## The Ludic Fallacy

I have grandchildren who bring me pleasure in many and diverse ways.

The oldest of them is a smart guy, who has good analytic skills and curiosity.  As a student, if you can have only two skills, they will do.

A couple of years ago he was taking probability theory in mathematics class.

Being a grandfather has many advantages, not the least of which is permission to appear eccentric.  I said, “Suppose I have tossed a coin and it has appeared as heads twenty consecutive times.  What is the probability for the next toss?”

He, of course, answered “50-50.” and I of course said “No!”

He argued that the previous events had no relationship to the current case and therefore 50-50 was the right answer.

I had to point out that he had just seen something unusual happen and that had to be considered.  In this case, the odds of it happening were 1,048,576 to 1 against.  How can you ignore that?

“It doesn’t matter.  It is still 50-50.,” says he.

“Wrong”

The probability is that you should examine the coin.

I know people who would have been examining the coin by the time it came up heads four times, never mind twenty.  They are the ones who ask, “Am I being paranoid enough?”

If an observed event is so improbable that it casts the validity of the system into doubt, you will usually do better by checking the system than by blindly following theory.  It is what Nassim Nicholas Taleb calls “The Ludic Fallacy.”  Essentially, statistics that are artificially confined or confined by specific rules.  Game-like statistics.  The real world does not have these limits.

If you have not read “The Black Swan” do so immediately.  The new edition has some material on fragility.  Worth the price.

It is far from well-written but the ideas within it overshadow that defect.  You can also learn a lot by looking at edge.org.  Particularly this essay.  http://www.edge.org/3rd_culture/taleb08/taleb08_index.html

Try and explain 19 October 1987 when the market fell 22.61% in the day.  Using the conventional approach to market statistics, that is a 20.98 sigma event.  The biggest up tick occurred 13 October 2008 at +11.82 sigma.

The odds of a 10 sigma event are roughly 1 in 100,000,000,000,000,000,000,000.   A 20 sigma event cannot happen.  Not ever!  Well, maybe if the universe was a billion times older than it is and the stock market had been open every day since it began.  Even then it would be improbable.

It can however happen if the system you are using to create your idea of reality is flawed.  Truth is stranger than fiction because fiction has to be plausible.  The moral here, in the same way, is real world statistics are stranger than academic constructs because academic constructs have to make sense.

Pay attention to the system for analyzing portfolios.  There are other opinions out there as to how you should do it.  If the system in use is not right all the time, then you have the the problem that you will do worse by knowing methods that are wrong than you will do by knowing nothing.  If you know nothing, you can still be right by accident.

I know the grandson is catching on to how numbers work.

Shortly after the probability episode, he asked if I would help him design a campaign for class president.  Being cynical, I suggested he just behave like other politicians and bribe the folks.

His reply, “Actually, I would only need to bribe half of them.”

## The 1% Solution

Vilfredo Federico Damaso Pareto was an Italian Renaissance man born 250 years too late. He was an engineer, an industrialist, a philosopher, a sociologist and best known as the first modern economist. He is the one who noticed the 80-20 rule. The Pareto Principle.

It would be hard to find someone who has not heard of Pareto. 20% of the effort gets 80% of the results. Focus on key customers, key markets, key products, key processes, key investments.

Focus will make you rich.

Might be true, but all that focus causes you to miss another important aspect of the principle.

The Pareto Principle is a power law. That means that you can go further. If 80% results from 20% of the effort, then 80% of the 80% resulted from 20% of 20% of the effort. The 64-4 result. The third is 51.2% of the results for 0.8% of the effort.  More follow but the point is clear.  There are only a few things that really matter.

51% of the result for 1% of the effort is a nice deal, but, there is a lot of clutter to toss before you can see it.

You start by thinking about where the 1% may or may not be.

It won’t be in filling out forms for the government or collecting receivables. Planning a better parking lot, signing cheques, or counting inventory won’t help much either.

Cost analysis, automation, engineering and marketing are worth looking at, but might not include the 1%.

The 1% most probably is in freeing time to do only those things that you are the best at doing. It is not enough that you are the best compared to others, it must be your personal  best best.

You might be the best salesman in the room but you are that only by a narrow margin. You may be the best customer relations person or the best inventor or the best leader by a much wider margin. Let the others carry the ball where they can do nearly as good a job, even if it takes two of them, and spend your time on the things that may include the 1%

Sweet reward here! Employees will like it and do better than before.

