I got interested in game theory in 2011 because of my interest in poker. Some of the better players were using it, and it looked like a fun study. Well, if it's possible to have a quasi-spiritual epiphany as an investor, game theory was mine.
GAME THEORY: I won't go into the arcane details of game theory here, other than to say it's a mathematical approach for making decisions in a game of strategy. Developed by John von Neumann in the 20's (he worked on the Manhattan project, among other things, and was known for playing practical jokes on Einstein), it's a tool for making decisions in games with less-than-complete information, like poker, or investing in the stock market.
For me, it wasn't about the math, but about how to approach stock picking in the first place. Viewed through the lens of game theory, I wasn't designing a portfolio comprised of ten stocks. I was engaging in ten separate and distinct one-on-one battles. It was buyer versus seller at the point of transaction, one of whom was making a mistake.
Why a mistake?
Investing at the point of transaction is a zero sum game. One party benefits in proportion to the other party's loss. Amazon (AMZN) is up 77% since I made it my first pick for my top ten list a year ago; my gain is proportional to my opponent's loss, or opportunity cost. (You can review my stock picks here.)
If both buyer and seller had perfect information at the point of transaction, one party would want to cancel the deal. In the case of my purchase of Amazon last year, if the seller had known Amazon was going to have such a great year, he would've wanted to back out of the deal.
Once I framed the issue in the context of game theory, it fundamentally shifted the way I approach stock selection. To begin with, I am crazy competitive (actually, both), and I have to confess, the one-on-one battle metaphor resonated in a way that Warren Buffett's wait-for-the-fat-pitch didn't.
It's a battle of wits, buyer versus seller, and only one can win. When I'm considering a trade, I actively imagine a person on the other side. I've got him pegged as smart, sophisticated, rational. A big part of game theory involves understanding your opponent. I like to get inside his head, to see and understand exactly how he views his position. My bearish call on IBM (IBM) last year - I imagined both Buffett and Bill Gates collaborating on the other side, and I tried to see how they viewed their position, what they were looking at.
Is winning every time possible?
This obsessive/compulsive says yeah, winning every time is possible. And I've crafted a plan to help accomplish the objective. My weapon is my biochemical computer and the quality of its decision-making process; brain science shows performance is highly variable. Elimination of distractions, rituals, there's all kinds of things you can do to think better. I've found if I consciously slow down the research process, I get the best results. Really dive deep into one thing at a time, to the exclusion of all else. Make it personal, get obsessed sort of thing.
To work diligently and slow takes a lot of time, of course, and I've developed lots of silly time-savers. Same sandwich for lunch everyday, you'd be surprised how much time that saves, no more where to go, what to eat. No football watching or playing golf for last two years. (Of course, I hope my opponent enjoys such things, and to the fullest extent.)
Ambidextrous shaving in the morning, what of it? You've got two hands. Two cheeks. For the cost of an extra shaver you get the job done in half the time. Good for hand-eye coordination too. Saves 14 hours per year.
Should money managers be perfect?
A ridiculous question, don't you think? But here's the way I see it: If I were assigned a random stock to trade, my win rate wouldn't be anything special, certainly nothing close to perfect. Here's General Motors (GM), get after it. Eh, well. I'm not a car guy. If don't bring passionate interest or expertise to the table, how do I get an edge?
On the other hand, if I get to choose the stock to battle over, I should win every time - because I won't play unless I've got the nuts.
To suggest perfection is attainable won't win me any friends among money managers. What the hell, I've offended just about everybody else in recent columns. Elite money managers should be near perfect, yes. Here's where virtually every manager gets it wrong: They spread themselves too thin, their universe of stocks is invariably too vast.
The fact that mutual funds have 100 stocks in a portfolio makes it impossible to outperform, but the handcuffing of money managers is more fundamental than that. Excess diversification has become institutionalized. The net effect: it doesn't matter how intelligent or skilled the money manager, his decision-making process is superficial - it's based on a shallow understanding of companies.
If managers went deep, instead of broad, they'd have a shot at beating the S&P 500. But given a lack of focus, managers can't outperform. They're not going to win because they're not put in a position to win.
And what about investors? How do they fit into the equation? Investors can make a fortune with one brilliant idea per year. Investors can't do much with 100 superficial ideas per year.
Listen, I'm thrilled if I can generate two or three smart ideas in a calendar year. Producing a top ten list each year, it's just not practical. My top ten list for 2012 was an aberration, a case of being at the right place at the right time. Because 2011 was such a lousy market, and a choppy one at that, it wasn't difficult to go ten for ten. But I struggled to come up with ten quality ideas for 2013's top ten list, as you can see. So I doubled up on one, bought the twin of another, recycled two oldies, and filled out the list in namby-pamby fashion with low-risk names like GE (GE) and Berkshire Hathaway (BRK.B). Check the performance here.
There's no guarantee in this game, and I don't want to come off suggesting there is. We're just talking opportunity. Who knows, I may come up bone dry for the next several years. Reversion to the mean is a powerful vacuum. Whoooooosh! There goes Arne … 0 for 10 again?
Thanks for reading
Okay, cherubs, it's time to give the keyboard a rest, to put a wrap on two years of sharing. I hope I leave you with a sense of optimism for the future. We're hurtling at warp speed toward a fully connected, largely automated, robot-centric economy, one marked by less variance and more benign cycles. Work re-imagined. Happiness re-defined. Government re-invented. With everything connected and fully transparent, I'm hoping it's a kinder, gentler world.
Still, that's way in the distant future. Don't let it distract you from the task at hand. Until we get there, it's gonna be chaos. We're iterating an entirely new economic ecosystem. Disruption is underway, the economic pie is being divided up anew (still very early days), and … and I think I'm done writing. Enough.
Except one last thing comes to me now … a crazy old stockpicker has hallucinations every once in a while, you know (see, you were right to suspect something); anyway, I'm having a vision right now … I see an Everest-sized mountain of chips, piled high on a table … lots of players … two open seats, way in the back corner… hmmm, looks like nobody's paying attention back there … wait a sec, gimme a chance to check out the competition, gauge the oppor …