Things to Do In June: the CFA Program Level II exam

Last Saturday was a beautiful balmy day here in London. The kind of day that sends Londoners into a frenzy of delight involving some combination of parks, booze, snacks and proud displays of lobster torso.

Me, though, I had another plan. Along with nearly 10,000 other hopefuls I trooped over to the Excel Centre in London’s Docklands to sit 6 hours worth of exams – the dreaded CFA. Level 2 in fact. It is quite brutal – physically and mentally extremely demanding from 9am until you’re released back into the world at 5pm  wondering what the f**king hell just happened!

It is a kick.

The results aren’t out so this is the time to cast a critical eye on  the revision and exam journey. My guiding principle is always to accentuate good process over outcomes but this is easier said than done when the outcome is staring at you in the face. My thoughts focus on how I would approach the study process if I had to repeat. These are somewhat ex tempore but want to capture them while still fresh, they tend to reflect other guides on Level 2 Here goes:

1. Level 2 is not just an extension of Level 1, it has its own flavour.

What worked for level 1 won’t cut it here. I don’t mean in terms of how hard we have to work or in relative difficulty – both are extremely difficult and the pass rates attest to that. Level 2 did seem more difficult but there is a recency effect that most likely accentuates that impression.

They do test in different ways and we have to adapt our study to appreciate the differences. In level 1 the questions are discrete; while in level 2 we have the itemset, a 1-3 page block of text followed by 6 questions.

This requires a more joined up understanding of the various concepts in the exam and makes working on exam technique far more important. First order knowledge is not enough.

2. Time, intensity and the order of study

From the weights below you can see which topics dominate and from a little investigation you’ll get an idea which are the hardest topics for you:


Source: CFA Institute

The oft repeated heuristic is that 300 hours of study are needed to be in a good place come exam time. Assuming this is a fair number (seems fair) then I would change elements of how I approached this.

For level 1 I started in late February or so and was quite meticulous in my planning and execution such that by early May I was in a decent position. This time I planned on starting in March but in reality only got going toward the end of March and it was only going into May that I really pushed the throttle and went for it. This lateness was my first and biggest mistake and why I needed to work on so many second level techniques – so the best advice I can offer is give yourself the time you need.

Additionally it would have helped if I was more considered with my ordering of topics. I had ‘the fear’ in (the highly weighted) FRA (Financial Reporting and Analysis) and FI (Fixed Income) but I decided to tackle the easier topics before approaching them. A surer method would have been to break the back of the hard ones early, at least to the degree that the fear and tension that came from their unknownness is dissipated.

Instead they hung over me. Unfairly so, as when I eventually dug into FRA topics such as Intercorporate Investments or Pension Accounting they were not only (relatively) manageable but far more enjoyable (and useful) than I expected.

I never got to that degree of confidence with FI but if I had I would be far more confident in passing.

3. Knowing is best, but it’s how you handle what you don’t know that will get you over the line

There are two ways to answer a question. The first is the obvious way – know the answer or the method to get the answer. This is the best way; but there is a lot to know so you may not possess all the necessary elements. Also questions are often designed to stress this knowledge (by using second order elements or masked terminology for example).

If we don’t know we must fall back on the second method which is to make probabilistically informed guesses aka guessing with style. This was a technique I practiced with care and deliberation, my style was something like the following:

a) Chunking and understanding conceptual frameworks – my aim was to proceed with an eye on learning (within reason) rather than merely to pass. I decided to study with the intent of understanding rather than rote learning (as far as I was able). This surprisingly turned out to be a good method even if the initial time and effort commitment is larger and you’ll sweat your brain in brutal ways.

We can break out a topic into different levels. The first is to build a relatively complete understanding of the core structure and flow of the topic area and the links to other topics. We can learn the Free Cash Flow formulae verbatim (this is a good summary) or we can try to understand the different starting points and why some adjustments are necessary or not. This provides a more supple and contextual grasp of the material. Hopefully when answering a question, we have texture and the flow thus don’t need to recall facts that are dangling in a vacuum.

b) Less is more (if it is the right less)The next level is to fill in the core elements. My technique here was to not over learn. Take the example of accounting for inventories which has an emphasis on LIFO-FIFO. In the study materials we find a long list of the effects on key ratios and statements using the two methods with a “LEARN THIS LIST!” command.

I ignored this. Once I understand the adjustments required I didn’t need to know anything more as I could think through the flow when required. It takes a little longer than just knowing the answer but I save a bundle of time in the learning, understand the concept and am not reliant on my (creaky) memory.

c) Work backwards Then there are the questions which leave us clueless or our bête-noir topics. These are still valuable points so we hone a variety of tools for dealing with them.

I struggled with swaps to the last day, a topic that induces paroxysms of despair (btw this is the best explanation I could find anywhere. In truth swaps aren’t so bad but there is a lot going on and it is easy to find yourself dazed and confused.)

