On Being Too Smart

https://www.bloomberg.com/news/articles/2018-03-01/harvard-b…

We talk about a lot of strategies, market timing, options, etc. More power to those who can successfully and systematically profitably pull these things off. Sure, I have done the same quite well myself in the past. But what almost always happens is we get “too smart” for our now britches and it eventually ends in a disaster of some sort as we take on more and more risk as we become so impressed with our own successes.

The link above is a story of how Harvard, thinking they were the smarter of all, blew their investments. They actually paid more than $30 million over 3 years to one of the investment managers to obtain returns that they could have obtained by a mixed equity/bond index fund.

The simple strategy of buy and hold quality would have kicked butt on any of the returns mentioned in the article, but even more so for Harvard who went out and took the most aggressive investments, with the “smartest” investment managers, employing “experts” in the field of their investments. And the result…not good. Not good at all.

Being smarter than everyone else in the room (or here, more accurately, thinking they were smarter than everyone in the room) appears to be the precise recipe for dramatic underperformance vs. the much “dumber” peers.

I thought it applicable to our discussions sometimes on investment strategies. A conversation we were having on the TTD Rule Breaker board. Discussion of options, and my discussion of using options can actually get in the way of better returns, and doing so with more risk as well.

So for whatever this example is worth to add to our investment strategy discussions. Sometimes the KISS principle, using patience as a very valuable ally as well, may be a much better technique than hiring the smartest people that Harvard can find to invest money.

Tinker

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The link above is a story of how Harvard, thinking they were the smarter of all, blew their investments.

Wow, Tinker, what a sobering story. They averaged only 4.4% over the last 10 years, well below the averages, and in an almost unremitting bull market, by using what they thought were smart advisors, to whom they paid hundreds of millions of dollars in management fees in spite of poor results (just like a hedge fund). I suspect they started to realize something was wrong after a few years, but no one wanted to be the one to say “The emperor has no clothes!” and if he had, everyone would have pooh-poohed him or her and made excuses.

Saul

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All they had to do was buy Berkshire Hathaway and similar “boring” stocks to do very well. Even a couple of well-run REIT’s would have done much better.

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They also should have had some clauses in their agreement to pay no fees unless the manager beat some kind of basic hurdle. I think Buffett only charged fees with his old partnership when he made more than 6%. Mohnish Pabrai and Guy Spier copied this arrangement with their current funds.

‘It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.’ (C. Munger.)

The sense would have been even better (to me) if he had said ‘over-intelligent’, but whatever, the point is well-made, that compounded mistakes amount to a really bad effect on compounded final returns.

After a recent foray into a commodity about which, and about the market for which I knew nothing, I feel I should write out the above 100 times!

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A conversation we were having on the TTD Rule Breaker board. Discussion of options, and my discussion of using options can actually get in the way of better returns, and doing so with more risk as well.

Tinker, as I was one of the other folks in that conversation, could you expound on whether your experience was mostly due to an opportunity cost of not having enough of a portion of your capital invested in shares for the long term?

From the other discussion (the tax and risk items are quite self-evident):
Playing w options, even when I was right, cost me returns, dramatically actually, while creating tax burden and increasing my risk. 10 years from now you may very well say, dang it, Tinker was right!

For the bolded part to have occurred, I am going to guess that the funds used for the options had an opportunity cost associated with not purchasing shares. Is that a correct guess?

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‘It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.’ (C. Munger.)…

After a recent foray into a commodity about which, and about the market for which I knew nothing, I feel I should write out the above 100 times!

Hi streina, you’re not the only one. Here’s a horror story for you. Back in the old days, maybe 30 years ago, before the internet and discount brokers, I had an account with a full service broker (Merrill Lynch, I think it was). They came up with an outside advisory service that would help you get rich in commodities. You’d pay them a fee and they’d provide specific trades for your account. After a couple of months of making small reasonable gains in things I didn’t know anything about like corn and pork bellies, they happened to put me in wheat contracts I think it was (long or short, I don’t remember). They did okay for a few days, slight gains, but then some bad news hit (or good news, if I was short) and they opened “limit down”. (What that means for those not familiar, is that the exchange limits how much a contract can move in a day. If it hits the limit it’s “limit down” and there’s no more trading. You can’t sell your contract [or if it’s a short contract you can’t buy back your short]. You are locked in. If it OPENS limit down, you never get a chance to get out, AT ALL. It opened limit down three days in a row. I lost more than 100% of what I was investing with them, and had to make up the additional by paying my broker. No more commodities, currencies, etc for me.

