An Interview With Behavioral Investing Expert Michael Mauboussin

As Managing Director and Head of Global Financial Strategies at Credit Suisse, Michael Mauboussin advises clients on valuation and portfolio positioning, capital markets theory, and competitive strategy analysis. He has also authored three books -- Think Twice, The Success Equation, and More Than You Know -- and is an adjunct professor of finance at the Columbia Business School, and chairman of the Board of Trustees at the Santa Fe Institute.

Mauboussin recently sat down with Foolish analyst Matt Koppenheffer to discuss his multidisciplinary approach to investing, and what investors can learn from poker games and horse races. He shares a multitude of outlooks and tips on valuation, luck vs. skill, competitive advantage, "exotic" investments, the critical distinction between fundamentals and expectations, and more.

A transcript follows the video

Matt Koppenheffer: I'm here today with Michael Mauboussin, Managing Director and Head of Global Financial Strategies at Credit Suisse, also the author of numerous investing books, including More Than You Know, and The Success Equation. Michael, thank you so much for joining me today.

Michael Mauboussin: My pleasure to be with you, Matt!

Koppenheffer: Let me start out ... way back when, when I got my hands on More Than You Know, it changed a lot of the way that I felt about investing. One of the things I thought was really interesting is, you bring a very multidisciplinary approach to investing, and it reminds me a lot of the way Charlie Munger goes about it. Have you gotten a lot of your influence from Munger and the way he approaches?

Mauboussin: Absolutely, and very directly. Of course, I'm a big Warren Buffett fan, I think as most people are, and a Berkshire Hathaway (BRK.A -0.28%) (BRK.B -0.68%) shareholder, but for me in many ways Charlie Munger has been more influential.

I think the metaphor he uses is that of a toolbox. If you have one tool in your toolbox -- say, a screwdriver -- you're going to do a great job with screws, but when you're faced with different types of problems you're unlikely to be as successful. He says, "Build out your toolbox. Learn from different disciplines. Learn the big ideas, so when you're faced with a problem you can go to your toolbox to have the right tool to apply to the right problem."

It's this whole mental models approach, which requires reading across different disciplines. I always like to say, it's obviously fun to do -- there are a lot of intellectual cul-de-sacs -- but when you do face a problem that you've got a solution for, it's really exciting and I think it gives you a really exciting dash of insight.

Koppenheffer: In terms of pulling tools from that toolbox, one of the ones that Charlie Munger really likes, and has emphasized a lot, is knowledge of statistics, and I see a lot of that in your work. Do you think that's one of the key things that somebody needs, to be a good investor?

Mauboussin: I think there's no question. Good investing requires a few basic things -- accounting, understanding core things about business -- but statistics, I think, is incredibly helpful.

And by the way, it's not natural for us. I think most of us really relate much more to stories, and storytelling. As a consequence, if I'm telling you a story it's going to have a lot more salience for you than statistics.

But stepping back, thinking about the use of statistics -- for example, base rates in understanding businesses, what's happened before, what that's likely to mean for what's going to happen in the future -- I think it's incredibly helpful.

You need to learn the basics. You don't have to go to the high, fancy stuff, but just the basics can be extraordinarily helpful to clarify your thinking, in thinking about the future.

Koppenheffer: Going from there to what you were just talking about with storytelling ... there's a lot of story stocks. There's a lot to understand the narrative part of a business and a strategy. What are some ways that investors can avoid going into pitfalls by following that narrative part of the story?

Mauboussin: One of the constructs I love the best on this is what Danny Kahneman calls "the inside versus the outside view." When you're faced with a problem, all of us -- for example a stock or an investment idea, or even planning into the future -- the natural way for us to think is to gather a bunch of information, combine it with our own inputs, and plan into the future. And stories can be very powerful in developing that theme.

What he argues is better, is something called the outside view, which is saying, "Rather than thinking about my specific circumstances in this story, let me think about this as an instance of a larger reference class. What happened when other people were in this situation before?"

You might say of a story stock -- there are some explosive growth expectations -- you might say, "Are there other story stocks that were in similar situations before? What happened? How did the movie end?" This idea of the outside view, I think, can be very useful in tempering, especially the enthusiasm for these kinds of things, by referring to base rates.

