Portrait of a Very Serious Investor


Hello again, ET readers! I have been struggling with a lack of inspiration on the writing front recently. Fortunately, recent events have jolted me out of my creative malaise. Today, I am writing to share a cartoon I have been sketching.

Meet the Very Serious Investor.

Back in the halcyon days of 2012, during the sturm und drang surrounding the US budget deficit and credit downgrade, Paul Krugman began using the phrase “Very Serious People” to describe politicians he deemed better at sounding serious than developing policy solutions. As another blogger once put it: “being Tom Friedman means never having to say you’re sorry.”

Love or hate Krugman, I’ve always found this a useful little cartoon. Recent events have caused me to extend it to the concept of the Very Serious Investor (pictured above). Very Serious Investors are a direct product of the Wall Street money machine. For the Wall Street money machine greases its gears with credentialism. If you have made your career in finance, you are almost certainly aware that credentialism and its attendant rituals are essential to the smooth generation of fee income.

There is a difference between sounding correct and being correct about a thing. The business of investing (as opposed to the actual act of making money in financial markets) is much more about the former than the latter.

Very Serious Investors, and the discipline of Very Serious Investing, are first and foremost rent-seeking. The Very Serious Investor wears the face of a risk-taker. An optical resemblance to risk-taking is of critical importance to Very Serious Investing. In actuality, Very Serious investing is focused on the extraction of large and (relatively) predictable revenue streams via “heads I win, tails you lose” (HIWTYL) fee structures.

The best thing that ever happened to Very Serious Investors was the transformation of markets into political utilities.

Now, no Serious Investor will ever admit this in conversation. There are appearances to be maintained. There are fists to be shaken at a burdensome regulatory state. Clouds to be shouted at while justifying charging 1.5 and 15 on market beta to LPs (even Very Serious Investors are not immune to some fee compression these days). There are compelling stories about top stock positions to be told.

Through all of this, it is of the utmost importance that the seriousness of investing be conveyed. Investing is not some game to be played. It is not a source of amusement or crass “lulz.” Investing is a science to be practiced by a properly-credentialed, properly-educated, properly-connected professional. Such professionals ought, in turn, to be compensated in a manner befitting their station and breeding.

Thus, the Very Serious Investor is quite disturbed by recent goings-on in illiquid, small cap stocks with high short interests. These happenings represent an assault not only on the Very Serious Investor’s livelihood, but his entire cosmology. For the Very Serious Investor, this offends the natural order of things. Imagine! People placing profitable discretionary trades in the financial markets when they lack even a single Ivy League degree. How dare the plebians challenge their betters?

 Ordnung muss sein.

The Very Serious Investor couches his objections in the language of finance.

“stocks divorced from fundamentals”

“inefficient capital allocation”

“significant mispricings in the cost of capital”

By dazzling the unwashed masses with his scientism, the Very Serious Investor endeavors to put them in their proper place. What matters most to the Very Serious Investor is that a particular cosmic order is preserved. A great chain of being with the plebs located somewhere above the oyster and the Very Serious Investors somewhere up near the seraphim. 

Yet how often does the Very Serious Investor take to CNBC when his long positions become badly divorced from fundamentals?

How often does the Very Serious Investor bemoan the ways in which explicit government policies of rock-bottom interest rates and permanent liquidity support distort his portfolio’s value?

Where was the Very Serious Investor’s shame when she beseeched the Fed to reverse course on rates in December 2018 after blaming the Fed for the prior four years’ underperformance in every quarterly investor letter?

Where were the Very Serious Investor’s anxieties about the integrity of corporate finance when his airline holdings levered up their balance sheets to engage in reckless and unsustainable returns of capital? Where were her high-minded ideals when she tweeted in favor of an airline bailout?

Of course, to pose these questions is beside the point.

The Very Serious Investor does not care about any of these things. What the Very Serious Investor cares about is money. He can hardly abide when others are making more of it than him. Least of all when those people are his inferiors.


The End of the Beginning


“Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.” 

Winston Churchill

I have not written much since the coronavirus outbreak blew up. Not because I’m not thinking about things. But I simply haven’t had much to say. I have no unique perspective to add regarding epidemiology or public health policy. Sometimes the best thing to do is simply hang back and reflect. This post contains some thoughts on where we’ve been, and where we might be headed.

One indisputable consequence of this pandemic is that we have quickly transitioned from a disinflationary or even (I would argue) mildly stagflationary regime to a deflationary economic regime. The duration of this new regime is an open question. Policymakers, particularly on the monetary side, have reacted as expected. They did MOAR. And they will continue to do MOAR to backstop financial markets, so long as they deem it necessary. Unsurprisingly, this has done wonders for financial assets. Particularly duration sensitive assets such as long bonds and growth equities.

Some dominant themes/narratives I think we will grapple with as this evolves:

The transformation of financial markets into political utilities is complete. It has always been a mistake to assume markets are a perfect reflection of the real economy. Now, markets are probably less a reflection of the real economy than ever before. A consequence of MOAR is that markets (or at least pockets of them) have seemingly become completely untethered from the real economy. There are sensible reasons for this, of course: ultra-low discount rates; the fact that solvent businesses with liquidity to draw on should not see long-term impairment of value as a result of the virus, etc. But as with the financial crisis, policy geared toward owners of financial assets has been implemented quickly and decisively. Much more decisively than policy geared toward vulnerable small businesses and their employees. This will have social and political consequences.

We are all MMTers now. Government deficits will never matter again. Well, at least not unless/until an inflationary bill is acknowledged as having coming due. Central Banks are explicitly engaged in debt monetization. This is mainstream. It is accepted. Yes, there are a different flavors of it. There is the progressive flavor, with its Green New Deals and job guarantees. Then there is the “fiscally conservative” flavor, with its tax cuts and its endless promises of shrinking government (of course, government is never actually shrunk in a material way). I’m not interested in arguing over whether this dynamic is right or wrong at this point. All I care about is acknowledging is that it IS. Because it matters. It matters a lot.

Politics is going to get nastier. The United States government is now explicitly in the business of choosing winners and losers in the economy. As usual, owners of financial assets have been selected as winners. As usual, those who do not own financial assets are losers. I expect the long-simmering political conflict between Capital and Labor to further intensify as a result. Political rhetoric will become more extreme. Politicians will become more ridiculous. Congress will become even less effective (difficult to imagine such a thing is possible, I know). Fun times.

Investment-wise, it’s going to be MOAR of the same. Beyond the obligatory post-recession bounce, there will not be significant mean reversion in value versus growth factor performance. Long duration growth bets will continue to perform well, because there is no opportunity cost to making them. I suspect long duration bonds will also continue to perform well in the short-term, against all odds. Because despite what Jerome Powell says in his pressers, I believe we will test negative interest rates here in the US before we test higher interest rates. And convexity is a thing people seem determined to refuse to understand.

Now, this idea of long duration growth bets merits some additional comment. It’s something that doesn’t get enough pixels, in my opinion. Certainly not relative to its importance. 

Most investors are familiar with the concept of a fixed income security’s duration. It’s a (linear) approximation of a bond’s price sensitivity to interest rates. The longer a bond’s duration, the more sensitive it will be to changes in interest rates. But at the end of the day, a bond is just a bunch of cash flows. From a discounted cash flow perspective, all cash flows are sensitive to changes in the cost of capital.

The archetypical example of a long duration equity is probably development stage biotech. These companies have no free cash flow in the present. They burn cash on R&D and regulatory approval processes. Their free cash flows lie far out in the future. But, if a biotech succeeds in developing and commercializing a therapy with a large addressable market, the future cash flows can be enormous. In the meantime, these equities are kind of like the world’s craziest zero coupon bonds.

In this sense, any breakeven or cash burning growth equity can be seen as a duration play. Much of the small cap enterprise SaaS space fits this profile, for example.

Ultimately, interest rates are financial gravity. When rates are high, and gravity is strong, valuation multiples collapse. When rates are low, and gravity is weak, everything floats. And the longest duration stuff either falls or floats the most.

But how does it all end? I see a few very different endings to this story. The first, of course, is some kind of inflationary or stagflationary regime triggered, in part, by relentless monetary easing. But people like me have been worried about this for a long time. And it’s never shown up. Another possibility is that some kind of transformational technological innovation, similar to the internet, allows us to return to much higher trend growth rates. This would be ideal. Perhaps the darkest scenario is that the political conflict described above spirals completely out of control, and we get to live through a reprise of the 1930s and 1940s.

This is not a very hopeful post. It is not hopeful because I do not have a very positive outlook on the macroeconomic and political trends of the day.

That said, this is also not an argument for bearish positioning in a portfolio. If you follow me on the Twitter, you may recall my exhortation to “dare to be smart enough to be dumb.” Flexibility is key here. I can forgive people (myself included) for not grasping how monetary policy would impact financial market behavior post-2008. That mistake is less forgivable today. In my opinion, it is nigh on impossible to invest today without accounting for the gravity of monetary and fiscal policy.

To be perfectly explicit, as things stand today:

Quantitative deep value (“owning really cheap things because they are really cheap”) is at best a tactical trade.

