How many histories are there?

In Taleb’s book, Fooled By Randomness, there is an interesting take on analyzing history. He calls it summing across histories. His point is that regardless of the actual outcome, it’s the many possible outcomes that we should consider when determining after the fact if the right choice was made.

For example, let’s say a janitor buys a lottery ticket every day of his life and wins one of those times, thus making him rich. That outcome of him winning, even with buying a ticket every day, is highly unlikely to happen. If he repeated his life a million times, he would probably never win the lottery in all those other life paths.

On the flipside, let’s say a dentist drills teeth every day for a 30-year career and then retires with a large nest egg. If the dentist repeated his life a million times, it is highly likely that he would end with a large nest egg in the majority of life paths.

The point here is that when we analyze history, we shouldn’t let the actual outcome affect whether we consider a decision a good one or not. Rather we should consider all the paths equally and not give undue weight to a good result that wasn’t also highly likely to happen.

Hindsight bias

We aren’t too bad at acknowledging that there are possibilities in the future, but we are terrible at seeing the possibilities that existed in the past. In behavioral finance, this blind spot for the possible past paths is called the Hindsight Bias. A more common name for it is Monday morning quarterbacking.

Once we know the outcome we generally think that things could only have turned out the way that they did. For the lottery winner above, even though it is highly unlikely that he would win the lottery, and is a waste of $365 a year to play, if he wins, no one will tell him that he was stupid for playing. Instead, they will likely congratulate him and tell him he was smart for playing.

This is very similar to the way that mutual fund managers are treated. We see the returns they have generated in the past and assume that they must know something. They must have learned some skill or intuition that allows them to pick the right stocks at the right times. And we believe that this same skill will allow them to pick the right stocks at the right times in the future after we give them our money to invest. And we think this no matter how many times we hear the words “Past performance is no indicator of future results.”

Ignore the best-case

Summing over histories implies that we should pay more attention to the worst-case scenario (since we usually ignore it), and for the most part ignore the best-case scenario (since we usually over emphasize it, meaning we get greedy). It also implies that we should be looking to reduce the range of the possible paths to a range that includes only possible results that we are comfortable with.

So let’s look at two examples of what we might expect as possible histories from our investing. Since we have difficulty seeing the possible past histories, I’ll use two examples of real stocks, one that has gone well up to now, and one that has not. By using two examples with different outcomes, maybe we can make it clearer to our brains what we are missing when we only look at the actual outcome and not the possible outcomes.

Johnson & Johnson

One possible good path a stock could take in the coming 20 years is the path that Johnson & Johnson has taken over the last 20 years.

We want to believe that of course we knew 20 years ago that JNJ would still be around today and still be a strong brand with a high stock price. But at the time 20 years ago we couldn’t have known that. We may have believed we knew it, but there are many possible paths where JNJ could have taken a turn for the worse, and not ended up where it is today.

It might help if we briefly list off a few things that could have happened to derail the stock’s upward climb, but did not.

One possibility is that their products could have been the targets of multiple terrorist attacks. A few randomly poisoned bottles of baby oil could lead to massive recalls and a drop in sales as people prudently switched to a safer brand.

Another possibility is that their management team could have been embezzling funds like Enron or Tyco.

Another possibility is that some other company could have merely out competed JNJ and stolen market share from them.

So the path that JNJ has taken so far is really only one of many, and is actually an example of one of the better paths the company could have taken. Many other unsavory ones were just as likely 20 years ago (and even today).

The chart below shows the value of one dollar invested in JNJ over the last 20 years. One line represents the buy and hold strategy, and the other line represents the no lose strategy. With the no lose strategy the losses are completely removed , while the gains are only dampened. In this case we’re assuming a 15% lag in the profits for the no lose strategy. So if JNJ goes up 20% in a year, the no lose strategy only gains (20% – 15%) 5%.

With the buy and hold strategy we could have made 22 times our money over the last 20 years. So we start out with $100k, and we end up with $2 million. Seems pretty simple. Nice and easy. We know how great of a company JNJ is so we just drop the money down and wait 20 years. (But of course as pointed out above, we don’t know that JNJ is going to be a great company, we only think we do.)

With the no lose strategy we could have only made 5 times our money over the last 20 years. So we start out with $100k, and we end up with $500k. That’s not bad. It’s a return of about 8.2% a year over the 20 years. But it’s a far cry from the $2 million for buy and hold.

If we stopped our considerations here our biases would convince us that buy and hold is the better strategy. Buy and hold had a higher return over the long-term, but we’d be ignoring the possibility of a loss on the downside.

Fannie Mae

Now consider a possible bad path that a stock could take like the path that Fannie Mae has taken over the last 20 years.

There are probably a great many pundits saying that they knew that FNM would collapse one day, and another great many that said FNM could never fail because of it’s implicit government guarantee. But again, 20 years ago, we had no way of knowing what path FNM would take. The changes in interest rates, the wars or lack of wars, the changes in different countries’ governments and economies are all things that were unknowable. We couldn’t know these things and so we couldn’t accurately predict how they would affect FNM in the future (whether or not we now believe we could have).

The chart below shows the value of one dollar invested in FNM over the last 20 years. One line represents the buy and hold strategy, and the other line represents the no lose strategy. With the no lose strategy the losses are completely removed, while the gains are only dampened. In this case we’re assuming a 15% lag in the profits for the no lose strategy. So if FNM goes up 20% in a year, the no lose strategy only gains (20% – 15%) 5%.

With the buy and hold strategy we could have made about 20 times our money over the last 20 years, with a peak of as much as 45 times our money. However, the chart only shows FNM through January of 2008. If we pushed it forward to today, where the last FNM closing price is $0.74 per share, we would have a 26% loss from our original money. So over 20 years, if we started with a $100k investment, we would have at one point had $4.5 million, but eventually only $74k left of our original investment.

