Anyone familiar with Warren Buffett’s views probably knows he thinks volatility is not a good measure of risk. Yet it is used by millions of finance professionals and is taught in universities around the world. So what can we learn by Steel manning this argument as value investors?
Assuming that the market is mostly efficient, the degree of historical volatility expresses how agreeable market participants are about intrinsic value. If there is a lack of consensus on a subject by informed/experienced observers, it means there is likely a higher degree of uncertainty as to what the answer is (in this case the asset’s intrinsic value). For example pre revenue biotechs trade a lot more volatile than a company like Pepsico, or a US government bond. And I am sure that Warren Buffett would agree that pre revenue biotechs are in fact more risky.
But for volatility to work as a risk metric, most of the market needs to NOT believe in it. Most of the market needs to actually do fundamental analysis and come up with their own valuation. And measure the degree of risk by how far over or under the asset is trading from its intrinsic value. These fundamental investors form a market together and all their opinions are expressed in price action and order books.
You could say that looking at volatility is a derivative way of measuring risk. It is a bit parasitic because the market will become less efficient when the majority starts using this as their main risk metric. In contrast, figuring out the delta to intrinsic value of an asset while ignoring the market, is a fundamental way of measuring risk.
Business schools are dominated by efficient market theorists so they mostly teach the derivative way. I suppose they hope that pure greed will balance things out? Most professors leave fundamental risk measurement to small groups of mythical sorcerers high on a mountain somewhere. Word on the street is that if students want to know more about this dark art, they have to face a windowless dorm room mirror and say “mental models” 10 times in a row. A hunched over pale creature with a can of diet coke in one hand, and a stack of annual reports in the other will then appear. He will yell at you to just read “the intelligent investor” and drop out of business school to do something useful like becoming a plumber instead before disappearing again leaving a trail of peanut brittle. Only to briefly reappear to proclaim that you will probably fail and should give up now before it is too late.
No wonder then that nice, clean and simple metrics like volatility, beta and ev/ebitda are more popular.
What’s interesting is how widely applicable this concept of fundamental vs derivative is. Science for example can be seen through this lens. Trying to find statistical correlations is a derivative way of doing science while finding causation (gaining an understanding in the underlying mechanism and inner workings of a subject) is more fundamental. The latter being a lot harder, but also having a higher pay-off. Einstein’s theory of relativity gave us a more fundamental understanding of nature while Clair Cameron Patterson discovered through statistical analysis of water and ice that lead levels were rising much much too rapidly right as leaded gasoline became widely used.
Both were very important, but Einstein will be remembered for longer. And pure mathematics is of course the ultimate fundamental intellectual endeavour.
Trying to build a billion $ business, solving an open Math problem, writing a constitution or creating a groundbreaking piece of art is more fundamental than being a doctor, divorce lawyer or a corporate website designer. A clear manual exists for the latter, not so much for the former. If this manual is more complicated it leads to higher prestige and earnings. But the reward will still be capped. A more fundamental approach to life often leads to failure, but when successful might result in a major breakthrough, potentially creating a massive fortune, greater satisfaction and possibly even your own wikipedia page.
When passing judgement on someone based on what others are saying, that is derivative, while trusting your own experience and assessment of a person (possibly going against negative stories from others) is more fundamental. But of course it also requires spending more time with that person to have the required information.
Fanatics who adhere to some niche (version of a) belief system are called fundamentalists, and putting the word religious in front of it gives it a negative connotation.
The derivative approach typically offers a shortcut. It relies on the collective brain power of others to do most of the hard thinking, or simply allows one to gain insight in a subject that is too complex/large to gain a fundamental understanding in (like the human body) by statistical analysis. It is also useful when doing something that has been done many times before, while a more fundamental approach is required when dealing with a unique and novel situation. Say for example predicting the odds of a Dermatology drug being approved using base rates vs the odds of a nuclear war happening. I would say that the vast majority of activities and thinking that goes on in the world leans towards the derivative as most people reason by analogy or use statistics.
There is a cyclicality to it. When too many people take a derivative approach it creates low hanging fruit for a more fundamental approach. In the corporate world as a company is overtaken by the MBAs, it usually strays more and more towards a “safe” derivative approach. To squeeze more and more money out of products and services that some geniuses in a backroom have created who didn’t care that much about monetization and might not have the greatest social skills.
When that inevitably stops yielding results the suits go to the few knowledgeable engineers still working there for new ideas. When those engineers are out of ideas they go to the scientists, and when the scientists are out of ideas they go to the mathematicians (I will let you guess where politicians rank in this hierarchy). Often the company starts imploding before they can turn around as they will have an increasingly difficult time attracting talent. As a more nimble start-up will have taken their place. And in case of success, the MBA’s will run away with the profits.
