My $2 Million Apple Mistake

It was Thanksgiving weekend twenty years ago. I had been watching the stock for a couple of months. It was pummeled on soft results in September and seemed cheap to me. On Sunday night, I looked at the Value Line report and on Monday I reviewed the latest financial statements. On Tuesday morning, I pulled the trigger. I was now the proud owner of 500 shares of Apple purchased at $18.1

Hindsight bias is pernicious. By perceiving past events as more predictable than they actually were at the time, we mentally torture ourselves regarding outcomes that could not have been foreseen. Even worse, when we believe that we had foresight in the past that we did not really have, we are more prone to be overconfident regarding current events. This can lead to underestimating the vicissitudes in life that could upend the future.

This article is a true story of a trade nearly two decades ago that seemed smart at the time but, in hindsight, carried a severe opportunity cost. Was the decision a good one based on the information then at my disposal? Or was it a foreseeable debacle that should have been avoided?

Flashback to 2000

Let’s take a journey back two decades to the fall of 2000. By the end of September, the Nasdaq composite index was well into bear market territory, having fallen nearly 30 percent from its high in early March, but the worst was yet to come. Back then, Apple was a struggling computer maker that had suffered greatly in recent years and found itself on the verge of bankruptcy before its iconic founder, Steve Jobs, returned to engineer a turnaround.

When you read about the turnaround today or look at a 20 year chart of the stock, the turmoil of late September 2000 will hardly be noticeable. But the company was having problems that fall and did not sell as many computers during the key back-to-school season as analysts had expected. When the company warned that sales were soft ahead of the end of the fiscal year, the stock was pummeled, falling over 50 percent on September 29.

I started watching the stock.

I cannot reconstruct the story exactly. I did not keep any type of journal in 2000. I was not very experienced when it came to investing nor did I have much capital to invest. But for some reason, Apple’s sharp drop in September caught my attention and I began to follow the company. It is likely that I pulled up the Value Line report on Apple and I’m sure that I also read its latest 10-K and quarterly report, but I doubt I did much more than that. However, by November, I was ready to act.

The Trade

Following its earnings warning at the end of September, Apple continued to fall for the next couple of months. By the end of November it was trading around $18 which must have seemed attractive to me based on the numbers published in the company’s latest 10-K. The company seemed to be on the right track and was trading under ten times trailing earnings:

In addition to being cheap on an earnings multiple basis, the company had book value of over $12 per share and had over $4 billion in cash and short term investments on the balance sheet. The market capitalization was around $6 billion. The market reaction must have seemed overdone to me and the cheapness of the stock suggested a margin of safety. It would be nice to believe that I developed an investment thesis more complete than what I just described but I doubt that was the case.

On Tuesday, November 28, 2000, I purchased 500 shares of Apple at 18 1/16 for a total cost of $9,051.25, including a $20 commission. On March 5, 2001, I sold the 500 shares for $20.25 for proceeds of $10,105 after another $20 commission. My short term capital gain was $1,053.75.

The chart below shows the price action for Apple stock from July 1, 2000 to June 30, 2001 along with my trades:

Source: Yahoo! Finance

This capital gain of slightly over a thousand dollars represented a 11.6 percent gain in just over three months, or an annualized gain of over 50 percent. But it wasn’t smooth sailing during those three months. The stock bottomed at $14 in December and I was substantially underwater before realizing the gain in March.

What was my rationale for selling?

I can only guess.

I suspect that I was attracted by the round number of the $1,000 capital gain. A thousand dollars remains a lot of money in absolute terms, in my view, and certainly back then it was very meaningful. I had made this money in a short period of time and probably wanted to take it off the table.

What did I do with the proceeds?

On this question, I can reconstruct the events with more certainty. The first purchase I made after selling Apple on March 5 was a purchase of 5 shares of Berkshire Hathaway Class B on March 16 at $2,145 per share.2 It so happens that I still own those shares of Berkshire today.

The Aftermath

We all know the story of Apple since I sold in 2001. In the fall of that year, Steve Jobs unveiled the first iPod music player followed by the first iPhone six years later. Today, Apple is a behemoth – the largest company in the United States with a market capitalization in excess of $1.4 trillion.

If you calculate what I left on the table by taking the current stock price of around $317, subtracting $20.25 and multiplying by 500, you would get a figure slightly under $150,000. That’s a lot of money to leave on the table!

But it is worse than that.

Much, much worse!

Apple shares split 2-for-1 in 2005 and split again 7-for-1 in 2014. This means that the 500 shares I sold in early 2001 would be the equivalent of 7,000 shares today. If you take $317 and subtract $1.446 ($20.25 divided by 14) and multiply by 7,000, you get a horrifying $2,209,000!

But wait, there’s more!

Apple started paying a dividend in 2012 and has paid a total of $16.87 per share of dividends over the past seven years. Take $16.87 and multiply by 7,000 to arrive at an additional $118,000 opportunity cost!

But let’s look on the bright side. I still own the shares of Berkshire purchased with the proceeds of my Apple sale. Those five shares of Berkshire Class B have become 250 shares due to Berkshire’s 2010 stock split and are now valued at about $57,000. This represents a compounded annual return of 9.3 percent over the past nineteen years. Not too bad, right?

Evaluating Decisions

Was my decision to trade Apple a mistake? Should I have held those shares purchased in November 2000? Based on what we know today, the answer is self-evident. With benefit of today’s information, it was insane to sell those shares in March 2001!

The problem is that there was no crystal ball in March 2001 that could have predicted the company’s meteoric rise. I could not have predicted it and neither could anyone else. Apple had not even released the first iPod at that point. There was no iOS ecosystem to lock in consumers. It was a struggling personal computer maker in the early years of a turnaround engineered by a visionary but highly erratic leader. It was extremely cheap, however, and had a margin of safety.

Arguably, the stock continued to have a margin of safety when I sold it and there is little doubt that I had a “trading mindset” at that time, at least when it came to Apple. My profits reached a round number and I cashed in my chips and used the proceeds to invest in something I understood well for the long run. Buying Berkshire, in contrast to Apple, was intended to be a multi-year commitment and it turned into a multi-decade commitment — one that I understood well.

