Weekend Reading #43

This is the forty-third edition of our weekly newsletter, Weekend Reading, sent out on Saturday 16th November 2019.

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What we're doing.

This week we were back in Jakarta, following up with everyone we’ve met over the past year as our fund approaches launch. The key message hammered home at each meeting? Downside protection and full alignment. Or, as we were told in one meeting, “a proper hedge fund”.

Conversations with potential counterparties and partners (including brokers and local legal advisors) were also had, as we prepare for an important milestone. The next few weeks will see us hit the bricks again – first in South Africa, then Turkey.

This is only the first phase of our journey as a company, and it’s one we have relished greatly. As a great man once said, “This is not the end, it is not even the beginning of the end, but it is perhaps the end of the beginning.”

What we're reading.

If you’re interested in the fraught relationship between democracy and technology in China (and elsewhere), you should read this piece from Niall Ferguson in the Boston Globe. In it, he argues that “The Great Firewall of China is crumbling. And, as with the Berlin Wall 30 years ago, pressure from outside is going to accelerate the process.”

It’s also worth digging into this earlier article on “China’s three-body problem”, in which Ferguson explains why he bet the Chinese economist Justin Yifu Lin 20,000 yuan that China’s economy – defined as GDP in current US Dollars – will never overtake that of the US.

What we're watching.

This week we revisited Brad Pitt’s zombie flick, World War Z, some of us for the third time! It’s a superb movie, one that commands your undivided attention from the very first scene and maintains it for a full two hours and three minutes.

One scene in particular grabbed us. In it, the leader of Israel’s defence against thousands of hyper-aggressive zombies explains the concept of “The Tenth Man”, namely if ten people are in a room and nine agree on how to interpret and respond to a situation, the tenth man must disagree. This is actually inspired by true events in the aftermath of the 1973 Yom Kippur War:

“Following the recommendation of the Agranat Commission in 1973-1974, Military Intelligence established a Control Unit that was expected to play this role of the devil’s advocate. Its responsibility was to produce a range of explanations and assessments of events that avoided relying on a single concept, as happened in 1973."

We won’t spoil the movie for you, but this concept of institutionalising contrarianism is incredibly interesting and relevant to investors. Every day, we come into the office and actively seek dissent amongst our team – not to protect ourselves from killer zombies, but from our own psychological biases and the groupthink that can afflict investment management professionals if allowed to go unchecked.

After that emotional rollercoaster we reacclimatised with this brief, entertaining and enlightening speech from CZ, Co-founder and CEO of Binance. In it he shares advice on how to build a successful ecosystem, in addition to some valuable thoughts on how he thinks about utility value vs equity profit.

The parallels with how we are approaching our business are plentiful. Right now our focus is squarely on product, building the features and functionality that our customers want. That applies to everything we’re working on – from our hedge fund to our private deal platform, to any other opportunities that may arise along the way. If we get that right, the wider ecosystem will flourish. And like Binance, we are hugely ambitious.

What we're writing.

Our take on the psychology of investing.

In the era of CSR and ESG, corporate websites tend to host well-crafted statements of corporate intent, reverse-engineered around a founder’s origin story or a marketing guru’s insight.

Browsing the web on a cold and wet Tuesday evening, we came across something interesting. The company we stumbled upon didn’t seem to care much for marketing theory. There was no statement of values, no mission statement, no brand manifesto. There was simply a list of things the company was doing.

Beautifully simple and deceptively powerful.

“You are what you do” is a beautifully simple (and deceptively powerful) concept that’s been largely ignored in favour of branded corporate identities, constructed with reference to the same NYT bestsellers and Youtube videos. But people and companies that do great things on a consistent basis (rather than simply talking about their intentions) will always outperform.

Indeed, a16z’s Ben Horrowitz is out with a book on this very subject, elegantly entitled “What You Do Is Who You Are”. The last decade has been characterised by exuberance (rational and otherwise), but it feels like we’re entering a new phase in which “boring” qualities like solid unit economics, cost control and profitability will be sought after by investors. These are things that are done by companies, not kicked down the road for another few funding rounds.

The habit industry.

Such positive outcomes are a function of good habits – the things that companies do every day. Habits play a pivotal role in defining who we are. They can literally make or break or business, a relationship, a life.

Productivity gurus like Tim Ferris, Tony Robbins and James Clear do more than flog info products and conference tickets. They sell a worldview that seeks to elevate every individual to their full potential. Whilst some people label them false prophets, experimenting with their ideas can have a dramatic impact on our quality of life. Despite the hype, it’s really just a repackaging of what your parents told you when you apologised for (best-case) mischievous (worst-case) outrageous behaviour – namely that actions speak louder than words.