Case in point the invention of the blue LED: Shuji Nakamura who was working for the Nichia corporation in the early 90’s. Nobuo Ogawa, who was the founder of Nichia and who made his company succesful by taking sizeable fundamental risks and not going with the safe and proven approach. He allowed Nakamura to go to Florida to do research to find a way to make a bright enough blue LED light, which no one had been able to do so far.
In a lot of ways Nakamura took a highly unusual path. Instead of going with the more promising Zinc Selenide route he went with Gallium Nitride. At a large applied physics conference the former approach had over a 100x as many talks compared to the latter. And due to his lack of credentials, he had to build his own MOCVD machine (used to make the materials for a potential blue LED) in Florida up almost from scratch. As he was not allowed to use the existing ones.
Then when Nobuo Ogawa resigned and his son in law became CEO, he tried to force Nakamura to go the safer Zinc Selenide route. Nakamura repeatedly ignored him and because of his now intimate knowledge of his MOCVD machine he was able to modify it to his needs and this allowed him to make more precise changes which led to the creation of powerful blue light LEDs.
And for his achievement he got paid a $180 bonus (yes that is not a typo) despite his company reaping enormous profit growth from his breakthrough. And a nobel prize in physics much later. And it only went downhill from there between Nakamura and Nichia. He actually moved to California and founded a nuclear fusion company a year or so ago.
Of course it is tempting to see Ogawa’s son in law as a villain here, but it is good to remember that survival bias is at play here. In most instances the scientist would look like a crack pot in hindsight and the boss would end up looking like the sane one. Yet despite that it is better for society to have seemingly too many potential crackpots trying crazy things rather than too little.
One is not necessarily superior to the other though. It would be foolish to take a completely fundamental approach to life. Take for example estimating the risk of flying. You could try to gain a deep understanding in aerospace engineering to find out how safe flying exactly is. But obviously this would not be very practical as there would be little time left for anything else. And would probably not even be possible to do for one person with insane complexity of planes today. Instead it is much easier to just look at the data. In fact most people don’t even look at the data, they assume that because everyone does it, it must be safe. If it wasn’t there would probably be some kind of widespread panic about flying right?
It is important to pick your battles and try to take a derivative approach as much as possible. This requires a certain degree of trust. A reliance on the collective brain power of others (especially experts), but in a few strategic places that you feel passionate about do your own deep thinking and take a more fundamental approach. The world is far too complex to be adequately understood by one brain no matter how brilliant.
Warren Buffett also takes this approach with Berkshire. He lets his companies be run by fanatical specialists with almost no involvement and focusses 100% on investing the cash flows instead. Knowing that no one is smart enough to know better how to run the wide diversity of companies Berkshire owns all at once.
In fact it can be dangerous to be too convinced of our own logical sounding explanations of how the world works. The larger and more complex a system is, the higher the chance that our understanding of it is incorrect. No matter how logical it all sounds in our head. Steve Jobs was the ultimate warning here, eating only fruit and refusing treatment when he had a very treatable cancer. He took a fundamental approach on one of the most complex systems in our known universe (the human body), overestimating his own intellectual capacity, when he should have just listened to his doctors. And paid the ultimate price for it. Generally this is liable to happen because of overconfidence in the wake of an extended streak of successes.
Even when taking a fundamental approach with investing I still try to go derivative as much as I can. For example I look at historical and peer valuation or valuations of the same security on a different exchange. When I look at a stock that hasn’t traded much above a certain earnings multiple for a long time, I assume the market probably knows something I don’t, unless I get really fat dividends or something very significant has changed within the business.
In general I have a very healthy respect for mean reversion.
However when I do my own deep thinking, I employ a few specific methods. This quote from a VC from a reddit AMA resonated with me:
“Venture teaches you to pattern match, but by definition, you are supposed to invest in companies that break patterns. Following the same mental heuristics as your peers will get you nowhere.”
My interpretation of this concept is that it’s important to regurlarly shake things up. It's important to understand that our natural instinctive filter is not that unique. And that hidden opportunities are in places where others are not looking often for seemingly logical reasons.
This means starting out with a forced perspective that you may not agree with and then embracing confirmation bias in a controlled way. What do I mean by this? The legal system is actually a great guide here. In each case the exact truth has to be extracted if it goes in front of a jury/judge. And there are two parties who are highly biassed in opposite directions towards guilt and innocence. This means both parties are more likely to find counter intuitive truths that more initially sceptical persons might miss. Then they argue it out following some rules of engagement (like no compound or leading questions, no speculation, not being argumentative, no hearsay etc).
I use this when I search for new investments to aggressively overwrite my initial biases. Starting out with a pretty wide filter, I assume every stock is the most amazing investment ever and I just have to find out why. Then after I have built the bull case, I let it rest for a while and then go into bear mode to try and ruthlessly destroy the bull case.
