The Hedonic Treadmill

I sent a note to my students on The Hedonic Treadmill.

Amit Wadhwaney Returns

My friend Amit Wadhwaney, who spent a couple of decades managing money at Third Avenue Value came to my class at MDI in 2014 and addressed my students on global value investing.

This year, Amit returned to MDI as portfolio manager and co-founding partner of Moerus Capital — an investment firm based out of NYC. The website of Amit’s firm tells us the story behind term “Moerus.”

Moerus’ name is derived from the Classical Latin word describing a city’s defensive walls, which were designed to protect both a city and its inhabitants from risks, both predicted and unforseen. Though we are unabashed value investors, we cannot emphasize enough that cheapness alone is not enough to warrant an investment. We believe a keen awareness of the risks facing an investment is essential to generating solid returns over the long run.

The opportunities that we often find ourselves pursuing typically face near term challenges, risks, and uncertainties. We welcome such transitory turmoil, as it sometimes provides unusually compelling opportunities. However, because of this short term turmoil, we seek to populate our portfolios with companies that have a “Moerus” – the strength, staying power and wherewithal – to withstand a variety of risks.

My students and I totally enjoyed learning from Amit who spoke about his firm’s approach towards investing with a particular focus on risk. I particularly enjoyed the part when Amit spoke about the importance of “knowing the neighbourhood that you are going to.” There’s a fabulous lesson in there and many more in the talk. I am confident that you’ll enjoy watching Amit’s lecture video and slides.


What did HE mean when he said Never Lose Money?

A while back I clarified what Warren Buffett really meant when he said:

You should invest in a business that even a fool can run, because one day a fool will.

Now, it’s time to clarify another one of his famous, and often misunderstood quotes which goes like this:

There are only two rules in investing. Rule # 1: Never Lose Money. Rule # 2: Never Forget Rule # 1

Here’s what I think Mr. Buffett really means with those words.

  • It means don’t get into a situation no matter how high the NPV, if it carries even a minuscule probability of financial ruin.
  • It means don’t play Russian roulette — even when the gun has a million chambers in it with a bullet in just one chamber. Or jump out of planes with parachutes which have a probability of opening up 99% of the time.
  • It means don’t do trades that will make money most of the time but carry a small chance of blowing you up. Don’t do what LTCM did. Or many other funds which blew up suddenly after delivering excellent returns for a while.
  • However, it doesn’t mean being loss averse. It’s perfectly OK to lose all your money in a few investment operations so long as they won’t cause ruin at the portfolio level.
  • It means be that one should be risk averse (where risk is defined as probability of financial ruin) but not necessarily loss averse.


The thoughts behind this post were triggered because of a tweet by Mr. Samir Arora on twitter for which I thank him.

The Multiplication Rule

The Multiplication Rule

Remember, back in school, when you were learning elementary probability?

One of the topics covered was the “multiplication rule.” My favorite mathematician, John Paulos explains the rule.

If two events are independent in the sense that the outcome of one event has no influence on the outcome of the other, then the probability that they both occur is computed by multiplying the probabilities of the individual events.
For example, the probability of obtaining two heads in two flips of a coin is ½ x ½ = ¼ since of the four equally likely possibilities—tail,tail; tail,head; head,tail; head,head—one is a pair of heads.

Like you, I too encountered the multiplication rule in school. I learnt how to use it to solve questions of probability relating to flipping coins, drawing cards, rolling dice or picking marbles. And then I forgot all about it.

Many years later, when I became a student of business and value investing, I started appreciating the practical significance of the multiplication rule. I found that its utility lay beyond the textbook probability world of coins, cards, dice or marbles.

Multiplication Rule in Investing and Insurance

My first encounter with the multiplication rule outside the abstract world of coins, cards, dice and marbles occurred when I discovered Ben Graham.

Graham never really talked formally about the rule. But, he did recognize the need to “spread the risk” over somewhat uncorrelated (“independent”) risks.

For example, in these these passages in two of his books — Security Analysis and The Intelligent Investor — he wrote about diversification.