In truth, “we are what we do” is a simplification. It’s more accurate to say “we become what we do”, and more helpful, too. After all, identify formation is a process, a continual journey we embark upon in order to fulfil our potential. But how does this process of becoming actually work? And what does it mean for our careers as investors?

More than a feeling.

The characterisation of the process by which people acquire attitudes and traits dates back to the philosopher Gilbert Ryle (famous for his critique of Cartesian dualism and the eponymous phrase “the ghost in the machine”). It was later formalised by the social psychologist Daryl Bem as Self Perception Theory. Bem (currently Professor Emeritus at Cornell University) isn’t particularly well known outside of academic circles and you won’t find his books on the shelves of your local Waterstones, but his work is a gift to investment managers who are willing to venture off-piste and open their minds.

Before Bem came along, it was assumed that people behave the way they do because of their personality traits. A man returns a lost wallet because he is honest. A woman writes a story because she is creative. Bem turned this supposition on its head, arguing that a man is honest because he returns a lost wallet; a woman is creative because she writes a story. Via a series of simple experiments, he proved that people draw inferences about who they are by observing their own behaviour.

Psychologist James Laird’s experiments in the mid 1970s back this up. Laird asked college students to enact different facial expressions to convey emotions including happiness, sorrow and anger, they subsequently reported feeling those emotions. The moral of this particular anecdote is that to be happier people, we should all smile more!

A gift to investment managers.

If we buy into the idea that our actions determine our personality traits, and not vice versa, it follows that we need to reappraise everything we thought we knew about ourselves.

Many of our assumptions about our personalities – our likes, dislikes, talents, hopes and fears – might be false. Of course, they might also be correct, but it’s fair to say we might not know ourselves as well as we thought. And we can only get to know ourselves better by observing our own behaviour. This is unsettling, but it’s also tremendously powerful. Being more observant and self-aware can help us to become better people, and better investors, too.

Of course, Bem’s theories predate the popularisation of psychotherapy in the 1980s and 90s, a trend that continues to this day, often with a focus on challenging people to enact behavioural changes in order to change or somehow “correct” dysfunctional psychological and emotional states. It didn't work for Tony Soprano, but it’s worked for millions of other people. And investment managers looking to generate absolute returns would do well to observe their own behaviour before even logging into their Bloombergs.

Multiple psychological headwinds.

But confirmation bias is just one mental battle that investors have to fight every day. Sitting at our desks, wading through bank research, scrutinising charts and meeting with company management, we face multiple psychological headwinds – confirmation bias that tells us we’re right everywhere we look, endowments effects that tell us assets we already own are more valuable than those we don’t, availability heuristics by which we overestimate the importance of something based on how easily an example comes to mind, hubris with regards to our ability to call market movements... the list of handicaps is endless. Such is the human condition.

Ultimately, it’s not our convictions that make us good managers. The stories we tell ourselves about ourselves are just stories, after all. What makes us who we are as investors is what we do. And not just on the days where the stars align and everything comes together beautifully. What makes us who we are is what we do day in, day out.

Behavioural investing is big business, but the focus tends to be on the behaviour of others. It’s easy (and fun) to judge other people, but it’s far more useful to appraise ourselves. At Three Body Capital, we believe it’s important to actively observe our own behaviour in order to understand who we are as managers, what we are doing right and where we are going wrong. By dispassionately observing ourselves, we can develop and refine an effective investment process, one that allows us to flourish. We can begin to navigate our way to self-actualisation, and as a fortuitous by-product, we can deliver attractive returns for our clients.

The Three Body Process.

So many managers and traders are ideologically invested in their trades. Just look at the ongoing Twitter war over Tesla. We admire that level of passion and existential commitment, but it’s yet another psychological obstacle that we must overcome in order to achieve absolute returns.

Researchers recently evaluated about 10,000 “episodes” (full cycles of a given position from first entry to last exit) across 43 portfolios over 14 years, and found that “alpha starts out strong and fades sharply with age.” Which is finance-speak for “cut your losers quick”. We know from experience what it’s like to see hard-won alpha wiped out by holding into losing positions for too long.

Whilst ideas and convictions are an important part of investing, giving us a base to work from, process is paramount. There is no one-size-fits-all approach to this. You have to do what works for you, and what works for us is avoiding the illusion of a singular “truth”, anticipating multiple paths and actively seeking dissent. As we recently pointed out, rather than allowing our emotions and biases to entangle with the narratives that we inadvertently buy into, our focus is on constructing and executing a scientifically objective investment process, implemented by our entire team. We seek to exclude significant downside in order to access asymmetric upside opportunity.

If you are busy, or simply uninterested in lengthy blog posts from startup hedge funds and keen to skip to our reading and listening recommendations, that’s okay. But please take this away with you:

Who we are is not set in stone. We can change. We can return the wallet. We can write the story. We can become better people by doing better things.

Weekend ReadingEdward PlayfairNovember 18, 2019