Saul

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wish I could recommend this 20 times

Harvard’s returns have been poor over 10 years, but this article, like many posts here there and elsewhere, confuses ‘good process’ with ‘high returns.’

They wrote down ~3% of the value of the portfolio on this particular investment, not including whatever profits and dividends they made in the interim. As noted, Mendillo made tons of money previously investing in timber for Harvard.

Surely a fair article discussing Harvard’s ability to properly value those assets for trading should net out the 2x they made money and this time they lost money? It’s intellectually dishonest otherwise.

If investors here made money on two different trades on Arista, and are now down 10% on their current holdings, would we assume they were ‘too smart’ for their own good?

There’s nothing in the article to indicate their process w/r/t timber was flawed or wrong, just the latest result.

Of course, looking at their decade’s returns, and too large foray into private equity and RE in the prior decade shows that they certainly used to have some flawed processes in Harvard Yard.

ps Any graduate there who says a $37bn fund should ‘just index’ is a moron. Indexing lost 50% in short order 2x in the past decade, not something that can be allowed to happen when you’re paying current costs and retirees/pensions. Risk matters. Trading one poor risk for another is still a bad trade.

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<<<For the bolded part to have occurred, I am going to guess that the funds used for the options had an opportunity cost associated with not purchasing shares. Is that a correct guess?>>.

Any type of losses, actual losses, and opportunity cost losses.

I am not one to say don’t do it. Do use options if you understand how in a systematic program, or to sell calls for income, or whatever works for you. And then also, that once in a decade sort of opportunity or so. Sometimes once every few years anyways, at the most. As such opportunities to go naked long with risk that is appropriate is a rare occurrence.

Mostly, for me, it has been opportunity cost. You get in a short-term mentality, want your money now! Once you make it, you move on to the next and the next and the next, getting cocky all the while.

What you end up doing is paying taxes yes, but you also use a small portion of your money to do these trades, with each such trade not mattering much to the overall scheme of things (as you might imagine, this was never my issue, but is what most people do) and they start using more and more of the more money and more and more option trades, and at some point, it does not work anymore.

So what happens when it does not work anymore? You double or triple down, because now stock prices have fallen, and what a deal they are! They are on sale! And worse, you have now lost money and you want it back. So instead of buying these “on sale” shares, you leverage with options (because you can control the same amount of shares with less money that way). And this accelerates the downfall.

Whereas, instead, had you just systematically bought the best companies in the world, understanding you won’t always make money, sometimes the share prices, as they have gone up, will go inexplicably down, but with patience, if they are great companies, whoooshhhh! Rise again they will, and you will have been systematically buying the stock when everyone else was selling.

End result, with options (naked longs or shorts anyways) you end up losing and holding an expiring ticket, with the equities you are holding an asset with no time expiration.

I am looking at this from the perspective of the guy who lost everything on Celera using margin. Even with this, had he simply systematically bought the best companies in the world 17 years ago, today he would be sitting here as a senior investor, most likely financially independent if he chose to be.

That is a very large opportunity cost.

There is also the smaller such costs even if your correct, like I gave the example with Vertex when I got a nice double out of a 50% share price rise, just missing the big money before my LEAPS expired. Took a few more months, and I would have had the huge money, but the LEAPS were expiring so what could one do.

I had the shares at $13, I could have just kept buying and holding them. Instead I settled for a far lesser, and much riskier return by going long naked LEAPS.

Finally, we are all human. Along the course of time our emotions can start playing havoc with us. Especially those close to the market. When the market goes down, you go down. You anchor on what you had, what was, instead of what can be. And you start to take riskier and stupider decisions to get back what was.