Economic policy will hamper mean reversion.

As investors, trends are our friends for the foreseeable future.


Hyakujos Fox


Once when Hyakujo delivered some Zen lectures an old man attended them, unseen by the monks. At the end of each talk when the monks left so did he. But one day he remained after they had gone, and Hyakujo asked him: `Who are you?’

The old man replied: `I am not a human being, but I was a human being when the Kashapa Buddha preached in this world. I was a Zen master and lived on this mountain. At that time one of my students asked me whether the enlightened man is subject to the law of causation. I answered him: “The enlightened man is not subject to the law of causation.” For this answer evidencing a clinging to absoluteness I became a fox for five hundred rebirths, and I am still a fox. Will you save me from this condition with your Zen words and let me get out of a fox’s body? Now may I ask you: Is the enlightened man subject to the law of causation?’

Hyakujo said: `The enlightened man is one with the law of causation.’

At the words of Hyakujo the old man was enlightened. `I am emancipated,’ he said, paying homage with a deep bow. `I am no more a fox, but I have to leave my body in my dwelling place behind this mountain. Please perform my funeral as a monk.’ Then he disappeared.

– Excerpt from the koan Hyakujo’s Fox

In Zen, a koan is a story or dialogue designed to trigger and test understanding. It’s a fascinating literary form. Incredibly dense. Often, koans convey multiple layers of meaning in less than a hundred words. Sometimes just a few sentences.

The koan Hyakujo’s Fox, sometimes called the Wild Fox Koan, is of particular interest to me because it touches on many of the themes near and dear to us here at Epsilon Theory. Here a monk transforms himself into a fox by “clinging to absoluteness.” While this is absurd on its face, it’s really just a fancy way of arguing that perception is reality.

You are what you eat, the saying goes. More importantly: you are what you think.

Recently, a friend and I were texting about the meaning of life. (what? you and your friends don’t text regularly about the meaning of life?) My friend wrote that in the end, all you can really do is carry your cross to the finish line. I quite like this. It cuts right to the heart of the issue. There are no Answers. There is only Process. I did suggest adding an inscrutable Zen twist, however. My version:

In the end, all you can really do is carry your cross to the finish line. Except there is no finish line, there is no cross, and there is no you.  

People sometimes ask me, if all the world is narrative and meme, then how can we tell what’s real?

As far as social reality is concerned, it’s about as real as any game or theatre production. There’s the White Collar Corporate Power Game, for example. There’s Partisan Political Theatre. There’s the Social Status Game. If you prefer more high-brow forms of entertainment, you can indulge in Religious Theatre and Intellectual Theatre (I have a soft spot for the latter). But let’s not kid ourselves. It’s theatre and games, all the way down.

This shouldn’t come as news to anyone. Heck, it’s been right there in the Bible for over a thousand years. That bit about the camel passing through the eye of the needle easier than the rich man making it to the Kingdom of Heaven? That’s Jesus teaching that wealth and status are not inherently meaningful or worthwhile. Accumulating wealth and power are just games we play.

A while back, I wrote a note about this manufactured nature of social realities. I wrote then that it was a clear eyes note. Well. This is the full hearts sequel. 

You see, I’m pretty confident asserting that social reality–what we think of as “how the world works”–is the output of the following chaotic process.

nature (basically physics & biology) + nurture (operant conditioning) + randomness (error term)

I say this is a chaotic process because social reality is a three-body problem. There’s no closed-form solution. And the process is extremely sensitive to starting conditions. Everything else, as they say, is commentary.

I’m pretty sure the above is true. Yet it troubles me. First and foremost, it induces many a dark night of existential dread—that thick, dark curtain of despair that tends to descend whenever we contemplate our inevitable end. It’s not really physical death that bothers us (if it were, we wouldn’t find very much consolation in religion). No. What really bothers us is ego-death. What really bothers us is the dissolution of the self.

After all, physical death is no biggie if your consciousness (soul) transcends physical death. If that’s the case, then dying isn’t much different from moving to another country. Ego-death, on the other hand, is true death. Ego-death is non-existence. The void.

So what if there is no grand meaning to it all?

What if it all really does reduce down to nature + nurture + randomness, and the entire arc of the history of our universe is just a single run in some elaborate Monte Carlo simulation?

Frankly, you can take this to some pretty dark and nihilistic places. Perhaps no one articulates it better than the Misfit, the psychopathic antagonist of Flannery O’Connor’s short story, “A Good Man Is Hard To Find.”

“Jesus was the only One that ever raised the dead,” the Misfit continued, “and He shouldn’t have done it. He thrown everything off balance. If He did what He said, then it’s nothing for you to do but throw away everything and follow Him, and if He didn’t, then it’s nothing for you to do but enjoy the few minutes you got left the best way you can—by killing somebody or burning down his house or doing some other meanness to him. No pleasure but meanness,” he said and his voice had become almost a snarl.

The Misfit is one of my favorite antagonists in literature. You can read him almost any way you want. Maybe he’s nothing more than a rambling, murderous redneck. Or maybe he’s the most coldly rational, self-aware, introspective character in the story. The Misfit spent an awful lot of time in prison, after all. He’s had plenty of time to meditate on The Meaning of Life.

“Some fun!” exclaims his accomplice, Bobby Lee, after their gang finishes killing the Grandmother and her family.

“Shut up Bobby Lee,” the Misfit said. “It’s no real pleasure in life.”

(SPOILER) That’s the last line of the story. These days I like to read the Misfit as a kind of anti-zen monk. He’s got it all twisted. But he hasn’t necessarily got it wrong. He’s Hyakujo’s Fox. For clinging to absoluteness, he has been sentenced to suffer 500 rebirths as a psychotic spree killer.

So what the hell are we supposed to do about all this, exactly? How does one cultivate a clear-eyed view of our world without embracing murderous nihilism?

For starters, we quit looking for Answers. They don’t exist. Self-actualization has no closed-form solution.

But there is a Process.

The three images above are all of ensōs. An ensō is just a circle, drawn in a single stroke. Hitsuzendō is a form of zen practice where one draws ensōs as a meditative practice. The process is simplicity itself. You just draw a circle with a calligraphy brush. Maybe you close the circle. Maybe you don’t. Maybe you’ve got a thick, continuous circle. Maybe not. It doesn’t really matter what the circle looks like. Don’t overthink it. Just draw a circle.

Here’s the trick: everything we do in life and investing is as simple as drawing an ensō. Every. Single. Thing. As Ben wrote in his Clear Eyes, Full Hearts, Can’t Lose manifesto:

“You want freedom? You want an autonomy of mind and spirit? You want that as an inalienable right? A right that is yours simply because you are a human being? Well, that comes at a price. And the Kantian price is this: everything you do, you must do for the right reasons.

It’s really as simple – and as difficult – as that.

What are the right reasons? You don’t need me to tell you. You already know what they are, in every situation you’re in. You have a moral compass. But I’ll tell you anyway. Acting for the right reasons means acting in a way that reflects who you ARE as a moral human being. It means acting for your identity as a moral human being, not as a propitiation to some god or potentate, not as an exchange for some “greater good” that someone else has talked you into pursuing. Not even for gaining a Supreme Court seat. Not even for denying a Supreme Court seat.”

Note that I wrote this was simple above. I didn’t say it was going to be easy.

Question: Is morality socially constructed through a process where biological systems are socially conditioned to respond in particular ways to particular stimuli, or is morality an innate moral compass manifested in Kantian ethics?

Answer: Yes.

Now draw yours.


On The Great Jihad And Other Possible Futures


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“He had seen two main branchings along the way ahead—in one he confronted an evil old Baron and said: “Hello, Grandfather.” The thought of that path and what lay along it sickened him.

The other path held long patches of gray obscurity except for peaks of violence. He had seen a warrior religion there, a fire spreading across the universe with the Atreides green and black banner waving at the head of fanatic legions drunk on spice liquor […]

He found that he could no longer hate the Bene Gesserit or the Emperor or even the Harkonnens. They were all caught up in the need of their race to renew its scattered inheritance, to cross and mingle and infuse their bloodlines in a great new pooling of genes. And the race knew only one sure way for this—the ancient way, the tried and certain way that rolled over everything in its path: jihad.”

Frank Herbert, Dune

Dune is easily one of the greatest works of science fiction ever written. I’d go so far as to say it’s one of the greatest works of popular fiction ever written.

That’s not to imply Dune is an easy read. Or even a pleasant one. The first couple hundred pages are incredibly taxing. But it’s all downhill from there. In fact, I’m convinced this is precisely what us Dune fans love about the book. Itsdepth rewards you for your effort. But you have to earn it. Dune is truly a book for “idea people.”

This is precisely why Dune movie adaptations inevitably disappoint. Sure, Dune has a sci-fi plot. It’s got fairly well-drawn characters. It’s got action. But the real draw are the Big Ideas—ideas about how politics, science and religion shape humanity’s evolutionary path. Ideas about how politics, science and religion are used to manipulate humanity’s evolutionary path.

