Optionality, Fragility and Liquidity

25 year old Sunil Darshan was hurting.
It was a crisp Tuesday morning outside. One of the first sunny mornings after 10 dreary winter days.
But Sunil couldn’t see all of that. His eyes were glued to the computer which was flashing his networth.
And this was the 16th day straight where it was falling.

But that was not why he was in pain. He over the course of a fortnight lost 60% of his networth. And he knew he couldn’t do much here. His hope prevented him from selling at a loss, his guts prevented him from holding onto the toxic garbage he put together.

Darshan is not alone here. The sins of Darshan have been repeated by the majority since time immemorial and yet few have figured it out.

6 years later, Darshan still remembers that morning.

“Much of the positions I was holding that day were based on one core theme- infrastructure play” says a much more chastened 31year old. Indeed an analysis of his investment highlights quite a many lacunaes in his thinking.

Out of 25 stocks he held, all of them were directly connected to one big theme in his mind- infrastructure. So though he believed he had multiple positions in his portfolio, he was betting on the continuance of “good fortune” of one particular industry.

However, lack of diversification was not really Darshan’s fault. It was not even half of his fault. His fault lay in not assessing the risks. Bob Pozen in his prescient advice about career mentioned something extremely interesting- ” you should begin by thinking carefully about why you are engaging in any activity and what you can expect to get out of it.”

Darshan never really questioned his actions or motives. Even worse he never assessed the probabilities, payoffs and the risks associated with any investing action of his.

When asked why he bought what he bought- “They were good companies, I thought they were making nice stuff” explains Darshan. However on buttonholing him regarding what he believed the measure of goodness was for these companies, Darshan couldn’t make a convincing argument.

“They were growing well, they were giving good returns”, adds Darshan hastily.

The problem with Darshan’s strategy is not what his measure of goodness is. But his lack of connection of that measure of goodness with the risks involved.
In short, he failed to assess his ideas in an objective way.

While much of this story is a hashed, rehashed topic exhorting people to be intelligent in their investing decisions and so on, but that is not the deeper idea here.

The deeper idea is the lack of the concept called fragility (popularised by Nassim Nicholas Taleb) in investors’ minds and portfolio. Fragility is a concept which tries to reason out which entities benefit from randomness and which don’t.

Perhaps robustness will give a better image.
Think about the ceramic vase sitting on your drawing room. Give it one jolt, and it will fall and break in thousand pieces. Think about the rubber ball. It can absorb huge amount of shocks and yet return back to its shape without discernible difference.

Anti-Fragility survives. Fragility doesn’t.
And one of the most important aspects of anti-fragility is diversity.

Darshan’s strategy of picking investments were based on only one criteria- past stock price performance. That itself is a recipe for fragility. He should have known that in any “market” the more the number of participant strategies running, the higher amount of diversity there is and the more “robust” that market is to external developments.

Here each stock represents a market in itself. And with Darshan’s strategy of picking up stocks based on past performance, he picked out such markets where the diversity was low. The only dominant strategy was “bigger fool” strategy. So when any new developments came in the form of less than optimal macroeconomic news, the shares tanked.

However successful investors don’t limit themselves to avoiding momentum stocks themselves. They go one step deeper and broader. They first bring the concept of fragility inside their head. Ed Seykota, the famous trend follower argued that winning without losing money is much like breathing in without breathing out.

Munger mentions in the same vein (without any possibility of any of them knowing each other) when asked about the drop in the value of Berkshire Munger said in a very direct way:

“Zero.  This is the third time Warren and I have seen our holdings in Berkshire Hathway go down, top tick to bottom tick, by 50%.  I think it’s in the nature of long term shareholding of the normal vicissitudes, of worldly outcomes, of markets that the long-term holder has his quoted value of his stocks go down by say 50%.  In fact you can argue that if you’re not willing to react with equanimity to a market price decline of 50% two or three times a century you’re not fit to be a common shareholder and you deserve the mediocre result you’re going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations.”

Successful ones don’t jump around when they see declines, randomness, less than optimal outcomes. They have strengthened their minds with it.

And that’s one deep aspect of building anti fragility in their portfolios.

The second aspect of making investments fragility-proof is to make small bets (diversification) or make big bets in antifragile companies. The latter is the big idea here. A portfolio of anti fragile companies can also render the portfolio anti fragile.

Think how Buffett chooses his companies – companies existing for a long period, with high amount of predictability in its daily affairs, with high amount of return on capital, with very few or no change in its principal business in its entire history and in an industry which sees no significant change in its structure.

Phew!
Survivability (anti fragile survives). Check
Predictability(anti fragile to macroeconomic conditions). Check
Anti Fragile Industry. Check.

Often companies with high return on capital are symptomatic of anti fragility built in them. Moat is an essential marker of anti fragility. It absorbs shocks without hampering the business.

That’s a very good idea. Contrast it with how we handle our investment decisions. We seldom investigate companies keeping anti fragility in mind.

But Buffett & Munger surpasses even in their traditional ways of combating randomness. They incorporate OPTIONALITY in their portfolio.

But what is optionality!

Take a look at these ideas-

“Our basic principle is that if you want to shoot rare, fast-moving elephants, you should always carry a loaded gun”

-1987 Annual Report

“…then act decisively when, and only when, the right circumstances appear.”

-Munger

“It takes character to sit there with all that cash and do nothing. I didn’t get to where I am by going after mediocre opportunities.”

-Charlie Munger

Buffett and Munger know the value of optionality. They understand that they need to carry a lot of cash not as a substitute for equity but as a means to buy equity.

They are carrying loaded guns all the time to pounce of deals when no one can else make such deals. And their “loaded guns” are $49bn.

A very similar idea we have to use in our own portfolio. As the markets rise, every dollar kept in cash is going to hurt us. Every dollar.

However going all in also prevents us from exploiting opportunities when they arise.
A lot of people in the wake of GFC 2008, realised that things have got tremendously cheap, but didn’t have the money to buy it.

Think about it for a moment. What can you do when you have cash in your hand in a sellers market?

But optionality doesn’t only stretch to buying mispriced deals. It also stretches to situations where we don’t know the outcomes, the probabilities of outcomes and the exact payoffs from such outcomes.

As the philosopher Taleb says- complex payoffs and extreme outcomes.

Betting against an earthquake in California- complex payoffs.
Insuring such an outcome, with payoff 5 times the actuarial amount- extreme outcome.

Check. Check. Fly in Buffett and he pulls his trigger. He did this exact deal in 1997 California. (more information by Richard Zeckhauser)

Complex Payoffs and Extreme Outcomes also require one to build a portfolio of such options. Bet small on each option, hoping law of large numbers to click in your favour.

But lottery tickets seldom makes one rich. We also need a portfolio of provable investment channels- in my words portfolio of equity. It can be investments in yourself or in others. However they have to have a proven trackrecord.

Think Buffett and his share purchase of Coca Cola.

And then, to really take care of rainy days- you need a portfolio of bonds with you. It can be a job in government where there is ample job security or you can have a portfolio of fixed income assets supplementing your income.

Or even, some cash to burn.

And top all of it with plenty of cash. To move into any of the portfolios whenever you need it.

Recently, I had this idea that we can extend this even to individual careers.

As market rises all over the world, we are going to sacrifice process in favour of outcomes. We are going to increasingly sacrifice flexibility in terms of returns. And we are going to keep exhausting our cash piles only to be left with none when the horsemen of apocalypse come.

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