Since Rangeley Capital is sponsoring a tennis tournament, I have been thinking about some of the similarities of my job as an investor with my strategy as a tennis player. Tennis and investing are both games where one must make decision amidst real time risk and uncertainty against opponents who are trying equally hard to win.
In the Middle Solves the Riddle
Anyone who plays doubles in tennis has at one point in time had an opponent hit a passing shot down the line while they were at net. It's embarrassing, it's frustrating, and it likely causes the net player to move a little closer to the alley to defend against that shot in the future. So when most club level players set up at net, their focus is on guarding the line.
The problem, hitting the ball down the line for a passing shot is hard! 99% of the time the opponent is going to hit the ball in the middle of the court because that is where they have the highest probability of success with the lowest probability of failure. Although you may risk looking stupid once in a while, when playing the net in doubles you increase your chances of winning substantially by focusing on the middle and letting the opponent try to hit low probability winners down the line. Allow the Bryan's to demonstrate.
Investing is not all that different. If one observed the behavior and conversations that occur in most investment firms, I believe a significant amount of time, energy and money is wasted trying to avoid looking stupid. Human beings are inherently perception maximizing, we care what others think of us, and nobody likes to appear stupid.
Value investing is at its core the opposite of perception maximizing, we take on a degree of uncertainty and risk looking stupid in return for a price that offers a large degree of safety. Most investors prefer certainty, but with greater certainty come higher prices and larger downsides.
Forget the Past
There are not many sports like tennis where one has the ability to reset at 0-0 in the beginning of each game and each set. The player who has the mental acuity to focus on the shot, point and game directly in front of them usually has a big advantage. One can learn from the past, but cannot change it, so worrying about it does little to help accomplish what needs to be done in the present. A tennis match is a long game, and in order to compete, one must focus on each shot, and determine in that moment what they can do to have the highest probability of success.
When to buy and when to sell a given security is one of the hardest decisions for many investors to make. It's easy to say buy low, sell high, but it's always hard to leave money on the table and walk away when a stock is going up and it's always hard to buy when a stock is in decline. We're hard wired to lose at this game.
In tennis and investing, using the right tense matters. Most investment conversations take place in the present tense. For example, "Tesla's stock is going up" is the present tense, but that is not accurate. The past tense, "Tesla's stock went up", is the correct phrasing, and it also helps us refocus our decision making to the circumstances at hand. The active risk decisions in a portfolio are irrespective of past price movement.
When there is a meaningful difference between the price of the security and our calculation of the expected value, we will build a position long or short. The closer the market gets to accurately reflecting our expected value, the smaller our position gets. We never want to be in a position where we have to hope for the upside, we just prefer to take advantage of mispricings that exist in the market. Sometimes we're right and sometimes we're wrong, but decision making is always a function of current price and expected value.
"The depressing thing about tennis is that no matter how good I get, I'll never be as good as a wall."
- Comedian Mitch Hedberg
The markets are made up of thousands of rational, intelligent, self-interested investors and some cheaters. Pitting one's judgment against the market when the price system works effectively is a lot like trying to beat a wall at tennis. There are, however, opportunities to take advantage of corners of the market where the price system itself cannot work effectively. These opportunities exist because some investors may be forced to act based on a factor other than price - narrow mandates, excess leverage, an agency problem, policy, regulatory changes, etc.
In the early days of tennis it would have been considered rude to stand at the net and go for winners. Oh how I wish I could have played the game back then! Markets provide these opportunities to savvy investors who look for them, it is our job to arbitrage them away.