← Excess Returns 
Excess Returns
The Most Powerful Investing Tool You Aren’t Using | Four Lessons from Michael Mauboussin
00:47:29
Loading summary
Transcript104 lines
- [00:00]
Podcast Host
We have now asked our standard closing Based on your experience in markets, what is the one lesson you would teach the average investor to hundreds of guests, we have decided to take the best answers from that question and turn them into a book. Our tentative title is the Most Important Investing what the World's Best Investors Would Teach you. Rather than write the book behind the scenes, we thought the best way to do it would be to learn in public. So we have started a substack, excess returnspod.substack.com where we will post each of the draft chapters to get feedback from our audience. We hope you will subscribe and follow along in this episode of our separate podcast, two Quants and a Financial Planner. Jack and Matt discuss the first chapter, which is based on Michael Maubouson and his idea of base rates. We hope you enjoy it and we'll follow along with us on the substack as we write the book.
- [00:37]
Michael Mauboussin
I think that I would encourage people to learn about and apply base rates as they think about the world of investing. By the way, it's not just valuable for investing, but really business or your life. Actually, the point I make over and over is that multiples are not valuation. Let me just stop there. Multiples are not valuation. They are a shorthand for the valuation process, and one should never confuse those two things. Expectations investing has three steps. The first step is to go backwards and say the only thing we know for sure in this whole equation is the price. So let's go back and reverse engineer using a discounted cash flow model, which is an appropriate way to think about economic, both theoretically and, I think, practically think about what has to happen for this current stock price to make sense. Skill is not not only high, but it's uniform. Right? And you think about how many smart people go into this industry and how motivated they are and how hardworking they are and how thoughtful they are. It just defies logic that there's no skill. There's huge amounts of skill.
- [01:32]
Jack
It's just.
- [01:32]
Michael Mauboussin
That's the problem, right? And that skill gets reflected in prices. And if prices to the degree to which they're largely efficient, then means. That means the random walk kind of thing comes into play.
- [01:42]
Jack
So, Matt, apparently we're writing a book. I don't know if I've told you yet, but we are.
- [01:46]
Matt
What.
- [01:49]
Jack
And you're the best writer of all of us, so you may need to lead up the effort here because, as you know, I'm a very C writer at best.
- [01:56]
Matt
No, no, no. You're. You're a very functional writer. But I'm really excited for this because it felt like we're having all these great conversations. We're even in many cases making notes or doing stuff to memorialize these. It's. It's not a big extra step for us to go, let's put this in some type of format so people can have this and put on their shelf. I would have bought. The book I feel like we're writing is a book that I would have loved to have on my shelf 15 years ago. And that's a really cool feeling.
- [02:22]
Jack
Yeah. Because what we realize is, you know, we have this standard closing question, which is based on your experience in markets. If you could teach one lesson to the average investor, what would it be? And we've asked, like, some of the best investors we know. I mean, we've asked like 200 people that question right now. And that sort of logically flows into a book which are, what are the. What are the best lessons that these best investors would teach you? And the working title we have is the most important investing lesson. What the world's best investors would teach you. And so I think it's a really cool way to bring together all those lessons. Obviously, the book does not exist yet, so there's no leak to buy it or anything. But what we want to do is, the best way to force us to do this is to do this in public. And so we started a substack. It's excess returnspod.substack.com the primary goal was to put the book chapters up as drafts and to work with our audience, you know, to revise it and to get it, make it better as we go. But Also the excess returnspod.substack.com will also be a depository for all the old episodes, the old transcripts, some other original content we're creating. So if you do follow us and you like our stuff, that's a good place to go to get all this.
- [03:20]
Matt
Come visit us, say hi. And let me put the highlighter when Jack just said, we want feedback on this. So if you look at, like, what we're going to talk about today, if you look at that chapter, if you look at those ideas and something's really resonating, we'd love to know we did something right. But more so if you're like, ah, this part doesn't really work for me, or this is. I'm confused by this. That's why we're putting it on substack first. Because Leaves of Grass, baby. Do you get that reference? Do you know about the rewriting of. That's all right. Millions and millions of redrafts has been normalized in history, and I will anchor us on that as long as the day is.
- [03:56]
Jack
And yeah, we're used to, you know, we've had to develop a little bit of a thick skin here because we're used to operating on YouTube, which is. We're used to getting instantaneous comments about a variety of things we do. So it would have been weird to, like, write a book and then be like, here's the whole book that we've done in the background. It would make sense for us, like, it's better to work back and forth with our audience like we have on everything else, and to try to make it as good as possible when we eventually do it, which we don't even know when that's going to be, but we're going to shoot for every week or two to get a chapter up and, you know, hopefully in the next year or so we'll get it done.
- [04:23]
Matt
Here's two giant baby steps, Jack. Let's see if a book comes out on the other end.
- [04:29]
Jack
So now let's. Let's move on to the topic of today, which is the first chapter we wrote is about Michael Maubison. And I can't think of a better person to write the first chapter about because there's just so many. Like when I went back through his episodes, there's so many great lessons in there. And maybe the. One of the biggest ones is this idea of base rates. So that's the first section of that, is what the primary goal of that first chapter is. And so let's start before you and I get into base rate, let's hear Michael talk about base rates. So here's Michael talking about what a base rate is.