The worst of these are fixed-for-floating currency swaps. If I get a question on this, the initial reaction is to freeze, squint hard and the brain fog to descend. But in an exam I don’t have the luxury of indulging this fear, I need to give myself a chance of answer correctly.

Somehow crack some air into this coffin.

One way to do this is to start with the end – the answers. One of them is right. Without having complete knowledge how can I put myself in a strong position to choose it? How can I deconstruct this question into elements that will help me? What do I know?

I know there are two relevant strands in the swap – the currency exposure and the fixed for floating payments . If I glance at the question I can ascertain hopefully (with crude calculation) which way the swap will be a winner and a loser and also the magnitude. As an example if there is a big currency move and the interest rate differentials are small then the currency element is likely to dwarf the net effect of the payments. With this information alone I may be able to answer the question. At the very least I should be able to eliminate one answer.

Then I look to refine the order of magnitude in terms of payments (again crudely) to hopefully give me a clearer choice. I keep an eye on the discounting required and the dates but if the rates are low then I can almost ignore these. Finally you make your best guess and look to revisit time permitting. It is a 3 minute question and 1 mark like all others, so to fritter 8 or 9 mins is not good practice.

d) Permutations – Another practice with calculation dense questions if you are a little unsure of a few elements – such as in FCF, pensions etc. is to calculate the elements where you are comfortable, leave that subtotal and then calculate the permutations of the other inputs. But you do this with an eye on the answers. This is handy when you’re not sure whether to add back tax, amortisation etc etc. – calculate them all.

e) Clear Working – heavily related to the last point and rather obvious but if you set out your working clearly you’ll find questions far easier and the permutation technique is vastly improved. Often I would make the necessary calculations and find the answer was not close to the answers on the sheet (especially when you are tapping furiously on your calculator and not looking that you’ve put in the correct numbers). When I looked back at my scribblings they were incoherent so I would start over.

The solution was so easy and effective. Just write it out properly. That way you can also keep an eye out for dates and other assumption tricks that may catch you out.

4. Practice papers and itemset formats

If you have access to something like the Schweser question bank that is great (I didn’t use this for level 2). I used the great Investopedia resources initially. They are really valuable during the initial learning phase but they offer only individual questions so don’t develop the necessary itemset skills.

As soon as is practical (and depending on availability) I would move to working on itemset type questions. The CFA Institute offer a whole load of practice questions and a free practice paper but however many you can get your hands on will pay for themselves over and over. (side note: they have to be decent quality, I looked at some which ended up confusing me). This is where a candidate working off the corporate budget has a huge leg up as they’ll have access to plenty of good quality question sets.

The first few practice exams I took (or half exams to be accurate) were depressing in outcome but invaluable in directing and honing study.

I can’t stress how important it is to master itemset type questions through practice, feedback and development.

5. Embrace the Chaos

Level 2 is a chaotic, seething ocean of information and our challenge is to skillfully engage with that chaotic unknown and bring enough order and insight to provide good answers. All under time pressure.

This is a point worth considering long before exam day. In the exam we will be exposed to conditions outside our control. It is useful to not require specific conditions or mental or emotional states in order to perform well.

I practiced tackling questions when agitated, annoyed, despondent, hungry, tired or when there was noise or other distraction. And I sought space and concentration in all circumstances as well as accentuating releasing tension in between stress moments (thank you Josh Waitzkin).

In this manner I found the exam experience far more pleasant than level 1. Not just the familiarity with the process but the comfort of knowing that emotional or physical states wouldn’t put me off track.

6. Looking after yourself.

This is an intense experience and you’ll do yourself a load of good by taking care of yourself in the build up and on the day. Running yourself into the ground is risky and not pleasant.

There will very likely be moments of deep despair (in the last week I bumped into many people studying in my regular haunts and they all had that wide eyed, gaunt and slightly unbelieving look in their faces – “there’s so much!” despaired one girl when I asked how it was going).

Hopefully you’ll have a good support network who will help you along. If you don’t give me a buzz and I’ll give some pep talks J

My nadir was after my second practice exam. I scored extremely poorly and felt terrible, complaining and moaning to all and sundry (“I’ll never pass, it’s useless blah blah”). That evening (after attending a talk on the Rwandan genocide) I had a stern word with myself. Instead of complaining I would get on, do my best, learn. And enjoy.

This is a privilege, not a torture.

The next few weeks were calm and far more pleasant (although after my outburst everyone tiptoed around me a little when asking how it was going.)

 Wrapping Up – Passing, Failing, Regrets and Singing Badly

Now it is just the wait for the results. The first question people ask after ‘how was it?’ is ‘do you think you passed?’. I have no ready answer – the base rate pass rate is 40-45% of candidates so the likelihood is that I haven’t (assuming the quite reasonable assumption I am about the same level as most other candidates). This is an exam of fine margins with large effects. We shall see.