Psychological Perils

No matter how much we learn about human psychology, we must never, for a second, pretend that we are studying the mentality and behavior of others. We are, in fact, studying ourselves because we are just as subject to all of the pitfalls as anyone else. Understanding human psychology helps us to understand ourselves better but never immunizes against second guessing and regret. Until recently, I never calculated the opportunity cost of selling those shares. I obviously knew that I had owned Apple years ago and sometimes it occurred to me that those shares would be worth a fortune if I had held. But I avoided the calculation until recently when I posted the results on Twitter:

It turns out that personal humiliation will result in many retweets and likes, but in reality, is there much of a reason to feel humiliated? Not really. After all, little known Apple co-founder Ronald Wayne sold his 10 percent stake in Apple way back in 1977 for a mere $800. Today, this stake would be worth about $140 billion. Mr. Wayne is 85 years old today. Maybe he dwells on the idea that he could be the richest American alive today, but hopefully not. There is no way anyone could have predicted the rise of Apple over the past 43 years.

The endowment effect is just as pernicious as hindsight bias when it comes to investing. If I had just considered trading Apple back then but never actually owned shares, I would not give my “mistake” even a passing thought today. It is the fact that I did own those shares and then decided to sell them that makes it an issue. For some reason, it is not similarly problematic to know that I missed out on other meteoric success stories such as Amazon or Netflix. I never understood either and certainly never owned shares.

Even if I had held those Apple shares beyond March 2001, I know that I would never have continued to hold them until today. For better or worse, I have long been a skeptic regarding Apple knowing that the past is littered with examples of consumer electronics firms that have fallen out of favor. I would have doubtlessly taken money off the table during the early years of Apple’s ascent to reduce risk exposure. The only way I would have held those shares without interruption would be if I had fallen into a coma.

In contrast, I have held shares of Berkshire for multiple decades and I have other investments that I have held for very long periods of time as well. In all of these cases, I had a firm understanding of the businesses involved and a sense of their futures. That was never the case with Apple.

The Headline Was Click-Bait …

So, was this a $2 million “mistake”? I don’t think so. The $2 million in “lost profits” represent a fictional illusion, no more real than if I had won a lottery. But hopefully this story sheds some light on the nature of decision making and the importance of not falling victim to hindsight bias when evaluating past decisions.

Disclosure: Individuals associated with the Rational Walk LLC own shares of Berkshire Hathaway which has an equity ownership interest in Apple.


  1. My purchase was 500 shares at 18 1/16. Stocks were still traded in fractions back then. This is the equivalent of 7000 shares of Apple at $1.29 per share after accounting for a 2:1 stock split on 2/28/2005 and a 7:1 stock split on 6/9/2014. []
  2. This is the equivalent of 250 shares at $42.90 based on Berkshire’s 50:1 stock split on 1/21/2010. []

Farnam Street’s Great Mental Models

“So whatever you wish that men would do to you, do so to them; for this is the law and the prophets.”

The Golden Rule as expressed in Matthew 7:12

Hanlon’s Razor advises us to give others the benefit of the doubt when we interpret the intent of their actions. This is such a simple concept. Taking this approach makes life much more pleasant than it would be if one constantly assumes the worst in others. Most people are busy living their day to day lives and it is not uncommon to be on the receiving end of actions that are negative, whether it involves being cut off on the road or receiving a terse text message from a colleague. When we witness actions that seem unjust or wrong, we have a choice regarding how to respond. We can adopt the mindset of Hanlon’s Razor and attribute the action to stupidity or inadvertent neglect, or we can choose to assume malign intentions.

There are many more people in the world who are inconsiderate or lazy than people who are intentionally evil. Assuming malign intent is not really the best way to bet if we are affected by an action that we do not like. However, we also want to avoid being fools, and in cases where the stakes are particularly high, is giving the benefit of the doubt the intelligent way to behave? And how would we want others to behave in response to our actions if the situation was reversed?

Hanlon’s Razor is an example of a mental model that can help us make better decisions in life but, taken in isolation, a single mental model can be ineffective or even dangerous. We need what Charlie Munger has called a “latticework of models” in our brains that we can call upon when making decisions. Shane Parrish founded Farnam Street to help people “master the best of what other people have already figured out.” Parrish, who worked for many years as a cybersecurity expert at Canada’s top intelligence agency, was heavily influenced by Charlie Munger and spent several years covering various mental models on his website. His new book, The Great Mental Models: General Thinking Concepts, is the first volume in a series that seeks to distill and expand on the content already published on Farnam Street.

The Latticework

Farnam Street’s take on mental models has been heavily influenced by Charlie Munger’s “latticework” approach which has been described in vivid detail by Peter Kaufman in Poor Charlie’s Almanack. Munger realized early in life that the conventional way of making decisions suffers from massive flaws, most seriously the tendency of people to look inward to their own field of expertise and fail to borrow concepts from other disciplines:

“You must know the big ideas in the big disciplines and use them routinely — all of them, not just a few. Most people are trained in one model — economics, for example — and try to solve all problems in one way. You know the old saying: ‘To the man with a hammer, the world looks like a nail.’ This is a dumb way of handling problems.”

Charlie Munger, Poor Charlie’s Almanack, p. 55

Those who fail to adopt a multi-disciplinary approach and compete with those who do so will resemble “one legged men in an ass kicking competition.” Yet, the majority of people go through life either without any notion of mental models at all, being reactive to what the world throws at them, or overemphasizing the few mental models that they are familiar with. What is the solution? As Munger says, you need to grasp multiple models and then use them. You cannot just memorize facts and figures and expect to be able to use them without having a latticework of models that you refer to automatically. Parrish expands on this concept:

“A latticework is an excellent way to conceptualize mental models, because it demonstrates the reality and value of interconnecting knowledge. The world does not isolate itself into discrete disciplines. We only break it down that way because it makes it easier to study it. But once we learn something, we need to put it back into the complex system in which it occurs. We need to see where it connects to other bits of knowledge, to build our understanding of the whole. This is the value of putting the knowledge contained in mental models into a latticework.”