That combines two things. One is the behavioral stuff, and also appealing to statistics, to some degree, to help inform your view.

Koppenheffer: A lot of your more recent work has looked at the difference between skill and luck in everything from sports, to investing, to business. When you're thinking about being an investor, and building skill as an investor, one of the things we've heard -- and Malcolm Gladwell has talked a little bit about this -- is 10 years of deliberate practice. What are ways that investors can go about doing deliberate practice, and gaining that experience?

Mauboussin: This is a super interesting question, because I actually think the deliberate practice model can be somewhat misleading for investing -- or really, any exercise that's probabilistic.

What's the key for deliberate practice? It works in domains where your outcome is very indicative of your skill. If I want to know if you're a good tennis player, Matt, or a good piano player ...

Koppenheffer: To answer the question, I'm both!

Mauboussin: I can watch you or listen to you and, if I know what I'm doing, I can judge that. In fact, as you progress -- if you have a good coach or teacher -- they can help you get better. That's where the deliberate practice, the 10,000-hour stuff, really works well.

But as you slide over and introduce more luck and more probabilities, it becomes much more difficult.

I'll give you a very simple example. Let's say now you go to Atlantic City to play blackjack. Well, there's standard strategy, and you could play correctly and lose for a short period of time, or you could play foolishly, and win. There's a disconnect between, in a sense, your skill and the outcomes.

As a consequence, what I argue is, you need to have a process. For me, an investing process -- to your point -- has three specific components.

One, let's call it Analytical, which is being able to analyze financial statements, understanding future cash flows ... all those sort of analytical tools that we all need to succeed.

The second I'm going to call Behavioral, which is, we all tend to fall for certain types of mistakes, patterns of mistakes. Learn about those things and trying to manage or mitigate them yourself.

The third I'm going to call Organizational. It may be less relevant for an individual -- although it has some applicability for an individual as well -- but certainly organizationally. What's going on in your company, or in your environment, that allows you to be either more successful or less successful?

All three of those factors I think are really important. What you want to do is be as effective as you can across all those. Be a good analytical investor, minimize your behavioral mistakes, and then be in an environment that's conducive to making good long-term decisions.

Koppenheffer: The process versus outcome that you talk about, that was one of the real "eurekas" that I got from a lot of your work. If those are the tools that you need to build your process, what's the best way to go about evaluating your process, once you have a process in place?

Mauboussin: Extremely difficult, but there are certain things you want to look for. One is that it's something that you can repeat over time; the idea of reliability, that it can be repeated. The second is, you want to make sure that it's economically sound, so we know that it's based on some foundational things that are very good.

Those, to me, are the main things to be looking for. Then you want to keep track of the kinds of decisions you've made, so you can see how effective you've been.

For example, I'm thinking about a stock and I think about probabilities of outcome. I might say, "There's a small chance something good will happen, an average chance not much will happen, and there's a small chance something bad will happen." Do that over time, for lots of different stocks, and keep track. It will give yourself quality feedback about how good you are, and how well-calibrated you are at making those kinds of judgments.

It's a tricky one to answer. I think evaluating processes in investing is a difficult thing to do, but a couple things on reliability, on economics, and keep track and monitor yourself, and give yourself that kind of feedback.

Koppenheffer: Keeping an investing journal would be the kind of thing that would help you out with that.

Mauboussin: An investing journal actually doesn't take much time, but it does take a fair bit of discipline. I think if you do one of these things, it's a little bit disconcerting because you look back in your journal and you start to realize ...

Koppenheffer: You see what you don't want to see!

Mauboussin: Yes. "Could I have believed that before?" Because the natural thing for all of us is that, once the world unfolds in front of us, we have hindsight bias -- which is that we start to believe that we knew what was going to happen with a greater probability than we did.

The second thing that happens is called creeping determinism, which is you start to believe that what happened is the only thing that could have happened. The reason is, you now have the facts, so your mind is quick to put it all together.

Fighting hindsight bias, fighting creeping determinism -- an investment journal is really effective in doing that. Also, as I mentioned before, it helps you understand how well calibrated you are. If you think a high probability event's going to happen, if it happens a lot, then you're pretty well calibrated. But if you say something's only going to happen 20% of the time, it should happen one out of five times.

