“As they say in poker, “If you’ve been in the game 30 minutes and you don’t know who the patsy is, you’re the patsy.”” — Warren Buffett
“Patsy” is defined as someone who is “easily taken advantage of, especially by being cheated or blamed for something.”
Here’s a problem which helps spotting patsies:
Assume that a coin is fair. That is, it has an equal probability of landing heads or tails when tossed. I toss it ninety-nine times and get heads each time. What are the odds of my landing tails on the next toss?
If this question is posed to a mathematics student in school, the answer, almost always will be:
“The probability of getting a tails on the 100th toss will be 50%.”
When asked to provide the reasoning for that answer, the student will promptly puke out what he or she learnt in school. Which is this:
“These are independent events. The coin has no memory. It does not remember that it landed heads 99 times in a row. The probability of it landing tails on the 100th toss is exactly what it was before each of the previous tosses. And that’s unchanged at 50%.”
This student is a patsy. He or she is displaying what we call as naïvety which is defined as “a state of having a lack of experience, understanding or sophistication, often in a context where one neglects pragmatism in favor of moral idealism.”
What does this mean? It means that the student continues to believe that coin is fair, even if has landed heads 99 times in a row!
A person of “experience, understanding and sophistication” will never make that mistake. Such a person would reason along the following lines:
“The probability that the person who is tossing the coin is lying (or is mistaken) about its fairness is vastly more than the probability that a FAIR coin will land heads 100 times in a row. Therefore, I must bet that the coin is unfair. It’s a rigged game!”
It’s easy to work out the probability of getting 100 heads in 100 tosses in a FAIR coin. That’s simply 0.5^100. Or 1 in a 1,267,650,600,228,229,401,496,703,205,376 chance.
To be precise, that’s 1 in 1 nonillion 267 octillion 650 septillion 600 sextillion 228 quintillion 229 quadrillion 401 trillion 496 billion 703 million 205 thousand 376. That comes to a somewhat low probability of 0.0000000000000000000000000000007888609052210118054117285652827862296732064351090230047702789306640625. Not zero, but it might as well be zero.
A man of “experience, understanding and sophistication” will reason that the probability of the coin being rigged is vasty more than 1 in a 1,267,650,600,228,229,401,496,703,205,376 chance. So he will bet that the coin is rigged and that both sides are heads. He will bet that coin will land on heads on the 100th toss. He will not bet on tails because there’s NO tails in the coin.
The moment you discard the belief that the coin is fair, you are instantly freed from the belief that those 99 tosses were “independent.” And if you drop the independence assumption, your conclusions must change. Completely.
To those of you who are familiar with Nassim Taleb’s work, you will recognise this as the “Fat Tony problem” in The Black Swan where “Fat Tony” is the street-smart trader of “experience, understanding and sophistication.”
Fat Tony does not take anything on face value. He does not assume anything without evidence. He carefully looks at evidence and he thinks in terms of probabilities.
And if he has to choose between believing that either (1) someone is trying to fool him; or (2) a virtually impossible event will occur, he will pick (1)
And that’s why Fat Tony is not a patsy and he not naïve.
Are there generalized lessons in financial markets from this story? I think there are many. I will list and describe just a few of them. But first let’s go back to that definition of naïvety.
What was the definition? Here it is again. Focus on the CAPITALISED WORDS:
Naïvety: “a state of having a lack of experience, understanding or sophistication, often in a context where one NEGLECTS PRAGMATISM IN FAVOR OF MORAL IDEALISM.”
What do the CAPITALISED words mean?
They means that a naïve man believes that the world is a fair and moral place and he is not being fooled, even when the odds of that happening are monumentally higher than those of the other alternative.
This man is not “pragmatic,” a term that’s defined as someone who “evaluates theories or beliefs in terms of the success of their practical application.” That is, a naïve man is not a practical man who would see the world as it truly is. Such a naïve man is “morally idealistic” who does not assume ulterior motives in others when he deals with others.
By the way, generally speaking, naïve people are very likeable people precisely because they are not born skeptics, they believe in humanity, they are trusting, they have this cute, child-like innocence (gullibility) about them that makes you want to protect them from the “evil world” out there, especially if you are a pragmatic, but not a manipulative person.
Capitalism, however, has this evil aspect to it. It has this zero-sumness to it which turns naïve people into natural prey for the predator-types. Being naïve in life in general may not cause you much harm if you’re lucky. But being naïve in financial markets virtually guarantees significant harm, and even ruin.
Ok, now let me return to the “functional equivalents” of the Fat Tony example in the financial markets. Remember, we are dealing with situations where you are being over-trusting of someone else even though there is strong evidence to suggest that you shouldn’t. We are talking about the “functional equivalents” of situations where you think that the coin is fair when in fact it’s overwhelmingly likely that it’s not, and the game is rigged and you are the patsy in the game.
What are these games in the world of financial markets?