The Great Mental Models, p. 35

This sounds complicated, but Munger believes that eighty to ninety important models carry most of the burden and that mastery of the most important of these models can greatly improve decision making. And while this may sound like a great deal of work, Munger counsels us to go about it in a systematic way to benefit from the compounding effects of the knowledge over time. It turns out that gaining an understanding of mental models can be a great deal of fun if we learn and apply the models to our day to day decisions which will begin to resemble puzzles for us to solve using our growing toolkit.

General Thinking Concepts

Parrish has undertaken a very ambitious task and the first volume of his Great Mental Models series introduces what he refers to as general thinking concepts. The nine concepts covered in the book are not from any specific academic discipline but instead take a step back and provide guidance on how one should approach thinking in general. The general concepts include:

  • The Map is not the Territory
  • Circle of Competence
  • First Principles Thinking
  • Thought Experiment
  • Second-Order Thinking
  • Probabilistic Thinking
  • Inversion
  • Occam’s Razor
  • Hanlon’s Razor

Before taking a look at a few of the concepts in more detail, it is worth noting that the Farnam Street website covers many of these topics, if not all of them, in quite a bit of detail, and this information is freely available to anyone with internet access. Given that this is the case, is it worth reading the book? Obviously, everyone can decide for themselves and there are some negative Amazon reviews that suggest the website is more useful. However, the physical book is aesthetically pleasing and very well presented and can serve as a useful reference volume. There is something to be said for the combination of aesthetics and knowledge found in a well-made physical volume. These are timeless concepts and they seem best presented in a timeless printed format.

Model Blindness

In various disciplines, especially in social sciences, academics tend to develop elegant models purporting to describe human behavior and sometimes even give these models a quasi-mathematical justification. What many people forget, however, is that a model is inherently a simplification of the real world.

The idea that the map is not the territory is a recognition of the fact that maps are reductions of what they purport to represent. As Parrish states, “if a map were to represent the territory with perfect fidelity, it would no longer be a reduction and thus would no longer be useful to us.” If we allow our knowledge to become restricted to the map rather than the territory, we inevitably run into major problems. The world is too complicated to navigate without making use of abstractions, but we cannot treat abstractions as gospel.

Not only can maps (or models, more generally) not show everything about the real world but they are made from a certain perspective and only represent the world at a specific point in time which is subject to change. Parrish cleverly presents a world map created in 1450 and asks “Would you be able to use this map to get to Egypt?” Were it not for accidentally spotting the boot of Italy presented upside down, the map would have been totally indecipherable to me. But when the page is flipped upside down, suddenly it becomes clear and I probably could use it to get to Egypt. The map was made from a different perspective than we are accustomed to today.

The Great Mental Models, p. 46

We must make use of maps and models to navigate anything complicated, but we should do so bearing in mind that reality always trumps models. It is imperative to update models based on what we experience and observe, understanding that the territory does change over time.

And Then What?

Howard Marks, Chairman of Oaktree Capital Management, often emphasizes the need to ask a simple question: “And then what”? In his widely read memos to clients and in his latest book, Mastering the Market Cycle, Marks advises investors to look beyond the surface, or gut level, reaction to events and consider the second and third order consequences that others may be neglecting. Parrish describes second order thinking as follows:

“Second-order thinking is thinking farther ahead and thinking holistically. It requires us to not only consider our actions and their immediate consequences, but the subsequent effects of those actions as well. Failing to consider the second – and third – order effects can unleash disaster.”

The Great Mental Models, p. 109

Pretty obvious, isn’t it? Well, not so much based on several high profile disasters that have happened over time due to people ignoring important second-order effects usually powered by strong incentives. Parrish describes how the British colonial rulers in India attempted to reduce the number of venomous snakes in New Delhi by offering rewards to Indian citizens who brought in dead snakes. Did this reduce the number of snakes in New Delhi? No, it did not because the Indians responded to incentives by breeding more snakes in order to be able to kill them and claim rewards!

Charlie Munger again helps us out when it comes to second-level thinking. His admonition to “never, ever, think about something else when you should be thinking about the power of incentives” can help us to detect second order effects in many cases. Had the British colonial rulers of India considered incentives, they would never have put in place a policy that was sure to make the problem worse!

Parrish notes that we need to avoid allowing the prospect of second and third order effects lead to decision making paralysis. We cannot operate effectively in life if we worry about every conceivable effect of the effects of our actions. We have to use the mental models we have accumulated to make rational decisions.

Pick Your Razor

We opened this article with a brief discussion of Hanlon’s Razor which counsels us to not attribute an action to malice when it can be more easily explained by stupidity or neglect. The book covers this model along with Occam’s Razor which is more widely known. Occam’s Razor encapsulates a very straight forward concept: We should default to explanations that are simple rather than complicated when the simple explanation adequately describes a situation.

There is always a risk of oversimplifying a complex situation but that is not what Occam’s Razor advocates. The explanation must be sufficient to explain the scenario in order to qualify. If one has several explanations, all of which seem to be plausible, the one with the fewest complications is more likely to be true because it has fewer moving parts and assumptions. Furthermore, a simple explanation is easier to falsify, or prove incorrect. Used properly, Occam’s Razor can allow us to make better decisions more rapidly and avoid chasing down dead ends and wasting resources.

There is an interesting tension between Occam’s Razor and Hanlon’s Razor that is worthy of some thought. There are many events in life where one encounters a negative situation caused by another person and, often, the simplest explanation is that this person intended to do us harm, and perhaps this explanation is what we should adopt according to Occam’s Razor. However, human beings are fallible and there are more good people than evil people in the world. Hanlon’s Razor counsels temperance and the benefit of the doubt. How are we to choose?

The answer clearly depends on context, common sense, and the consequences of being wrong. If you are in an auto accident in broad daylight in a busy intersection where the other car made an illegal left turn and slammed into your car, it would seem best to adopt Hanlon’s Razor and assume negligence or stupidity rather than malice and be kind to the other driver.

But if you are waiting at a red light at 2 am and the car in front of you backs into your car without warning, the simplest explanation is that this individual has malign intent. It is possible that they shifted into reverse by accident, but that is not the likely explanation, and the consequences of being wrong are high. It would be best to not get out of your car and instead drive away to a safe location where you can summon help.

