Margin of safety

6 minute read

Margin of Safety

Smart people often think that their achievements in one field qualify them to make decisions in another. Nowhere is this attitude more ruinous than in the evaluation of investment opportunities. The main reasons for this are selection bias and the fact that trading is to a large extent a zero-sum game. Investment opportunities that appear in front of you are not an unbiased representation of the universe of investment opportunities. If an investment opportunity represents deep value, the average layperson will only get a gimpse of it after it is picked over by sophisticated investors. In contrast, the average patient that appears in a hospital has not been passed over by thousands of other hospitals. with the probability that their ailment is treatable decreasing at each pass. In addition, the preponderance of medical procedure make money for the hospital, while trades are much closer to 50-50.

In the face of these forces, the best attitude is one of financial nihilism. As a retail investor, it is exceedingly difficult to be confident you are making a positive expectancy trade. In response the best we can do is follow the following general principles, in order of importance.

  1. Have a system of some sort
  2. Limit your downside
  3. Pay attention to your gut when you get a bad feeling.
  4. Make positive expectancy bets
  5. Minimize taxes
  6. Minimize fees
  7. Take risk in line with your life goals

In addition, it’s important to keep in mind that investing simply isn’t that important. Financial markets work quite well, and it takes a lot of discipline and hard work to make above-market returns. A dentist who focuses on achieving world-class professional results and making boring passive investments will out-perform one who is only average and spends all his time chasing the hottest investments.

General principles

Have a System

The emphasis here is to have a system of some sort that changes relatively rarely. Even a crappy system that doesn’t work is better than no system. This is meant to act a sort of statistical regularization on our trading, preventing us from overreacting to the latest market fads or emotional swings. Even state of the art techniques in statistical regularization can appear rather crude, even though they perform with stunning efficacy in practice. It’s fine if this system starts out crude, it can always be updated as time passes.

I recommend you structure your system as a fast and frugal decision tree. Each node should have two children, and one of them should be terminal. In other words, choose a set of criteria and only invest if every criterion is met. The benefit of this is that these types of evaluations are much easier to do in your head than a quantitative model would be. The main downside is that you might miss out on great deals this way. In general, this is fine because life is long and opportunities are many.

For example:

Hot Real Estate deal
| Do the GP's have any skin in the game?
|-- If not, don't invest
|-- Is there free cash flow every month with a cap rate of at least 7%?
|---- If not, don't invest
|---- Are you at most 2 degrees of separation from the GP?
|------ If not, don't invest
|------ Invest

Limit Your Downside

Don’t make bets that have unlimited downside, ie selling naked calls or getting involved with a mafia. Life is long, and if you keep doing this, you’ll eventually go bust. Beyond this, choosing the right sizing is a bit fiddly. You can go one of two routes if you want a systematic way of doing this. One simple technique is to choose a fixed max bet size that is some fraction of your net worth. If you always use the same bet size, you have the advantage of being able to look at all your investments in a spreadsheet and immediately being able to know how well they have done. A better technique is to use the Kelly Criterion, but this requires you to estimate the incredibly fiddly parameter of probability of success.

Listen to Your Gut

There’s a lot of information about the world that you know subconsciously, but is difficult to systematize. You can’t quantify a bad feeling. Even if everything else tells you to invest, investing in things you don’t believe in is rather painful and you’ll frequently question yourself.

Make Positive Expectancy Bets

Every time you enter an investment, you should compute your expected payoff. If you are making a bet that isn’t positive expectancy, it is at best a form of charity and at worst a mistake. The one exception to this is when you are buying insurance for the sake of making a different positive expectancy bet. For example, life insurance is negative expectancy, but maybe you can’t live your positive expectancy life with peace of mind without it.

Minimize Taxes

Know the difference between long and short-term capital gains. Frequent trading will cause all your returns to be subject to short-term capital gains. It’s a lot harder to make money at a 35% tax rate than at a 15% rate. In addition, this acts as a sort of crude regularization on trading volume, pruning out frivolous transactions and freeing up your mental energy. It should require a lot of conviction to turn a long-term position into a short-term one. Tax-advantaged accounts are similar. If you aren’t maxing these out, that’s the lowest hanging fruit beyond paying off credit card debt.

Minimize Fees

In an efficient market, it should be hard to make or lose money in expectation, with the glaring exception of fees. Always read the fine print, and don’t assume that fees are “reasonable”, or that “you get what you pay for”.

Take Risk in Line with Life Goals

If you’re young, just ignore this one and focus on making positive expectancy bets. If you’re old, take little to no risk.

Fast and Frugal Trees

These are some decision-making rules that I have found useful. It’s useful to separate out private from public markets for this purpose since the difference in selection bias is so extreme. The next Google is not looking for 50K min investment from a bunch of white collar workers. They will get a big chunk from Sequoia or a small chunk from YC in exchange for a great network. You can’t offer them convenience, stewardship, or a network, so by and large investment opportunities you see are ones that more sophisticated investors have passed on. Of course, if it’s your best friend chasing a specific local opportunity, this concern is less relevant. On the flipside, if you’re looking at some nano-cap pink sheet stock, the private market list might be more applicable.

Private Markets

  • The people you’re investing in need to have a lot of skin in the game.
  • This should not be the first time they’ve taken outside money
  • The expected return should be in line with other market opportunities (not too good to be true).
  • They have more than just a website / prospectus and smart people
  • Capital will be locked up for less than 10 years
  • No correlation between existence of company and success (ie, in the case where they succeed, you own none of it).
  • No spelling mistakes
  • This is the best team for this opportunity
  • Contract has no weird clauses that you haven’t seen elsewhere. Ie, avoid deals with creative lawyers.
  • Real return of at least 5%
  • Don’t make a greater fool trade.

Public Markets

  • Cyclically low P/E
  • Momentum is going in your direction
  • Do you know something that you have reason to believe is not priced in?
  • Not at ATH