1.
A blackjack player has 19, takes a hit and gets a 2 for 21. Was the decision to take a hit a:
Correct Answer
B. Bad decision
Explanation
Bad decision. A blackjack player with 19 has a higher expected return staying than hitting no matter what the dealer is showing. To maximize the long-term expected return of their play they should always stand on 19.
2.
Letting “winners run” should enhance portfolio returns:
Correct Answer
B. False
Explanation
False. As a "winner runs" its position size increases, the potential upside decreases, and the potential downside increases. This equals greater exposure to a lower expected return asset.
“We as a firm are always going to buy too soon and sell too soon. And I’m very at peace with that.” –Seth Klarman , Baupost Group
When asked how he had become so rich? He replied, “I sold too early.” – JP Morgan, famous financier
“The riskiest moment is when you’re right. That’s when you’re in the most trouble, because you tend to overstay the good decisions.” – Peter Bernstein, legendary investor
“Make a rule: Whenever an investment doubles in price, find out who has the most negative view of it and give this devil’s advocate a full hearing.” – Jason Zweig, author of Your Money and Your Brain
3.
You buy a house for $1 million that subsequently declines in value to $500,000. Someone offers you $800,000 for the house. Do you:
Correct Answer
A. Take the deal
Explanation
Take the deal. The decrease in value from $1 million to $500,000 is a sunk cost. The question should always be, "if I were investing in this asset for the first time today, what would I do?" In this situation you would take the deal because you could turn around and buy another house of similar properties for around $500,000 and collect $300,000 in profit.
4.
Instincts are efficient tools for portfolio management:
Correct Answer
B. False
Explanation
Instinct, gut, and heuristics are all subject to the emotional bias of our mental calculators. Behavioral Finance and Neuroeconomics have spent the last 40 years explaining why humans are not well designed to make financial decisions. Compound that fact, with the calculation overload of managing a portfolio of multiple assets with constantly changing prices, position sizes, and fundamentals and it becomes impossible to manage without being a savant.
“The wise are instructed by reason; ordinary minds by experience; the stupid, by necessity; and brutes by instinct.” – Cicero, Roman author and politician
"A rational man knows—or makes it a point to discover—the source of his emotions, the basic premises from which they come; if his premises are wrong, he corrects them. He never acts on emotions for which he cannot account, the meaning of which he does not understand. In appraising a situation, he knows why he reacts as he does and whether he is right.” – Ayn Rand, author
“Time is your friend; impulse is your enemy.” – Jack Bogle, founder of Vanguard
“…human nature makes it hard for the markets to be efficient.” –Seth Klarman , Baupost Group
“Presented with almost any data, your investing brain will feel it knows what’s coming – and it will usually be wrong.” – Jason Zweig, author of Your Money and Your Brain
“The best investors make a habit of putting procedures in place, in advance, that help inhibit the hot reactions of the emotional brain.” – Jason Zweig, author of Your Money and Your Brain
"Emotions are your worst enemy in the stock market." – Don Hayes, market analyst
5.
Your five best risk-reward ideas should be your five largest positions:
Correct Answer
A. True
Explanation
True. There is no better way to maximize long-term portfolio expected return than to ensure that the best risk-adjusted return assets are the largest positions in the portfolio. See the Alpha Theory™ Monte Carlo simulation that shows Expected Return based position sizing is 18% better than the next best method for creating long-term returns.
“We construct portfolios the way theory says one should, which is different from the way many, if not most, construct their portfolios. We do it on a risk-adjusted rate of return.” – Bill Miller, legendary investor
“When faced with a choice of wagers or investments, choose the one with the highest geometric mean of outcomes.” – John Kelly, scientist and name sake of the Kelly Criterion (Fortune’s Formula by William Poundstone)
6.
The best time to buy is when:
Correct Answer
B. Fear in the market is high
Explanation
Fear in the market is high. Imagine the market is a huge pendulum that swings around intrinsic value. In times of elation the pendulum swings way past real value and in times of panic, the pendulum swings in the opposite direction, which presents arbitrage opportunities for investors.
“Fear is the foe of the faddist, but the friend of the fundamentalist.” – Warren Buffett, Legendary Investor
“Most of the time common stocks are subject to irrational and excessive price fluctuations in both directions as the consequence of the ingrained tendency of most people to speculate or gamble... to give way to hope, fear and greed.” – Benjamin Graham, father of Value Investing
"It is our job to help our clients be fearful when others are greedy, and look at opportunities when others are fearful." – Warren Buffett, Legendary Investor
7.