Keeping track of those kinds of things takes a little bit of discipline. It doesn't take a lot of time or cost, but it takes discipline, and I think it can be extraordinarily helpful.

Koppenheffer: You just mentioned blackjack a little bit, before. In some of your recent work, you talked about people playing poker and finding the right venues to play poker. It reminded me that, when I've done well playing poker, it's generally been in off-strip casinos! Now, I'm not a very good poker player, so that's mainly why.

In terms of finding the pools that investors can fish in, you talked about where institutional investors might want to look, which makes sense given your position. Where might individual investors want to look, if they want to try to gain an advantage?

Mauboussin: Really, you want to go where you think fewer people are participating, or people that are not as skillful as you are. That's the basic idea. It's actually a very difficult game to play.

I'll tell you a quick story on this, because I love this. Where I got this idea, or it crystalized for me, was a guy named Jim Rutt, who used to be the CEO of Network Solutions. He talked about playing poker when he was a young man.

Koppenheffer: He's probably a lot better than I am!

Mauboussin: By day, he would learn about the different probabilities, and look for poker tells and pot odds, and all this stuff, and by night he would play. He played in progressively tougher games, and won some, lost a little. Eventually, his uncle pulled him aside and said, "Jim, it's time to be less worried about getting better, and more worried about finding easy games."

This is a really important lesson for investors, because there are two key things. One is basic proficiency -- some of the things we talked about in terms of process a moment ago -- the second is finding those games.

There might be other things that might be interesting. For example, less-developed markets; emerging markets or even frontier markets might be an interesting example.

Frontier markets are a place where it's not big enough for institutions to participate, really, because there's not enough scale for it. But that might be a place where an individual might be able to make it worthwhile.

Some areas like that. The other one I'll say -- it's a tough one to find, though -- is when there are institutional constraints; when people are doing something on the other side of the trade because they have to. They have to, or they want to.

One example is spinoffs. Spinoffs -- there's nice literature on this for 25 years -- often, big institutions just sell off the spinoff components they get in their portfolios. They want nothing to do with them. They're often small, a little bit messy. That also might be something that might be an interesting opportunity for an individual to say, "I can step into that, get on the other side of those big institutions, and actually do well." There's some good evidence that, over time, spinoffs have been a very nice, profitable strategy.

Koppenheffer: In a recent piece of yours, you broke apart the two main components of price to earnings ratio, the P/E ratio that everybody talks about. One of the things that you said was that a lot of investors don't use discounted cash flow models, which is a way to value a stock.

Just about everybody uses the P/E, but they're not really using it correctly. Can you explain that a little bit?

Mauboussin: Sure. The first thing I'll say is, the value of any financial asset -- whether it's a bond or a stock or real estate, it doesn't make any difference -- is always the present value, future cash flows. I don't think anybody would disagree with that. It's very foundational.

Yet, in the investing world, the equities world particularly, we use a lot of shorthand as you pointed out. Price to earnings multiple; price of the stock, divided by earnings -- usually next year's earnings -- that's a shorthand that almost everybody uses.

Sometimes, a little more sophisticated, people talk about enterprise value, the EBITDA; earnings before interest, taxes ... the same basic concept.

The first thing I'll say is, these are shorthands for the actual valuation process. They're not valuation. They're shorthands for the process. What's good about shorthands? They're quick. What's bad about shorthands? They sometimes have biases.

What I want to do there is say, let me just take a big step back and say, if you're thinking about a P/E multiple, what is really foundational here? What do we really know?

I went back to the most seminal paper on valuation, written by two academics in the 1960s, where they said, "You could think about the value of a business in two pieces."

One is what they called the Steady State Value. This is what the business would be worth if they had the current earnings today, and did it forever. One way you might think about that is, let's say McDonald's (MCD -0.05%) never built a new restaurant. The restaurants they have today are all you'll ever see. What would that be worth? They can earn what they're earning now for a pretty long time.

The second component these academics talked about was what they called Future Value Creation, which is the investments that will earn excess returns in the future. In the McDonald's example you might say, "These would be the stores they will build in the future, that will create value."

Both of these things, together, is the total value of the company.