Let me end with the beginning – Jay Z and regrets. This is the tinge when we think of the (too many) answers we should have known. What could have been? These are the songs of our lives and a proxy for all our stumbling and falling. Success hides regrets, failure shoves them in our face. But the only regret we should heed is the regret of omission. The song not sung. Or sung in a whisper.

For someone not used to this mindset this directional shift is pleasing: Try, try well, learn, improve, enjoy – keep going. The rest will take care of itself. Maybe.

Strangely it is this pleasure that will linger.

Peace and all the best.

Some articles:

And resources:

… and of course 300 hours and investopedia have so much good stuff (not forgetting the CFA Institute)

Zugzwang *

“I notice that my opponent is always on the go
Won’t go slow, so’s not to focus, and I notice
He’ll hitch a ride with any guide, as long as
They go fast from whence he came
– But he’s no good at being uncomfortable, so
He can’t stop staying exactly the same.” – Fiona Apple, Extraordinary Machine

Walking is a pleasure, I try for at least an hour a day (assisted by my trusty fitbit). Sometimes it is practical – A to B but often it is just the pleasure of wandering and drinking in the ebb and flow of the city – the shift of place, of feel, of time. Cities for me are a bit of a love, harsh yet familiar and beautiful.

While strolling (as that is my preferred pace) I may put on some music and think through a particular issue; sometimes try and be in the world. Otherwise I use the time to learn. For this I use the (still mindblowing) medium of podcasts.

The other week as I wandered from home in Bermondsey through Southwark Park to my current morning haven of Canada Water library. I listened to the inimitable Tim Ferriss’ podcast with a man who was wholly unfamiliar to me, Josh Waitzkin.

It was a whoa moment! Like someone handed me properly corrected spectacles after an age of slightly blurry ones.

I bought his book ‘The Art of Learning’ and read it with pleasure (exam procrastination 1 passing CFA 0). Josh, through discussion of his life of competitive chess then tai chi chuan push hands, breaks down the essence of top tier peak performance – how to perform with consistency at the very top level. And he does this with razor sharp clarity. Like all superior books it feels a gift and privilege to share time in his head.

In my reading, this is a book about something more than outcomes or even the learning process although it has plenty to say on those. The growing awareness of mindfulness and presence is a good thing but it is often discussed with valuable elements ignored. Josh doesn’t leave them out:

“I believe that one of the most critical factors in the transition to becoming a conscious high performer is the degree to which your relationship to your pursuit stays in harmony with your unique disposition. There will inevitably be times when we need to try new ideas, release our current knowledge to take in new information—but it is critical to integrate this new information in a manner that does not violate who we are. By taking away our natural voice, we leave ourselves without a center of gravity to balance us as we navigate the countless obstacles along our way.”

This is a theme on which I am very keen (although most look at me blankly when I start blathering so I mostly restrain my blather to these pages.)

Some principles: Micro to Macro, Presence and Feedback

In this piece I want to highlight a few passages of interest. I see doing and being in two levels – there are the broad strokes, getting the base right. If you want to want to grow crops, plant in good soil rather than in sand. Simple and most of the work is done just with that one decision. This is my world, I am good at this. This is the bedrock of the Elif Fund and I guess of me as a human being. This will secure us a life. It is comfort, food and shelter and is much neglected (imo). There is a second element, and this is the detail of the doing. Which crops to plant, how, when, what are best combinations? We can satisfice this, the soil is good so whatever I plant will be good enough. But if we look with a keen eye there is presence in the minutiae that refers back to the whole. Done well and with diligence this leads to a deeper practice, one that not only enhances results but will enrich life and self. We build deep connection and pleasure. Waitzkin sets it out as follows:

“The learning principle is to plunge into the detailed mystery of the micro in order to understand what makes the macro tick. … When nothing exciting is going on, we might get bored, distracted, separated from the moment. So we look for new entertainment, surf channels, flip through magazines. If caught in these rhythms, we are like tiny current-bound surface fish, floating along a two-dimensional world without any sense for the gorgeous abyss below.”

This is a discussion of harmony and presence that is, oh so, active. He continues:

“In every discipline, the ability to be clearheaded, present, cool under fire is much of what separates the best from the mediocre. In competition, the dynamic is often painfully transparent. If one player is serenely present while the other is being ripped apart by internal issues, the outcome is already clear. The prey is no longer objective, makes compounding mistakes, and the predator moves in for the kill.”

This may be obvious in external competition but less so in other domains, he delves into this by inverting the frame to set up the same point:

“While more subtle, this issue is perhaps even more critical in solitary pursuits such as writing, painting, scholarly thinking, or learning. In the absence of continual external reinforcement, we must be our own monitor, and quality of presence is often the best gauge. We cannot expect to touch excellence if “going through the motions” is the norm of our lives.”

