December 2022

Written By Jason Slowbe

ONE MORE THING...

  • Keep it simple

  • Correlation vs causation

  • Is bad news actually bad again?

  • Justin Bieber learns the hard way

  • When you look at it that way…

Kevin O’Leary:  Bad investment or bad process?

FTX is the now-bankrupt cryptocurrency exchange that has landed founder Sam Bankman-Fried in serious legal trouble.  

Kevin O'Leary, one of FTX’s celebrity endorsers who Likely had more sway than other FTX endorsers given his business and investment acumen, stated the obvious: “[FTX] was not a good investment Andrew, okay.  I don’t make great investments all the time, luckily I make more good ones than bad ones, but [FTX] was a bad one.”  

Sure, losing $15 million is not a good investment.  And to be fair, the nature of venture investing is that most deals go to $0 anyway.  Celebrity endorsers (Tom Brady, Gisele Bundchen, Larry David, Stephen Curry, others) can be excused for taking the money and not understanding the financial intricacies of FTX’s business.  But financially sophisticated endorsers like Kevin O’Leary cannot be excused in the same way.  They know and have due diligence understandings that ought to have seen the many FTX red flags.  So Why were the Investing Pros Such Suckers for FTX?  

One explanation is that at this level of investing, it is less about the financial models or business fundamentals and more about the people.  Matt Levine of Bloomberg made this case in Everyone Wanted to Buy Twitter With Elon: 

Similarly, after Musk announced that he wanted to buy Twitter, he went looking for financing, including equity financing: He wanted other people to invest in the deal alongside him. Last week, an assortment of text messages from Musk’s phone became public as part of the preparation for the trial, later this month, about whether Musk can get out of the deal he signed in April. Some of these texts are Musk’s friends, acquaintances and strangers texting him to say “hey can I invest with you” and Musk saying “I would love that” or “sure whatever” or “no, not you,” as the case may be. The general approach is refreshingly casual. Here are Musk and Larry Ellison on April 20 (the day that Musk delivered his financing commitments to Twitter):

Musk: Roughly what dollar size? Not holding you to anything, but the deal is oversubscribed, so I have to reduce or kick out some participants.

Ellison: A billion … or whatever you recommend

Musk: Whatever works for you. I’d recommend maybe $2B or more. This has very high potential and I’d rather have you than anyone else.

Ellison: I agree that it has huge potential … and it would be lots of fun.

Musk: Absolutely :)

There were other similar texts also.  Levine continues:

People got mad about these texts? Charlie Warzel:

In no time, the texts were the central subject of discussion among tech workers and watchers. “The dominant reaction from all the threads I’m in is Everyone looks ... dumb,” one former social-media executive, whom I’ve granted anonymity because they have relationships with many of the people in Musk’s texts, told me. “It’s been a general Is this really how business is done? There’s no real strategic thought or analysis. It’s just emotional and done without any real care for consequence.”

…

Also, I have spent the last few years promoting the Elon Markets Hypothesis, which says that “the way finance works now is that things are valuable not based on their cash flows but on their proximity to Elon Musk.” If you believe that, and I suppose I do, then any due diligence, beyond making sure that you have the correct phone number for Musk, is superfluous. 

So is this simply how business is done at that level?  

Anyway, so O’Leary made a bad investment.  But did O’Leary make a bad decision? 

An important point of maturity for investment managers is understanding that the process is more important than the outcome.  

Investment outcomes obviously vary with the gyrations of uncertain markets.  A good process will sometimes produce bad outcomes - that’s the consequence of decision-making amidst uncertainty.  But importantly, a good process will produce more net profitable outcomes than losing outcomes over the long run.  

Likewise, a bad process will sometimes produce good outcomes - these situations are truly dangerous!  If a manager is not reflective, they are Likely to misattribute a good outcome to their own skill rather than the actual explanation of luck.  Such managers are bound to reapply that bad process in subsequent investments, inevitably their luck will run out, and the negative expected value of their bad process will catch up with them.

So again I ask: Did O’Leary make a bad investment or a bad decision?

Here’s one part of O’Leary’s answer:

Sorkin: “Let me ask you this though, when you made this arrangement, this is back in August 10, 2021, you said the following: you said ‘to find crypto investment opportunities that met my own rigorous standards’, that was your phrase, ‘of compliance, I entered into this relationship with FTX, it has some of the best crypto exchange offerings I’ve seen on the market.’  Given you were the spokesman, an ambassador for this company, what kind of diligence did you do around this issue of compliance, given where we sit today?”

