Bill Miller: What's luck got to do with it?

This interview is from July of this year and since I don't believe I posted it before now, here it is.

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Bill Miller on poker and investing
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Question: Right. Who's Puggy Pearson, and why should anybody care?

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Answer: Well, the late Puggy Pearson was a professional gambler, lived in Las Vegas, had a 5th grade education, but nonetheless became legendary in poker, and really in other gambling circles, because of his undeniable skill at a game that involves a high degree of chance.

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And he won the World Series of Poker, I think in 1973. He also told me he actually won it one other time, but they awarded it to somebody else, because they didn't want him to win it twice. (Laughter) Back in the early years.

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Question: In the old days.

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Answer: I didn't know whether to believe him or not, but that's what he said. But in any case, he summed up the skills required for successful poker in a pithy way. And those skills, in my view, are also the skills necessary for successful investment.

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Somebody once asked Bill Ruane [the late manager of the legendary Sequoia Fund], and I happened to be in the audience that day, "How do you learn about investing?"

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And Bill said, "Well, if you read Ben Graham's Security Analysis and The Intelligent Investor you'll be well versed in it. And then if you read Warren Buffett's shareholder letters and understand them too, you'll know everything there is to know about investing. And you will become a successful investor."

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And I think Bill was right, but it takes a lot of time to do that. Puggy Pearson made it a little pithier when he said, his line was, "There ain't only three things to gambling. Knowing the 60/40 end of a proposition, money management, and knowing yourself."

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And if you translate that into investing, knowing the 60/40 end of a proposition means knowing when you have some competitive advantage over somebody else. And you don't bet, you don't gamble, you don't invest, unless you have some competitive advantage. I'll come back to what that means in a second.

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Second, money management means well, okay, if I've got a competitive advantage, how much do I invest? Do I invest 10 percent? 20 percent? 50 percent? Three percent? So knowing the proper money-management strategy, the proper amount of money to invest is the second thing.

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And then knowing yourself, that means knowing how you react to stress, how you react to adverse outcomes, how you react when things go well. Do you get giddy and overconfident when things are going well? Do you get morose and difficult when things go badly? Do you make bad decisions at both extremes? Just understanding your own psychology, what your weaknesses and strengths may be, as it comes down to evaluating decisions when the markets are at extremes.

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Those three things are really all that successful investing involves.

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Let's go back to the first one, though, and the 60/40 end of a proposition. There's three sources of competitive advantage in investing: informational, analytical and behavioral.

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Informational is - well, let's say you manage money for a Middle Eastern government, and you go over there and the oil minister tells you that they're going to double oil production in the next three months, you know something other people don't know.

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But informational advantages are very difficult to get. They're difficult for two independent reasons. Number one, the [U.S.] government tries to keep you from getting them, because they want a level playing field. There are rules against inside information and acting on it. People know when companies are going to release their earnings, and there's supposed to be equal access to that information. And then the hedge funds are the other independent reason. Many of them are trying to get an informational advantage. With so many of them out there doing this full time, it's very difficult for people to get an informational advantage - even other professionals such as ourselves.

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The second category is analytical advantages. This is where you know the same things that other people know, but you weight them differently, you give them different probabilities. And that can happen a lot. If you've owned the company over a long period of time, you can get a sense of how their business is evolving, how their capital allocation is going to work, that other people aren't thinking about. And you might have a different sense of their risk, the risk in assessing the investment. So the analytical advantage involves different probabilistic weights on the same information that other people have.

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And then the third one is behavioral. And that's the most enduring, because behavioral advantages arise out of the manifest tendencies of large numbers of people to react in predictable ways to certain kinds of situations. So we know that people are risk averse. We know that their coefficient of loss is about two to one - which means that they feel the pain of losing a dollar twice as intensely as they feel the pleasure of gaining a dollar.

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Question: Correct.

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Answer: People overweight the most recent information. They overreact to dramatic information, or dramatic circumstances. They tend to have what's called outcome bias, which is they judge things on their outcome, and not on their process. So a lot of these behavioral elements are things that you can actually identify and exploit to your advantage if you are aware of them - and aware also that no matter how much you're aware of them, you're not immune to them yourself. You really have to have a sense of discipline and patience, and understanding in that.

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Question: Okay.

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Answer: That was a very long explication of Puggy's very short, pithy remark.

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Question: All explanations of short pithy remarks are long.

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Answer: I think so, yes.

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Question: What's the Kelly criterion?

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Answer: The Kelly criterion is named after J.L. Kelly, Jr., who in 1956 wrote a paper for The Bell System Technical Journal called "A New Interpretation of the Information Rate," drawing on work by Claude Shannon, the father of information theory.

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What Kelly did was to take an aspect of Shannon's work and derive a formula that had broad applicability outside of information theory. What it enabled you to do was to maximize the growth rate of anything, if you used this formula. So gamblers quickly used it to adopt money management strategies.

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It's known as a fixed fraction strategy. So what it tells you is what fraction of your bank roll you should commit to any particular probabilistic endeavor, whether it be a gambling debt, or an investing debt, if you know the probabilities that pertain to it. And if you know those preconditions, you will either maximize your bankroll at the fastest possible rate, or you'll minimize your loss at the slowest possible rate.

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The rough formula, in a grossly oversimplified form just for the purposes of discussion, is:

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2p - 1

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where p is the probability [converted from percentage to decimal form]. So, to make it easy, if you were 100% certain that a particular investment would pay off at your expected rate, then 2 times that p is 2.0, minus 1, yields 1. That means 100% of your bankroll should go into that investment.

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Now if you were only 60% sure, then it would be two times .60, which is 1.20, minus 1, equals .20. So 20% of your bankroll should go into that proposition.

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What the Kelly criterion does is it gets you to focus on the probability that you are correct in your assessment, and then to understand that the amount of money you should commit is directly related to the probability that you are correct. It also shows that if you have less than a 50/50 proposition, you shouldn't bet at all. Which again, makes perfect sense.

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Question: Let's boil all that down for people who can't do 2p - 1, because it's too much math.

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Answer: (Laughter) Well, what Kelly says is the same thing Puggy Pearson says, which is you have to know the 60/40 end of the proposition. You have to be confident that you have an edge, that you have some positive probability of an expected positive gain, before you commit any amount of money. And if you can't identify that edge, you probably don't have it. And if you can't identify it, you probably shouldn't commit the capital to it.

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Question: Right. And how much capital you commit -

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Answer: - depends crucially on your assessment of how big your edge is. And that's why the government punishes inside information. Right? If you have a tip that comes from somebody that knows Company X is bidding for Company Y, then you would commit large amounts of your personal capital to that, following perfect Kelly fashion.

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Question: Right, because your P is 100.

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Answer: Exactly. Your P is 100.

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Question: But doesn't this bring us to a really difficult problem which is that since humans have an incorrigible tendency to be overconfident, how do you calibrate your P so that it's correctly less than 100?

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Answer: Well, I wouldn't advise people to go so far as to try to do calibrations on it. I would advise them basically to understand, A) people are overconfident, and B) that therefore whatever probability you think you have of being right, it's probably less than you think.

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So if you think you have a small edge, you probably don't have any edge at all.