- [04:57]
Michael Mauboussin
I think that I would encourage people to learn about and apply base rates as they think about the world of investing. By the way, it's not just valuable for investing, but really business or your life. Actually, it's good for your life. And again, a base rate, you know, the, the, the. The basic setup is the natural way to think about the world or solve your problems is to gather a bunch of information and combine it with your own inputs and experience and project into the future. And that's, that's what we all do. Left our own devices using base rate says, I'm going to think about what I'm facing now or my problem as an instance of a larger reference class. I'm going to basically ask what happened when other people or Organizations were in this position before. And it's a very unnatural way to think because you have to leave aside, you know, sort of your own information gathering and your own experience. We all tend to place a lot of value on that. And you have to find an appeal to the base rate, which may not be at your fingertips and often it's not. So you have to go out and make a little effort to find it. But once you do, I think it reshapes how you think a lot about the world and I think makes you more grounded in terms of how you think about how things are likely to unfold. So to me, if that would be the one idea is to say, let's think about base rates. You know, you mentioned before jokingly that we're in that sort of season where people do forecasts. You know, that's a great example where base rates would be very helpful. And you, you sort of made the joke 10% with some standard deviation. But that's actually the right way to think about it. That's, that's actually the right answer. And that was, that's informed by, by base rates. So you're, you, you got to the right place and the right way to think about it using that actual technique. So to me, that would be the one bit of advice I would give. And if I could go back to my 20 year old self, that's certainly what I would teach. And by the way, I would just say that it's remarkable how underutilized this concept is, notwithstanding its demonstrable power.
- [06:33]
Jack
I don't know about you, but this, this idea kind of flipped a lot of things for me, you know, because I'm the person who's sitting there and trying to analyze any situation and say, all right, let me look at all the facts on the ground and let me figure out what's going to happen. And this sort of inverts that completely and it says, all right, no, let's not do that. Let's just look at when these circumstances existed in the past, what is happening? And so, so a good example would be like if a company's growing its earnings 50% a year or something, I could probably look at their business and say, are they going to continue to grow 50% a year? And that's probably part of what I should do. But the other thing I could do is say, let's look at every other company that was growing their earnings 50% a year in the past. Like how many of those were able to sustain that growth rate? And that may give me valuable Information as I analyze that company, this whole.
- [07:14]
Matt
Idea, and this is a repeating, if not iterative, iterative thing with Mosen's work is you take an idea like the inside, outside view, you take an idea like base rates and how you set them, and then you learn, like you read the Gary Antonacci stuff on, on Momentum and you go, okay, am I comparing something against myself or one thing comparing it against itself and then comparing it against a broader reference class. How's this doing relative to all these other things? You start to see all the ways these line up and it falls through on all sorts of levels. It could be on the company. Where you go, this company is growing at 15% a year. Well, how have those conditions existed for companies growing at this clip in a broader reference class? That ability to zoom out to the wide angle view and then zoom in to the really narrow, what's going on in the ground level view and then reconcile the two, that is a crazy hack that has applications well across finance, if not across life.
- [08:11]
Jack
And one thing I think people get wrong is the idea that I should just use base rates or I should just apply the outside view. Like what Mobis is talking about is you should use this to supplement what you're doing. So, for example, if I looked at base rates and I looked at the Mag 7, I would have been like, this thing's all over, it's done. These companies will never grow at these rates. And yet they did. And so some smart investors figured out, yes, there are base rates about this, but there's different things about these companies where they're going to maybe defy those base rates. So it's just like a tool in the toolkit. It's not the entire thing you do.
- [08:40]
Matt
Yeah, and that's that interchangeability. Because once you know that this is not historically normal, but I can find one off smaller examples of if these criteria happen, this is how a company sustains those growth. Now you can reconcile them with each other. You can't use these in a vacuum, but you can use these as a reconciliation system to figure out how does this work.
- [09:02]
Jack
And it carries into life too. I mean, there's so many examples where no matter what you're doing, you can look at it and say, all right, historically, when this situation occurred, what happens? You know, whatever it is, if you're starting a small business, you know, you at least know the odds of success, like of a small business in the category you're starting it. That doesn't mean you don't start the small business. It just Means that, you know, like this restaurant or this bar that I want to open down the street, like, it's probably not going to work out based on the base fees. I don't know what the base rates are on bars, Matt, but I would assume they're, they're quite irregular.
- [09:28]
Matt
They're, they're pretty low. It's basically like, you're going to start this bar. Well, what future do you see, Jack? How do you like, do you like tax fraud or divorce better? Like, which way do you want to. But, but no, seriously enough, like, on the financial planning side, this is huge because people will talk about it might be paying for your kids for school, it might be paying off your mortgage, it might be paying off all this stuff. And the first view you're going to take is, okay, well, if you're going to save a bunch of money, you're going to pay that mortgage down faster. What's your propensity to save? What's your capacity to save? How good are you doing things like this? Personally, in the past, now we can zoom out and go, what's the experience of other people similar to your capabilities and what they've done? And you know, did this make them happy or is this something that they're like, ah, this, this didn't really make sense. If you can reconcile those two views, what makes sense to you, what makes sense in an optimal stance, then you can pick which one you have to override, which one you have to adjust, which one, which one you want to reverse course for. If you want to throw in the towel and open up that bar, restaurant, you can go in those directions once you have all this stuff on the, on the table.
- [10:33]
Jack
So this next lesson we focused on in the book was the investing lesson from Maubousn, which is this idea of expectations investing. And this is another thing that really flipped things for me when I, when I started thinking about things this way. So here's Michael talking about that.
- [10:43]
Michael Mauboussin
So expectations investing has three steps. The first step is to go backwards and say the only thing we know for sure in this whole equation is the price. So let's go back and reverse engineer using a discounted cash flow model, which is an appropriate way to think about economic, both theoretically and I think practically think about what has to happen for this current stock price to make sense. Right. So, and that's going to be typically articulated in things like drivers of value, which would be sales, growth rate, margins, capital intensity, those kinds of things. Right. And so the key to step one is to try to be Sort of agnostic, right? Like you don't have a view of the world necessarily. You just want to say what has to happen or what does one need to believe for today's stock price to make sense? Right. So if you want a metaphor for that, it would be where is the bar been set for the bar, A high jumper. We don't know how high that high jumper could jump yet, but we know the bar set at 2ft, 5ft, 10ft, whatever it is. Step two is then introducing historical analysis, but more importantly, strategic and financial analysis and to judge whether that company is going to meet, exceed, or come short of those expectations. Right. So that's really where the rubber meets the road analytically. And again, history can be a really good guide for that. But. But it's also. And by the way, the other thing that comes out of this is really important is, you know, typically lower multiples are associated with lower expectations. A higher multiple, high expectations. But you might notice that that whole discussion goes out the window, right? It's not really the difference, just low multiples. It's really how will the company perform vis a vis what's priced in? Right. So that's step two. And of course, the. And I should say too, that that is a very probabilistic exercise. We argue that coming out of step two, what you should have is a number of scenarios for potential outcomes and you should attach probabilities to those. So we're really, we're going to think about the world in an expected value terms rather than, you know, here's the answer. And then step three is of course, buy, sell, or hold as appropriate, based on steps one and two.