At its core, Dune is all about narrative.

(Funnily enough, it seems like Jodorowsky “got it”, at least in his own loony way. But his Dune adaptation was never made)

One of the recurring images in the book is what we in finance know as a probability tree. In the world of Dune, if you are at least a little bit psychic, and you amplify that psychic ability with a generous helping of hallucinogenic “spice,” you can catch a glimpse of the branching probability tree that is the as-yet-unrealized future.

Here in the investment and financial advice businesses, we, too, seem to have reached an evolutionary crossroads. I don’t claim to know exactly what the industry will look like in ten or twenty years. But like Dune‘s protagonist, Paul Atreides, I think I can peer through the haze of a spice trance to glimpse some of the branching possibilities.

Each of these possible futures has different implications for financial markets and the financial advice business.

The Great Jihad

In many ways The Great Jihad is the most straightforward path. It’s just not a particularly pleasant one. Here, we as a species fail to transition from competitive games to cooperatives games. Inevitably, this leads to big wars and violent revolutions. In this future state of the world, our portfolios and advisory practices are the very least of our concerns. We’ll be much more concerned with the simple things in life. Things like not getting shot, or sent to re-education camps, or starving to death.

If you truly believe we are headed for the Great Jihad, you want to own gold, guns, crypto and seeds.

The Zombification of Everything

We’re pretty familiar with the playbook for this future, because it’s more or less what we’ve been living since the 2008 financial crisis. Here, growth and interest rates remain low for many, many years. Decades. What’s more, the Nudging State and the Nudging Oligarchy somehow succeed in stabilizing the social and political tensions that this state of affairs tends to create.

This is a policy controlled world of zombie companies, zombie investors and zombie civic institutions.

From an investing standpoint, cheap, beta-oriented strategies will continue to dominate the product landscape. There will, of course, be niche opportunities for traders and stock pickers to make money, but never to such a degree that the policy controlled nature of economic and market outcomes can be called into question.

As far as financial advice is concerned, this future will amplify current trends toward focusing on financial planning and even financial therapy. The role of investment selection in an advisory practice will be increasingly marginalized, and advisor compensation will increasingly be divorced from client investment portfolios. There is no need to worry about investment outcomes in a policy controlled world. Why would anyone pay a premium for investment advice in such a world?

What’s more, two “truths” will be self-evident in a zombified world:

  1. Always be buying.
  2. Always be long duration

This is a future without bear markets and without interest rate risk. Financial asset valuations will have “permanently” re-rated higher on the back of common knowledge that the cost of capital will always and forever remain pinned near zero, and that economic cycles have been tamed.

In this world, Ben Graham style value investors are extinct. To the extent people who consider themselves value investors still have money to manage, they will claim to adhere to “evolved” value philosophies that emphasize “quality” or GARP.

However, the Zombification of Everything does not strike me as a stable equilibrium, precisely due to the social and political tensions that must be managed to maintain it. This future isn’t so much a destination as a layover on the way to something else.

The Great Reset

Great Reset is a kind of middle way. It’s not quite the dystopian hellscape of the Great Jihad. But it ain’t exactly a bed of roses, either.

I see two possible paths here. The first (and more unnerving) is that of debt jubilee and MMT. Here it is common knowledge that neither debt nor deficits matter. This is a future of structurally higher inflation. It’s only a question of degree. To me, this is the highest probability future of the three examined here.

Of course, the worst possible outcome is hyperinflation and revolution (shades of The Great Jihad there). But I believe there is a “milder” way forward, too, with “merely” high single digit or low double digit inflation. After all, this kind of inflation is the most politically expedient solution to the debt burdens and unfunded liabilities borne by today’s developed market policymakers.

What does this mean for our portfolios?

Much of what we think we “know” about investing will no longer work. Stocks and bonds will be positively correlated. Conventional wisdom about asset allocation will disappoint. Long duration bets will get crushed. Equity multiples will re-rate lower as the cost of capital rises.

The differences between stocks will matter again. Why? Pricing power is why. Businesses with pricing power will survive and even thrive. Businesses without pricing power will struggle. Many will die.

Naturally, this could open the door to a renaissance in stock picking. Even a renaissance in more traditional forms of value investing.

And what of financial advisors?

We will have to get to grips with the fact that many of our investing heuristics will not be particularly effective in this regime. They may even be counterproductive.

The diversification offered by a 60/40 portfolio will disappoint. Portfolio construction and stock selection will matter again. Financial therapists whose understanding of investing is limited to the heuristic that a low cost, 60/40 portfolio is always and everywhere best portfolio will find themselves at a disadvantage versus competitors who adapt more quickly to this new economic regime.

Both the Great Reset and The Great Jihad represent explicit rejections of the Zombification of Everything. Likewise, they represent explicit rejections of the Cult of the Omnipotent Central Banker. We will probably still have central bankers after the Great Reset. But common knowledge will mark them as sorcerer’s apprentices. Everyone will know that everyone knows that policy controlled markets are a febrile delusion.

I suppose there is also a kind of Golden Path here, where the Cult of the Omnipotent Central Banker is cast down without debt jubilee or MMT. How might such a thing happen? Policymakers themselves might eventually reject the idea of policy controlled outcomes and the tired tropes that come along with it (Fed Days, forward guidance, etc.). But the Golden Path is a narrow one, and it strikes me as a low probability outcome.

I conclude with a final Dune quote worth meditating on, whenever we consider the branching possibilities in life, business or the financial markets:

“And he thought then about the Guild–the force that had specialized for so long that it had become a parasite, unable to exist independently of the life on which it fed. They had never dared grasp the sword… and now they could not grasp it. They might have taken Arrakis when they realized the error of specializing on the melange awareness-spectrum narcotic for their navigators. They could have done this, lived their glorious day and died. Instead, they’d existed from moment to moment, hoping the seas in which they swam might produce a new host when the old one died.

The Guild navigators, gifted with limited prescience, had made the fatal decision: they’d chosen always the clear, safe course that leads ever downward into stagnation.”

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What You Call Love


Don Draper: What you call love was invented by guys like me. To sell Nylons.

In certain circles, it’s fashionable to assert that “words are violence.” That is to say, certain language is used to perpetuate and reinforce existing (typically oppressive) social power structures, and this is a form of coercion on par with physical violence. For brevity, I’m going to lump everyone who espouses these beliefs together under the broad umbrella of postmodernism.

In other circles, it’s fashionable to ridicule postmodern ideas and the oft-ridiculous policies they inspire.

However, to the extent postmodern thought keys in on narrative, and particularly the role of symbolic abstraction in shaping individual and group identities, I’d argue there’s plenty of analytical utility to it.

Where people run into trouble is when they attempt to turn a methodology for analyzing signs and symbols into a belief system. Because this type of deconstruction is an inherently nihilistic activity. Ultimately, there’s no there there [Incidentally, this also applies to science. Science is a methodology, not a belief system. And belief systems are what separate the Jonas Salks of the world from the Josef Mengeles]. Or, as Venkatesh Rao put it (much more eloquently):

“Losing [all sense of objective meaning] is a total-perspective-vortex moment for the Sociopath: he comes face-to-face with the oldest and most fearsome god of all: the absent God. In that moment, the Sociopath viscerally experiences the vast inner emptiness that results from the sudden dissolution of all social realities. There’s just a pile of masks with no face beneath. Just quarks and stuff.

But that’s a subject for another note. A full hearts note. This is a clear eyes note.

And in case you’re wondering, no, words are not equivalent to physical violence. That is nonsense.

What is not nonsense is the notion that if you can deftly manipulate the symbols people use to assign and create meaning in their lives, you can manipulate their thoughts and behavior. We have a name for this outside academia and the culture wars.

It’s called advertising.

Let’s unpack that Mad Men quote that led off this note. Don Draper is describing what academic types would call the “signified” and the “signifier.” The signified is the abstract concept, love. The signifier is the ad selling Nylons. The ad signals what love means—how love manifests itself in the world. How you should express it. How it should make you feel.

This relationship is the basis for language (human or otherwise). Heck, it’s the basis for conscious thought. It’s therefore the building block for both fiat news and fiat thought—the raw material our missionaries use to build their wolf traps.

Every missionary has his own version of the Don Draper quote.

Politician: What you call values were invented by guys like me. To win power.

Fancy Asset Manager: What you call ESG was invented by guys like me. To gather assets.

The Sell-Side: What you call a rotation trade was invented by guys like me. To earn commissions.

An important thing to remember here is that awareness of how missionaries manipulate signs and signifiers is NOT the same as saying there are no such things as facts. It is NOT the same as saying there is no point to believing in anything. It is NOT an invitation to nihilism.

It IS, however, the foundation for a clear-eyed view of your world.


Every Shot Must Have a Purpose


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I rather enjoy playing golf. But there’s no denying golf is infested with raccoons trying to sell you stuff. Swing trainers. Special clubs. Systems “guaranteed” to lower your handicap.

This ranges from the oversold…

…to the utterly ridiculous.

Not to mention a fair bit of coattail riding on anyone with an aerospace engineering background.