No Shortcuts

The fact is that building a latticework of mental models that you know well enough to draw upon takes years of hard work and continual effort. Charlie Munger’s quest for worldly wisdom has taken decades and, at age 96, he hasn’t stopped learning yet. It is unrealistic to think that one can pick up a book like The Great Mental Models or Poor Charlie’s Almanack and suddenly emerge worldly and wise. But while you may not become as wise as Munger or Parrish overnight, reading books like this are required to have a chance to improve over time.

The good news is that the process of learning mental models is not boring, when approached with the right mindset, and can actually be a great deal of fun when approached as a series of puzzles to solve. Knowledge compounds over long periods of time and the progress is not linear. Sometimes the combination of multiple mental models leads to breakthroughs or insights that result in “aha!” moments. You cannot predict when or if such moments will come, but you can add some positive optionality to your life by being prepared.

Berkshire Hathaway’s Culture of Trust

“Buffett trusts me so much with Berkshire’s money that I am even more careful in handling Berkshire capital than in handling my own.”

Bruce Whitman, former CEO of FlightSafety International

Trust takes a long period of time to fully develop but can be destroyed in an instant. This asymmetry is inherent in a world where trust continues to be the foundation of all human societies. The stakes could not be higher and, as a result, a sense of wariness is built into our evolutionary instincts. Misplaced trust is extremely costly, but the flip side is that attempting to live your life in a culture of constant skepticism regarding the intentions of others is both exhausting and likely to lead to many missed opportunities. Finding the right balance is imperative in both personal and business relationships. In order to strike that balance in a business context, it makes sense to closely examine the successful trust-based culture of Warren Buffett’s Berkshire Hathaway.

Few writers are more familiar with the intricacies of Berkshire Hathaway than Lawrence A. Cunningham whose unique perspective was shaped by a 1996 symposium he organized in which Warren Buffett and Charlie Munger discussed Berkshire’s business and culture at great length. Shortly thereafter, Cunningham released his first compilation of Berkshire shareholder letters organized by topic and, more recently, he published a book specifically regarding Berkshire’s management succession plans. In Margin of Trust, Cunningham and co-author Stephanie Cuba take an in-depth look at the unique management philosophy that has made Berkshire so successful over the years and continues to allow an enormous conglomerate to operate without the type of command-and-control bureaucracies that exist at almost all large firms, and especially at large conglomerates. By demystifying how Berkshire ticks, Cunningham and Cuba uncover generic concepts that could help other organizations improve their culture.

Charlie Munger

Charlie Munger often speaks about how a “seamless web of deserved trust” represents the highest form a civilization can reach. Why is this? Quite simply, when you have a culture in which the key participants can be trusted implicitly to do the right thing and act in the interests of the organization, you do not need to put in place the endless systems of controls that would be required in a culture where no one trusts each other. In other words, a company can run much more efficiently when trust is presumed to exist. The flip side is that in such a culture, a rogue individual can do a great deal of harm until he or she is finally detected. Clearly, some balance is required to harness the benefits of trust while protecting an organization from severe harm if that trust proves to be misplaced.

The culture of Berkshire Hathaway is one of extreme decentralization and autonomy, with power over operational matters delegated from the holding company run by Buffett to subsidiary CEOs. Until recently, nearly all subsidiary managers reported directly to Buffett who maintained compensation arrangements with the subsidiary CEOs personally. Recently, Buffett has put in place two Vice Chairmen, Ajit Jain and Greg Abel, to oversee all insurance and non-insurance subsidiaries, respectively. However, Berkshire remains extremely decentralized with no corporate-wide central functions and a bare-bones headquarters staff of about two dozen employees.

Trust is an extremely effective motivator, as we can see from Bruce Whitman’s quote leading this article. When one is given a great deal of trust, the level of perceived responsibility increases commensurately. It is often thought that personal loyalty to Buffett drives subsidiary CEOs to not want to disappoint him, but it is also the fact that they have been given remarkable power and trust and they seek to reciprocate by providing excellent results.

The Pillars of Berkshire Hathaway

Cunningham and Cuba set out to dissect Berkshire’s structure and what makes the company tick by examining the individuals presently involved in managing the company, the partnership mindset that permeates everything that managers do, and the specific methods used to achieve outstanding results. At present, the key players are Buffett, Munger, Abel, and Jain, individuals who have been with Berkshire for decades. The board is structured not to oversee management but to provide an advisory role and nearly all board members have significant skin in the game in the form of Berkshire stock that they purchased on the open market. Berkshire’s shareholders are an unusually stable and knowledgeable group, as evidenced by the tens of thousands who attend annual meetings every year. Berkshire shareholders are so devoted to the company that Munger often jokingly refers to them as “cult members“.

The partnership structure, which is not empty happy talk as is the case at many companies, completely permeates how Buffett has run the firm for decades. Cunningham and Cuba note that Buffett’s partnership model goes well beyond the legal definition of an equity owner in that he actually views shareholders as owners of the underlying business rather than merely the claimants on the residual after liabilities are subtracted from assets. This might seem like a distinction without a difference, but it represents a mindset. The fact that many of Buffett’s partners have an unusually large stake in Berkshire as a percentage of their net worth clearly has influenced Buffett’s willingness to take on leverage and driven his preference for leverage in the form of insurance float and deferred taxes rather than explicit debt on the balance sheet. Much of the debt on Berkshire’s balance sheet is attributable to the railroad and energy subsidiaries and, importantly, are non-recourse to Berkshire itself.

Berkshire has grown through acquisitions over the years, necessitated by Buffett’s policy of retaining all earnings. Buffett is famous for making pledges to leave the firms that he is acquiring alone in terms of operational decisions and only requiring a subsidiary CEO to consult with him on matters of capital allocation and management succession. Additionally, Buffett pledges to the selling shareholders that Berkshire will be a permanent home for their business, and he has followed through on this commitment even in cases where the acquisition failed to live up to its promise. All of this builds the culture of trust which is vital when a family is selling a long held business and cares about what will happen to its customers and employees.

