Don’t Be Stupid
Not being stupid matters more than being smart, but...
Welcome, everyone, and especially to the many, many new readers and subscribers who arrived on account of last week’s TBL, The Index Mindset, which seems to have struck a nerve. I hope everyone sticks around.
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This week’s TBL will consider why and where indexing works well and where it doesn’t. If you like The Better Letter, please subscribe, share it, and forward it widely.
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Don’t Be Stupid
The late Fidelity Chairman Edward Johnson, III, spoke for most of the investment world when he said, back when index funds were new, that he couldn’t “believe that the great mass of investors are going to be satisfied with receiving just average returns.”
He was wrong.
As my friend Morgan Housel said about investing, “‘Excellent for a few years’ is not nearly as powerful as ‘pretty good for a long time.’ And few things can beat, ‘average for a very long time.’”
Twice each year, S&P Global Indices publishes its SPIVA Scorecards, which compare the performance of active equity and fixed income mutual funds against their benchmark indices over a variety of time horizons. The results are consistent and powerful across markets and countries: Indexing works. Note the representative examples below.
Why index funds work so well turns out to be both interesting and surprisingly simple: Not being stupid is more important than being smart. Avoiding errors matters more than making good choices. And I can prove it (the video below is an example, not the proof, although it is mighty compelling).
Indexing works as well as it does in the investing world because, as Charley Ellis famously established, investing is a loser’s game much of the time, with outcomes dominated by luck (rather than skill) and high transaction costs. Charley employed the work of Simon Ramo, a scientist and statistician, from Extraordinary Tennis for the Ordinary Player, who showed that professional tennis players and weekend tennis players play a fundamentally different game.
The expert player, playing another expert player, needs to win points affirmatively through good shot-making to succeed. The weekend player wins by not losing – keeping the ball in play until his or her opponent makes an error – because weaker players make many more errors.
“In expert tennis, about 80 per cent of the points are won; in amateur tennis, about 80 per cent of the points are lost. In other words, professional tennis is a Winner’s Game – the final outcome is determined by the activities of the winner – and amateur tennis is a Loser’s Game – the final outcome is determined by the activities of the loser. The two games are, in their fundamental characteristic, not at all the same. They are opposites.”
Similarly, note what Charlie Munger wrote to Wesco Shareholders while he was chair of the company.
“Wesco continues to try more to profit from always remembering the obvious than from grasping the esoteric. … It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent. There must be some wisdom in the folk saying, ‘It’s the strong swimmers who drown.’”
It turns out that we can quantify this idea more precisely. Not being stupid matters demonstrably more than being smart when a combination of luck and skill determines success.
Suppose you are the GM of an NFL team, and you are preparing for the annual draft of college players. In that context, avoiding a mistake helps more than being smart.
Let’s say you have the 15th pick in the draft. You look at a player the NFL consensus says is the 20th best player and think he is better than that – perhaps the 10th best player. By contrast, the consensus on another player is that he is the 15th best player, but you think he is only the 30th best. What are the rewards and consequences if you are right about each player when the draft comes?
If the underrated player is available when your pick comes, you can snap him up for an effective gain of five spots. You get the 10th best player with the 15th pick. That is great. Of course, since everybody else is scouting too, you may not be the only one who recognizes the underrated player’s true value. Anybody with a pick ahead of you can steal your thunder. If that happens, your being smart didn’t help a bit.
Similarly, in the investment world, good trades get crowded and cease to be good trades. Michael Mauboussin described this phenominon as the paradox of skill.
“As skill improves, performance becomes more consistent, and therefore luck becomes more important.”
On the other hand, if the overrated player is available when your turn comes up (in theory, he should be, because he is the consensus 15th pick and you are picking 15th), you will pass on him, because you know he isn’t that good. If you had not done the scouting and done it right, you would have taken him with your 15th pick and suffered an effective loss of 15 spots by getting the 30th best player with the 15th pick. In that case, then, avoiding a mistake helped.
Moreover, and crucially, it does not matter if any other teams scouted him correctly. You have dodged a bullet no matter what.
Recognizing the undervalued player (being smart) only helps when you are alone in your recognition. Recognizing the overrated player (avoiding a mistake) always helps.
