Thursday, September 20, 2007

Memo to Students: Bob Hamman Video

Bob Hamman is considered to be one of the best bridge players in the world. He runs a very interesting company called SCA Promotions.

Wikipedia Page:

Warren Buffett is a fan of Bob Hamman. Buffett and Ajit Jain (the genius who runs BRK's super-catastrophe insurance operation) often do things similar to what Bob does. Here is what Buffett wrote in this connection in his 1995 letter:

"Ajit Jain is the guiding genius of our super-cat business and writes important non-cat business as well. In insurance, the term "catastrophe" is applied to an event, such as a hurricane or earthquake, that causes a great many insured losses. The other deals Ajit enters into usually cover only a single large loss. A simplified description of three transactions from last year will illustrate both what I mean and Ajit's versatility. We insured: (1) The life of Mike Tyson for a sum that is large initially and that, fight-by-fight, gradually declines to zero over the next few years; (2) Lloyd's against more than 225 of its "names" dying during the year; and (3) The launch, and a year of orbit, of two Chinese satellites. Happily, both satellites are orbiting, the Lloyd's folk avoided abnormal mortality, and if Mike Tyson looked any healthier, no one would get in the ring with him."

You can view a very interesting video of Bob in which explains what he does i.e. how he sets odds in a risky situation. You can view this video from:

The Bob Hamman video can be seen by clicking the link titled "Risky Business"
The video may play only if you have an older version of Real Player installed on your comp. You can get an older version - the Real Player 8 from

Lectures 03 & 04: Risk Arbitrage, Fermat-Pascal, and Life

List of topics discussed in Tuesday's class:
  1. Graham, Buffett, and Rubin suggested as role models for learning risk arb and the fermat/pascal way of probabilistic thinking.
  2. Case on Arcata Corporation from the Buffett letters was discussed at length to illustrate the idea behind risk arb
  3. Risk arb defined, Buffett's four questions on risk arb deal analysis (probability of deal going thru, time to consummation, chances of icing on the cake, and worst case scenario)
  4. Graham's framework on special situations from the appendix of the 3rd edition of Security Analysis, Walter Schloss on that appendix, and how my own career was deeply influenced by it.
  5. Robert Rubin's philosophy on risk arb (students were asked to do substantial reading on Rubin prior to class), Graham-Newman's arbitrage results over a long time, Buffett's own results in the field.
  6. Extended discussion of the the GE Shipping spinoff deal, the twists and turns in that deal
  7. Discussion of some old deals from my experience involving bailouts, mutual fund arbitrage, creating cheap shares in schemes of arrangements, tender offers, buybacks, going-private transactions, merger arb, dividend capture, and recapitalizations.
  8. Fermat/Pascal system of thinking, the necessity of developing an expected value frame of mind (Fermat/Pascal letters can be seen from here.
  9. Rubin's four principles of decision-making - the uncertainty principle, probabilistic thinking, decisions and actions being different (includes the ideas of preserving optionality and sometimes having to choose the least worst option), and the importance of process over outcomes.
  10. Process vs. Outcome- bad process will inevitably produce bad long term outcomes, but bad short-term outcomes do not necessarily imply a bad process, importance of luck in success.
  11. Frequency-Magnitude framework of expected value, how the world focuses on frequencies and not magnitudes and expected values, the jellybean experiment, how people give up an idea because they think its too tough without thinking thru the consequences of success, how long term-success almost never comes from the first idea, how conviction in oneself and cumulative learning produce good long-term outcomes even though they are improbable (you only have to get rich once), the venture cap model (low chance of success, high magnitude of success in a few cases), how someone can be wrong most of the time, and be right just a few times (Taleb's bleed strategy).
  12. Preserving optionality - the deep simplicity behind black-scholes - options have value even when they are out-of-the-money because of time and volatility, the more the volatility, the more the value of the option, the importance of not making a decision i.e. deferring it, particularly in a dynamic situation, allowing new information to come in which changes the odds, Graham's idea of never converting a convertible, how risk arb teaches the benefits of keeping options open till the last possible moment ("stuff happens"), we will cross the bridge when we come to it.
  13. Contrary viewpoint - when to burn bridges, when to close options and make decisions, how often big decisions in life often involve burning bridges, while generally the preserving optionality model is very useful, particularly in investing.
  14. Probability Blindness, how people make big mistakes when they estimate probabilities, denominator blindness (an example of anchoring bias), the monty hall problem, believing that trends are destiny, wrong perceptions of risk because some bad event has not happened for a long time (people assume its become safe when the exact opposite is true e.g. some earthquake-prone areas which have not experienced an earthquake for a long time), conjunction fallacy, mistakes in interpreting causal chains (a chain cannot be stronger than its weakest link)
  15. Why is risk arb fun apart from the money? Forces you to think rationally using expected value framework which is dynamic requiring frequent calibration of thinking in response to new information and new interpretation of old information, forces you to think about
    opportunity cost, requires multi-disciplinary thinking (e.g. probability, psychology particularly game theory, law particularly corporate and securities law, and finance), and of course the availability of un-co-related to market opportunities arising out of corporate actions, giving the arbitrageur plenty of very interesting things to do...
  16. How the expected value framework, so well-taught by practicing risk arbitrage, can also be be used in regular straight value investing, Buffett's case on investing in Wells Fargo, how he estimated worst case scenario and exploited the perception-reality gap in the