Example 1: IPOs
If you buy into IPOs, you are a patsy in the game. The people on the other side of the game (the companies that come to market and their helpers) have certain advantages over you which they will use against you.
One, information asymmetry. They know more than you. They are insiders and you are not.
Two, timing. They decide when to come to market and they will come only when circumstances are more favorable for them. And “more favorable” for them means “less favorable” for you.
Three, scarcity. They can create artificial scarcity by limiting the quantity of shares they will sell in the IPO market and the hype that’s created prior to the IPO will suck in the patsies.
This happens over and over again in IPOs.
Example 2: Heavy Promotions
Generalising from IPOs, anything that’s being heavily promoted where the person doing the promotion is has a financial incentive to pitch you, even if the product or service being promoted is unsuited to you, or worse, is toxic.
This should be fairly obvious, right? If someone tells you to buy x (say, bonds of a company) and the person who created x, and not you, pays a lot of money to the person who pitches x to you and if you think that the person pitching x to you is acting in your interests, then you are a patsy in the game.
This applies not just to investment advice. It also applies to over-promotional managements talking up their stock and sometimes indulging in aggressive accounting to portray a more beautiful picture than reality to basically trap investors.
And it also applies to credit rating opinions and audit opinions.
Let me state one thing here. I am not suggesting that you must never trust credit ratings or audit reports. I am saying that the default position you should take is to not trust them blindly. If you do, then you are the patsy in the game.
Example 3: Spotting Frauds
People who are pragmatic and do not take anything at face value, and are not prone to give into what Robert Cialdini calls “authority bias” and bias from “social proof,” are well positioned to spot frauds well before other “believers” who will turn out to be patsies in the game.
My favorite example here is that of Harry Markopolos and Bernie Madoff. Markopolos is the analyst who spotted Madoff’s USD 50 billion dollar ponzi scheme in the garb of a hedge fund through which he promised and delivered low risk “returns” to willing believers (“patsies”) for decades.
Markopolos is a trained mathematician and a “certified fraud examiner,” a qualification which, you will agree, requires him not to be sort of the person who will “neglect pragmatism in favor of moral idealism.”
From 2001 to 2005, Markopolos made several submissions to the SEC claiming that Madoff was a fraud. No one listened. Nothing happened. The fraud was discovered in 2008 not because of whistleblowing by Markopolos but because Madoff turned himself in. And the shit hit the ceiling. In 2009, Markopolos was called for a testimony before the U.S House of Representatives Committee on Financial Services. Among many other things, here’s what he said in his 61-page testimony:
“The biggest, most glaring tip-off that this had to be a fraud was that BM only reported 3 down months out of 87 months whereas the S&P 500 was down 28 months during that time period. No money manager is only down 3.4% of the time. That would be equivalent to a major league baseball player batting .966 and no one suspecting that this player was cheating, and therefore fictional.”
Here, Markopolos is Fat Tony. He doesn’t believe other investors. He doesn’t believe the auditors. He doesn’t believe the claimed performance. Indeed, he thinks the performance is just too good to be true. And he believes that if something’s too good to be true (like landing 99 heads in a row in a “fair” coin), then it probably is.
This “too-good-to-be-true” aspect about Fat Tony, Markopolos, and similar skeptics, may not make them very sociable, likeable creatures. It does, however, prevent them from getting hurt in many “predatory” settings like the financial markets.
Example 4: You Fooling Yourself
While I was writing the above, I was thinking about myself and I thought that well I don’t do IPOs and I am wary about “over promotional” activity in financial markets (although I admit I am not immune and have been burnt more than once), and I don’t blindly trust auditors and credit rating companies. But, all of these are situations where I try to protect myself from being fooled by someone else who has a financial incentive to part me from my money.
And then I thought: What about protection from myself? Is the “game” in which you become a patsy necessarily a multiplayer game?
According to Richard Feynman, no.
“The first principle is that you must not fool yourself and you are the easiest person to fool.”
Take, for example, of what happens when you are invested in something and new evidence comes that ruins your hypothesis. Maybe the business is no longer as good as you thought. Maybe the management is really not as good as you thought or maybe the valuation model was wrong. There could be so many reasons which can ruin any investment hypothesis. The correct thing to do, in such situations, is to recognize the mistake, scramble out of it, and then try not to make that type of mistake again.
Well, the normal outcome, as many of us know, is the opposite. And this happens for reasons we may label as “commitment bias,” “endowment effect,” “psychological denial,” “blind overconfidence” etc etc. We may use all sorts of names to describe this tendency, but do we know that we are fooling ourselves? I don’t think so.
Knowing something is not the same as knowing the name of something. That was Feynman again.
When we choose to ignore overwhelming evidence showing that we were wrong but continue to stay invested in situations which just don’t make sense anymore, how different are we from that naïve school kid who continued to believe that the coin was fair even after it had landed heads 99 times in a row?
We are not that different at all. And by not being any different from that naïve kid, we become a patsy in the game.