Markets and Casinos

Once the unsettling fact of the risk in money is accepted, we can begin to separate gambling from investing not by the type of activity, but by the skill, dedication, and enterprise of the participant.

Peter Lynch

To an outside observer, the stock market may look an awful lot like a casino where people greedily gamble their hard earned money in the hopes of cashing out more than they put in. The financial media display colorful, animated graphics as up-to-the-second price quotes continually scroll across the screen. This four letter one is up, this three letter one is down. Oof, this two letter one is down bigly. The rare five letter one must surely be up! Clapping and bell ringing accompany every open and close, and especially when milestones are hit, “All time high! Jackpot!” Viewers are drawn in, envious of those that put it on black, I mean AMZN. It can only go higher they say. But, of course, what the market giveth, it can taketh away in a heartbeat. Why didn’t you cash your chips beforehand?

One of the seminal books on investing, published over 70 years ago, is The Intelligent Investor by Benjamin Graham. Although much has changed since, some insights are still apt to this day. In the first chapter, Graham describes one of the most important distinctions in investing: the difference between investors and speculators. Understanding the difference in mentality between the two is paramount when observing financial markets.

Investors buy and sell ownership stakes in businesses, as represented by stock certificates. Speculators buy and sell pieces of paper worth a certain price, as represented by stock certificates. Investors primarily look at business characteristics in an attempt to estimate the intrinsic value. Speculators primarily look at stock price characteristics in an attempt to guess which way the stock price will go. Speculators attempt to predict crowd behavior; investors are agnostic of crowd behavior. In sum, investors spend time assessing businesses; speculators spend time assessing prices.

The differentiation mainly manifests in time horizon and trade rationale. Speculators possess a short-term time horizon and try to anticipate price movements, whereas investors possess a long-term time horizon and try to anticipate intrinsic value movements. Investors wouldn’t mind if the markets were closed for an extended period of time because businesses would continue to operate. Speculators would care a great deal because prices could not be followed. Since prices fluctuate more rapidly than business values, the number of transactions and amount of money gained or lost will differ as well. Speculators trade more often, as they are either proven right or wrong relatively quickly, but wager less money on each bet. Investors trade far less often, possessing patience for their thesis to play out one way or another, but have much more money at stake.

Frankly, there are a lot more speculators than investors, and many investors who are closet speculators. The appeal of instant gratification and deferring thinking to external forces is difficult to resist. Independent thought is a prerequisite for investing, yet speculators spend less time thinking about the businesses that underlie the stocks they buy than which restaurant they’ll eat at. It takes a lot more effort to read through company filings to understand the mechanics of a business and evaluate its probable future than it does to simply look at stock charts and price multiples. However, the former drives the latter, so betting on a change in the latter without understanding the former seems like backward logic. With that said, speculators aren’t necessarily bad or wrong, they’re just more often than not playing roulette whereas investors are playing poker. The odds will vary accordingly.

Another revolutionary concept introduced by Graham was the idea of Mr. Market; an allegorical, emotional character with business interests in the offering for others to buy from or sell to, day in and day out. When jubilant, he’d quote high prices; when discouraged, low prices. The actions of all market participants determine the mood and behavior of Mr. Market. How speculators and investors interact with Mr. Market differs.

Speculators take their cue from Mr. Market, likely causing them to jump in and out at inopportune times. When Mr. Market becomes frightened with bad news and begins offering lower prices, speculators will also become frightened and instead of buying, they sell at lower and lower prices assuming imminent further declines. Nevertheless, the market often bounces back in spite of the dour news. And those who sold proclaim irrationality. Gains are missed until they reluctantly buy again, only to witness the market decline again. Thinking how stupid they were to buy when obviously the market shouldn’t have gone up, they sell again, possibly at even lower prices. Inevitably, the market resumes its rise. But fool me once, shame on you; fool me twice, shame on me right? Due to the prior experience, their reluctance is even greater this time, unfortunately forgoing even greater upside as the market takes off and never looks back. Although not predestined, the pattern is all too common when following the whims of the crowd.

