Epsilon Theory Manifesto

Our times require an investment and risk management perspective that is fluent in econometrics but is equally grounded in game theory, history, and behavioral analysis. Epsilon Theory is my attempt to lay the foundation for such a perspective.

The name comes from the fundamental regression equation of modern portfolio management: y = α + β+ ε where the return of a security (y) is equal to its idiosyncratic factors (alpha) plus its co-movement with relevant market indices (beta) plus everything else (epsilon).

The language of professional investment is dominated by this simple econometric formulation, and the most fundamental questions regarding active portfolio management – does an investment strategy work? how does an investment strategy work? – are now entirely framed in terms of alpha and beta, even if these words are not used explicitly. When investors ask a portfolio manager “what’s your edge?” they are asking about the set of alpha factors that can differentiate the performance of an actively managed portfolio from a passively managed portfolio. Even a response as non-systematic as “I know everything about the semiconductor industry and I have a keen sense of when these stocks are over-valued or under-valued” is really a statement about alpha factors. It is a claim that there is a historical pattern to security price movements in the semiconductor industry, that these movements are linked to certain characteristics of semiconductor companies, and that the manager can predict the future state of security prices in this industry better than by chance alone by recognizing and extrapolating this historical pattern.

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Comments

  1. Avatar for fvc fvc says:

    Thanks Ben for highlighting the manifesto. For us who joined your conversation late, it is rewarding to see you outline the geography. Fun to see how Cui bono has developed…

  2. In regard to analysis of narratives, there is a case, some years ago, in which a set of related narratives were sanded and polished and had concrete conclusions then drawn from them, namely, the detective stories of Agatha Christie. Via concordance analysis of her work, the following patterns were noted:

    1. If the story is less than 55K words, the culprit was probably female.
    2. If the story is over 71K words, the culprit was probably male.
       
      To see the rest of the patterns, including the remark that Christie herself was probably unaware of these patterns, follow this link:
       
      https://www.kiangle.com/notes-from-the-agatha-christie-code/
       
      Also, again based on concordance research, it seems that Christie was succumbing to dementia later in life (which itself is a narrative-analysis type result: “Vocabulary Changes in Agatha Christie’s Mysteries as an Indication of Dementia”). To see this discussion, follow this link:
       
      https://www.researchgate.net/publication/242107161_Vocabulary_Changes_in_Agatha_Christie’s_Mysteries_as_an_Indication_of_Dementia_A_Case_Study
  3. channeling Ogden Nash:
     
    Pursuing epsilon is fraught with strife,
    Frightful even for Mack the Knife.
    But at this task you can safely take a whack,
    If you have the pack to watch your back.

  4. I guess that the premise of this manifesto (common knowledge and game theory) is why I liked “The Big Short” so much. Dr. Burry’s short on MBSs didn’t require guessing, strategizing, or theorizing what someone else thought, it just required some mathematics and calculating that people weren’t going to be able to repay their mortgages. Eventually no matter what people thought about housing, it goes bust if people aren’t able to pay. With stocks, even if the stock is “ugly”, as long as enough people think (or think that other’s think) that they are pretty the price can stay high.
    So while I will continue to invest (play the game of anticipating common knowledge) I will save my biggest bets (investments) for where the common knowledge is just wrong and no matter what happens eventually the common knowledge will be proven wrong.

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