An investment might be justified in a group of issues, which would not be sufficiently safe if made in any one of them singly. In other words, diversification might be necessary to reduce the risk involved in the separate issues to the minimum consonant with the requirements of investment.
The instability of individual companies may conceivably be offset by means of thoroughgoing diversification.
There is a close logical connection between the concept of a safety margin and the principle of diversification. One is correlative with the other. Even with a margin in the investor’s favor, an individual security may work out badly. For the margin guarantees only that he has a better chance for profit than for loss—not that loss is impossible. But as the number of such commitments is increased the more certain does it become that the aggregate of the profits will exceed the aggregate of the losses. That is the simple basis of the insurance-underwriting business.
A margin of safety does not guarantee an investment against loss; it merely guarantees that the probabilities are against loss. The individual probabilities may be turned into a reasonable approximation of certainty by the well known practice of “spreading the risk.” This is the cornerstone of the insurance business, and it should be a cornerstone of sound investment.
Pure Grahamites believe in wide diversification because in their worldview, while bad things can happen to a handful of portfolio businesses at the same time, the probability of bad things happening to all portfolio businesses at the same time is remote, thanks to the multiplication rule.

Graham drew strong parallels between the worlds of value investing and insurance underwriting. Both the value investor and the insurance underwriter, according to Graham, should worry about aggregation of risks. Don’t put all your eggs (portfolio positions) in one basket (e.g. one industry). They may be different eggs, but they are one basket and if the basket falls, they will all break together.

Graham’s most famous student — Warren Buffett — has also written about the multiplication rule, although like Graham, he too didn’t mention it specifically. For example, in an essay in one of his letters, he described a principle followed by disciplined insurance underwriters.

They limit the business they accept in a manner that guarantees they will suffer no aggregation of losses from a single event or from related events that will threaten their solvency. They ceaselessly search for possible correlation among seemingly-unrelated risks.

The Deceptive Guise of Independence

Independence of events is a very important notion in probability but is also a deceptive one. This is especially true for some domains like financial markets which lie outside the world of coins, cards, dice or marbles.

Many global investors who practice wide diversification by spreading their money across “seemingly-unrelated risks” across geographies and asset classes found this in 2008 and 2009 when the global financial apocalypse of the time proved diversification to be a fair weather friend. He failed to come to their rescue just when they needed him the most just like an home insurance policy which expires moments before an earthquake strikes.

When shit hit the ceiling, their so-called diversified portfolios were slaughtered by the carnage that took place in asset prices across geographies and asset classes. The prices of  almost every financial asset other than US treasuries crashed. Having one’s eggs in many baskets didn’t really help because what was thought to be “independent” and “uncorrelated” turned out to be anything but.

That experience, made Warren Buffett make an acute observation:

When there is trouble, everything co-relates.

So much for the multiplication rule!

My own thinking about diversification changed quite a bit post the 2008-09 experience but that’s not the subject matter of this post. Let’s stay focused on the multiplication rule instead.

Multiplication Rule in Aircraft Design and Engineering

A few years ago, while researching the idea of “margin of safety” for my class, I came across another idea related to the multiplication rule from the world of engineering. That idea is called “redundancy.” Here’s an example from the world of aircraft design, as illustrated by Wikipedia:

Duplication of critical components of a system with the intention of increasing reliability of the system, usually in the case of a backup or fail-safe… In many safety-critical systems, such as fly-by-wire aircraft, some parts of the control system may be triplicated. An error in one component may then be out-voted by the other two. In a triply redundant system, the system has three sub components, all three of which must fail before the system fails. Since each one rarely fails, and the sub components are expected to fail independently, the probability of all three failing is calculated to be extremely small. [Emphasis mine]

Obviously, this is a very powerful idea. The practical applications of the multiplication rule in engineering — of which aircraft design is just an illustration — have proven to be hugely beneficial for civilization by providing it with, amongst many other things, safer and more reliable planes, cars and nuclear power plants.

What I found interesting was that while “seemingly unrelated risks” in the world of financial markets proved to be not so unrelated after all, in the world of engineering, this wasn’t so. And so, my respect for the multiplication rule returned.


Multiplication Rule in Investment Thinking

Over the years, my appreciation of the multiplication rule has only increased. And even though the rule failed to protect widely-diversified investment portfolios (including mine) from collapse during the global financial meltdown of 2008-09, I continue to apply it to my investment process in other ways.

One of them involves the application of a related principle:

A chain is no stronger than its weakest link.