People who have searched for the 1% found important things:

1. If you have no idea of what the 1% might be, you could stop doing it by
accident.
2. It is not the same 1% all the time and in every situation.
3. Your employees know and will do more than you think. Let employees be
4. Customers know the difference between price and value. Deliver value.
5. Customers know how they will be changing in future, ask them.
6. Customers know what they don’t like. Ask them and listen.
7. Some of your investment decisions are better than others

Looking for the 1% works. No one ever finds it, but finding a little of it is a big win.

Start Now!

## Are You Listening To The Signal Or The Static?

When I was in high school, I listened to baseball on the radio.  Joe Chrysdale and Hal Kelly on AM 580, CKEY told the story of the Toronto Maple Leafs baseball team.  Sparky Anderson played there in the early ‘60’s.  Who could forget Rocky Nelson?  He was a very good hitter, but the story was that he kept his glove in oil lest it get rusty.  Clang!

If there was no Leaf game, you could catch Harry Caray with the Cardinals on KMOX.  You could hear Gibson versus Koufax or Drysdale or Marichal, and follow Stan Musial at the end of his brilliant career.  You had to pay attention though, because listening to KMOX required that you ignore the static.

AM radio stations send a strong clear signal and the vagaries of the atmosphere and the receiver’s location interferes with it.  That is what static is.

Sort of like the stock market.

In the stock market there is a clear underlying value driver (the signal).  Obscured by short term variability (static)

The signal that results for a given security or even an index is a combination of things.  The economy, the business and its management, products, population growth, demographics, competitors, technology, brand.

If you track values of the S&P 500 since the early 1920’s, you will find the signal is almost exactly 10%.  The values tend to run in a trough between 9.8% and 10.2%.  It is moderately clear.  Values don’t stay far away for very long.  Year over year variations are seldom more than 3 times the size of the signal.  Most years lie between minus 20% and plus 40%

For 250 trading days a year, 10% annually is a bit less than .04% daily.  Looking at daily returns however, you find that you cannot see the .04% signal at all.  Static dominates.

There are days when the change has been more than 100 times the expected .04%.  There is one day when it was more than 500 times.  Yet, at the end of several years, the static all cancels and the underlying signal remains.

What does that mean?

1. Most of the intense traders are trading noise not signal.  Day trading does not use investment rules for success even though it sometimes looks like they are.  It is hard to imagine how the static contributes information but I suppose, for a trader, it must.
2. If you are an investor, as opposed to a trader, the static will be confusing.  Ignore it
3. You will usually be upset with the stock market if you follow it too closely.  How so?  I should have less risk if I pay attention.

True if you are a robot.  Not so much for humans.

According to Nobel Prize winner Daniel Kahneman, people are about twice as upset over a given loss as they are happy for an equal sized gain.  To give yourself a chance of happiness, you should look at intervals where you are about twice as likely to see a gain as a win.  If you look at the market every day, the odds are about equal that you will see a loss or a gain.  Emotionally though, that is plus one and minus two.

I am sorry to say that I am not as fluent with math as I once was, and my awareness of the Central Limit Theorem is vague at best, but I think if you look at the stock market about once every 42 months you should expect to see positive results twice as often as negative results.

This will not and probably should not change your behavior, but at least you can console yourself that the market is working, just not today or this month, or however often you look.

Here’s the real defense to static.

Think about buying a small part of a business instead of buying a share.  They are exactly the same thing, but when you think about buying part of a business, the day-to-day variances are in context.  If instead, you buy a stock it is easy to fall into the volatility trap.  If the share price is the only thing you relate to, then the variability will be more apparent and thus more disturbing.

Warren Buffet buys businesses not stocks.  The difference from you is that he buys the whole or most of the business rather than a minute fraction of it.  He has said however, that he would not care if they closed the stock exchange for 10 years after he buys.  He seeks management, market position, products, techniques and people.  Day to day differences do not change those.

You might want to do the same or find a manager who does.

Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario. don.s@protectorsgroup.com

## Good Managers Are Right More Often Than Bad Managers. Yes???

Many years ago, one of my cousins attended the Advanced Management Program at Harvard.  This is a program for seasoned executives and most find it quite fulfilling.  One of the things they do when they are there is work as a team and carry out a research project.

Their Project was:

Discover how strong managers make better decisions than weak managers.

That is a very interesting topic and one that would have a huge payback if you could discover the underlying principles.

They investigated information accumulation, assessment skills, personality, delegation skills, strategic insight, tactical awareness, implementation skills, and more.

They found that weak managers made decisions that were wrong about two thirds of the time.  On the other hand, strong managers made wrong decisions about two thirds of the time.  Not a vast difference there.

