On Speculation

Meditations on a dirty word

“There is intelligent speculation as there is intelligent investing.”

— The Intelligent Investor (Chapter I), Benjamin Graham

Gambling vs. Speculating

There are two kinds of games in our universe: games where the odds are known and games where they are hidden.

The odds at the casino table are known. They tell you what the rules of the game are. You can figure it out with some simple math.

Playing with chance is not what makes you a gambler.

Gambling is betting when these 3 things are true:

a.) the odds are known,
b.) the odds can’t be influenced in your favor,
c.) and — most importantly — those odds are not in your favor.

Playing on the opposite side of a gambler is called being a business. The casino is rolling the dice just like you. All a casino needs is a small advantage (51% vs. your 49% ) to cross that invisible line in the middle of the table — from “gambler” over here, to “business” over there.

You do not want to be a gambler.

But…if you can be a casino — by all means, roll dice all day.

Speculation, on the other hand, is playing in a game where the odds are hidden. And in our normal everyday life, speculation is the game that the universe has forced us to play.

The Expected Outcome

All games of probability have correct solutions.

This is known as Expected Value: multiply what you would win by the probability of winning. Multiply what you would lose by the probability of losing. Subtract the second answer from the first.

If it’s positive, you have a positive expected outcome. You will know if you are the gambler or the businessman.

Just because you made money on a bet doesn’t mean you made the correct bet. You should create space between the decision and the outcome and evaluate them independently.

Of all things, this is the hardest — the mind revolts at this idea. It’s hard to tell the lotto winner he made the wrong decision when he bought his winning ticket.

It bears repeating: in a game of probability, you can lose with a correct decision. And win with an incorrect one. But you should always bet the right way.

Be careful of how you evaluate your decisions. Be the casino.

When to Play “Lotto”

Low probability games are usually bad bets. Like Lotto and Powerball where the expected outcome is to lose everything — anything — you bet.

However, a game can be both low probability and positive expected outcome at the same time.

How? This can happen if the money at risk is very small, the prize is very big and the odds to win are just high enough.

Note: It sounds like lotto — but it is worlds apart. The probability might be low, but the expected outcome is actually in your favor, unlike lotto. You crossed the invisible line. The math worked.

Imagine Lotto where your chance to win is 6% (instead of a typical 0.000007%). A lotto with this setup would never exist in real life for obvious reasons. But if it did, then the advantage could be on your side — even though a “94% chance of losing” might sound and feel like the odds are stacked heavily against you.

I would consider good venture bets to be of this nature: odds that sound and feel “risky” — 1%, 5%, 10%… chance of winning, but have positive expected outcome in the end. (see: Black Swan Farming)

This is especially true of contentious ideas — those good ideas that initially look like bad ones. The mainstream might dismiss a strange, revolutionary idea and give it a 0% chance. But if you have insight, the true odds could be “low, yes… but actually high enough”. You wouldn’t go all in, but in these rare cases, a bet would be rational.

To summarize: not all bets with big prizes are good. And not all bets with low odds are bad.

Make sure to do the math!

The Game of Hidden Odds

Games in which the odds are hidden can be tackled with the same strategies as games where the odds are known.

Intelligent speculation, then, is making the same rational decisions based on assumed odds. Unfortunately, this is the best us mortals can do. This is the art of speculation.

The gambler is usually focused on possibility. Do the opposite: always bet on probability. Be on the side of positive expected outcome even if it’s based on assumed odds.

Assumptions, about the odds, about the way things are, are everything in this game. Calculation and logic is easy. It’s the inputs that are hard.

Logic is a sneaky trap, especially for thinkers. You can be lulled by the beauty of your own reasoning — but then fail to recognize the wrong assumptions lurking underneath your rock solid logic.

Changing assumptions that lie at the bottom are what take time. They usually involve a lot of resistance initially, but are the cause of revolutions and breakthroughs.