Compliance

In recent years, high profile scandals at individual companies as well as the effects of corporate mismanagement on the entire economy have led policymakers to put in place laws and regulations, such as the Sarbanes-Oxley and Dodd-Frank Acts, designed to improve corporate governance. These rule-based regulations seek to define, in much detail, exactly how companies must comply from a corporate governance perspective. As Cunningham and Cuba note, this trend is exactly the opposite of the approach taken at Berkshire Hathaway.

One key change is that regulators want corporate boards to take on the role of monitoring company management to a much greater degree than in the past. In order to accomplish this, standards have been set defining board member “independence”, among other things. In Warren Buffett’s view, a qualified board member must have business savvy and a substantial personal investment in Berkshire Hathaway. However, it is possible for such a board member to be deemed “not independent” by regulators if there are certain personal or business relationships involved.

It is easy to be cynical regarding Buffett’s intentions here because clearly he does not want Berkshire’s board to oversee his activities. Instead, he seeks an advisory board comprised of intelligent and engaged members who have skin in the game via Berkshire ownership and he trusts that that incentive is enough to ensure effectiveness. If not for the permeation of trust throughout Berkshire, cynicism might be warranted but, taken it its totality, Berkshire’s culture and board structure is congruent and has proven effective.

The Risk of Rogue Actors

Any organization that runs on the concept of a “seamless web of deserved trust” will inevitably be vulnerable to a rogue actor who is able, temporarily, to deceive the organization and proceeds to take actions that are not consistent with the culture. Buffett and Munger are not naive when it comes to this risk but consider it a risk worth taking given the many benefits that their culture provides.

Cunningham and Cuba go into some detail regarding the sad case of David Sokol who resigned from Berkshire in March 2011 amid controversy over the Lubrizol acquisition. Sokol took an ownership interest in Lubrizol prior to suggesting that Berkshire acquire the company and made contradictory statements subsequent to his resignation that caused many shareholders to voice concern regarding management controls.

The authors suggest that Sokol’s violations of company policy were relatively minor compared to the outcome, wherein Sokol lost his job and the potential opportunity to succeed Buffett as Berkshire’s CEO. However, disproportionate reactions to violations of Berkshire’s culture may be a form of immunization against future attacks on the culture. Sokol was cleared of legal wrongdoing by the Securities and Exchange Commission but Buffett’s standards were higher than merely what was required by law. By eventually speaking out forcefully against Sokol’s actions, Buffett sent a very clear message to other managers at the company.

Time Will Tell

As of early 2020, Warren Buffett is 89 years old and Charlie Munger recently turned 96. Both men have had remarkable runs and their careers are not yet over as they have stated their intention to continue to be involved at Berkshire for the remainder of their lives or until they can no longer serve. Anyone who has attended an annual meeting will note that these men are able to answer questions for five hours in a format that would exhaust most executives half their age. The last chapter has yet to be written.

But what will eventually happen when Buffett and Munger are no longer on the scene? Will Berkshire’s unique culture of trust continue or will it be attacked by outsiders who seek short term gain or wish to exploit the trusting culture for their personal benefit?

Ajit Jain

The truth is that we do not know for certain. It seems very likely that the culture of trust will prevail for at least a decade after Buffett and Munger depart the scene because the executives they have designated to succeed them are equally immersed and committed to the culture. Ajit Jain and Greg Abel will be responsible for maintaining this culture and passing it on to a new generation of managers who will one day succeed them. They both have very significant personal stakes in Berkshire Hathaway and can be said to have “skin in the game” in addition to the trust of Buffett and Munger. The management succession that is most worrisome is not from Buffett to Abel and Jain, but from Abel and Jain to whoever takes over after them.

It is likely that we are fifteen to twenty years away from the point where Abel and Jain turn the reins over to new managers. Obviously, who their successors will be is unknown at this point. The 2040s rather than the 2020s may be the decade when we discover whether Berkshire’s Margin of Trust will prevail or fall under attack.

Disclosures: Individuals associated with The Rational Walk LLC own shares of Berkshire Hathaway. The Rational Walk LLC received a review copy of Margin of Trust from Columbia Business School Publishing.

Book Review: The Ride of a Lifetime

“The decision to disrupt businesses that are fundamentally working but whose future is in question—intentionally taking on short-term losses in the hope of generating long-term growth—requires no small amount of courage.”

— Robert Iger

The risk of potential disruption strikes fear in the hearts of corporate executives in long-established and highly profitable industries. Basic economic theory has long held that consistent profits well in excess of the cost of capital will inevitably attract additional investment in the long run which will tend to drive down returns over time. Comfortable industries such as newspapers and network television enjoyed high profitability for decades due to economic moats that led to natural oligopolies. Until close to the end of the twentieth century, such industries seemed nearly immune from serious disruptive pressures. The economic moats around businesses in the media industry did not eliminate competition by any means, but competition was well defined and predictable. The internet forever changed this dynamic as the twenty-first century began and formerly comfortable executives have been scrambling ever since.

Robert Iger has been running The Walt Disney Company since 2005 and has published an interesting account of his business career in The Ride of a Lifetime. The first half of the book is a relatively slow account of Iger’s early years moving up the management ladder at ABC which was acquired by Capital Cities in 1985. During those early years of his career at Cap Cities, Iger worked for Dan Burke and Tom Murphy who encouraged a decentralized and spartan organizational structure. Iger thrived in this culture, finally rising to President and COO of Cap Cities in 1994, just before the company was acquired by Disney. At Disney, Iger found himself working for Michael Eisner in a much more centralized corporate structure. Iger provides a dramatic account of his rise to the top of Disney which finally took place in 2005 and the narrative runs all the way to the remarkably well received introduction of Disney+ in 2019.

Michael Eisner was one of the most highly regarded CEOs in America at the time he turned over the reins to Bob Iger in 2005, but by the end of his tenure, there were significant areas of conflict with Disney’s board as well as with important business partners, including Steve Jobs. Disney had a longstanding relationship with Pixar, which Jobs controlled, but a series of business disputes led to a near dissolution of the relationship by the time Iger took over as CEO of Disney. Iger believed that it was essential to repair the relationship with Pixar due to the poor state of Disney’s animation business. Iger needed a better relationship with Jobs, and reached out to him immediately after becoming CEO.