Let me explain this with the help of an example. A few days ago, my colleagues and I were discussing the investment merits of a situation involving a company which had, a few quarters earlier, announced plans to manufacture a product related, but not identical to, it’s existing products. The new product required a new plant. Moreover the company would need to sell the new product to its existing customers. Also, before the company could start manufacturing the new product, it needed some environmental approvals which, as it happened, had already been delayed.

Furthermore, our analysis revealed that a very significant part of the total expected return from the proposed ownership of this business (acquired at prevailing market price) over the next few years was largely dependent on the success of this initiative. So, in a sense, the entire investment thesis rested on this project.

We saw three, independent risks on this project:

  1. a prolonged delay in receiving the environmental approvals. We figured the probability of this risk materialising was 50% which meant that there was a 50% chance of no further delays
  2. production related risks relating to product quality and cost, given that this was a new product which the company had never manufactured before. Considering the extensive experience of the company, however, we figured that there was only a 20% chance of this risk materialising, which meant that there was an 80% probability of no production hiccups
  3. the inability of the company to sell the new product to its customers. We figured the probability of this risk materialising to be only 10%, which meant that there was a 90% chance that it would be able to sell the product.

For the project to succeed, none of the risks should materialise and the probability of that was simply the product of the probabilities of each of these risks not materialising or

(1-0.5)*(1-0.2)*(1-0.1) = 0.36 or 36%

Therefore, there was only a 36% chance of success on all three parameters which, of course, meant that there was 64% chance of failure. As the consequences of failure were no return for us, we passed the opportunity.

To be sure, this type of thinking is deeply subjective but to paraphrase Keynes, we would rather be subjectively right than be objectively wrong.

Now, imagine that the company does indeed get the environmental clearances. So, risk # 1 is eliminated. What is the joint probability of success now? The multiplication rule tells us that the probability of success has now doubled to

(1-0.2)*(1-0.1) = 0.72 or 72%

Suppose, however the market ignores this development or under-reacts to it. Clearly then, there might be an excellent opportunity to make an investment in this situation, if it looks attractive in relation to other opportunities available at the time.

– – – – – –

A few years ago, Warren Buffett wrote on probability chains derived from the multiplication rule, which would serve as an even better example on how the rule should be used in one’s investment thinking.

Last year MidAmerican wrote off a major investment in a zinc recovery project that was initiated in 1998 and became operational in 2002. Large quantities of zinc are present in the brine produced by our California geothermal operations, and we believed we could profitably extract the metal. For many months, it appeared that commercially-viable recoveries were imminent. But in mining, just as in oil exploration, prospects have a way of “teasing” their developers, and every time one problem was solved, another popped up. In September, we threw in the towel.
Our failure here illustrates the importance of a guideline – stay with simple propositions – that we usually apply in investments as well as operations. If only one variable is key to a decision, and the variable has a 90% chance of going your way, the chance for a successful outcome is obviously 90%. But if ten independent variables need to break favorably for a successful result, and each has a 90% probability of success, the likelihood of having a winner is only 35%. In our zinc venture, we solved most of the problems. But one proved intractable, and that was one too many. Since a chain is no stronger than its weakest link, it makes sense to look for – if you’ll excuse an oxymoron – mono-linked chains. [Emphasis mine]

Clearly, Buffett learnt an important lesson there. The way I see it is that some business models, by their very nature are so complex (e.g. drug discovery) that one has to worry about lots of “moving parts” — independent risk factors. For the investment to be successful, all of those risks must be mitigated. And given the way the multiplication rule works, that’s a long shot. To be sure, long-shots can sometimes be offset by bonanza profits if success does occur, but that kind of investing is more in the nature of a venture capital operation than a value investing operation.

In contrast, other things remaining unchanged, simple, easy to understand businesses with fewer moving parts carry much lower risk of disappointment. As Buffett writes:

Our investments continue to be few in number and simple in concept:  The truly big investment idea can usually be explained in a short paragraph.  We like a business with enduring competitive advantages that is run by able and owner-oriented people.  When these attributes exist, and when we can make purchases at sensible prices, it is hard to go wrong (a challenge we periodically manage to overcome).
Investors should remember that their scorecard is not computed using Olympic-diving methods:  Degree-of-difficulty doesn’t count. If you are right about a business whose value is largely dependent on a single key factor that is both easy to understand and enduring, the payoff is the same as if you had correctly analyzed an investment alternative characterized by many constantly shifting and complex variables.

– – – – – –

My own, intuitive application of the multiplication rule can also be understood by another example.