Our treatment of feedback in development and experiencing the ‘good life’ is absolutely critical. This flow is continual while our awareness of it is at best intermittent and our consideration of its quality far less than that. Geometrically more so in the internal domain. Without awareness we have little connection to the process of living, or any chance of control of our life. Waitzkin encapsulates this, quite beautifully, by dropping in the piece de resistance, the element of creativity:

“On the other hand, if deep, fluid presence becomes second nature, then life, art, and learning take on a richness that will continually surprise and delight. Those who excel are those who maximize each moment’s creative potential—for these masters of living, presence to the day-to-day learning process is akin to that purity of focus others dream of achieving in rare climactic moments when everything is on the line.”

The Lotus Effect and Scorecards

Working on openness and creative presence has been an area of practice for me. When I sit to meditate there can be this experience he describes but drop some stones in the pond and that presence becomes muddled. This is where Waitzkin becomes really interesting, he seems to be one who can retain reflective and constructive presence under incredible duress, in fact he thrives in this state. He discusses this first through the question of mindset and being invigorated by challenges rather than subdued; and then at a deeper level on habituating oneself to maintain clarity and presence despite confounding factors or suboptimal conditions.

First on mindset while discussing youth chess players:

“Many kids like this are quite talented, so they excel at first because of good genes—but then they hit a roadblock. As chess struggles become more intense and opponents put up serious resistance, they start to lose interest in the game. They try to avoid challenges, but eventually the real world finds them. Their confidence is fragile. Losing is always a crisis instead of an opportunity for growth—if they were a winner because they won, this new losing must make them a loser.”

This speaks very much to the idea of inner and outer scorecards. For Waitzkin the joy was mastery and learning and the object that allowed him to develop this was competition, he mirrors Tim Gallwey in this message. This is a struggle for many (cough me), we don’t have the awareness and egolessness not to be confounded. We lose balance when put out, and instead our focus shifts to relief of the discomfort. The result is to be stopped in our tracks. Stymied. Stuck. Here is an alternative:

“When aiming for the top, your path requires an engaged, searching mind. You have to make obstacles spur you to creative new angles in the learning process. Let setbacks deepen your resolve. You should always come off an injury or a loss better than when you went down. Another angle on this issue is the unfortunate correlation for some between consistency and monotony. It is all too easy to get caught up in the routines of our lives and to lose creativity in the learning process. Even people who are completely devoted to cultivating a certain discipline often fall into a mental rut, a disengaged lifestyle that implies excellence can be obtained by going through the motions. We lose presence.”

The Investors Mindset and Avoiding Spirals

Investing is a strange activity. Not being a trader the way I engage is not intense in a conventional sense, it does not require honed reactions or minute to minute alertness. It is nonetheless taxing, there is a constant and endless background tension of being engaged against the unknown. This tension can rise to the fore with surprising rapidity and intensity and that can be challenging.

If our success is predicated on consistency there is the requirement for clarity and right process at all times. During successful periods or after long and grinding periods of poor outcomes. An experience of constant and unbroken negative feedback can be exhausting and become internalised in ugly ways. This is despite the fact that loss and failure are an essential and unavoidable element of the business. This passage will be familiar to all investors, it isn’t just actions but thoughts to which this applies:

“One idea I taught was the importance of regaining presence and clarity of mind after making a serious error. This is a hard lesson for all competitors and performers. The first mistake rarely proves disastrous, but the downward spiral of the second, third, and fourth error creates a devastating chain reaction”

He also maps out an lovely benefit of being able to expunge the tensions and problems of what has gone before:

“As we get better and better at releasing tension and coming back with a full tank of gas in our everyday activities, both physical and mental, we will gain confidence in our abilities to move back and forth between concentration, adrenaline flow, physical exertion (any kind of stress), and relaxation. I can’t tell you how liberating it is to know that relaxation is just a blink away from full awareness.”

Waitzkin focuses on two particular environments – chess and martial arts. They are closed environments for the most part. Life and investment aren’t closed, in those we have to adapt to our lack of control, or ability to forecast outcomes with great certainty. Nonetheless the tenets he espouses are always relevant, always applicable.

You can read many writers that tell you if you believe and be true to yourself then success will come. As if you don’t need to develop the skill and put in the blood and sweat that goes with that process. Insidious stuff. You can also read others that tell you exactly the skills and the hard work required but take no account of how that fits with the person. You stamp the external scorecard but never sleep in peace. Doubly insidious.

This book fuses those strands and like all good fusion comes out with something that obliterates such distinctions and with it their limits. Thank you Josh for the kicks, let me sign off with words from another who says it all, Maya Angelou:

“Surviving is important. Thriving is elegant.”



