Thursday, November 21, 2013

Fool’s Wisdom # 3: Tennis v/s Roulette

Students of behavioral finance and game theory would have probably read about the group mind exercise which involves choosing a number between 0 and 100 such that the winning number is 2/3rd the average of the guesses of the group. 
(Spend some time here before reading ahead if you are not familiar with the game).

We find the interpretation of this game truly fascinating and instructive when applied to markets. But, before we explain the reasoning behind our fascination, we need to first critically examine whether this game can be used as a proxy for market behavior.
To start with, just as beautifully explained by Keynes, this game mimics the need for participants in markets to attempt to always stay that one step ahead, in the process demonstrating how difficult the attempt is!!
Another similarity with markets that we see is that the same information is available to all. However, each participant in the game, just like in markets, interprets and processes the information as per his own understanding. While some think that they understand the problem particularly well, others play along without having the slightest clue of what is going on. Quite similar to markets we feel :-)
The most interesting takeaway however for us is the outcome for the insider. Insiders here are defined as those who have already played this game before and thus know that the correct answer is 0. Think for a minute that you are an insider. If you were playing to win, should you guess 0??
As beautifully put in the Wikipedia write up on this topic
“This game illustrates the difference between perfect rationality of an actor and the common knowledge of rationality of all players. Even perfectly rational players playing in such a game should not guess 0 unless they know that the other players are rational as well and that all players' rationality is common knowledge. If a rational player reasonably believes that other players will not follow the chain of elimination described above, it would be rational for him/her to guess a number above 0.
Interestingly, we can suppose that all the players are rational, but they do not have common knowledge of each other's rationality. Even in this case, it is not required that every player guess 0, since they may expect each other to behave irrationally.”

Thus if you were playing to win, you should not guess 0 and your guess should be a number depending on your judgement of how rational the other players are!! How insanely complex can that be?? When this game was conducted in real life instances, the winning number was found to be somewhere in between 13 and 21. However, think about it for a moment. Is there any argument, which can help somebody reach a logical conclusion for the winning number?? Obviously not. Thus even if you had been right in deducing 0 as the correct answer, you would be a winner only if you luckily stumbled on to the average answer. It thus follows that it would be ‘luck’ and not ‘skill’ that would determine the winner.
Let us take an example of Jubiliant Foodworks Ltd, a company we have tracked for a while and are fascinated with. To apply the game in here we would classify the market participants in the following categories:
  • Fan followers: People who have seen/ tracked the stock since its IPO and seen the phenomenal wealth it has created for the shareholders. They are truly sold on the concept of “Buy and Hold” despite the fact that they may not be holding the stock. They have no regard for short term over-valuations but the 10 years story for Pizzas look great in India.
  • Technical Analysts: Looking at the past trends and using weird sounding terms like morning stars, doji, candle, resistance, supports, RSI, MACD etc come up with forward looking price trends / targets. Price is up for a few day in a row they have a Buy and vice versa.
  • Lay people: Have no clue of the valuations / business model but have seen/ eaten a Dominos pizza and hence think they know of the company. These people typically act on the basis of some tips or are shooting in the dark with logic of their own.
  • Fundamental Analysts: Valuations for the business are too high, the incremental ROCEs are likely to fall as expansion in Tier 2/3 cities increases, same stores sales growth is coming off, margins are under pressure but the size of the opportunity is huge, management is competent and demonstrated the scalability of the business etc. They are readjusting their numbers every quarter based on the results declared and commentary of the management.
  • Insiders/Management: We know the business the best, recently the going has been a bit tough with consumer spending slowing down, our commentaries have been cautious, we have withdrawn the guidance for FY 2013-14 but still price is at life time highs – Lets SELL a bit!! (They have sold 0.5m shares recently in the market).
  • Operators/ HNIs: 90% of the shares are either with management OR FIIs (largely long only) with hardly 10% in the markets, given that F&O open interest is equal to total shares in the market (non institution) we are in control of the game. We can drive the price when we want to. If you want to increase the price spread rumours of Burger King franchise agreement and Voila!! stock is up 15% in a couple of days despite bad quarterly numbers.

Given the various sets of thinkers for Jubiliant present in the markets, let us assume the winner is the one who guesses the return for next one month / 6 months / one year / 5 years. Who do think would be the winner? Our answer – NO IDEA!!
So this is why we are fascinated with this game. Let us say, that we have a fair value assessment for a certain stock idea and for a minute assume that we are perfectly right in our judgement. Just like the insider in the above 2/3rd game, we would still be completely exposed to the consolidated irrationality of the various market players as a whole during the price discovery process. Even if our assessment of a stock's fair value is correct, we would win only in case we luckily stumbled on to the average right answer. Making money would thus almost always involve a huge slice of luck and we would be foolish if we were to mistakenly attribute our success only to our skills.

Luck or Skill?