Wednesday, September 19, 2007

Memo to Students: Ben Franklin's Prudential Algebra

Benjamin Franklin wrote this to a friend in 1772:

To Joseph Priestley

Dear Sir, London Sept. 19. 1772 In the Affair of so much Importance to you, wherein you ask my Advice, I cannot for want of sufficient Premises, advise you what to determine, but if you please I will tell you how. When these difficult Cases occur, they are difficult chiefly because while we have them under Consideration all the Reasons pro and con are not present to the Mind at the same time; but sometimes one Set present themselves, and at other times another, the first being out of Sight. Hence the various Purposes or Inclinations that alternately prevail, and the Uncertainty that perplexes us. To get over this, my Way is, to divide half a Sheet of Paper by a Line into two Columns, writing over the one Pro, and over the other Con. Then during three or four Days Consideration I put down under the different Heads short Hints of the different Motives that at different Times occur to me for or against the Measure. When I have thus got them all together in one View, I endeavour to estimate their respective Weights; and where I find two, one on each side, that seem equal, I strike them both out: If I find a Reason pro equal to some two Reasons con, I strike out the three. If I judge some two Reasons con equal to some three Reasons pro, I strike out the five; and thus proceeding I find at length where the Ballance lies; and if after a Day or two of farther Consideration nothing new that is of Importance occurs on either side, I come to a Determination accordingly. And tho' the Weight of Reasons cannot be taken with the Precision of Algebraic Quantities, yet when each is thus considered separately and comparatively, and the whole lies before me, I think I can judge better, and am less likely to make a rash Step; and in fact I have found great Advantage from this kind of Equation, in what may be called Moral or Prudential Algebra. Wishing sincerely that you may determine for the best, I am ever, my dear Friend, Yours most affectionately, B Franklin


Note the underlying wisdom in the Franklin system of decision making. By making a list of things that would go in favor of, as well as, a list of things that would go against, a potential decision, he prevented his mind from jumping to conclusions (first conclusion bias as a subset of availability bias). This procedure also ensured that Franklin did not over-weigh any particular factor which could mis-influence his decision (availability bias). Further, his insistence on not making sudden decisions without reflecting over them for a few days ensured that he "preserved optionality" allowing new information to come in which could change the odds (Robert Rubin's idea of preserving optionality is valid here). Finally, his roughly-right system of dealing with trade-offs works way better, in my view, than the "optimization systems" you see in the modern world.

Keynes had it right when he said, "its better to be roughly right than to be precisely wrong."

Btw, I love doing "Prudential Algebra" on my mind maps...

Monday, September 17, 2007

Memo to Students: Robert Rubin as a Role Model

The next two classes will deal with the Fermat/Pascal way of thinking.

In my view, the best way to understand Fermat/Pascal thinking style, from an investment viewpoint, is to see how risk arbitrage works. And one of the best ways to learn the dynamics of risk arb is to study the experiences of Graham, Buffett, Greenblatt, and Rubin.