*German word for “compulsion to move.” Zugzwang is a term used in chess when it’s your turn to move a piece, but regardless of where you move, you will be at a disadvantage. In other words Zugzwang is when you need to move, but you don’t want to because of the terrible conditions. – Urban Dictionary

The Tim Ferriss Interview

Interview with Josh


Collecting Pens and Stuff

Auditur et altera pars. (The other side shall be heard as well.)” – Seneca

“There are two types of people: Those who come into a room and say, “Well, here I am!”, and those who say, “Ah, there you are” “- Frederick L. Collins

This update finds me in a grumpy mood. I am sulking at the intransigence of a market which refuses to see the beauty in the stocks I hold. It instead concentrates on the ever so slight hiccups in their operations (what’s a profit warning or two between friends?). Of course the foolishness of expecting the valuation irrationality (subjective) to suddenly be recognised and rectified due to my participation doesn’t pass me by.

Vanitas vanitatum.

Warm Up

Last weekend I spent the day sauntering around the UK Investor Show at the QEII conference hall. I can’t help but enjoy these events even though I spend most of them slack-jawed at some of the things I hear. There is much to be learned though, most of it second order. I apologise in advance for the critical nature of this post, my intent was not to pick on one person (MPs don’t count) but to consider the question of impressions using a live example.

It was a beautiful sunny day when we arrived. Armed with pastries and coffee, me and my associate,The Sheikh, settled into the opening talk by the Tory MP Sajid Javid. It was doom and gloom scaremongering of the most blah kind. He did redeem himself a touch during the Q&A but I’m not a fan of lowest common denominator politics. Sadly it seems to work.

On a general note, on days like these you hear lots of strong views. Holding strong views or talking your own book is one’s right, but perhaps there is a more constructive dialogue to be had if we keep in mind that how we experience the world may be very real to us but it doesn’t make it true.

Not for Love or Money

After Sajid we took a short interlude to hear Luke Johnson (entrepreneurs good, big business bad) before heading to a presentation from a company whose shares I hold. Following the dictum of Warren Buffett to praise by name but criticise by category I’ll leave names out.

The presentation itself was a damp squib, the environment far too noisy to hear what was being said, magnified by a CEO who presented as if on autopilot. It was all rather bizarre.  We decided we would go and find him after lunch as we both had questions. Unsuitably nourished (my biennial trip to McDonalds – still terrible, see you in 2017) we sauntered over the company stand and I introduced myself as a shareholder with some questions.

After some small talk we got down to business, I wanted to get a better sense of what was what at the company. Their problem is a common one, namely the narrative is not matched by performance.This is a consistent theme that comes up with this company.

This was the perfect forum for the CEO to disabuse me of my nervousness. Unfortunately he seemed almost desperate to avoid anything of the sort. He just seemed so disinterested, we might as well have been talking about the type of wood for his coffin. He would answer a question giving no impression of wanting to present the case for his company or engage. As we talked the thought buzzing in my head was why bother attending if you’re not going to bother?

Perhaps this is just his manner. To be fair this is a man who has built a very successful company in a tough industry. As a minnow he managed sell the product to large companies, which as anyone who has tried knows is extremely tough.I don’t want to discount him. Maybe he only turns it on when necessary, but for all he knew I could have been holding 2.99% of the shares. The Sheikh, a man who spends his working week dealing with the wealthy and successful, was less charitable in his assessment.

Post-interview I’ve been asking myself what judgment one can take from these interactions? What ‘useable’ and ‘robust’ information can i take? On this I am not sure. Having some little understanding of the manner in which the mind structures information there is the ever present danger of misplaced inference. I, as much as I am able, try and create balance by shifting the view. This is a continual and uncomfortable process but fruitful. Without it we may end up cementing false judgments through selective memory – fine until the wheels stop turning, at which point we have problems. The downside is you have to hold variant views which makes decisive action taking rather uncomfortable (perhaps …., what if …. etc etc.) .

Earlier in the year I had a conversation with an investor who visits and talks to many companies – he told me something that stuck in my (slightly wine-addled) mind. Meeting companies once is ok but meeting them many times is worth a lot. See someone once and you create an anchor (which is prone to confounding factors). Meet them again and you have another observation point. He gave the example of a company he used to meet where the CEO was dour and cautious in his speech even when they were doing well. One time while visiting, the CEO used slightly more emotive language, ever so slightly. Coming from someone else it would be meaningless, but from the mouth of this particular guy it was a clarion call. I like that, but of course there is great skill in this – good listening is under practiced.

Back to my CEO. This stock was on borrowed time and this interaction just sharpens the claws. There is much to like about the company but my active dictum is “show, don’t tell!”.

So Mr CEO either do more showing or align your telling (please). (UPDATE 22/05: CEO looks like he has been victim of a boardroom coup, the plot thickens)

The first rule of Dodgeball …

Taking a step back, this mirrors a wider feeling. For the most part I’m lukewarm on too many of my holdings. There is naturally the effect of the flow of poor operational updates, but even in my better performing issues the story vs the valuation is mostly unappealing.

