Mailbag! Midsummer 2017 Edition

Back by popular demand, it’s the Epsilon Theory Mailbag! Today’s edition covers notes from the past two months including “Tell My Horse”, “Post-Fed Follow-Up”, “Notes From the Field”, “The Goldfinch in Winter”, “Gradually and Then Suddenly”, and a podcast or two.

Keep those cards and letters coming …

I have been in Cash for the last 4 years and feel like a Wet Monkey. Expecting a 50% Market reset that simply does not happen…

I feel that The Fed has been buying stocks via ETFs since 2013, notice the slope of SPY since 2013, with a “Buy the dip” program ….

Do you think that is possible, or just the Brain Worm talking?
– James

Sorry, James, but that’s a Brain Worm talking. The Fed doesn’t need to buy stocks directly, not like the Bank of Japan, anyway. And not like the Swiss central bank. No, the Fed has deputized each and every one of us to act on its behalf, which is really the way you want to set these things up. You want to establish a meme of Central Bank Omnipotence … err, excuse me, I meant to say “expanded forward guidance” as part of “communication policy”, so that you don’t need to get your hands dirty directly. You want to control the meme. You want to control the Brain Worm. THAT’S the power of the Common Knowledge Game.

And now two letters for the time capsule. If one of my daughters ever asks me what investing was like in the Hollow Market, I’ll show her these.

I just read through your piece (and then I read it again) [“Tell My Horse”]. It was a sobering start to the day as it pretty succinctly captured and reflected back to me my broken spirit. I used to love this business. I used to believe in its methodology and the integrity of its analytics. Now, like a priest having had a crisis of faith, I can no longer stand in the pulpit and preach the gospel. I don’t [know] what to believe. I don’t know what the message is anymore. The “markets as political utility” meme strikes me as correct, but one can’t represent that to clients much less prospects. I have slowly made “accommodations” for this environment: including a quant sleeve, including more overseas exposure, including structured ETFs. All the while, I have held to my deflationary thesis and stayed long bonds and overweighted to alternative selections. Performance has been middling but sufficient. But, there is zero joy to it. The sole satisfaction comes from still believing that I am doing the “right” thing by my clients, even though the market rarely affirms my conviction. I do surround myself with like-minded (but open minded) folks, and while there is a risk of isolating oneself in an echo chamber, the constant cacophony of mainstream narratives is more than enough to provide balance with the “bull” thesis. My real fear is that we’re so far down the rabbit hole that we’ll never again see the light of day. I don’t think this business will ever be the same again (and I don’t really even know what I mean by that). Perhaps this business was never what I thought it to be! The sole goal at this point seems to be survival. I do think there will be a massive come-uppance at some point. But if so, I know there will be little satisfaction in having been “right”. Thus, it’s just one day at a time as I try to take some comfort in the wisdom of the ages that “this too shall pass”.

So I cannot thank you enough for expressing what is at the pit of my stomach. Both in the underlying distrust of the bull market, and in the Hollow Market analogy. You see our business is in fact losing its soul.

I met with a board member of the CFA Institute who lives in our area. After beating me up on fees for a half hour, he then asked about our recent GIPS compliance project. Did we find it helpful? Was it a benefit in managing accounts?

So being well trained after years of attempting to control reactions and impulses, with varying degrees of success, I was actually able to restrain myself from both dipping his head in his soup, or erupting into a cascading use of the f bomb in its many derivative forms. But I was tactful and I pray professionally pointed in my response. That compliance with GIPS costs a full analyst position, or PM position. That as fees decrease, and costs escalate we are squeezed. That as we are squeezed we cannot do more with less, so we either have to employ less CFAs or pay them substantially less, making the skill set less valuable. Did I find it helpful? No, I found it eroding my abilities to deliver the very product he wants with no pricing power.

What I did not say, but thought about substantially on my drive home, is that the other far-reaching consequence is that the institutionalization of money management has made career risk more and more an issue, as analysts and PMs become benchmark huggers, and allocators in varying percentages. That compliance standards which now prevent personal investment destroy the skill set of the “investors” that are professional PMs. That in fact the destruction of Alpha and investing skills has been the professionalization of the industry.

So I sit here invested, raising cash, feeling stupid, wondering about my personal investing skill, as I cannot figure out where to place funds with strong conviction. It’s a strange new world we work in, Ben. I feel disoriented in this Hollow Market, not trusting the upswing in the markets. Too afraid to sell out, but too afraid to implement cash into it either….. maybe I will buy some passive product…..wait, but what about excellence?

But what about excellence? That’s the cry that goes echoing through the canyons of Midtown Manhattan, fading more and more into the distance each and every day.

Lately I’ve been thinking about the old adage: “a broken clock is right twice a day”.

It is universally accepted (sans Yellen) that a correction will occur at some point in the future. The debate isn’t so much around the existence of economic cycles but around distance (time) until the back end of the current cycle arrives. I would place us (the broad Epsilon family) among the minority who believe that the inevitable correction will occur sooner rather than later. I would also admit that we (I) have been a believer of sooner rather than later for some time now. The question I keep asking myself is that if the correction does come over the nearer term. Will we (I) be vindicated, or will we (I) have been patient enough for that broken clock to be telling the current time?

I don’t have a good answer… at least not one that is satisfying.

You and me both, brother.

I wonder what you think of the following- We know that the feds QE and the govts build up of massive debt fragilizes (to use a N.N. Taleb word- another genius) the economy. However, I wonder if you think there is a chance that these ridiculous policies will get bailed out if they just reduce GDP by some percentage points, say from 5pct to 2pct annually for some amount of years. This would cost us trillions of dollars in never realized growth over the long run, but it could all be blamed away on other factors of course. In a similar way to how a Ponzi scheme can dig itself out of a hole with a really lucky grand slam investment (Pharma boy Shkreli did it until he mouthed off on twtr).

In this case there may not be a financial asset crash and instead we just blow up at a WAY later date when swaths of countries can no longer pay their debts.

Do you see this as plausible? Or is it inevitable that assets eventually tank and the economy gets into real trouble again?
– David 

Absolutely plausible, although I’d bet on joint U.S.-Japan-Europe debt monetization as the weapon of mass jubilee if it comes to that (google “trillion dollar coin” and try not to gag). There’s nothing inevitable about any of this, including an asset price crash.

I think this is more “sky is falling” stuff and “getting out” out stocks and bonds and establishing a “short bias” has been proffered by many over the past years. Those that have acted on that advice are much poorer today. Not because they were less prudent but because after they took action to get out of stocks and bonds no one told them what to go in to…the price friction of getting out of stocks and bonds and then back in (forget the timing aspect) is very expensive. The loss of income is catastrophic if not timed properly. You appear to know exactly when to get out. Not sure how…

We all know that recoveries don’t die of old age but are always due to a Fed that is over tightening money supply. With $4T in excess reserves on the books of the major central banks, having a market accident, given how well capitalized now the US banks are, seems like a remote possibility. This Minsky moment that you’re holding up to us is either not happening, or at the very least, not happening any time soon.

You could well be right, and I’ll be the first to admit that my risk antennae have been quivering violently at seven of the last two market corrections. But that’s my job and my nature — to have risk antennae that suffer Type 1 errors (false positives) to avoid Type 2 errors (false negatives). I think that’s better than the alternative, certainly for wealth preservation, although it makes me totally unsuited for any job on the sell-side, ever.

I’ve gotta call ‘em like I see ‘em, though (which includes noting a couple of narrative-driven investable rallies, so I’m not exclusively a Cassandra), and what IS demonstrably different today as opposed to five years ago or three years ago or even one year ago is that the Fed has turned their barge around to engage in a program of rate hikes and balance sheet reductions. The ECB is in the process of turning their barge in the same direction. To paraphrase Churchill, this is not the beginning of the end of QE and negative rates and all of the other exercises in Magical Thinking we have endured over the past eight years, but it IS the end of the beginning. It IS an inflection point. It IS a change in the second derivative of monetary policy accommodation, a reduction in the acceleration of policy even if we’re not yet at a reduction in the level of accommodation.

Because if I’ve learned one thing as a student of markets and human behavior over the years, it’s this: markets, no matter how big and no matter how small, happen on the margins. Inflection points not only matter, they are everything to the Game of Markets. Some of my very first Epsilon Theory notes were about this [“2 Fast 2 Furious”], and I think they’re worth reviewing again today.

Geez – when are you guys going to get off this “the Fed rules the world mantra?” Do you really think in the board meetings during the AMZN – WFM negotiations that anyone really got up and said, “maybe we should wait and see what the Fed might do?“ Outside of the financial industry how many board meetings do you think have The Fed on the agenda?? I have asked many CEOs and funny I get the same answer — none! I’ve asked the ex-CFO of WMT – same answer – never! I asked him did the Fed ever come up in any strategic decisions, any mergers or acquisitions – same answer – NEVER! I’ve asked the CEO of Simon, retail – one would think might be influenced by rates – same answer – NEVER came up. Wake up and smell the roses – businessmen run the world – not central bankers.

I once asked my boss, the founder of a very successful investment firm, what his most important lesson learned had been. “Remember this, Ben,” he said. “It’s not about the money. It’s. About. The. Money.”

So I ask you, David, who makes the money? I mean, who literally makes The Money? And sets the price of The Money. And buys trillions upon trillions of dollars of stuff with The Money year after year after year. And has implanted a meme in everyone’s brain (except yours, apparently) that even if they’re not literally making money and buying stuff today … well, they might tomorrow. Or might not.

Do you think I enjoy delivering this message? Because I don’t. It makes me sick that global stocks added more than a TRILLION dollars’ worth of value over the past few weeks because Janet Yellen said something that was perceived as dovish. It makes me sick because global stocks will LOSE more than a trillion dollars’ worth of value if she turns around next week and says something that is perceived as hawkish. It’s a joke. It’s a perversion of what a small-l liberal market should be. But that doesn’t make it any less real.

“Businessmen run the world” … I wish that were true. But if wishes were horses, beggars would ride. Don’t be a beggar.

Where I continue to struggle, is why in the world a man like President Trump, who I believe cares about winning and self-promotion, more than the long-term success of our country, is going to appoint a Fed chair that will continue raising rates in 2018, when he knows that higher interest rates are anathema to higher stock and real estate prices, at least in the short-run?

What I have been telling my clients is that I have a hard time believing President Trump will elect someone who will make it harder for him to “appear” successful. You and I both know that our country needs higher “normal” rates as well as a much better taxation system (a national sales tax and get rid of the deductions for borrowing money) to truly stabilize and revitalize our economy in the long-run. But, you won’t get to better long-term policies without short-term pain . . . and we seem to be (as a country) in the pain-minimization mode at present.

Do you believe that President Trump will appoint a Federal Reserve Chair that will focus on the long-term health of the “real” economy, or just another Alan Greenspan groupie, who cares more about the level of the S&P than GDP?
– Joel

I think that Trump wants to have his cake and eat it, too, meaning that he needs both higher short-term rates AND a steepening yield curve (i.e., higher long-term rates) to support a reflation narrative for the 2018 and 2020 campaigns, and he thinks that a reflation narrative will keep the S&P chugging along (in particular, supportive of financials as part of a rotation away from growth and into value). That would be the narrative accompanying, say, Gary Cohn taking the FOMC reins — that the Fed is raising short-term rates and shrinking the balance sheet for the right reasons, thus steepening the yield curve. And you know that the Street would absolutely eat this narrative up, even though everyone also knows it’s just another Big Lie. Wait, did I just say that out loud? Scratch that. What I meant to say is that I, for one, welcome our new Goldman Sachs overlords!

A lot of forces want to see Trump fail. Are the current Fed and Chair carrying that same agenda? Seems like they could be a lot more powerful than the politicians and the press’ infatuation with Russia, Russia, Russia. Is there a bigger motive at work here when the Fed aggressively raises rates? “Politics Always Trumps Economics”? how about “Fed Always Trumps House/Senate Investigations?

Are there examples in the past when a Fed/Chair was working to hurt the economy to make the President look bad?
– James

Back in 1960, Richard Nixon blamed his loss to JFK in large part on the Fed’s tight monetary policy, claiming that William McChesney Martin — a Truman appointee — had deliberately sabotaged the economy to damage his incumbent candidacy (Nixon ran as Eisenhower’s VP in 1960). So when Nixon won the presidency in 1968, he got rid of Martin as soon as he could and appointed Arthur Burns, who was basically Nixon’s lapdog. Nixon famously told Burns to keep interest rates low leading into the 1972 re-election campaign, and when Burns resisted, Nixon planted negative stories about him in the press until he finally gave in. So yes, politics have always been a big part of Fed policy, and I think the Yellen Fed would be perfectly happy to hang a recession around the Donald’s neck, so long as it didn’t damage their post-Fed earning potential … err, I mean, their credibility and gravitas as prudent bankers.

Of course, what’s new today and is the biggest difference-in-degree-but-not-in-kind between Trump and Nixon is that Trump plants negative stories about everyone, including the Justice Department, which is just about the most depressing thing I can write. I’ve said it before [“Virtue Signaling, or … Why Clinton is in Trouble”] and I’ll say it again: Trump breaks us, not because of his policy specifics, but because he transforms every game we play as a country — from our domestic social games to our international security games — from a Coordination Game to a Competition Game.

I travel a LOT, speaking with investor groups all over the country, of every political persuasion. Plus I have dual citizenship, having grown up in Red America and now living in Blue America, so I speak both Good Ole Boy and Team Elite fluently and without an accent. My observation from this perch is that we are utterly divided as a country, that the polarization is getting worse, and that political entrepreneurs (including the one in the White House and a whole host of smaller players on the Democratic side) are doing what political entrepreneurs always do — they’re embracing and accelerating this sea change in our social behaviors and institutions, and they’re using Fiat News to do it.

Welcome to Westworld.

Your conclusion is very clear, but I’m confused by the path you get there. You suggest that Yellen’s response function has flipped since the Trump election (implying that she is being politically partisan?), and yet you also seem to suggest that she is being consistent with the long term real job of a central banker, which is to maintain the power of capital and so prioritizing the suppression of wage inflation. Is it just co-incidental that the job market is becoming “unstable” after Trump’s election, or has that been there, ignored, for a while, and Yellen is picking it up now as an excuse to damage Trump?

Lots of letters about the Fed wanting to damage Trump. I really don’t think there’s an animus here as much as there’s an intense desire to declare institutional victory and cement a legacy. If that legacy means a headache for the Donald … well, so be it, but that’s not the primary motivation. This has been brewing for a while. I wrote a note about this last September, called “Essence of Decision.”

Yesterday I was listening to Neil Howe’s presentation at the Mauldin Strategic Investment Conference last month, during which he suggested that a recession/downturn is exactly what Trump needs to make progress on his agenda. That is, because the economy is doing so well and stocks continue to rise, no one in DC or NY has any incentive to compromise. However, should things start to go into reverse – and Fed tightening has been the trigger for almost every recession – that’s when he can really get stuff done. Thus, in the current bizarro world we live in, malice toward Trump by the Fed could actually end up helping him.
– David

Too clever by half. I once had an analyst tell me that he wished that a stock we owned would go down so that we could buy more. Ummm … no. Neither life in markets nor life in politics works that way. Buying more may be the right reaction to an unlucky beat, but show me a PM who wants to lose today in order to win more bigly tomorrow, and I’ll show you a PM who’s not long for this world. Ditto for presidents.

Would I say there will never, ever be another financial crisis? You know probably that would be going too far, but I do think we’re much safer and I hope that it will not be in our lifetimes and I don’t believe it will be.

I dunno, Janet, that’s a statement that might not age well, the sort of thing that ends up as a rueful tagline on an otherwise distinguished career. Just ask Chuck Prince about dancing until the music stops. George W. about “Mission Accomplished”. Statements like this are rewardless risk. You know, kinda like negative interest rate bonds.

