Ted Seides, our latest guest on The Value Perspective podcast, has achieved a great deal since he started his career at the Yale University Investments Office in 1992, under the tutelage of the great David Swensen. He has run a successful multi-billion-dollar investment firm, has written two books and now hosts one of the world’s most listened-to financial podcasts. And he once lost a $1m (not-for-profit) bet to Warren Buffett.
Given the running theme of our podcast series is decision-making at times of uncertainty, this seems as good a place as any to begin our conversation. Seides has had three years to reflect on the episode – and has put a lot of effort into understanding what he is nevertheless able to sum up in just four words. “This was a losing bet, from my perspective,” he says, “but one I put in the bucket of ‘good process, bad outcome’.”
In essence, the bet boiled down to hedge funds versus the main US equity market over the decade to the end of 2017, with Buffett’s horse in the race being the Vanguard S&P 500 index fund, while Seides’ former firm Protégé Partners picked a portfolio of five funds of hedge funds. The prize – funded by each side putting $320,000 into an account that, via a zero-coupon bond, would accrue to $1m over 10 years – went to charity.
Right at the start, Buffett and Seides were each asked for their thoughts on their probability of success – and Seides and his team assessed theirs as 85%. “Our thinking at the time was as follows,” he explains. “Hedge funds are going to do their own thing. They try to generate equity-like returns – let’s think 6% to 8% a year – in a way that is relatively uncorrelated to the wider market. And we think that will continue.
“Now, back then, the return had been higher and since then it has been lower – but let’s assume we are going to see 6% to 8%, independent of what happens in the markets. The question then is what will the S&P 500 do? Given there is correlation but the S&P 500 has much more market exposure, you could imagine that, if you had a strong period for the market over those 10 years, the market would probably win.
“Equally, if you had a particularly weak period for the market, the market would probably lose – and, if it was a historically average period, well, then it is a fair bet and we would see what happened. Now, the big part of the reason I made the bet was, back in 2007, the S&P 500 was trading at historically high valuations – and let’s also keep in mind that short-term interest rates were about 4%.
“So you did not have the argument you could make today that valuations were high because interest rates were low. If you looked at all the historical data, then, you would expect that the S&P 500 was likely to have a very weak 10-year performance. In fact, from the starting valuation, the data would have told you it would have been in the lowest decile of future returns probabilistically.”
The actual percentage chance of 85% Seides gave himself was, he says, picked “out of thin air”. “Still, if you look back from 10 years later, the S&P 500 ended up being up 7% or 8% a year, despite being down in the financial crisis the first year,” he continues. “So it went down, the Fed stepped in and the market compounded at about 17% a year from March 2009 through to the end of the bet.
“If you ask the question – at the end of those 10 years, based on history, what was the probability the S&P 500, from its starting valuation, would end up at about 7% a year? – the answer was 15%. So if we had only been handicapping the S&P, 85% was actually about right – but that was only half the bet. The other half was on what hedge funds would do – and there things happened I could not have anticipated.
“We likely put too high of a probability of winning the bet based just on an assessment of the S&P, which probabilistically looked about right, but the hedge funds did not quite do their part either. So maybe that was a bit aggressive. Looking back to 2007 and making that probability assessment in the same set of conditions, maybe I would now have said 75%, but it still would have been a very high outcome.”
For his part, Buffett put his own chances of winning the bet at around 60% – although, at the time, he never really explained his thinking. When we ask Seides to speculate on how Buffett might have arrived at that number, however, he prefers to approach the question from a different angle. “I did talk to Warren,” he begins. “It was probably three or four years ago now, while I was trying to work on my own decision-making.
“And I asked him that question: what was he thinking at the time? The interesting thing is, if you read, say, his annual letter from the end of 2016 – the year before the bet ended – from everything he said about it, you would have thought he thought he had a 100% chance of winning at the time. I would argue he was suffering from some significant hindsight bias at that point in time!
“So I called Warren one day and said, ‘Hey, I don’t know if you remember this, but you said you thought your probability of winning was going to be 60%. Was it because of the valuation?’ But he just replied he did not know that much about hedge funds but thought the fees were high. So he had a very simplistic way of looking at the situation, which is actually what I was trying to call him on.
“He is absolutely right that fees are high but his argument about fees being high and that meaning the average investor loses – that is only true in a confined market, where the participants collectively make up the market return. If that is the case, that is a mathematical tautology – but the problem with using that argument against hedge funds is you are investing in two different opportunities sets.
“As such, it is more likely the relative returns of the opportunity sets will matter more than the degree of fees – and, in fact, that played out in the bet as well. To give you one example, Warren happened to pick the S&P 500 but, in those 10 years, the performance difference between the S&P 500 and international equity markets was so wide that, if he had picked the Morgan Stanley World index, say, it would have been about a wash.”
Process v outcome
Such ‘if’s or small margins can make the difference between what most people would perceive as a ‘good’ or a ‘bad’ bet or decision. And yet what we need to be focusing on as investors is not the outcome but the process through which that outcome was reached – a point neatly made by a two-by-two matrix that allows you to analyse process (good or bad) versus outcome (good or bad).
Originally promoted by the behavioural scientists J Edward Russo and Paul Shoemaker, this matrix was referenced last year by another of our podcasts guests, market strategist and author Michael Mauboussin. In words that Seides will know – and no doubt take some consolation from – he told us: “If your process is good and the outcome is bad – in other words, one of the low-probability events shows up … well, that happens.
“But if your process is well-calibrated – meaning it recognises the event happens the ‘right’ percentage of the time – then you just dust yourself off and do it again tomorrow, right? Because even when you are playing a hand in poker, say, or decision-making within a sports match, there can be things that don’t have good outcomes that were still right to do and you would want to do them over and over.”
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