Against The Machine

Positive Black Swans and The Dip

November 21, 2020 Terrence Hooi Season 1
Against The Machine
Positive Black Swans and The Dip
Show Notes Transcript

Strategic “Optionalities”  is the secret of successful investors, entrepreneurs and organizations. Reactive cutting loss or investors who switch between strategies are the bane of those that strive (and fail) to get what they want. And most people do just that. They quit (cut losses) when it’s painful and stick when they can’t be bothered to when the fundamentals of the markets have changed. 

There are two curves that define almost any type of situation facing you as you try to grow your portfolio. (A couple of minor curves cover the rest. Understanding the different types of situations that lead you to cut losses prematurely). Understanding the different types of situations that lead you to cut loss or quit- is the first step toward getting what you want.



Positive Black Swans and The Dip 

The Magic of Staying in the Game

Just About everything you learned in school about life is wrong. In fact, schools don’t teach you how to handle adversity of how difficult it is to start and scale a business. The long-held assumption with our industrial-age outdated education system might very well be this: Being well rounded is the secret to success.

When I was in first grade, when I came home from school with two As, and B+ and three Bs, I was doing just fine and my teachers loved me. But then I had a streak of having an A+ and five 5s, boy, I was in trouble both in school and at home.

Fast forward a few decades from those school days, and think about the decisions you make today- about which stock to pick, which restaurant to visit or which dentist to go to. How often do you look for someone’s who is actually quite good at the things you don’t need her to do? How often do you hope that your dentist is a safe driver or a decent golfer?

Ten years ago, I read a book that changed my life. It was called Black Swans by Nicholas Nassim Taleb. I actually don’t remember that in one quick moment, it changed the way I thought about success especially in the investing world. 

My hope is that the next paragraph or two might do the same for you when you think about investing or trading. I want to change the way you think about investing (and cutting losses early).

Most gurus will tell you that you need to trade more- to try harder, put in more hours, get more training and work hard. “Don’t quit!” Or “Study hard and Put in more hours in Trading the Markets” they implore.  Then why do investors less motivated so called “Trade more” than you succeed? Why do individuals less talented than you win

It involves understanding the architecture of Optionalities, believe it or not, it means trading a lot less than you do now.

Strategic “Optionalities”  is the secret of successful investors, entrepreneurs and organizations. Reactive cutting loss or investors who switch between strategies are the bane of those that strive (and fail) to get what they want. And most people do just that. They quit (cut losses) when it’s painful and stick when they can’t be bothered to when the fundamentals of the markets have changed. 

There are two curves that define almost any type of situation facing you as you try to grow your portfolio. (A couple of minor curves cover the rest. Understanding the different types of situations that lead you to cut losses prematurely). Understanding the different types of situations that lead you to cut loss or quit- is the first step toward getting what you want.

Curve 1: The Dip

Coined by Seth Godin in his book The Dip, he mentioned that “Almost everything in life worth doing is controlled by the Dip.”

At the beginning, when you first start something, it could be a business, trading, investing or sports, it’s fun. It could be golf, piloting a plane or starting a consultancy firm. I must admit, it’s more than fun, everything seems interesting, and you get plenty of good feedback from the people around you especially friends and family. 

And over the next few weeks, the rapid learning you experience keeps you going. Whatever your new thing is, it’s easy to stay engaged in it

And then something happens, the Dip happens. 

Godin added, the Dip is the combination of bureaucracy and busywork you must deal with in order to get certified in dentistry or scuba diving.

The dip is what separates the easy “beginner” technique and the more useful “expert” approach in trading or fashion design.

The Dip is the long stretch between beginner’s luck in investing and real accomplishment. 

The Dip is set of artificial screens set up to keep people, the 95% of bad traders from profiting consistently. When in school, organic chemistry is the killer class where most people who attempt to go to medical school would quit. Because academia do not want unmotivated people to enter med schools. So you can’t go to med school you don can’t handle organic chemistry. 

Now let's relate this to investing. At the beginning, when you announce you’re an investor, you get all sorts of feedback from the markets, both positive and negative. Your grandmother can’t believe her good fortune because you helped her buy a fruit shaped company 20 years ago and now it’s the most valuable technology company in the world. But soon, the incredible grind of handling the ups and downs in your portfolio kicks in, and you realize the stocks you bought are doomed. 

Any experienced Medium to longer term trader of a LEAP Option “Long-term Equity Anticipation”  would understand the first few weeks or months of an investment that is not getting anywhere. Remember that stock that you’ve just purchased and that stock you are hoping it would go higher is just not going anywhere. There’s no getting around that. But if you stretch out the time frame, you can allow the stock to go finish its consolidation period before it starts taking off where the returns can be enormous.  

At trade shows, you see dozens of companies trying to break into an industry. Most invested time and money to build a product and then a marketing organization and then rent a booth space. All in all, trying to tap into a huge and lucrative market. Fast forward a year later, most don’t return. Most of those products are discontinued are some of it gone, because they are unable to get through the Dip. 

The same thing happens to people who dream of the untold riches and power that accrue to the owner of early stage investors of Uber, Tesla, Airbnb, Facebook or Alibaba. Private Jets, TechCrunch events, fancy country clubs. Who wouldn’t want to live like a modern-day royalty?

