Warren Buffett is a man who needs little introduction. He’s America’s most famous and successful stock picker. His holding company Berkshire Hathaway has seen spectacular returns in the past.

This is a story that sets the stage for Roger Lowenstein’s biography Buffett. The very opening of the book is a graph comparing the astounding growth of Berkshire Hathaway, the fat line, compared to the market benchmark the Dow Jones:

It’s this graph, the awesome stock returns, that have made Buffett a household name and a legend amongst investors.

This success has brought attention on celebrity level and raises many questions. Who exactly is Buffett as a person? How did he transform from delivering Cokes door-to-door in Omaha into a mighty investor? What are his investing principles?

These are all addressed in Lowenstein’s wonderful biography. I read this book a couple years ago, and I wanted to share some of my lasting impressions for why I liked it.

(I owe a special thanks to a friend who gifted me this book–thanks for the fantastic read)

The book covers a lot of time

The biography covers some of Buffett’s childhood in the 1930s when he was instilled religious and secular values by his dad and goes until about 1995, which is about when the book was first published.

There is an entire chapter about Benjamin Graham and his influence on Buffett as well as one about how Berkshire Hathaway, a manufacturing company and cotton mill, became the name of Buffett’s holding company.

I remember liking that the book moving smoothly and not dragging in its narration.

The details are amazing

The book includes just enough detail to keeps things interesting. One of the stories I remember is about young Buffett raising money from investors.

Here is how the story goes. At the age of 26, Buffett was raising money and pitching to clients. But he was brazen and wanted to play by his rules. Some of the terms he had were: he would not disclose any of the holdings, he would only give a yearly summary of results, and he would only allow one day of December 31 for withdrawing or adding capital. And some people agreed to this!

In hindsight these investors made a great decision. But it makes me see why some people did not invest with Buffett given the tremendous risk and secrecy of it all. I have a feeling I would not have invested in a young guy asking for such strict terms.

The personal side

The book also has interesting personal details, so it’s not all business. There are stories beyond his love for Coca-Cola and his modest house in Omaha. Some that I remember are how he got married and how he pored over newspapers and data as his craft.

Lowenstein did a great job of interviewing close friends and relatives and incorporating this in the book.

Check it out

In conclusion, I highly recommend Roger Lowenstein’s Buffett: The Making of an American Capitalist both for how it is written and its fascinating topic matter–it’s well worth a read.

In honor of St. Patrick’s Day, here’s a classic puzzle that works well as a bar game.

The only thing you need is enough beer coasters to cover a table. You can ask a server for them or you can bring some from home (beer coasters are cheap)

The rules

Here is how the game works:

–Someone goes first and places a coaster anywhere on the table

–The other person goes by placing a coaster anywhere else that’s open on the table

–The game continues with each player moving in turn to place a coaster on the table

–The winner of the game is the person who puts down the last coaster, i.e., there is no more open space on the table

To make it interesting, you can play with a rule that the loser has to buy the next round.

It’s a simple game, so what’s the best way to play? Is it better to go first or second? Is there a winning strategy?

I don’t think it matters if the table is round or rectangular, nor does it matter if the coaster is round or a square. My answer for the two-person game is in the comments.

Variations

The two person game is fun to analyze but perhaps that makes it less fun to repeat. Here are a few ways to spice up the game:

–Start the table with a random configuration of coasters and then flip a coin to see who goes first.

–Play this game with more than two players–the strategy quickly becomes more complicated!

–Try this game at a dinner party using small plates on a dining table.

Try this game and its variations out and let me know what you think!

(Just be careful if your opponent also reads this blog and you’re doing the two-person game)

Do you know of a cool bar game? Let me know and I’ll feature it so you can share your game.

Diversification is usually discussed as a method to lower risk. And rightly so: investing in many stocks reduces the influence of any particular holding.

But there is another, lesser talked about benefit to diversification: big returns for long-term investors.

I learned about this benefit during a high school investment seminar, and it has stuck with me till this day. The example was refreshing and I hope you’ll find it interesting as well.

An exercise

Suppose you are looking to invest $10,000. You’re looking to invest for retirement 25 years later.

You have two investment choices with the following characteristics:

Investment A

Offers an expected annual return 6.25% if you invest all $10,000

Investment B

Offers a blended return and money is invested in five chunks:

• $2,000 is risky and may get lost totally
• $2,000 is safe and breaks even
• $2,000 is expected to earn 5% annually
• $2,000 is expected to earn 10% annually
• $2,000 is expected to earn 15% annually

Which investment returns more over a 25 year period? (assuming expected returns are realized)

The answer

It surprised me to learn it was investment B that won out–and by a large margin at that!

Here is the year by year breakdown:



You can see that the safe investment is a better choice for a long time. It takes about 10 years before investment B starts to look better.