I start out with presentations, and end up in the footnotes. Then finally I weigh it all to come to a conclusion. This final weighing process I find, is more subconscious and instinct plays an important role. This can easily blow up in my face though. That is why I like to call it weaponized confirmation bias. It is important to go through all stages equally, the positive confirmation bias stage, the negative confirmation bias stage (or sceptical stage) and the weighing stage. Probably go through the sceptical phase twice, just to be sure. This can feel uncomfortable after building up a nice thesis, so it is important to embrace that discomfort and not shy away from it.
Premature scepticism can be a handicap here, it closes the mind and protects against insanity. Which is great when a good solution to a common problem has been found already. But not when trying to compete with other talented people to find the proverbial needle in the haystack. That right combo of mathematical symbols, that handful of stocks that are mispriced, an amazing and unique looking combo of shapes and colours or a sequence of precise modifications needed to create something entirely new and valuable.
It is like walking a tightrope. For a short period of time become formless and go temporarily insane. Then insert a dose of scepticism into it to get back to reality with a new perspective. Too much uninterrupted open mindedness and your brain will fall out and too much scepticism and fear of being wrong will lead to a completely unremarkable boring life.
A lot of great ideas in the past were considered insane. Until they weren’t. Of course a far larger quantity that were considered insane, turned out to actually be insane. So again, that is why it’s imperative to ruthlessly cull your ideas with a dose of scepticism on a regular basis.
Some degree of isolation is needed for the insanity to happen. We are social animals and through social osmosis absorb information and thought patterns from the world around us in ways that we often don’t realise. Some are more susceptible than others to this. I sometimes have a tendency to self censor more absurd sounding thoughts and ideas when around other people. Even when I clearly wasn’t planning to say them out loud. Possibly because of an urge to have internal and external consistency? And it can be intimidating to meet someone very smart in your field who might argue that taking X or Y approach is a complete waste of time, especially if they have a dominant personality. And if you haven’t spent enough time on that approach yet, it will be tempting to give up prematurely.
Find the right degree of specialisation. Being too specialised can cause tunnel vision, but spreading one self out too thin can cause burn out and a lack of focus. In the above example about the invention of the blue LED, Nakamura became both somewhat specialised in LEDs and in the inner workings of the machine that was used to make the materials for the LEDs. For this reason it can be useful to learn about random new fields/subjects, even if it does not seem initially useful or interesting.
Taking long walks is also important. Gets the blood flowing and being in a place with a high ceiling or no ceiling at all has been associated with more diffuse thinking. While being in a small room facilitates more focused thinking.
Finally with any fundamental undertaking you have to enjoy yourself. It has to be something that bursts out of you. If you have to ask if it is a good idea to do it, then it probably isn’t. Given that the likelihood of failure is potentially much higher, if you enjoyed the process, then at least the effort was not in vain.
Are there better words other than fundamental and derivative to express this concept? I considered statistical instead, but it wasn’t broad enough for my taste. Follower and contrarian are too specific as well (and a lot of contrarians are really massive sheep). These two terms have nicely connected a lot of different concepts for me. Derivative and fundamental seem like opposing extremes that define a concept like introvert and extravert, hot and cold, complex and simple etc.
Very entertaining mini documentary by Veritasium about Nakamura’s journey to find the blue LED.
Andrew Wiles describes what it was like to find the proof of Fermat’s last theorem.
The VC Reddit AMA mentioned above.
What is interesting is how Einstein, who could be considered an ardent fundamentalist by the definition of this essay, refused to believe that “God plays dice with the Universe”. This referred to Einstein’s dissatisfaction with the role of probability in Quantum mechanics. Essentially meaning nothing could be precisely predicted (for example if one particular photon will bounce off or go through a surface, only the odds of going through can be determined precisely). He was proven wrong right after his death by experiment, God does in fact play dice with the Universe on the smallest scale.
When writing this essay I remembered Isaac Asimov also had some interesting thoughts on this subject. He wrote over 300 books, so he knows a thing or two about creativity.
Jim Simons, founder of Renaissance capital, has the following principles:
1. Be guided by beauty. Just as a great theorem can be very beautiful, a business managed efficiently can be beautiful.
2. Surround yourself with the smartest and best people you possibly can have, and let them do their thing.
3. Don’t run with the pack. If everyone is trying to solve the same problem or a group of people think something is the great thing to do - don’t do that. “I’m not the fastest runner, I'm not the fastest thinker”. Do something original and don’t follow the pack.
4. Don’t give up easily. Stick with it. Not forever - but really give it a chance.
5. Hope for good luck. This is the most important principle.
novel perspective.
have often wondered if people (like howard marks) are using a superior measure of risk, why dont they have the guts to present those risk-weighted returns in quarterly reports?
there will always be critics (e.g., look no further than oaktree's owner, brookfield that presents its internal measure of valuation).
but its time for something new here from the elites, rather than berkshire implying they never invest in anything with permanent risk of impairment and thus their risk is zero. (are we still waiting on the pcp acquisition? alibaba?)