Some time ago, I read a story in The Economist which promoted me to quote it in a tweet

Screen Shot 2015-11-28 at 15.26.36

I followed that tweet up with a blog post titled “Who will Bail Shale” in which I was asked to comment on the probability of oil prices remaining low for the next few years. While my original, tongue-in-cheek response was to estimate that probability to be “somewhere between zero and 1,” I subsequently wrote:

My head starts spinning when I think about the economics of shale, gas, regular good old crude oil, wind power, solar power and how they interact with geopolitical developments in Russia and USA and Syria and and Iran and Iraq and Saudi Arabia. I could go on and on but I hope you get the point. There are too many variables and too much variability. This one goes in my “too tough basket.”

Contrast the complexity involved in predicting the future price of oil or other commodities with the simplicity of investing in a business like Relaxo — India’s largest footwear manufacturer which despite volatility in input prices, does not experience volatility in its profit margins.


Because Relaxo follows the simple notion of buying commodities and selling brands. It has the ability to pass through cost inflation to customers without fear of loss of unit volume or market share. The business that manufactures EVA has lot more “moving parts” than the business that uses EVA to make and sell branded footwear.

– – – – – –

If you have used the multiplication rule in your investment process in a manner different from what I described above, I would love to know more about it.

Note: The use of Relaxo in the post was just an example to illustrate a point and must not be construed as a stock recommendation.



The Achal Bakeri Lecture @ MDI

On 17 November, Achal Bakeri, founder and CEO of Symphony Limited, delivered a fantastic talk to my students at MDI.


Achal Bakeri @ MDI

Many students later told me or wrote to me that they accumulated more wisdom in this lecture than any other lecture they had attended. For me too, it was a wonderful learning experience to meet Mr. Bakeri for the first time and learn from him.

As per my request, Mr. Bakeri covered the following topics:

  • Your journey as an entrepreneur;
  • The history of Symphony;
  • The struggles faced by you;
  • Early mistakes, and what was learnt from them;
  • Symphony’s M&A strategy;
  • Any ethical dilemma you faced and how you dealt with it; and
  • Key lessons to students from your life.

He also described in detail the business model innovation that he and his team have brought about at Symphony and the remarkable results that innovation resulted in excellent fundamental financial performance.

There is much to learn from Mr. Bakeri’s lecture. You can view the recording from here.

An earlier note sent to students from here.

My introductory comments are here.

And you can get the teaching notes I had sent to students before the lecture from here.

NOTE: This was an academic event focusing on a listed company’s financial performance over the years and the likely causes of that performance. The lecture video and any material referenced above should not be construed as a stock recommendation.


Achal Bakeri, Learning Machine

Text of a Note I sent to my students at MDI today:

Achal Bakeri, Learning Machine

In July 2015, I delivered a talk in which I profiled Achal Bakeri — founder and CEO of Symphony Limited as a “learning machine.”

Next week, Mr. Bakeri will deliver a talk in your class where he will share with you some of the most important lessons he learned as an entrepreneur.

This talk is not going to be about the valuation of Symphony. Rather, it will be about the journey of a very successful entrepreneur who learnt a few key lessons and who has generously agreed to come to MDI to share them with you.

You should regard Mr. Bakeri as a role model. But to get the maximum out of your interaction with him, you must spend time reading about how, over the course of a few years, he transformed Symphony from an unfocused, asset-heavy, highly leveraged, unprofitable business to an extremely focused, asset-light, debt-free, and one of the highest return on operating assets businesses in India.

There are two methods by which you can do this — the long method and the short method. The long method involves reading the past annual reports of the company slowly while making notes about improvements led by Mr. Bakeri to the company’s business model.

If you use the long method, try to relate business improvements in fundamental operating performance with specific business model changes by focusing on key words like “asset-light,” “debt” and “learning.”

You can get the annual reports from here.

The short method would be to simply read recent media coverage about Mr. Bakeri and Symphony. Here are three links:

1. Economist
2. Business Today
3. Forbes

I urge you to use the long method. It’s a lot of fun to learn directly from source documents than to learn from media coverage where you rarely get to read about success stories before they have been recognized by the world out there. So, clearly, it’s in your interest as an investor to take the long road.

I have never met Mr. Bakeri before and so, like you, I will be meeting him for the first time next week. Together, let’s learn whatever we can from the accumulated wisdom of a learning machine.