This is reflective of my preference. My job is to find the unpopular kid with unrecognised talents. At the moment not only are they harder to find but my judgment on these kids has been so off (in my perception) – it is like Dodgeball without the redemption (or cuddliness). Probably my ‘meh’ is just an outward reflection of my feelings on my performance and skills.

There it is, a fun Saturday in Westminster. On a positive note I did pick up enough pens to last a year and some of those squishy balls that you squeeze to release the tension. In tough times you got to take the love where you can.


22/05/15 – update to correct some of the more egregious grammar fails.

Always Outnumbered, Always Outgunned (Part 2)

Hi all, I hope that the first blooms of spring are brightening your day. I am always touched by the hypnotic joy that takes over Londoners when the first pleasant weather hits. At least before the rage sets in :-)

This is the companion piece to the last post, from my 2014 report. The question I asked was whether there was scope to further improve returns ? I had made the easy steps – reduce fees, lower turnover, maximise tax benefits etc. The unspoken assumption in that is that the extra juice has to be durable.

My answer was that yes I felt there was some extra returns available that would hold true for a good few years. This came from a couple of sources. The first was my excessive caution (more risk, more risk) and the second is below – it touches on the crux of what I stand for as an investor. Analytical skill yes, impeccable process of course …  but beyond that, and crucially, some idea of psychological savvy particularly in a world where we are for the most part outclassed but hold huge advantages in being able to pick and choose where we engage.

Much of this is a repetition of earlier posts. Unsurprisingly as those posts were the thinking process that led to this report. Anyhow maybe a regular reminder is no bad thing.

(By the way when I mention arbitrage I do not refer to it in the classical sense of buy and selling to guarantee profit. I refer to the process of exploiting a finite resource to the point of extinction. Not a classical use of the word but hopefully acceptable.)


Many investors have had hot streaks and performed well for a time, but with an edge that was not durable at some point their advantage fades. It is either arbitraged away; the texture of the market changes (I had this in my CMC day-trading days for example); or perhaps the manager develops hubris, pride, greed, envy or some such leak and topples themselves.

My question is whether I can increase my expected return in a manner that is sustainable (i.e. predictable, available and not prone to being arbitraged to extinction)?

Integral to this thinking is the likelihood that my fellow market participants are almost certainly better informed, skilled, committed and organised. And improving each day. I say this without intention to demean myself, but more with a belief that there is a substantial advantage if the probability of long term success is not dependent on me understanding, timing or executing better than others.

So what to do? Two ideas point the path by two guys who know well enough – Howard Marks and Warren Buffett:

Inefficiencies – mispricings, misperceptions, mistakes that other people make – provide potential opportunities for superior performance. Exploiting them is, in fact, the only road to consistent outperformance. To distinguish yourself from the others, you need to be on the right side of those mistakes. – Howard Marks

Your win-loss percentage in tennis will not be determined by the absolute level of ability that you possess. Rather, it will be determined by your ability to select inferior opponents. If you select with care it will be quite easy to attain a winning percentage higher than, say, Cliff Richey while he is playing on the tour. Application of this principle is the key element in bridge, poker, or investments. (Harder to apply in the latter, however — it is easier to identify a couple of palookas at the bridge table,) – Warren Buffett

There it is – The Loser’s Game, as set out by Charles Ellis, is the equivalent of the tennis player who can succeed only through the errors of his opponent (i.e. most). Top players cannot play this game and win, their opponents are too good. They must play the Winner’s Game and defeat their opponent through superior play. Ellis has this to say on middling tennis players:

He will try to beat you by winning, but he is not good enough to overcome the many inherent adversities of the game itself. The situation does not allow him to win with an activist strategy and he will instead lose. His efforts to win more points will, unfortunately for him, only increase his error rate. As Ramo instructs us in his book, the strategy for winning in a loser’s game is to lose less. Avoid trying too hard. By keeping the ball in play, give the opponent as many opportunities as possible to make mistakes and blunder his, way to defeat. In brief, by losing less become the victor.

Most investors see themselves as winners, we aim to be the best and the ease of participation in the market process encourages our confidence in our ability to win. Unfortunately markets are akin to the Loser’s Game. We face challenges on two fronts:

1. The paradox of skill. If you wish returns above beta (market returns), success is not a function of how capable you are but how capable you are relative to your opponents (i.e. whoever is taking the other side of your trade). Over time as participants improve, skill differentials decrease (less suckers) thus leaving chance as the dominant element in deciding winner and loser.

2. Degree of control. Markets are not tennis or chess. When Federer swings his racket he will know 99 times out of 100 where he’ll connect with the ball and where it will go. When George Soros (the equivalent master) shorts S&P futures he may have reasonable confidence in the outcome but the timing, path and duration are trickier to ascertain. Key to this point is that humans have insufficient appreciation of this factor, and even less appreciation of their control in particular environments.