What's cool about this is that we can take the Steady State Value and then we can figure out the P/E multiple that should be attributed to that piece. Then we can figure out, if the P/E is above that, what is being attributed to the future.

To be concrete, roughly -- on current interest rates and equity risk premium -- the base steady state P/E multiple is about 12.5x. So, if you are looking at a stock that's trading over 12.5x, what that implies is you're paying something for future value creation. Then the question becomes, how much are you paying? Is that a reasonable thing to pay?

I just think it's an extraordinarily useful framework for thinking about what those P/E multiples mean, and the relative contributions from what we've got in the bank, versus what's on the come.

Koppenheffer: In terms of valuing that growth component of it, that's where interest rates can come into that, and all that kind of stuff as well, so you've got a lot of different moving parts in there as well. Is that correct?

Mauboussin: The value creation piece, there are really three big things. Things like interest rates and equity risk premium are very difficult to predict, so the three big things are:

One, what will the returns be on incremental investments? Am I going to invest in something with very high returns, market returns, or below the cost of capital returns?

The second component is, how much money can I invest? Sometimes you can have small spreads above the cost of capital but you can do a lot. Other times, you have high spreads but you can't do that much, so how much do you invest?

The third component is, for how long you can find investment opportunities? Because it's a finite world, and there's a lot of competition. The idea is, how long can I find investments that are profitable in this way?

Return on invested capital is the first component. The second component is the amount of investment, and the third is this time horizon component. Those are the three things that comprise that present value, future growth.

Koppenheffer: I focus a lot on financial companies and banks, and usually in that sort of thing there is a disclaimer of, "For non-financial companies." Would this same kind of analysis work for a bank or a financial company?

Mauboussin: It would, yes. I usually put those disclaimers in, myself!

I think, for banks, we tend to use less P/Es -- well, you're the expert, not me -- but less on multiples, and more on things like price to book. The reason is because book value for a bank is market-to-market, so you presume that that asset value is something that is current in terms of the values.

But the ideas are the same, no question. Same thing; banks have current activities. If they keep doing them, what are the things they can do in the future? That could be expanding, for example, your retail bank franchise, it could be expanding your loan book in some other part of the world, what have you.

Those concepts would still apply; maybe a little trickier, but I think they would apply.

Koppenheffer: Just while we're on the subject, that disclaimer in general ... in thinking about a bank or a financial company, is it that much different? Thinking about a guy like Buffett -- Berkshire owns Wells Fargo (WFC -0.56%) as its biggest holding -- and he's thinking about that in terms of its franchise value, so there is an overlap with something like a McDonald's.

Mauboussin: No question Matt, and I would just say, going back to first principles, present value, future cash flows -- that, we can say, is fairly universal; any asset class, any sector of the economy, what have you, so you're right.

I think that the reason we often say the disclaimer is because the nature of the accounting is slightly different, and the role of debt, for example, is quite different. Debt is often considered to be almost like a raw material for a bank.

Typically our cash flow model is, instead of a free cash flow discounted back to the firm value, for banks or insurance companies it's usually equity cash flow that's discounted back to an equity value. So, there are some differences in the details, but the basic concept, the big picture concept, absolutely is the same thing.

Koppenheffer: As long as we're on Buffett ... moats. Can't talk about Buffet without moats!

You had a great piece recently on evaluating moats. One of the things you did was break it down into three component parts. This was for competitive advantage. There was the process advantage, the consumer advantage, and then -- I forget what you called it -- but it was the government advantage, basically, if there's a government protection there.

Can you explain the basics of these, and how they give one business an advantage over its competitors?

Mauboussin: Sure. There might even be an easier way to say this. It would be, work done by Michael Porter -- and I think most of these people sort of align to the same thing -- Michael Porter says there are two generic ways to get a competitive advantage.

One would be low cost producer, and we call that a process advantage. Low cost producer means, "We can produce this good or service cheaper than everybody else, and it's of reasonable quality" -- so it's not like it's totally horrible -- and we can go into the market that way. When you think about low cost producers, you typically think about things like Wal-Mart (WMT 1.32%) in retail. You might think about Southwest Airlines (LUV -0.54%) in airlines -- people coming in that way.