Finding an incorrect assumption is like finding treasure — and the deeper, lower, and more widely accepted that incorrect assumption is — the bigger the reward.

Investing is the art of finding incorrect assumptions. It is the art of finding opportunity by finding where you disagree with the world.

Don’t just reason from first principles. Challenge them too.

**** As you have probably gathered, I do not attach any bad connotations to the word speculation. Value investing in my opinion is also a form of (grounded) speculation.

The Infinite Sequence

Let us pause for a moment. What do we mean by “hidden” odds?

At the casino table, you only need to assume that the dice and cards are fair to know the odds exactly.

On the other hand, calculating the odds that “XYZ will meet earning estimates next year” requires assumptions about the free will decisions of management, of competitors, the strength of foreign economies, the actions of the Fed, breakthroughs in technology….

A dice roll only needs few assumptions — whereas a bet in the markets involves many, many assumptions that stack up. We can estimate the odds — but they will always be opinions, not mathematical certainties. The odds are hidden. (Also see chaos or the three body problem).

Just because you have done your meticulous analysis doesn’t mean you have left the realm of speculation. Unfortunately: you are still speculating. You may have felt the odds, but you will never truly see them.

Imagine reaching into a bag of colored stones. You draw one stone. It’s red. The next one…. white.


After drawing out a few:


We could start to make some educated guesses about the odds of this bag. You might reason that this bag is, probably, mostly reds.

After drawing out a hundre of these stones, you might get very confident and bold in your call. But — we will never know what the true distribution of the colors were inside the bag until the final stone is drawn. The final stone tells all.

Now consider: time hides an eternity of “stones” in the dark…

It is critical that you account for this immovable curtain. In a card game where expected outcome is on your side, you can simply protect yourself from bad luck by being well capitalized.

But in a game of hidden odds, you must increase this moat and also protect yourself from being absolutely wrong about those odds in the first place.

Predictions vs. Forecasts

TV pundits earn their money from making confident predictions. Tarot card readers, too. They sound bold, certain, authoritative. Like a true expert.

Forecasts, on the other hand, are almost never 100% confident. They speak in probabilities. And they shift over time. Forecasts are what weather scientists do. Be a weather forecaster.

It’s not about how often you change your mind — but why you do it. If you vigilantly look for information to change your mind and look at the right things — you will likely find that you change your mind less.

The price dropped 3 seconds ago. Should you sell? Now it is up. Should you buy? Did the above say something meaningful about the future? This is not to say that price itself cannot affect reality (see Reflexivity). But be clear about the causal chain behind your prediction.

Couch and hedge your predictions with caveats. Be “wishy washy”.**

Always say: “I predict X…but only if...” This does two things. First, it reveals the equation you are using. And second, it forces you to reveal your assumptions.***

If you are aware of both your assumptions and your equations, then you can evaluate and improve them. Predicting without this is like writing down an answer to a math problem without showing the work. You learn nothing from a random answer, even if it happens to be correct. Show the work and let the world teach you.

Do not invest by authority — never blindly copy, even from the most revered legends of your field. Listen, but decide via reasoning. Do your own work and see if you reach the same conclusions.

Do not attach your calls about the future to your ego. It is not just a matter of humility, it is a matter of your survival.

** Howard Marks’ memos at Oaktree are a great example. Fantastic reads — but infuriating if you are looking for “just tell me what to do” predictions about the future.

*** There is also the case for non-predictive approach to life. See Taleb’s Anti-fragile.

“We might have trouble forecasting the temperature of the coffee one minute in advance, but we should have little difficulty in forecasting it an hour ahead.”

The Predictability of Hydrodynamic Flow

Broad Strokes and Truisms

It is sometimes easier to predict what is bigger and far out in the future than something small, in the coming moment. The ripples are hard to catch, but we know the coming of the tides.

There are many things that change in this world. But it is more important to find what probably won’t, and then reason from that.

To revisit and rephrase an earlier definition: Investing is the art of finding what is inevitable, but still contentious.