But in the end, it is the compounding returns of the diversified portfolio’s high-returning chunks that win out.

The final values after 25 years are investment A is worth about $45,550 versus investment B is worth $96,280–quite the difference.

So whenever I invest in a diversified portfolio, I remind myself to keep a long-term view about the gains.

Addendum: more realistic returns

My friend points out the example is slightly misleading because 15 percent is an aggressive expectation, not one that is sustainable over 25 years.

So let’s take a more realistic example. Suppose the guaranteed return is more like 4 percent, and the tiered diversified portfolio returns 5, 7.5, and 10 percent. Even in this case the diversified portfolio comes out on top: $42,640 versus $26,660. The diversified portfolio also lags for about 10 years.

Diversification still wins though the total returns are not as much in either case. The caveat therefore is these returns are all illustrative and should not be taken as practical expectations.

Patterns are fun to find in Google trends, a tool that visualizes search traffic volume.

Look at the graph for the search term IRS in the United States:

The graph generally has two spikes yearly. Why might this be? I’ll take a guess.

The first spike is in Jan-Feb when people are probably double-checking definitions and new rules (what is a dependent, how much charity is deductible, etc)

The second spike is for April when people are likely scrambling to file near the deadline.

(And if you’re wondering, the lower, more regular graph, is about news references and shows fewer spikes.)

I’m working on tax stuff now…not quite last minute, but definitely contributing to the March traffic.

How’s your tax prep going?

I came across an interesting video clip about bluffing in poker.

The video clip features mathematician Ken Binmore and concerns betting strategy in poker. Binmore explains why poker pros bluff wildly and suggests the reason why amateurs don’t bluff enough.

The advice was timely as it actually helped me in my most recent friendly poker game. Though admittedly, I am far from arriving at an optimal mix.

Here is the two minute video clip, courtesy of ponderabout.com. Be sure to watch till the end with the Star Trek clip of a virtual reality poker game between Stephen Hawking, Albert Einstein, Isaac Newton, and Data:

Link to Youtube video The art of bluffing

My transcription of the video

[Narrator] Game theory. That means using equations and logic to work out the best way to play a game. One of the games mathematician Ken Binmore enjoys studying is poker.

[Binmore] You have to go to the world poker championships–you know where they play for millions of dollars, very experienced players–and you see them sit at the table. And they bluff like crazy, with really bad hands, with really large sums of money. This is what turned me on to game theory in the first place. And I just didn’t believe it could be optimal to bluff so much, as is frequently the case in game theory.

[Narrator] Okay, I’m going to try this out on Friday night.

[Binmore] Haha. You probably don’t bluff enough, because the reason you are bluffing is not because you might win it. You are bluffing because you want to be called sometimes when you are bluffing so that people can see that sometimes when you bet high, you have a bad hand. If you never bet big with a bad hand, as soon as you bet big, everyone will know you have a good hand, so you will make no money on your good hands. So you bet big on some bad hands so that you will make a lot of money on your good hands.

[Narrator] So game theory is all about developing strategy, and it turns out to be a mix of highly complex mathematics with a large dollop of psychology thrown in.

(Rest is about poker game in Star Trek–just watch it!)

How much punishment is enough?

This is an interesting question for game theory. One of the reference models is the repeated Prisoner’s dilemma where players have to use the threat of punishment as a means to achieve cooperation.

Sometimes harsh punishment is the right move. I discussed this before in the context of the grim trigger strategy used in estate planning, specifically the Crummey trust.

But often excessive punishment is the wrong move. Ashish asks me the following question:

My economics professor talked about why Draconian laws don’t work in real life (if you steal an apple, we will chop your hands off)…Can you tell me how that works from a game theoretic standpoint? Why do cops need speeders? Why aren’t speeding tickets draconian – we take your car if you speed beyond 90 mph?

This is a very interesting topic, so let me give a few thoughts.

The short answer

One issue is that excessive punishment can lead to more dangerous behavior. To see this, suppose anyone who speeds over 90 mph will be executed, and consider a speeding driver being chased by the cop. How will this turn out?

The speeder faces death if he gets caught. So in a sense, he has nothing to lose from trying to evade the cop. He will drive faster and faster. He might think, hey why not speed and try to escape? I am going to executed if I am caught. I will resist with full force.

This example might seem trivial, but it is illustrative. The same type of logic happens with enemy soldiers who face excessive punishment and interrogation, as discussed briefly in Zachary Shore’s nice book Blunder: Why Smart People Make Bad Decisions.

Another cost of excessive punishment

The topic of setting punishment is also discussed in the fun game theory book Thinking Strategically.

Here is an excerpt from a chapter regarding the Prisoner’s dilemma that discusses another issue with excessive punishment:

Next we ask how severe a punishment should be. Most people’s instinctive feeling is that it should “fit the crime.” But that may not be big enough to deter cheating. The surest way to deter cheating is to make the punishment as big as possible. Since the punishment threat succeeds in sustaining cooperation, it should not matter how dire it is. The fear keeps everyone from defecting, hence the breakdown never actually occurs and its cost is irrelevant.