Jobs was initially cautious but he and Iger hit it off and they were soon collaborating on providing content for the first version of Apple’s Video iPod which was released in October 2005. That collaboration increased the level of trust between the two men and soon they were in discussions for Disney to acquire Pixar. Iger was still very early in his tenure and did not have a great deal of political capital with Disney’s board, but he decided to bet his future on the $7.4 billion acquisition. Perhaps more important than the addition of Pixar to Disney, Steve Jobs became a very large Disney shareholder after the acquisition and his influence on Iger was apparent from this point forward.

Acquiring Content and Talent

Steve Jobs was a fanatic and a perfectionist when it came to product design, and his innovations ended up disrupting many industries. The rise of the iPhone, accompanied by the destruction of the seemingly impregnable mobile phone incumbents, is the most obvious example. Iger developed a close friendship with Jobs and he was one of the first people outside of Jobs’s family to learn about the return of his cancer in 2005. Jobs thought it was important to let Iger know about his diagnosis prior to moving forward with selling Pixar, but Iger declined to pull out of the deal. Jobs would end up being a key member of Disney’s board until his death in 2011.

In addition to the Pixar acquisition, Iger made two additional transformational acquisitions with the purchase of Marvel Entertainment and Lucasfilm. In both cases, the acquisition of these companies allowed Disney to greatly expand its library of content and, perhaps more importantly, acquire human capital that would drive future content forward. Iger learned a great deal about managing creative talent by watching how Jobs handled the Pixar sale.

Steve Jobs was known as a mercurial manager and he had little patience for mediocrity, but the flip side is that when he found talent that he felt was indispensable, he showed it and this created tremendous loyalty from those who worked for him. This was a lesson Iger took to heart when he saw how Jobs treated John Lasseter and Ed Catmull:

Steve told me he would seriously consider it [Disney buying Pixar] only if John and Ed were on board. After we talked, he contacted them to say that he was open to a negotiation, and to promise them that he would never make a deal without their blessing. We planned that I would meet with each of them again, so I could explain in more detail what I was imagining and could field any questions they had. Then they would decide if they were interested in going forward with a negotiation.

The Ride of a Lifetime, p. 140

It is extraordinary for a controlling shareholder of a company to give his employees effective veto power over selling the business. However, in creative fields, a company is often highly dependent on the talents of a few individuals and, without those individuals, future prospects would look bleak. Iger obviously came to the same realization and would likely not have wanted to acquire Pixar without Lasseter and Catmull on board. The reader gets the sense that Iger learned critical lessons from watching how Jobs interacted with creative talent.

The Courage to Disrupt Yourself

In Chapter 12, entitled “If You Don’t Innovate, You Die”, Iger outlines the major challenges facing media companies in the 2010s. Traditional distribution of content was still highly profitable for Disney and there did not appear to be a need to change course immediately. Iger believed that Disney needed to get ahead of the curve by developing a technology platform that would allow the company to start delivering its own content without intermediaries. Iger had seen the type of disruption that had already affected newspapers and his business relationship and friendship with Jobs clearly played a role in his aggressive posture. He was convinced that Disney could either disrupt itself or find itself disrupted anyway.

In mid 2017, Iger decided that Disney needed to buy a controlling stake in BAMTech and use that company’s technology platform to launch Disney and ESPN streaming services directly to consumers. This was the original genesis behind the Disney+ rollout that took place in 2019. Iger announced the decision in Disney’s August 2017 earnings call:

That announcement marked the beginning of the reinvention of The Walt Disney Company. We would continue supporting our television channels in the traditional space, for as long as they continued to generate decent returns, and we would continue to present our films on the big screens in movie theaters all over the world, but we were now fully committed to also becoming a distributor of our own content, straight to consumers, without intermediaries. In essence, we were now hastening the disruption of our own businesses, and the short-term losses were going to be significant.

The Ride of a Lifetime, p. 192

Iger was choosing to accept short-term losses with the expectation that future growth will more than make up for it. Although Wall Street is often ultra-short term oriented, Disney stock reacted favorably to Iger’s August 2017 announcement. But Iger had additional work to do in order to make this radical change work. He had to revise compensation policies that incentivized executives to protect the old model. Iger ended up making executive compensation more subjective than it used to be in order to be in a position to reward executives who made progress with streaming even if it came at the expense of short term profits.

As of early 2020, it appears that Iger’s bet on Disney+ will be a success. The $6.99 per month price point for the service is very aggressive and Disney has spared no expense in making compelling original content that is available exclusively on Disney+. Iger leveraged the Star Wars franchise acquired with Lucasfilm to develop The Mandalorian, an eight episode series about a bounty hunter that includes an unexpected star popularly referred to as Baby Yoda.

Pick Your Poison

One of the key takeaways from Bob Iger’s memoir is that it is not possible to hide from disruption. Sometimes, disruption comes from out of the blue leaving executives with little time to react, but at other times one can see that changes are coming far ahead of time. If you are leading a dominant company in an industry that appears vulnerable to disruption, you can choose to either ignore the threat, take defensive steps, or go on the offense using the strength of your current position as a springboard to turn the tables on your new competitors.

The final verdict on Iger’s tenure as CEO of Disney is yet to be determined. He still has two years left on his contract and it is likely that we will have a better idea of the progress made in the streaming initiatives by the time he departs. However, he does deserve credit for having the foresight to accept the fact that streaming of content is the future and taking concrete steps to be relevant in this new environment. He understood that owning not only the content but also the distribution channel would be critical to success. Ten years from now, we will be in a much better position to evaluate the outcome of his strategic moves.

The Man Who Solved The Market

“Higher mathematics may be dangerous and lead you down pathways that are better left untrod.”

— Warren Buffett, 2009 Berkshire Hathaway Annual Meeting

Success in most areas of life requires having a clear and coherent view of reality along with the mental fortitude to pursue your goals consistently over a long period of time. From an economic standpoint, doing things that are easy to implement and obvious to everyone else is unlikely to yield more than middling results. Whether you are opening a new restaurant, writing a book, or trying to achieve superior results in financial markets, you need to establish an edge of some kind if you hope to enjoy above average results. The world is simply too competitive to bestow great success on people who never stray from doing what everyone else is doing.

