The Checkmate Investment

| About: SPDR S&P (SPY)

Summary

As a dilettante investor, I look for similarities between investing and my day to day life.

Chess is an amazing game, from which investors can learn a lot.

This article shows how thinking of investing like a game of chess can help shape your decisions.

One concept that people enjoy throwing around in finance is what is often referred to as Charlie Munger's "latticework of mental models." Berkshire Hathaway's vice chairman has expressed the urge to integrate mental models to your thought process in several speeches he has given over the years.

"You have to learn all the big ideas in the key disciplines in a way that they're in a mental latticework in your head and you automatically use them for the rest of your life."

USC Law School Commencement Speech 2007

"You've got to have models in your head. And you've got to array your experience ‑- both vicarious and direct -‑ on this latticework of model"

USC Business School Speech 1994

The idea is that to become wise, so to speak, you need to master models to observe reality, day to day life, and why not to make investment decisions. These models should come from various fields such as mathematics, physics, engineering, accounting, biology, physiology, psychology, and so on. Robert Hagstrom wrote a good book for people looking for a starting point: "Investing, The Last Liberal Art."

While I don't claim to have yet mastered all of the mental models worth knowing, I have made it a habit to look for applicable lessons in my day to day life. A random day in my life would include cooking, eating, playing basketball, playing chess or poker, and maybe drinking a few beers. Writing an article on how drinking beer makes you a better investor would surely attract a broad audience. Sadly, I haven't yet figured out if it really is the case. You'll have to settle for an article underlying the similitudes between investing and chess.

source: shutterstock

I enjoy playing chess. When I was younger, I'd compensate for the frustration of systematically losing against my father by taking it out on my kid brother. Unlike investing, chess is somewhat predictable. Each side has 16 pieces, 8 pawns, 2 bishops, 2 knights, 2 rooks, a queen and a king. The beginning of each game starts in perfect equilibrium, white disrupts the equilibrium, black resets it, and a victor emerges by exploiting his opponent's mistakes.

KNOWING THE RULES VS KNOWING HOW TO PLAY

In chess, like in investing, knowing the rules is easy. Different pieces move around the board. You can buy and sell different securities. You try to checkmate your opponent. You sell or cover at a profit. But knowing how to play is hard, it requires more than just practice.

First, in both chess and investing, you need to master a basic toolkit. In investing you need to know accounting, valuation methods, and understand financial economics theory (even if only to fully comprehend why it's wrong). In chess you need to know different opening variations, how to successfully implement gambits, forks, pins, and skewers.

Second, you need to analyze historical games or trades. In both cases, there is nothing new under the sun. Chess, as we know it, emerged in Spain in the late 15th century. The first company to issue stock, the Dutch East India Company, did so less than 150 years later, in 1602. Since, both have come a long way. This means as students of both chess and investing, we have more than enough material to learn from our predecessors' mistakes. Whether in chess you want to learn how to play the fried liver attack (one of my favorites, and not only because of the great name), or in investing you want to learn how some investors profited from the crash of 2008, there is a plethora of high quality information. In investing you can learn about the PE effect, and how and when it appeared at different periods of time in different geographies. You can also analyze winning and losing trades of praised investors such as Buffett, Soros, Ackman, and so on. Long story short, if you want to compete in either arena, you need to be well versed in history and tactics.

There are three stages in all games of chess: the opening game, the middle game, and the end game. Viewing your investments as such can aid in thinking strategically.

THE OPENING GAME.

source: author's data

Whether you're facing the board, or the vast array of investable securities, you have to make your first move. You can shoot darts at a list of companies, and you can move any pawn at random, but dumb luck will rarely help you in the long run. In chess there are very few first moves which are worthwhile. Most openings start by either pushing the Queen's pawn forward two squares, or the King's pawn forward two squares. Likewise in investing, there are relatively few great first moves. Yet your stock selection will ultimately make or break your dreams of beating the market. The d4 and e4 moves in chess are the most common not because they are particularly strong, but because everything else is mostly worse (although some have succeeded in opening with c4). When playing against a skilled player in chess, your opening moves are intended to have a fair middle game. In investing, you are seeking to have an unfair middle game, as if you were playing chess against a novice.

This is what the industry calls "edge". The edge can come from industry expertise, exploiting anomalies, having more time than your peers, and sometimes, mere common sense. When you step into the investment arena, you need to know what your edge is.

