronicle: Yes.

Mauboussin: It takes some time, as you know.

It may be driving around or sitting in the shower, but it takes some time. But it’s absolutely vital to thinking well.

MartinKronicle: That last question I have for you is more of a statement, and it’s kind of an easier one. It’s a good last question to have. I can say, probably with decent certainty, that we’re both pretty much influenced by the late, great Peter Bernstein, who wrote some of the best books on finance that I’ve come across. And one of the things that you quote of his in your book is that “consequences are more important than probabilities.” Can you discuss that as it reflects the things we spoke about today?

Mauboussin: Yes, first of all, he is, he was one of the real great thinkers. He actually wrote the forward to my first book that I wrote with Al Rappaport which was a great honor for me, and we traded letters. He was one of the few guys who actually used to write letters, incredibly thoughtful. And he was an extraordinary man in many ways.

MartinKronicle: Big loss.

Mauboussin: Even in his later years, extraordinarily productive, highly active mind. Just a great guy. He liked to use this idea of Pascal’s wager. Pascal asked the question “Is God, or is God not?” Does God exist? And he went through a little matrix of thinking about the alternatives and the basic conclusion was, hey, you know you should act as if God is, because then you’ll lead a better life. If He’s not, then you’ll have given up some pleasures, but you’ll still be in good stead.

MartinKronicle: Right.

Mauboussin: But if he is, on the other hand, if you sought those pleasures and He does exist, then you’re going to be damned into eternity.

To take a little more secular view of this, I’ll give you one personal story on this.

For me, and this is going through the stock market turmoil of 2008 in particular, going through that turmoil, if you had talked to me at any point, I would have told you that I was at the highest percentage of cash in my portfolio that I’d ever been in my whole life and since as well. And I would have told you probably not too quickly after that I thought the long term prospects for the stock market were pretty good. In fact, I wrote a piece in the fall of 2008 picking up on some cues from Warren Buffett basically to that effect, just take a long term view, things look pretty good.

So you say “All right, how are you having it both ways? You’re sitting on cash and you’re telling the world that you think the long term point of view is good.” You mentioned this at the very, very outset. Here’s why I did it; because I have five kids, I have to put these kids through college. And I thought the probability of the market going down substantially in the next three to five years was low, 5%, 10 percent, I don’t know, but low.

But if that 5 or 10 % appeared, and I couldn’t put my kids through school, that would have been devastating for me. So I thought the consequences in this case, of not being able to do that, are more important than the probabilities and so I sat on cash.

So that’s a very personal example of going through that. Intellectually, there may have been one course of action, but the consequences would have been too difficult to suffer. So that’s the point I think people always have to think about. If a low probability event occurs, what are my consequences and can I live?

By the way, this is something you know a lot from your world. I think what you see a lot is this idea of over betting. People start to take on leverage, they put on more aggressive trades even in low probability events, and they’re going to do well, well the feedback will be good. But if the 1 % event shows up, or the 2 % event shows up, so it goes adversely and you’re leveraged, you’re done, right? And rule number one in trading is live to see another day, right?

MartinKronicle: Yes.

Mauboussin: So money management is absolutely essential. So they’re violating principles of money management. To me, that would be the intimate link back to what we were talking about in trading is consequences are more important than probabilities is that ultimately you have to live to see another day. You have to manage your affairs so as to be able to do that. And I think that that’s sometimes a lesson that we lose or lose sight of, especially in these sort of optimistic times.

MartinKronicle: Well I appreciate your candor and your honesty. This has been a great chat, probably the best one I’ve done so far, & I’ve done quite a bit with some pretty smart folks.

Mauboussin: Yes, it was great visiting with

you. Great questions and important discussion.

MartinKronicle: Yes, I think so, for all types of students. The book is called “Think Twice: Harnessing the Power of Counter Intuition.”

You can get it on Kindle and hardcover.

Michael, it’s been a great pleasure, great honor to speak with you. I’m influenced by your work since the days of Consilient Observer.