The problem with this approach is that it ignores the risk of mistakes. The detection process may go wrong…If punishment is as big as possible, then mistakes will be very costly. To reduce the cost of mistakes, the punishment should be the smallest size that suffices to deter cheating. Minimal deterrence accomplishes its purpose without imposing any extra costs when the inevitable mistakes occur. (105-106)

Mistakes in detection and miscommunications are frequent in business and personal relationships, and excessive punishment raises the cost of these errors.

Summary

It seems strange, but economics and game theory show why zero crime or full compliance may be unrealistic goals. There is usually an optimal level of punishment that can both deter crime at a cost effective level with low costs of mistakes.

After a late night out, I found myself at the only eatery still open in the suburbs, the late night haven that is Denny’s.

When paying for the meal, I noticed a curious offer on the receipt that read something like:

If your receipt does not list a food or drink you ordered, let us know and you will get the item free plus a $5 gift certificate.

What is the reason behind this message? Why are they paying customers for incorrect bills?

My friend was quick to explain the logic.

The issue at hand is the principal-agent problem between Denny’s management and its wait staff. The management wants waiters to offer good service and ties compensation heavily to tips.

This system normally works. But a rogue waiter may play outside of the rules, say, by giving free drinks or food to seek a higher tip.

Denny’s management loses out big on the free food and it is unable to monitor this illegal activity.

What to do? The proposed solution is about changing the game. The offer on the receipt gives customers a reason to report fraud. Even more important, it destroys a waiter’s incentive to give free food or drinks. It might even be that the waiters have to pay for the gift card from their wages.

I’ve seen similar policies at supermarkets and other businesses where they pay customers if a cashier fails to issue a receipt. The logic would apply similarly.

Anyone ever cash in on such an offer? How did the management/cashier/waiter react?

image credit: muffet

I often end up with leftover food in the fridge. It may be because I buy groceries generously, or because I cook in bulk, or because I often bring food home from restaurants.

A while back I had a refrigerator full of leftovers including things like Parmesan cheese, a homemade vegetable soup, Chicago style pizza, and leftover gourmet sandwiches from a catered event I attended.

The situation made me deliberate, and several issues came to mind, like:

–Waste versus cost: is it better to prioritize eating all the food or the most expensive items?

–My money or not: should it matter whether I bought the food or it was given to me for free?

–Diet versus waste: is it okay to throw away gifted food because it’s unhealthy? should I throw it away and just lie to the friend that I liked it?

I’m not sure these questions can be answered generally, for all people, but there were a few thoughts that came to mind.

Waste versus cost
I run across this issue many times. There are many times when frugality and quality conflict.

The pattern is as follows. I’ll buy a ripe avocado, forgetting I already have one. I attempt not to waste anything so I eat the old and slightly overripe one first. In a few days when I get to the new one, it has turned overripe.

I feel foolish that I ended up eating two overripe products. In the pursuit of not wasting food, I have wasted quality.

I could have just as well thrown the overripe avocado and simply enjoyed the fresh one, and then bought another fresh one when the time came.

I face this pattern with leftovers too. I try to balance quality with frugality, though it is a constant struggle since I don’t wish to waste food. But I think quality is the way to go.

My money or not
I know it shouldn’t matter if I bought the food or not. This is evident from the idea of sunk costs.

The food is already purchased. It should not matter whether I paid for the pizza or whether the sandwiches I got were free from an event.

But deep down it is hard to forget. I still remember the time I threw away $10 of guacamole dip, or the time I wasted fine artisan cheese.

So I remind myself about sunk costs, and slowly I am getting better at this. I think the answer here is to prioritize the foods you enjoy.

Diet versus waste
This is perhaps the trickiest area. Occasionally a relative or family friend will be thoughtful enough to send over some food. But what to do if I don’t want it?

I would feel awful throwing it away. It seems like a real slap in the face to the chef.

But I am not always thrilled about eating the food given to me–for instance I don’t usually enjoy sweets besides chocolates, but I still end up getting Indian sweets and cakes.

I have come to a sort of halfway solution here. I usually eat a small amount so I can honestly thank the person for the food. But I usually freeze the rest so I can manage food inventory better.

What do you do?

I’ve shared a few of my experiences with leftovers and would like to hear about yours.

Do you take leftovers from restaurants?

What do you feel bad about wasting?

How can you manage unwanted food given to you?

The Prisoner’s Dilemma is a great example from game theory. The game illustrates why individuals might not cooperate even if it is their best interest to do so.

I will briefly summarize the game below, but if you’re familiar with the Prisoner’s dilemma you can safely skip ahead to the section below about poker tournaments.