Two edges which we tend to forget we have as retail investors is that we are time insensitive, and are small enough that our investment world includes even microcaps. An edge we don't have is an informational edge. When you are on your own, you don't have the privilege of having an army of analysts, thousands of dollars' worth of research. So next time you form an opinion on Apple (NASDAQ:AAPL), or on any of the constituents of the major indices for that matter, ask yourself what you know that isn't being priced into the stock. If there are half a dozen articles on Seeking Alpha addressing the same issue, that it made the cover of The Wall Street Journal, assume that the market has taken this into account, and that what you believed to be an edge isn't.

An unfair opening game doesn't guarantee you a win, but it sure sets you up for one. If you want to play a fair game, just put your money into an S&P 500 ETF (NYSEARCA:SPY).

SPY Chart

SPY data by YCharts

Also don't mistake your overconfidence for skill. In chess there is a mistake that many beginners make, which is known as the Queen's raid. It tends to be effective against an unskilled player but ultimately leaves you in an unprofitable play against an opponent who is worthy of your time. You don't want to find yourself in such a situation in investing, where your pursuit of an unfair edge results in you being on the receiving end of the stick: underperforming the market.

But let's assume you have managed to find an investment within which you dominate the center. The patience you had to get a good price serves as defense just like when you choose to castle. The industry you picked is experiencing favorable tailwinds, like when you skillfully move your knight to a square where he is both defending and attacking. And you have identified the catalysts and threats which, if handled properly, will ultimately result in a win. Now the game has to be played.

THE MIDDLE GAME.

source: author's data

Unlike in chess, in investing the middle game is mostly passive. Management make decisions, consumers' taste evolves or remains the same, unexpected global events occur, and you're stuck watching the stock price. This is why I urge you to find investments which offer you asymmetrical chances of success. By this I mean situations where the probability of making money times the amount of profit versus the probability of losing money times the amount of loss is positive. It's not an exact science since it is hard to assess any of the four variables, but it remains the goal.

You need such investments because events will seldom play out as you expected. Since management will be playing the middle game for you, it is imperative that they know how to do their job. Can they take calculated risks? Or will they expose you dangerously? Will they think through their next moves? Or will they move boldly, ignoring the opponent's upcoming move? Are they truly interested in winning this game of chess, or did they show up to the tournament for the free food and drinks?

You can't blame everything on management though. You will need to look around you for a change in the landscape. This is where chess becomes child play and investing gets scary. In the real world, unlike in chess, there are no rules so to speak. It is possible that in a whim, government makes a decision, adds a 9th row to the chess board and fills it with queens. All of a sudden, you have lost. The business cycle might contract, rearranging the pieces on the board, which leaves you scratching your head. What has just happened? Everything was perfectly set up, and in no time at all, it seems as if you have already lost. Welcome to the world -- exogenous events happen.

Thankfully, in chess like in real life, if you know you are going to lose, you can resign. After all there is no point wasting time in a battle which can't be won. There are signals, however, that things won't go your way. Has your opponent taken control of the center and retained more material than you in doing so? Are valuations stretched to historically high levels and are we 7 or 8 years into a bull market which is losing steam? Those are questions for which you will have to figure out the answers. Don't trust economists. One economist I know predicted the last crash. The only problem is he predicted it 12 times.

Now if you survive all the way to the end game, you're not done yet.

THE END GAME

source: author's data

In chess the end game is the point where there are few pieces left, and pawns become more important. The line between the middle game and the end game is not precisely marked, but this doesn't matter much. What matters is that there are three scenarios: One, you are winning and you want to get efficiently to a checkmate. Two, it is close, and you want to get the upper hand. Three, you are losing and want to force a draw.

In today's metaphor, I will only consider the former scenario as a way to view a winning trade. In chess you have more material, more pawns, and you know you have won. In investing you have a hefty profit, your catalysts worked out the way you expected, and management didn't do anything dumb. Now is not the time to rush. You must ask what your alternatives are. Do you sell because you have made money? All your position or part of it? Or do you hold on because you're going for the kill? If so you must make sure you're not in a situation where the opponent promotes one of his pawns to a Queen, changing the dynamics of the game.

How often have you wondered, boy if only I sold back then? It is hard to call a top, so I like to unwind a part of my position once I have attained a target, then a second part if it moves a certain amount up or down from my first exit point.

There is a lot to be said about buying stocks, like there is a lot to be said about chess openings, but the really hard part is deciding how to sell. There is no perfect answer, and there seems to be a consensus among professionals that selling never gets easier.

Finally remember that no loss is fatal, and that if you lose, you can always put the pieces back on the board and play the next game. Also, in investing, unlike in chess, you can beat the computer.

source: wired

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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