Posted on by CTKS

Three Lessons From A Singaporean Favourite Game

Apart from red packets and delicious snacks, there is one other thing that everyone look forward to during the Lunar New Year. It’s Mahjong! On top of being a good game to stimulate your brain and catch up with your relatives and friends, this household favourite game yields many lessons about investing and life.

Lesson 1: You can’t win it all

The first lesson is a tough pill to swallow. No matter how skilled you are at reading the cards of others or how disciplined you are at playing defence, you cannot always win in Mahjong. Sometimes, people just keep winning from 自摸 (drawing the tile themselves). Disgusting! Trust me, I understand how frustrating this is (been on the receiving end of that multiple times). Unfortunately, this is something that is completely out of our control. You win some, lose some. Sometimes you are lucky, and sometimes you are not.

Thankfully, doing nothing is perfectly fine! Luck comes and goes, but in the long run, over many repetitions, what gives one an edge is skill and the right mentality. Thus, by directing our efforts to the things we can control, we can poise ourselves to seize opportunity when the tides turn.

This is very applicable to investing and anything that involves a mixture on luck and skill, even life. Given the infinite number of factors affecting the outcome, there is a infinite possibilities that could occur. Even if we have done everything we can to the best of our ability, some things are just out of our hands. In investing, we should expect a third of our decisions to not work out. With that in mind, we should have a sound plan and take precaution to ensure that we can remain financially resilient. Eventually, lady luck will once again shine on us.

Lesson 2: Take calculated risk

Mahjong also teaches us a thing or two about risk, something that is hard to understand simply by reading or listening. This makes it challenging to learn anything much about risk from our formal education. Yet, risk is pervasive in life. At every step of the way since birth, luck and risk is at play regardless of whether we are aware of it, and arguably much more so in investing. In my opinion, the best way to learn about risk is to learn from experience, and playing Mahjong is an excellent opportunity to do that.

Take for example a situation where someone is calling (waiting to win) a 满台 (the maximum “points”, usually 5 in Singapore) and the best you can do with your hand is 三台 (three “points”). In this case, the downside if you throw the winning tile is huge while the potential gain of winning a 三台 is relatively small. So, what would you do in that situation? As rational players we should play defence when we draw a tile that we think may be the winning piece for the other player. While doing so may mean that we submit to fate that we won’t win this round, we do not risk losing more. We much rather wait for another round where the reverse is true, when we are calling a 满台 and others are calling only two or three 台. These situations where the payoff is skewed in our favour present excellent opportunities to play aggressively.

In investing, we want to “bet” big on situations which has a huge upside and minimal downside. Or in the words of Monish Pabrai, “heads I win, tails I don’t lose much”. The converse is also true. We should ignore investments that have small upside but could potentially lead to large permanent losses. We much rather wait for the low risk high reward opportunity. Following this logic, I never short a stock. This is because the upside is at most a 100% while the downside is unlimited. When we invest in a company, the upside is unlimited. Why would I take the first bet? When we make rational decisions based on this sound principle, they cease to be bets. Instead, they are strategic moves involving calculated risks. Such opportunities are few and far between so when we are lucky to find one, make sure to capitalise on it.

In both Mahjong and investing, there are many nuances that writing cannot encapsulate. However, the idea of looking for “bets” with huge upside and minimal downside remains the core of a winning strategy. As mentioned above, the best way to learn about risk is by experiencing it. In order to truly appreciate how luck and risk come into play, one has to put themselves through those situations, and one of the best ways to do so is playing Mahjong.

Lesson 3: You can’t know everything

Building on the concept of risk, the next lesson drawn from Mahjong applies to investing and life as well. Picture this:

You are calling a 满台 and it is your turn to draw. You look at the tiles on the table and know that another player is gunning for a 清一色 (full suit) 索子 (bamboo). You pray to god to draw anything but a 索子. As you draw your tile and slide your thumb across the face of the tile, you feel sticks… and you heart drops. You know that he wants 索子 but you are not sure which exact piece he needs (unless you have a PhD in mahjong like the Aunties and Uncles). At this point in time you face a major dilemma. Do you throw the 索子 and risk losing a lot of money? Or do you play defence and miss out on the potential of winning a lot of money? In such situations, there is no easy way out. Neither is there a correct answer. It all depends on you.

Similarly in investing, you cannot pinpoint what the future beholds. The best you can do is assess all available information and make a decision that you are comfortable with based on your current financial situation, risk appetite and goals. If you think that the risk-reward ratio is attractive after thorough assessment of the available information, you just have to take the leap of faith. As such, we can expect that unknown unknowns may occasionally derail some of our theses. This makes the case for a certain degree of diversification, never put all your eggs in one basket.

That being said, I am not promoting gambling. We all have to take responsibility of our actions and know our limits. Sometimes before making a big decision, a certain friend of mine will look in his drawer to count his chips. In both investing and Mahjong, we only risk what is reasonable. And what is reasonable, depends on a variety of factors such as our risk tolerance and financial resilience. I simply hope to share that there is value we can gain from playing intricate games such as Mahjong that formal education cannot offer us. So, the next time you play Mahjong, pay attention to the life lessons that this Singaporean favourite game has to offer.