All in all, UNLESS you are in a well thought out, systematic, sophisticated options strategy (Denny as an example has one that he uses for his own purposes) you are going to have large (1) opportunity cost losses, and (2) your bad habits, which have turned you from an investor in companies to a trader in shorter term price swings in equities, will eventually cost you real and actual losses that mere patience cannot make up. The options will be gone, the money will be gone, never coming back, and the MARKET WILL TURN! It will turn. Amazon will still be churning, it will come back, or something else will, but your stock options losses will not.

(3) what happens when you have these losses but yet earlier in the year you had short term capital gains? Well, the taxes are still due! Disaster.

In the end, is it worth all of this when the KISS principle is likely to produce far better returns in the end?

Each to their own.

I find just the bad habits developed, and it does become somewhat like going to Vegas (albeit, your odds are better with us for sure) are the thing that destroys your ability to become a wealthy man in good order.

If you are younger than 34, and thinking age 50 is too far away, and too old! That simply comes from youth. Use age 40 then. Women are still beautiful at either age, the wine is sweet, the ocean water irresistible, and there is nothing better in life than waking up and doing exactly what you want to do! Every day, because you want to do it, and can do it, because you have put enough away that no one can control your life.

Pretty much the gist of it. I do not recall any great losses I made in actual big dollar terms. What I do recall is this syndrome, described above, and it will hit, UNLESS, you are very systematic, sophisticated, and stay within the program. WHICH AGAIN IS INVESTING LONG-TERM. And if you are going to invest long-term anyways, why not do it in the one proven method to achieving wealth.

But my kids (young teenagers now) won’t bother to listen to me either, so for whatever it is worth.

Tinker

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Btw/ Do you think my returns in SHOP, or NVDA would have been better if I used options? Yes, there are the taxes, and the taxes will always be short-term taxes that count as income. So as 30% from those returns. And then after you take those 70% net returns after taxes, are they still much greater than that held by just holding the equities long-term? Perhaps so, but not by that much more.

Further, then what happens you are finally wrong? SHOP crashes due to Citron from out of nowhere, or NVDA goes down because of a short-term trade war. Or shooting breaks out in Iran…

No, I do not think you can possibly make more money trading long options than you can by being a long-term investor in companies.

What you can do, is make one huge score (I started out investing with $6k, and I made a huge score on QCOM to RMBS LEAPS (I only invested $2k of my $6k in it). But that was a one time thing. RMBS had some more ups and downs, but finding such one time scores like this are rare things. But if you do get such an opportunity GO FOR IT!

But I simply find trying to “juice” up your returns with naked long options to be counterproductive.

Tinker

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Thanks for the additional commentary, Tinker.

The shift of going from recognizing that the future is unknowable to the hubris of thinking you can have some knowledge of the future price movements definitely seems like the most dangerous aspect of using options.

Setting a hard cap on the percentage of net worth to use with options is something I’ll likely institute (something less than 2% sounds like a decent maximum…maybe even only 1%).

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Vol,

One last thing. When the time comes when you absolutely have to go for it because your entire essence is screaming then go for it!

One of my largest regrets was not going for it on one occasion. Not that long ago in the scheme of things. I will not reveal it. I still made a lot of money on this investment but…my mistake was telling my spouse of my plan. I knew what I was doing and was not strong enough in character to just do it w those who had not as much confidence in what I could do. Doing extraordinary things scares people who do not understand things as you do. Means you sometimes have to exclude such people. You don’t want yes men, or no women, just people who trust and love you. Even if it is just your dog!

If I come across such an opportunity again I will not hesitate. But these things are rare, and there have been a few. Hopefully we will find such an opportunity again. Perhaps on this board! But that is wholly different from using options to juice your gains w naked calls.

KITE was one such candidate. I was most certainly not desiring such drama when that came to our knowledge. But it has been nearly 2 years since I’ve returned and would not be remiss if such an opportunity might come our way.

Thanks Volfan.

Tinker

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One last thing. When the time comes when you absolutely have to go for it because your entire essence is screaming then go for it!