By the way, just to be a little sophisticated for a second, often the way they do that is by having very rapid capital velocity, so they're not making a lot on margins, but they're able to use their capital very efficiently.

The second generic way to get to competitive advantage is so-called "differentiation." That means you have typically higher than average prices, and you're OK on cost, but your key is that you're differentiating yourself. You might think about luxury goods, for example.

Koppenheffer: Tiffany (TIF). That's the first thing that popped into my head.

Mauboussin: Tiffany should pop into your mind. You think about luxury automobiles, or what have you. They're charging a higher price, you're willing to pay it for whatever reason. Again, their costs have to be competitive, and that can allow them to satisfy this interesting niche.

Those are the two generic ways to get competitive advantage.

One of the things I'll say as an interesting side note is, technology seems to be coming along and busting a lot of this stuff. It used to be the case that you'd want to be one or the other, but now companies are coming along and they're actually quite effective on a number of fronts.

Technology is allowing companies to deliver goods or services in a very customized way, which would be consistent with the differentiation strategy, and do that on a very low cost basis. You may think about a retailer like Amazon.com (AMZN -1.64%). We were talking about books before we came on the air, but these guys know pretty well what you like to read, and what you're likely to read next.

Koppenheffer: They know better than I do, I think!

Mauboussin: They often know better than you do, and they can deliver it to you very cost effectively, either electronically or even in a physical version. That's also a very interesting set of developments, is how is technology even affecting these two typical categories that we talk about for competitive advantage?

Koppenheffer: Then the third bucket; the government bucket, if it's an industry or company that's protected by regulation or something else like that. Just from your perspective as an investor, is that an advantage that you'd want to rely on, versus the other two? It seems maybe less durable.

Mauboussin: Yes, I would feel less comfortable with it. Now there are some categories -- things like patents -- where patents were explicitly set up as a way to compensate people for taking risks ...

Koppenheffer: That would fall into the government bucket.

Mauboussin: That would be sort of in the government bucket, and licenses, and those kinds of things.

But to your point, whenever you have things that are related to government actions -- on taxes, or what have you -- you have to be very careful because, obviously, you're subject to the vagaries of government policies and the whims of government policies, to some degree.

So, yes, patents are obviously fine, but I'd rather see less of that aspect as a main driver of your investment thesis, and more one of those two generic strategies we talked about.

Koppenheffer: Another one of your recent works regarded forming good teams, and well-functioning teams. One of the things that I was just thinking about, from a bigger-picture perspective, is for an individual investor, for instance, is it wise to have a team investment approach? To have people that they're sharing their investments with, helping them make those investment decisions, or are they better off on their own?

Mauboussin: It depends!

That's one of those classic "it depends." There's actually been a really nice amount of work done on investment clubs. It's a little bit further than just having a bunch of people, but investment clubs. That work was done by Brooke Harrington.

What she found in studying this is that all-men groups and all-women groups didn't do as well as combined-gender groups. The premise behind that was that these combined groups were able to extract more diversity. They were able to get more differing points of view on the table, and that actually really enhanced their decision-making.

Going back to your question, the key to an effective team is to have diversity of thought, cognitive diversity; and to allow that diversity to rise to the surface, so it's not just having the information, but also talking about that information.

If you can find some friends, as an individual investor, who can help counterbalance you -- when you're overly optimistic to bring you down a little bit, when you're pessimistic to bring you up -- that can be extremely valuable.

Now, there's also evidence -- and there have been studies of this -- that some people can do this themselves, in their own head. They have the little diversity in their own minds. They've got their own movies playing.

But the idea is this notion of diversity is clearly what is the essential ingredient to making those good decisions, so whether you can generate it yourself -- that's awesome -- but if you need to, or you can, tap into another group of people to help you do that, that too is great.

Koppenheffer: But finding a bunch of people that agree with you already is probably a bad idea.

Mauboussin: Not probably -- it is a bad idea!

Koppenheffer: It's a very bad idea!

That hits, again, on the behavioral mistakes people make. When I read More Than You Know -- that was 2006, right? To me, that was one of the first books that, for me, brought the behavioral part to the fore. There was a lot of academic work done before.

Do you think, between then and now, the wave of behavioral investing books and knowledge that has come to the market, has that helped people, or are they still making the same mistakes?

