Friday, June 19, 2009

Enrico Fermi's Rule

Fermi believed the ability to effectively estimate was an important skill for physicists. A good way to solve physics, and other complex problems, was by coming up with simple shortcuts to make approximate, but meaningful, calculations.

Fermi was known for his ability to make good approximate calculations with little or no actual data, hence the name. One well-documented example is his estimate of the strength of the atomic bomb detonated at the Trinity test, based on the distance traveled by pieces of paper dropped from his hand during the blast. Fermi's estimate of 10 kilotons of TNT was remarkably close to the now-accepted value of around 20 kilotons. - Wikipedia 

In physics, it is known as a Fermi problem. Here is an excerpt from an article that applies Fermi's approach to investing.

In competitions named after him (Fermi), engineering contestants were asked to estimate unusual values as closely as they could...tasks where precision is impossible, but where you can quickly estimate a range for the right answer.

So before putting a bunch of effort into measuring with precision, make a rough estimate of the answer, then decide whether it's worth going further. The competitions were meant to teach students the value of making meaningful rough estimations and to help them develop effective estimating skills.

The article also added this:


I've always thought this advice was as good for investing as for physics. And, you may be surprised to learn, Warren Buffett has been using something quite similar...

and...

Indeed, all true value investors do quick value estimations, à la Fermi, to hone in on bargains...

The article also explains a simple method to estimate the intrinsic value* of a business then closes with the following thought:

Better be approximately right than precisely wrong.

Spreadsheets not required. It also notes that that it works best for firms with predictable earnings and a strong business franchise.

Precisely valuing a business is impossible, but approximately estimating the value of a business is straightforward and becomes even easier when you focus on the great business franchises.

The reason? Qualitative judgments you make on a business are more important than the quantitative (brand strength, distribution, management capability etc). Will competition or a new technology adversely impact the economics of this business over the next ten years? Will the strengths of the franchise remain in tact? Let's say you think the economics will remain healthy and the franchise will remain strong for the next decade but you get it wrong. If that happens the detailed calculations you've made won't matter. So the qualitative stuff matters in a big way.

The article makes the point that it is much easier to correctly make those judgments with a proven franchise.

"It means we miss a lot of very big winners. But we wouldn't know how to pick them out anyway. It also means we have very few big losers - and that's quite helpful over time. We're perfectly willing to trade away a big payoff for a certain payoff." - Warren Buffett at the 1999 Annual Meeting

Check out the full article.

Adam

* Intrinsic value will increase over time for a good business franchise. An investor can attempt to estimate the present intrinsic value (a static value snapshot of something inherently dynamic) and then also make a rough judgment as to how that value is likely to change over time. If done well, the estimates should be meaningful even if rather imprecise.
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