O’Leary: “Well, I obviously know all the institutional investors in this deal, we all look like idiots.  Let’s put that on the table, okay?  We relied on each others’ due diligence, but we also relied on another investment theme that I felt drove a lot of the interest in FTX.  Sam Bankman-Fried is an American.  His parents are American compliance lawyers.  There were no other American large exchanges to invest in if you wanted to invest in crypto as an infrastructure play.  So many of us said wait a second, who’s coming to this deal?”

And here’s a second part: 

Sorkin: “Let’s go back to the compliance issue, and the reason I’m asking is, look, I think a lot of people have looked to you over the years as somebody who is an investor, and is a successful investor, and they’re following you, that’s the point of why, right, and so they’re looking at this and saying ‘what kind of compliance did this guy do?’  And, just asking around, and seeing who else was investing is not compliance unto itself.”

O’Leary: “Well, we did compliance, and the way we did it, we said, let’s look at the platform, and let’s see if it can link to our actual porting systems, is it robust enough to allow us to be compliant because I also issue securities through other investments like O’Shares.

Sorkin: “But did you ask questions about, for example, I mean look, the board piece of it, the CFO piece of it, all of those would be considered compliance red flags.”

O’Leary: “But Andrew, if you’re asking did I do enough due diligence, the answer is no.  Did I rely, like others did and Joe’s concept of groupthink, yes we all did that.”

Look, everybody is Monday morning quarterbacking this one, I will not be piling on that train.  What can we learn from the endorsers and investors who fell for FTX?  Thinking in Likelyhoods, the psychological biases seem extremely explanatory: 

  • Fundamental Attribution Error - overemphasizing personal qualities in explaining positive results while underemphasizing situational explanations

  • Overconfidence - unsubstantiated confidence relative to market uncertainty

  • Resulting - judging quality of decisions by their outcome not process

  • Herd Mentality - following others under the assumption that the herd has already done the research that one ordinarily would do themselves 

If somehow FTX had not blown up and eventually recovered to become a stable, healthy company, O’Leary’s decision to endorse FTX, given the information known and due diligence actually done at that time, would still have been a bad decision.  That’s a critical distinction to make for managers and investors to avoid similar outcomes in the future.

Lesser Known Statistics:  Variability

Understanding variability is foundational to effective risk management.

Would you take a 50-50 bet in which a win pays $110 while a loss loses just $100?  Or, roughly equivalently, would you take a bet in which 70% of the time you win $1 and 30% of the time you lose $1?

Nassim Taleb and Richard Thaler disagree on these answers.  Thaler, the Nobel Prize-winning behavioral economist, tweeted this:

 
 

“NNT” refers to Nassim Nicholas Taleb.  Thaler’s point here is of loss aversion, a central finding in behavior economics in which the pain of losing money impacts people psychologically more than the pleasure of winning that same amount of money.  For example, if you offer people $10 for a win and $0 for a loss, or offer them a coin flip for either winning $110 or losing $100, people will choose the $10 outright to capture the same $10 advantage in both offers while avoiding the potential for having to pay out losses - no surprise.  But what if the offer changes to be just $5 outright versus either winning $110 or losing $100, would people accept missing out on that extra $5 to avoid the potential for loss?  That $5 reduction can be thought of as the loss aversion “penalty” for preferring to avoid losses.

A cool 19 months later, Taleb featured Thaler’s tweet in this video takedown of Thaler and Behavioral Economics for not understanding variability over multiple periods, How you will go bust on a favorable bet. (Kelly/Shannon/Thorp) .  Here’s Taleb:  

“If someone offers you a bet, you have 70% probability of making a dollar and 30% probability of losing a dollar, should you take it?  Well, no.  In many cases you should not take it.  Not because you’re risk averse.  Simply you should not take it because it’s not a good strategy.  And we’re going to see how.  This answers of course some of the behavioral financial nonsense that you hear, because they view things as one period model, not as a multi-period model.  For example, your grandmother does not analyze the notion of smoking as a single event where you smoke a cigarette, but rather an activity of smoking, so risk taking is an activity, not a single event.  So once you put dynamics, as I’ve explained in this current game, a lot of the results in behavioral finance become nonsense, total nonsense.”

