Wednesday, July 06, 2005

Buffett plays the odds (and mental mathematics)

[3/2/06] Along the same lines is this excerpt on Bill Nygren from the book Five Key Lessons from Top Money Managers
Bill’s interest in risk and return led him to explore various types of financial risk taking and the average payoffs each offered.

He discovered, for instance, that if you put a dollar in a state lottery,
the state typically keeps fifty cents. Almost everybody comes
away empty-handed, and someone hits a huge home run. If you
bought all the tickets, you would get back only half your money.
Not good odds.

In horse racing, the track keeps between 15 and 20 percent
of your money—better than the lottery, but still a net loss.
At the very positive end of the gambling spectrum, casinos
keep about 1 percent of what you bet at the craps table.

Further up the return/risk scale, you move into the field of
investing, where expected returns are positive. Put money into
high-quality bonds and you will typically earn just a tad above
inflation. It’s a low-risk/low-return venture, but at least the result
is positive, which beats any of the gambling options. Stocks on
average outperform bonds by several percentage points, and the
longer you hold them, the more certain you can be that your returns
will beat other asset classes of investments.

So Bill learned early on that just because a venture is risky
doesn’t mean you should avoid it. Some risks make sense to
take, and investing in stocks is one of them.

[11/12/05] brknews passes along this Sanjay Bakshi article about Buffett's game of dice that he proposed to Bill Gates.

[7/6/05] "The bet was the kind that rich golfing buddies like. Investment wizard Warren Buffett's $10 against $20,000 that he wouldn't score a hole-in-one over the three-day outing.

"Eight of us had gotten together to play Pebble Beach, and in a loose moment, after dinner and a couple bottles of wine, I offered the bet," recalled Jack Byrne, [former] chairman of Fireman's Fund. "It was meant as a fun thing, and the other six took me up on it. Everyone except Warren.

"Well, we heaped abuse on him and tried to cajole him - after all, it was only $10. But he said he had thought it over and decided it wasn't a good bet for him. He said if you let yourself be undisciplined in the small things, you'd probably be undisciplined on the large things, too."

-- from Of Permanent Value (1994 edition), Chapter 59



I'm looking for the recent article where Buffett says you don't need a high IQ to succeed in investing. But then the article goes on to cite some head-scratchingly clever mathematical calculations in his head. I seem to recall Buffett referenced Richard Feynman for one of the calculations.

Being stumped, I ventured up the distant mountain to ask The Nameless One. Sure enough he was able to trace it to a chapter in Robert Hagstrom's book The Warren Buffett Portfolio, entitled The Mathematics of Investing.

That chapter is summarized at WallStraits where they talk about GARP, though I fail to see where Hagstrom's book is credited as the source material.

Buffett has never even owned a calculator. When interviewed about how he does complex calculations in his head, like what is 99 times 99? Buffett immediately answers 9,801, and he jokes that he read the answer in a book about the US atomic bomb project by Nobel laureate in physics, Richard Feynman. (Sure enough, the answer is in the book by Feynman.) When pressed to share his secrets, the interviewer asked Buffett another question, "If a painting goes from $250 to $50 million in value in 100 years, what is the annual rate of return? Again, Buffett instantly answered: "13.0%". When the stunned interviewer asked how he did that, Buffett pointed out that any compound interest table would reveal the answer. The interviewer asked if he memorized the table...Buffett said, "good heavens no, but another way to approach the problem is to go by the number of times it doubles in value ($250 doubles 17.6 times to reach $50 million, or a double every 5.7 years, or about 13% a year)." Simple, Buffett seemed to imply. Not so simple for the rest of us, but fear not, Buffett insists only basic math is needed to be a superior investor!

Looking at Feynman's biography, "Surely You're Joking Mr. Feynman!", I fail to find the exact method Buffett used to calculate 99 x 99. But he likely used this multiplication shortcut of breaking down the numbers into more manageable parts.

99 x 99 = (100 - 1) x (100 - 1) 
= 100 x 100 - 100 - 100 + 1
= 10,000 - 200 + 1
= 9,800 + 1
= 9,801

The chapter on mental mathematics in SYJMF is titled Lucky Numbers. I found a couple of excerpts on the web.

Here's something I just found out after doing a search of SYJMF on the web, it produced a link to MatthewBroderick.net's guestbook. It turns out the Broderick did a movie in 1996 about Feynman called Infinity (three stars from Ebert). Broderick directed it and played the part of Feynman. There's two listings of this DVD on Amazon. Here's the cheaper one.

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