- [12:37]
Jack
This is so rare, I think, because when I'm analyzing a company, what I want to do is I want to say, like, here's what I think the company is worth, and then I want to compare that to the stock price. And this is taking that in the exact opposite direction. This is saying there is a stock price. What are the expectations that exist in that stock price? And then I could start looking at the world and how I think the world might play out relative to those expectations that are in the stock price. So it's sort of like flipping around the way people typically analyze a situation like this.
- [13:05]
Matt
When did you come across expectations investing? That, that book and this whole idea. Do you remember when this found you in the world?
- [13:13]
Jack
It was definitely before. I mean, I think. I think this interview we're playing Cliffstone for Michael was in like 2022 or something like that. It was well before that. But I don't know exactly.
- [13:22]
Matt
Somewhere for me, probably in like the 2000, somewhere between 2010 and 2015, maybe 2017, somewhere in that window. And it would have been because probably, like, I heard him on Consuelo Mac or something like, like, however he, like somebody introduces you to him and you started reading, like, the Leg Mason stuff and all the. The behavioral papers and whatever. I was like, I should get this book, that book. And this whole idea of instead of doing what you just described having, like, this is what I think the stock is worth. Here's five scenarios of what I think the stock is worth. If this is happening, if this is happening, if this is happening, this happened. Bear cases, bull cases, base cases, and variations in between as many as you need to have. Because then once you figure out what's the stock worth and all these different considerations, then you can start going, how do I probabilistically weight each of these things? And that guides you to what's the Elroy Dimson? The risk means more things can happen than will happen. It's something like that. Do you know what I'm talking about?
- [14:22]
Jack
Yeah, I think that's right.
- [14:23]
Matt
Okay, so risk means more things can happen than will happen.
- [14:25]
Jack
So.
- [14:26]
Matt
So the whole spot pot of spaghetti noodles, like only one of those noodles becomes the historical record. But it's like all these variations that have to be there and you want to be aware of in order to inform that call. That's such a different way to look at the world and look at people going, like, I think this is worth that, like, maybe 60%. What are we putting on this?
- [14:49]
Jack
Also, what you just said about probabilities is so important because even when people use this expectations, investing, they want to say, like, here's the way I think the way is going to the world, the way the world is going to play out. And they have like, this one scenario, and it's. What Mobison is talking about is taking a bunch of scenarios and probabilistically weighting those scenarios and then looking at it from that perspective. And that's very different than those of us who think we have the confidence. Because, you know, as we know from, like, behavioral research, all of us are very, very overconfident, and we think we know what the scenario is going to be. But it's more important to think about all these scenarios, both good and bad, and to sort of look at it from a probabilistic standpoint like that, that.
- [15:22]
Matt
And then it can tell you, on average, this is something we use in the financial planning sphere. All the time too, where it's like, on average, are you at or above the, not even the expectation where you want to or hope to be. And so it's like we're going to take into, into consideration all these like dreadful scenarios and if we still bake those in and on average it's like, yeah, this is an acceptable outcome. That's what we're aiming for. Like, we can't aim for 100%. I can't tell you if you're going to get, have some like horrible affliction in your future. But I can say when we weigh out all these options, we still think this is better off on this path. That mode of decision making where you let go of an absolute knowledge or control of the future is, is actually quite empowering if you can train your brain or retrain your brain to embrace it.
- [16:08]
Jack
And that mag 7 example I gave before, I think is a really good example here because like, if I look back, you know, whatever it is, you know, eight years ago or something, looked at Google, I would have said, wow, there's a lot of expectations built into that stock. But somebody who was analyzing, using this framework, who had a different view with that can say the actual reality ended up being way, way, way beyond those expectations. So it was a good way to look at it and say, yes, there are these expectations in the stock. But the people that were right about Google realized there's a much bigger future in line here or there's a higher probability of this bigger future that far exceeds those expectations.
- [16:41]
Matt
There was a couple of people back when it was back when Amazon started to break off the Amazon Web Services reporting because remember, for a long time they didn't report those. So they had launched the business, but they weren't telling you like what was going on. They might tell you how much that segment grew, but they didn't break it out. And somebody had done like a sum of the parts analysis to try to back it up. And I remember Ben Thompson at Strachekery writing one of these posts being like, it's somewhere in these ranges of what this is probably worth. I remember reading that and very unfortunately it did not cause me to put like a million dollars into Amazon or something, otherwise we might not be having this conversation. But it did make me realize, like, even under the hood of this company that already feels so big and so richly valued. And so I remember being like, but it's twice the valuation of like Walmart or whatever, is that really what not having stores are worth? And it's well, there's this other growth engine inside that nobody knows how to evaluate. So how can we start thinking through what this could mean, either in upside for the company or in development or in other forms of leverage that we're not yet understanding? And it's constantly making sure you're aware of putting that stuff back onto your radar. And sometimes it comes from unexpected places, like it comes from like a Ben Thompson at stratacherie in 2015 or whatever the hell year it was.
- [18:00]
Jack
Yeah. And then obviously for value guys like me, there's the flip side of this, which is a decade ago we were like this retailer in the mall. Just, you know, those expectations are so low, it couldn't possibly do any worse than that.
