In preparation for the annual Montaka offsite, where the team gathers to discuss our investment process and whether tweaks can be made to improve performance, each team member is required to study Chapter Two of Nassim Taleb’s book, Fooled By Randomness. It’s worth asking what could make one chapter so important and worthy of this collective discussion?
Chapter Two of Taleb’s magnum opus discusses alternative histories and probabilistic thinking, both of which have profound implications in the realm of investing. In framing the idea of alternative histories, Taleb uses the vivid example of Russian roulette:
“One can illustrate the strange concept of alternative histories as follows. Imagine an eccentric (and bored) tycoon offering you $10 million to play Russian roulette, i.e., to put a revolver containing one bullet in the six available chambers to your head and pull the trigger. Each realization would count as one history, for a total of six possible histories of equal probabilities. Five out of these six histories would lead to enrichment; one would lead to a statistic, that is, an obituary with an embarrassing (but certainly original) cause of death.”
What is fascinating is that a positive outcome – in this case surviving the game and receiving the $10 million – can cause many to ignore the extreme risk taken in getting to that outcome. The recipient of the $10 million may be praised and lionized, and the fact that the remaining five alternate histories are unobservable frequently causes them to be forgotten, with the more sinister of the five alternative histories simply being pushed from our minds.
In transferring these ideas to investing, it’s worth trying to assess the risk an investment manager has taken when producing their investment track record. A manager that has taken highly concentrated bets on speculative stocks, benefitting only because the binary outcomes had by chance worked out in their favor, is building their investment returns on a house of cards. At some point the luck turns and this imprudent risk management can blow up a portfolio.
Much like the player of Russian roulette, the more rounds in which this risky behavior is repeated, the smaller the likelihood of survival. Taleb goes on to say “if a twenty-five-year-old played Russian roulette, say, once a year, there would be a very slim possibility of his surviving until his fiftieth birthday – but, if there are enough players, say thousands of twenty-five-year-old players, we can expect to see a handful of (extremely rich) survivors (and a very large cemetery)”.
Rarely do we recall the defunct investment funds that had great potential but fell victim to bad luck, with survivorship bias ensuring that we instead only remember the investors that have had outsized success, irrespective of the risks they took. The key implication from Taleb’s work for investing is that luck washes out over the long term, and it is crucial to focus on what can be controlled: the investment process.
A key tenet to the Montaka approach is to adhere to a rigorous, and sound investment process – we invest in undervalued high-quality businesses, and short businesses using the proprietary Montaka short framework. At Montaka, we seek to above all else to limit downside risk, and are consistently seeking opportunities that can’t hurt us if they don’t play out as expected. Risk, as Elroy Dimson eloquently put it, is the fact that more things can happen than will happen, and we explicitly try to envision the many possible scenarios that could transpire before we make an investment.
In addition to seeking individual investment positions with favorable risk characteristics, the short component of the Montaka portfolio provides downside protection for investors. This is akin to an insurance policy if markets have a downward correction. Whilst a posteriori, frustration may result from paying for downside protection while the market marches upward, it’s impossible to know when a market fall will occur and thus when downside protection is required.
Taleb makes an important point:
“Finally, there is an ingratitude factor in warning people about something abstract (by definition anything that did not happen is abstract). Say you engage in a business of protecting investors from rare events by constructing packages that shield them from their sting…Say that nothing happens during the period. Some investors will complain about your spending their money; some will even try to make you feel sorry: “You wasted my money on insurance last year; the factory did not burn, it was a stupid expense. You should only insure for events that happen…There are some (though very few) who will call you to express their gratitude and thank you for having protected them from the events that did not take place”.
While Montaka has had strong performance, the headline performance numbers that are reported mask the fact that these returns were generated with only approximately 50% exposure to the market. In other words, our investors have enjoyed these solid returns whilst taking far less risk than equivalent returns achieved with a higher net market exposure. Whilst these returns are pleasing, it’s crucial to continually pressure test portfolio positions, asking ourselves what are the alternative histories that could hurt us, in order to continue the strong performance for our clients.
George Hadjia is a Research Analyst with Montaka Global Investments. To learn more about Montaka, please call +612 7202 0100.