Mauboussin: It's a super interesting question, and I think that the jury's out on that. Clearly, more people are aware of these behavioral issues than they were, as you pointed out, even 10 years ago, and certainly 15 years ago. But it's not crystal clear that that's helped people make better decisions.

Even in organizations where you talk about these ideas, unless you really have specific ways to manage these problems or mitigate these problems, the knowledge in and of itself, or even the language in and of itself, doesn't appear to be all that you need.

I think that's actually a bit of a frustration of a lot of these pioneers in decision-making and even the behavioral stuff, which is they've been able to unearth all of these very interesting issues -- and I think they genuinely want to help the world -- but they've struggled.

Now, there's one area where it seems to have worked quite well, and that is this work on choice architecture, Nudge. Cass Sunstein and Richard Thaler wrote a great book on this. Even in some public policy practices, they've been able to implement defaults, for example, that tend to be good.

Even in my company -- and I suspect many other companies are like this -- there are defaults now for how much you save. It goes into your 401(k), and those defaults are set quite high so if you do nothing, you're going to save a lot, which is probably a good thing. Only by telling them that you don't want to save so much, will you come off of that number.

Those are the kinds of things that are almost ingrained into the system, that I think can be very helpful. But for our day-to-day in our own organizations or as individuals, I think the jury's out that it's really ... the awareness is up, but I'm not sure it's changed behaviors meaningfully.

Koppenheffer: Is that the kind of thing that could be helped by a checklist or is it still, the checklist could be there, but your brain just overrides it?

Mauboussin: I think there's no question a checklist helps. I guess the evidence for that is, wherever checklists have been implemented with fidelity, they've improved outcomes.

Clearly, you would never get on a plane -- I don't think any of us would want to get on a commercial plane -- without the pilot having gone through his or her checklist in great detail. That is now much more prevalent in medicine. Certainly, even before any sort of procedure or operation, those checklists have been very, very effective. We've seen incredible, and fairly recent, case studies on how that's worked.

The world of investing is a little bit more tricky, because it's not as procedural. If you're a pilot, there are certain procedures you need to go through, and it's going to be pretty much the same every single time. Medicine, certain setup things will be very procedural.

But investing is a little bit less like that. There are areas I still think checklists can be very, very helpful, but perhaps the utility is not quite as clear or high, so that's why I don't think it's been a widespread thing.

But in my investment firm, we always developed checklists to make sure that we were doing things methodologically correct. I think just that step can be very useful for people.

Koppenheffer: And that can at least let you go back and evaluate it more easily in the future.

Mauboussin: Absolutely.

Koppenheffer: In terms of setting up that process -- particularly, again, in terms of investing -- a lot of it boils down to figuring out what matters. In your experience, what does matter for investors? Are there particular numbers that matter more than others? Should investors be listening to conference calls? Reading press releases? What is it that does matter?

Mauboussin: I think that the number one thing I would always say to everybody -- and I think this is the biggest mistake that people make -- is to always focus on the distinction between fundamentals and expectations.

These are two very different things. If you want to say it, fundamentals would be value, and expectations would be price. These are very distinct things, and I think great investors understand they're distinct.

Let me use, for example, a very easy metaphor to make this clearer. If you're a handicapper -- you bet on horses -- there are two things that are relevant.

One is the odds on the tote board, and those odds express very directly and clearly the probability of the horse's success in that particular race. The second thing is the fundamentals, which is how fast the horse is going to truly run in that particular race. That would be the horse's prior track record, the track conditions, the jockey, and so on and so forth.

Now it turns out, if I tell you the winner of every race, it doesn't make you money because it's all priced in. It doesn't make you money. The way you make money in horse racing is finding differences between expectations and fundamentals -- what the odds and tote board said, and how fast the horse is going to run.

That mind-set can translate right over to the world of investing. The key question you're always asking is, what's reflected in the stock price, and is the reality going to unfold in a way that's different than that?

All the things you described -- certainly, numbers can help give you some guidance on that -- but just be clear, the investment community is replete with noise, as well; lots of idle chatter, lots of talking heads that really don't make that much of a difference.