- [18:09]
Matt
You're going the last series, it did a lot yelling at, yelling at Bezos.
- [18:15]
Jack
Right.
- [18:16]
Matt
You're going to be another bankrupt mall. Your fee is too high.
- [18:20]
Jack
But this does relate to value investing in that what value investors are betting on to some degree is that across a wide number of cheap companies, the expectations are too low for those companies and the reality on average across them is a little bit better. Now, that didn't play out in the past decade or so, but that has played out over 100 year period. So it does relate a little bit to, to what I do with value investing.
- [18:40]
Matt
And this goes back to your probabilistic argument because there's different strategies. Much of value investing boils down to can genuinely awful become less bad, not can good become great. Growth and momentum investing is can good become great or can we. Can good become amazing? But most good value investing turns into can genuinely awful turn into maybe not totally terrible?
- [19:03]
Jack
Why did I think a lot of investing strategy like where genuinely off what I want to happen is genuinely awful to turn into bad? That doesn't sound like a very. When you put it that way, Matt, it's like maybe a different approach is.
- [19:14]
Matt
In order, you know, not necessarily. It takes, it does take a village and somebody has to have the really dark and sadistic humor. So I like to think we all have a place.
- [19:25]
Jack
So as we, as we move on to lesson three here, this is a great one because this, this applies to life, to investing, to everything. All of us want to use shortcuts and often when we use the shortcuts, we have no idea what they actually mean. So here's Michael talking about that.
- [19:37]
Michael Mauboussin
The point I make over and over is that multiples are not valuation. Let me just stop there. Multiples are not valuation. They are a shorthand for the valuation process and one should never Confuse those two things. Right. So the valuation process is the present value, future cash flows. Multiples are shorthand. Now, what's good about multiples? What's good about shorthands in general? Right. They save you time. Right. And by the way, I should just be clear. I use multiples. If you and I were having a convers, casual conversation, we might, I would maybe drop multiples about a particular business, whatever, that's fine. But the key is that you understand the economic implications of the multiples that you're using. So you're saying, I think this should be a 15 times EBITDA or the 30 times earnings. So what is that? What do I have to believe for those multiples to make sense? And so, as you know, we spent a lot of time writing about, we wrote a piece called what does a PE multiple mean? We wrote a piece called what does NVD but down multiple mean? Essentially creating a bridge between those multiples as people tend to use them, and the economic, the underlying economic assumptions that you need to make in order for those to, to justify those multiples and just to be really explicit about those things. And you know, as wat the motor. And at New York University, sort of the Dean evaluation, he's talked a lot about this. He surveyed investor reports and he's found, or analyst reports, pardon me, and he's found that, you know, nine out of ten rely predominantly on multiples. So this is how people tend to talk to one another. So again, as I tell my students, the end of the, you know, sort of end of our evaluation module, you have to sort of earn the rights to your multiples. You, you can use them, but earn the right. And, and the way you earn the right is to demonstrate that you understand the underlying economic assumptions that are embedded. Right. So the last thing I'll say, and this goes back to expectations investing, broadly speaking, which is the assumptions about future value creation, investment needs all the. That's implicit in a multiple. It's implicit. It's not that it's not there. It's implicit in a DCF model. It is explicit, right. So people go, oh, well, you just change the assumption a little bit. The value, absolutely. But that's explicit. So the question is, would you rather have something implicit and buried? And then we don't really know exactly what we're doing or explicit and overt. And then we could debate, right. And then that, that to me, of course, the latter is a vast, vastly more attractive proposition than the former. So. So economic cul de sac might be a little bit strong, but but that's, that's the basic idea. And then a related idea I'll just mention quickly is there's a presumption often that growth in and of itself is a good thing. And what we, and we demonstrate this in a simple appendix in chapter one, I think it is actually that growth in and of itself is not value. It needn't be value creating. So the key concept is growth adds value when a company's earning above the cost of capital. Right. So qualifying growth, in fact, the way you should think about it is return on capital, cost of capital, spread is first and foremost. And then growth amplifies, right? Makes a good thing better. And if your spread is negative, it makes a bad thing.
- [22:19]
Jack
Even this thing he said in that clip of multiples are not valuation. Like, that has stuck with me forever. Like, I've used that in a bunch of podcasts. We've done, like, ever since he said that. Like, like that. I don't know. That just like, got stuck in my head. But, but he's talking about this idea that everybody wants to be like, well, it's seven times earnings. I love this business. And they have absolutely no idea what it means that, that the business trades at seven times earnings. And, and if you take Moon's class, which, you know, thankfully I don't have to, because I would have to go through this whole process. You are. He takes you all the way through the process of understanding what that multiple actually means. And when you can prove to him that you understand that, then you can use the multiple.
- [22:56]
Matt
This I remember, too. I remember reading this in that paper that earned the right to use the multiple paper. And I remember the pin coming into my ego balloon and being like, oh, boy, this is. This is tough. Because different valuation multiples, they're good shortcuts, they mean different things, but they're not the same. And then there's. There's layers to them. I specifically remember this layer too, because I remember. I remember thinking about. I was. Did you ever have this experience? Some people have it with sports. I definitely had it with sports and music. At least where you realize you're like, you're better than average or you're good at something, and then all of a sudden you find out, like, just how high the ceiling is for certain other people who are in the more special class than you are. You know that feeling?
- [23:40]
Jack
Yeah, yeah, No, I do know that feeling. I was like a. I was like an above average. Which is, which is terrible because it's very cliche with my name, but I was an above average tennis player growing up. And then like I got to.
- [23:51]
Matt
And then, and then I got to.
- [23:51]
Jack
Kind of high school and like my, my school that I went to, Fairville High School in Connecticut, was like one of the top teams in the country. James Blake was on the team. And I quickly realized that I was not good at all. And I like, basically capped out at like the upper JV team. And that was the end of it for me.