As a result, many have resorted to trying to anticipate Mr. Market’s mood, buying and selling before the market reverses course. But predicting the unpredictable can be equally infuriating. A continuously rising market can cause some to feel the need to realize gains because it surely ought to pull back eventually. It could, but nobody can know when, or by how much. Notwithstanding the tax implications, selling at the exact top is impossible, and over the long term will not result in wealth accumulation since the market will climb to ever greater heights.

Additionally, the majority of market participants acknowledge it’s impossible to consistently time the market. So why do so many still try? No amount of lines, patterns, numbers, or ratios will reveal knowledge of where price is headed next. There’s a saying, often misattributed to Albert Einstein, that doing the same thing over and over and expecting different results the definition of insanity. I guess it depends on the action, but if it has been proven to be futile, like trying to time the market, the sentiment hits the nail on the head.

The amount of oxygen and mental energy wasted by very smart individuals declaring what level the market will or should trade at is baffling. Most times, people simply enjoy pontificating. However, it’s not a far leap for words to turn into actions, which have real consequences. It’s not the professionals’ faults, though, because the incentives are aligned for them to do so; they’re paid to have a view and to act on it. But it seems borderline arrogant to declare foresight or that the market should conform to your worldview.

The factors that impact market sentiment are numerous, highly variable, and include both known unknowns and unknown unknowns. Even if the outcomes of the known unknowns could be known, predicting how the market would react is still impossible. Since it’s uncomfortable to idle in ignorance, forecasts are made. But effective forecasters understand when the cone of uncertainty is so wide it renders the act useless. Additionally, they don’t take one forecast too seriously and try to understand the perimeter of the cone more accurately than the center. Poor forecasting overemphasizes biases, causing a strong opinion to be held too strongly, leaving little room for open-mindedness.

If the market is irrationally trading at a high multiple of earnings, why couldn’t it be equally irrational to trade at a low multiple? The rational level must be the historical average then, right? But why? What compels the market to assign the same multiple of earnings for the current set of companies than a completely different one in the past? Are the business models, quality of cash flows and earnings, and growth and reinvestment prospects comparable? A solid and healthy economic backdrop usually coincides with highly priced markets, but the market multiple fluctuates in all types of macro environments. Warren Buffett and Charlie Munger, among other great investors, are therefore macro and market agnostic. Succinctly worded, “Charlie and I don’t pay attention to macro forecasts.” Further, Buffett has written, “As far as I’m concerned, the stock market doesn’t exist. It is there only as a reference to see if anybody is offering to do anything foolish.” If an investor doesn’t find any foolishly marked down bargains within their circle of competence, there is no need to swing at Mr. Market’s pitch. But yelling at the cloud won’t cause Amazon, Google, or Microsoft to make any less money.

Even if one accepts the future is unknowable, which they should, saying, “I don’t know, but because of these few observations and chart patterns, I have a feeling the market is going lower and positioning my portfolio accordingly” is vastly different than, “I don’t know, but I’ve tried to gauge the risk and reward and positioned my portfolio for a wide range of outcomes.” Even better, in my opinion, would be, “I don’t know where the market will go – nobody can know – but whatever happens I will thoroughly and unemotionally assess the new information, update my probabilistic forecasts, assess them against the newly embedded expectations, and take advantage of perceived mispricings between price and value, which of course, could be wrong.” But that’s too rational.

Managing a portfolio is a responsibility that economists and market prognosticators usually do not to have. Fortunate for them, I might add, since their “calls” rarely prove prescient. The game appears so much simpler from the stands than on the field. For those that do have skin in the game, the difficulties are compounded by the institutional pressures to have a well-reasoned narrative for the market given the state of the economy or actions of the Fed and other market participants. In fact, it may even appear negligent not to! But, ironically, intellectual humility is a sign of strength, not weakness. In One Up on Wall Street, Peter Lynch says it best, “When it comes to predicting the market, the important skill here is not listening [to the “experts”], it’s snoring. The trick is not to learn to trust your gut feelings, but rather to discipline yourself to ignore them. Stand by your stocks as long as the fundamental story of the company hasn’t changed.”

