Since coming to work for The Motley Fool, I find I've been able to read more. And the more I read, the more interesting connections I find.
I recently finished Robert Rubin's "In an Uncertain World." It's a great account of his life, including his experiences on Wall Street and as Secretary of the Treasury. It was interesting to see where economics and politics intersect, but I'll stick to the investment wisdom in the book. That comes from Rubin's success, which he attributed to good, probabilistic decision-making in an uncertain world.
Before we get into the details, let's introduce another character into the story. While I was reading, my mind kept thinking of Puggy Pearson. You've probably never heard of him. I certainly hadn't until I read Michael Mauboussin's paper, "Puggy Pearson's Prescription: All Any Investor Needs to Know."
Puggy Pearson, PHD (poor, hungry, and determined)
Pearson, who passed away recently, was the polar opposite of Rubin. He grew up very poor in Tennessee and only completed an eighth-grade education. He was a prolific gambler who won the World Series of Poker in 1973. I imagine most of you have never heard of him; he's certainly not the type of personality studied in business school. But if Puggy's wisdom is good enough to help Mauboussin and market-beating philosopher/money manager Bill Miller generate fantastic returns for Legg Mason's (NYSE: LM ) mutual funds, I'll listen. Here's what Pearson has to say:
"Ain't only three things to gambling: Knowin' the 60-40 end of a proposition, money management, and knowin' yourself."
Of course, knowing the 60-40 end of a proposition means understanding the odds associated with the opportunity and making sure they're stacked in your favor. If they're not, you're small-f foolish to play.
Money management, I think, is about risking the proper amount of money based on your assessment of the wager. (If you're interested in another great book that talks about how the Kelly Criterion can help with this task, check out William Poundstone's "Fortune's Formula.") But it's also about making sure no single bet can kill you. Sure, watching poker players go "all in" and double up is exciting. But it happens far too often, in my opinion. How else can contestants get pared down to the final table without losing everything on one hand?
As I've written before, I made a big bet on AES (NYSE: AES ) when I thought it was ridiculously priced by the market, but I didn't put everything I had into the stock. The risk of bankruptcy, while remote, was still very real. I was confident, not stupid.
Knowing yourself can be interpreted in many different ways. I look at it this way: Know and utilize your strengths, and know and overcome your weaknesses. For example, I have absolutely no knowledge of biotechnology, and I have no business messing around with a company like Encysive Pharmaceuticals. But fellow Fool Charly Travers has that expertise, and he used expected value tables (probabilisitic decision-making) during his analysis. I can't compete against that, so why try?
Robert Rubin, former Treasury secretary
Rubin takes every opportunity to teach the importance of understanding probabilities in decision-making -- the 60-40 ends of the proposition. He talks at length about the yellow legal pads he filled with expected value tables when trying to decide whether an arbitrage trade was a good investment while at Goldman Sachs (NYSE: GS ) . Rubin recounts the intricacies of decision-making at Ford (NYSE: F ) when determining what to do about then-CEO Jacques Nasser. He also discusses his time at Citigroup (NYSE: C ) as a member of the office of the chairman, and his role as facilitator to help Sandy Weill and John Reed run the company as co-CEOs. And Rubin used the same probabilistic process when dealing with the currency crises around the world during his tenure in government. Man, would I love to see those yellow legal pads to get a better idea of what was going on in his brain!
Near the end of the chapter called "Greed, Fear, and Complacency," Rubin writes, "In theory, you don't ever want to be in a position where even a remote risk can hurt you beyond a certain point -- and you have to decide what that point is." That's money management, folks. That means betting what you can afford to lose based on the odds, not going "all in" all the time.
And here's the quote that brings Puggy Pearson and Robert Rubin, two very different people, together: "You take yourself with you wherever you go, so you had better know who you are."
Whoa. That's eerily similar. But then again, maybe I shouldn't be too surprised.
"All Any Investor Needs to Know"
Is this really all we need to know? Well, there's plenty to fill in on the way to making decisions, but I think this is a good road map. And here's how we should use it.
- Pay attention to it: Puggy survived using these rules. Rubin rose to the highest executive levels of Wall Street, and to one of the highest levels in government, using his decision-making skills. If you want to improve your portfolio returns, understand what they're trying to teach.
- Use it: If something doesn't look right, or looks too risky, let it pass, even if others are making money. On the opposite end, if you think the market is misinterpreting the odds, get out a yellow legal pad and find a way to exploit it.
- Refine your skills: Take notes like Rubin did. And don't make decisions until you've actually put them on paper. That way, you can see your reasoning in front of you and make sure you haven't missed anything. This also allows you to hold yourself accountable to the decision, because now you have a written record. There's no fooling yourself if the analysis is in your own handwriting.
When I went back over my notes regarding my decision to invest in telecom operator Qwest Communications (NYSE: Q ) , I found little more than speculation. I wrote an article about my decision to sell. More recently, I reviewed my decision to buy shares of growing outdoor sporting goods retailer Cabela's (NYSE: CAB ) earlier this year. I think my thesis is still good, because according to my calculations, its new stores more than cover their cost of capital. But had I been more patient, I could have gotten in at a better price. Again, I put my decisions down on paper and reviewed them, because the last thing I want to do is fool myself into thinking I'm a better investor than I really am.
A winning hand
Pearson and Rubin are as different as night and day, yet these gentlemen have used the same rules to survive and thrive in their very different lifestyles. Do we use those rules at The Motley Fool? We try. Whether in poker or politics, I think they're fundamental truths that can help us become better investors.
For more Foolishness on decision-making:
This article was originally published on September 29, 2006.
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Legg Mason is an Inside Value recommendation. Encysive Pharmaceuticals is a Rule Breakers selection. Cabela's is a Motley Fool Hidden Gems recommendation.
Retail editor and Inside Value team member David Meier loves learning and is thankful he gets to read so much at his job. At the time of publication, he owned shares of AES and Cabela's but did not own shares in any of the other companies mentioned. You can view his profile here. The Fool takes its disclosure policy very seriously.