It is important to recognize that there is no single path to success in most fields because every human being is born with unique attributes and develops further strengths and weaknesses over time based on the environment in which they live. Innate intelligence and talent combined with the circumstances of the first two decades of our lives plays a huge role in how we see the world and the manner in which we go about trying to achieve our goals. New skills and talents can certainly be developed, but underlying temperament and interests drive and define us from a relatively early age. Someone who is obsessed with business and making money from an early age is likely to approach investing with a different perspective than an equally intelligent person who had an early obsession with mathematics and science.

In 1959, Jim Simons was a twenty-one year old newly married graduate student at the University of California, Berkeley with a $5,000 wedding gift1 that he was eager to turn into a greater fortune. After an initial foray into stocks that barely moved and bored Simons, his broker suggested buying soybean futures. Simons quickly earned thousands of dollars in profit, only to lose the gains within a few days. This experience was enough to hook the young mathematician who became fascinated with financial markets and the possibility of scoring short-term profits. Simons, who is now a 81 year-old multi-billionaire, went on to achieve goals beyond his wildest expectations from that modest start sixty years ago. Although Simons was not eager to have his story told, Gregory Zuckerman managed to uncover many fascinating details regarding Simons and the firm he founded. The Man Who Solved The Market is a riveting account of how Simons used his mastery of mathematics to achieve enormous success in financial markets.

“It’s nice to be very rich”

Jim Simons had no interest in business during his formative years, but he did have an interest in money. He grew up in a family of fairly modest means, but was exposed to wealth at an early age and observed that “it’s nice to be very rich”. However, his natural inclination was to pursue science and mathematics rather than business. Like Warren Buffett, Simons had very unusual skills with numbers as a young boy but, unlike Buffett, Simons was attracted to the elegance and beauty of pure mathematics and intellectual life. The problem with the intellectual life of an academic is that it can lack adventure, and Simons soon had an “existential crisis” at the age of twenty-three wondering whether he would be stuck in an academic rut for the rest of his life.

Simons had a meteoric early rise in academia and accepted a position at Harvard in 1963 where he established himself as a popular professor, but he was not satisfied with the pay and taught additional courses on the side at a community college. Simons “hungered for true wealth” and saw how money can buy influence and independence. He soon left Harvard to join the Institute for Defense Analysis (IDA) where he doubled his academic salary and, perhaps more importantly, began his lifelong quest to come up with a system to profit in financial markets.

Simons was a code breaker at IDA focused on cracking Russian codes and ciphers that had been impenetrable for over a decade. Simons would spend his days creating algorithms based on mathematical models designed to interpret patterns in the data. Simons did not have expertise in programming but proved to be a master at developing algorithms that others would encode. He achieved a breakthrough that leveraged an error in the Soviet code to gain insight into the construction of the system and developed the means of exploiting it.

Why Ask Why?

Inspired by his success in code-breaking, Simons used the flexibility he enjoyed at IDA to develop a unique stock trading system on the side, along with his colleague Lenny Baum:

Here’s what was really unique: The paper didn’t try to identify or predict these states using economic theory or other conventional methods, nor did the researchers seek to address why the market entered certain states. Simons and his colleagues used mathematics to determine the set of states best fitting the observed pricing data; their model then made its bets accordingly. The why’s didn’t matter, Simons and his colleagues seemed to suggest, just the strategies to take advantage of the inferred states.

The Man Who Solved The Market, p. 29

Simons approached financial markets in a manner diametrically opposed to the fundamental analysis practiced by investors such as Warren Buffett. Simons did not care about the underlying economics of the financial instruments he sought to trade. He did not scrutinize macroeconomic variables such as GDP growth, inflation, housing starts, or rail shipments, nor did he analyze microeconomic variables specific to individual businesses. Simons focused exclusively on what he could learn by observing market data and detecting hidden patterns in that data that could be exploited for short term gain. It would have been just as impossible for Simons to adopt Buffett’s approach as it would have been for Buffett to adopt Simons’s approach. Simons had no interest in business and Buffett had no interest in attempting to understand the minute-by-minute gyrations of financial markets. Each brought to the game their own personal proclivities and talents.

Simons returned to academia when an opportunity came up to lead the mathematics department at SUNY Stony Brook on Long Island. His work on predicting financial markets was still fairly crude and he did not implement it for several years but the seed had been planted in his mind. By 1978, Simons decided to leave academia for good and founded what would eventually become Renaissance Technologies.

A Pure System

“I don’t want to have to worry about the market every minute. I want models that will make money while I sleep. A pure system without humans interfering.”

Jim Simons quoted in The Man Who Solved the Market, p. 56

Readers of Zuckerman’s book will never get a true sense of how the systems Simons and his colleagues built actually work. For one thing, the mathematics behind the systems are no doubt penetrable only to experts. These are models developed over decades by dozens of PhDs who worked with Simons to perfect his trading models. In addition, the models are obviously proprietary and Zuckerman’s sources were mostly bound by nondisclosure agreements. So readers looking for magic formulas will be disappointed but those of us looking for a fascinating story will enjoy the details nonetheless.

The early efforts of Simons, Lenny Baum, and James Ax led to success in developing models for various commodity, bond, and currency markets with positions generally held for a day or less. The system provided encouraging early results but it took on a life of its own and made strange decisions that no human could discern, leading to odd situations like nearly cornering the global market for potatoes. In the early 1980s, Baum shifted to a more traditional fundamental style of investing and Simons branched out into venture capital. Baum in particular began to take positions using intuition and instinct and started to make significant money for the firm.

A pattern seems to emerge in the book where Simons and his colleagues develop systems with a high degree of automation but they never seem to fully trust these systems, often falling back on intuition and instinct which eventually fails. Baum ran into trouble in 1984 with a bet on bonds that was poorly timed and caused a rift with Simons and Baum’s departure from the firm. Years later, James Ax would come to rely on his instincts for a portion of the portfolio he managed, leading to his departure in favor of a more automated system put in place by Elwyn Berlekamp. It seemed like the mathematicians did not fully trust their own models.