- [24:06]
Matt
So what's crazy is like, you learned the fundamentals of this sport. You understand the things. Like you understood the shortcuts you could take to like win at games on average against average and below average competition. But then there's like a whole next level. And I remember part of reading this thing from him and explaining like, how you have to earn the right to use these multiples and see how they fit in different industries, in different sectors and different like, well, these are the growth assumptions you're baking into these scenarios that you're, you're mapping out. And it's like even earning the right to just baseline pass. I can tell you why this multiple exists for, you know, whatever tech companies should trade about against this much free cash flow, but these other companies, these industrials should trade against this version of operating income. And here's why. And here's where I use enterprise value. Here's where I don't care, like, all that stuff. There's also the next level. There's the Michael Mobisons and like Bill Miller. So the world running around, and I don't want to get on the court with them. It's very intimidating. There are rights.
- [25:09]
Jack
Mo was someone. I would not want to be up against anything on any level that requires any sort of intellectual skill. But the other point he made, which I think is important too, is it doesn't mean you can't use the multiples and it doesn't mean you can't use shortcuts in life. It just means that, like, when I'm talking about the multiples, I have to understand what's going on behind the scenes. So Moses mentioned in that clip that he, when he's talking to some other very smart investor, they'll say like, oh, yeah, that business is at eight times free cash flow or something. Like, they'll have that in the conversation. But implicit between the two of them will be both of us understand what that actually means. And we're not taking that as like that's the only thing we're looking at here.
- [25:42]
Matt
Exactly. And that's. You just said the point I was trying to make a little bit clearer. It's when you're using those shortcuts, those shortcuts are still, they're still essential. You still have to use them. They help us communicate, they help us tell the story. They also help us go, I just did all this work and compressed it into this one area. You still put all those man hours in on the tennis court to go. Now I don't have to think when I do this forehand, this swing, whatever it is.
- [26:11]
Jack
So it's.
- [26:11]
Matt
You get these things, you bake them into your head, you bake them into your logic and your thinking and then you can use them because you can apply them. Those shortcuts are still essential. You just have to earn your way up to getting there so that they don't turn around to bite you because otherwise they become bad habits.
- [26:26]
Jack
Yeah. And I don't know if this too relates it completely to this point, but like, I've been thinking about this a lot with the LLMs because shortcuts are becoming more and more available to getting towards places. And I'm thinking a lot about like the efficiency I gain by using shortcuts versus what I lose. And like in each thing I'm doing with them, I'm having this trade off between like, am I using the shortcut or am I thinking about it more deeply? It's just something, it may be a side point that's not completely related to this, but it's just something I've been thinking about a lot recently.
- [26:52]
Matt
They make it so easy to outsource your thinking if you're not really on top of not letting it do that. I, I would say that applies here too. It's any place where there's a, a shortcut, a hack, a way to just quickly get from one point to another where you almost feel like there's a little bit of like a cheat code going on, then just, it's stopping to say, wait, wait, wait, that that's a shortcut. We are bridging. Two very large sets of data are very like, there's a lot of depth and nuance here that we are now skating over the surface of. And if we start to unpack it, there's a lot of color that we're going to start to extract. And we want to make sure that we're not doing that for the wrong reasons. I see that with LLMs. I see that with, you know, post cultural analysis of the Little Mermaid in Disney films. Like there's lots of places you can present a very compelling argument but you want to make sure you can drill down and be comfortable with those results. And they justify the shortcut you're using.
- [27:48]
Jack
Yeah, because when you use them improperly, they prevent learning, basically. And that's kind of what I was getting at with the LLM thing. And that's what I worry about, like with my kids, too, is as they grow up in a world where these things are going to be dominant, is this idea that if you can do the shortcut and you never do the work, you don't have that knowledge and that you know that compounds over time if you continually do that over and over again.
- [28:06]
Matt
Yeah. If you just let ChatGPT and Claude write the entire book for us, Jack, will we really be authors?
- [28:14]
Jack
I don't know. I mean, I guess I think a lot of people are going to test that theory based on how good these things are getting. You're probably going to see a lot of books that you have no idea were written by Chat gdc.
- [28:22]
Matt
There will be, if there aren't already, tons.
- [28:25]
Jack
It's all the M Dash, nat.
- [28:26]
Matt
Right.
- [28:26]
Jack
You just got to look for that M dash. I don't even want to get you going on this.
- [28:29]
Matt
Don't get me going on the M Dash. I'll defend Emily Dickinson to the death.
- [28:34]
Jack
Matt and Chat GBT are going to be the last two people using the. The M dash, basically, and Matt's going to actually be writing with it and everybody else.
- [28:42]
Matt
I don't even use EM dashes. I've always been scared of them. I grew up with two English teachers as a mom and a grandmother. Like, I'm terrified of EM dashes and semicolons. It's just seeing those all show up. I'm like, you don't have the confidence for that. That's. Yeah, you're. You're throwing around valuation multiples with no idea what you're doing here, people. This is a danger zone.
- [28:59]
Jack
Well, I was never a good enough writer to properly use it, so if you see it in my writing, the likelihood is that I. I've done it via ChatGPT would be. Would be the right guess in that case.
- [29:07]
Matt
I.
- [29:09]
Jack
So as we move on to lesson four here, which is the fourth lesson we had in the chapter, which is the life lesson. But this is also, and I feel like I say this every time we're talking about one of Mobas things that it changed the way I think. But, like, he's one of the few people where you can say that about a ton of stuff he's talked about. So here's Michael talking about the paradox of skill.