Posted on by CTKS

Three Lessons From “Thinking Fast And Slow”

Many often associate rational thinking with investing. However, cognitive biases are in fact widespread amongst investors, limiting their ability to make the optimal decisions. In this article, I share three lessons from Daniel Kahneman’s “Thinking Fast and Slow” that we investors can learn from.

1. The Illusion of Understanding

In his book, Kahneman explains that we humans are prone to suffering from the illusion of understanding. The core of this is that we THINK we understand the past and therefore, can foresee the future. When in fact, we actually understand less than what we think and discount the role of other factors such as luck. In hindsight, we can all agree that Google was a sure success. Two computer science students from Stanford creating a superior search engine. Yet, the founders wanted to sell Google for 1 million at some point, only for the buyer to decline the offer because they think the price was too high. The lesson here is that we should not place too much weight on predictions, especially if they were made by looking at the past. People often overestimate their ability to do things and this applies to analysts and economists as well. By studying how markets perform in history, they think that they can predict when the next crash can occur. In doing so, they fail to recognise that many things are in fact left to chance.

For instance, many analysts have been warning of a stock market bubble since last year. Yet, the S&P500 year-to-date gain is 22.8%. Had we suffered from the illusion of understanding and stayed out of the stock market, we would have incurred huge opportunity costs in terms of potential gains forgone. Thus, don’t let these noise affect your decision making and paralyze you.

There are many ways to manage your emotions. First, do not see whether to invest or not to invest as a binary decision. Think of it as a spectrum. If you think there is a chance that the market will crash soon but are not 100% sure (as no one can be), maybe start by investing 30% of your money you plan to invest and dollar cost average the rest over the coming months. Dollar cost averaging is an excellent method to remove emotion from the decision making process. By investing $200 every month like clockwork, your emotions will not get in the way of decision making.

2. Risk Policies

The next lesson is related to Risk Policies. Read the following and make a decision for BOTH i and ii.

Decision (i): choose between

A. Sure gain of $240

B. 25% chance to gain $1,000 and 75% chance to gain nothing

Decision (ii): choose between

C. sure loss of $750

D. 75% chance to lose $1,000 and 25% chance to lose nothing

When faced with the above two decisions, people tend to choose A for decision (i) and D for decision (ii). Instead, when you look at things from the broader perspective, you realise how irrational we are.

A and D: 25% chance to gain $240 and 75% chance to lose $760

B and C: 25% chance to gain $250 and 75% chance to lose $750

At the heart of this is that humans are naturally risk averse when dealing with gains and risk seeking when dealing with loses. The above experiment substantiates how this can lead to suboptimal outcomes.

The lesson for investors here is that looking at the bigger picture will allow you to make better decision for your portfolio. Do not view each investment individually. Instead, review your portfolio as a whole. No matter how much you know about each business, there is always a chance that things do not go according to plan. Therein lies the case for diversification. Even if there are multiple losers in your portfolio, all you need is one or two big winners to make a worthwhile return (as long as the loses are small and gains are larger). In value investing, we always seek for capital preservation. Which involves careful study of the company’s fundamentals in order to limit our downside. More on value investing philosophies here.

3. Mental Accounts

The third lesson is on mental accounting. Mental accounting refers to the different values a person places on the same amount of money, based on subjective criteria, often with detrimental results. Essentially, we tend to compartmentalize things when making decisions and this often leads to suboptimal decisions being made. Consider the following thought experiment:

Imagine you require money to buy a house. And you own 2 stocks, one is a winner: currently worth more than what you paid. The other is a loser. Which will you sell?

Most investors will sell the winner and add a success to his record. This is because if he chose to sell the loser, he would add a failure to his record.

This is mistake that afflicts individual investors when they sell stocks from their portfolio. As Peter Lynch once said “Selling your winners and holding your losers is like cutting the flowers and watering the weeds.” The lesson here is that you should not sell your winners and keep your losers because you don’t want to realize loses. If the winning stock is still undervalued, you will be missing out on a lot of gains by selling it early. Likewise, the losing stock may remain a losing stock due to various reasons. You could have missed out something or the company fundamentals have deteriorated.

Of course, the caveat here is that there are some scenarios where you should sell your winners (when its price is irrationally high) and buy the losers (when the fall in price has nothing to do with its fundamentals). Thus, always fall back on the business fundamentals and not how the stock price has performed in the previous months.

These are merely three lessons for investors from “Thinking Fast and Slow” and is by no means exhaustive. In his book, Daniel Kahneman also tackles other heuristics and biases. It is a book filled with wisdom and countless lessons for life and more. It is a book I will definitely recommend to anyone who wants to learn more about the human mind and how decisions are made. If you are interested in learning more about investing, check out my other article on 7 Timeless Concepts From “The Intelligent Investor”.