If you stick to this; my main thing is fundamentals versus expectations. When our expectation is running way head of what's likely to happen -- or way behind -- those, I think, end up being the most fruitful investments.

The last thing I'll say on that, it is often the case that when everybody is euphoric, you should be the one that's more concerned, and when everybody is scared is when you should be a little bit more optimistic -- and that's a very, very difficult thing to do, emotionally. Intellectually, you maybe can do it, but it's very difficult to do emotionally.

To me, fundamentals/expectations, and then getting into the mind-set of saying, "I'm going to try to do it differently than everybody else is doing."

Koppenheffer: Now I've got to ask this, since you brought up horse racing. I've done a little bit of that. I lived in Las Vegas -- you have to!

One of the things that I've read is that, because of the way the betting happens on the horse tracks, going into the exotics, where there's more uncertainty, there's more potential for money to be made, versus just betting a straight win bet, or a show bet, or something like that.

Taking that over to investing, is there reason for investors to go beyond just buying a stock -- going into options, going into stuff that's more exotic -- to look for better opportunities?

Mauboussin: Super interesting question. By the way, I was looking at this not too long ago and, in the 1970s, like 75% of all bets were win, place, show bets. They were just plain vanilla bets, and that's really changed quite radically in the last 20 or 30 years. Now, most bets are exotic bets.

But there's an interesting feature about exotic bets that's important to underscore. It's that, even when you make those successfully, you lose a high percentage of the time. But when you win, you win a lot. It's this very different payoff scheme, which is you lose, lose, lose, lose, and then you make a lot.

Psychologically, that's very difficult for people to deal with. I think for the average person, it's very difficult. I think the sharp handicappers can make a living betting the exotics, but it's very difficult for the average handicapper.

Moving over to the world of investments, look. My attitude is, for most investors, keeping it simple makes the most sense -- which is having a diversified portfolio that's relatively low cost, and rebalancing. Those are the things that actually probably make the most sense for most people.

Now, if you have time and attention, and some proclivity to do this, you might be able to use some sort of strategies that are options strategies and so forth, but for me, wandering too far away from that core ... I guess it depends what you want to do, but wandering too far away from that, the payoffs don't seem to me to be too exciting. I would probably ...

Koppenheffer: Stick to the ... it's hard enough, within just ...

Mauboussin: It's hard enough. Again, even following basic principles, it's hard enough.

One of the things I will say -- and I call it the most depressing statistic in investing -- is that you look at the market over, let's say, the last 20 years for the S&P, it's up about 9% or so. And the average mutual fund is up 7.5% or so; the difference being, primarily, fees. But the average investor has only earned about 6%.

It doesn't seem to make sense at first blush -- 6% when they're investing in mutual funds -- but the answer is, it's because of bad timing. They're putting money in at the top, and they're pulling money out at the bottom.

Say 6 over 9, so their earning ... call it 60-80% of the market returns. You compound that over a generation or two ...

Koppenheffer: It's huge.

Mauboussin: It becomes very substantial. To me, if you say, "Where are my opportunities?" rather than saying "I'm going to get fancy with exotics," it's saying, "I'm going to try to get rid of that behavioral mistake, and that 150 basis/2 percentage points of performance," and by staying the course get much closer to the market's rate of returns, and let that compound.

That's going to be a much more fruitful, and I think much more powerful way to get to your financial objectives.

Koppenheffer: That compounding notion is so huge. Buffett loves to talk about that. I was looking back over the last 100 years of returns the other day, and I wasn't thinking, and I did the calculation without adding back dividends.

I kept going over the numbers again and again and saying, "This just doesn't look right. This looks way too low." I added back in the dividends, and it was much larger. The effective dividends over the past 100 years has been huge.

Now, is that because they're dividends, or is that just a capital allocation decision, that the returns would have been relatively the same, regardless?

Mauboussin: Matt, this is a huge question. I think a lot of people are very confused about this concept. Just to be clear, as you pointed out correctly if you look at the returns for the market, say the S&P 500 over the last 100 years or so, it's probably been, on a real basis -- that means after inflation -- sort of 6-7% range. But if you take it before dividends, it's something like 1-2%, so it's a massive difference.

I'm going to make sure I say this correctly. If your goal is capital accumulation, which is gathering lots of money, the only thing that matters is actually capital appreciation.