Overconfidence encourages us to treat investment as a version of the winner’s game. If we are not outdone by skill then we are reliant on good fortune (in time of course as in any shorter timespan anything is possible). All the while we shall be expending blood and sweat. The winners of this game will be few but with large payoffs. The only other winners are those that sell the dream (brokers, commentators etc.). The rest of us are varying flavours of fish food.

The idea of iatrogenics – damage caused by the practitioner (as in doctors causing illness in the course of trying to heal) – is relevant and is discussed in depth by Ellis and Taleb (in Antifragile). The actions of humans trying to outperform other humans becomes the dominant driver of instability in the market. This error is compounded by our blindness to this situation – greater intelligence or resource or motivation only feeds the situation.

My belief is that any advantage I can parse from this theme will be relatively durable.

I identify my transactional advantage in 3 opportunity sets (the assumption is a solid level of analytical skill on my part):

i) Go where it is less crowded – Addressing areas of the market where attention is distributed or participants are less skilled, small caps in particular.

ii) Go where others are too ‘cool’ to go – Mispricing emanating from the incentive structures of professionals. Most are unlikely to take positions with poor narrative that would expose them to benchmark or reputational risk (J.K Galbraith quipped ‘In these matters, as often in our culture, it is far, far better to be wrong in a respectable way than to be right for the wrong reasons.’).

iii) Go where others are too emotional to go – Markets and stocks in the midst of emotional extremes (primarily times of fear and greed). In these cases even the most able and savvy investors will make decisions on the basis of narrowed and affect laden frames (esp. when they are concerned about jobs, reputation and suchlike).

Note that in either of these cases I can go with the flow (trends, momentum) or fade it (mean reversion). Most of the time I err on the mean reversion side but exuberant trends are rich pickings. Also it is important to remember that these are not sure things, we can still be very wrong. Nonetheless instead of a 50-50 bet we perhaps have a 60-40 bet. We also hope that we also increase the potential payoff of the bet. This is a potential double whammy in terms of long term advantage.

In all other times and areas, the assumption is that markets are generally efficient – my advantages are minimal. In these periods my focus is to try and keep up as best as I may but primarily to minimise errors.

This is a contextual focus, not absolute. The specifics may change over time but the underlying logic holds. The narrative and framework may change but until the participants consider the underlying issue (everyone is trying to beat everyone with the same tools) opportunities will continue to present themselves (assuming I am able to recognise them).


Underinvestment: Baking in Structural Underperformance (Part 1)

I am currently writing my FY2015 Elif Fund Review and referring back to last year’s report. Some of it is worth sharing. First up is the question of excess caution, it is less exciting than the opposite story and that is what makes it all the more insidious (some prior thoughts on this here). Even if it isn’t directly relevant to you, there are lessons here on the narratives that dominate and direct us. Often they are less than useful.


A dominant narrative I hold is that I am a mediocre stock picker and trader who is saved by good structure and discipline.

On closer examination perhaps this narrative is flawed. Here is another possible narrative: I am a competent stock picker and trader who has baked in underperformance through structural under-commitment of capital. This is a much healthier narrative. My invested percentage as shown below tells the story:

456In the table below I have tried to play this out (crudely but to make a point). Compared are:

i) actual returns

ii) implied returns if 90% invested AND

iii) returns if 90% invested but if the marginal return of the extra invested capital was only 60%.

123The caveats in this analysis are many but the point is clear – the benefit of those extra 2-5% per year are huge. There is a cost in greater volatility and poorer risk adjusted metrics but this must be a trade-off I choose all day and all night.

The root cause of this under-investment is most easily traced to good old fashioned over active risk aversion. There is also the issue of narrow framing leading to myopic loss aversion. Greg Davies writes very well on this topic (I think this is in a Barclays white paper but need to track down the source):

It is worth starting with the word that occurs at both the start and end of the chart: reluctance. This is the ‘default’ state of most investors. In normal circumstances we fear taking a risk and getting it wrong, more than we fear missing out. This reluctance to get involved is compounded by another strong behavioural effect: loss aversion. Simply put, when we make decisions, “losses loom larger than gains” – we believe we will feel more emotional pain from losing a certain amount than the pleasure we experience from gaining the same amount.

The cost is double in my case – the Elif fund is risk capital and to be have reduced commitment with capital that is purely for risky investment is pointless. It is one of those absurd stances in life that bring no benefit but leave us satisfied as we are allowed to defer the discomfort of entering the valley of uncertainty and risk.

Back in 2011 I took on the challenge of upping my committed capital. It was a painful process but well worth it (not just in this sphere). The results have been good, the patient survived the operation. There is still more work ahead correcting and adjusting, but the ugliest part is done. In the chart below you see the difference between the past year and 2010/11.


