This article was originally written by Dave Meier, and the words below reflect his tone.
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, about 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.
As I was reading, I kept thinking of Puggy Pearson. Perhaps you've heard of him? I 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 eighth grade. He was a prolific gambler who won the World Series of Poker in 1973. He's not the type of person 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
"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. (Another great book that talks about how the Kelly Criterion can help with this task is 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 do 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
Puggy's advice about knowing yourself can be interpreted in many ways. I look at it this way: Know and use 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 does have that expertise, and he used expected value tables (probabilistic 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 he was deciding whether an arbitrage trade was a good investment while at Goldman Sachs
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."
"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 to 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 your ideas on paper. That way, you can see your reasoning in front of you and be 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
A winning hand
Pearson and Rubin are as different as night and day, yet they used the same rules to survive and thrive. Do we use those rules at The Motley Fool? We try. In poker or in politics, they're fundamental truths that can help us become better investors.
For more Foolishness on decision-making:
This article was originally published on Sept. 29, 2006. Check out our entire series on special-situations investing.
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Mike Kasprzyk updated this article which was originally written by David Meier. Mike does not own shares in any of the companies mentioned. Legg Mason is an Inside Value recommendation. Encysive Pharmaceuticals is a Rule Breakers selection. Cabela's is a Motley Fool Hidden Gems recommendation The Fool takes its disclosure policy very seriously.