With the no lose strategy we could have made about 23 times our money over the last 20 years. So we start with $100k and end up with $2.3 million. That’s actually quite good, better even than the JNJ buy and hold above. That’s the equivalent of a return of about 16% per year.

Summary

The thing to realize here is that both JNJ and FNM, and all stocks, are highly affected by randomness, and are vulnerable to situations and circumstances that we can’t know about beforehand. Even something that looks really good today (like JNJ now, or FNM about 6 years ago), could eventually turn sour, and do so very quickly. And it is nearly impossible to tell when a stock is turning permanently sour, or just “correcting” before moving higher.

The idea then is to choose the strategy where the possible paths lead to a comfortable outcome the most often, even if that outcome is not the highest success conceivable. So we give up a shot at the best-case result, in exchange for avoiding the worst-case result, and getting a high likelihood of hitting a comfortable-case result.

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4 thoughts on “How many histories are there?”

  1. This strategy is very interesting and very effective. Though I believe that over the course of time, buy and hold is a much more appealing strategy. Think of it if this way; In order to use the no-lose strategy, you have to find a stock that pays dividends and use those dividends to pay for the put options toward your stock as an insurance just in case something happens. Like i mentioned in the beginning, this strategy is very effective but only to short-term stocks. (1-2 years; not 20 years) Why I say that is because no one will sit and ride a bear market especially if the stock is dropping from 65 to 35. Personally as soon as I see a major decline I pull out (mm lets say at least by 10-15$ is my limit decline) Lets take FNM as an example you have above. FNM reached a high of $45 per share, and then dropped dramatically. Now personally I would have pulled out everything when it was $35-30. Why? News, newspapers, research, etc.. are the fundamental things needed to be done for the stock you own. Also since my strategy is buy and hold, my dividend payment could be used as a backup for any additional loss (in your case it would be a put as an insurance)Getting to the point is that the no-lose strategy works great for short term stocks (1-2 years) because as you always need to check your stocks occasionally (just like in the no-lose you have to check for the expiration of the puts in order to renew)likewise with the buy and hold you have to check occasionally for any major changes. Major changes do not happen overnight. Stocks do not drop from $45 to $10 in one day without the news,newspapers or online research informing you ahead of time. Like I mentioned before, the no-lose strategy would fit better for 1-2 year investment, and as the stock continues to rise, there is no point of spending the dividend for put option as an insurance to protect the investment. (It's a safe idea, but it will not reward you as much)But a reward is something better than nothing correct? I would totally agree, but a 20 times greater reward to the no-lose strategy is worth a lot more if individuals keep up with research, news,etc for their investment and pull out at a certain time (such as using the dividends as a backup– once the stock drops in price to the accumulating dividends, its a good time to pull out some or all)The no-lose strategy is a good strategy if you are Warren Buffet or for short term. I did sign up and checked your listings. Since no-lose strategy requires to purchase option put, then stocks need to be purchased by 100. Average stocks are 20-30$ per stock, which makes it expensive would tie your money to this stock until all your dividends are paid in order to not have a loss.Again, good strategy, but personally I would use buy and hold. Having a return of 0.01-0.20 with no-lose (plus the money being tied up till puts expire) is not worth the time nor the money to invest as it cancels the prospect to capture a greater opportunity.

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    1. “…no one will sit and ride a bear market especially if the stock is dropping from 65 to 35.”

      I’m not sure that’s true. You may be different, but the standard small investor emotional profile is someone that goes into denial when their stock drops. They just hold on hoping it will come back.

      Also, someone does sit and ride a bear market. For one investor to sell, another investor has to be willing to buy.

      “…just like in the no-lose you have to check for the expiration of the puts in order to renew”

      Just wanted to clarify, the No Lose Stocks strategy does not call for renewing the puts. The investor buys the combination and waits to see if it pops within the time frame of the put. If the put expires before the stock pops, then the investor looks for another No Lose Stocks combination. Often the “No Lose” pricing is not available for more than a day or two for a particular combo.

      “Having a return of 0.01-0.20 with no-lose (plus the money being tied up till puts expire) is not worth the time nor the money to invest as it cancels the prospect to capture a greater opportunity.”

      Again, just to clarify, with the No Lose Stocks strategy, the intent is not to make a return on the dividends. The intent is only to use the dividends to pay for the put and HOPE that the stock goes up high enough in the mean time to make a profit.

      Personally, I’ve started just buying the equivalent call option instead of the put and dividend stock combo. The interest rate in the last column of the spreadsheet is the interest rate that the core capital needs to be earning to make the call a better deal than buying the put and stock combo.

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  2. Most investors who use a buy and hold also have a stop loss percentage. So FNM losses over 20 years would not have happened as your above example.

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  3. Hi Tony,

    Thanks for the comment. I really appreciate your thoughts on this.

    Do you have a source for the statement that “most investors who use a buy and hold also have a stop loss percentage”? Anecdotal evidence leads me to believe that most investors don’t use stop losses, but that could definitely be wrong.

    I’d be hesitant to call investors that do use stop losses “buy and hold” investors. Generally “buy and hold” means you don’t sell because you think the company is going to be strong forever. (Exactly what I’m arguing against in this post…)

    What stop loss percentage should be used in order to still be able to make a gain/profit, and not to be continually getting stopped out, and also not to be losing so much on each trade that you can’t afford to lose again?

    How many times should you be able to lose?

    And if you do get stopped out, when is it “safe” to get back in the same stock?

    These are questions that I could never find satisfactory answers to. I’d be interested in hearing your ideas on these though.

    Thanks,
    Aleks

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