Good to hear Devin’s thoughts [podcast with Devin Anderson, “Does It Fly, Really?”], and that I wasn’t the only one who enjoyed McCullough’s take on Orville and Wilbur’s empirical method. Kill Devil Hills is sacred ground. When you talk about American Makers …. I’ve flown and kitesurfed that area frequently, keeping aware that I’m standing on the shoulders of giants.

On another note – people who misuse history – especially Thucydides – should have to read May’s Thinking in Time with their eyes wired open.

Two great books: David McCullough’s The Wright Brothers (2015) and Richard Neustadt and Ernest May’s Thinking in Time (1986). Thucydides wrote a great book, too. I’ve taught a course on it. But Brendan is right. The Peloponnesian War was 2,500 years ago. The U.S. ain’t Athens and China ain’t Sparta (much less the other way around, which would be a lot more accurate to the power dynamics that Thucydides actually described). So give it a rest, all you war hawks on both the left and the right. Just stop it with the “lessons from history” that you cherry pick. Want a lesson from Thucydides about war and conflict? Go read about the Syracuse campaign and then get back to me.

I was particularly struck by the below claim in your note [“Tell My Horse”]. I tried unsuccessfully to find a source on google, so I was wondering if you could help by pointing me in the direction of the data that supports this? “ETFs and index products — of which there are now more such aggregated securities listed on U.S. markets than the company stocks which comprise them!”

Here’s a link to the article that sourced the more-indices-than-stocks quote. I believe that the Economist also wrote a similar piece recently.

My background is science; I am/was a forestor. The late great Stephen Jay Gould was also a master of telling one story by telling the tale of another more common event. I read everything he wrote.

So you talk about diversification being the ‘bird’ for all seasons. Not as flashy as the Goldfinch [“The Goldfinch in Winter”], but more reliable. I’d like to offer a viewpoint from an ecologists POV about your field and birds.

I would offer that portfolio diversification is more like your field and surrounding forests than the occasional flock of birds that visit. Because you make the effort to knock back the growth in that field you get new plants and new plant growth, which attract flocks of birds. Even to the extent of keeping them around through the year. From an ecologists POV this is called ‘robustness’; an environment that has a greater number of species co-existing has a greater chance of maintaining a greater number of species through a greater variation of conditions.

So, you keep clearing out that field occasionally and clean out the underbrush near the edge of the forest (the interface between forest & field is where the greatest local biological diversity will occur) and you will continue to be rewarded with occasional delights of all god’s creatures. I dare say you might be visited by the Fox or even the Owl in winter.

There really is a parable for investors here.

And where there’s a parable, there’s an Epsilon Theory note not too far behind! Did you know that there’s been a widescale commercial effort in Russia to domesticate the fox through genetic modification? Sometimes these notes just write themselves.

In my client reviews, I like to leave them with something thoughtful or philosophical, and many of those nuggets start in Epsilon.

One original one I wanted to share, which has likely been thought of in a different way. “it is not often that both US stocks and bonds are at all time highs at the same time – those are the things we are thinking about while managing your money”.

Have you done any research about what that means for diversification?

Your recent posting regarding the Fed’s decision to unwind its massive securities portfolio contained the following comment:

“Or just ride your 60/40 vanilla stock/bond allocation through the cycle, which is the whole point of the 60/40 thing (even, though, of course, you’re really running a 95/5 portfolio from a risk perspective).”

Is it possible to provide a brief explanation of what you meant by “95/5 portfolio from a risk perspective?” I’m a small investor, admittedly currently following a Vanguard-inspired “vanilla” strategy.

Nothing wrong with vanilla, Jim, and to Vince’s question, yes, the Salient Brain Trust has done a tremendous amount of work on what all this means for diversification. A couple of points before I suggest further reading.

  • Allocations like 60/40 are talking about the dollar amounts you have invested in different asset classes, in this case 60% of your dollars allocated to stocks and 40% of your dollars allocated to bonds. But a dollar invested in stocks has a different amount of risk associated with it than a dollar invested in bonds; i.e., the historical volatility of the stock market is a lot higher than the historical volatility of the bond market. So from a risk “budget” perspective as opposed to a dollar budget, a 60/40 stocks-to-bonds portfolio is really more like a 95/5 stocks-to-bonds portfolio.
  • Even if stocks and bonds are positively correlated, as they have been on the way up over the past eight years and as they may be on the way down (if there’s ever a down), a diversified portfolio should still own plenty of bonds. Period.
  • When we’re thinking about diversification, it’s useful to consider dimensions beyond just stocks vs. bonds. That includes the risk/volatility dimension. That includes the asset class dimension (commodities, real assets, corporate credit as distinct from government bonds, etc.) That includes the geography dimension. That includes the classic Fama/French dimensions. That includes behavioral dimensions such as momentum. Markets radiate information on many different wavelengths, not all of which are naturally visible to the human eye, but all of which are important to take into account in a well-balanced portfolio.

For further reading, particularly on the risk-budgeting approach, I’d point you to “The Free Lunch Effect: The Value of Decoupling Diversification and Risk” and any number of whitepapers on the Salient website. I’d also recommend the AQR Library as a source of smart and useful thinking on this topic.

After reading all of these, I continue to have one question: how does one set expectations for returns? Assuming a solidly built (nothing is perfect), diversified portfolio and 10(?) years, what is the curve of return with the horizontal axis being vol tolerance…
– Matt

And one more recommendation. Rusty Guinn’s latest Epsilon Theory notes, “Whom Fortune Favors, Part 1” and “Whom Fortune Favors, Continued” answer this question from Matt. Not-to-be-missed reading for anyone who deals with portfolio construction for a living.

While your logic seems counterintuitive at first, on second thought, I get that there could be a zone where rates are still low enough that raising them is inflationary not deflationary as the world is not so black and white as the investing masses assume (i.e. too much brain damage to think in greyscale). Do you have the data to support the thesis (either in our market or a similar market … am guessing we won’t have a lot of statistical significance)?

We’ve got eight years of data on the original premise of QE — that more central bank printing of money and buying of financial assets would lead to greater amounts of money getting into the real economy to spur more real economic activity — and the inescapable conclusion is that it doesn’t happen. Money goes into bank reserves but it doesn’t get out, in a classic example of a roach motel … err, I mean a liquidity trap. That fact, which was clear to all by 2012, led to a bit of a schism in the High Church of Monetary Policy, with one Pope saying that QE 1 was a good idea, but that subsequent printing and buying sprees were a wash at best, and we should stop doing more of this. That Pope’s name, believe it or not, is Ben Bernanke, which is why the U.S. denomination of the High Church is way ahead of the other denominations in unwinding their QE experiment.

Unfortunately but unsurprisingly, the other Popes weren’t convinced when Bernanke started saying that QE doesn’t really work that well in the real economy, particularly when they saw how well it could work to prop up financial asset prices and deliver political stability. As a result, the other Popes have generally been of the mind that the answer wasn’t to do something else, but to do MOAR! than the U.S. Church ever thought possible. Hence we got negative rates and efforts to outlaw cash and direct central bank buying of equities and all the other madness of the past three years in Europe and Japan. But MOAR! didn’t work in those real economies, either, although it sure did cripple the banks, which is why Pope Draghi is now coming around to Pope Bernanke’s view.

On the reverse argument — that as central banks now start to tighten monetary policy through both traditional interest rate hikes and nontraditional balance sheet contraction, inflation and loan growth will actually start to pick up — we have zero historical evidence that this will be the case because we’ve never been in this situation before.

What we do have, however, is both a supply and a demand argument for why this will happen. On the supply side, central banks pay commercial banks interest on the reserves they hold. As the Fed raises rates, they pay the banks more interest, which — given the massive reserves in the system — is a non-trivial boost to the capital position of the banks on a present value basis. Boosting the capital ratios of the banks should make them more willing to take risk and put money out. Couple that with a steeper yield curve (see my earlier response regarding the forthcoming Gary Cohn narrative) to generate higher net interest margins on these loans, and you should see the velocity of money really pick up as banks reduce lending standards and push, push, push on getting those loans out the door.

The demand argument isn’t talked about as much, because it’s not under the direct control of the regulatory mandarins of the Fed and the ECB. Central banks control all the levers on the supply side. To repeat, they literally make The Money. And they control its distribution. But they don’t control who asks for a loan or what that loan is used for. They don’t make the demand. They can influence the demand by making the price of The Money cheaper (lower interest rates), but even there they only have direct control over the price of short-term money.

My opinion is that when the price of money gets exceptionally low AND you’ve got a massive buyer of financial assets waiting in the wings, it tilts the risk and reward of debt-taking away from making stuff and towards investing in stuff, towards what’s commonly called “financialization.” I think we see this tilt everywhere in the modern economy, particularly in the largest corporations with essentially unlimited access to capital. Why take the chance of building a new factory or launching a new growth initiative when you can generate a highly predictable and substantial earnings growth rate or return on equity through a buyback or dividend program? If you don’t have unlimited access to capital — and most small businesses don’t — then you’re limited to the avoidance of making stuff without the ability to embrace financialization. So you just stall. It’s not terrible. You’re getting by. But you’re just getting by.

So what diminishes the demand for “financialization” loans and increases the demand for “productive” loans? I promise you that it’s not cutting the price of money by another 50 basis points. On the contrary, the price of money has to go UP and the reward of markets DOWN before the risk-reward calculus of debt-taking shifts back to making stuff in the real economy.

Whew! That was a long-winded explication. Here are some letters that say it more pithily than me …

That’s just crazy enough to be totally dead on.

Your idea will also accelerate the velocity of money in the great American bingo parlor of life.
– John

The current Fed policy effectively injects liquidity into the financial system through raising the IOER rate — printing money to make interest payments on reserves banks hold on deposit at the Fed. This compares to the traditional monetary where the Fed drains reserves from the financial system to drive the Fed Funds rate higher. We are years off to getting back to traditional monetary policy. Maybe not in our lifetime.

No wonder markets are going bonkers. We believe this is why the Fed has quickened its pace to start shrinking their balance sheet. Rather than being forced to overshoot interest rates, which could adversely affect the economy, the Fed will start draining reserves through balance sheet reduction hoping to introduce some risk aversion and sense back into the giddy global markets.
– Gary

You are describing [“Gradually and Then Suddenly”] a self-reinforcing positive feedback loop whch can be described mathematically as a geometric or exponential function, until it reaches a maximum.

Has the “barge” already left the dock, or will it have done so only upon the fact of FED balance sheet run-off commencing? The jawboning this week was only a damper, contemporaneous as it was with weak data. Last month’s Draghi comments whch lifted the global sovereign yield curves, I believe, was the barge tooting its horn as it departed its mooring at the dock.

Buy DUST and hold it through the FED’s asset sales.

Interesting, apparently crazy, and probably dangerous times, indeed. Good speculation and investing. Thanks for your writing.
– Robert

So you are talking about the unintended consequences of policy-driven interest rates. Hmm. John Locke talked to the parliament about the exact same thing in 1691 (sic!). Then one and a half century later came Bastiat with “That which is seen, and that which is not seen” addressing similar concept. I’d guess Adam Smith’s “invisible hand” is related to (positive) unintended consequences as well.

That’s some of the biggest names of libertarianism 🙂

Today’s short letter was so empowering and enlightening, I almost didn’t miss your beekeeper stories or movie quotes.

The counter argument would be that each country that has tried QE, has seen their economies slip back into recession when they finally took the QE punch bowl away.

This has been true in the past in the US, Europe, Japan, and China (sort of) – so could we have a recession AND inflation?
– West Coast Investor

You mean stagflation? I kinda doubt it, because it generates an unstable political equilibrium, but it’s absolutely possible. Market gives this less than zero odds, of course, which is … interesting, from a macro trading perspective.

That said, it’s smaller businesses, those without access to the financialization goodies of the modern monetary policy system, that are already suffering from a form of stagflation-lite. And on that note …

I suspect another, and perhaps more direct, answer to your question is that while we do not have wage inflation, we have compensation inflation (compensation = wages + benefits). For example (and this may be the key driver) medical costs continue to rise much faster than overall inflation and someone is paying that. To put numbers to my example: if a company is spending $4k a year on benefits on a $40k a year employee and the cost of those benefits goes up 10% then there is 1% compensation inflation. Add that to 2.5% wage inflation and you have 3.5% compensation inflation.

I have not seen anyone write about this and that may be due to the fact that there is a scarcity of good data on the subject. I am aware of this only because I have been a small company CEO.

By the way and for what it’s worth, wages in the construction industry are already off to the races. We are paying our professionals/ semi-professionals and experienced people probably 30% more than 2-3 years ago. At a meeting yesterday with one of the large Gen Contractors, they told me young guys are heading straight into field jobs out of the construction management schools (Auburn, Clemson, Ga Tech, etc) where they can make a lot more than they could coming in to an office as a trainee. This ship has turned fast in our business. I guess the difference is that we (as non-public entrepreneurs) ARE investing significantly. Just a data point thought you might want to hear.
– Alan

You don’t have to wonder, we are at 4.3% unemployment and were not seeing acceleration yet, so clearly NAIRU has been structurally lower this cycle. The other thing that is clear we will get there and it is not years away, but more likely months.

If you look at states where unemployment is lower, like NH and ME, you have wages moving up in the 4-5% Y/Y range currently so we know the concept is sound. After all we are talking about the most basic principle of economics here – supply and demand.

Companies we talk to are baffled by the government numbers, they see it and are worried about maintaining margins (raising prices). There is a fair amount of anchoring and it is important to keep in mind that each crisis occurs because people are worried about the last crisis. In this case fighting the psychology of deflation.

So yes, NAIRU is lower, but it is also likely to be a coiled spring. That realization, along with a positive correlation between stocks and bonds, will sow the seeds of the next collapse.
– Alan

In exactly the same way that almost every financial advisor I speak with feels “stuck”, so does almost every small to medium business owner I speak with. There’s a trickle-down wealth effect from their personal accounts, which is all well and good, but they’re not feeling the love from the last eight years of QE in their businesses because they can’t access the financialization wonder drug of public markets. At best they get it second hand if they can find an LBO buyer. But the LBO buyers are all mega shops today, so juiced up on the financialization steroid themselves that they don’t have time to mess around with the small to medium guys.

It’s just another manifestation of the central truth of life in 2017, on every level of aggregation and scale — if you’re in the Club, life is good. If you’re not, life is very very anxious.

Ben, I just read the piece that you sent out yesterday [“Gradually and Then Suddenly”] and I have a question for you regarding productivity. Other authors that I have read have put forth the theory that productivity growth is low because we are measuring productivity in a manner that doesn’t fit the new economy. In other words, measuring widgets produced per hour is not the accurate measure of productivity in the digital economy. They admitted that we don’t know yet how to measure productivity in the digital economy but that we would be well served to think about it.

I would very much like to hear your thoughts about their theory.
– Ann

I got a lot of good letters on the Great Productivity Debate, too many to address directly in what is already an overly long Mailbag. I’ve reposted a handful below, because they do a good job of covering the waterfront. The topic deserves a full-fledged Epsilon Theory note of its own, so that’s what I’ll do next week in a new Note From the Field. I’ve already got the title picked out: “Horsepower.”