Some critics of our previous post on diversification pointed out that concentration is not for everyone. So if you reread Buffett’s quote in the earlier post, he recommends betting heavily ONLY if ‘you know what you are doing’. Michael Mauboussin brings in a fresh perspective to this debate. He says that for probabilistic activities like investing, luck plays an extremely large role, much larger than we would like to believe. Thus even the ‘expert’ is not really in control of the outcome.
Taking examples from various fields, Mauboussin in his book ‘The Success Equation’ talks about the ‘Skill – Luck continuum’. Thus games like tennis, chess or running a marathon fall on one end of the continuum. Here your skill is the primary determinant and thus the ‘expert’ is largely in control of the final outcome. On the other end of the continuum lie games like playing roulette, tossing a coin or snakes and ladders. Here there is no skill involved and thus the outcome is entirely random and uncontrollable. According to him a large number of games like poker, bridge, cricket etc. fall somewhere in the middle. While degrees vary, the outcome here is dependent on a mix of luck and skill.
So where does INVESTING rest on this continuum?? Without doubt it is a mix of skill & luck!!
But isn’t it more skill and less luck than the other way round?? In a fascinating thought experiment, Mauboussin takes a leaf out of Munger’s book and suggests that we ‘invert’ the problem to get a better judgment. He argues that if we were truly in control of outcomes, we should be able to influence both ‘positive’ and ‘negative’ outcomes. It can thus safely be said that a tennis game and a game of chess can be ‘thrown away’ if the player so wished. Likewise, a marathon runner can lose a race on purpose quite easily. It can therefore be said that these games are about skill and very little luck. Be it winning or losing, a skillful player is largely in control.
Now, try going to the other end of the continuum and attempt losing a game of roulette, snakes and ladders or a coin toss competition!! You are neither in control of winning nor losing and thus it is entirely about luck.
We tried to apply the same inversion principle to investing and therefore started identifying future losers. Immediately, the obvious names sprang to our mind. Kingfisher Airlines, Alok Industries, Financial Technologies, PSU Banks, Suzlon, HCC, Anil Ambani group of companies etc..etc... The names kept popping up. But hang on…Were we really sure?? After some introspection we came to the conclusion. NOT REALLY..
Were we certain that Vijay Mallya, Jignesh Shah and Tulsi Tanti would not be able to do a ‘Houdini’ and get out of their current mess?? Low probability in our judgment, but what the Heck!! Who knows for sure!! Similarly for the other names while we felt negatively about their future outlook, we were unwilling to put money where our mouths were. Kal kya hoga kisko pata!! We realized that in effect we were trying to identify candidates for shorting and were reminded of the wise man who once said that it is much more difficult to go short than long!!
We already knew that our attempts at seeking positive outcomes (making money on our portfolios) had been largely futile :-) We now knew that we were neither in control of losing money on purpose. So were we in charge of our destiny?? Put differently, did we satisfy Buffett’s ‘fit and proper’ test of ‘knowing what we were doing’?? Probably not!!
While in most professions one gets more confident with time, investing has taught us to be less sure of ourselves as we have gone along!!
Best of Manufactured Luck !!


  1. Hi Guys, whilst these posts make great reading, most of what you're writing is already available to Value Investors via the web. You'll should consider writing a post on what is it that you'll did in the month of August when the markets were getting hammered, did you buy/sell, how did your portfolio hold up? Also in the post you could consider adding whether you consider Indian stocks to be expensive right now and if not, what are the pockets where you are finding value & buying right now. Good 'manufactured' luck to you'll. Cheers,

    1. Hey Sam,

      Thanks for your feedback..Keep visiting!!

  2. Interesting post

    What do you think about the role of Luck in case of a investor using fundamental analysis to invest with horizon of 5 years. Do you think luck plays a dominant role or skill....

    1. Hi Anil,

      We think, irrespective of the time and the type of analysis, the role of luck cannot be eliminated. It might be fair to say though that the role diminishes with time..

  3. Hi Niren, what do you guys think about the continued turmoil in the sugar industry in UP? Any solution coming up in the near future?

  4. Hi Kenthomson,

    Clearly looks like a binary outcome with the entire industry up in arms against the arbitrary policies of the state government. Either government in some form accepts the recommendations of the Rangarajan committee report and hence links cane pricing to end products ..OR a worst case in our view (low probability) is that the state government takes over all the sugar mills. There is also a talk of the state government compensating the farmers directly like they do for a lot of other things. Given the controversies and the uncertainty of cane prices going forward,there is a possibility is that sugar farmers decide in favor of not sowing sugar for the next season. Too many moving parts with elections round the corner and UP being a huge swing factor.

    Keenly watching the space for further action , till then Best of ML !!!!

  5. Great post guys !!!...Always a pleasure reading.

    While u guys have aptly inferred that luck does play a big part in investing apart from skill, it is more talking from the point of shorting the stocks, isn't it?... undoubtedly in shorting there are various factors ( such as the ones u put up by listing the incentive for various players in the market) beyond your control which makes it difficult to make money over the relatively shorter investment period, i am not too sure whether it holds the case in Long term investing to that large an extent....surely there would be events that still would still impact the stock but in this case at least considering the time horizon the chances of evening out the impact is higher....making money out of shorting the obvious duds would require a great deal of patience which could indeed be very painful in terms of MTM losses....

    1. Hi Abhi,
      Thanks for the feedback. We believe luck has as much role to play even in long term investing. Any long term buy and hold idea is susceptible to host of issues like change in regulation, change of ownership, change in CEO, emergence of a substitute, obsolescence of technology, increasing competition etc. etc. On our view on shorting and having patience in the same - may be subject matter of the whole new post some time :) .

  6. Hi,

    Good article.

    It is no surprising, why successful investors are humble. They understand the role of luck very well.

    Investing unlike other professions teaches one to become human, humble and kind. Unknowingly or knowingly one becomes philosophical or spiritual. Other professions with increasing success can make one egoistic, over confident etc.


  7. Lovely article.

    Your blog is in my fav list. I am new to investing.


    1. Thanks Madhu & Biraj. Glad you resonate with our thoughts..

  8. Thanks for sharing your thought with us.