The moral of the story: In loser’s games, like investing, not being stupid matters more than being smart. Smart gets neutralized by other smart people. Stupid does not.
Thus, the importance of the error quotient becomes obvious (and, obviously, the lower the better).
The same principle can also be demonstrated mathematically.
Gather a group of people and show them a jar that contains equal numbers of $1, $5, $20, and $100 bills. Pull one out, at random, so nobody can see, and auction it off. If the bidders are generally smart, the bidding should top out at just below $31.50 (how much less will depend on the extent of the group’s loss aversion), the value of the average bill {(1+5+20+100) ÷ 4}.
If you repeat the experiment but this time let two prospective bidders see the bill you picked, what happens? If you picked a $100 bill, the insiders should be willing to pay up to $99.99 for it. Neither of them will benefit much from the insider knowledge. However, if it is a $1 bill, neither of the insiders will bid. Without that knowledge, each of the insiders would have had a significant chance of paying $31.50 for the bill and suffering a loss of $30.50. On an expected value basis, each gained $3.05 from being an insider.
Thus, avoiding errors matters more than being smart.
That investing successfully is really hard suggests to most of us that being really smart should be a big plus in investing. Yet, while it surely helps, the existence of other smart people together with copycats and hangers-on greatly dilutes the value of being market-smart.
On the other hand, the impact of bad decision-making stands alone. It is not lessened by the related stupidity of others. In fact, the more people act stupidly together, the greater the aggregate risk and the greater the potential for loss.
This stupidity risk grows exponentially. Think of everyone piling on during the tech or real estate bubbles. When nearly all of us make the same kinds of poor decisions together – when the error quotient is especially high – the danger becomes enormous.
Time for the big but.
Passive investing works very well, but it also doesn’t win big. It leads to less competition and increasing correlation, which are counterproductive in a variety of environments.
Trading 101 says to avoid crowded trades. The index mindset seeks out crowded trades and counts on capital flows continuing to crowd in, supporting the trade and the choice.
Here’s the thing: Sometimes market performance isn’t good enough.
For example, founders, innovators, and disruptors can’t afford to index their markets. Intense, company-level competition won’t allow it. As Keith Rabois explained, “product market fit is forged, not discovered.”
Let’s consider this problem by, once again, looking to the NFL Draft generally and, more particularly, at NFL quarterbacks, the most important players in any sport. In today’s NFL, it is possible to win a Super Bowl without a great (“franchise”) quarterback, but it’s rare enough that no team should want to try. That goes a long way toward explaining why two-thirds of first overall picks in the salary cap era (30 years) have been QBs.
Nearly all Super Bowl winning QBs in the salary cap era (from 1994) have been outstanding (roughly top quartile overall). The exceptions were (a) two excellent QBs who won Super Bowls in years that weren’t their best (2007 season Eli Manning and 2008 season Ben Roethlisberger), (b) two QBs who had stellar playoff runs before mean reverting (Joe Flacco and Nick Foles), and (c) the only two true outliers (Brad Johnson and Trent Dilfer).
Due to salary cap restrictions and the value of franchise quarterbacks, it is generally better to draft a great quarterback than to buy one on the (sort of) open market. Of course, that’s much easier said than done.1
Terry Bradshaw, Jim Plunkett, Troy Aikman, Steve Young, John Elway, Peyton Manning, Eli Manning, and Matthew Stafford were first overall picks who won Super Bowls. However, over that same period (since the first Super Bowl in 1967), 19 quarterbacks who were first overall picks have not (at least not yet) won championships,2 including nine of the last ten and and 15 of the last 17. And these as yet non-winners include some spectacular busts (JaMarcus Russell, ladies and gentlemen — see above), as Cleveland Browns fans understand particularly well.
Of the QBs who have won Super Bowls in the salary cap era, only Kurt Warner (undrafted), Brad Johnson (9), Tom Brady (6),3 Russell Wilson (3), Nick Foles (3, but subbing for a 1 in Carson Wentz), Drew Brees (2), and Brett Favre (2) were not first round picks. Passer Ratings decline with every round of the draft except the sixth, the numbers for which are skewed by Brady. But only about half of first round QBs “make it” in a meaningful way.