Political hamstringing of entrepreneurs, yes. Focus on stock price not business, yes. But a simpler causation is that cheap money and open borders help suppress real wages (and, via govt spending and consumer credit, both, make up for them ) and THEREFORE mean less need to substitute with invested capital, in turning keeping marginal gain to labour low-added and so reacting back on itself.
– Sean

– Justin

Can you address the role of globalization on your theory of inflation going up with monetary tightening? I believe the world is awash in industrial capacity brought on mostly by Chinese overbuilding in numerous industries. I know the Chinese can’t subsidize forever, but right now they seem to be cranking out product they have no idea where it will go. Solar panels is a great example. Look what happened to the price of solar panels since January? They are selling with a negative gross margin! Every other competitor is going out of business. I think the same may be true for steel and other industrial commodities. Why invest in more capacity when you can’t compete with a Mercantilist.
– John

My theory Ben is social networking is what’s keeping Prod Growth from happening. People are spending way too much time on FB and the like snapping selfies in front of fountains, inputting jokes and nonsense and not working!.. They’re not even driving their cars properly but stuck with their darn face in front of a nonsense networking device…my 0.02
– Steve 

I can point to one other potential reason we aren’t seeing inflation and lower productivity – at least in engineering and construction. There are a whole lot of boomers retiring and taking with them both their experience and higher pay. The new folks are coming on at much lower pay but are also much less productive. The good news, if I’m right, is that we will start to see increasing productivity as these folks are assimilated into the work place. Assuming of course we don’t have a downturn first.
– Brian

Perhaps one of the reasons productivity gains are so low is that the latest wave of the “New Economy” are companies like Uber, Door Dash and EZ Home. They provide personal services which are pretty low productivity and even with the .com overlay, there are limits to what one worker can do. For example, Uber drivers can only carry a few people around at one time, and probably only generate $60,000/yr in gross revenue working full time. The corporate organization leverages this into a high productivity and growth story on their level, but it is built on a large low productivity business. I’m sure they all have plans (fantasies?) of someday replacing all their field workers with robots, in which case productivity might soar, but that is a ways down the road.

I live in Menlo Park, Ca and the local economy (and perhaps productivity) is growing at a fast pace because companies like Uber are headquartered here. I suspect that other parts of the country are growing much more slowly or not at all because they have the low productivity economic activity that supports Uber and the like but don’t benefit from the corporate leverage.

Thanks for your stimulating articles! I never took econ but was a bad math major. To me econ theory seems to rest on two axiomatic relationships: supply and demand, unemployment and wages. In the 1980’s, we bought well-made solid wood shiny brown furniture for thousands of dollars apiece. There has been no physical depreciation, and yet those pieces today go for hundreds of dollars. Similarly for oriental rugs, sterling silver, china, etc. Only those pieces deemed worthy by the ultra-rich seem to ‘hold’ their value. Meanwhile, the overall ‘quality’ is going down (this means regular replacement of shovels, software, hardware, and phones). That combined with atrocious service (except for the ultra-rich) and regular discovery that what one just bought is actually a ‘second’ inevitably leads to consumer demand malaise, except for consumables. It is no wonder then that the children of the boomers aren’t buying material possessions, except for baby stuff. Famous economists call this area ‘aggregate demand’, and when they have to consider NIRP to stimulate aggregate demand, you know the goose is cooked. Spending on consumables, vacations, and experiences would increase; savings would decrease, and so on. The above four axiomatic econ words just do not mean much in today’s fast food, landfill economy. They are glittering generalizations of an economy that once was. I don’t know what the replacement terminology should be, but I know it’s out there somewhere.
– John

You have missed the boat on unemployment and wage inflation. As long as more people enter the work force and have the proper skills then wages do not have to increase. There are other factors but job automation and people entering the work force seem to be the current keys.
– Jam

How is the productivity improvement of the rise of Uber or Google search or online shopping on Amazon captured by the gov’t? They are not.

There are hundreds of examples like this. They don’t improve some form of production, they change how we run our personal lives by vastly improving our non working efficiency. Some technology, like smart phones, have revolutionized our personal lives and have a bleed over effect in productivity but that is minor in comparison to the non working efficiency. Since people use their smart phones at work for personal reasons you might even conclude they reduce efficiency.
– Art

I’ve never thought to link the fact that the current low growth in productivity seems to rule out the concept that technological advancements aren’t the driving force behind low wage growth.

In saying that, can you not see a case whereby technology is driving people out of once productive jobs (manufacturing etc) and into poorly productive and lower paying jobs (retail, hospitality, etc) where they work a similar amount of hours? In this case we still have the same amount of production (with machines/new tech doing the bulk of the work) AND the same amount of hours worked, but with the % of hours worked in poorly productive sectors now representing a much greater % of the overall total?

In other words, both the numerator and denominator stay the same, thus it appears productivity has slowed to stall speed, but the real story is the change in distribution as to who benefits from productivity advances AND what is happening to those displaced by technology, i.e you move from working 8hrs/day on a factory line contributing $100k/pa to GDP, to driving for a cab/Uber 8hrs/day and contributing $40k/pa?

This also explains the growth in inequality, with those who own the technology/plant benefiting from the increased productivity of their business, while “labour” suffers with stagnating/declining wages. Seems to all fit in with the secular stagnation and growth in under employment themes too.

Good letters all. To be continued next week.

I also got a lot of good letters pointing out that “it’s the debt, stupid”. In other words, that it’s going to be deflation and economic weakness just as far as the eye can see. Here are a few …

The biggest question I have about this analysis comes from the fact that all these companies that have been buying back stock this entire decade are now up to their eyeballs in debt, and (depending on how this debt is structured) rising rates are going to crush earnings and free cash flow sooner or later. This will lead to crushing the broad market and the wealth effect it has created. Inflation offers a way out, but will inflation pick up fast enough to outrun the monster of corporate debt service?

Isn’t the Fed (or shouldn’t they be) more concerned with the demographically-induced effects on consumption than they are with potential inflation? Haven’t we seen this movie before, with the biggest demographic disaster in the formerly second largest economy sucking wind for 20 years + of ZIRP? Then again, maybe Japan only had to start raising rates ca 1995 to reach escape velocity, according to your logic herein.

Isn’t the real issue the shifting of consumption and production away from the developed world to the emerging economies? Millions every day joining the global economy, urbanizing, getting credit cards and bank accounts? Isn’t the more apt analogy the one to 20th century Europe as America thrived?
In previous notes, you have discussed the possible effects of nationalist/populist leaders, both here and abroad. The real question I’m curious about: would a trade/immigration war be inflationary or deflationary?
– John

Ben, on most things we see eye to eye. However, on this one I’ll take the under. I don’t think wage inflation is or is going to be a problem at all. The 4.3% UE rate is an utter fiction. Low paying service jobs are the only ones driving any labor “growth”, and the largest segment of the population securing these jobs is people over 55 years of age. Further, I think that any Fed “tightening” will be whitewashed by other global CBs continuing to prime the pump to the tune of > $2.5TR per year. There can be no credit contraction without GDP cratering and equities falling off a cliff, and equities can’t be allowed to fall off a cliff as then the faux “recovery” narrative will be exposed and untold amounts of debt will be subject to default. Fed and all CBs are stuck. More of the same coming.
– Bill

Thanks for sending this. It is obviously appealing intuitively, because it is so counter-intuitive. It makes sense, within its own parameters. The question is will this scenario play out, and I fear that no-one knows, because no-one has ever been in this position before.

He doesn’t seem interested in the problem of the quantity of debt — public corporate and household – that are now burdening economies. But for many people, including myself, that is the primary issue.

See this as an example of what happens when you start to treat the debt as unpayable and stop pretending that it’s fine. In this case, the US is moving it from private to public debt, because the larger deficit also has to be funded. You can’t make debt disappear without huge balance-sheet consequences (aka bankruptcy).

What if the reason why corporates are not investing is because there is no final demand out there to satisfy? That the current final demand is debt-driven and not real. That demand is in secular decline, for demographic reasons (ie Harry Dent approach).

Bottom line: I don’t think he is drilling deep enough to get to the bottom of the mysteries he is discussing.
– P.

I’m actually very sympathetic to this view, that the massive debt of the world hangs like a millstone around our collective neck, preventing any sustained resurgence in growth, and you can find plenty of Epsilon Theory notes expressing that. But my views have “evolved”, to steal a line from our new White House Communications Director. I think that in the land of the blind, the one-eyed man is king. I think that 2.5% to 3% real economic growth is absolutely attainable here in the U.S., massive debt or no massive debt, and that will feel like 4-5% growth back in the day. I think that there’s enough entrepreneurialism and desire still left in the American tank that changing the debt-taking risk/reward calculus from investing in stuff (financialization, if you can get it) to making stuff can absolutely drive 2.5 – 3% real growth in this country. Will changing the risk/reward calculus be painless for markets and the real economy? No. Is it worth it? Yes

And now for a big Mailbag finish … 

On the side, I write financial poems. Here’s my latest on our fabled Fed:

Chaperoning the Dance
Arrive at the Spring Fling, not a soul on the dance floor.
For you and other teachers, watching over’s a chore.
You encourage some kids. None budge and desperation ensues.
Eventually, spike the punch and pray for the effects of the booze.
For some of the kids, all it takes is a couple of sips.
They are the brave few who start shaking their hips.
Slowly but surely, others get the urge to join in.
Satisfied by your work, success brings on your grin.
Unthinkable just a few hours ago, some ruckus is brewing.
To your horror, most students are now tobacco chewing.
We’ve much surpassed the time to encourage more fun.
You try and sneak away the punch bowl to curb this run.
Despite prospect for future hangovers, the students protest.
Your actions make you the villain, the one to detest.
Controlling the party is a thankless task.
Be careful with the power. Ration that flask!
– Tim

Actually not half bad.

It may be that you lived in an alternate universe in which Fess Parker had a different role [“Notes From the Field”], but when I wore my coonskin cap, I sang about Davy Crocket, not Daniel Boone.
– Kit

Fess Parker played both Daniel Boone AND Davy Crockett in the respective TV shows! The Daniel Boone show ran for five or six years while Davy Crockett only aired a few times as a special series on The Wonderful World of Disney. Yep, that was my Sunday night ritual — Mutual of Omaha’s Wild Kingdom, followed by whatever was showing on The Wonderful World of Disney. Simpler times, for good and for ill.

And then there’s this: scientists have embedded 5 frames of the “Horse in Motion” into the DNA of bacteria. And people think memes are far-fetched.

Gif and image written into the DNA of bacteria – BBC News

Images and a short film are inserted into bacteria DNA and recovered with 90% accuracy.

Complex times, for good and for ill.

PDF Download (Paid Subscription Required):

Whom Fortune Favors: Things that Matter #1, Pt. 2

Click here to read Part 1 of Whom Fortune Favors

Fook: There really is an answer?

Deep Thought: Yes. There really is one.

Fook: Oh!

Lunkwill: Can you tell us what it is?

Deep Thought: Yes. Though I don’t think you’re going to like it.

Fook: Doesn’t matter! We must know it!

Deep Thought: You’re really not going to like it!

Fook: Tell us!

Deep Thought: Alright. The answer to the ultimate question…of Life, the Universe, and Everything…is… “42”. I checked it thoroughly. It would have been simpler, of course, to have known what the actual question was.

— Douglas Adams, Hitchhiker’s Guide to the Galaxy

As investors, our process is usually to start from the answer and work our way back to the question. Unfortunately, the answers we are provided are usually pre-baked products, vehicle types or persistent industry conventions, which means that the answers we get when we actually focus on the questions that matter may be counterintuitive and jarring. The entire point of developing a personal code for investing is knowing which questions matter and ought to be asked first, before a single product, vehicle or style box gets thrown into the mix.

The purpose you undertake is dangerous.’ Why, that’s certain. ‘Tis dangerous to take a cold, to sleep, to drink; but I tell you, my lord fool, out of this nettle, danger, we pluck this flower, safety.

William Shakespeare, Henry IV, Part 1, Act 2, Scene 3, Hotspur

Thomasina: When you stir your rice pudding, Septimus, the spoonful of jam spreads itself round making red trails like the picture of a meteor in my astronomical atlas. But if you stir backwards, the jam will not come together again. Indeed, the pudding does not notice and continues to turn pink just as before. Do you think this is odd?

Septimus: No.

Thomasina: Well, I do. You cannot stir things apart.

Septimus: No more you can, time must needs run backward, and since it will not, we must stir our way onward mixing as we go, disorder out of disorder into disorder until pink is complete, unchanging and unchangeable, and we are done with it forever. This is known as free will or self-determination.

Thomasina: Septimus, do you think God is a Newtonian?

Septimus: An Etonian? Almost certainly, I’m afraid. We must ask your brother to make it his first enquiry.

Thomasina: No, Septimus, a Newtonian. Septimus! Am I the first person to have thought of this?

Septimus: No.

Thomasina: I have not said yet.

Septimus: “If everything from the furthest planet to the smallest atom of our brain acts according to Newton’s law of motion, what becomes of free will?”

Thomasina: No.

Septimus: God’s will.

Thomasina: No

Septimus: Sin.

Thomasina (derisively): No!

Septimus: Very well.

Thomasina: If you could stop every atom in its position and direction, and if your mind could comprehend all the actions thus suspended, then if you were really, really good at algebra you could write the formula for all the future; and although nobody can be so clever as to do it, the formula must exist just as if one could.

Septimus (after a pause): Yes. Yes, as far as I know, you are the first person to have thought of this.

— Tom Stoppard, Arcadia, (1993)

On this most important question of risk, we and our advisors often default to approaches which rely on the expectation that the past and present give us profound and utterly reliable insights into what we ought to expect going forward. As a result, we end up with portfolios and, more importantly, portfolio construction frameworks which don’t respect the way in which capital actually grows over time and can’t adapt to changing environments. That’s not good enough.

Most of these notes tend to stand on their own, but this one (being a Part 2) borrows a lot from the thinking in Part 1. If you’re going to get the most out of this note, I recommend you start there. But if you’re pressed for time or just lazy, I wanted you to take away two basic ideas:

  • That the risk decision dominates all other decisions you make.
  • That the risk decision is not exactly the same as the asset class decision.

Children of a Lazier God

Before I dive into the weeds on those ideas, however, I want to tell you about a dream I have. It’s a recurring dream. In this dream, I have discovered the secret to making the most possible money with the least possible effort.

Hey, I never said it was a unique dream.

It is, however, a unique investing case. Imagine for a moment that we had perfect omniscience into returns, but also that we were profoundly lazy – a sort of Jeffersonian version of God. We live in a world of stocks, bonds and commodities, and we want to set a fixed proportion of our wealth to invest in each of those assets. We want to hold that portfolio for 50+ years, sit on a beach watching dolphins or whatever it is people do on beach vacations, and maximize our returns. What do we hold? The portfolio only needs to satisfy one explicit and one implicit objective. The explicit objective is to maximize how much money we have at the end of the period. The implicit objective is the small matter of not going bankrupt in the process.

This rather curious portfolio is noteworthy for another reason, too: it is a static and rather cheeky case of an optimal portfolio under the Kelly Criterion. Named after John Kelly, Jr., a Bell Labs researcher in the 1950s, the eponymous criterion was formally proposed in 1956 before being expanded and given its name by Edward O. Thorp in the 1960s. As applied by Thorp and many others, the Kelly Criterion is a mechanism for translating assessments about risk and edge into both trading and betting decisions.

Thorp himself has written several must-reads for any investor. Beat the Dealer, Beat the Market and A Man for All Markets are all on my team’s mandatory reading list. His story and that of the Kelly Criterion were updated and expanded in William Poundstone’s similarly excellent 2005 book, Fortune’s Formula: The Untold Story of the Scientific Betting System that Beat the Casinos and Wall Street.  The criterion itself has long been part of the parlance of the professional and would-be professional gambler, and has also been the subject of various finance papers for the better part of 60 years. For the less prone to the twin vices of gambling and authoring finance papers, Kelly translates those assessments about risk and edge into position sizes. In other words, it’s a guide to sizing bets. The objective is to maximize the geometric growth rate of your bankroll — or the expected value of your final bankroll — but with zero probability of going broke along the way. It is popular because it is simple and because, when applied to games with known payoffs, it works.

When we moonlight as non-deities and seek to determine how much we ought to bet/invest, Kelly requires knowing only three facts: the size of your bankroll, your odds of winning and the payout of a winning and losing bet. For the simplest kind of friendly bet, where a wager of $1 wins $1, the calculation is simple: Kelly says that you should bet the difference between your odds of winning and your odds of losing. If you have a 55-to-45 edge against your friend, you should bet 10% of your bankroll. Your expected compounded return of doing so is provably optimal once you have bet against him enough to prove out the stated edge — although should you manage to reach this point, you are a provably suboptimal friend.