Golf’s a lot like investing that way. And a lot like life, for that matter. Once I realized this, I began to enjoy the game much more, as an exercise in both mental and physical discipline.

Any progress I’ve made on that front, I credit first and foremost to the book Every Shot Must Have a Purpose, by Pia Nilsson, Lynn Marriott and Ron Sirak. It’s rather critical of current methods of golf instruction and training—particularly of what the authors see as an overemphasis on technical mechanics at the expense of player psychology. Early on, they write:

This is where honesty comes into play. The first step toward expanding our perception of the game in general and reaching a better understanding of our own game in particular is to face reality. If that bad swing was caused because you tensed up under pressure, hitting a million practice balls won’t fix the problem.

Rather than the minutiae of swing mechanics, or gimmicky shortcuts, you’re better off focusing on:

  • Course strategy and risk management
  • Shot commitment
  • Focus and tempo

We see this in investing, too. Particularly when we’re investing other people’s money. The most grievous portfolio construction issues I see inevitably seem to center on basic issues of strategy and commitment. Particularly around whether a portfolio should be built to seek alpha or simply harvest beta(s). 

You don’t have to shape your shots every which way and put crazy backspin on the ball to break 90 in golf. Likewise, not every portfolio needs to, or even should, strive for alpha generation.

There are few things more destructive (or ridiculous) you can witness on a golf course than a 20 handicap trying to play like a 5 handicap. And it’s the same with portfolios. For example, burying a highly concentrated, high conviction manager in a 25 manager portfolio at a 4% weight. Or adding a low volatility, market neutral strategy to an otherwise high volatility equity allocation at a 2% weight. (See: Chili P is My Signature

I’ll go out on a limb and suggest very few financial advisors and allocators build portfolios capable of generating meaningful amounts of alpha. The hallmarks of portfolios purpose-built for alpha generation are concentration and/or leverage.

The hallmark of a portfolio lacking strategic direction and commitment, on the other hand, is optical diversification that rolls up into broad market returns (more pointedly: broad market returns less expenses).

I’m absolutely not arguing every portfolio should be highly concentrated. Or that every portfolio should use leverage. I’m merely arguing that portfolios should be purpose-built, with portfolio construction and manager selection flowing logically from that purpose. 

How is it we end up with portfolios that are not purpose-built?

We don’t commit to the shot.

Nilsson, Mariott and Sirak describe a textbook golf example:

Patty Sheehan, the LPGA Hall of Fame player, was playing the final hole of a tournament when she needed to hit a fairway wood second shot to a green protected by water on a par-5 hole. A birdie was essential to play in contention, and the possibility of an eagle was a chance she had to take. What resulted, however, was her worst swing of the day–in fact, probably one of the worst swings she ever made in competition—and she cold topped the shot. As the ball bounded down the fairway and into the creek short of the green, she watched her chances of winning disappear with it. […]

[T]he TV commentators missed the point. If they wanted to run a meaningful replay they should have shown the tape of the indecision BEFORE Sheehan hit the shot. First she had her hand on a fairway wood, then she stepped away from the ball and her caddie handed her an iron. Then she went back to the fairway wood. The indecision in the shot selection led to a lack of commitment during the shot. The poor swing resulted from poor thinking.

For an investment committee, the rough equivalent is the four-hour meeting that results in a 50 bps change (from 4.50% to 5.0%) to the emerging markets weight in the Growth model portfolio.

At best you are rearranging deck chairs with these kinds of moves.

Granted, when it comes to investing some of us will have a more difficult time managing shot commitment than others. For the self-directed individual, this is simply a matter of managing your own behavior. Advisors and institutions, on the other hand, must manage other people’s behavior, often in group settings.

There’s no easy solution to this issue. It can be fiendishly difficult to manage. But there’s at least one essential precondition for shot commitment in investing and that’s a shared investment philosophy. A code.

I’m not talking about the obligatory investment philosophy slide of everyone’s investor deck that’s included to pay lip service to a “process orientation.” I’m talking about genuine philosophical alignment. The kind of philosophical alignment that runs deep into the marrow of the decision makers’ bones and therefore permeates every aspect of portfolio design and management.

What does this look like in practice?

More time spent on philosophical discussions around persistent sources of returns and, more importantly, whether the investor(s) can credibly access them.

Significantly less time spent on chasing shiny objects, debating the merits of individual investment manager performance and statistical rankings of investment manager performance. (In fact, it’s okay to spend basically no time on this at all)

Significantly more time spent on managing the alignment of expectations across investment professionals, clients and other stakeholders in an accessible, plain-language manner. 

This is fairly straightforward in principle, but extremely challenging to execute.

  PDF Download (Paid Subscription Required):  Every Shot Must Have a Purpose


The Life Aquatic


In his note, This Is Water, Ben described the fourth pillar of the current zeitgeist. That pillar is financialization.

Financialization is squeezing more earnings from a dollar of sales without squeezing at all, but through tax arbitrage or balance sheet arbitrage.

Financialization is the zero-sum game aspect of capitalism, where profit margin growth is both pulled forward from future real growth and pulled away from current economic risk-taking.

Financialization is the smiley-face perversion of Smith’s invisible hand and Schumpeter’s creative destruction. It is a profoundly repressive political equilibrium that masks itself in the common knowledge of “Yay, capitalism!”.

This is a note about living and investing in the waters of the current zeitgeist: the life aquatic.

The Life Aquatic also happens to be the title of a 2004 Wes Anderson movie, where a vaguely Jacques Cousteau-like character, Steve Zissou (Bill Murray), attempts to exact revenge on the shark that ate his friend.

Financialization is a kind of jaguar shark. Financialization is all about using financial engineering techniques, either securitization or borrowing, to transfer risk. More specifically, financialization is about the systematic engineering of Heads I Win, Tails You Lose (HIWTYL) payoff structures.

One of my new favorite writers, Ribbonfarm’s Venkatesh Rao, wrote at length about HIWTYL in his series, The Gervais Principle.

This is a simple and child-like example of the operation of a basic human instinct: the heads-I-win-tails-you-lose or HIWTYL (let’s pronounce that “hightail”) instinct. It is the tendency to grab more than your fair share of the rewards of success, and less than your fair share of the blame for failure.

In business, and especially in finance, we see this playing out everywhere.

Debt-financed share buybacks? HIWTYL.

Highly-leveraged, dropdown yieldcos? HIWTYL.

Options strategies that systematically sell tail risk for (shudder) “income”? HIWTYL.

(aside: corporate borrowing can be viewed as management selling put options on a company’s assets. I’ll leave it to you to consider what that might imply about government borrowing)

Management fee plus carry fee structures? HIWTYL.

Literally every legal doc ever written for a fund? HIWTYL.

There are two ways to effectively handle a counterparty that has engineered a HIWTYL game: 1) refuse to play the game at all, 2) play the game only if you have some ability to retaliate if your counterpaty screws you. Legal action doesn’t count. The docs and disclosures are written to be HIWTYL, remember?

You need to be in a position to hurt your counterparty for real.

You need to be in a position to hurt your counterparty economically.

Steve Zissou: Now if you’ll excuse me, I’m going to go on an overnight drunk, and in 10 days I’m going to set out to find the shark that ate my friend and destroy it. Anyone who wants to tag along is more than welcome. […] I’m going to find it and I’m going to destroy it. I don’t know how yet. Possibly with dynamite.

[a woman asks a question about the shark Zissou is hunting]

Festival Director: [translating] That’s an endangered species at most. What would be the scientific purpose of killing it?

Steve Zissou: Revenge.

-The Life Aquatic (2004)

I’ll assume by now we’re all pretty familiar with the prisoner’s dilemma—the simple game where the payoff structure incentivizes “defection.” There’s also the iterated prisoner’s dilemma, where the game is played more than once. What’s interesting is that in this version, the “always defect” strategy that dominates the single-play version performs poorly.

Robert Axelrod analyzed the topic in depth in his 1984 book, The Evolution of Cooperation, in the context of a tournament where various strategies for the iterated prisoner’s dilemma competed for a high score. The winner ended up being the simplest of the strategies, “tit for tat”. Here’s how “tit for tat” worked.

On Turn 1, cooperate.

Thereafter, mirror your opponent’s decision.

It’s fine to swim in the waters of the zeitgeist, admiring the aquatic fauna. But should a jaguar shark suddenly emerge from the depths and devour your best friend, you’d best chase it down with dynamite and destroy it. Traders understand this principle deeply and intuitively. Particularly if they trade in an illiquid or opaque area of the markets.

In our highly-financialized world riddled with HIWTYL payoff structures, we’re most likely to get screwed when we engage in one-off transactions with counterparties we can’t effectively retaliate against.

Unfortunately, a lot of financial transactions fit this profile. Particularly for small investors.

The best we can reasonably hope to do is mitigate the risk of getting totally and irrevocably screwed. There are a couple ways to do this. One is to stay liquid. Don’t get involved in fund structures or transactions where you have no liquidity, or where someone is doing potentially illiquid things in an optically liquid structure where they can in fact lock you in at their discretion (*ahem* every hedge fund ever). Or, where someone else will likely be in a position to squeeze you, if and when you want to sell (*ahem* credit). You can still get screwed but you can also get out.