If your goal is capital accumulation, the only thing that matters is capital appreciation. Let me try to unpack that a little bit. You have a stock that trades at $100 a share, and it pays a $3 dividend. What happens? Well, the day it goes ex-dividend, you now have a $97 stock and $3 in cash, in your dividend.

What you need to do then is, you have to reinvest that dividend back in to make it $100 again. As a consequence, if you keep reinvesting your dividends over time, it is the price appreciation that accumulates your capital.

Now, for that comparison of reinvesting dividends and not reinvesting dividends, there's something we leave out of that, which is that people can consume. In other words, the difference between 6% dividends is because I'm consuming. I'm getting money, and I can go spend the money, so there's utility in that. So that's really not such a fair comparison.

The point being -- and I think this is a big point -- is very, very few people ever earn total shareholder returns. First, most people don't reinvest their dividends. Second is, there's tax on dividends, and third is going back to our behavioral mistake.

The question is, how do I get as close as possible to earning the total shareholder return for the market? The answer is, automatically reinvest your dividends, do it in a tax-efficient fashion, and dollar-cost average, or have some way to be investing methodically, versus getting emotional and pulling money out and putting money in at peaks and valleys.

Koppenheffer: Then, looking at a specific company, it's not necessarily a bad thing if they don't pay that big dividend -- and I guess that partially goes back to what you were talking about, about investment opportunities within a company.

Mauboussin: That's a great point, Matt. That's the thing. If they're not paying a dividend or repurchasing shares, what are they doing with the money? If they're investing it at a very high rate of return, more power to them.

Koppenheffer: Like Buffett.

Mauboussin: That's what we want. But if they can't, then it's perfectly reasonable -- and I think even appropriate and maybe responsible -- for them to give the money back to the shareholders. The reason is, of course, you in turn can take that money and invest it in something else if you so choose.

By the way, buying back stock is tantamount to paying a dividend, because you can sell. It's interesting; when a company buys back your stock, if you do nothing, it's actually an act of decision, because you're effectively increasing your ownership stake in the company. You can create a synthetic dividend by selling the same proportion as they're buying back, so you'll have a little cash and you'll still have the same proportion of the company. Then you could take this money, you can reinvest it or do whatever you'd like.

But that is an important consideration in the buyback dividend debate is, does the company have investment opportunities they should be funding, or not? By the way, some of the problem is we have some of these companies that are earning so much, they're building up these huge cash balances. They can't even find things to do with the money -- some of these big technology companies, for instance.

Koppenheffer: Just spitballing, would the right thing be for them to start distributing that, if they don't have the place to put it?

Mauboussin: I think the answer is yes, and I think there's been a lot of pressure for them to do that. Slide the money back into the capital markets, and let the capital markets reallocate it if you can't do something with it.

The idea there is that markets are pretty good at figuring this stuff out. It's not perfect, clearly, but pretty good at this. The question is, this company that's sitting on a lot of cash, is there an investment opportunity that's being starved now, as a consequence, if that money went back in?

I think from a systemwide point of view, that discipline of returning cash to the capital markets makes enormous amounts of sense.

Koppenheffer: Finishing off from a very, very big-picture perspective, skill versus luck, and thinking about investing in terms of investing in stocks -- as pieces of paper, the things that trade back and forth every day -- versus businesses, and evaluating a business, evaluating the fundamentals. Reading all of your work, it seems like there's no competition between the two.

Mauboussin: No competition. You want to clearly be the person who's thinking about a stock as a percentage ownership of a business. You really want to say, "I'm a proprietor to this business. How do I think about it from that point of view?"

That requires you to think carefully about the business itself. It requires you to think carefully about the prospects for that company, the competition for that company, and ultimately the economics of the business.

You get much less focused on the day-to-day movements of the little ticker symbols, and much more focused on, "Is this company building value over time?" with some confidence that that value will be ultimately reflected in the stock.

You get away from the day-to-day noise, focus on the business, and focus on value creation. I think it extends your time horizon, which I think is very healthy, and it gets you to focus on the real right drivers of value.

Koppenheffer: Great. Michael, thank you so much for joining us.

Mauboussin: My pleasure, Matt, thanks.