- [29:24]
Michael Mauboussin
It's one of these things that's not at first blush intuitive, but it's. I think it's right. So when you think about skill, you can think about it on two levels. The first is absolute skill. And I think we'd all agree, and all the listeners would agree that if you look around the world, not just investing, but business and sports or whatever it is, that the absolute level skill's never been higher, Right? And part of that is because we have better training, better techniques, better in investing, we have, you know, computing power and access to information and so on and so forth, right? So I think that's, there's not a lot of doubt about that. The second issue, though, is the one that's more important for our discussion, which is relative skill, right? Which is the difference between the very best and the average participants in each field. Now, I learned about this idea. It was not my idea at all. I learned about it from Stephen Jay Gould, who wrote a book called Full House back in the mid-1990s, and he was ruminating on why no one has hit over.400 in major league Baseball since Ted Williams did that in 1941. And you know, the argument he said was because essentially the standard deviation of batting average has come down a lot, which is there's more uniform skill. So even though the batting average hasn't changed all that much, and in fact the powers that be at Major League Baseball will change the rules to keep it sort of in a reasonable band, the standard deviations come down a lot. So Ted Williams was a three standard deviation event. And if you're a three standard deviation event now, you'd hit like 380 or. 385, which is awesome. You'd win the batting title. But you're not anywhere near breaching that.400 level. So I think the same thing's true in investing. And we can measure that, right? We, we measure by looking at essentially the equivalent of batting average, which is a standard deviation of alpha. And historically that's come down a lot. Now, I'll just say one thing, Justin, which is a little bit weird, is it, it's actually flattened and bumped up a little bit in couple of years. So for reasons I'm not sure I can pull fully put my arms around, so a part of that might just be, it's correlated with the actual dispersion of markets to some degree. So, so it, it there, there's some other external factors that come into play. But, but yeah, so, so that's the way to measure it. So when you look around and, and by the way, sports leagues, this is a really good sort of framework to think about this sport.
- [31:31]
Matt
League.
- [31:31]
Michael Mauboussin
Sports leagues are actually grinding toward parity. I know some of them have like salary caps in order to try to encourage parody, but they're all grinding toward parody because these guys are all so good. Right? So even the bad teams are really good. Right? And, and certain sports like baseball or, or hockey are, are very, very. The. The level skill is very high and very uniform. And as a consequence, luck has, appears to make, make a bigger, have a bigger role in the outcome. So that this is the thing I, and I, I push back. You know, in, in Danny Kahneman's book Thinking Fast and Slow, he's got a little section where he talks about investment managers and gee, they're so clueless about there's no skill in this industry. And I, and I went to him and I said, you know, it's actually the opposite. You know, the way to think about it is the skill is not not only high, but it's uniform. Right. And you think about how many smart people go into this industry and how motivated they are and how hardworking they are and how thoughtful they are. It just defies logic that, that, that there's no skill. There's huge amounts of skill.
- [32:28]
Jack
It's just.
- [32:28]
Michael Mauboussin
That's the problem. Right. And that skill gets reflected in prices. And if prices to degree to which they're largely efficient then means. That means the random walk kind of thing comes into play.
- [32:35]
Jack
This one is the most like mind bending for me of. So it's. This idea is as the absolute level of skill rises relative skill or becomes less important and luck becomes more important. So you might be able to explain it better than me, but this is like. It's something that takes some thinking to kind of wrap your arms around it.
- [32:51]
Matt
Yeah, I mean it's the losers game thing, right? Like this goes back to Charlie Ellis and the losers game in tennis where he basically points out if a pro is playing an amateur, the pro is going to smoke the amateur nine times out of 10, one times out of 10 or whatever the stats are. I'm throwing my own stats into his. Largely you have the right to make your own historical. Charlie, no one's fact checking. We're on a first name basis in the case though. Like that amateur might have a really lucky day and beat the pro. And we have to acknowledge that if the amateur beats the pro, it's probably out of luck. And statistically it's only going to happen once in a great blue moon, however, when we get too two pros or two amateurs. But let's focus on the pros for a second. Two highly skilled individuals with absolutely the same stuff, and we've set them off against each other. That game, the outcome will be determined on luck because one of them's gonna flub a shot, one of them's gonna do something, it's probably gonna make an error, and that's gonna be the unlucky reason that they lose the game. And I think with the skill luck continuum, as Mobison frames it, it's understanding that, like, with luck, you have to think of unlucky and unlucky, especially in competing situations, too, because you can have all the skill in the world and somebody else just gets luckier than you or you get unlucky or whatever else happens too. And then this framework just plays out in so many different domains. And that, to me, that's the lesson of that book.
- [34:13]
Jack
So there's a. There's a couple good examples. One is in baseball and one is investing. So in baseball, this is, this is hard to understand, but like baseball players are, I think anybody would argue baseball players are way better than they were back in the day. I mean, did you, have you seen Babe Ruth? Did you see what he looked like? Like, relative to these guys that are playing today?
- [34:27]
Matt
Yeah, he looked like. He looked like Kyle Schwaber, let's be honest, right?
- [34:31]
Jack
So maybe he would be. Maybe he'd be better than I think he'd be. But the point is, like, on an absolute basis, the baseball players are way better today, but yet nobody's ever come. Nobody comes close to hitting.400. And so why is that? And this whole. This whole paradox of skill explains this idea. Baseball players are way more crunched together now. They're all better, but they've crunched together in terms of standard deviation. And that explains it's actually harder now to hit.400, despite the fact that everybody's better.
- [34:56]
Matt
And there's, there's all sorts of examples across domains. And that becomes one of the most important insights of the book. You should look at each domain. You should think about the people who are on that field and competing against each other, and then try to determine where on that skill luck continuum things exist. Because that can also tell you where to place your focus. It can tell you if. If I'm going to play jack forehand in tennis, even if you're, Even if your tennis game is not good, I assure you, like I played tennis A couple times in gym class in high school. I think, like, that's the extent of my experience. You should smoke me. But I should walk into it with the confidence that, hey, there's a chance I could get wildly lucky, be the same thing. Have I actually ever golfed in my life? Done enough mini golf on the boardwalks and other fine places in strip malls, but I don't play real golf. But could I go out there and have, like, an insanely lucky day? Yes. Most likely I'll have an insanely unlucky day and it'll be a disaster. But there's just. I'm going to approach those domains where I don't have skill of luck will determine this outcome. If it is a domain where I have skill, I want to understand my relative skill next to the other players to try to go, how can I tilt luck in my advantage?
