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Supplemental material for Best Practices for the Intelligent Real Estate Investor

Cornwall Capital theory on making money

Michael Lewis’s best-selling book The Big Short tells of the approach of a number of iconoclastic investors who made huge profits in the subprime crisis. One is Cornwall Capital. Here is their theory as described by Lewis:

…[Cornwall Capital money manager] Charlie Ledley—was odd in his belief that the best way to make money on Wall Street was to seek out whatever it was that Wall Street believed was least likely to happen, and bet on its happening. Charlie and his partners had done this often enough, and had had enough success, to know that the markets were predisposed to underestimating the likelihood of dramatic change.

When they were told what a good idea it would be to bet against subprime mortgages, they wondered,

Why isn’t someone smarter than us doing this?

I talk about that mindset in my book Succeeding in the “Little Old Meism” chapter.

…private stock markets may be more efficient than public ones (NYSE, AMEX, etc.) [You want to invest in the most inefficient market]…public markets lacked investors with an interest in the big picture…parochialism is common to modern intellectual life. There is no attempt to integrate.

Cornwall Capital…search for market inefficiency …globally, in every market: stocks, bonds, currencies, commodities.

There were times,[stock guru] Joel Greenblat explained, when it made more sense to buy options on a stock than the stock itself.

After making $526,000 on some long-term Capital One options they thought were too cheap, they began to search for lond-term options.

The longer-term the option, the sillier the results generated by the Black-Scholes option pricing model, and the greater the opportunity for people who didn’t use it.

…people, and…markets, were too certain about inherently uncertain things.

They were combing the markets for bets whose true odds were 10:1, priced as if the odds were 100:1. “We were looking for nonrecourse leverage.”

We didn’t get yelled at by [our] investors because we didn’t have any investors.

Counting winners and losers

Another bad instinct for investors is identified by Bookstaber on page 203 of A Demon of Our Own Design: investors who are more interested in their winning-deals percentage than in maximizing their cumulative net profits. For example, they would rather win eight $10 bets and lose two $1,000 bets, so they can brag at cocktail parties about their .800 “batting average,” than make more money with a couple of large winning bets that are outnumbered by small losing bets.

This is the kind of mistake that always using expected values takes care of. Expected value is explained on page 5 of Best Practices for the Intelligent Real Estate Investor and is discussed on ten of its pages.

House effect

On page 169 of A Demon of Our Own Design, author Richard Bookstaber talks about how investors’ willingness to take risks goes up as their gains mount. He calls it “house effect,” meaning investors feel at that point that they are playing with “the house’s” money to use a casino gambling phrase. They do not feel so bad about losing “the house’s” money as they do about losing “their own” money.

That’s not logical. It’s all your money including money you unexpectedly and recently made in the market. I call it a variation on the easy-come-easy-go syndrome I talked about on page 82 of Best Practices… in Chapter 7 “Bad Instincts for Investing.”

On that same page, Bookstaber also says that the longer an investor makes gains, the greater his conviction tat his investment approach is right. In fact, he usually is making money in spite of his approach, not because of it. So the more he makes, the dumber he gets in terms of his ability to recognize when the approach is disproved. That is, he will hang on to the investment longer than he would have if he had only been making gains for a short time. That reminds me of the old Wall Street saying,

In a bull market, everyone thinks he’s a genius.

Experimental neurosis

In the super book A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation by Richard Book staber, I read some interesting stuff about risk management. One was his description of experimental neurosis.

As you know, scietnists often make lab rats go through mazes, pound a pedal, or whatever to see what makes them tick. Sometmies, all hey learn is that experimental neurosis exists. Bookstaber says,

An animal in the laboratory, beset by a strange environment and events that are outside of tis past experience, will sometimes simply curl up in a ball and ignore all of the stimuli.

Investors and others in the financial markets sometimes do the same for the same reason. You cannot do that. You need to do your best to figure out what to do. And you have to be decisive and prompt just as in any other situation like taking advantage of a profit opportunities. Sometimes, all of your options are bad. But you cannot respond by locking up. You still have to promptly and decisively choose the least worst of the bad options.

Ahead of the Curve

I recently read the book Ahead of the Curve by Philip Broughton. It had a number of pertinent statements about risk management.

Page 16 ...the idea is not to find certainy but to deal more comfortably with uncertainty, to find handholds, however tenuous, in the otherwise sheer rock face of financial decinion making.

Page 94-5... OCRA—optimal combination of risky assets—It’s the point where you get the maximum benefit from diversification. You have diversified enough to minimze risk for this level of reward, but not diversified so much that you are atually getting less than you should.

...serious investors think as much about risk as they do reward.

You can achieve alpha [deliberate above-market profits] in all kinds of ways, but there are two basic ones: picking the right investment and piking te right mix of investments, which, bundled togeter, provide higher reward for lower risk than any of te individual investments would. Serious investors will always insist on talking not about return but about risk-adjusted returns. This was one of te most important lessons I took from Finance.

Page 195 ...We had been told time and again that entrepreneurship was not about taking risk but about managing it.

Page 201 ...[Treasury Secretary Robert] Rubin wrote that the risks most people ignored were the very low probability risks of catastrophic outcomes. They spent an inordinate amount of time worrying about the 20 percent chance of having a bad day and no time thinking about the 1 percent chance of their entire life being turned upside down.
Hidden threats to your ability to pay your bills