Do they actually disagree? They certainly are framing the problem differently with respect to critical details of variability.  Plenty of people in the replies made this point in different ways:

 
 

Indeed, I have made the same point in the context of card counting in Blackjack: 

Thorp’s risk was determined by his bankroll relative to the variation in outcomes.  So long as Thorp had a sufficient bankroll to ensure his solvency through the worst drawdown, his card counting system’s positive expected value and the law of large numbers assured Thorp would beat the casino in the long run.  

It’s no different with investing.  Investors can get a “risk free” treasury bond paying a low but guaranteed interest rate, or they can take on greater risk - and greater variability - with products like index funds, stocks, futures, options, meme stocks, cryptocurrency, or dare I say FTX.  It is critical that investors understand the risks associated with these products before investing, including the variability in such products so as to avoid margin calls and other complications if the variability moves too severely against them.

Here is a Risk of Ruin simulator to explore some basic scenarios in variability - play with some numbers yourself.

 
 

For example:

  • With a $200 initial bankroll, 50% win probability, and $110 gain vs -$100 loss, the risk of ruin is approximately 80%...

  • …but increasing the initial bankroll to $1000 while holding the other parameters constant, the risk of ruin decreases to approximately 39%.

This exploration quantifies the critical detail behind Thaler’s and Taleb’s spat - in order to reliably capture a positive long term expected value, one needs to have a sufficiently large bankroll to withstand the variability in avoiding ruin.  Provided one avoids ruin, the law of large numbers will work in their favor as they accrue that positive expected value in the long run.  

Unfortunately, too many investors and investment managers get too aggressive with the ratio of bet size to bankroll.  Although this juices the return percentage via a smaller denominator, this practice also increases the risk of ruin.  

That’s why understanding variability is foundational to effective risk management.

Not-So-Stop Losses 

Here’s a fascinating stat brought to us by the Wall Street Journal’s Jason Zweig, How to Make Peace With Your Stock Market Losses:  

In the recent study, 40% of the time the online traders who’d already placed stop-loss orders took any action related to their positions, it was to lower those stop-loss thresholds even further.

The more the prices of their holdings fell, the farther the traders dropped the levels at which they would automatically be forced to sell. Instead of stopping their losses, these traders ended up chasing them. They intended to quit, but they couldn’t.

Surely professional investors are better at selling?

Surely you jest.

New research shows that fund managers lose an average of about 0.8 percentage points of return annually through poor selling decisions. The managers tend to sell either their most extreme recent winners or losers—which, on average, go on to outperform after the funds dump them.

“They could have done substantially better by throwing a dart at their portfolio and selling whatever it hit instead of the stocks they actually sold,” says Alex Imas, one of the study’s authors and a finance professor at the University of Chicago.

To learn whether your selling decisions are any good, you’ll have to track not only the investments you hold, but those you sold. If what you sold is outperforming what you hold, you’ve been selling the wrong investments—something you’ll never learn unless you are willing to look.

Hindsight Bias Buster

Speaking of psychological biases, try incorporating a "Hindsight Bias Buster" into your process:

Looking back at yourself a year ago, what you know now has indelibly altered your perception of what you knew then. 

This pattern, which psychologists call hindsight bias, makes us feel that we foresaw the future all along, what happened was inevitable and anybody who didn’t see it coming is a dope. It’s close to irresistible—and it’s an illusion.

That’s why I recommend an annual exercise I call the Hindsight Bias Buster. 

...

A year from now, look back at your answers. Suddenly what felt obvious may seem obscure; blame that appeared clear may turn ambiguous; certainty may seem silly.

And you will have taken a big step forward as an investor.

There is much to be learned from the past.  This is challenging to do in a media and technological environment in which news flows quickly and the gusher of content easily exceeds our attention spans.  Nevertheless, managers are Likely to make better decisions when they ask of their previous outlooks “Where are they now?” (Likelyhoods, Dec 2021).  


ONE MORE THING…

The information and opinions contained in this newsletter are for background and informational/educational purposes only.  The information herein is not personalized investment advice nor an investment recommendation on the part of Likely Capital Management, LLC (“Likely Capital”).  No portion of the commentary included herein is to be construed as an offer or a solicitation to effect any transaction in securities.  No representation, warranty, or undertaking, express or implied, is given as to the accuracy or completeness of the information or opinions contained herein, and no liability is accepted as to the accuracy or completeness of any such information or opinions.  

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Jason Slowbe
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