58: Ignore Investing's Mathematical Underpinnings at Your Peril

Tracy Alloway (0:08)

Hi, and welcome to another edition of the Odd Lots Podcast. I'm Tracy Alloway.

Joe Weisenthal (0:12)

And I'm Joe Weisenthal.

Tracy Alloway (0:14)

Joe, I gotta ask, when you were at school, were you good at math?

Joe Weisenthal (0:18)

So, it's really funny that you should ask that, because, so my dad is a physics professor.

Tracy Alloway (0:24)

Oh, that's right, yeah.

Joe Weisenthal (0:24)

And he started me on math training when I was very young, and I was really good at math, and really good at mental math, and super good at multiplications, up until like fourth grade.

And then as soon as it like hit the level of like where I actually had to do work and couldn't just do stuff in my head, I just like, I just totally became very average. So I went from being like really good at math to really mediocre very fast. But I do really love math, and I do really like doing sort of math in my head and thinking about math and stuff like that.

Tracy Alloway (0:55)

So I think I have a love-hate relationship with math. I find it very, very difficult to do, and it was probably my most hated subject.

But conceptually, I think it's really interesting. And statistics, I was actually quite good at. So I like thinking about math ideas. I hate actually doing the math.

Joe Weisenthal (1:15)

I think we're probably in the same boat on this one.

Tracy Alloway (1:17)

OK, well, we're going to talk about math.

Joe Weisenthal (1:20)

And math ideas.

Tracy Alloway (1:20)

Yeah, we're not going to do math, because that would be the world's most boring podcast ever. But we are going to talk about mathematical ideas and specifically how they apply to investment and markets and finance.

Joe Weisenthal (1:32)

And we have a very cool guest who is probably better able to talk about math and investments than just about anyone else.

Tracy Alloway (1:40)

Yeah, that's right. So anyone who's ever heard of long-term capital management, you know that there was a quant there, a co-founder called Victor Higani, and basically was hugely instrumental in the founding of that firm and is a mathematical expert of the highest order, I suppose you would say.

Joe Weisenthal (1:59)

Right. And so these days, there's so much interest in, like, algorithms and computers and quantitative finance and stuff, and they were, of course, really ahead of the curve on a lot of these ideas.

And now there's much more interest. So we're going to talk about the connection between math and finance and particularly some important mathematical concepts that investors should understand.

Tracy Alloway (2:20)

Maybe we'll get an LTCM question in there, too. Who knows?

Let's bring in Victor Higani. Like I said, he was at LTCM, but he is now the CEO of Elm Partners, which is basically a portfolio of low cost index and exchange traded funds. Victor, thanks so much for joining us. So Victor, we actually brought you on after reading a paper that you did, basically about what coin tossing and the probabilities involved in coin tossing can teach us about investment. Can you tell us about that paper?

Victor Haghani (3:04)

So it came out of an experiment that I did with a colleague of mine who I worked with at Elm Partners, Rich Dewey.

And we had heard about some research that had been done involving coin flipping and how people managed situations where they were given a favorable odds kind of investment opportunity. And I don't know, I can't remember it with these things. Sometimes you can't quite remember where the ideas come from. But we decided to do this experiment where we would give participants some real money and allow them to flip a coin that was biased to come up 60% likely to come up heads, 40% tails. And we told them that to begin with. And we gave them a half an hour to flip to bet as much of their starting $25 as they wanted. And at the end, however much money they had left in their bank, we would pay them up to a maximum amount of $250. And what we found was that our participants who were pretty quantitatively trained young men and women didn't do very well. And they didn't kind of get some of the basic concepts of decision making under uncertainty, or they didn't quite get the independent nature of the flips, and the fact that it just made sense to keep betting on hedge, to bet some modest constant proportion of how much they had in their bank at any point in time on hedge.

And so, yeah, it was really interesting to think about how people were having trouble with that, and to give us some ideas for trying to help with education as well on that topic.