There are things that people naturally underestimate. The sheer magnitude of exponential growth. The real value of things that are “imaginary” and can’t be touched.

An example of a “tide” is Bits vs. Atoms (summarized brilliantly here). These are big, lasting changes that underly human civilization. Note: like all things, this too can change, reverse, or die. But the tide moves slower, and the turns are easier to catch.

Be careful of time tested “knowledge”. Many are still speculations in disguise and should be treated with the same caveats.

For example, there is no law in physics that says the S&P500 will return 7% in the future.

This is not to say that this is an unreasonable assumption to make. But be sure you know how we got to that piece of knowledge. And always be prepared when the assumptions or equations beneath it change.

“Apples have always fallen to the ground, and always will” is different from saying “Apples fall because of a principle called gravity…”. It is a different kind of knowing.

Both kinds of knowing are important but always seek to also learn the second kind. And always question how you know.

Induction is the art of forming assumptions based on prior experience. Deduction is the art of performing valid logic on top of those assumptions.

As mere mortals, we need to perform both to make sense of the world.

circa 1956

The History of the Future

When speculating about the future, you should to not just look at history: what happened at each point in time.

You should also look at the “history of the future”: what people thought would happen next, at each point in time.

Our predictions form a parallel timeline to actual events. The “future”, as it exists in our heads, and how it emerges in culture, has an evolution, a trajectory and a pattern just like the real events themselves.

It’s a good exercise to read up on old articles and books that have met their expiry date. Books about the impending Y2K bug. Movies and Scifi written in the 50's about the very futuristic year 2010.

Our past selves react to new technologies in predictable ways. Examples like this, this and my favorite this. Unlike forecasts being made today, we can evaluate these ways of thinking with full clarity thanks to the power of hindsight.

It is tempting (and a bit fun) to laugh at older, bad predictions. Instead, recognize that we are in the same boat. Someday our current movies, our books, and what is said on TV will be viewed in the same way. Dissect the equations they used. Try and see which key assumptions they got wrong. Is there a pattern?

You will begin to see differences in how people extrapolate into the future. Compare the consensus with the outliers. What did people like Jobs or Bezos ignore about the present? Try and see with their eyes as they stood at the edge. It’s ‘85 and nobody is using a mouse. It’s ‘95 and shopping over the internet is a pain. It’s 2017. And we are looking with 2017 eyes…

Seeing with 1995 eyes: “But there’s a difference”. Bill was able to identify the Internet as a kind of “primitive” — something completely and fundamentally new, at a low level. From there he could make a leap of imagination and ignore the details of what made it (truly) “suck” at present.

Steve Jobs: The most compelling reason for most people to buy a computer for the home will be to link it into a nationwide communications network. We’re just in the beginning stages of what will be a truly remarkable breakthrough for most people — as remarkable as the telephone.

Playboy: Specifically, what kind of breakthrough are you talking about?

Steve Jobs: I can only begin to speculate. We see that a lot in our industry: You don’t know exactly what’s going to result, but you know it’s something very big and very good.

1985 Playboy Interview: Steve Jobs. A good read. Compare how the interviewer thinks vs how Steve does.

The Final word: All-in, usually isn’t

When you go “all-in” in a poker game, you never actually are. An “All-in”, in the truest sense, would mean selling the house and kids…

It’s possible to make bold bets and yet live to see another day. Companies need to make risky but smartly contained bets in order to survive (see Google X, Bell Labs, Loonshots and moonshots, and R&D in general…).

“When starting SpaceX I thought the odds of success were less than 10%, and I just accepted that I would probably just lose everything. But that maybe we would make some progress. If we could just move the ball forward, even if we died some other company could pick up the baton and keep moving it forward. So that would still do some good.”

The games we play are sub games, of sub games, of sub games… There is always one game larger. There will always be one bigger “why”. And in the largest game of all where the prizes are priceless, those crazy risks you take might not be crazy after all.