Most of the finance papers that apply this thinking to markets have focused on individual trades that look more or less like bets we’d make at a casino. These are usually things with at least a kinda-sorta knowable payoff and a discrete event where that payoff is determined: a single hand of blackjack, an exercise of an option, or a predicted corporate action taking place (or not taking place). It’s a lot harder to get your head around what “bet” we’re making and what “edge” we have when we, say, buy an S&P 500 ETF instead of holding cash. Unless you really are omniscient or carry around a copy of Grays Sports Almanac, you’re going to find estimating the range of potential outcomes for an investment or portfolio of investments pretty tricky. Not that it stops anyone from trying.

Since I don’t want to assume that any of us is quite so good at algebra as to write the formula for all the future, at a minimum what I’m trying to do is get us to think about risk unanchored to the arbitrarily determined characteristics and traits of asset classes. In other words, I want to establish an outside bound on the amount of risk a person could theoretically take in a portfolio if his only goal was maximizing return. Doing that requires us to think in geometric space, which is just a fancy way of saying that we want to know how the realization of returns over time ends up differing from a more abstract return assumption. It’s easy enough to get a feel for this yourself by opening Excel and calculating what the return would be if your portfolio went up 5% in one year and down 5% in the next (works for any such pair of numbers). Your simple average will always be zero, but your geometric mean will always be less than zero, by an increasing amount as the volatility increases.

So, if we knew exactly what stocks, bond and commodities would do between 1961 and 2016, what portfolio would we have bought? The blend of assets if we went Full Kelly would have looked like this:

Source: Salient 2017. For illustrative purposes only.

Only there’s a catch. Yes, we would have bought this portfolio, but we would have bought it more than six times. With perfect information about odds and payoffs, the optimal bet would have been to buy a portfolio with 634% (!) exposure, consisting of $2.00 in stocks, $3.21 in bonds and $1.13 in commodities for every dollar in capital we had. After all was said and done, if we looked back on the annualized volatility of this portfolio over those 50 years, what would we have found? What was the answer to life, the universe and everything?

44. Sorry, Deep Thought, you were off by two.

Perhaps the only characteristic of this portfolio more prominent than its rather remarkable level of exposure and leverage, is its hale and hearty annualized volatility of 44.1%. This result means if all you cared about was having the most money over a 50+ year period that ended last year, you would have bought a portfolio of stocks, bonds and commodities that had annualized volatility of 44.1%, roughly three times the long-term average for most equity markets[1], and probably five times that of the typical HNW investor’s portfolio.

And before you go running off to tell my lovely, charming, well-dressed and distressingly unsusceptible-to-flattery compliance officer that I told you to buy a 44% volatility super-portfolio, allow me to acknowledge that this requires some… uh… qualification. Most of these qualifications are pretty self-explanatory, since the whole exercise isn’t intended to tell you what you should buy going forward, or even the right amount of risk for you. This portfolio, this leverage and that level of risk worked over the last 50 years. Would they be optimal over the next 50?

Of course not. In real life, we’re not omniscient. Whereas a skilled card counter can estimate his mathematical edge fairly readily, it’s a lot harder for those of us in markets who are deciding what our asset allocation ought to look like. Largely for this reason, even Thorp himself advised betting “half-Kelly” or less, whether at the blackjack table or in the market. When asked why, Thorp told Jack Schwager in Hedge Fund Market Wizards, “We are not able to calculate exact probabilities… there are things that are going on that are not part of one’s knowledge at the time that affect the probabilities. So you need to scale back to a certain extent.”

Said another way, going Full Kelly on a presumption of precise certainty about outcomes in markets is a surefire way to over-bet, potentially leading to a complete loss of capital. Now, scaling back is easy if we are starting from an explicit calculation of our edge as in a game of blackjack. It’s not as easy to think about scaling down to, say, a Half Kelly portfolio. There is, however, another fascinating (but intuitive) feature of the Kelly Optimal Portfolio that allows us to scale back this portfolio in a way that may be more familiar: the Kelly Optimal Portfolio can be generalized as the highest return case of a set of portfolios generating geometric returns that are most efficient relative to the risk they take[2].

This may sound familiar. In a way, it’s very much like a presentation of Markowitz’s efficient frontier. Markowitz plots the portfolios that generate the most return for a given unit of risk, but his is a single-period calculation. It isn’t a geometric approach like Kelly, but rather reflects a return expectation that doesn’t incorporate how volatility and non-linearities impact the path and the resulting compound return. There have been a variety of academic pieces over the years covering the application of geometric returns to this framework, but most have focused on either identifying a single optimal geometric portfolio or on utility. Bernstein and Wilkinson went a bit further, developing a geometric efficient frontier.

All of these analyses are instructive and useful to the investor who wants to take path into account, but because the efficient frontier is heavily constrained by the assumed constraint on leverage, it’s not as useful for us. What we want is to take the most efficient portfolio in geometric terms, and take up or down the risk of that portfolio to reflect our tolerance for capital loss. In other words, we want a geometric capital market line. The intuitive outcome of doing this is that we can plot the highest point on this line as the Full Kelly portfolio. The second, and perhaps more satisfying outcome, is that we can retrospectively identify that scaling back from Full Kelly just looks like delevering on this geometric capital market line.

The below figure plots each of these items, including a Half Kelly portfolio that defines ruin as any scenario in the path in which losses exceed 50%, rather than full bankruptcy. The Half Kelly portfolio delivers the highest total return over this period without ever experiencing a drawdown of 50%.

Source: Salient, as of December 31, 2016. For illustrative purposes only.

When we de-lever from the Full Kelly to Half Kelly portfolio, we drop from a terrifying 44% annualized volatility number (which experiences an 80% drawdown at one point) to 18.5%, closer to but still materially higher in risk than most aggressive portfolios available from financial advisors or institutional investors.

This can be thought of in drawdown space as well for investors or advisors who have difficulty thinking in more arcane volatility terms. The below exhibit maps annualized volatility to maximum loss of capital over the analysis period. As mentioned, the 50% maximum drawdown portfolio historically looks like about 18.5% in volatility units.

Source: Salient, as of December 31, 2016. For illustrative purposes only.

For many investors, their true risk tolerance and investment horizon makes this whole discussion irrelevant. Traditional methods of thinking about risk and return are probably serving more conservative investors quite well. And there are some realities that anyone thinking about taking more risk needs to come to terms with, a lot of which I’m going to talk about in a moment — there’s a reason we wanted to talk about this in geometric terms, and it’s all about risk. But for those with a 30, 40 or 50-year horizon, for the permanent institutions with limited cash flow needs, it’s reasonable to ask the question: is the amount of risk in the S&P 500 Index or in a blend of that with the Bloomberg Barclays Aggregate Bond Index the right amount of risk to take? Or can we be taking more? Should we be taking more?

Did you think that was rhetorical? Nope.

Many investors can – and if they are acting as fiduciaries probably ought to — take more risk.

If every hedge fund manager jumped off a bridge…

This may not be a message you hear every day, but I’m not telling you anything novel. Don’t just listen to what your advisors, fund managers and institutional peers are telling you. They’re as motivated and influenced by career risk concerns as the rest of us. Instead, look at what they’re doing.

The next time you have a conversation with a sophisticated money manager you work with, ask them where they typically put their money. Yes, many of them will invest alongside you because that is right and appropriate (and also expected of them). But many more, when they are being honest, will tell you that they have a personal account or an internal-only strategy operated for staff, that operates at a significantly higher level of risk than almost anything they offer to clients. Vehicles with 20%, 25% or even 30% volatility are not uncommon. Yes, some of this is hubris, but some of it is also the realization on the part of professional investors that maximizing portfolio returns — if that is indeed your objective — can only be done if we strip back the conventions that tell us that the natural amount of risk in an unlevered investment in broad asset classes is always the right amount of risk.

Same thing with the widely admired investors, entrepreneurs and business operators. The individual stocks that represent their wealth are risky in a way that dwarfs most of what we would be willing to tolerate in individual portfolios. We explain it away with the notion that they are very skilled, or that they have control over the outcomes of the company — which may be true in doses — but in reality, they are typically equally subject to many of the uncontrollable whims that drive broader macroeconomic and financial market outcomes.

Then observe your institutional peers who are increasing their allocations to private equity and private real estate. They’re not just increasing because hedge funds have had lower absolute returns in a strong equity environment, although that is one very stupid reason why this is happening. It’s also happening because institutions are increasingly aware that they have limited alternatives to meet their target returns. While few will admit it explicitly, they use private equity because it’s the easiest way to lever their portfolios in a way that won’t look like leverage. In a true sense of uncertainty or portfolio level risk, when the risk of private portfolios is appropriately accounted for, I believe many pools of institutional capital are taking risk well beyond that of traditional equity benchmarks.

Many of the investors we all respect the most are already taking more risk than they let on, but explain it away because it’s not considered “right thinking.”

To Whom Much is Given

When we make the decision to take more risk, however, our tools and frameworks for managing uncertainty must occupy more of the stage. This isn’t only about our inability to build accurate forecasts, or even our inability to build mostly accurate stochastic frameworks based on return and volatility, like the Monte Carlo simulations many of us build for clients to simulate their growth in wealth over time. It’s also because the kinds of portfolios that a Full Kelly framework will lead you to are usually pretty risky. Their risk constraint is avoiding complete bankruptcy, and that’s not a very high bar. The things we have to do to capture such a high level of risk and return also usually disproportionately increase our exposure to big, unpredictable events. If you increase the risk of a portfolio by 20%, most of the ways you would do so will increase the exposure to these kinds of events by a lot more than 20%.

Taken together, all these things create that famous gap between our realized experience and what we expected going in. This is a because most financial and economic models assume that the world is ergodic. And it ain’t. I know that’s a ten-dollar word, but it’s important. My favorite explanation of ergodicity comes from Nassim Nicholas Taleb, who claims to have stolen it from mathematician Yakov Sinai, who in turns claims to have stolen it from Israel Gelfand:

Suppose you want to buy a pair of shoes and you live in a house that has a shoe store. There are two different strategies: one is that you go to the store in your house every day to check out the shoes and eventually you find the best pair; another is to take your car and to spend a whole day searching for footwear all over town to find a place where they have the best shoes and you buy them immediately. The system is ergodic if the result of these two strategies is the same.

There are infinite examples of investors making this mistake. My mind wanders to the fund manager who offers up the fashionable but not-very-practical “permanent loss of capital” definition of risk, a stupid definition that is the last refuge of the fund manager with lousy long-term performance. “Sure, it’s down 65%, but that’s a non-permanent impairment!” Invariably, the PM will grumble and call this a 7-standard deviation event because he assumed a world of ergodicity. Because of the impact of a loss like this on the path of our wealth, we’ll now have to vastly exceed the average expected return we put in our scenario models in Excel just to break even on it.

“It’s not a permanent impairment of capital!”

It matters what path our portfolios follow through time. It matters that our big gains and losses may come all at once. It matters to how we should bet and it matters to how we invest. You cannot stir things apart!

So if you’ve decided to take risk as an investor, how we do avoid this pitfall? Consider again the case of the entrepreneur.

The entrepreneur’s portfolio is concentrated, which means that much of his risk has not been diversified away. A lot of that is going to be reflected in the risk and return measures we would use if we were to plot him on the efficient frontier. That doesn’t necessarily mean his risk of ruin will appear high, and his analysis might, in fact, inform the entrepreneur that he ought to borrow and hold this business as his sole investment. He’s done the work, performed business plan SWOT analyses, competitor analyses, etc., and concluded that he has a pretty good grasp of what his range of outcomes and risks look like.

In an ergodic world, this makes us feel all warm and fuzzy, and we give ourselves due diligence gold stars for asking all the right questions. In a non-ergodic world, the guy dies using his own product. A competitor comes out of nowhere with a product that immediately invalidates his business model. A bigger player in a related industry decides they want to dominate his industry, too. And these are just your usual tail events, not even caused the complexity of a system we can’t understand but by sheer happenstance. For the entrepreneur, all sorts of non-tail events over time may materially and permanently change any probabilistic assessment going forward. How do we address this?

The first line of defense as we take more risk must be diversification. After all, there is a reason why the Kelly Portfolios distribute the risk fairly evenly across the constituent asset classes.[3]

Even that isn’t enough. Consider also the case of the leveraged investor in multiple investments with some measure of diversification, for example a risk parity investor, Berkshire Hathaway[4], or the guy who went Full Kelly per our earlier example, but without the whole perfect information thing. This investor has taken the opposite approach, which is to diversify heavily across different asset classes and/or company investments. His return expectation is driven not so much by his ability to create an outcome but by the exploitation of diversification. As he increases his leverage, his sensitivity to the correctness of his point-in-time probabilistic estimates of risk, return and correlations between his holdings will increase as well. In an ergodic world, this is fine and dandy. In a non-ergodic world, while he has largely mitigated the risk of idiosyncratic tails, he is relying on relationships which are based on a complex system and human behaviors that can change rapidly.

Thus, the second line of defense as we take more risk must be adaptive investing. Sometimes the only answer to a complex system is not to play the game, or at least to play less of it. Frameworks which adapt to changing relationships between markets and changing levels of risk are critical. But even they can only do so much.

Liquidity, leverage and concentration limits are your rearguard. These three things are also the only three ways you’ll be able to take more risk than asset classes give you. They are also the three horsemen of the apocalypse. They must be monitored and tightly managed if you want to have an investment program that takes more risk.

It’s not my intent to end on a fearful note, because that isn’t the point at all. More than asset class selection, more than diversification, more than fees, more than any source of alpha you believe in, nothing will matter to your portfolio and the returns it generates more than risk. And the more you take, the more it must occupy your attention. That doesn’t mean that we as investors ought to cower in fear.

On the contrary, my friends, fortune favors the bold.

[1] Back in 1989, Grauer and Hakansson undertook a somewhat similar analysis on a finite, pre-determined set of weightings among different assets with directionally similar results. Over most windows the optimal backward-looking levered portfolio tends to come out with a mid-30s level of annualized volatility.

[2] For this and the other exhibits and simulations presented here, I’m very grateful to my brilliant colleague and our head of quantitative strategies at Salient, Dr. Roberto Croce.

[3] And that reason isn’t just “we’re at the end of a 30-year bond rally,” if you’re thinking about being that guy.

[4] One suspects Mr. Buffett would be less than thrilled by the company we’re assigning him, but to misquote Milton Friedman, we are all levered derivatives users now.

PDF Download (Paid Subscription Required):

Algorithmic Complexes, Alpha Male Brains, and Winnie the Pooh (by Silly Rabbit)

Massively complex complexes of algorithms

Let me come straight out with it and state, for the record, that I believe the best current truth we have is that we humans, along with all other living beings, are simply massively complex complexes of algorithms. What do I mean by that? Well, let’s take a passage from the terrific Homo Deus by Yuval Noah Harari, which describes this concept at length and in detail:

In recent decades life scientists have demonstrated that emotions are not some mysterious spiritual phenomenon that is useful just for writing poetry and composing symphonies. Rather, emotions are biochemical algorithms that are vital for the survival and reproduction of all mammals. What does this mean? Well, let’s begin by explaining what an algorithm is, because the 21st Century will be dominated by algorithms. ‘Algorithm’ is arguably the single most important concept in our world. If we want to understand our life and our future, we should make every effort to understand what an algorithm is and how algorithms are connected with emotions. An algorithm is a methodical set of steps that can be used to make calculations, resolve problems and reach decisions. An algorithm isn’t a particular calculation but the method followed when making the calculation.