Medallion Fund

In 1988, Simons founded the Medallion Fund but he did not experience immediate success and, within six months, the fund was suffering. However, by the end of the year, the fund was up 16.3 percent before fees and 9 percent after fees. Medallion was small initially with assets of just $20 million. Simons was well beneath the radar of Wall Street and Medallion was destined to remain a small player for several years.

Over the next five years, Medallion strung together several years of impressive performance, culminating in an amazing 93.4 percent gross return in 1994. However, Medallion had problems scaling up in size because its trading strategy was limited in terms of the amount of capital it could successfully employ without moving the market. Simons closed the fund to new investors in 1993 when assets reached $280 million due to worries that it was becoming too large.2

Simons realized that he would have to extend Medallion’s portfolio to equities in order to grow the business beyond its traditional focus on commodity, currency, and bond markets. A key turning point came in 1993 when Simons hired Peter Brown and Robert Mercer, both computer scientists recruited from IBM. Mercer and Brown used their coding skills to build a system that would implement a single trading model for all of its investments rather than specific models for different investments and market conditions. Their model was built to handle complications that previous models could not handle or simply ignored.

Even geniuses make mistakes and one amusing part of the story involves a bug in Mercer’s code discovered by David Magerman:

Early one evening, his eyes blurry from staring at his computer screen for hours on end, Magerman spotted something odd: A line of simulation code used for Brown and Mercer’s trading system showed the Standard & Poor’s 500 at an unusually low level. This test code appeared to use a figure from back in 1991 that was roughly half the current number. Mercer had written it as a static figure, rather than as a variable that updated with each move in the market.

The Man Who Solved The Market, p. 194.

Magerman’s insight marked a turning point. Medallion’s equity team started to post better results, but equities were still providing only 10 percent of the firm’s profits in 1998. By 2003, however, Brown and Mercer’s stock trading group’s profits were twice as large as the profits from Medallion’s other trading strategies. Zuckerman goes into some detail regarding how this was accomplished through the use of basket options and substantial leverage. With the equity market puzzle solved, Medallion was able to grow significantly reaching about $5 billion by 2002.

Returning Capital

Medallion’s amazing performance in later years must be understood in the context of the policy of returning capital to investors on an annual basis. The size of the fund remained nearly static from 2002 through 2009 at $5 billion while net returns ranged from 22 to 82 percent over that span. Obviously, retaining these gains and reinvesting in Medallion’s strategy was not possible. If it had been possible, the size of Medallion would have grown exponentially. Instead, capital had to be returned to investors who, by this point, were mostly comprised of current and former Renaissance employees.

In an appendix to the book, Zuckerman presents a chart comparing the returns of Medallion with the records of George Soros, Steven Cohen, Peter Lynch, Warren Buffett, and Ray Dalio. Simons trounces all of these men in the table Zuckerman presents. However, there are problems with this direct comparison. For one thing, the period during which the returns were generated vary greatly with some investors having much longer track records than others. More importantly, Warren Buffett’s Berkshire Hathaway posted the 20.5 percent annualized returns from 1965 to 2018 while retaining all of the capital generated over the decades.3 Additionally, Zuckerman does not include Simons’s record prior to Medallion fund, which was not as impressive, while excluding Buffett’s early record which was even more impressive than his record at Berkshire.

Many Ways to Win

Intellectual humility requires us to recognize that there are many ways to succeed in any given field. For a value investor, the manner in which Jim Simons generated his wealth might seem like casino gambling and, indeed, it does share some characteristics with the economics of the “house” in a casino. By developing models that predict human behavior, Simons can be right just slightly more than half the time and still grow fabulously wealthy. He used his innate talents and interests to “solve the market” in his own way.

A value investor like Warren Buffett, on the other hand, takes exactly the opposite approach and scrutinizes businesses looking for enduring competitive advantages and then holds those investments for years or decades. Buffett’s temperament lends itself to this style of investing and it is arguable that Buffett’s approach is far more comprehensible for the vast majority of investors. Most of us are not math geniuses like Simons. Most of us are also not business geniuses like Buffett. But we can at least comprehend Buffett’s strategies and the manner in which he built his wealth is more accessible because he did so in the form of a public company. We can also invest alongside Buffett whereas we cannot invest with Simons given restricted access to his investment vehicles.

Ultimately, we all need to decide how we will approach investing. First, we have to decide whether to try to beat the market at all. Once we decide to make that attempt, we need to figure out what our edge is. Can we compete with men like Jim Simons at his game? The prospect of doing so seems very unlikely. But we can compete with Warren Buffett, especially since Buffett can no longer play in smaller opportunities given Berkshire’s massive size. And if we do not want to compete with Buffett, we can at least invest along with him, and we can do so in an investment vehicle that carries minimal fees and, thus far, has been able to reinvest all of its capital.

Disclosure: Individuals associated with The Rational Walk LLC own shares of Berkshire Hathaway.

Note to Readers: The Rational Walk will launch a free periodic newsletter named Rational Reflections on January 1, 2020. You can subscribe by clicking on the link and entering your email address which will not be sold or shared, and you can unsubscribe at any time. If you already subscribe to Rational Walk articles via email, you will be automatically subscribed to Rational Reflections and you do not need to sign up. Full articles after this one will no longer be distributed via email, but all new articles will be mentioned in the newsletter with a link provided to the full article.

  1. $5,000 in 1959 dollars is nearly $44,000 in 2019 dollars due to the effects of inflation. Simons was playing with a substantial sum of money for a young, newly married graduate student. When reading about dollar amounts in the 1950s, one can simply add a zero to the figure to approximate the ravages of inflation over six decades. []
  2. Zuckerman provides detailed performance data for Medallion in Appendix 1 to the book. The net performance is even more remarkable in light of the extremely high fees. Medallion has always carried a 5 percent management fee. The performance fee was initially 20 percent but was later raised to an astounding 44 percent! Despite the burden of these fees, Medallion had 39.1 percent average returns from its founding in 1988 through the end of 2018. []
  3. With the exception of a single ten cent dividend paid by Berkshire Hathaway in 1967 []
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