As the course progresses, we will be talking about all of these experts. At this time, however, I'd like you to do some work on Robert Rubin.

Rubin learnt risk arb at Goldman Sachs. And the lessons he learnt, he says, served him very well in his life. Risk arb teaches a lot of things about life, as you are about to find out. So, please make the effort of reading/viewing the following:

  1. Rubin's page at Wikipedia;
  2. The first three minutes and fourteen seconds of Rubin's interview with Charlie Rose;
  3. Rubin's commencement address at Harvard;
  4. Rubin's interview with Carol Loomis;
  5. The following pages from Rubin's book "In an Uncertain World": A note from the author, pages 7-8, Chapter 2 (A Market Education), Chapter 3 (Inside and Outside Goldman Sachs), pages 173-176, Chapter 10 (Hitting Bottom), pages 340-350, and page 382.
  6. This article on Rubin in the New York Times Magazine and this letter about that article; and
  7. This press release issued by Rubin's office when he was Treasury Secretary.

Just do it!

Saturday, September 15, 2007

Mindmaps in Investing

As mentioned in my class yesterday, I frequently use Mindmaps for my investment thinking.

Here are two mindmaps - one is historic and one is current.

You will need mindjet viewer to be able to see the maps which you can download from here.

Friday, September 14, 2007

Lecture 02: Introduction to Mental Models & Mental Tricks- II

Topics covered in today's class:

  1. Surfing as a mental model, There's a tide in the affairs of men, which taken at the flood, leads on to fortune - Shakespeare, example of Sunil Mittal who rode the GSM wave and because one of India's richest men. A lot of business fortunes are made because someone happened to be in the right place at the right time - i.e. luck.
  2. Two views of the world - Bell curve world, and the Power Law world, Scalability in the Power Law World, Winner-takes-all model, importance of scale in valuation.
  3. Diseconomies of scale, bureaucracy, eventual decline of all great corporations inevitable.
  4. Mental Trick: Importance of using checklists in dealing with availability bias, first conclusion bias, and confirmation bias, the pleasure of exploiting other people's availability bias, examples.
  5. Mental Trick: Effects have effects, Peltzman effect, Carol Loomis on The Risk that Wont Go Away, Need to think like a chess grandmaster, unintended consequences, America's futile war on drugs, Price controls, Jim Roger's Law (you can control the price, or the supply but not both), examples of Licence Raj, Ration Shops, Smuggling and Arbitraging. Need to do "second step analysis" as Buffett did in shutdown of textile operations, how price changes everything (in stock market crashes), how people respond to changes in tax policies and how markets tend to assume that tax changes are permanent, how Indian companies became more profitable and not less after opening up of Indian markets to competition in 1990, How Y2k did not end Indian IT Industry, how in cyclical businesses are influenced by effects of effects, the inability of excel to capture the power of the human sprit to fight and bounce back.
  6. Mental Trick: Backward thinking, proof by contradiction, its utility in security analysis, expectations investing, how to find absurd valuations using backward thinking, the removal of need to make elaborate predictions when using backward thinking, using backward thinking in risk arbitrage and in option markets (implied volatility), the need to falsify first conclusions, negative empiricism, the asymmetry between proving something and disproving it.
  7. Mental Trick: Zooming in - the need to focus on what is going on at the detailed level e.g. segment data of Microsoft and ITC reveals something very interesting which is camouflaged when one looks at overall financial performance.
  8. Mental Trick: Zooming out - Need to step back and look at a situation, e.g. Buffett's decision to shutdown textile operations, need to think like an allocator of capital and not as someone married to a business.
  9. Mental Trick: Be creative: use mind maps, creative whack pack, innovative whack pack - examples of creativity in investment thinking e.g. changing viewpoints, asking what if, using metaphors and Aesop's fables (e.g. the rabbit runs faster than the fox because the fox is running for his dinner but the rabbit is running for his life), the need to invert, the need to check your timing (e.g. instead of asking is this attractive at this price, asking how can I make money in this deal, corporate event etc), the need to be aware of unintended consequences, the need to be very curious about things around us, the need to see the opposite viewpoint, and the need to kill your own best loved ideas, the need to be charmed by randomness...

