Spotlight

While making an investment decision or while accepting or rejecting any bet, the important question to ask always is – “What’s the alternative?”

Warren Buffett, in his 2014 letter to shareholders, wrote…

We will never play financial Russian roulette with the funds you’ve entrusted to us, even if the metaphorical gun has 100 chambers and only one bullet. In our view, it is madness to risk losing what you need in pursuing what you simply desire.

Russian roulette is a game where the player is given the option to take a revolver, having only one bullet, put it on his own head and pull the trigger. If he survives, he stands to win a huge sum, say US$ 10 million. What’s the expected payoff for such bet?

In this game, the probability of surviving is 5/6 (assuming 6 chambers in the revolver) and the upside is US$ 10 million. Whereas probability of encountering the bullet is 1/6 and outcome of this event is the loss of one’s life. You can’t really calculate the expected payoff in this case for how do you put a loss amount on death? I guess it’s infinite.

So even if the payoff were to be in billions and even if the revolver had not six but 1000 chambers with only a single bullet, you still can’t calculate the expected value since the downside is infinite. Buffett was implying that if the downside of a bet is unacceptable to you, no matter how low the probability, you shouldn’t accept the bet.

[Read more…] about Spotlight: What’s the Alternative?

Note: This post was originally published in the August 2016 issue of Value Investing Almanack. To read more such posts and other deep thoughts on value investing, business analysis and behavioral finance, click here to subscribe to VIA.

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On April 10, 2003, Pepsi announced a contest called “The Pepsi Billion Dollar Sweepstakes”. It was scheduled to run for 5 months starting from May in the same year.

For the contest, Pepsi printed one billion special codes which could be redeemed either on their website or via postal mail. According to Pepsi’s estimate, about 200-300 million of these codes were redeemed. Out of these, 100 codes were chosen in a random draw to appear in a two-hour live gameshow-style television special. Each of these 100 people were assigned a random 6-digit number, and a chimpanzee (to ensure a truly random number and of course to rule out any monkey business) backstage rolled dice to determine the grand prize number. This number was kept secret and the 10 players whose numbers were closest to it were chosen for the final elimination. On the evening of September 14, the final day of the contest, the event, titled Play for a Billion, was aired live. If a player’s number matched the grand prize number, he would win US$ 1 billion.
(Source: Wikipedia)

Given the scenario, it was highly unlikely that anyone would win a billion dollar. The chances were literally 1 in a billion. In spite of that, Pepsi was unwilling to bear the risk of the possible billion-dollar prize. So they arranged for an insurance company to insure the event. They paid US$ 10 million to Berkshire Hathaway to assume the risk. Yes, Warren Buffett’s Berkshire Hathaway. The same guy who is famous for his two iron rules –

1. Never lose money
2. Don’t forget rule number 1.

Then why would Buffett expose his company to such a big risk for a relatively paltry premium of US$ 10 million? Isn’t this akin to playing Russian roulette?

[Read more…] about Be Risk Averse, not Loss Averse

If you are a long-term investor, the very thought of selling a stock comes with a host of emotions and dilemmas. In this post, we bring in experienced investors to share their thoughts on how they have managed to overcome the issues surrounding selling their own stocks.

Barbara Streisand, an American singer and actress found a new occupation for herself in 1999, during the heydays of the dot com bubble. She became a stock picker. What’s more, she started managing funds of her close friend Donna Karan, a leading US fashion designer, of the DKNY fame.

Times were so good then, that in just five months of intense trading, Streisand turned Karan’s investment of US$ 1 million to US$ 1.8 million.

Now, for all her dabbling in the risky territory of stock trading, Streisand admitted that the volatility made her nervous. As she confessed then to a friend, “I can’t stand to see red in my profit-or-loss column. I’m Taurus the bull, so I react to red. If I see red, I sell my stocks quickly.”

Well, for a die-hard fan of Streisand or a stock trader, this rule of selling stocks – whenever they are in the red – may sound like a gospel truth. In fact, some of the smartest and most successful traders would agree to the fact about cutting their losses as soon as possible.
[Read more…] about Spotlight: When to Sell Your Stocks

Risk aversion is different from loss aversion, and investors who understand this are the ones who succeed.

On April 10, 2003 soft drink company Pepsi announced a contest called “The Pepsi Billion Dollar Sweepstakes”. It was supposed to run from May 1, 2003 to September 14, 2003.

For the contest, Pepsi printed one billion special codes, which could be redeemed either on their website or via postal mail. Of all the codes redeemed, which Pepsi estimated to be 200 – 300 million, 100 were chosen in a random draw to appear in a two-hour live gameshow-style television special. Each person was assigned a random 6-digit number, and a chimpanzee (to ensure a truly random number and of course to rule out any monkey business) backstage rolled dice to determine the grand prize number. This number was kept secret and the 10 players whose numbers were closest to it were chosen for the final elimination. On the evening of September 14, the final day of the contest, the event, titled Play for a Billion, was aired live. If a player’s number matched the grand prize number, he would win US$ 1 billion.

Given the scenario, it was highly unlikely that anyone would win a billion dollar. The chances were literally 1 in a billion. Inspite of that, Pepsi was unwilling to bear the risk of the possible billion-dollar prize. So they arranged for an insurance company to insure the event. They paid US$ 10 million premium to Berkshire Hathaway to assume the risk.
[Read more…] about Spotlight:Be Risk Averse, Not Loss Averse

A strong moat is about being resilient to competition. But antifragility is beyond resilience. Using the example of Berkshire’s insurance operations, we explore the characteristics of an antifragile business.

Wind extinguishes a candle and energizes a fire. Likewise with randomness, uncertainty, chaos: you want to use them, not hide from them. You want to be the fire and wish for the wind. ~ Nassim Nicholas Taleb

If you threaten a lizard, it may sometimes run away leaving its tail behind. As a kid it was the most fascinating thing I ever witnessed while conducting my own zoology experiments. It’s common in many lizard species to shed a part of their tails and this trick is employed by these reptiles to allow them to escape when captured by the tail by a predator. The detached tail writhes and wiggles, creating a deceptive sense of continued struggle, distracting the predator’s attention from the fleeing prey animal. That’s a fascinating self-preservation mechanism that evolution has given to lizards. And what’s more fascinating is that these lizards can grow that tail back in a matter of few weeks. What a robust way to deal with loss! If that sounds cool, then you must also know about Hydra. It is a serpent-like creature from Greek mythology. Hydra grows two new heads every time you cut one off. In Indian mythology, there is a similar character called Raktabija. A demon (asura) who has the magic boon that every drop of blood shed from his body give rise to another Raktabija (literally the blood borne).
[Read more…] about Spotlight: Don’t Just Look for Moat, Look for Antifragility