That’s part of the “problem” that comes with the benefits of running a concentrated portfolio. With having a smaller universe of companies that can be followed much more closely, there have been a few recent instances where short-term prices seemed completely irrational and likely to correct in short order, thus appearing to be “fat pitches”. The following 3 examples all come from stocks for which my positions with shares amount to 23.8%, 12.4%, and 4.9% as of closing prices on 3/2/2018.

Advance warning, the following discussion will include options talk, so feel free to skip over it if options aren’t your thing.
Also, apologies in advance, since options aren’t what Saul’s board here is about, although this will somewhat tie together with some concentrated portfolio thoughts.

1.) Late last week, Arista Networks was sitting at under $250/share. On Thursday, it looks like it might have gone up to about $244. With all the discussion on the board here, I didn’t think there was much of any chance that that low price would last. I woke up Friday morning thinking “I really need to look at buying some relatively short term Arista options today”. Ultimately, I started a position with the March 2 2018 $255 strike, paying $2.40 per contract…the price of Arista actually dipped a bit just after I made my purchase, so the same strike could have been had for maybe $1.80 or less at that point for a perfect market timer. Monday, Arista shares shot up pretty nicely, closing at $260. Prior to the end of that day, I sold out of my position for $4.50 per contract as I figured share price increasing that quickly was pretty fortunate and a near double in under 2 days was pretty sweet. On Wednesday, Arista shares got as high as about $272…so the $255 strike price option then had about $17 of intrinsic value per contract. The closing price today was about $271 for >$16 of intrinsic value at expiration. So, I made a profit, so nothing to complain about…could have made a substantially larger percentage profit but c’est la vie. There was certainly a degree of luck involved with the rapidness of the share price increase, and the market today specifically was pretty crazy.

Further context/disclosure: I purchased shares of Arista Networks after-hours on 2/15/18 the day they reported earnings and some more on Thursday 2/22/18, the day before this options play.

2.) Another example was the recent UBNT price drop following the disclosure of the SEC inquiry. Due to how closely I follow the company and the depth of wouter28’s discussions about their accounting with KPMG’s signing off on everything, I had a high degree of confidence that the market had oversold Ubiquiti, thus I bought some calls options ($60 March expiration and $70 January 2020 expiration). I have already sold the March expirations for a nice profit and am still holding the 2020 $70 calls, planning to hold until they’re a long-term capital gain.

3.) Third example is NVidia’s share price drop yesterday. The drop to below $230 seemed quite irrational to me, so I ended up starting a position with the March 2 2018 $235 strike price, paying $1.20 (don’t recall the underlying price at the time). The price opened down this morning and fell further. When the price fell further, I started a position with the March 2 2018 $232.50 strike price, as I felt like the market could recover. I didn’t end up holding these long enough to get the most I could have out of them, but ended up netting a small gain across the 2 strikes. Actually this is a terrible example (unless you’re talking about an example of potentially detrimental behavior), and I shouldn’t have engaged in this degree of a short term play despite it ending in profit. The net profit with these positions was merely a fortunate occurrence, as NVDA’s rapid share price recovery today was not something that should be “expected” (the low-to-high price range here on 3/2/18 was $14.95…almost my cost basis for NVDA shares).

Actual point.) Now, to the point I intended to include relating to the NVDA situation, for any passers-by who might doubt some of Tinker’s wisdom about the allure of the potential of options. For this I will simply list the intra-day range of actual transaction prices for the 2 NVDA March 2 2018 strikes that I referenced in the prior paragraph (mostly to close out this section of thought and get it out of my head…and hopefully continue honing my investing habits and limiting short term trading to only the fattest of fat pitches).

NVDA March 2 2018 $232.50 C
Day Low: $0.15
Day High: $4.20

NVDA March 2 2018 $235.00 C
Day Low: $0.04
Day High: $1.80

Those ranges are insane and being aware of them has potential to induce all sorts of chemical releases in a human brain.

So, only the fattest of fat pitches should be swung at with options…but maintaining a concentrated portfolio could certainly cause a person to think that they’re seeing more fat pitches than they actually are.

