Turtles in Omaha

     "If you can keep your head when all about you
    

Are losing theirs and blaming it on you,
    

If you can trust yourself when all men doubt you
    

But make allowance for their doubting too,
    

If you can wait and not be tired by waiting…"
          — Rudyard Kipling, "If"

Michael Mauboussin, at Legg Mason, published a great piece in May of this year titled The Turtles of Omaha: The Mindset of Great Investors. In it, he discusses Curtis Faith’s new book, "Way of the Turtle" as well as Nassim Taleb’s latest book, "The Black Swan". His article is a must for investor and entrepreneur alike and can be downloaded here…Download TurtlesOmaha.pdf

In the early 1990’s, Richard Dennis, one of the most successful pit traders in the world, had a debate over whether great traders were born or made (nature vs. nuture). They decided to solicit applications from a broad array of fields, screen them for set characteristics, train them and give them each a small stake to invest. Those that did well each month got more money and those that underperformed lost capital. They were called  the Turtles. Faith was only 19 at the time, the youngest of the group yet he delivered the best results. Why? Temperment & discipline.

He discusses three classic psychological tendencies investors must overcome to be successful:
1) Loss aversion
2) Frequency vs magnitude
3) Role of randomness

Loss Aversion
As I’ve written in the past, humans are programmed, through millenniums of  adaption, to suffer pain twice as much as we  enjoy gain. Those that did not, probably found themselves as T-Rex snack. In trading and venture capital, over 50% (and sometimes 70%) of transactions are not profitable. Fearing loss, many investors will pull out of proven investment approaches prematurely. In one case, Faith said that over one ten month period, following the set trading strategy, traders would have lost 24 out of 28 times (avg $930 loss each time) but would have had 4 winning trades that averaged $20,000 each. Better yet, the first 17 trades were all loses as the market stubbornly refused to trend where it needed to. Many of the other Turtles bailed on the system, thereby missing several of the 4 wins. As Buffett says, "Be greedy when others are fearful and fearful when others are greedy." Recency bias trends us towards extrapolating that the future will look just like recent past.

Frequency vs Magnitude
Buffett would say that rule #1 is "never lose money". Faith would say that loss is inevitable in trading (and in venture capital). However, limiting your losses while positioning for the big upside is the key to success. It is not the frequency of the win or loss but rather its magnitude. He mentions that George Soros, who has made billions trading, is often wrong over 50% of the time. However, when he wins "it’s a grand slam". Many smart people, needing to be "right", will sub-optimize long-term performance in order not to be "wrong" in the short term.

Role of Randomness
Randomness plays a central role in investing. In the short run, markets or strategies don’t always play out as expected. Investors will attribute this to a good or poor process. The reality is that often people, fearing loss and focusing on the noise (assuming it is signal), will pull the plug too early. They hard part is knowing when something is noise and when it is a new trend.

In general, Faith outperformed the other turtles, not because he was smarter, but rather because his temperament allowed him to avoid many of the emotional traps that befell the other traders. As Kipling wrote, "If you can keep your head when all about you are losing theirs and blaming it on you…" 

Mauboussin also makes reference to another recent book by Nassim Taleb called the Black Swan. Taleb claims that market results do not follow the believed bell curve but rather are lumpier out towards the tails. Furthermore, it is the tail events that drive performance and they usually break from historical patterns when they occur (non-linear chaos theory…). Ironically, we experienced a Black Swan in August as all of the quant shops saw their models crash as credit markets backed up unexpectedly. He mentions that outliers that vary from historical norms drive most of the losses and gains in the market. Goldman Sachs took over $1B in losses, stating that events from early August should have occured only once every 100,000 years according to their historically determined models. Taking the 50 worst days out of 30 years worth of trading data drives S&P returns from 9.5% to 23.5% and removing the 50 best days out drives the returns down to 3.5%. As a result, it is important to rely more on exposure (likelihood of something happening using common sense) and less on experience (what historical trends indicate).

Since technology markets follow very similar, non-linear patterns and inflection points, these very same lessons apply to entrepreneurs as they do to investors. Minimize your losses (burn, etc) while you wait for markets to turn, minimize emotional & instinctual responses to developments and realize that when things inflect, they can explode upward much more significantly than expected or predicted (just look at YouTube or Skype). As Mauboussin concludes: focus on your process (value proposition), recognize where your risk is, look for favorable odds and realize that over time, rational factors will play out through the noise if you don’t let emotions short-circuit you. Watch your behavior to assess how you truly are responding emotionally to developments.