Sanjay Bakshi
14 November, 2015

Farnam Street Interview Transcript

Earlier this year — on 24 August — I had the privilege of sitting down for a chat with Shane Parrish who publishes the Farnam Street blog. That chat took place in the room of the wonderful Waldorf Astoria hotel in NYC — the one where Indian PM stayed recently and the one in which one of my favorite movies — Scent of a Woman — was shot in 1992. (Watch this scene).

Needless to say, meeting Shane and interacting with him was a memorable experience.

Shane, who has been a dear friend for many years, has now generously allowed me to make the transcript of our chat public. You can get it from here.

Thanks Shane.

Worldly Wisdom in an Equation

Here is the transcript of my today’s talk at October Quest 2015 in Mumbai.

Meeting With Triumph and Disaster: Some Lessons

Here’s a the transcript of something I wanted to tell my BFBV class students yesterday and today but the time ran out. So, I am putting it down here…

Danny Kahneman’s famous work on Prospect theory can best be described by an image and a quote from Charlie Munger. Here’s the image:

Screen Shot 2012-09-24 at 17.27.56

And here’s the quote:

“The quantity of a man’s pleasure from a ten dollar gain does not exactly match the quantity of his displeasure from a ten dollar loss.” — Charlie Munger

A few days ago I had presented you with a problem. You had to choose between an 85% chance of winning $100 (the gamble) or a sure gain of $85 (the sure thing). Most of you chose the sure thing, presumably because you thought of yourself as a conservative person who thought at a bird in hand is worth two in the bush.

So far so good. But look what happened when I presented the exact same problem by changing a “gain frame” to a “loss frame.” That is, when I asked you to choose between an 85% chance of losing $100 (the gamble) or a sure loss of $85 (the sure thing), most of you became gamblers! Think about that and the power of words. Just by changing a few words, without changing the problem, I turned you from being a conservative person to a gambler. That, dear students is loss aversion. As Danny Kahneman writes:

The reason you like the idea of gaining $85 and dislike the idea of losing $85 is not that these amounts change your wealth. You just like winning and dislike losing—and you almost certainly dislike losing more than you like winning.

Loss aversion made you a risk seeking person.

Loss aversion explains human behaviour in situations of conflict such as labor negotiations. Kahneman wrote:

It is well understood by both sides that the anchor is the existing contract and that the negotiations will focus on mutual demands for concessions relative to that anchor. The role of loss aversion in bargaining is also well understood: making concessions hurts.

The concessions you make to me are my gains, but they are your losses; they cause you much more pain than they give me pleasure. Inevitably, you will place a higher value on them than I do. The same is true, of course, of the very painful concessions you demand from me, which you do not appear to value sufficiently!

Negotiations over a shrinking pie are especially difficult, because they require an allocation of losses. People tend to be much more easygoing when they bargain over an expanding pie.

Loss aversion also explains the difficulty in carrying out “reorganizations” and “restructuring” of companies, or rationalizing a bureaucracy. Kahneman writes:

As initially conceived, plans for reform almost always produce many winners and some losers while achieving an overall improvement. If the affected parties have any political influence, however, potential losers will be more active and determined than potential winners; the outcome will be biased in their favor and inevitably more expensive and less effective than initially planned. Reforms commonly include grandfather clauses that protect current stake-holders—for example, when the existing workforce is reduced by attrition rather than by dismissals, or when cuts in salaries and benefits apply only to future workers.

Loss aversion also explains the behaviour of gamblers (and day traders and even stock market investors) who become risk seeking immediately after experiencing a string of losses. They will do almost anything just to “get back in the game.”

Indeed, this inability of most human beings to treat losses and gains equivalently explains many things about human nature. The rational person, on the other hand, treats losses and gains equivalently. For them, the quantity of pleasure from a ten dollar gain is no different from the quantity of misery from a ten dollar loss.

One such rational person, of course, is Warren Buffett. Over the years he has not only demonstrated his ability to treat losses and gains equivalently, he has also taken advantage of those who don’t (or can’t given their dependence on the need to not look foolish.)

Here are a few excerpts from Buffett’s letters which illustrate this point:

Extract from 1989 Letter

Our willingness to put such a huge sum on the line for a loss that could occur tomorrow sets us apart from any reinsurer in the world. There are, of course, companies that sometimes write $250 million or even far more of catastrophe coverage. But they do so only when they can, in turn, reinsure a large percentage of the business with other companies. When they can’t “lay off” in size, they disappear from the market.