- [36:05]
Jack
And this helps to refute this idea. Like, a lot of people will say, oh, there's less and less active managers, so it's way, way easier to outperform. But it's not because the active managers that are left are all really, really good and they're tightly bunched together. And so you actually have a situation where it's harder to outperform now. So Michael kind of takes that. The simple thing that I used to say for years, which is this idea that, oh, let's, let's get rid of all the active managers and I'm going to be outperforming. Like, that's wrong. And when you look at it from this context, you understand why.
- [36:29]
Michael Mauboussin
Yeah.
- [36:30]
Matt
And I would also throw that into spaces where this is also where you get into, like, degenerate tendencies. This is where you also get into moral hazard. This is where all this stuff comes from too. Because if all of a sudden you've neutralized skill, then you start to incentivize bad actors or stuff. So you look at a place where it's like, oh, a lot of money's flowing into, I don't know, crypto or private credit or pick, pick your punching bag vehicle. And then you go. This is what encourages bad actors, which also encourages them to get horribly, horribly unlucky. When the tide turns and you have to be aware of these, of these things, what's neutralizing the skill? What's that doing to luck? What's that doing to the way people are acting? Because sometimes that last return you can squeak out is not for the best reasons. And that's what ends up smoking you.
- [37:15]
Jack
Yeah, this is just a good thing to think about across life. And we had this as a life lesson in the chapter. But the idea of if I'm competing in something like, how tightly are people bunched? How high is the absolute skill? If I look at those variables, then I can kind of understand what's more important here. Not that skill is not important. And, you know, Mobis is not arguing. Obviously, investing, you know, skill is still important, but you just have to understand the. How luck comes in and how that relates to this, you know, this crunching variance and the level of skill.
- [37:42]
Matt
So when you're flexing on excess returns, channel growth, and you're looking at all those channels that you've passed, you're. You're just like, I am so much more skillful than all those peons. Right? That's why you always say this to me.
- [37:53]
Jack
I think I'm like the best YouTube thumbnail designer of all time. I probably should be looking at what is the level of skill of all YouTube thumb designers and how. What is the variance of that? And I don't know how you would ever calculate any of that, but I would say, thankfully, I'm operating in the world of investing channels and I'm not operating, like, against Mr. Beast, because those would obviously be two different levels of skill, two different pawns I'd be playing in there.
- [38:16]
Matt
It's okay, you can be. Miss your beast, something like that. We'll get you a nice variation.
- [38:22]
Jack
So this was actually your idea. So one of the things I like about what we did at the end of this chapter is you did something and this was your idea to do it. We did something here that I think maybe a lot of books or a lot of things you learn from don't do, which is it's great to read all this stuff and try to learn from it, but then you sort of have to challenge yourself and say, like, what am I actually taking away from this? What do I do in my life where maybe I'm not learning from this rule? And so we've got some sort of a lightning round here. Some quick questions maybe you could ask yourself to see. Am I gaining any value from, like, what I'm reading, from what these people are writing? And these are questions I have to ask myself all the time, too.
- [38:53]
Matt
This is the live capture of. And I learned this from doing my cultish creative post. This is the live capture of, like, I started to make a little dump file of the existential dread and questions that come up when I'm like, starting to think about these. I'm like, I don't really know how to answer this, or I'm going to try to answer parts of this. And I just started to save them because I was like, oh, well, maybe these will help other people. And I've gotten really great feedback on them. So I started prepping this chapter. I was like, I should just write down my existential dread as I'm going through this data. And then at the end, we can kind of like, target it so people can experience and share that existential dread. So this is sadistic, but go ahead.
- [39:31]
Jack
This is the thing that happens when everybody, whenever you talk to anybody about, like, these behavioral flaws we have as investors is like, you'll talk to them about them, including myself, and they'll be like, oh, yeah, that's great that they have those problems. And then you'll go back into your investing life and you'll just do all of those things because they're sort of, you know, naturally ingrained in you. So I think it's important to at least ask the questions afterwards and say, like, what am I taking from this? So, like, in a good example is like, the humility question we had here is, are we willing to start with base rates that might contradict our optimism? And that's an important question because all of us have this inside view, and we have to be able to look outside and say, all right, what am I doing in my life right now where I'm taking this inside view? And maybe I'm not looking at the base rates.
- [40:07]
Matt
We see that, dare I say, constantly in financial planning because we have to talk about negative scenarios. We have to talk about. We have this. The known unknowns risk segment that we do at the. At the end of the financial planning process as sort of like a. A recheck of all the work we just did to map out the other scenarios. And it's, what happens if I live longer than expected? What happens if I die sooner than expected? What happens if I get sick? What happens if I get sued? And these are all Debbie Downer moments. There's no fun, really, in any of these things because you're running out of money or something disastrous is happening at the end of all of them. But we know that once we've taken somebody through that process, of all the ways we're imagining life could go, we can't just look at the positive ones. And we have to interject those in and go, are we comfortable with these paths, too? And the plan's not really complete until we've rumbled through those hard conversations. So, yeah, yeah, you gotta have that humility.
- [41:02]
Jack
This next one is a great one. This idea of the reference class question, which is how do we decide what similar situations actually are? Because going back to like that earnings growth rate example I gave, maybe not looking at every company in history and saying what happened to every company that had a 20% earnings growth rate that might not be the proper reference class. Because this type of company, there might be a completely different reference class that's more important. So it's very important to at least look at that and say, do I have the right reference class? Because if you have the right, if you have the wrong reference class, you also are going to end up with the wrong base rates.