Consider, for example, the following survival problem: a baboon needs to take into account a lot of data. How far am I from the bananas? How far away is the lion? How fast can I run? How fast can the lion run? Is the lion awake or asleep? Does the lion seem to be hungry or satiated? How many bananas are there? Are they big or small? Green or ripe? In addition to these external data, the baboon must also consider information about conditions within his own body. If he is starving, it makes sense to risk everything for those bananas, no matter the odds. In contrast, if he has just eaten, and the bananas are mere greed, why take any risks at all? In order to weigh and balance all these variables and probabilities, the baboon requires far more complicated algorithms than the ones controlling automatic vending machines. The prize for making correct calculations is correspondingly greater. The prize is the very survival of the baboon. A timid baboon — one whose algorithms overestimate dangers — will starve to death, and the genes that shaped these cowardly algorithms will perish with him. A rash baboon —one whose algorithms underestimate dangers — will fall prey to the lion, and his reckless genes will also fail to make it to the next generation. These algorithms undergo constant quality control by natural selection. Only animals that calculate probabilities correctly leave offspring behind. Yet this is all very abstract. How exactly does a baboon calculate probabilities? He certainly doesn’t draw a pencil from behind his ear, a notebook from a back pocket, and start computing running speeds and energy levels with a calculator. Rather, the baboon’s entire body is the calculator. What we call sensations and emotions are in fact algorithms. The baboon feels hunger, he feels fear and trembling at the sight of the lion, and he feels his mouth watering at the sight of the bananas. Within a split second, he experiences a storm of sensations, emotions and desires, which is nothing but the process of calculation. The result will appear as a feeling: the baboon will suddenly feel his spirit rising, his hairs standing on end, his muscles tensing, his chest expanding, and he will inhale a big breath, and ‘Forward! I can do it! To the bananas!’ Alternatively, he may be overcome by fear, his shoulders will droop, his stomach will turn, his legs will give way, and ‘Mama! A lion! Help!’ Sometimes the probabilities match so evenly that it is hard to decide. This too will manifest itself as a feeling. The baboon will feel confused and indecisive. ‘Yes . . . No . . . Yes . . . No . . . Damn! I don’t know what to do!’

Why does this matter? I think understanding and accepting this point is absolutely critical to being able to construct certain classes of novel and interesting algorithms. “But what about consciousness?” you may ask, “Does this not distinguish humans and raise us above all other animals, or at least machines?”

There is likely no better explanation, or succinct quote, to deal with the question of consciousness than Douglas Hofstadter’s in I Am a Strange Loop:

“In the end, we are self-perceiving, self-inventing, locked-in mirages that are little miracles of self-reference.”

Let’s accept Hofstadter’s explanation (which is — to paraphrase and oversimplify terribly — that, at a certain point of algorithmic complexity, consciousness emerges due to self-referencing feedback loops) and now hand the mic back to Harari to finish his practical thought:

“This raises a novel question: which of the two is really important, intelligence or consciousness? As long as they went hand in hand, debating their relative value was just an amusing pastime for philosophers, but now humans are in danger of losing their economic value because intelligence is decoupling from consciousness.”

Or, to put it another way: if what I need is an intelligent algorithm to read, parse and tag language in certain reports based on whether humans with a certain background would perceive the report as more ‘growth-y’ vs ‘value-y’ in its tone and tenor, why do I need to discriminate whether the algorithm performing this action has consciousness or not, or which parts of the algorithms have consciousness (assuming that the action can be equally parallelized either way)?

AI vs. human performance

Electronic Frontier Foundation have done magnificent work pulling together problems and metrics/datasets from the AI research literature in order to see how things are progressing in specific subfields or AI/machine learning as a whole. Very interesting charts on AI versus human performance in image recognition, chess, book comprehension, and speech recognition (keep scrolling down; it’s a very long page with lots of charts).

Alpha male brain switch

Researchers led by Prof Hailan Hu, a neuroscientist at Zhejiang University in Hangzhou, China have demonstrated activating the dorsal medial prefrontal cortex (dmPFC) brain circuit in mice to flip the neural switch for becoming an alpha male. This turned the timid mice bold after their ‘alpha’ circuit was stimulated.  Results also show that the ‘winner effect’ lingers on and that the mechanism may be similar in humans. Profound and fascinating work.

Explaining vs. understanding

And finally, generally I find @nntaleb’s tweets pretty obnoxious and low value (unlike his books, which I find pretty obnoxious and tremendously high value), but this tweet really captured me: “Society is increasingly run by those who are better at explaining than understanding.” I pondered last week on how allocators and Funds of Funds are going to allocate to ‘AI’ (or ‘ALIS’). This quote succinctly sums up and generalizes that concern.

And finally, finally, this has nothing to do with Big Compute, AI, or investment strategies, but it is just irresistible: Winnie the Pooh blacklisted by China’s online censors: “Social media ban for fictional bear follows comparisons with Xi Jinping.” Original FT article here (possibly pay-walled) and lower resolution derivative article (not pay-walled) by inUth here. As Pooh says “Sometimes I sits and thinks, and sometimes I just sits…”

PDF Download (Paid Subscription Required):

Where’s the Punch Bowl?

On episode 23 of the Epsilon Theory podcast, we’ve assembled the all-star team — Jeremy Radcliffe (Salient’s President), Rusty Guinn (Salient’s EVP of Asset Management), Neville Crawley (Founder & CEO of Engram Labs) and of course, Dr. Ben Hunt — to discuss whether we are at the inflection point when the proverbial punch bowl is taken away, and, as investors, what we do now.

2016-07-et-podcast-itunes 2016-07-et-podcast-gplay 2016-07-et-podcast-stitcher

Gradually and Then Suddenly

“How did you go bankrupt,” Bill asked.

“Two ways,” Mike said. “Gradually and then suddenly.”

“What brought it on?”

“Friends,” said Mike. “I had a lot of friends.”

Ernest Hemingway, The Sun Also Rises (1926)

What do socialism and modern monetary policy have in common? Magical thinking. For both, it’s true on the giddy years up, and it’s true on the sad years down.

If you’ve been reading my notes immediately before and after the June Fed meeting (“Tell My Horse” and “Post-Fed Follow-up”), you know that I think we now have a sea change in what the Fed is focused on and what their default course of action is going to be. Rather than looking for reasons to ease up on monetary policy and be more accommodative, the Fed and the ECB (and even the BOJ in their own weird way) are now looking for reasons to tighten up on monetary policy and be more restrictive. As Jamie Dimon said the other day, the tide that’s been coming in for eight years is now starting to go out. Caveat emptor.

The question, then, isn’t whether the barge of monetary policy has turned around and embarked on a tightening course — it has — the question is how fast that barge is going to move AND whether or not the market pays more attention to the actual barge movements than what the barge captain says. I promise you that the barge captains of both the Fed and the ECB believe they can tighten and taper without killing the market so long as they jawbone this constantly. This is the Common Knowledge Game in action, this is the Missionary Effect, this is Communication Policy … this is everything that I’ve been writing about in Epsilon Theory over the past four years! And as we saw with the market’s euphoric reaction to Yellen’s prepared remarks for her Humphrey-Hawkins testimony last Wednesday, which were presented as oh-so dovish when they really weren’t, this jawboning strategy could absolutely work. It WILL absolutely work unless and until we get undeniably “hot” inflation numbers — particularly wage inflation numbers — from the real world.

So what’s up with that? How can we have wage inflation running at a fairly puny 2.5% (Chart 1 below) when the unemployment rate is a crazy low 4.3% (Chart 2 below) and other indicators, like the NFIB’s survey of “Small Business Job Openings Hard to Fill” (Chart 3 below) are similarly screaming for higher wages?

Chart 1: US Average Hourly Earnings, annual % change

Source: Bloomberg Finance L.P. as of 7/13/17. For illustrative purposes only.

Chart 2: US Unemployment Rate

Source: Bloomberg Finance L.P. as of 7/13/17. For illustrative purposes only.

Chart 3: NFIB Small Business Job Openings Hard to Fill

Source: Bloomberg Finance L.P. as of 7/13/17. For illustrative purposes only.

The answer, I think, can be found in Chart 4 below: vanishing labor productivity. Productivity is the amount of stuff that workers make (output) divided by the amount of time it takes them to make it (hours worked). You can have productivity growth for good reasons like in the 1980s and 1990s and early 2000s (more stuff made per hour worked as companies invested in things like the personal computer or the Internet) or bad reasons like in 2009 and 2010 (massive layoffs, so making a bit less stuff but over waaay fewer hours worked).

Productivity growth for the right reasons (I know, I sound like a contestant on The Bachelorette) is just about the most important economic goal that policy makers have, because it’s how you get your economy growing in a sustainable, non-inflationary way, and for the past seven years we’ve had none of it. By the way, if new technologies were really responsible for keeping wage inflation down (something I hear all the time), we would have seen that through increasing labor productivity. We haven’t.

Chart 4: US Labor Productivity Growth (2-year moving average)

Source: Bureau of Labor Statistics as of 7/13/17. For illustrative purposes only.

This is a huge question for the Fed, maybe the biggest question they have. How is it possible — with the most accommodative monetary policy in the history of the world, with the easiest money to borrow that corporations have ever experienced, with all the amazing technological advancements that we read about day in and day out — that companies have not invested more in plant and equipment and technology to improve their labor productivity, to make more with the people they’ve got?

The answer, of course, is the answer that the Fed will never admit. The reason companies aren’t investing more aggressively in plant and equipment and technology is BECAUSE we have the most accommodative monetary policy in the history of the world, with the easiest money to borrow that corporations have ever seen. Why in the world would management take the risk — and it’s definitely a risk — of investing for real growth when they are so awash in easy money that they can beat their earnings guidance with a risk-free stock buyback? Why in the world would management take the risk — and it’s definitely a risk — of investing for GAAP earnings when they are so awash in easy money that they can hit their pro forma narrative guidance by simply buying profitless revenue? Why in the world would companies take any risk at all when the Fed has eliminated any and all negative consequences for playing it safe? It’s like going to a college where grade inflation makes an A- the average grade. Sure, I could bust a gut to get that A, but why would I do that?

How does this apply to wage inflation? It’s the same thing. Why in the world would a company pay up to fill a position when it’s a risk they really don’t need to take? Yeah, we’ve got job openings, and yeah, our skill positions are increasingly going unfilled, and yeah, we’d like to expand and grow … I suppose. But, hey, we’re hitting our numbers just fine as it stands and, if you hadn’t noticed, our stock price hit a new high yesterday. Why mess up a good thing?

How does this change? As the Fed slowly raises rates, as the barge slowly chugs down the tightening river, it will force companies to play it less safe. It will force companies to take on more risk. It will force companies to invest more in plant and equipment and technology. It will force companies to pay up for the skilled workers they need. You want wage inflation? You want productivity growth? Then raise rates!

And god forbid if we actually get a tax reform bill passed. That’s the off-to-the-races moment.

My point is a simple one. In exactly the same way that QE was deflationary in practice when it was inflationary in theory, so will the end of QE be inflationary in practice when it is deflationary in theory. That’s the real world impact I’m talking about, the world of wages and output and productivity. You know, the real world that used to be the touchstone of our markets.

And here’s my other point. In the Bizarro-world that central bankers have created over the past eight years, raising rates isn’t going to have the same inflation-dampening effect that it’s had in past tightening cycles, at least not until you get to much higher rates than you have today. It’s going to accelerate inflation by forcing risk-taking in the real world, which means that the barge is going to have to move faster and faster the more it moves at all. I think that today’s head-scratcher for the world’s central banks — why haven’t our easy money policies created inflation in the real world? — will soon be replaced by a new head-scratcher — why haven’t our tighter money policies tamed inflation in the real world?

My view: as the tide of QE goes out, the tide of inflation comes in. And the more that the QE tide recedes, the more inflation comes in. I know that this sounds like a nutty scenario today, with everyone talking about how inflation is dead and gone, and how the Fed will be “fighting” inflation by raising rates, but I gotta call ‘em like I see ‘em. It’s a scenario that neither central banks nor markets have contemplated in any serious way, but it’s going to be a focus for Epsilon Theory.

PDF Download (Paid Subscription Required):

One Model to Learn Them All and AI Is/Isn’t Taking Over the World (by Silly Rabbit)

One model to learn them all

The Google corporation recently shared this technical paper: “One model to learn them all” (less technical write up here by VentureBeat). While the model in and of itself is not transformational, the approach is a pretty big deal as it lays out a template for how to create a single machine learning model that can address multiple tasks well.

And in other Google machine learning news, Google and Carnegie Mellon University ran an experiment using ‘enormous data,’ taking an unprecedentedly huge collection of 300 million labeled images (rather than a more typical one million images) to test whether it’s possible to get more accurate image recognition not by tweaking the design of existing algorithms but by feeding them much, much more data. The answer, unsurprisingly, is yes, you get better-trained models using enormous data sets and having fifty powerful GPUs grind on the data for two months solid.

Semantic scholar

Semantic Scholar is a neat search engine for scientific papers, which has been gaining traction with Microsoft, Google and Baidu joining the Open Academic Search working group.

Quote by Oren Etzioni, the CEO of the Allen Institute for AI (AI2), who produce Semantic Scholar: “What if a cure for an intractable cancer is hidden within the tedious reports on thousands of clinical studies? In 20 years’ time, AI will be able to read — and more importantly, understand — scientific text. These AI readers will be able to connect the dots between disparate studies to identify novel hypotheses and to suggest experiments that would otherwise be missed. AI-based discovery engines will help find the answers to science’s thorniest problem.”

AI is/isn’t taking over the world

Depending who you ask, AI is either just about to take over the world or is embryonic and trivial in its achievements to date.

In the taking-over-the-world corner, we have this canonical article titled “How AI is taking over the global economy in one chart.” The absolute comparisons of R&D budget sizes in this article (and the oversimplified social conclusions) seem pretty dubious, but the point is most likely directionally correct on the relative size of R&D spending of ‘the big eight’ compared to smaller industrialized nations, as well as the fact that the ability to fund R&D is going to be very decisive for both companies and nations over the next few decades.

For illustrative purposes only. Source: Axios 2017.

And in the embryonic-and-trivial corner, Evolutionary biologist Phil Madgwick points out that, “Artificial intelligence does not mimic natural intelligence, and it is not clear that there have been significant developments toward anything with rabbit-like intelligence, let alone human-like intelligence.”

My view: both of these things are simultaneously true in that while we are far from human-level machines, woe betide companies and countries which are currently under-investing in applied AI R&D.


MOV37, a Fund of Funds (FoF) put out their thesis/manifesto for ALIS (Autonomous Learning Investment Strategies), which, as well as being a handy anthology of every known AI trope in the last 12 months, is also, in my opinion, a pretty accurate perspective on the next wave of AI-driven investing (except for the ‘two people and a laptop’ bit, which just doesn’t jibe with anything we’re seeing in any other machine learning field, per the ‘enormous data’ link above).

The real question this piece left me with is: who is going to decide which ALIS funds to invest in? Here in the Valley, ‘Deep tech’ investors are typically ex-tech entrepreneurs with deep engineering backgrounds, so they somewhat understand what they’re investing in. What’s unclear is how the majority of FoFs and allocators are going to arrange themselves to invest in ALIS machine learning strategies without any actual experience in developing ALIS-type machine learning strategies. Perhaps the FoF strategy will be more the Consumer-VC strategy of ‘just seed a bunch of small things with limited discrimination, let most die, and wait until a couple become scaled breakouts like Instagram/Pinterest/Snapchat and return the fund.’

Time will tell.

Kai Fu Lee, Commence!

And finally, as a genre, I really like commencement speeches. Speakers seem to push themselves to ‘tell their best truth’ as well as address the meaning of their achievements (while keeping it short and accessible).

Here is a great commencement speech to the Engineering School of Columbia University by legendary engineer Kai Fu Lee (of Apple, Microsoft and Google fame).


PDF Download (Paid Subscription Required):

The Goldfinch in Winter

I’ve learned that people will forget what you said, people will forget what you did, but people will never forget how you made them feel.

Maya Angelou (1928 – 2014), author of I Know Why the Caged Bird Sings

And in our business, people will forget what price targets you set, people will forget what funds you managed, but people will never forget how you impacted their personal account.