More context/disclosure: My portfolio closed the week out at an all-time high after being down >2% (maybe >3%) at some point during the day this morning. Since starting investing in individual companies in October 2014, my portfolio’s CAGR is at 22.2% compared to 10.0% CAGR for the S&P 500 w/out dividends for the same period. Over the past 2 year period (since 2/29/2016), I’m at 57.3% CAGR compared to 18.0% for the same dividend-less S&P 500.

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Hi Volfan,

Yeah I agree, I don’t think those are the screaming opportunities Tinker was thinking about. Thanks for the reflection regarding seeing more fat pitches than there actually are. We could all probably take note as well given the returns this past year. I’m sure most of us agree NVIDIA and ANET are going to be significantly higher in 5 years time vs now, but after a drop from $307 to <250 for ANET, the price could have still gone either way in the short-medium term.

I believe Buffet even advocates going virtually all-in on certain opportunities. He’s oft mentioned he could trounce the market if he had a small portfolio, and I’m sure he would use margin or options to leverage a small portfolio. But I don’t pretend to have the aptitude he has to determine what are sure-shots.

For example, with UBNT, I’m with you and wouter. I am with the belief that the likelihood of fraud that would cause UBNT to default is miniscule. The subpoena was an amazing opportunity. I added to my position. However, it is still a ‘gamble’. Using margin here could have an effect of wiping you out. Using options could net you nothing if, like BOFI, the effect of the subpoena causes massive tailwinds for over a year on the stock price, despite the company performing.

I try to imitate top tournament poker players. Very early in the tournament, if they end up in a position where they know they have a 90% chance of winning to double or even triple their chips if they go all-in, they fold. It’s extremely tempting, but it’s not worth it - they could be knocked out early. There’s usually so many low-hanging fruit for their skill level that they don’t need to take such risks. They can bully, intimidate, and slowly take the chips from the weaker players without needing to risk the whole pot.

I imagine history is littered with screaming opportunities and examples of legends who followed their gut, bet big, and were rewarded well. But how many have lost who we’ve never heard about?


Finally, we are all human. Along the course of time our emotions can start playing havoc with us. Especially those close to the market. When the market goes down, you go down. You anchor on what you had, what was, instead of what can be. And you start to take riskier and stupider decisions to get back what was.

All in all, UNLESS you are in a well thought out, systematic, sophisticated options strategy (Denny as an example has one that he uses for his own purposes) you are going to have large (1) opportunity cost losses, and (2) your bad habits, which have turned you from an investor in companies to a trader in shorter term price swings in equities, will eventually cost you real and actual losses that mere patience cannot make up. The options will be gone, the money will be gone, never coming back, and the MARKET WILL TURN! It will turn. Amazon will still be churning, it will come back, or something else will, but your stock options losses will not.

In the end, is it worth all of this when the KISS principle is likely to produce far better returns in the end?

Each to their own.

I find just the bad habits developed, and it does become somewhat like going to Vegas (albeit, your odds are better with us for sure) are the thing that destroys your ability to become a wealthy man in good order.

If you are younger than 34, and thinking age 50 is too far away, and too old! That simply comes from youth. Use age 40 then. Women are still beautiful at either age, the wine is sweet, the ocean water irresistible, and there is nothing better in life than waking up and doing exactly what you want to do! Every day, because you want to do it, and can do it, because you have put enough away that no one can control your life.

Pretty much the gist of it. I do not recall any great losses I made in actual big dollar terms. What I do recall is this syndrome, described above, and it will hit, UNLESS, you are very systematic, sophisticated, and stay within the program. WHICH AGAIN IS INVESTING LONG-TERM. And if you are going to invest long-term anyways, why not do it in the one proven method to achieving wealth.

But my kids (young teenagers now) won’t bother to listen to me either, so for whatever it is worth.

Tinker

Thanks Tinker, love these little notes and life lessons. Reminds me of Saul’s very recommended wonderful post regarding wealth, health and youth. I’m often asked why I don’t use options, and this pretty much nails it. The KISS method (although not as simple as your 2 company port), so I can go ahead and enjoy other parts of life.