But, there were still weak and strong managers.  How Come?

Eight weeks later, they knew the answer.

Strong managers quit doing stupid things sooner.  Addition by subtraction.

That is crucial.  Let the good decisions run and kill the bad ones.  That is least wasteful of resources, least demanding for service, least error prone, and least depressing.  Everything you are involved with is either working or new and that sounds like fun.

Why doesn’t everyone do that?  Insecurity, pride, psychopathic persistence, irrational optimism, nurturing personality.  Who knows?

Understand and operate under the law of symmetry of ownership.

At a given price, the decision to invest in a project and the decision to keep that project at the price it would sell for if you already own it are identical.  Each offers the choice between having a given amount of money or the project.

Assuming you have given it a fair shot and if you would not buy the project for the price it would sell for, you should not keep it either.  That is true even if the price to sell is zero dollars.  Some gifts are liabilities.

It is like golf.  There is not a lot of point spending time and thought deciding how to make a downhill 20-foot putt with two turns in it.  Get it close and move on.

Quit Quick!

## How Many Hours Will You Work In Your Career?

If you own your own business or are a professional like a doctor, lawyer or engineer, the number likely is greater than 100,000.  If you are an employee, it is likely to be more than 70,000.

Together with your skills, and risk, and sacrifice of other things that would have been nice, those hours represent the economic value of “You.”  We can agree that the value is quite large.  Enough to pay for your living, and fund your retirement and leave something for the children.

Write 100,000 on a piece of paper.

Now stroke off zeroes until you come to the number of hours that you will spend, in your lifetime, planning what to do with that very large number with the dollar sign in front of it.  Be honest.

I presented this idea in a seminar once and after I stroked off a couple of zeroes someone in the back said, “Get real.  Stroke off the one.”  It is not far from reality for most people.

Most give the financial planning task to people who ask too few questions to find out what you want, do not ask enough about priorities or policies, and do not supply enough options.  Typically, they are quite interested in your current and near future resources.

Reality – most people don’t do financial planning because they don’t know how.

You might want to give some thought to learning a little more about it.  Your part is actually straightforward and knowing that part, you immunize yourself against weak methods from the others.

## Answer To The Howard Hughes Rate of Return Test

People are not intuitive about compound interest problems so  you need to learn a way to approximate rates of return.

On Friday I presented this problem.

Howard Hughes inherited \$400,000 and died 53 years later worth \$2,000,000,000.  What was his average rate of return?

There are several ways to solve this with a calculator or a computer.  And, there is at least one way to solve it without those tools.  All start with the realization that he ended with 5,000 times more.

My financial calculator using PV=1, FV=5000, PMT= 0, N=53 computes i to be 17.433468%

Using Excel Create A = LN(5000)/53;  Interest rate = EXP(A)-1 = 17.433468%

Or we can get a good guess this way. Use the handy Rule of 72

First, find out how many doubles there are.  5,000 lies between 2 to the power 12 (4096) and 2 to the power 13 (8192).  Around 12.3 doubles. So each double took about 4.31 years.

We also know that if you divide the number of years it took to double into 72 you get an approximate interest rate.  In this case 16.7%.  It also works the other way.  If you know the interest rate, it will tell you how long to double.

Was your guess close to 17%?

If not, be sure to do the arithmetic in future.  Your intuition may fail you.

## You Can Overdo The Tool Thing

No one wants an electric drill.

They want holes.  The drill is how they get them.

Financial products are like that.  No one wants to own life insurance or an RRSP.  They want what life insurance or an RRSP can do.

Many financial plans fail because some people like their tools too much.  Tax shelters, limited partnerships, trusts, pension plans, corporate mutual funds, segregated funds, Alberta trusts, some kinds of life insurance, and hundreds more.  Design matters and is exciting in some way.  You might be the only one who has one of these tools.  Pretty cool.

It is not that these are bad tools.  It is just that they don’t work the same way for everyone and some of them don’t work at all for you.

You can tell if you should have one.  Focus entirely on what the tool does, not what the tool is.  If you cannot see the “How I get whatever it is that I want” part, (like the drill gets holes) then probably the tool is not for you.  Strategy first.  Tactics next.

If you are a financial adviser, you should not show a client any tactic or tool that is not in the context of solving a problem or exploiting an opportunity that the client knows about and values.

Doing tactics first means the tool has value without the context of its purpose.  It would be  like Armani selling quarter-inch, designer drills for \$800 each.

They don’t, do they?

You can never be sure any more.