Longer summer means longer winter.

traditional Westerosi saying

We’ve got a five acre field that I brush hog once a year if I’m feeling particularly industrious, and one day I suppose we may do something with it.

In late summer this fallow field of thistle and hay is one of my favorite spots, particularly in the early morning and late afternoon, because of the flocks of goldfinches that swoop in and around the field. The goldfinch is exactly as the name implies — a small bird with a bright yellow, almost tropical, plumage — and it looks out of place in the Northeast, like maybe it’s an escapee from a gilded cage in Greenwich. But they love these Connecticut summers, and it’s not uncommon for me to count 30 or more flying around in a swarm that at times seems to be the animal itself.

The flocks are never as big as the far more famous murmurations of starlings, which is a good thing, of course, but they generate that same sense of awe in that there is clearly some sort of order and method to the flowing chaos of all these birds moving together. Most unlike the starlings, however, is that the goldfinch flocks are absolutely beautiful. The glints of yellows and gold moving through the air like a living liquid, the morning sun piercing the flock … it’s a natural poetry that has no good reason to exist, but does all the same.

I’m as much a dilletante birdwatcher as I am a dilletante farmer, so when the beautiful yellow birds stopped making their appearances over the field every fall, I just assumed that they were like the robin, flown south for the winter. I assumed this was the case for years, And in fact some goldfinches do migrate south every year, particularly the ones who set their breeding nests up in southern Canada.

But not our goldfinches. No, our field and its thistles, together with the nearby woods and the river that runs through it, is just too good of a home base to leave even for a season (I agree!). So they don’t fly south. They don’t go anywhere at all. They stay the whole winter, there in the field and the scrub and the forest all along.

Why didn’t I see them in the winter? Because they change color, or at least the males do, exchanging their flashy yellow feathers for a quite pedestrian dull brown. Just an ordinary little bird, one you’d never give a second glance at, even if now you remember seeing so many at the bird feeders you set out when the snows come.

Yes, the goldfinches were there all along. I just didn’t know where to look.

What’s the investing lesson here?

Goldfinches are like Value investing. Or Growth investing or Momentum investing or whatever your investment style might be. They have a season where they seize the stage, blistering in their radiance. And then they recede. They don’t go away. They just fade into the background and become a pedestrian little bird, until their appointed season returns — it always does! — and they seize the stage once more, zipping around in a glorious flock with some sort of fractalish order-in-chaos.

Unfortunately for us investors, though, the seasonality of investment styles is more like Westeros on Game of Thrones than Connecticut here on Earth. “Winter is here” on Game of Thrones today, but it took a long time coming … summer lasted a good nine years this time around, and legends tell of a winter back in the day that lasted for an entire generation. The winter currently being experienced by Value investors only seems like it’s lasted for a generation.

Not surprisingly, then, investors are always asking the same question: is there a bird for all seasons? Is there an investment style or process that can be more than just a pedestrian performer come winter, spring, summer, or fall, and no matter how long or how deep those seasons might be?

The answer, I think, is yes. The answer, I think, is diversification. There’s your bird for all seasons.

But here’s the problem with diversification, and it’s a problem I’ve written about extensively in Epsilon Theory, most recently in “It’s Not About the Nail” and “It’s Still Not About the Nail”, and in an oldie but goodie titled “Don’t Fear the Reaper”.

Diversification isn’t a pretty bird. Diversification doesn’t make my heart skip a beat like a flock of goldfinches in July. Diversification, by design, is going to have winners and losers simultaneously. Diversification, by design, is never going to look pretty doing its job, because if your portfolio is all working in unison, swooping through the market in a beautiful glint of gold … well, you may be making money, but you sure aren’t diversified. Diversification is undeniably effective, but it’s effective like a rat is effective, wonderfully adapted to do pretty well in pretty much any possible environment without calling too much attention to itself. That’s actually one of the rat’s primary survival mechanisms. It’s not flashy. It’s not pretty. It’s a freakin’ rat.

Diversification doesn’t make us feel good like a winning value or growth investment makes us feel good, and as Maya Angelou so brilliantly said, how you make people feel is ALL they remember.

I don’t have an answer for the simple fact that diversification doesn’t sing. I can’t make a financial advisor’s client feel good about diversification. I wish I could, because I would be … umm … a very rich man. But what I do know is that it’s a mistake to gussie up diversification as something that it isn’t. You can’t sell diversification as a beautiful song bird. You have to be honest about what diversification can and can’t do, not just for a portfolio’s performance, but also for a portfolio’s experience. The more years I spend in this business, the more I am convinced that how one lives with a portfolio, how one experiences its ups and downs over time, is more important for business success and business staying power than that portfolio’s performance. And I’m not just talking about volatility, which is usually how we think about the path of a portfolio and its ups and downs. No, I’m talking about how a portfolio makes us feel. Most of us need those goldfinch moments of wonder and awe, even if they just last for a season, to feel good about our portfolios, and those are moments that diversification has a really hard time delivering.

To every thing there is a season, and a time to every purpose under heaven. That holds for portfolio construction, too.

PDF Download (Paid Subscription Required):

Notes From the Field

To make a prairie it takes a clover and one bee,
One clover, and a bee,
And revery.
The revery alone will do,
If bees are few.
― Emily Dickinson (1830 – 1886)

I’ve said it before, and I’ll say it again.
Emily Dickinson is a total badass.

When a livestock farmer is willing to “practice complexity”— to choreograph the symbiosis of several different animals, each of which has been allowed to behave and eat as it evolved to — he will find he has little need for machinery, fertilizer, and, most strikingly, chemicals. He finds he has no sanitation problem or any of the diseases that result from raising a single animal in a crowded monoculture and then feeding it things it wasn’t designed to eat.
Michael Pollan, The Omnivore’s Dilemma: A Natural History of Four Meals (2006)

In modern farming and in modern investing, we have become prisoners of the monoculture. It’s efficient. It’s necessary for a mass society of ever-increasing Desire. And yet …

Oh, and one more thing. In the investment monoculture, you’re not the farmer.

Up on the Ft. Peck Reservation
(Assiniboine and Sioux)
just as I passed two white crosses
in the ditch I hit a fledgling meadowlark,
the slightest thunk against the car’s grille.
A mean minded God
in a mean minded machine, offering
another ghost to the void to join the two
white crosses stabbing upward in the insufferable
air. Wherever we go we do harm, forgiving
ourselves as wheels do cement for wearing
each other out. We set this house
on fire forgetting that we live within.
 Jim Harrison, “To a Meadowlark” (2008)

One thing that has gone wrong in America is the general acceptance of bad ham.
Jim Harrison (1937 – 2016)

After gaining widespread fame as an explorer and “Indian fighter” during the Revolutionary War (yes, that used to be a profession, and a respected one), Daniel Boone earned his living in the Kentucky wilderness by producing what was known as bear bacon. It wasn’t “bacon” as we know it today, which typically comes from the sides and bellies of pork. Instead, Boone would take the whole bear and portion it into large hunks of meat that were brined and smoked. Living out of a lean-to shelter, he and his family hunted the bears with the help of tracking hounds. They soaked the meat in handmade barrels filled with a brine of water, salt, and sugar. They got the salt from mineral licks, and they got sugar by tapping the sweet sap from maple trees. Once the meat was brined, it was smoked and loaded onto keelboats headed up the Ohio River. Riding along with the meat were barrels of lard, rendered down from bear fat, as well as stretched and dried bear hides. All of it was sold in the eastern settlements. In one particularly productive season, Boone brought to market the meat and by-products of 155 black bears.
Steven Rinella, “First Catch Your Bear: Recipe for Smoked Black Bear Ham,” Cured v.1, Fall 2016

I had a coonskin cap when I was a wee lad, and I can still sing the Daniel Boone theme song. Not sure I can imagine Patricia Blair boiling down bear fat and living in a lean-to, any more than I can imagine Fess Parker being an “Indian fighter”. I mean … the bad Indians, sure, but Daniel Boone was a great friend to the good Indians like Mingo. Right?

Of all the occupations by which gain is secured, none is better than agriculture, … none more becoming to a free man.
Cicero (106 – 43 BC)

Men are not so much the keepers of herds as herds are the keepers of men.
Henry David Thoreau, Walden (1854)

The land is ours. We are the land’s.

Robert Frost wrote a similar line to lead off a patriotic anthem (“The Gift Outright”), most famously delivered at JFK’s inauguration when he was 87 years old. The poem rings poorly to the modern ear. Too jingoistic. Too rah-rah. But there’s a deeper meaning, I think, whether Frost intended it or not. The land is ours. There is a freedom that comes from working one’s own land, a groundedness — in the truest sense of the word — that was the foundation of Roman civilization and the republican virtues that inspired Jefferson, Madison, Hamilton, and the rest of the Founders gang.

But the land owns us, too. That encompasses nationalism and patriotic duty, for sure, which is how I think Frost meant it. It also encompasses civic and social duty, which is how I mean it. This is the price of civilization, that we allow ourselves to be the land’s. It’s a price worth paying.

Regular Epsilon Theory readers may know that I’m originally from Alabama but now live out in the wilds of Fairfield County, Connecticut. Politically this is a failed state, but it’s still a beautiful one, and we’ve had nothing but happiness raising our four daughters here on a “farm” of 44 acres. I put that word in quotations because although we have horses and sheep and goats and chickens and bees, my grandfather — who owned a pre-electrification, pre-refrigeration, pre-pasteurization dairy farm in Alabama during the 1920s and 1930s — would surely have a good belly laugh at the notion of calling this a “farm”. But it’s a farm to us, and it’s been the bedrock for how we’ve educated our girls, who along with their mother do every bit of the work required to keep these animals alive (except for the bees, which are my thing, and anything that requires using the tractor). There are lessons from training a mustang to take a saddle, from shearing a sheep, from watching how goats defend the weak and how chickens torture the weak … lessons that have made my daughters strong and wise way beyond their years … lessons that you can’t get anywhere else but a farm.

It’s been a learning experience for me, too, of course. The dilettante farmer has been a stock comedic character since Cicero’s day, and Eddie Albert on Green Acres is a farming savant compared to me. One of the nice things about the land, though, is that it doesn’t hold a grudge. It forgives. Stick with it long enough and you can start figuring out the rhythms, or at least injure yourself less frequently. Plus, in case I wasn’t clear earlier, this is freakin’ Fairfield County, Connecticut. I’ve installed a really excellent wifi router in my barn so I can download instructional videos on, say, replacing the oil filter on my tractor. I expect Amazon Prime drone delivery service for said filter to start up any day now. And if all else fails it’s a 10-minute drive to a couple of really good bars where I can nurse my wounded pride with some artisanal Mezcal and whatever locally-sourced amuse-bouche the chef has whipped up that day. I mean, this isn’t exactly Grapes of Wrath material.

By the way, the joke in that last paragraph for farming cognoscenti is how easy it is to change an oil filter on a modern tractor. It’s a four-inch canister that pokes out from the engine. You literally unscrew it by hand (“remember, lefty-loosey!” says the instructional video, clearly designed for dilettante Team Elite tractor owners like me) and screw the new one on tight. Maybe put a little fresh oil in the new filter before attaching if you wanna show off a bit. But, yeah, that’s all it is.

Still, I have learned a few things over the years from the farm and its animals, and they’ve helped me to become a better investor. Those are the notes from the field that I want to share in this Epsilon Theory letter.

#1: Fingernail Clean

Fresh eggs are, in fact, one of the best things in life, and they (almost) make up for the necessity of dealing with the evil reptilian brain of the modern-day chicken. A fresh egg is notable for both its yolk (an orange-yellow that seems to glow, not the flat yellow-yellow you get in a store-bought egg) and its white (the fresher the albumen, the greater its coherence, so that you can, for example, poach a very fresh egg without putting vinegar in the water). A fresh egg is also notable for the fact that, depending on where it was laid and when it was collected, it may have dried chicken poop on the shell.

Now an eggshell is semi-permeable, and a fresh eggshell has a thin anti-bacterial protective layer called the “bloom”, so you don’t want to soak it in soapy water, or really any water at all. You can use an enzymatic egg wash to loosen the “dirt”, but really all you need to do is moisten the spot and scrape it with your fingernail until it’s clean. Not scrubbed. Not pristinely clean. Just fingernail clean. That’s really the optimal outcome.

Here’s another truth about fresh eggs: you don’t need to refrigerate them. They’ll keep for a month just sitting out on your kitchen counter. They don’t rot. They don’t start to smell. They don’t serve as a Petri dish for salmonella or some other dread bacterium. Seriously.

So you don’t have to refrigerate your fresh eggs. But if you scrub your eggs all nice and perfectly clean, removing the anti-bacterial bloom layer in the process, then you have to refrigerate them. Similarly, if you start refrigerating an egg, then you have to keep refrigerating it. You can’t go back and forth.

Of course, you can’t scrape eggs fingernail clean on an industrial scale, and there really are dread diseases running rampant in every industrial protein monoculture facility, whether it’s for eggs or chickens or cows or pigs or whatever, which is why antibiotics are constantly fed to these animals. You can’t be certain that industrially produced eggs will get to a buyer within a month, and you certainly can’t be certain they’ll be kept at room temperature over that span. So you wash the hell out of the industrially produced egg, and you introduce it to refrigeration as soon as you can for storage and transport. That’s why the spotless, refrigerated egg is all we know. It’s necessary for effective and profitable industrial production.

But because the spotless, refrigerated egg is all we know, we believe anything to the contrary must be a defective and potentially diseased egg. Not a better egg, which is the truth, but a worse egg. A bad egg. You see this all the time when you give people fresh eggs. They’re disturbed if the eggs aren’t housed in an egg carton and cool to the touch. They get freaked out if the eggs aren’t perfectly, and I mean perfectly, clean.

We have been well and truly trained to accept the Industrially Necessary Egg as the Good Egg.

It’s the same with all dairy products. It’s the same with all industrially produced proteins. It’s the same with all industrially produced anything.

So many ideas that we take as immutable truths of safety or goodness, whether those truths concern the food we eat or the stocks we buy, are not truths at all. They are conveniences, and not conveniences for us, but for the sellers of the food we eat or the stocks we buy.

Do you really think that an ETF (and let’s recall what those letters stand for — an Exchange Traded Fund) was designed for your benefit? I wrote the following in September, 2015 in an Epsilon Theory note called “Season of the Glitch”. It bears repeating.

The key letter in an ETF is the F. It’s a Fund, with exactly the same meaning of the word as applied to a mutual fund. It’s an allocation to a basket of securities with some sort of common attribute or factor that you want represented in your overall portfolio, not a fractional piece of an asset that you want to directly own. Yes, unlike a mutual fund you CAN buy and sell an ETF just like a single name stock, but that doesn’t mean you SHOULD. Like so many things in our modern world, the exchange traded nature of the ETF is a benefit for the few (Market Makers and The Sell Side) that has been sold falsely as a benefit for the many (Investors). It’s not a benefit for Investors. On the contrary, it’s a detriment. Investors who would never in a million years consider trading in and out of a mutual fund do it all the time with an exchange traded fund, and as a result their thoughtful ETF allocation becomes just another chip in the stock market casino. This isn’t a feature. It’s a bug.

More recently, both Rusty Guinn and I have been hammering on this point in Epsilon Theory notes: ETFs are the epitome of active trading. They exist because we can’t help ourselves. We demand the ability to actively manage our portfolio on a minute-by-minute, second-by-second basis. We’re addicted to the “news” on CNBC and the rush we get from playing the hand and the false sense of security we derive from the immediate liquidity and the false satisfaction we derive from making the decision ourselves. We fancy ourself to be a macro investor — able to select this sector or that sector, this geography or that geography, this theme or that theme, this asset class or that asset class — and that’s why ETFs exist. We’ve been sold the idea that we’re excellent macro investors, just as smart and observant and on top of things as all those fat cats we read about. We’ve been sold the idea that it’s a Good Thing for us to “take control” of our portfolio and give the boot to all of those “so-called experts” with their “out of control fees”.