The game

In the classic story, two suspects are apprehended. The police have insufficient evidence and need at least one confession to convict. The police come up with the following questioning scheme.

First, they interrogate the suspects separately to prevent communication. Second, they offer a conditional sentence to each suspect:

–If a suspect testifies, and the partner remains silent, then the testifier goes free and the other gets a 10-year prison sentence
–If both confess, then each gets a reduced 5-year sentence
–If both stay silent, then they can only be charged with a minor offense and will face a 6-month sentence

What should the prisoners’ do? It is tempting for both to stay silent and receive the minimum. But each is worried the partner might squeal and walk away, leaving the other to serve a 10-year sentence.

The strategic method is to examine each choice conditional on the other’s decision. And here is what the logic shows:

–If the partner stays silent, then it would be best to confess (no sentence) rather than stay silent (6 months)

–If the partner confesses, then it would be best to confess as well (5 years) rather than stay silent (10 years)

And this is the devious trap set up by the police. It is readily apparent that each suspect does better by confessing, and so both will confess and accept 5-year sentences.

The outcome is so devastating it feels like the police have cheated. It just feels bad that the suspects could do much better, if only they had a little more trust. But alas that is the trap the police knowingly have set.

The police win because they divided their opponents and created seemingly fair but ultimately devious conditions. And this is a lesson Las Vegas casinos have taken to heart.

Poker tournaments

My friend Jamie is a professional poker player, and he came across a great example along the lines of the Prisoner’s Dilemma.

Here is what he reports:

I played a poker tournament at Caesar’s Palace last night with the
following setup: The buy-in is $65, which gets you 2500 chips. There
is also the option to buy an additional 500 chips for $5 more, giving
you a total of 3000 chips for $70. At 1 cent/chip, this add-on sounds
like a great bargain compared to the 2.6 cents/chip of the regular
buy-in.

The kicker is that the house keeps the entire $5 add-on fee; none of
it goes into the prize pool.

It is the last sentence that reveals the devious set-up. The casinos are playing on individual incentives just like the police did to the suspects.

Since none of the extra money goes to the pot, the ideal solution would be for no one to buy the extra chips. The pot would stay the same and everyone’s chip stack would be equal at the start. This is analogous to both suspects staying silent in the Prisoner’s Dilemma.

And that is the rub. No one can be sure the other players will cooperate. It is therefore necessary analyze the decision based on what other’s might do:

–If the other players do the standard buy-in, then it would be best to buy more chips (bigger stack = more power) rather than to do the standard buy-in (equal chips)

–If the other players do the extra buy-in, then it would be best to do the extra buy-in as well (equal chips) rather than to do the standard buy-in (small chip stack)

This is a devious trick to get everyone to contribute extra money to the house.

Or, as Jamie puts it:

So while each entrant is motivated to purchase the additional chips
at a big discount, the net effect is that everyone still starts with
the same size stack, and the house is $5 richer for each entry.
Though the players are best off if everyone refuses the add-on,
any one player can gain an advantage by buying it, and thus all do.

This is a devious yet ingenious application of game theory, and I hear
all the major Vegas casinos have a similar policy.

This is a remarkable example as it about as close to textbook game theory as I’ve seen. It is apparent Jamie bought the extra chips, and I have no doubt I would do the same.

Anyone else see this practice in poker tournaments? Any ideas on how players could retaliate?

Discussion questions

1. How would you apply this lesson to selling raffle or lottery tickets? an office pool?

2. What could the players do to change the game?

3. How might the game change if the tournament is repeated annually?

4. What would happen if the extra chips could be resold among players?

A few readers pointed me to an amusing and devious bidding war featured on the site Gizmodo.

You can see the full-sized picture by clicking on the thumbnail image I’ve posted:

The postings suggest an interesting story. Someone has lost her iPod touch and is offering $50 as a reward. And someone else sees a bidding opportunity and unscrupulously offers a higher reward.

What do you make of all of this?

There are many angles and here are some of my instant reactions.

Making a serious offer

The bid topper seems to think an extra dollar will matter to the finder. But this is a curious assessment. If the finder were after money, then it would probably make more sense to steal the iPod touch–worth several hundred dollars–and resell it or gift it.

If the finder were after money, a serious bid like $100 might be more sensible.

Faking it right

The choice of $51 is a give-away that the bid is fraudulent. Imagine if the fake bidder also chose $50. Or perhaps even underbid at $40? This might give the finder second thoughts about which bid is real.

Taking a joke too far

The joke bid actually does more harm than it perhaps intends to. Such a bid may raise the suspicion that the entire thing is a scam. This is the same type of suspicion that you might feel when you get multiple emails to lose weight or make money. With spam and security, the bad tends to crowd out the good.

Anyway, these are my thoughts on the picture. What are yours?