Berkshire’s policy, conversely, is to retain the business we write rather than lay it off. When rates carry an expectation of profit, we want to assume as much risk as is prudent. And in our case, that’s a lot.

We will accept more reinsurance risk for our own account than any other company because of two factors: (1) by the standards of regulatory accounting, we have a net worth in our insurance companies of about $6 billion – the second highest amount in the United States; and (2) we simply don’t care what earnings we report quarterly, or even annually, just as long as the decisions leading to those earnings (or losses) were reached intelligently.

Obviously, if we write $250 million of catastrophe coverage and retain it all ourselves, there is some probability that we will lose the full $250 million in a single quarter. That
probability is low, but it is not zero. If we had a loss of that magnitude, our after-tax cost would be about $165 million. Though that is far more than Berkshire normally earns in a quarter, the damage would be a blow only to our pride, not to our well-being.

This posture is one few insurance managements will assume. Typically, they are willing to write scads of business on terms that almost guarantee them mediocre returns on equity. But they do not want to expose themselves to an embarrassing single- quarter loss, even if the managerial strategy that causes the loss promises, over time, to produce superior results. I can understand their thinking: What is best for their owners is not necessarily best for the managers. Fortunately Charlie and I have both total job security and financial interests that are identical with those of our shareholders. We are willing to look foolish as long as we don’t feel we have acted foolishly.

Extract from 2000 Letter

In another example of his versatility, Ajit last fall negotiated a very interesting deal with, an Internet company whose goal was to attract millions of people to its site and there to extract information from them that would be useful to marketers. To lure these people, held out the possibility of a $1 billion prize (having a $170 million present value) and we insured its payment. A message on the site explained that the chance of anyone winning the prize was low, and indeed no one won. But the possibility of a win was far from nil.

Writing such a policy, we receive a modest premium, face the possibility of a huge loss, and get good odds. Very few insurers like that equation. And they’re unable to cure their unhappiness by reinsurance. Because each policy has unusual  and sometimes unique  characteristics, insurers can’t lay off the occasional shock loss through their standard reinsurance arrangements. Therefore, any insurance CEO doing a piece of business like this must run the small, but real, risk of a horrible quarterly earnings number, one that he would not enjoy explaining to his board or shareholders. Charlie and I, however, like any proposition that makes compelling mathematical sense, regardless of its effect on reported earnings.

Extract from 2006 Letter

Lloyd’s, Equitas and Retroactive Reinsurance

Last year – we are getting now to Equitas – Berkshire agreed to enter into a huge retroactive reinsurance contract, a policy that protects an insurer against losses that have already happened, but whose cost is not yet known. I’ll give you details of the agreement shortly. But let’s first take a journey through insurance history, following the route that led to our deal.

Our tale begins around 1688, when Edward Lloyd opened a small coffee house in London. Though no Starbucks, his shop was destined to achieve worldwide fame because of the commercial activities of its clientele – shipowners, merchants and venturesome British capitalists. As these parties sipped Edward’s brew, they began to write contracts transferring the risk of a disaster at sea from the owners of ships and their cargo to the capitalists, who wagered that a given voyage would be completed without incident. These capitalists eventually became known as “underwriters at Lloyd’s.”

Though many people believe Lloyd’s to be an insurance company, that is not the case. It is instead a place where many member-insurers transact business, just as they did centuries ago.

Over time, the underwriters solicited passive investors to join in syndicates. Additionally, the business broadened beyond marine risks into every imaginable form of insurance, including exotic coverages that spread the fame of Lloyd’s far and wide. The underwriters left the coffee house, found grander quarters and formalized some rules of association. And those persons who passively backed the underwriters became known as “names.”

Eventually, the names came to include many thousands of people from around the world, who joined expecting to pick up some extra change without effort or serious risk. True, prospective names were always solemnly told that they would have unlimited and everlasting liability for the consequences of their syndicate’s underwriting – “down to the last cufflink,” as the quaint description went. But that warning came to be viewed as perfunctory. Three hundred years of retained cufflinks acted as a powerful sedative to the names poised to sign up.