It’s a powerful idea because, like all powerful ideas, there’s more than a little truth to it. Fees are often too high. Experts and advisors are often just marketing shills. That’s all true. But what’s also true is that you are not an excellent macro investor. Sorry. And more to the point, there’s no need for you to be an excellent macro investor and still achieve your investment goals. But so long as we allow ourselves to be well and truly trained into believing that the Industrially Necessary Financial Innovation is the Good Financial Innovation, it’s harder to achieve those goals. Like a store-bought egg, ETFs are occasionally necessary, and always convenient. But they can’t hold a candle to a fingernail clean fresh egg.

#2: Structure Is a Cruel Master

I like animals that pay the rent. It’s why I put up with chickens and sheep, both of whom are just about the stupidest and most selfish animals on this green earth. And it’s why I’m particularly interested in bees, because honey is the best rent I collect. Honey is another food product where, like eggs, the necessities of industrial production have led to the general acceptance of bland honey as good honey. In truth, the best tasting and healthiest honey will have bits of raw pollen in it, maybe a bit of wax, maybe — brace yourself — other impurities. But that’s not my point in this note from the field. My point here is about the particular genius of bees, which is that they are hard-wired to create amazing structure out of complete chaos. Usually that genius results in a triumph of both social and physical engineering, but occasionally it goes awry. Ditto for humans.

I use a top-bar hive design for my bees, rather than the far more common Langstroth hive design. The top-bar hive essentially mimics a hollow log, providing nothing more than a flat ceiling and some holes in the “log” for the bees to fly in and out. It’s completely up to the bees how they build their combs within the “log”, and I’ve got a plastic window on one side of the structures so I can see their progress. Think of it like an ant farm for grownups. Alternatively, the Langstroth design forces the bees to build their combs in a deterministic manner, providing pre-waxed, precisely distanced slats within tight boxes that can easily be stacked and moved. The Langstroth hive is a wonderful design for transporting bees for commercial pollination services, and similarly effective for maximizing honey production and extraction. Neither of which I care about.

What I do care about, beyond collecting the occasional honey comb, is understanding, experiencing, and learning from the bees, and that’s what a top-bar hive allows me to do. The downside to a top-bar hive is that it doesn’t provide any “guardrails”, to use a management term du jour, for the bees. Plus, any honeycombs you collect are likely to have a few, or more than a few, larvae in the comb, making it more of a challenge to extract the honey without the yucky stuff. But both of these negatives are positives in my book. I’m not trying to get a ton of honey, and I want the responsibility of identifying and rectifying any structural wrongs that might develop in the hive. Or so I thought.

My first year with a top-bar hive, I thought it would be helpful if I gave my new colony a bit of a head start by placing some pre-waxed Langstroth hive sheets (basically a wax sheet held together with thin strands of wire) in the bottom of their “log”. Sure enough, the bees quickly harvested the wax and used it for their new combs, leaving the thin wires at the bottom of the hive. Mission accomplished!

One month later, though, and my hive was a mess. The bees didn’t physically harvest the thin metal wires like they had the pliable wax, but they had harvested the idea of the wires. You see, bees will use any structure as a template for their structure-building instincts. The reason a top-bar hive works is that it mimics a hollow log. Any structure within the log, any at all, even a few wires jumbled at the bottom, will be seized on as a structural framework. So instead of only getting the classic honeycomb built from the ceiling down in beautiful straight lines with exactly ¾ of an inch between combs, I also got a blob comb built from the floor of the hive up. To make matters worse, I had made the newbie mistake of not ensuring that my full hive, the “log” itself, was perfectly level when I set it up, and as a result the ceiling-built combs were listing downhill. Put it all together, and I got the disaster structure: cross-comb, where your hive becomes a maze of interlocked combs and lobes, impossible to interact with without destroying big chunks of the hive and killing large numbers of bees. If you’ve ever mistreated an engine to the point where it seized up, fusing into a solid block of metal, then you have a good notion of what I had done to this hive.

And here’s the kicker. I knew this was happening (remember the plastic window so I can see into the hive), and I still did nothing to stop it. Or rather, I suspected that something bad was happening, and rather than dig in and kill a few bees and wreck a small amount of comb in order to scrape out the wires and get the hive on the right track, I didn’t want to pay that price. There’s no way, I kept telling myself, that these bees would become so utterly focused on building around a few metal wires that obviously weren’t part of the master plan and obviously didn’t lead to a properly built hive. I was wrong.

So what are my lessons here?

Investors are like these bees, determined to find structure — i.e., meaning — in anything the beekeeper or nature gives them. They will find structure and meaning even if the beekeeper intended no such thing. They will find structure and meaning even if what they build is obviously flawed. They will keep building on this flawed foundation for as long as they are physically able to do so.

The architectural design for a beautiful end result — a productive hive or a productive portfolio or a productive market — is nowhere to be found in a bee’s brain or a human’s brain. What is in our brains is an algorithm — a process — where we take meaning from found structures and we build on them. And build and build and build. That’s what the bee and the human are biologically evolved to do, and that’s exactly why the bee and the human are two of the most successful species on the planet. Our algorithms work. For both bees and humans, our process is our genius. And it usually ends up as a grand success. Unless, of course, we’ve been given a flawed foundation. Unless, of course, we’re finding structure and meaning in a bunch of wires on the floor of the hive.

Central bankers are like me, the Hamlet-esque, dithering newbie beekeeper who left a destructive structure in the hive but can’t bring himself to accept that fact. Central bankers absolutely think of themselves as beekeepers. They absolutely believe that they, and only they, can keep the global economy from going off the rails. They absolutely believe that they provided the necessary materials to keep the hive alive in 2009 and 2012, albeit admittedly with a bit of detritus left behind in the form of massive balance sheet reserves. They absolutely do NOT believe that removing these reserves will be a big deal, so long as they keep saying the right words and go very very slowly. They are wrong.

To use another pastoral reference, what’s good for the goose is good for the gander. If Bernanke was right about the portfolio rebalance channel on the way up, he’s going to be right about the portfolio rebalance channel on the way down. What’s the portfolio rebalance channel? It’s the whole entire rationale for QE, the whole entire reason that central banks now own $14 TRILLION worth of stuff. By buying their fixed income stuff, central banks push down the yield on ALL fixed income stuff. They make ALL investors take on more risk than they otherwise would. The safe-as-houses U.S. Treasury buyer has to buy mortgages to get the same portfolio return as before. The cautious mortgage buyer has to buy corporate debt to get the same portfolio return as before. The corporate debt buyer has to buy equities to get the same portfolio return as before. It’s turtles all the way down. And it will be turtles all the way up as ALL investors are forced to take on less risk than they otherwise would.

This algorithm — what I’ve called in the past the Narrative of Central Bank Omnipotence, or the idea that Central Banks are responsible for all market outcomes — is now well and truly implanted in the human brain. Maybe it’s not in your brain. Good for you (although I don’t believe you). But would you deny that it’s implanted in enough human brains to make all the difference in market behaviors? I don’t know whether Bernanke was right about the portfolio rebalance channel. And I don’t care! What I care about is that enough people believe that the portfolio rebalance channel worked, just like enough people believe that Draghi’s Outright Monetary Transaction program worked, so that it DOES work. In either direction.

To make a prairie it takes a clover and a bee. Plus revery. Belief.

And belief alone will do.

PDF Download (Paid Subscription Required):

Whom Fortune Favors: Things that Matter #1, Pt. 1

President Camacho

Still, brave Turnus did not lose hope of seizing the shore first,
and driving the approaching enemy away from land.
And he raised his men’s spirits as well, and chided them:
‘What you asked for in prayer is here, to break through
with the sword. Mars himself empowers your hands, men!
Now let each remember his wife and home, now recall
the great actions, the glories of our fathers. And let’s
meet them in the waves, while they’re unsure and
their first steps falter as they land. Fortune favors the brave.’
So he spoke, and asked himself whom to lead in attack
and whom he could trust the siege of the walls.

— Virgil, The Aeneid, 10. 270-28

I had to take a verbal physical. A bunch of yes or no questions. But they were strangely worded, like, “Have you ever tried sugar… or PCP?”

— Mitch Hedberg

Imani: Am I not all you dreamed I would be?
Akeem: You’re fine. Beautiful! But if we’re going to be married, we should talk and get to know each other.
Imani: Ever since I was born, I have been trained to serve you.
Akeem: I know, but I’d like to know about you. What do you like to do?
Imani: Whatever you like.
Akeem: What kind of music do you like?
Imani: Whatever kind of music you like.
Akeem: I know what I like, and you know what I like, ’cause you were trained to know, but I would like to know what you like. Do you have a favorite food? Good! What is your favorite food?
Imani: Whatever food you like.
Akeem: This is impossible. I command you not to obey me.
— Coming to America (1988)

Natural selection, the process by which the strongest, the smartest, the fastest reproduced in greater number than the rest, a process which had once favored the noblest traits of man now began to favor different traits. While most science fiction of the day predicted a future that was more civilized and more intelligent, all signs indicated that the human race was heading in the opposite direction: a dumbing down. How did this happen? Evolution does not make moral judgments. Evolution does not necessarily reward that which is good or beautiful. It simply rewards those who reproduce the most.

— Opening Narration, Idiocracy (2006)

Lepidus: What manner o’ thing is your crocodile?
Antony: It is shap’d, sir, like itself, and it is as broad as it hath breadth; it is just as high as it is, and moves with its own organs. It lives by that which nourisheth it, and the elements once out of it, it transmigrates.
Lepidus: What colour is it of?
Antony: Of its own colour too.
Lepidus: ‘Tis a strange serpent.
Antony: ‘Tis so. And the tears of it are wet.
— William Shakespeare, Antony and Cleopatra, Act 2, Scene 7
He ended frowning, and his look denounc’d
Desperate revenge, and Battel dangerous
To less then Gods. On th’ other side up rose
Belial, in act more graceful and humane;
A fairer person lost not Heav’n; he seemd
For dignity compos’d and high exploit:
But all was false and hollow; though his Tongue
Dropt Manna, and could make the worse appear
The better reason, to perplex and dash
Maturest Counsels: for his thoughts were low;
To vice industrious, but to Nobler deeds
Timorous and slothful: yet he pleas’d the ear,
And with perswasive accent thus began.
— John Milton, Paradise Lost (1667)

For the whole earth is the tomb of famous men; not only are they commemorated by columns and inscriptions in their own country, but in foreign lands there dwells also an unwritten memorial of them, graven not on stone but in the hearts of men. Make them your examples, esteeming courage to be freedom and freedom to be happiness.

— Thucydides, Funeral Oration for Pericles

They don’t think it be like it is, but it do.

— Career journeyman Oscar Gamble, when asked about the New York Yankees clubhouse

The reality show president and the High King of Ireland

If you’ve seen the film, you know why it has become so fashionable to talk about Idiocracy’s prescience. If you haven’t, a brief synopsis: the film tells the story of humanity many years in the future. In this future, humans are very stupid. The biggest celebrity is the resilient star of a hit reality show about a man subjected to repeated groin injuries. Farmers water their fields with an electrolyte-laden sports drink since, after all, as the Brawndo company clearly states, “it’s got what plants crave.” Plus, with that kind of television programming available, it’s not like you’re going to have time to read debates among historians about whether Scipio Africanus truly ordered the salting of Carthaginian fields.

Well, all that and they elected a wrestling and adult film star as president.

Don’t worry. I’m not going where you think I’m going with this, although I will admit that even though I threatened to write in President Dwayne Elizondo Mountain Dew Herbert Camacho in two prior elections, when he actually appeared on the ballot I found it a bit more difficult to pull the lever.

So how did this happen (the movie plot, not Trump)? Well, the proximate cause proferred by the narrator is that all the smart, creative people saw overcrowding and a dangerous world and decided not to have kids. So it’s a gene pool argument. Underneath this purely genetic argument, however, lie truths about both evolution and social structures that form around and because of some of the trappings of genetics and lineage. From an evolutionary perspective, we are presented with the asymmetric potential of humanity that has solved most of its existential problems. If intelligence and creativity have little-to-no bearing on survival (more accurately, on a given human’s potential to procreate), what is the catalyst for the development of positive traits? Should procreation become associated with long-run maladaptive traits, however, the bigger issue becomes: how quickly do social power structures develop around and entrench those traits? How effectively do those structures prevent the emergence of adaptive traits when we need them again (e.g., knowing that you should probably just use water)?

You’re reading a note on a website long published with the header, “Politics trumps economics every time,” so I expect you won’t be surprised to learn that I think that over short periods of time, the pressure of the social structures is by far the stronger of these two dynamics. After all, the driving force behind the Idiocracy scenario is not entirely fictional. If you’ve participated in any sort of foray into genetic genealogy, you’ve seen the effect in action.

A few years back, a group of researchers from Trinity College Dublin identified that there was a strong relationship between certain genetic haplotypes and surnames that matched published lineages of a certain quasi-historical Irish king: the wonderfully named Niall of the Nine Hostages. Researchers found in subsequent testing of individuals with those surnames that many shared a mutation in their Y chromosome. At a location called 14902414 (don’t ask), where they expected to find guanine, which is what they’d find in researching any other human male they’d ever come across, they found adenine instead. We call this kind of mutation a “single nucleotide polymorphism.” These mutations are one of the most important ways we map the branching of lineages in male genetic history. Stable SNPs are passed down like a scar from generation to generation in a path-dependent chain.

Once this was discovered, we were off to the races in the usual ways. One of the largest DNA testing companies wasted no time in creating a special logo that was applied like “flair” to user accounts certifying them as a Descendant of Niall of the Nine Hostages! If you’re one of the few million men who would test positive for this mutation, you can still scrape a bit of your cheek into a vial, send it in and then download and print a certificate attesting to this, although they’ve softened the language somewhat. As always, lineage and genetics are far more complicated than they appear on the surface, and subsequent research made it clear that the mutation happened centuries before this man would have lived, probably in Cornwall and not Ireland, and included all sorts of other lineages as well.

Even if the specifics were a bit off, there was a kernel of truth in this mode of thinking: in general, rich people with swords who could afford food had more children that didn’t die early, and their children had more children who didn’t die early. In addition to really bad genealogical practices, this is why everyone you meet who has done any research into their family has found some super-famous king or viscount or third earl of something-somewhere from whom they’re descended. It’s also why when a particular common lineage seems to spring out of a place and time, we are drawn to the notion of the fecund king, whether it’s Niall or, say, Genghis Khan. A 13th century peasant farmer probably didn’t have healthy kids, and if he did he probably didn’t keep exquisite written records of them. But in the short run, evolution is a fickle, funny, random thing. Does the success of the line of someone like Niall mean that it had some significant, genetically heritable trait that made its members more likely to thrive? It’s possible, of course, and in many cases throughout history it is certainly true — evolution is a thing, after all — but over shorter horizons it is natural variation and randomness that dominate.

Yes, Niall himself may have successfully overcome his opponents because he was predisposed to carry more muscle mass and greater range of motion in his arms, and your 12th great-grandfather, the Marquis of Accepting Internet Strangers’ Shoddy Research, may have risen to his position from obscurity because of his stunning intellect. But power structures like nobility and primogeniture1 aren’t necessary to protect the remarkable. They are necessary to protect the weaker links in the chain that come as a result of even more remarkable genetic variation, and the resilience of the line over time is functionally the strength of the power structure that supports it — and must support it in order to endure such variation. In short, those power structures — the ideas of nobility, genetic superiority and divine right — are just narratives. Very, very strong ones.

1Or at least patrilineality. Unlike a lot of Germanic cultures, Irish (and later Scottish) traditions favored Tanistry, under which a sept could allow any male descendant of a chosen accepted ancestor to become the Tanist, the heir apparent. Often it was simply the King’s eldest son, but not always.