Frankly, however, that’s not ideal. Or even realistic.

A more flexible approach is to adopt a minimax regret mindset when making investment and position sizing decisions. “Assuming this all goes bad, how screwed am I going to be?” If you’ll be intolerably screwed under any but the most draconian scenarios, adjust your risk posture. Or hedge.

There’s an important distinction to be made here between risk mitigation and risk management.

Risk mitigation is about proactively reducing risk.

Risk management is about accepting risk, within certain parameters.

We confuse the two at our peril.

We tend to have more options when it comes to HIWTYL and tit for tat in every day life. Particularly at the office. Watch carefully how governance works. Watch how senior management makes and communicates decisions. Watch how rewards are distributed and blame is assigned throughout the organization. This is the thrust of the Ribbonfarm piece mentioned above.

[C]onsider the Golden Ticket example. It was a random idea that initially seemed good, then seemed to prove out bad, and then unexpectedly ended up as a win. Such are the uncertainties of life.

How would you attempt to bank such a success in predictable ways?

First you would cut a deal for a performance-linked bonus for a successful marketing campaign (but no penalty for failure of course).

Next, you would set up a committee and charter it to collect, vet and recommend ideas, perhaps with a promise of some nominal rewards, such as gift certificates, for successful ideas.

You would then drop hints and suggestions to create ideas, like the Golden Ticket scheme, that you personally favor.

And finally you would create the appropriate level of urgency in the work of the committee to achieve the risk-levels you want in the ideas produced.

If it works, you praise everybody generously, hand out a few gift certificates, keep your bonus to yourself, and move on. If it fails, you blame the people in charge of the work for failing to consider an “obvious” (with 20/20 hindsight) issue.

As usual, once you start looking for this stuff you will see it everywhere. So your homework is to take all this and apply it to politics. In the meantime, I’ll close with a final exchange from The Life Aquatic, between Steve Zissou and his financier, Oseary Drakoulias.

Oseary Drakoulias: The wire transfer came straight through from Kentucky, and the bank has agreed to gap-finance the rest. But there are a few hooks on it, so take a pew for a spell. Number One, the bank wants a drug screen for everybody on the boat, before they’ll forward the money.

Steve Zissou: A piss test?

Oseary Drakoulias: Yes, a piss test. Two, a stooge from the bond company will be riding along during the whole shoot, to keep you on budget.

Steve Zissou: Who’s the stooge?

Oseary Drakoulias: A chap by the name of Bill Ubell, and there’s not a damn thing you can do about that, Steve. Three, you must swear – legally swear – that you will not kill that shark, or whatever it is, if it actually exists.

Steve Zissou: I’m going to fight it, but I’ll let it live. What about my dynamite?


The Funnel


Lately I’ve been thinking about the mechanics of fiat news. By now we know what fiat news is: the presentation of opinion as fact. We know what fiat news looks like (pop on over to Vox and skim a few stories). But lately I’m more and more interested in how fiat news works.

The metaphor I like best is the medieval wolf trap.

Ben described the wolf trap in his note, Hot Rocks.

[W]olves expect to hunt and track their prey. By establishing a longer trail that must be navigated successfully the wolf becomes more committed to the trap the farther he goes. Third and most importantly, the design prevents the wolves from seeing each other until they get to the end of the blood trail, at which point it’s too late to escape what they now know is a trap.

Here’s the modern version of the medieval wolf trap. You probably recognize it. It’s a sales funnel.

This is how we hunt clients. Or readers. Or attention. Here’s some advice on creating a sales funnel from Forbes contributor Ashley Stahl (I can never resist a good meta joke). The part that really resonates with me?

Bottom Of The Funnel

By now, your customers trust you (as they should!). They’ve received all the benefits from the top of the funnel (the freebie they registered for on your website), and the middle of the funnel (be it emails with great content from you or otherwise), and they have some sense of who you are as a person. This is where you ask for the sale (hello, bottom of your funnel!). You want to continue to engage, of course, but you also want to offer something of even more value to your customers.

You’re a wolf. You’re doing product research or “shopping around” or consuming “some great content.” You’re in complete control.

Except you’re not. Your experience has been engineered to produce a particular outcome (a sale).

There’s nothing wrong with sales funnels. They’re not inherently evil. All sales processes more or less boil down to funnels. But the more sophisticated the funnel becomes, the less obvious it is the experience has been engineered. The more you’re led to believe you’re in control. Sophisticated funnels “nudge” your behavior while allowing you to believe the behavior was your own idea. The most sophisticated funnels replace your thoughts with fiat thought without you ever realizing it.

And this is where these funnel processes become problematic.

Fiat news is a kind of funnel process. It, too, is engineered. There are at least three stages to the fiat news funnel.

Perception: Fiat news filters the signals we receive. What is filtered out is every bit as important as what is allowed through.

Interpretation: Fiat news attaches subjective meaning to the signals it allows through the filter. This can be explicit or implicit. It’s more effective when it’s implicit, in the same way puppet theatre is more evocative when you can’t see the puppet strings.

Action/Reaction: Fiat news triggers a (relatively) predictable response to the assigned meaning.

Say I want to pump a sexy growth stock for clicks or subscriptions.

Perception: Emphasize huge TAM and “obvious” product/market fit. Downplay or omit mention of competition and low barriers to entry (if applicable). Keep the story as simple as possible. As Peter Lynch suggests, a small child should be able to understand the story in just a couple minutes.

Interpretation: The Future is coming. The Future is inevitable. People “in the know” about The Future are going to make a lot of money. Don’t be a Luddite. Luddites never make any money. Luddites are losers.

Action/Reaction: FOMO and FOMO-induced buying.

You can use this template as you go about your life, bombarded by various signals. Once you start, you”ll see it everywhere.

Rule #1 for fiat news funnel building is that you don’t allow contradictory signals through the filter. Contradictory signals induce confusion. Confusion leads to anxiety and indecision. This is the precise opposite of what the funnel is trying to achieve.

The fiat news funnel simplifies life. It adds meaning by subtracting cognitive dissonance. It remakes reality such that reality is legible and identity-compliant.

Back before I was contributing to Epsilon Theory, I wrote a short blog post about the link between sales and identity

If your job is to sell people stuff, the path of least resistance goes something like this:

1) Sell cheeseburgers to fat people

2) Sell advice on giving up cheeseburgers to fat people

The point here isn’t to poke fun at fat people. The point is that “fat person” is an identity with a lot connotations attached to it. One might go so far as to call those connotations “baggage.”

Other identities with a lot of connotations attached to them include: “retiree,” “former executive,” “doctor,” and “little old lady who wants a good rate on her CDs.”

We’ve all got identities. We’ve all got baggage. We’ve all got cravings.

One of the most obvious fiat news “tells” therefore is that fiat news will never draw attention to ambiguity, contradiction, or paradox.

The Power of And is anathema to the creators and purveyors of fiat news.

But reality does not resolve to a clean narrative. It is messy. It is frequently ugly and unsettling. It is full of seemingly intractable problems and irreconcilable contradictions.


The Ants and the Grasshopper


One bright day in late autumn a family of Ants were bustling about in the warm sunshine, drying out the grain they had stored up during the summer, when a starving Grasshopper, his fiddle under his arm, came up and humbly begged for a bite to eat.

“What!” cried the Ants in surprise, “haven’t you stored anything away for the winter? What in the world were you doing all last summer?”

“I didn’t have time to store any food,” whined the Grasshopper; “I was so busy making music that before I knew it the summer was gone.”

The Ants shrugged their shoulders in disgust.

“Making music, were you?” they cried. “Very well; now dance!” And they turned their backs on the Grasshopper and went on with their work.

I admit I’m quite fond of this fable. It promotes industry, a diligent work ethic and frugality. It also promotes effective risk management. The Grasshopper is not only lazy but blind to existential risk (a.k.a starvation). The Grasshopper not only fails to mitigate this risk but fails to identify it in the first place. The Grasshopper is the OptionSellers.com of the forest. And so the Grasshopper gets her comeuppance.


(of course there’s a BUT)

This fable “works out” the way it does because it’s set in a stable social system that respects the Ants’ property rights. Relax that condition and you might get very different results. Let’s pick up where we left off, for the extended edition:

“Making music, were you?” [the Ants] cried. “Very well; now dance!” And they turned their backs on the Grasshopper and went on with their work.

But the Grasshopper did not go back to dancing. Instead, the demoralized Grasshopper wandered the autumn landscape, sharing her tale of woe with other insects. Much to her chagrin, many others had not saved food for winter, either.

“What right do the Ants have to let us all starve?” the Grasshopper asked. “Why, wouldn’t that make them murderers?”

The other insects who had not gathered food for winter nodded in agreement, muttering among themselves about the greed and selfishness of the Ants. Did the Ants really deserve their hoard of food if they were going to lord the power of life and death over everyone else in the forest? It was hardly a crime to raise arms against someone who intended for you to starve to death, after all.