Then came asbestos. When its prospective costs were added to the tidal wave of environmental and product claims that surfaced in the 1980s, Lloyd’s began to implode. Policies written decades earlier – and largely forgotten about – were developing huge losses. No one could intelligently estimate their total, but it was certain to be many tens of billions of dollars. The specter of unending and unlimited losses terrified existing names and scared away prospects. Many names opted for bankruptcy; some even chose suicide.

From these shambles, there came a desperate effort to resuscitate Lloyd’s. In 1996, the powers that be at the institution allotted £11.1 billion to a new company, Equitas, and made it responsible for paying all claims on policies written before 1993. In effect, this plan pooled the misery of the many syndicates in trouble. Of course, the money allotted could prove to be insufficient – and if that happened, the names remained liable for the shortfall.

But the new plan, by concentrating all of the liabilities in one place, had the advantage of eliminating much of the costly intramural squabbling that went on among syndicates. Moreover, the pooling allowed claims evaluation, negotiation and litigation to be handled more intelligently than had been the case previously. Equitas embraced Ben Franklin’s thinking: “We must all hang together, or assuredly we shall hang separately.”

From the start, many people predicted Equitas would eventually fail. But as Ajit and I reviewed the facts in the spring of 2006 – 13 years after the last exposed policy had been written and after the payment of £11.3 billion in claims – we concluded that the patient was likely to survive. And so we decided to offer a huge reinsurance policy to Equitas.

Because plenty of imponderables continue to exist, Berkshire could not provide Equitas, and its 27,972 names, unlimited protection. But we said – and I’m simplifying – that if Equitas would give us $7.12 billion in cash and securities (this is the float I spoke about), we would pay all of its future claims and expenses up to $13.9 billion. That amount was $5.7 billion above what Equitas had recently guessed its ultimate liabilities to be. Thus the names received a huge – and almost certainly sufficient – amount of future protection against unpleasant surprises. Indeed the protection is so large that Equitas plans a cash payment to its thousands of names, an event few of them had ever dreamed possible.

And how will Berkshire fare? That depends on how much “known” claims will end up costing us, how many yet-to-be-presented claims will surface and what they will cost, how soon claim payments will be made and how much we earn on the cash we receive before it must be paid out. Ajit and I think the odds are in our favor. And should we be wrong, Berkshire can handle it.

Scott Moser, the CEO of Equitas, summarized the transaction neatly: “Names wanted to sleep easy at night, and we think we’ve just bought them the world’s best mattress.”

Needless to say, that was an expensive mattress but one that offered its loss averse owners a lot of comfort.

These examples show that risk aversion and loss aversion are not the same. Buffett, for example, is risk averse, but not loss averse. He gladly accepts bets where he could lose a large sum of money but where there is an expectancy of a gain, provided that if a loss does occur, it will not impair Berkshire’s balance sheet.

As an investor, you should seek businesses which are risk averse but not loss averse. You should avoid businesses who don’t want to even experiment a bit because they are petrified of losses should the experiments fail. Most of the time, you really don’t want to be an investor in businesses like this one:


The way Warren Buffett thinks about loss aversion is very rare. It has to be rare where people do not wish to look like fools even though they haven’t acted foolishly.

It is also the kind of thinking Kipling recommends in his beautiful, deeply inspirational poem “If.”

This poem has a number of lessons for you, but let’s focus on just one of them today, which is highlighted in below.

If, by Rudyard Kipling

If, by Rudyard Kipling

A few years ago, in a shareholders’ meeting, Mr. Munger spoke about Kipling’s poem.

Shareholder: When Bell Rich Oil goes up 35 times, it’s pretty…I imagine myself have a lot of regret or debilitating. How does one recuperate from something like that? A big missed opportunity? How does one recover from that? How do you end up not dwelling on that?

Munger: You know what Kipling said? Treat those two imposters just the same — success and failure. Of course, there’s going to be some failure in making the correct decisions… I think it’s important to review your past stupidities so you are less likely to repeat them, but I’m not gnashing my teeth over it or suffering or enduring it. I regard it as perfectly normal to fail and make bad decisions. I think the tragedy in life is to be so timid that you don’t play hard enough so you have some reverses.

And he spoke about Kipling’s poem again elaborating on what it teaches us about how to live a useful life in this wonderful interview with Becky Quick.