Investors heed Lynch’s advice. They are not guided by Mr. Market, nor do they try to time his mood. But rather, they estimate a company’s fair value and then compare it to Mr. Market’s offering. In their minds two are distinct; sometimes in unison and sometimes wildly divergent. Why do they diverge? Countless reasons, not least of which, as cited above, the reflexivity of speculators’ actions guided by price, pushing it to extremes in one direction or another. Sometimes it’s apparent, but more often than not it’s more nuanced and not easy to determine. Despite the uncertain future, investors are willing to try to envision the long-term future for the business, while at the same time understanding that many aspects, like the market’s fluctuations, are not in their control. Besides, if an investor holds a portfolio of assets believed to be undervalued, why should it matter what the market does? If the market declines, and with it those holdings, cheaper prices are a gift given the fundamentals remain unaffected.

Of course, determining the impact on fundamentals is the name of the game. But if the necessary work is put in, it’s a higher probability bet than reacting to or anticipating price gyrations. Investing in high-quality businesses with strong competitive advantages and a long growth runway is a winning strategy over time. Not only despite the market’s impetuous swings, but because of them. Peter Lynch again: “I’d love to be able to predict markets and anticipate recessions, but since that’s impossible, I’m satisfied to search out profitable companies as Buffett is. I’ve made money even in lousy markets, and vice versa.”

For speculators, a manic depressive Mr. Market causes anxiety. Risk is volatility, not permanent loss of capital. Investors think only of the latter. But oftentimes, many investors reveal their true speculator colors when volatility becomes permanent loss of capital. It’s not entirely nonsensical if quarterly performance is the focus; it’s hard to underestimate the influence of incentives. Maybe it can be disguised as prudent risk mitigation. But aren’t lower prices generally less risky? On the other hand, though, maybe they do re-evaluate the fundamental story given the new future probabilities. I hope so, because an investor buying or selling only because the price has gone up or down seems inconsistent.

Sometimes, prudent speculation can actually be a part of an investor’s strategy. Legendary investors like George Soros, Stanley Druckenmiller, and Paul Tudor Jones focus on price charts, supply and demand, and liquidity to inform their more macro-oriented trades. Their ability to understand what price action is indicating and to take advantage of the likely subsequent moves is extraordinary. But for each well-informed speculative bet, there are far more senseless gamblers overconfident in their clairvoyance.

Should stocks be bought at all time lows or all time highs? Should losers be cut and winners be added to, expecting continued momentum? Or should losers be doubled down on and winners trimmed, expecting mean reversion? Ironically, both momentum and value factors have exhibited statistically significant outperformance over time. There are no cut-and-dry rules for trading price movements. Prices will fluctuate in random walks over the short term, reacting to the bombardment of hot off the press headlines. Whether the news signifies a change in value or is just noise is for each investor to judge. Only time will tell, not price.

Near term stock price movements are completely dependent on what the marginal participant is willing to pay, which is heavily influenced by psychology and thus impossible to foresee. Still, speculation on daily, weekly, or monthly price movements is all too prevalent. Instant gratification and myopic loss aversion are powerful. As too is fitting in with the crowd. It can be quite uncomfortable to go against the herd despite the massive rewards for a lonely conviction proven correct. But being contrarian for contrarian’s sake will not guarantee riches. The truly successful investors are simply ambivalent; as Buffett says, “The most important quality for an investor is temperament, not intellect. You need a temperament that neither derives great pleasure from being with the crowd or against the crowd.”

When the crowd loves gambling, one does not have to participate. There is no need to join the loudly cheering throng surrounding the roulette tables when there are seats open at the poker table. You’ll likely walk away with more cash in the end; that is, if you recognize you’re not the patsy. If you have an edge, place your bets wisely, and are not be forced into actions that interrupt the wonder of compounding, the odds are more on your side. Further, knowing how much to bet is almost as important as what to bet on. The Kelly Criterion can be helpful in deciding how much money to risk based on your edge and the given odds. Without an edge, you shouldn’t bet. Unless the roulette wheel is rigged, the house always has the edge. But like those at the poker tables, investors can exploit their edge when the cards are appear favorable. Coincidentally, the formula has been used to beat the dealer as well as the market. Maybe the market is more like a casino after all.

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