Q: What are the important lessons about risk from your book Against the Gods?
A: Two things. First, in 1703 the mathematician Gottfried von Leibniz told the scientist Jacob Bernoulli that nature does work in patterns, but "only for the most part." The other part—the unpredictable part—tends to be where things matter the most. That's where the action often is.
Second, Pascal's Wager [see the box above]. You begin with something that's obvious. But because it's hard to accept, you have to keep reminding yourself: We don't know what's going to happen with anything, ever. And so it's inevitable that a certain percentage of our decisions will be wrong. There's just no way we can always make the right decision. That doesn't mean you're an idiot. But it does mean you must focus on how serious the consequences could be if you turn out to be wrong: Suppose this doesn't do what I expect it to do. What's gonna be the impact on me? If it goes wrong, how wrong could it go and how much will it matter?
Pascal's Wager doesn't mean that you have to be convinced beyond doubt that you are right. But you have to think about the consequences of what you're doing and establish that you can survive them if you're wrong. Consequences are more important than probabilities.
Q: Is Pascal's Wager only a guide for minimizing losses, or can it help you maximize gains?
A: In the late 1950s a grubby-looking guy asked us to take him on as a client. He had a huge portfolio, at least $200,000 on margin in just three stocks—AT&T, [aerospace company] Thiokol and U.S. Steel. He'd been a reporter for the Brooklyn Eagle and lost his job when the paper folded. He'd had $15,000 in the bank plus his wife's salary as a schoolteacher. So he'd decided to shoot the moon. If he lost it all, they'd just go broke one year sooner. But if it paid off big, it would change their entire life. So, for him, the consequences of being right dominated the probabilities.
Q: What happened to him?
A: He came to us because he could not bring himself to unwind the tremendous gains in his portfolio. His wife, meanwhile, had been very calm and supportive on the way up. But now that they had made it big, she was terrified of losing it. So we diversified the portfolio for them. By the way, when I managed money we had clients who saved, and clients who used capital. And I always seemed to find that the ones who spent it were nicer and more enjoyable than the ones who squirreled it away.
Q: What investing and personal advice do you offer your great-grandchildren?
A: As they are four and two (and about three months in the womb), they are not likely to take much of my advice, nor should I be giving them the kind of advice you have in mind. But I would teach them Pascal's Law: the consequences of decisions and choices should dominate the probabilities of outcomes. And I would also teach them about Leibniz's warning that models work, but only for the most part. I would remind them of what the man who trained me in investing taught me: Risk-taking is an inevitable ingredient in investing, and in life, but never take a risk you do not have to take. I guess I would also tell them not to worry if they lose the little gifts Barbara and I give them, because Daddy is there to bail them out. So they should be willing to take big risks with those little gifts. If they win, they will be off Daddy's back. If they lose, well, they are on his back anyway.
Q: You've often written that something important happened in September 1958. What was it?
A: [For the first time in history,] stocks began to yield less than bonds, and it was not something tentative. The lines crossed without any period of hesitation and just kept on going. It was just, zzzoop! All my older associates told me that it was an anomaly and it could not last. To understand why that happened and what that meant -- and to recognize that what was accepted wisdom for a couple hundred years could turn out to be wrong -- was very important. It really showed me that you don't know. That anything can happen. There really is such a thing as a "paradigm shift," when people's view of the future can change very dramatically and very suddenly. That means that there's never a time when you can be sure that today's market is going to be a replay of a familiar past.
Markets are shaped by what I call "memory banks." Experience shapes memory; memory shapes our view of the future. In 1958, younger people were coming in who had a different memory bank. That's also what happened [in 1999] when tech stocks were enormously exciting; most of the new participants in the market had no memory of what a bear market is like, and so their sense of risk was muted.
How strong is the memory of the inflationary nightmares of the 1970s? Anybody under 50 did not really experience it, in the sense that they were [then] too young to be decision-makers. I believe sustaining that memory is more important to the future than all the vivid memories of the bubble and its aftermath.
Sunday, March 2, 2008
Investment advice from Pascal
A bit old, but interesting interview with Peter Bernstein;