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3.) Third example is NVidia’s share price drop yesterday. The drop to below $230 seemed quite irrational to me, so I ended up starting a position with the March 2 2018 $235 strike price, paying $1.20 (don’t recall the underlying price at the time). The price opened down this morning and fell further. When the price fell further, I started a position with the March 2 2018 $232.50 strike price, as I felt like the market could recover. I didn’t end up holding these long enough to get the most I could have out of them, but ended up netting a small gain across the 2 strikes. Actually this is a terrible example (unless you’re talking about an example of potentially detrimental behavior), and I shouldn’t have engaged in this degree of a short term play despite it ending in profit. The net profit with these positions was merely a fortunate occurrence, as NVDA’s rapid share price recovery today was not something that should be “expected” (the low-to-high price range here on 3/2/18 was $14.95…almost my cost basis for NVDA shares).

Confession time, relating to temptation:
I noted that NVDA dropped down to about $230 again yesterday morning, and thought that was silly and had no good basis. With it back up to $242 now today, looks like some weekly options might have been capable of a quick triple within 2 days.

Disclosure: I have not participated in any options NVDA options this week.

Now for the truly potentially dangerous thoughts:
For a morality component to what I am thinking about, profits taken from exploiting short term price irrationalities could be justifiable for the purpose of creating value by doing a tiny, tiny part to aid in smoothing out share price changes over time.

Apologies for clogging up the board with these thoughts that only tangentially relate to the share price of one of the companies closely followed here on the board…and are mostly being typed out as a means of expunging them from my brain’s RAM.

volfan84

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Vol,

There is no morality either way. If you think :thinking: you can get better returns that way then go for it!

Be systematic and know what your doing. Remember every profit you make is taxed at your highest marginal income tax rate.

Absent a true system however, bullish naked options are transitory gains as you will lose as much or more when the market turns.

But if you enjoy :blush: it, are learning things and not risking your wealth, then have at it!

Tinker

Here’s an anecdotal bit that lines up with this…

I began investing in stocks back in early 2010, when I rolled over 2 401ks from previous employers into an IRA. I had a finance background and had been paper trading in stocks for a while and so I felt pretty comfortable investing on my own.

My first inclination was to divide the money up into 5 different stocks to start. Those stocks? AAPL, NFLX, PCLN, GOOGL, AMZN. With prices at the time the starting allocations would have worked out to

AAPL 22%
AMZN 22%
GOOG 11%
NFLX 22%
PCLN 23%

But I was so excited to have a decent chunk of money to start stock investing with I decided that was too easy. I could probably do better if I put some time in and took some calculated risks. I think there was a part of me that didn’t want to just set it and forget it and be done with it, I wanted to enjoy this and put in some work and do even better!

Basically, I tried to be too smart. And it backfired. Too much trading in and out and speculating in options.

I reformed. I recovered. I’ve done very well since.

Point is, I haven’t achieved anywhere close to the returns I would have had, had I just invested in those 5 companies like I had the initial instinct to do… AND HELD. I still keep track of the performance of those 5 since that date in a mock portfolio of what I would have today had I invested that starting sum in those companies. It’s a reminder to not overthink things and keep it simple.

For fun, the returns of those companies since then?

AAPL 435%
AMZN 1053%
GOOG 283%
NFLX 2833%
PCLN 705%

Even just $10k in these companies at the weights I mention above would be worth nearly $125k today. And that’s with a 40% drop in Apple at one point, the NFLX qwikster fiasco where the stock dropped from a split adjusted $40 or so to under $10 and multiple other “doomsday” scenarios.

So now I listen to my instincts a bit more, and one takeaway is sometimes the most obvious thing is the best course of action. While it’s fun to search for them, it’s not necessary to find that unheard of diamond in the rough to significantly outperform the market. Don’t make it too complicated. Be patient. Don’t be scared out of a company too easily. I have to remind myself of these more often because I can tend towards the other direction.

Best to all,
Michael
LULU, CROX, APPN, TREX ticker guide
long APPN, CROX, NFLX, AMZN, GOOG, PCLN, AAPL

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