Munger is telling you to listen to Kipling who suggests that great success shouldn’t give you a swelled head, and great failure shouldn’t discourage you, since both are in a sense flukish anomalies. Rather, you should react the same way to both.

Kipling’s words “If you can meet with Triumph and Disaster And treat those two impostors just the same” are inscribed on the top of a passage inside the Wimbledon tunnel as a reminder to the players entering that temple on how to behave inside the stadium.

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Watch this old video which shows Kipling’s inspirational words have been inside the stadium for decades…

To many of you, I hope, all this will look a bit familiar, and remind you about Indian spiritual thought on detachment as described in some of its most important works. Take, for example, this small passage from the Mundaka Upanishad:


The two golden birds, of course, are the ego and the self. The ego is what you need to control.

In his wonderful book, “The Practicing Mind: Bringing Discipline and Focus Into Your Life,” Thomas Sterner writes:

If you are aware of anything you are doing, that implies that there are two entities involved: one who is doing something and one who is aware or observing you do it. If you are talking to yourself, you probably think you are doing the talking. That seems reasonable enough, but who is listening to you talk to yourself? Who is aware that you are observing the process of an internal dialogue? Who is this second party that is aware that you are aware?

The answer is your true self. The one who is talking is your ego or personality. The one who is quietly aware is who you really are, the Observer. The more you become aligned to the quiet Observer, your true self, the less you judge. Your internal dialogue begins to shut down and you become more detached about the various external stimuli that come at you all day long. You begin to actually view your internal dialogue with an unbiased and sometimes amused perspective. I have had times where my ego is going on and on about something someone said to me that “it” considered “irritating,” and I am very separate and unaffected. I feel as if I am invisible in a room watching someone complain about something that is completely unimportant to me. This also extends into experiences of personal stress such as job deadlines or finances. I have witnessed my ego rambling on about how I am not going to finish a job on time. When I am aligned to my true self, the Observer, I find myself aware of the stress that my ego is experiencing, but also unaffected by it. I have a sense of “that’s just my ego fretting that it will experience disapproval by a certain party if it disappoints them by taking longer than it originally anticipated.”

When you are aligned with your true self you are immune to other peoples’ behaviors. When you feel that someone is acting inappropriately towards you, that comes from a judgment of the ego. From the perspective of the Observer, you find yourself just watching their ego rant and rave while you are listening quietly and unaffected.

The importance of knowing this is that when you decide to engage your practicing mind in any activity, you are evoking this alignment to the Observer, your true self. The ego is subjective. It judges everything, including itself, and it is never content with where it is, what it has, or what it has accomplished. The Observer is objective and there in the present moment. It does not judge anything as good or bad. It just sees the circumstance or action as “being.” In other words, the circumstance “just is.” Thus the Observer is always experiencing tranquility and equanimity.

In his “Upanishads (Classic of Indian Spirituality),” Eknath Easwaran writes about The Brihadaranyaka Upanishad

9. The human being has two states of consciousness: one in this world, the other in the next. But there is a third state between them, not unlike the world of dreams, in which we are aware of both worlds, with their sorrows and joys. When a person dies, it is only the physical body that dies; that person lives on in a nonphysical body, which carries the impressions of his past life. It is these impressions that determine his next life. In this intermediate state he makes and dissolves impressions by the light of the Self.

10. In that third state of consciousness there are no chariots, no horses drawing them or roads on which to travel, but he makes up his own chariots, horses, and roads. In that state there are no joys or pleasures, but he makes up his own joys and pleasures. In that state there are no lotus ponds, no lakes, no rivers, but he makes up his own lotus ponds, lakes, and rivers. It is he who makes up all these from the impressions of his past or waking life.

11–13 It is said of these states of consciousness that in the dreaming state, when one is sleeping, the shining Self, who never dreams, who is ever awake, watches by his own light the dreams woven out of past deeds and present desires. In the dreaming state, when one is sleeping, the shining Self keeps the body alive with the vital force of prana, and wanders wherever he wills. In the dreaming state, when one is sleeping, the shining Self assumes many forms, eats with friends, indulges in sex, sees fearsome spectacles.

16–17 But he is not affected by anything because he is detached and free; and after wandering here and there in the state of dreaming, enjoying pleasures and seeing good and evil, he returns to the state from which he began.


Interview with Farnam Street

Recently, I had the privilege of interacting with Shane Parrish, who is the publisher of Farnam Street blog.