Economic forecasts are an easy way to improve an investment thesis:
Correct Answer
B. False
Explanation
False. Economic forecasts, if accurate, are extremely telling, but the issue is determining how to get comfortable in the accuracy of the economic prognostication. Market and economic direction are multi-variable equations with thousands of inputs. You can find two Nobel Laureate economists with well-defended theses for divergent directions of the US economy. If they cannot figure it out, why should you try? Mental capacity is a precious commodity and should be focused on reasonable prognostication, like cash-flow generation potential of an individual company.
“We don’t come into the office with a view that interest rates, the dollar or the economy are going to do this or that. We come in with a view that this particular asset or security is trading for less than it’s worth and we want to buy it.” –Seth Klarman , Baupost Group
“We spend little time trying to outguess market prognosticators about the short-term future of the markets or the economy for the purpose of deciding whether or not to invest. Since we believe that short-term market and economic prognostication is largely a fool’s errand, we invest according to a strategy that makes the need to rely on short-term market or economic assessments largely irrelevant.” – Bill Ackman, Pershing Square
“We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen.” – Warren Buffett, 1994 Letter to Shareholders
"Based on my own personal experience, rarely do more than three or four variables really count. Everything else is noise.“ – Marty Whitman, Founder of Third Avenue Management
8.
Two stocks trading at $20 have the same potential upside to $40 and downside to $10. You have greater confidence in the upside being achieved for Stock One. Assuming all else equal you would:
Correct Answer
A. Have a greater exposure to Stock One
Explanation
Have a greater exposure in Stock One. The true value of an asset is a combination of the potential upside, potential downside and the probability of each. If one asset has a higher probability of upside then it has a higher risk-adjusted return and should merit a greater exposure in the portfolio.
“People don’t need extraordinary insight or intelligence. What they need most is the character to adopt simple rules and stick to them.” – Benjamin Graham, father of Value Investing
“The main reason investors struggle with how to react to bad news is that they really haven’t figured out why they own the stocks they own.” – Bill Nygren, Oakmark Fund
9.
Modern Portfolio Theory is the optimal method to manage a portfolio:
Correct Answer
B. False
Explanation
False. Modern Portfolio Theory has been roundly disavowed as an effective portfolio management system for fundamental managers. The primary issue is MPTs use of volatility to measure risk when a much more important measure of risk is your estimate of potential loss and the probability of that occurring. Value at Risk has had an equally spotty record because covariance is a poor measure of interrelation of asset in extreme environments. When considering the most important measures of risk for a fundamental manager, volatility would probably be 4th or 5th on the list behind potential loss (as measured by fundamental research), liquidity, leverage, and sector exposure.
“The risk-reducing formulas behind portfolio theory rely on a number of demanding and ultimately unfounded premises. First, they suggest that price changes are statistically independent from one another…The second assumption is that price changes are distributed in a pattern that conforms to a standard bell curve. Do financial data neatly conform to such assumptions? Of course, they never do.” – Benoit Mandelbrot, mathematician, A Multifractal Walk down Wall Street
VaR was “relatively useless as a risk-management tool and potentially catastrophic when its use creates a false sense of security among senior managers and watchdogs. This is like an air bag that works all the time, except when you have a car accident.” – David Einhorn, Founder of Greenlight Capital
“As far as I know neither (Paul) Samuelson nor (Robert) Merton nor indeed Ophir has challenged the basic principle imbedded in the geometric mean principle (Kelly Criterion) for long-run portfolio selection. If they or he wishes to adopt a significantly different policy and I follow the geometric policy, in the long-run I become almost certain to have more wealth than they. This hardly seems an erroneous or trivial proposition.” – Henry Latane, professor, University of North Carolina at Chapel Hill
“I am extremely skeptical of more automated , algorithmic, Value at Risk, and other business school sanctioned approaches to risk management. None of these approaches saved Lehman, Bear Stearns, Fannie, Freedie, AIG, WaMu, Wachovia or any of the other institutions that used these and other ostensibly more sophisticated risk management strategies.” – Bill Ackman, Pershing Square
“There are only two subjects that matter in investing; valuation and markets. I would get rid of options pricing, modern portfolio theory and efficient market hypothesis” – Warren Buffett comments to IMD Business School in Lausanne, Switzerland