Of course, if you look at the portfolio of Venture Capitalists or a Portfolio Manager, you’ll see that he endured a two to five year Dip before having that exponential growth in total portfolio value. For five years, he needed to suck it up, enduring emotional ups and downs, and skip that Mediterranean summer vacation because his money is in the markets. Day in and out, year after year.

It’s easy to be an investor. What’s hard to getting to be the top 1% and having a few 10 baggers every few years. There is a huge dip along the way. If it was easy, everyone would quit their jobs and start investing with their paychecks. Emotional Intelligence in investing, as we’ve seen, is the secret to becoming the top 1%. If there wasn’t a Dip, there’s be no scarcity in this skill which is one of the most lucrative skill on Wall Street. 

After going thought a couple of Dips in my trading career, I’ve found that successful investors don’t just ride out the dip. They don’t just buckle down and survive it. They lean into the Dip. 
Just because you’re in a Dip doesn’t mean you have to quit investing or cut losses early. Dips don’t quite as long when you whittle at them. For those who are more well versed in the investing universe, you would know that markets go through consolidations and breakout phases. In other words, when markets are in a narrow trading range, they often change their rules as they go. 


Curve 2: The Cul-De-Sac

The next curve will be called the Cul-de-Sac (French for “dead end”) is so simple to understand I don’t have to draw a chart. It’s a situation where you invest and put more money into a company and nothing much changes. It doesn’t get a lot better, it doesn’t get a lot worse. It just is. Take for example, the rail road industry or Airlines where margins are razor-thin. When a company's revenues have stalled, there are usually fewer opportunities for employees to grow their own careers. 

On the other hand, if you put your money in an autonomous driving company that might drive transportation costs lower, it is the opposite of the Cul-De-Sac, it could be a Positive Black Swan investment which I will explain more later in this article. 

There’s not a lot to say about the Cul-de-Sac except to realize that it exists and to embrace the fact that when you find one, the chances of of capturing Positive Black Swan kind of returns will be closer to zero. That’s it, now the two curves you need to understand, as an investor, you have to understand which curve the companies you’re invested in is sitting on. 

Over the years sticking with the Dips that are likely to pan out, like early years of Tesla, Twillio, Netflix, Workday, Zoom or Alibaba, and quit the Cul-de-Sacs to focus your resources. That’s it. 


Curve 3: The Cliff (Rare But Scary)

Day trading, it turns out, were designed by brokers and fake gurus to be particularly addictive and entertaining. If you were going to draw a chart of the pleasure of making few hundred bucks over time but having the Black Swan risks like blowing up the account when there is a market crash over time, it would look like this. Investment management is not art, it’s not science, it’s engineering. 

Same goes with Cigarettes, it turns out, were redesigned by scientists to be particularly addictive. Except the nasty and scary drop-off at the end (otherwise known as ehpysema or lung  cancer), smoking is a marketer’s dream come true. 

Long time smokers know it, the pain of quitting just gets bigger and bigger over time. It’s a situation where you can’t quit until you fall off, and the whole thing falls apart. This is the very reason why people have trouble quitting because most of the time, the other two curves are in force. Curve 1: The Dip and Curve 2: Cul-de-Sac aren’t linear. They don’t spoon feed you with little bits of improvement every day. They’re just waiting to trip you up.

In 1906, Vilfredo Pareto discovered the “Pareto Principle” or the 80-20 rule. If you look at the most destructive earthquakes, there are many times more powerful than all smaller earthquakes combined. Einstein might have created the power law, or named because the exponential equations to describe severely unequal distributions. It might define the investing world that we usually don’t even notice it. 

Venture capitalists aim to identify, fund and profit from promising early start ups. They usually raise money from institutions and accredited investors and pool it into a fun. If you take a look at a typical venture fund, you can also start to see the power law taking place where usually a handful of startups succeed and most fail. Most venture-backed companies don’t IPO, most fail before getting any traction. But companies in the top tier usually hit an exponential growth and start to scale rapidly moving towards the right end of the curve. 

Professional investors know that with a portfolio large enough, the bad companies that fail, mediocre ones staying flat and good ones usually return 5x to 10x their investment. According to the power law, only a small handful of companies radically outperform the rest of companies in a typical venture fund. Interestingly enough, pursing only few companies that can be overwhelmingly valuable and you will often miss on those rare companies in the first place. 

Most venture funds have a 10 year lifespan and every VC knows a “spray and pray’ approach is a surefire way to have a portfolio of flops instead of building a portfolio like a J-Curve. The key is to be psychologically prepared to lose.

Investing in Innovations has a Dip. The difference between a mediocre investor and a great investor isn’t inborn talent. It’s the ability to push through the moments where it’s just easier to cut losses and quit. Running a marathon has a dip too. It’s way more fun to complete a marathon than to drop off one, and the entire process is built around many people starting while most people quit.

The dip creates scarcity especially in the Disruptive Innovation investing game. And scarcity creates value.

It’s easy to complain that the advice of investing is brain-dead obvious.  I mean, who doesn’t already know that the secret to success in investing is to stay for the long run, and that you shouldn’t cut losses in the face of dips and seeing your account balance drop?

You don’t. That’s the bad news, because when your account balance drops, it is emotional. At least I call that a Dip. 

The good news is that Wall Street haven’t picked up on this emerging tech yet and Wall Street hates new emerging tech.


If it’s a Disruptive Technology, There’s Probably A Dip