And so the Grasshopper and the other insects murdered the Ants and ate all their food.

The End.

My extended edition of this fable is about metastability. Or, more accurately, a breakdown in metastability. A superficial reading of metastability might make it seem like a breakdown in law and order. That’s not quite what I’m talking about here. Law and order might break down within an otherwise metastable social system. Whenever there’s a riot in an American city, for example, law and order break down. But a riot in and of itself does not alter the core values and mythology shared by American citizens.

A social system remains metastable as long as there is a reasonably broad consensus regarding its core values and mythology. Without this consensus, metastability weakens. Put another way: first-order threats to social stability, such as isolated riots and street crime, are risks that lie in the body of the distribution of outcomes, both for individuals and society. Metainstability is a higher-order threat. The risks associated with metainstability lie in the tails of the distribution. They fall under the broad category heading of Really Bad Stuff and include things like:

  • violent revolution
  • war
  • property expropriation

Back to the Ants and the Grasshopper. Would it behoove the Ants to share a bit of food with the other insects to shore up the metastability of the forest’s social system?

There’s no “right answer” to that question. This isn’t physics. The policy wonks among us might propose developing some model for relating the conditions of the forest’s welfare state to the political inclinations of its citizens. A neat exercise, but a reflexive one. Ultimately, the whole thing hinges on the insects’ subjective perceptions of themselves and their relationship to the other entities in the forest. The insects’ perceptions of themselves and their relationship to the other entities in the forest may or may not have anything to do with wonky policy position papers. The insects are under no obligation to act “rationally.”

The serious existential risks associated with this concept of metastability, and the reflexive nature of social systems, are the reasons we negotiate a social contract. Modern society is the output of a long and tortured series of negotiations over how and why we should structure the social contract to limit the nastiness and brutishness of the state of nature.

In the language of Epsilon Theory, managing risks to metastability requires the following:

Clear Eyes. Look through narratives and symbolic abstractions to see the world as it is. 

Full Hearts. Treat others as principals in the negotiating process, in a way that promotes potentially cooperative game play. 

My personal answer to the question of whether the Ants should share some of their food (or rather, whether the state should compel the Ants to share some of their food) is yes. Of course, we can endlessly debate the finer points of how exactly such a system should be structured. But broadly speaking, I think it ought to consist of the following:

  • Some form of temporary unemployment insurance
  • Some minimum level of health insurance coverage
  • Some form of old-age pension scheme

Now, I certainly don’t believe these things are an unalloyed good. They have costs. There will inevitably be inefficiency and graft involved with their administration. People will free-ride on them. To me, these costs and inefficiencies are the price of some metastability insurance. 

Am I completely at ease with these policies?


I think any clear-eyed view of them has to acknowledge social welfare programs tend to expand over time, and the power of the state along with them. The historical example of Prussia is instructive here. In the 19th century, the Prussian state was confronted with increasing social and political tensions between its rural and urban classes. Recall that Marx believed socialist revolution would happen first in Germany, not Russia. The tension intensified following German unification in 1871. Germany had a metastability problem. The Prussian solution was, in large part, the creation of a social welfare state. 

In his history of Prussia, The Iron Kingdom, Christopher Clark writes:

The medical insurance law of 15 June 1883 created a network of local insurance providers who dispensed funds from income generated by a combination of worker and employer contributions. The accident insurance law of 1884 made arrangements for the administration of insurance in cases of illness and work-related injury. The last of the three foundational pillars of German social legislation came in 1889, with the age and invalidity insurance law. These provisions were quantitatively small by present-day standards, the payments involved extremely modest, and the scope of the new provisions far from comprehensive–the law of 1883, for example, did not apply to rural workers. At no point did the social legislation of the Empire come close to reversing the trend towards increased economic inequality in Prussian or German society. It is clear, moreover, that Bismarck’s motives were narrowly manipulative and pragmatic. His chief concern was to win the working classes back to the Prussian-German ‘social monarchy’ and thereby cripple the growing Social Democratic movement.

[…] By the eve of the First World War, the Prussian state was big. Between the 1880s and 1913, it expanded to encompass over 1 million employees. According to an assessment published in 1913, the Prussian ministry of public works was ‘the largest employer in the world’. The Prussian railways administration alone employed 310,000 workers and the state-controlled mining sector a further 180,000.

I don’t believe it’s possible to divorce the expansion of the Prussian welfare state, and the Prussian state more generally, from the subsequent arc of German history. Prussia is a cautionary tale.

So, where do we draw the line? Is there a way to balance a pragmatic view of social metastability with checks on the expansionist tendencies of the state? There’s no single answer to that. But there’s a process. Clear Eyes, Full Hearts, again. When considering a particular policy, ask:

Is this policy designed to promote equality of opportunity or equality of outcome?

How might this policy serve the interests of the State and Oligarchy?

What abstractions are being used to sell me this policy?

Does this policy respect my autonomy of mind, or is it a manipulative “nudge”?

Which brings me back to policy wonks. The way I write about policy wonks you might think I’m completely dismissive of them. Not so. We need folks out there conducting social science research. When that research is conducted with a proper scientific mindset (see The Road To Tannu Tuva), it provides valuable perspective on the tradeoffs associated with various policy initiatives. What I am suspicious of are policy wonks as optimizers–policy wonks promising The Answers.

Because there are always tradeoffs. There are always consequences. Some are intended. Some are unintended.

That’s what we learn from the Ants and the Grasshopper.


The Grand Inquisition

A live look in on the morose and whiny Epsilon Theory crew.

The rough idea for this note has been kicking around in my head for a while now. But it was our recent correspondent, “Charles from the North Shore”, who finally brought it together for me. If you haven’t yet read Ben’s excellent Fiat World note, Charles observed the following:

You and your contributors seem to be continuously complaining, whining and expressing a kind of morose discontentment. Why are you all so unhappy and dissatisfied? Maybe take a few of your intellectually earned dollars and buy yourself and each of your contributors a surfboard, mountain bike, snowboard, and climbing gear, with the proviso, all must be put to use.

I must admit, I’m a bit bewildered by any characterization of Epsilon Theory as whiny and “morose.” Personally, I find piercing the veil of Narrative abstraction incredibly empowering. To me, promoting autonomy of mind is a profoundly hopeful endeavor. Then again, I’ve spent more than a little time with Russian literature. So maybe my perspective is a bit skewed. But while I wait for my Epsilon Theory-branded surfboard to arrive in the mail (Ed Note: Chuck’s allusion to the idea that we need to enjoy real life a bit more rings a bit hollow since that’s maybe half of what we write about doing – but alas, with our interests, you’re more likely to get an Epsilon Theory-branded wool scarf), Russian literature is what I’ve got for this note.

I’ve long been fascinated by Fyodor Dostoyevsky’s parable, “The Grand Inquisitor.” It’s a story within a story. In The Brothers Karamazov, Ivan relates the parable to his brother Alyoshaas a meditation on the tension between the existence of free will and the existence of a benevolent God.  

The premise is simple. During the Inquisition, Christ returns to Earth and begins performing miracles. Rather than welcoming him with open arms, the Grand Inquisitor immediately has Christ imprisoned, fully intending to have him burned alive as a heretic. The Inquisitor spends most of the parable explaining himself.

The thrust of his argument is that human beings can’t handle free will. Freedom makes human beings miserable. Rather than embrace our freedom we spend our lives seeking new and inventive ways of throwing it away. As the Inquisitor puts it:

There exists no greater or more painful anxiety for a man who has freed himself from all religious bias, than how he shall soonest find a new object or idea to worship. But man seeks to bow before that only which is recognized by the greater majority, if not by all his fellow-men, as having a right to be worshipped; whose rights are so unquestionable that men agree unanimously to bow down to it. For the chief concern of these miserable creatures is not to find and worship the idol of their own choice, but to discover that which all others will believe in, and consent to bow down to in a mass. It is that instinctive need of having a worship in common that is the chief suffering of every man, the chief concern of mankind from the beginning of times. It is for that universality of religious worship that people destroyed each other by sword. Creating gods unto themselves, they forwith began appealing to each other: “Abandon your deities, come and bow down to ours, or death to ye and your idols!” And so will they do till the end of this world; they will do so even then, when all the gods themselves have disappeared, for then men will prostrate themselves before and worship some idea.

Sound familiar?

What the Inquisitor is describing here is a common knowledge game. It’s not a desperate quest for what you ought to believe. It’s a desperate quest for what you believe that everyone believes you ought to believe. The conflict between Christ and the Inquisitor is therefore a conflict between missionaries. Christ is of course God’s missionary. The Inquisitor reads as a missionary for what we refer to around here as the Nudging State.

I’m often tempted to think of the Nudging State in the context of some grand struggle between good and evil. There are certainly some strains of truth there. But on closer reading, I’d argue the animating impulse for the Nudging State isn’t oppression in the generic sense, or even power for its own sake.

The way I see it, the Nudging State is about freedom. A very particular kind of freedom.