What all this means is that (a) NFL teams recognize how important QBs are; and (b) NFL draft evaluators generally recognize who won’t be a great NFL quarterback but not who will be. In other words, they can usually eliminate those who aren’t good enough but don’t differentiate well among those who might be good enough.
Every year, teams select quarterbacks early in the draft, hoping against hope that they will catch lightning in a bottle. They fail much more often than they succeed.
Drafting quarterbacks is a high variance choice and is probably a net loser overall. Note, for example, that first overall pick “busts” are far more likely to be quarterbacks than players at other positions.
Suppose you are offered a chance to enter a coin-flipping contest that costs a dollar to enter where heads pays +50 percent while tails “pays” -40 percent. With sufficient flips and a fair coin, it seems that the net result should be positive. However, that only happens with a very large number of players pooling their resources. As Ole Peters has shown, the vast majority of players will crap-out on account of the “arithmetic of loss.” Positive outcomes are concentrated in a tiny number of lucky players who amass huge sums (that’s how VC works, for example). Accordingly, in that setting, and from an investment standpoint, it only makes sense to participate if you can “index” and play a very large number of games.
Creators, of course, like NFL General Managers, must roll the dice alone.
We are all faced with the constant struggle of making decisions about the unknown and unknowable future. Call it “Schrödinger’s fog.”
My general outlook is that, when your goal is to avoid losing, you should invoke the index mindset. When your goal is to win outright, you shouldn’t. In “loser’s games,” index; in “winner’s games,” don’t. In non-zero-sum (win-win) games, indexing makes sense. In zero-sum games, it doesn’t.
However.
The world is far too messy to fit into such neat categories very often. Most of the time, our approaches will need to combine both strategies. With respect to the NFL Draft, for example, teams worry about player “floors” and “ceilings” and remind themselves there are no “can’t miss” prospects (if you doubt this, you might recall Ryan Leaf, Tony Mandarich, or Len Bias).
In golf, even great players should play it safe sometimes. Leading by 3 strokes standing on the 18th tee at the home hole, Jean Van de Velde needed just a double-bogey 6 to claim the title and become the first player from France to win The Open Championship since Arnaud Massy in 1907.
A comedy of errors ensued.
As ever, success in life starts with not being stupid. However, while the index mindset is predicated upon not being stupid, sometimes we need to “go for it” to succeed.
Sometimes, not being stupid means going for it all.
Totally Worth It
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Here’s the late, great Roger Angell in the April 3, 1983 edition of The New York Times.
“With the exception of an Opening Day no-hit game pitched by Bob Feller in 1940, no baseball history was ever made Opening Day. Yet fans throng to their home parks in very large numbers for these chilly inaugurals, because Opening Day represents so much to them. It is a ceremony of renewal and welcome — a celebration of the simultaneous return of springtime and baseball time, a brief moment of pure hope, and a noisy, cheerful restoration of the bonds of loyalty and affection that bind the fans to their home club, and vice versa. The game means little to the players, who will be back the next day and the next week, of course, to struggle with the difficulties of their arduous profession, but its meanings for the fans are psychic and profound. The fans who turn up on Opening Day are not the family groups who come to the park in such numbers on warm summer nights or sunlit Sunday afternoons, nor are they the celebrities and frontrunners who appear in September when a team has suddenly become chic and famous because of its recent successes and its swollen autumn prospects. The first April crowds are the fans — the supporters and rooters who have thought about the team through the winter and have stood behind it through the years, not just when it was winning but also when it was down on its luck and out of contention. Their bonds to their own team are serious and of long standing; in most cases, their attachment predates that of the owner and of all the players on the field.”
I have been to (probably) hundreds of Major League Baseball games in my lifetime. Yes soon as I hit the send button on this TBL, I’m heading out to my first ever Opening Day. Go Padres.
An Illinois man has filed a class action lawsuit against Buffalo Wild Wings because its so-called “Boneless Wings” are breast meat, not wings. Airmen Halim’s suit seeks punitive damages for what he calls a “clear-cut case of false advertising.” The restaurant chain mocked Halim’s complaint, noting in a tweet that “our buffalo wings are zero percent buffalo.”