This isn’t about being careless, risk of ruin is not increased. The core task is survival, as it is only time that guarantees a sample size long enough to overcome chance. But it is not survival at any cost. It is survival while ‘in play’. There are obvious risks of commission but more insidious are those of omission. I follow the diktat of Nehru when he said (I know not where):

The policy of being too cautious is the greatest risk of all

‘Nuff said.

A tale of two portfolios

“Never discourage anyone who continually makes progress, no matter how slow.” – Aristotle

What counts for most people in investing is not how much they know, but rather how realistically they define what they don’t know. An investor needs to do very few things right as long as he or she avoids big mistakes.- Warren Buffett

I’ve been at this game for a little while but as the road unfolds there is the continual reminder how incomplete and patchy is my understanding. It is both disconcerting or invigorating depending on my mood. On the other hand over the past 15 years I’ve hit more high note than duds and done so without too many tears. Somehow or the other I’ve avoided big mistakes. Maybe I am some kind of master of the universe :p

These opposing narratives are perfectly showcased by the divergent paths of my value programs this year – the Large Caps are up 20% (while being only 60% invested) while the Small Caps are down 12% and sinking. Master of the universe or dolt?


One year is neither here nor there. 3 yrs + is more aligned to my average intended holding cycle (see below t0 = 1):


Nearly good. The Small Cap Value program (SCVp) has a 3yr CAGR of 9% (vs.15% if it had been a breakeven year) while the Large Cap Value program (LCVp) 3yr CAGR is 20%. Long term expectations are 15% for the SCVp and 12% for the LCVp.

It is review time. What to do with this information?

I can give you story: that for the SCVp the music stopped while the rest of the market hummed – just in the past few weeks we’ve had a profit warning from LRM (Lombard Risk Management) and meh finals from FCCN (French Connection) rocked the boat. While writing this last week SAL (SpaceandPeople) fell 15-20% on inline results and prospects. I have other stories as required but what is it worth? I’ve written on the pitfalls of reviews here and it is all still applicable. In my year end review I’ll keep the following in mind:

1. My intended holding period is 3 years even though the discussion is this past year.

Without care I look at the one year chart above and derive inferences of what went wrong or right based on that frame. Rather I must look at last year through the 3 year picture that I have decided is more relevant. Myopia is a favourite subject of this blog and operating on inconsistent time frames can leave you ever so muddled (unintended consequences et al). This is helped if the framework and intentions of the programs are clear.

2. These are concentrated portfolios with high idiosyncratic risk

Each position is a probability-payoff bet, there is no certainty although I hope there is mispricing. In addition I give positions a lot of breathing space.  I’ll let you into a secret, things will vary and shit will happen. To structure as I have and then bemoan the fact that results weren’t to my liking is churlish.

3. Good performance does not automatically mean good process or decisions and vice versa.

We tend to be driven to action when faced with what we consider to be ‘bad’. On the flip side we give little thought to areas that are ‘good’. This seems arbitrary. Review should encompass all programs of a similar nature equally.

4.  Review should concentrate on elements where I have control

Not ex post dissection of decisions involving coulda, woulda, shoulda’isms.

Where do I have control:

1. Design and structure of the program

2. Planning and execution

3. Analysis (Trade Selection)

I’ll ignore one as it is too important for 100 words. This leads us to:


There are two questions:

1) did I have a clear plan for each position?

2) did I follow it impeccably?

I feel my facial muscles tighten as I consider this as I’ve been extremely poor on these grounds. My levels of distraction and sloppiness have been higher than usual. Usually I get away with it. Sometimes I don’t.

Trade Plan – every important element of the investment should be specified before the action happens. Sizing, investment thesis and ‘hooks’, entry and selling criteria, targets and what to do when the unexpected hits. It isn’t set in stone but changes must happen outside the action.

Execution – If my planning phase has been incomplete when it is time to act I am stuck trying to decide what to do. I end up chasing and reacting. This has been too common the past year.

Impeccable isn’t an ideal for me, it is critical.


I am a believer in a forecast-lite heuristic analytical framework over detailed valuation (more here).

Was my analysis flawed in the SCVp (and therefore good in the LCVp)? It is tricky to know this – how to disentangle the random coin flip elements from the quality of analysis?

Let us sidestep this question as it is the wrong question.

The SCVp portfolio does what it says on the tin (value, small cap based on broad strokes and behavioural edge). If I think that is wrong then I should look at that.

My initial inclination was to lay the blame with the quality of my investment selection and undoubtedly there are elements that can be tightened. But otherwise this is mostly unfair – the quality of analysis has never been strong; the design of these programs are predicated on never needing to be strong.

Analysis is not the problem. The problem is the planning and execution missteps.The programs requires that element to be watertight.

They aren’t. And that dear friends won’t cut it!


01/04/2015 – minor editing for grammar and clarity