Thursday, September 13, 2007

Lecture 01: Introduction to Mental Models & Mental Tricks

Here is a list of topics covered in my BFBV class (in which I had an opportunity of discussing Charles Munger and Charles Ponzi together!)

  1. Mental models: definition, utility, Herb Simon's and Charlie Munger's idea of using checklists, the man-with-a-hammer syndrome.
  2. Warren Buffett's decision to shut down textile operations of BRK (students were given his essay in his 1985 letter as pre-reading material). Dissection of Buffett's textile experience into multiple mental models - competition from microeconomics, return on capital from accounting, opportunity cost from microeconomics, prisoners' dilemma from game theory, contrast effect from psychology and bias from commitment and consistency from psychology.
  3. The necessity of "jumping jurisdictional boundaries" and the futility of using a single tool like Microsoft excel to make decisions.
  4. The mental model framework - the Lollapalooza effect, the need to look at extreme outcomes and working backwards to mental models and also to see how mental models work together to produce lollapalooza effects (thinking forwards).
  5. Inherent contradictions between some mental models e.g. Adam Smith's invisible hand and Garrett Hardin's invisible foot.
  6. Feedback loops from engineering, their application in other disciplines, positive feedback loops (spiral, runaway, vicious circles) and negative feedback loops (self correcting e.g. business cycles). Examples of bank runs and stock market crashes and successful business models with embedded positive feedback loops (e.g. Buffett's example of dominant newspapers wherein circulation and advertising feed on each other, and Wal-Mart where low-prices create high volumes, which creates scale economics for the company which are passed on to customers in the form of low prices which create high volumes....)
  7. Regression to the mean from statistics - applicable in a gaussian bell curve world, Buffett on markets performance regressing to underlying business performance over time, the Graham voting machine weighing machine metaphor, mean reversion strategies, all trends are not destiny.
  8. Creative Destruction by Schumpeter and its relation to extinction in evolution - Sometimes trends ARE destiny, examples of digital cameras vs analogue cameras, mobile phones vs fixed line telephony etc - fascination about observing what goes on inside the heads of entrenched player in a industry who is about to be dislodged by an upstart who has made a better mousetrap, the light at the end of the tunnel coming from an oncoming train metaphor.
  9. Ponzi scheme from mathematics - importance of thinking in terms of Munger's "functional equivalents" i.e. in this case embedded ponzi schemes in RIETS, business models like Amway, venture capital, greater fool theory in IPOs, chain letters, pension funds etc.
  10. As a follow up reading, students were asked to read Charlie Munger's essay on S&Ls in Wesco Financial's annual report for 1990. They were asked to analyze his marvelous decision to get out of the S&L business when he could see the threat from money market funds and Freddie Mac (oncoming train), and how not only he got out of the way of that metaphorical train, he jumped on to it and made a billion dollars for his investors in the process.

Sunday, September 09, 2007

Two Nights Before...

My course - Behavioral Finance and Business Valuation (BFBV) starts on 9/11. Two more nights to go. Been busy preparing a revised course outline (I like to change my course every year otherwise it gets too boring to put the same slides again and again).

I will have a total of 30 contact sessions with 70-odd students. I wish I could have more contact sessions - there is so much material to cover! Soon, the students will be tormented by an avalanche of mails and assignments etc from me :-)

I have prepared a list of topics I want to add and those I want to delete. There is a list of movies to show, stories to tell, video scenes to play. There is a list of appropriate quotes to insert at the right moment. Its like writing a screenplay!

I am increasing the scope of behavioral finance component this year and hopefully students will like that. I have also incorporated many changes triggered by Nassim Taleb and his influence on my thinking. His latest book- Black Swan - is very good and I can relate what he has written to a huge number of real-cases which would be suitable for classroom discussions.

The photo at the top was taken by my wife while I was deeply engrossed with my friends i.e. my books. Two more nights and miles to go before I sleep...

My Bookshelf at Shelfari

You can see my bookshelf here which I am in the process of updating. I recommend this site to you.