Freedom from choice.

The Nudging State believes with every fiber of its being that freedom of choice is an unbearable burden to us. Left to our own devices, we’ll screw everything up. We won’t save money. We’ll mismanage our businesses. We’ll embrace nihilism and anarchy. We’ll give in to all our worst impulses.

The Nudging State seeks to protect us from all that—to free us from the burden of choice.

As the Inquisitor puts it:

We will give them that quiet, humble happiness, which alone benefits such weak, foolish creatures as they are, and having once had proved to them their weakness, they will become timid and obedient, and gather around us as chickens around their hen. They will wonder at and feel a superstitious admiration for us, and feel proud to be led by men so powerful and wise that a handful of them can subject a flock a thousand millions strong. Gradually men will begin to fear us. They will nervously dread our slightest anger, their intellects will weaken, their eyes become as easily accessible to tears as those of children and women; but we will teach them an easy transition from grief and tears to laughter, childish joy and mirthful song. Yes; we will make them work like slaves, but during their recreation hours they shall have an innocent child-like life, full of play and merry laughter. We will even permit them sin, for, weak and helpless, they will feel the more love for us for permitting them to indulge in it. We will tell them that every kind of sin will be remitted to them, so long as it is done with our permission; that we take all these sins upon ourselves, for we so love the world, that we are even willing to sacrifice our souls for its satisfaction.

So, back to this whole notion of being whiny and morose.

Freedom is not a pleasure palace. Exercising autonomy of mind is not a journey paved with endless delights and accented with rainbows and sunshine dust. It certainly CAN be those things. But it is also a struggle. It is also a burden. It brings fear, anxiety and existential angst. It’s in carrying this burden, and helping our friends, family and neighbors bear their burdens, that we create meaning in our lives.

The Nudging State would have us exchange freedom for the illusion of sunshine and rainbow dust.

The Nudging State would have us outsource the very meaning of our lives.   


The Alchemy of Narrative


[Ed. note: I’m often asked what authors have influenced me, or who they can read to get another perspective on narrative in markets. Top of the list should be Chancellor Palpatine George Soros, and the first book to read is “The Alchemy of Finance”. So glad to see ET contributor Demonetized rediscovering Soros with this note!

Also, if you want to read an oldie-but-goodie ET piece on all this, check out “The Music of the Spheres and the Alchemy of Finance“. It was one of my very first articles, and is also the origin story of my avatar, Claudius Ptolemy.]

I revisited some of George Soros’s writing on reflexivity over the weekend (thanks Ben!). In doing so, I realized my initial reading, years ago, had been extremely superficial. Back then, I focused on feedback loops as amplifying the usual cognitive and emotional biases we point to in investment writing. Things like confirmation bias and loss aversion and overconfidence. This reading of Soros wasn’t necessarily wrong. But it was narrow and incomplete.

When Soros writes about reflexivity, he isn’t just arguing cognitive errors made by market participants cause prices to diverge from the objective reality of the fundamentals in self-reinforcing feedback loops. He’s arguing the fundamentals are often, if not always, themselves subjective realities.  

In this 2009 piece published in the FT, for example, Soros wrote:

Feedback loops can be either negative or positive. Negative feedback brings the participants’ views and the actual situation closer together; positive feedback drives them further apart. In other words, a negative feedback process is self-correcting. It can go on forever and if there are no significant changes in external reality, it may eventually lead to an equilibrium where the participants’ views come to correspond to the actual state of affairs. That is what is supposed to happen in financial markets. So equilibrium, which is the central case in economics, turns out to be an extreme case of negative feedback, a limiting case in my conceptual framework.

When you model a stock, or an economy, or a real estate deal, you’re not transcribing objective reality. You’re drawing a cartoon. At best your cartoon will be a reasonable estimate of the probability-weighted present value of the future expected cash flows associated with your investment. But even that’s probably a stretch. Because most of the modeling we do is based on statements or assumptions with embedded reflexivity.

Soros again:

Consider the statement, “it is raining.” That statement is true or false depending on whether it is, in fact, raining. Now consider the statement, “This is a revolutionary moment.” That statement is reflexive, and its truth value depends on the impact it makes.

What Soros is describing here is Narrative–and in particular Common Knowledge. What isn’t made so clear in his writing, at least what I’ve read of it, are the precise mechanisms through which reflexive statements propagate. But it all clicked into place for me during my rereading. To borrow Soros’s framing: the truth value of a reflexive statement is a function of the credibility of the person or institution making it.

In other words, Missionaries drive reflexive processes. Why?

Because making reflexive statements with high truth values is something only Missionaries can do. Only Missionaries have the power to create and shape Common Knowledge

Consider the reflexive statement: “the fundamentals are sound.”

The statement has no truth value whatsoever if I write it on this blog. Not for any reason related to the intrinsic qualities of the fundamentals and their relative soundness or unsoundness, but because my writing on this blog will not have any impact on market prices. Form an Information Theory perspective, this blog contains very little information (if any).

Now, if Jay Powell says “the fundamentals are sound”, that’s an entirely different proposition. Because Jay Powell can do something I can’t. Jay Powell can move the market. Jay Powell can even alter the strategic calculus for his Missionary brethren. Most public statements Jay Powell makes are therefore chock full of information.

If the market accepts the statement “the fundamentals are sound” at face value, it may rise in acknowledgement of the sound fundamentals. On the other hand, the market might take the statement as meaning the Fed will raise interest rates to prevent the economy from overheating, and therefore fall in anticipation of tighter financial conditions. Likewise, the statement “the fundamentals are unsound” can have a positive effect, if market participants interpret it as a signal for looser financial conditions. Sound familiar? We have, after all, been living this subjective reality for the last decade or so.

The information content of Jay Powell’s statements is always high.

The truth value of Jay Powell’s statements varies with their impact. 

Missionaries use reflexive statements to create and shape subjective realities for the rest of us.

Fed Watching is the ultimate reflexive sport. If you believe there is some kind of capital-T objective Truth to be found in Fed Watching, I am sorry to be the one to tell you but you are one of the suckers at the table. The Fed knows we all know that everyone knows the information content of Jay Powell’s statements is high. (We call them Fed Days, for god’s sake) The Fed plays the Forward Guidance Game accordingly. Sometimes it uses its “data” and “research.” Sometimes it speaks through one of its other hydra heads. The tools and tactics vary, but they’re all deployed to the same end: to shape the subjective realities of various economic and political actors.

The thrust of Soros’s writing is that all social systems are subject to reflexivity.

In other words: it’s the Missionaries’ world, and the rest of us are just living in it.


They Live!


This is the second note from Demonetized, a new guest contributor. No, that isn’t his real name. Rather atypically, this guest contributor is anonymous. To you, anyway – we know who he is. But even before we did, we were admirers of his approach and many shared point of views. We don’t and won’t always agree, but we’re very happy that he’s doing some pieces for us here. We think you will be, too.

[Dollar Note with subliminal message]: THIS IS YOUR GOD

They Live (1988)

If ever you find yourself struggling to keep the difference between Narrative and narrative straight, think of John Carpenter’s 1988 sci-fi action flick, They Live. No doubt it’s a goofy movie. The basic premise will be familiar to anyone who’s seen movies like Dark City or The Matrix. Reality, as we perceive it, is an illusion. But, if you obtain the gift of special sight, you may see the world as it is. In the case of They Live, you put on a pair of special sunglasses only to discover the world is, in fact, controlled by hideous aliens, which use mass media to shape our behavior with subliminal messaging.

The subliminal messages are Narrative. Mass media is the delivery vehicle.

What I love most about They Live are its “alien vision” shots. (Okay, and Roddy Piper’s iconic line: “I have come here to chew bubblegum and kick ass… and I’m all out of bubblegum”) Anyway. Back to “alien vision.” The beauty of the production design here is how sharply it contrasts the superficial optics of media we’re used to seeing every day with the blunt force of the subliminal messaging.

It’s a wonderful visualization of how symbolic abstraction operates in our world. And who knows, maybe Jerome Powell and Janet Yellen really ARE hideous aliens.

But this isn’t a note about your Friendly Neighborhood Central Bankers, or even how symbolic abstraction can be weaponized to sell you a new refrigerator. This is a note about how symbolic abstraction is used to shape your investment behavior. Both your behavior and your clients’ behavior.

Look at the below chart. You’ve probably seen it before. Maybe in a white paper. Maybe in a blog post. Maybe it hangs in the conference room where your firm hosts client meetings.

Source: CRSP

Now let’s put on our special sunglasses:

I must confess I have come to hate this chart. I don’t hate it because it’s wrong. I hate it for how it’s used, which is to imply anyone who isn’t overweight US equities is some kind of charlatan or idiot.

Why do you suppose that chart hangs in your conference room? Why that chart, and not a chart of German or Russian or Japanese equity returns? Better yet, why not that chart alongside charts of all different countries’ equity returns? Isn’t there an important point about the path dependency of investment returns to be made here?