Over 60 percent of Americans are living paycheck to paycheck.
The great Tony Gwynn, MLB Hall-of-Famer, was a terrific college basketball player. He was drafted by the Padres and the NBA’s San Diego Clippers on the same day in 1981. Note this remarkable statistic: Tony had more assists in college (590) at San Diego State than strikeouts in his 20-year Major League Baseball career (434).
You may hit some paywalls herein; most can be overcome here.
This is the best thing I read or saw this week. The craziest. The creepiest. The coolest. The sweetest. The funniest, unless it’s this. The most interesting. He most interesting thread. The most impressive. The most insightful. The most original. The most obvious, brilliantly rendered. The most painful, also beautifully rendered. Knock-knock. Idiot criminal. Color me skeptical. He lost Dad on a pub crawl. Creative kids. Aggrieved. Good news (but it makes me nervous). I’ve seen this movie. Spectacularly missing the point. A cougar and a hot tub. Tweedledum. Tweedledee.
Please send me your nominations for this space to rpseawright [at] gmail [dot] com or via Twitter (@rpseawright).
“The authentic human being is one of us who instinctively knows what he should not do, and, in addition, he will balk at doing it. He will refuse to do it, even if this brings down dread consequences to him and to those whom he loves. This, to me, is the ultimately heroic trait of ordinary people; they say no to the tyrant, and they calmly take the consequences of this resistance. Their deeds may be small, and almost always unnoticed, unmarked by history. Their names are not remembered, nor did these authentic humans expect their names to be remembered. I see their authenticity in an odd way: not in their willingness to perform great heroic deeds but in their quiet refusals. In essence, they cannot be compelled to be what they are not.”
~ Philip K. Dick, How to Build a Universe That Doesn’t Fall Apart Two Days Later (1978))
Chidiock Tichborne was only 24 years old when he was hanged, drawn, and quartered for his role in the Catholic Babington Plot to assassinate Queen Elizabeth I in 1586. Tichborne’s Elegy, which he composed on September 19, 1586, on the eve of his execution, sounds powerfully up-to-date.
My prime of youth is but a frost of cares, My feast of joy is but a dish of pain, My crop of corn is but a field of tares, And all my good is but vain hope of gain; The day is past, and yet I saw no sun, And now I live, and now my life is done. My tale was heard and yet it was not told, My fruit is fallen, and yet my leaves are green, My youth is spent and yet I am not old, I saw the world and yet I was not seen; My thread is cut and yet it is not spun, And now I live, and now my life is done. I sought my death and found it in my womb, I looked for life and saw it was a shade, I trod the earth and knew it was my tomb, And now I die, and now I was but made; My glass is full, and now my glass is run, And now I live, and now my life is done.
The TBL Spotify playlist, made up of the songs featured here, now includes over 250 songs and about 18 hours of great music. I urge you to listen in, sing along, and turn up the volume.
My ongoing thread/music and meaning project: #SongsThatMove
Benediction
To those of us prone to wander, to those who are broken, to those who flee and fight in fear – which is every last lost one of us – there is a faith that offers hope. And may love have the last word. Now and forever.
Amen.
Thanks for reading.
Issue 148 (March 31, 2023)
I’m only using data from the salary cap era (1994 to date) to make for a fairer basis for evaluation.
I don’t count Drew Bledsoe, who backed up Tom Brady in Super Bowl XXXVI.
There were 198 players and six quarterbacks (Chad Pennington, Giovanni Carmazzi, Chris Redman, Tee Martin, Marc Bulger, and Spergon Wynn) selected in the 2000 draft before the recently retired Tom Brady, who became the GOAT.
I almost forgot Eric Foner and Jill LePore. They don’t teach Pareto, just rationality.
Enjoy the game!!
Hiya Bob. Yet another great newsletter. Good on ya. There are five people who I read diligently in order to minimize my own stupidity. You, Morgan Housel, Nassim Taleb, Ted Gioia and Heather Cox Richardson. In a world that most folks think is Gaussian, you all show us how to think about Pareto distributions and tails. Gracias.