- [41:32]
Matt
One place that my brain immediately goes to with this one is you'll be talking to somebody and they have a rental property or they have an investment property or a bunch of investment properties and they're like, well, if I sell these properties, then what do I do with the proceeds? Do I 1031 into a new one or do I turn around and buy a reit? And you immediately you get into these conversations of like the valuation differentials between these things. It's like, well, if you sold the, you know, pardon the expression, if you sold the crappy house that you've been renting for 10 years and you go buy some publicly traded REIT ETF, like, of course those are going to be very different valuation multiples because you're trading extreme concentration and whatever location that rental property was for some giant index version of extreme diversification and everything else, you would expect a differential. But there's different trade offs and benefits. When the toilet breaks in my whatever product, REIT etf, nobody calls me, like, that's gotta be worth something. And you have to normalize around this. And if you don't have a framework for normalizing around it, you might be stuck comparing not just apples to oranges, but apples to eight balls. That, that can be a real problem if you don't have a framework to handle it.
- [42:46]
Jack
And I won't get through all the questions. Cause you can go to the, you can go to the blog and you can see the, all the questions. But this last one is very interesting, which is what are the base rates of our own judgment? And this is probably one of the hardest questions to potentially ask because I probably think the base rates of my own judgment are way, way, way higher than they actually are.
- [43:02]
Matt
Yeah, go read bread. Donnelly. There's a reason the man is a living advocate for keep that trade journal and keep all the steps. And if You've never seen. I know we've had Brent on multiple times. If you've never seen a person, especially like an FX trader, basically mark down the full range of experiences, data points and emotion that go through like just a morning, like a morning when there's a central bank announcement and just cataloging all that stuff and what you can get right wrong and be confused about along the way. You have to have a journal. You have to be able to go back, reflect or study these things if you want to do. Now, that's trading professionally. But I would say any investment decision or whatever else, knowing the framework you were in when you made that decision becomes useful later on. And that's. That's a meta question for all of us. Hard to do.
- [43:46]
Jack
And this is something we talked about when we went on Value After Errors with Tobias Carlisle. But this, this idea that I think LLMs help us with this idea because now we can, as we're putting all this stuff we're doing into LLMs, I can sort of get an evaluation of my judgment over time. I can maybe get a better, you know, unbiased evaluation of what I've done and I can catalog what I've been thinking. Because Toby's less answer to this question, which I'm sure will become a chapter as well, was to write it down. So the one lesson he would teach the average investor is to write things down so you actually understand where you were at that point, how what you actually thought at that point. Because we misremember everything about what we actually thought when we made a decision. So I think maybe LLMs will be helpful for this in terms of, like, judging ourselves against the base rates of our own judgment.
- [44:28]
Matt
Cannot agree with that more. I love. I think I've told you this before. I will regularly in my conversations with Claude, I will ask for rankings of stuff. I'll say, rank this thing I just did against these other things, whether it's look in these prior chats or I'm going to paste some of them in, give me that reference example of what's there. Give me pros and cons. I want to know if I'm like growing, if I'm treading water, if, like, something's wildly different and these are tools that can look in a second at 10 different things and tell you what's going on. And the idea that we wouldn't take that type of feedback when we're looking for that feedback for growth. Like, what a gift to have some of these tools, but you have to pick those tools this goes back to the examples too, of like, if you want to up your skills, look at the tools that everybody else is using to up their skills. You probably are gonna have to use the same. It's not like every hitter in Major League Baseball there was that the whole like the torpedo bat thing this year. You know, it's like things become trends and you have to understand if those trends are helping you or not and if they can help you. And if they are, that's the only way sometimes you're going to keep upping your skills.
- [45:30]
Jack
By the way, it's amazing, like, how little people talk about the torpedo bat now. Like, at the time that was going to like, change the game of baseball, it was an unfair advantage to the people that were using it. And now, I mean, I'm sure there's still people that are using it, but like, you don't hear about it at all anymore.
- [45:43]
Matt
I yeah, this is one of those things where I was wondering at about it, seeing a couple of games this year and being like, oh, here's a bunch of funky bats. And then slowly but surely over the course of the year, I'm like, I don't see too many of those bats anymore. I don't know. I'm looking for the post hoc analysis on that. That'll be an interesting one. There's always a weird one. We've got a World cup, you know, coming up soon, and it's like the. They change the ball every four years, basically, and there's always some crazy hubbub about that. Just these little things that mess with the games we love.
- [46:12]
Jack
That's probably a good note to wrap up on. So the blog is xsreturnspod.substack.com Bobuson chapter is pinned at the top and we are like, we're honest and we say we'd love to hear feedback on this. I've been called about every horrible thing you possibly called on YouTube here by our loyal our viewers. So we want to make this thing better. We want to make the book really good. And also if you have suggestions for other guests, I believe we're going to do Liz Annsandra's next for our next chapter, which will become another one of these podcasts. But if you have suggestions for great answers you think we've gotten to our closing question or people you think we should include in the book, definitely let us know. But if, if you do like our work, if you can check us out there. Accessreturnspod.substack.com, we would certainly appreciate it.
- [46:50]
Matt
This is the book we wanted on our shelves. We're hoping this is the book you want on your shelves too, for a reason. So if you have insight, hey, now's the time. Get it on the ground floor. Give us some advice.
- [46:59]
Jack
Well, thank you everybody for listening and we'll see you next time.
- [47:02]
Podcast Host
Thank you for tuning in to this episode. If you found this discussion interesting and valuable, please subscribe on your favorite audio platform or on YouTube. You can also follow all the podcasts in the Excess Returns network@excessreturnspod.com if you have any feedback or questions, you can contact us@excessreturnspodmail.com no information on this podcast.
- [47:22]
Matt
Should be construed as investment advice. Securities discussed in the podcast may be holdings of the firms of the hosts or their clients.