No. There’s not. The chart doesn’t exist to educate you about the possible paths your portfolio’s performance might take, and the resulting impact on your financial position. The chart is there to send a message. It’s there to reinforce right thinking about asset allocation and portfolio construction in the minds of financial advisors and their clients.

Sure, we like to think we make investment decisions based on the objective analysis of data.

But in reality, it’s all negotiable. We modify asset allocations and financial plans all the time, for reasons that have nothing to do with data. We do it to accommodate the cognitive and emotional biases of our clients (home country bias being a prime example). We do it to protect our business relationships. Not because we’re charlatans or snake oil salesmen, but because if we don’t give a little on portfolio construction there’s a chance clients will fire us and hire real snake oil salesmen—smooth talkers who will tell them whatever they want to hear to their faces and do awful things to their finances when they’re not looking.

Most of us are overweight US stocks simply because an overweight position in US stocks has been forced upon us. We own cap-weighted index funds (particularly S&P 500 and US Total Stock Market funds) because when the US market goes up and up and up how can you do anything but get long the market while keeping fees and taxes as low as possible?

It’s right there in the data. How can we call ourselves fiduciaries if we ignore the data?

Investing according to that chart is common sense, right? I mean, we all know tactical asset allocation doesn’t work. It’s right there in the numbers.

Oops. Forgot to take off the special sunglasses. But you get the idea.

You might think by owning a bunch of index funds as cheaply and as tax efficiently as possible you can somehow “opt out” of making macro calls. “Forecasting is a fool’s game.” I get it. I’ve seen that data, too. But there’s no such thing as opting out of macro calls. Our 60/40 or 70/30 or 80/20 portfolios, implemented with the simplest, cheapest index funds and ETFs we can find, are themselves macro calls.

Now, I think there are good reasons why 60/40 portfolios have done well historically. I also think there are good reasons to be structurally overweight equities. I have a solid chunk of my own money in equities, and a healthy exposure to US equities at that. Why? Partly because it’s not clear to me capitalism works in a world where equities don’t earn a structural premium over bonds and cash. And if capitalism stops working, it’s not clear to me anything we do in our portfolios will help us build or preserve wealth. If you’re short the world, and the world goes to hell, taking the global financial system with it, then who’s left to pay you out?

Now, I can justify my macro bet in any number of ways, but I’ve still made a macro bet. It’s an implicit bet on the persistence of the conditions that have historically created equity outperformance, both in the US and abroad. It’s the kind of bet we should be making with Clear Eyes and Full Hearts.

We should place our bets after carefully weighing the various options available; our clients’ goals and circumstances; and a probabilistic view of future states of the world. We should not place bets (or do anything, for that matter) just because we’ve been conditioned to believe it’s what right-thinking and right-acting fiduciaries must do to serve their clients.

We place our bets with Clear Eyes and Full Hearts because in a Three Body Market, our bets can easily go the wrong way.

We know there are market regimes where today’s predominant macro bets won’t pay off. Ben wrote about them here: they’re the inflationary bust and the deflationary bust. Both spell trouble for equity beta. Big trouble.

And what works when cheap beta doesn’t?

All the strategies we’ve been conditioned to believe are BAD.

It’s low net long/short equity. It’s CTAs. It’s long vol and gold and discretionary global macro and farmland and pretty much everything else that’s less correlated, uncorrelated, or negatively correlated to equity beta. Basically, any bet against the successful transformation of financial markets into political utilities–any bet against the Nudging State’s agenda.

If you view the world through Clear Eyes, and hold loosely to your convictions, you’ll have an easier time adapting to a dramatic shift in the market regime than your competitors who’ve been lulled into a Narrative-induced fugue state. You’ll make up your own damn mind. You, your clients, and your business will all be better off for it.

Because we’re here to chew bubblegum and kick ass, both for ourselves and on behalf of our clients.

And, unfortunately, we’re all out of bubblegum.


Kobayashi Maru


From Ben and Rusty: With this note, we welcome Demonetized, a new guest contributor. No, that isn’t his real name. Rather atypically, this guest contributor is anonymous. To you, anyway – we know who he is. But even before we did, we were admirers of his approach and many shared point of views. We don’t and won’t always agree, but we’re very happy that he’s doing some pieces for us here. We think you will be, too.

In geekdom, the phrase “Kobayashi Maru” is synonymous with “no-win scenario.” It comes from a training exercise shown in the second Star Trek movie. The exercise presents a cadet with a crippled freighter, the Kobayashi Maru, broadcasting an SOS from restricted space. The cadet can either enter the restricted Neutral Zone and trigger an unwinnable space battle, or stand off and watch the crew of the Kobayashi Maru die. Like I said:  a no-win situation. It’s intended as an ethical dilemma, and as a test of character and leadership ability. Toward the mid-point of Star Trek II, Captain Kirk is asked how he fared in the exercise.

Saavik: On the test, sir… will you tell me what you did? I would really like to know.

Dr. McCoy: Lieutenant, you are looking at the only Starfleet cadet who ever beat the no-win scenario.

Saavik: How?

Kirk: I reprogrammed the simulation so it was possible to rescue the ship.

David Marcus: He cheated.

Kirk: I changed the conditions of the test.

Star Trek II: The Wrath of Khan (1982)

You know who’s struggling with the Kobayashi Maru these days? The long-only, discretionary active mutual fund manager. These firms are being squeezed by a proliferation of cheap beta; by increasingly demanding and fee-conscious financial advisory platforms; by their punitive tax treatment (compared to ETFs, anyway). You can either compete in the low-cost death spiral or you can exit the business.

Is there a way to beat this no-win scenario?

Well, like Kirk, you can try to change the conditions of the test. You can sell your product based on something other than fees and performance. You can sell product based on “values” and political identity. As we know, this is a particularly effective marketing strategy in a widening gyre. Consumer product companies have certainly figured it out. Nike has. So has Gillette. It’s a topic near and dear to Epsilon Theory.

In this note, I want to take a brief look at this strategy in the context of the investment business. That’s right, I want to talk about ESG.

ESG stands for Environmental, Social and Governance investing, and it’s all the rage these days. The idea is that your portfolio can (and should) reflect your values (assuming, of course, that your values are broadly in line with the Nudging State’s sustainability goals). In fact, many ESG proponents argue companies that score well on ESG measures perform better financially than those that score poorly.

The problem here is that the term “ESG,” much like “hedge fund,” is a cartoon. It’s so general as to be meaningless. There’s an incredibly broad spectrum of ESG strategies and scoring methodologies out there. Below is a stylized visual to illustrate:

This note isn’t meant to be broadly critical of ESG investing (though I think there’s a case to be made that much of the alleged performance benefit associated with ESG is just the Quality factor in disguise). I’m not dragging people who want to exercise their shareholder rights to influence corporate behavior, or people who want to fund specific projects related to education, housing, or renewable energy. I’m all for people exercising their shareholder rights, and putting capital at risk to fund projects they deem meaningful. To me, that’s economic freedom.

No, this note is meant to draw your attention to the Marketing BS end of the ESG Investing Continuum. This note is about ESG! the memeESG! as an asset manager’s solution to the Kobayashi Maru.

ESG! the meme isn’t about the performance benefits associated with ESG factors, or reducing the cost of capital for community lending cooperatives. ESG! the meme is about selling portfolios as virtue signaling devices, in an effort to stem the tide of outflows and fee compression.

Because here’s how ESG! is sold to financial advisors:

“The Millennials and The Women are going to inherit all the money when your Wealthy Male Clients die. The Millennials and The Women are the future of your business. The Millennials and The Women care about ESG! Here are surveys that show how much they care. And here is how to have the ESG!conversation with The Millennials and The Women. Once you have the ESG! conversation with The Millennials and The Women, you will be amazed at how much you can strengthen those relationships. Oh, and also here is some marketing collateral for all the new ESG! strategies we’ve either launched or acquired as the industry has consolidated.”

You might think I’m exaggerating here. I assure you I’m not. I’ve sat in several of these presentations over the last year. The script is remarkably similar across different firms. I’m merely stripping away the flowery language and storytelling a good salesperson will use to connect with the allocator or investor.

Now, this is an admittedly clever strategy. At least in theory, it moves the conversation away from fees and performance. Now we’re talking values. ‘Cause if performance is pretty decent, and the fees are reasonably competitive, wouldn’t you rather have a portfolio aligned with your values? Isn’t the alignment of your investment capital and your values worth it? Don’t you want to make a difference?

As a result, you see ESG! everywhere these days. Some days it seems as though it’s become a standard box for an asset manager to check. I’ve even seen it bolted onto municipal bond fund RFPs lately. (“Yeah, um, there’s not really an accepted definition of what ESG means for a municipal bond fund but we try and think about it, so sure, we do ESG analysis as part of our process.”)

Is it the worst thing in the world for people to invest this way?

No. You could do worse. Much worse.

But in keeping with the Epsilon Theory spirit, it’s important to view the proliferation of ESG products with Clear Eyes. Not only in terms of the efficacy of any given implementation, but in terms of how and why it’s being sold.

One man might call something ESG!

Another might call it “changing the conditions of the test.”