From the very beginning of Epsilon Theory — but reaching its zenith with When Does the Story Break — these pages and our thinking have focused on the almost-shocking resilience of the stories we tell ourselves and each other about markets and investing. In that piece, we placed the focus squarely on the inflection point: what does it look like when the narrative changes? When do gentlemen stop wearing the wigs they wore for 150 years? When and why do they stop wearing hats? When will we all stop knowing that we all know that markets are policy-controlled? When will Mike Judge’s future humanity accumulate enough negative results from maladaptive traits that marginally superior traits become relevant to reproduction again (so that we don’t die out as a result of malnourishment and repetitive concussive injuries to the groin)?

For such a narrative to break, our private knowledge — a collective state of understanding of something so agreed-upon as to be considered fact — must be influenced by new public knowledge. When it’s a pervasive idea, it resolves to a strong equilibrium, like the information surfaces we talked about in Through the Looking Glass. And it requires an awful lot of information for a narrative like this to break.

It’s true for High Kings of Ireland and it’s true for investing.

What manner o’thing is your manna

Let me tell you about an especially stupid investing idea that has managed to survive for a very long time.

Since we’ve covered dystopian fantasies, let’s imagine this stupid idea in context of something wonderful: let’s assume that we are 22 years old again, right out of college and talking to our first financial advisor about our 401(k) allocation. Now, it doesn’t matter if you’re a financial advisor yourself, an institutional allocator, an individual or a professional investor, you know what’s coming next. The book says 100% stocks. Maybe the home office dropped in some higher risk/return styles into their mean/variance model and so we probably get a dash of Chili P in the form of emerging markets and small caps too. All stocks, mostly U.S., with a bit more international, emerging markets and small cap than the average client. Sound about right?

Let’s unpack this advice. The financial advisor in this scenario is essentially telling his client the following:

I’m happy to inform you that the trillions of business decisions of billions of employees and managers of companies around the world, combined with the decisions of bankers who determined whether and how much to lend to those companies, the decisions of individuals who chose whether to buy or sell that company’s products, global weather phenomena, collective actions of terrorist groups, trillions of trading decisions made by computers and individuals alike on a microsecond-by-microsecond basis, the general pace of technological growth, the changing risk appetites of a dozen different classes of investors, the state of rule of law in various countries around the world, the changing policies of governments and central banks governing trade, commerce and financial markets, the current level of prices and valuations, and the way in which billions of individuals will perceive and estimate the outcomes of all of the above — that all these things together have conspired together to create an entity we call a stock, which, when taken in combination with a more or less arbitrarily determined number of other stocks and all of their differing characteristics, will create a stock market that just happens to have exactly the right amount of risk for you!

What a bunch of superstitious hogwash.

We treat asset classes like manna from heaven, preordained structures that were designed to meet our every need, in which the lowest-risk major asset class has just the right amount of risk for a retired person and the highest-risk major asset class is perfect for the most risk-seeking individual. The very idea pleases the ear because it asks little of us. You’ll eat your manna and like it! But be honest, can you think of anything else where the universe conspires so beautifully and elegantly to meet our needs?

Fortunately, at this point many investors at least pay lip service to the preeminence of asset allocation, but we often think of it in terms that commingle the types of risk we are taking and the amount of risk we take. We see this commingling — a thing we call asset classes, like broad definitions of stocks and bonds — as manna from heaven because we tend to inextricably link the concepts of asset classes with risk and return. We are trained by the investment industry to see our asset class decisions as a proxy for risk decisions. They aren’t, and the distinction matters.

It’s easy to get caught up in terminology and semantics here, so intead, think about the act of investing in its most fundamental sense. Strip away products, market conventions, regulation and structures like exchanges, even corporations. Investing is the act of using capital to buy an asset or pay expenses to support it. We invest so that we will either (1) produce income from the asset or (2) cause the asset to become more valuable in the eyes of other investors. In this sense we can think of our risk as the range of outcomes from (1) and (2) after considering the (3) nature of our claim on both. This is true for any investment.

What, then, is an asset class? Well, it’s a mostly sensible, if subjective, way to generalize how some investments are more like other investments. Asset classes define that similarity mostly in how their characteristics (1) and (2) above respond to the same stimuli. So ignoring that the right answer is, “because it’s just what we do”, why do we consider U.S. large cap stocks an asset class? Well, generally speaking, it should be because the things that cause risks to a company’s ability to generate earnings are pretty similar, and (rather self-prophesyingly) because the fact that it is considered an asset class influences how other investors are likely to respond similarly when they assess the value of all the other underlying constituents of the asset class.

In practice, however, the factors that influence the viability and the value of our claims on enterprises we invest in (i.e., companies, governments, properties, projects, etc.), and especially the magnitude of sensitivity to those factors, can be hugely variable within asset classes. TSLA and T theoretically have exposure to some of the same drivers of variability, but how much, really? Do people scale back their texting and phone plans during a recession? Eh, maybe. Do they stop buying $90,000 rolling batteries? Oh yeah. And yet, more often than not, investments like this move in sympathy. What is so fundamental about and shared within these asset classes that they can be aggregated like this? This is a critical thing to understand if you spend any time assessing risk or building portfolios:

The real reason that many investments behave like each other at all is that they are grouped into asset classes that most investors trade together.

It’s the sort of tautological, Schrodingeresque yarn that should be familiar to any Epsilon Theory reader: asset classes behave like asset classes because we treat them like asset classes. No matter how much we grouse about fundamentals not mattering, no matter how much we may wish this weren’t the case, it is. And it’s becoming truer as passive investing and indexing become more dominant. We may not think it be like it is, but it do.

If you find this dissatisfying, join the club. The cementing of this kind of mechanic is a big part of the hollow, petty, transactional, voodoo wasp-infested investing world we live in. I’m not asking you to pretend that it isn’t a thing. What I am asking you to do is consider whether it is right to anchor the way we think about portfolios and appropriate levels of risk for ourselves and our clients on the independent and recursively derived characteristics of “asset classes.”

In behavioral finance and cognitive psychology, this is a classic example of both the availability and anchoring heuristics. In the absence of a clear framework to assess how much risk we ought to take in our portfolios, we instead look at the continuum of risk/reward opportunities as expressed through these asset classes, whose risk characteristics are readily apparent — and available. We anchor on the “most risky” and “least risky” of those asset classes, and treat every individual as a relative or marginal analysis against those anchors. Thus, we arrive at all the variants of 60/40, 70/30 and 50/50 portfolios consisting of varying percentages of stocks and bonds. It’s a Coming to America conversation with every advisor: “How much risk is appropriate for a high-risk investor? Why, however much risk a broad market stock market index has.” “How much for a moderate risk investor? I don’t know, let’s add some bonds to whatever we just sold the last guy.”

The conflation of the types and amount of risk has other effects as well. A portfolio that is 80% bonds isn’t just less risky than a portfolio that is 80% stocks — it is also exposed to really different drivers of returns for what it holds. Thus, even in an asset class-conscious framework, the narrative holds. And it is a strong one.

Its missionaries take many forms: practitioners, econometricians, academics, and even regulators, who conduct all sorts of other analyses to support these conclusions. They anchor us to conventional definitions and groupings like asset classes, style boxes and the like, they take for granted assumptions (e.g., no leverage) that create massive bias in their conclusions, and they focus unerringly on improving utility theory to better understand what investors will do instead of identifying what they should do. In so doing they unwittingly conspire to force us into a set of investment options that reflect a sad mix of human behavioral tendencies, conclusions biased by massive abstractions and absurd faith in coincidences.

Have you ever tried sugar…or PCP?

I think it’s pretty unlikely this narrative goes anywhere any time soon. Its assumptions are too convenient, too perswasive, its conventions too embedded in product structure and regulation. Think Target Date funds, balanced funds and ’40 Act limitations. It’s also true that it can be pretty useful. As these pages have made clear, we have a pretty dim view of spending a lot of time sitting around talking stocks and we’re not in the business of wasting time on window dressing or fiddling. When we build portfolios, we use a lot of index-linked instruments — ETFs, futures, swaps — because they do a pretty good job of delivering many of the core sources of risk and return we want.

But believing in and using low-cost vehicles doesn’t require you to calibrate your whole framework of thinking around the characteristics of the indexes they track. So what is our framework? What will be robust to changing levels of risk and changing sentiment? What has a true north even when the drivers of asset classes are shifting? What allows us to answer something other than “Yes” or “No” when someone asks us whether we’ve ever tried sugar or PCP?

How much risk you take is probably the most important decision you will make as an investor. It is certainly the first decision you should make.

This is a deceptively simple point, but it matters. I am saying that before you spend a minute thinking about or designing an asset allocation, your complete focus should be on the quantity of risk you’re willing to take.

In some cases — decisions among similar asset classes — the risk decision is very obviously more important. This is most easily understood by example. Below we examine the risk and return of five different portfolios since January 2001 and rebalanced monthly:

  1. A portfolio invested 100% in the MSCI All Country World Index (“ACWI”)
  2. A portfolio invested 90% in ACWI and 10% in the S&P 500
  3. A portfolio invested 90% in ACWI and 10% in the MSCI Japan Index
  4. A portfolio invested 90% in ACWI and 10% in the MSCI Europe Index
  5. A portfolio invested 90% in ACWI and 10% in nothing (under a mattress)

Think of Portfolio 1 as our control. Portfolios 2, 3 and 4 represent — for the most part — an isolation of the “asset” dimension and an abstraction from risk. Portfolio 5 represents an isolation of the risk dimension. If we chose to overweight the U.S., Europe or Japan by 10% against a global market cap weighted index, the average difference in annualized return between the 10% overweight bets and the ACWI over this period was about 8 basis points. By contrast, taking off 10% of our risk took away about 30bp of return. Intuitively this is a function of the relative Sharpe ratios of various asset classes and how they differ, and so over different periods — such as ones in which the broad market was down — this analysis might have different signs. But over most of history and across most markets the magnitude, the importance of this decision, would be like what we show here.

Source: Salient Partners, L.P., as of 12/31/16. For illustrative purposes only. Past performance is no guarantee of future results. Certain performance information shown is compared to broad-based securities market indices. Broad-based securities indices are unmanaged and are not subject to fees and expenses typically associated with managed accounts or investment funds. Investments cannot be made directly in an index.

You could think about this in risk space as well. The volatility of the ACWI over this period was just under 16%, coincidentally not that far from what you would observe over many other long-term windows. In contrast, the volatility of the excess return between each individual market and the broad market — their tracking error — was always lower. On average using the U.S., Europe and Japan, the average tracking error is about 7.6%, less than half of the volatility of the market itself.

This analysis becomes a bit more convoluted if you’re comparing decisions across assets that tend to have very different amounts and types of risk — say, U.S. large caps and Treasurys. If we were able to achieve a similar level of risk from government debt, we’d see that the impact of the different types of risk becomes as significant as the risk decision itself. But even in this case, to get to a place where we are thinking in those terms, quantity of risk is our starting place. How much you own usually matters more than what you own.

For many investors, this is counterintuitive. It presents a strong contrast to the way in which many investors have taken advice from people like Peter Lynch and Warren Buffett, whose letters and books highlight the extent to which focusing on simple businesses they can understand or can “sketch with a crayon” has led to their own success. Much to Mr. Lynch’s dismay, for example, investors have often understood this to mean buying Procter & Gamble stock because they personally use a lot of Crest toothpaste and feel strongly that it’s a superior product to Colgate. I would extend this to include even the more sensible-sounding notion that a senior IT professional has some edge that should allow him to successfully manage a JNPR/CSCO pairs trade. Please.

Buffett and some others are probably an exception to our rule of thumb here, although only marginally so. Not because of his talent, but because of his extreme concentration. The idiosyncratic characteristics of the portfolio of companies in which he chooses to invest may sometimes be more different from those of other companies than the difference between holding the portfolio and holding cash. But that level of concentration is so extraordinarily rare among investors that I think it’s probably approximately correct to consider it irrelevant for our discussion.

So what am I saying to the “quality” and “buy what you know” investors? I am saying that unless you have a portfolio that is very concentrated in individual securities — by which I mean that more than 6 or 7% of your total net worth or investable assets are invested in an average stock or bond position — if you think that the unique characteristics of what you own are going to drive your success more than how much market risk you’re taking, you are wrong.

Measurement will be important as we walk down this road, but I don’t have a lot of interest in spilling more ink/electrons debating the best way to measure risk. We’ll get into it more in Part 2, but regardless of what measure for risk we choose, by and large, how much exposure we have to financial market risk will have more impact on our portfolio results than any other factor.

Primum non nocere

What does all this mean for the code-driven investor?

It means that anything lower in the priority must be considered in context of its impact on risk. This seems intuitive, but is extremely poorly understood. Take a look at this article from the world’s leading newspaper covering financial markets. Without tongue firmly planted in cheek, this author undertakes to compare hedge fund returns to private equity returns as part of explaining why private equity funds are raising so much more money. This is really stupid.

The first reason it is stupid is because the comparison is terrible. Most private equity — large buyout funds, anyway — is just levered stocks with high fees and a PM who calls himself a “deal guy” and wears Brioni instead of your long-only guy’s Brooks Brothers. It’s the exact same type of risk as mid-cap equities, and if it were in a constantly marked structure, it would demonstrate more risk than your average mid-cap equity benchmark. Not to be too on-the-nose about this, but hedge funds are usually hedged. Most try to avoid equity sources of risk, and almost universally avoid taking as much risk as traditional strategies. Evaluating and comparing absolute returns of these two assets because they’re both “alternatives” is like the guy with the butter-laden tomahawk ribeye gloating when I order the petit filet. Yes, we all saw the 26-ounce steak on the menu, guy.

The second and more disquieting reason it is stupid is because it’s kind of true. People and funds really are making this exact decision: to sell their hedge funds to fund private equity. At other times (usually after PE disappoints) they do the opposite. But I see decisions like this all the time. I see advisors trying to improve a client’s yield by swapping stocks for high yield. Selling their equity index fund to go into an unlevered low volatility equity fund. I see them going to cash because U.S. stocks feel expensive. I see them rotating from market-neutral hedge funds to high volatility CTAs and managed futures funds, or visa versa.  There are always good decisions why we don’t like Asset X and maybe some good reasons why we like Asset Y. But because our frameworks often don’t first think about the baseline expectations for risk and return for these assets, these decisions often fall victim to the pitfalls we highlighted in And They Did Live by Watchfires, where our temptation to tweak leads us to make small changes that have big unintended consequences. In a huge majority of cases, risk differences between assets will dominate the expected edge we have on views of the relative attractiveness of different types of return. More on this to come.

The other implication — and chief benefit — of starting the portfolio construction process with a risk target is that it frees us from the anchoring biases of a framework that begins from the arbitrarily determined characteristics of asset classes. That does place some onus on us to develop a view of the right amount of risk to take, of course. And while some of the techniques for developing such a view are standard fare, they also usually either revert to boundary constraints driven by asset classes and vehicles, or else focus on an exercise where the expected portfolio return just meets a return target or theoretically minimizes the probability of not reaching some horrifying outcome.

So, while I believe that your quantity of risk is the most important decision you can make, I can’t tell you how much risk you can tolerate. I can, however, generalize what I know many professional investors do in their personal portfolios:

  1. They take a lot more risk than you.
  2. They concentrate a lot more than you.
  3. The fact that they offer lower-risk products reflects their assessment of business risk, not investment merits.
  4. Tail risk becomes a much bigger consideration as we do more of #1 and #2.

I’ll be the first to say that the notion of “smart money” is mostly a myth, but there’s a reason why your fund managers behave like this. The notion that bonds are manna for conservative investors turns out to be just about right. Go figure. The idea that equities are manna for risk-seeking investors turns out to be pretty far off. For those of us in the risk-seeking camp, we need to start over on the question of the right amount of risk to take. For that, you’ll have to wait for Part 2.

PDF Download (Paid Subscription Required):