Notes From the Road: Roadkill

Get well soon balloon

Most species do their own evolving, making it up as they go along, which is the way Nature intended. And this is all very natural and organic and in tune with mysterious cycles of the cosmos, which believes that there’s nothing like millions of years of really frustrating trial and error to give a species moral fiber and, in some cases, backbone.

This is probably fine from the species’ point of view, but from the perspective of the actual individuals involved it can be a real pig, or at least a small pink root-eating reptile that might one day evolve into a real pig.

— Reaper Man by Terry Pratchett (1991)

This is Part 2 of the multi-part Notes from the Road series, introduced with Bayes and the Boreen. The Series explores how popular, otherwise adaptive methods we use to develop theories about political and financial markets based on priors and lived experience can subject us to unexpected new risks. The series tells the story of a range of journeys in history, sports, the arts and nature to illustrate the sources of those risks.

If, as Ben has written, memes are self-sustaining ideas that live in the human brain, I think there’s one that may predate all of the rest: Only the strong survive!

It’s a dumb meme about how we think evolution works that has spread, ironically, because of the way evolution actually works. Despite growth in scientific literacy, the popular conception of evolution continues to celebrate the idea that better/stronger/smarter things will prosper, and worse/weaker/dumber things will fail. The reality is much less sexy. Evolution is the process whereby nature necessarily favors traits which improve the ability of an organism to suvive until it reproduces. The idea that we are successful because of objectively superior traits – because only the strong survive! – is an idea perfectly adapted to the human ego. But on almost no dimension would we have judged our mammal ancestors superior to the dinosaurs they outlasted. But outlast they did, because – by sheer luck – their traits were better adapted to a post-Chicxulub state of the world.

That last observation is an important one. When we consider evolution as it truly is, we still usually focus on the organism, or in an Epsilon Theory context, the idea or the investment strategy in isolation. An individual organism mutates a new trait, which either makes it more or less well-adapted to the current environment. If more, then over time the trait is more likely to propagate. If less, then organisms carrying the trait will probably die along with it.  But for all the value that there is in constant improvement of our processes and philosophies in similar ways, the survival of a species or idea isn’t just a function of its own changing traits – it’s a function of the changing states of the world and the people in it.

For our investment principles and strategies, like any organism, observing that evolution is both a function of the traits of our ideas AND changes in the state of the world reveals two types of risks to our models and frameworks for understanding it:

  • Type 1 – The False Positive: We think and act like our principles are based on immutable laws of nature. They aren’t, and we get a rude shock when the world changes.
  • Type 2The False Negative: We believe that principles others believe are immutable laws are only representative of some temporary state of the world. We try to predict the change in the world, and it never happens. We waste returns, fees and client goodwill in the process.

Evolution is a painful journey for the individual. There’s not much solace in our failures becoming Harvard Business School case studies that help the species – or other investors. We must find some kind of middle ground between allowing ourselves to become speedbumps to a change in the state of the world on the one hand, or victims to the coyotes who would tell us “This Time It’s Different” about every bit of normal variability in the world on the other. We have to find that middle ground in our non-investing lives, too. Which of our heuristics and principles for evaluating life decisions are objectively true, or are at least true enough? Which are adaptations to our past environments and experiences, and will those be relevant to our new situation? When we make big life decisions, are the priors we rely on, well…reliable?  In the end, we muddle through, and more often than not, make it up as we go along.

Incidentally, that’s exactly what I’m doing. Next week, it’ll be 27 hours with a 2- and 3-year old in a blue pickup on the 1,712 miles of Dwight D. Eisenhower’s asphalt dream between old home and new. In honor of this journey, since we’re talking about growth, evolution and risk, and since I’m moving up to a part of the country where I won’t be able to talk about this sort of thing in polite company any more, I figure it’s as good a time as any to write about roadkill. And that’s saying something, because it’s always a good time to write about roadkill.

Full disclosure. If you’ve read this far, you’ve read the word ‘roadkill’ five times: once in Ben’s email, once at the top of this essay, twice in the prior paragraph and once in this sentence. You clicked on it, and I kind of feel like you’re already in for at least a penny here. But if you were squeamish about Ben’s disgusting tick infestation picture from a couple months ago, this one may not be for you.

Profiles in Roadkill: Dasypus Novemcinctus

Now that we’ve gotten all that out of the way, we can start talking vehicular critterslaughter. Allow me to introduce you to someone special.  This handsome fellow on the left is a nine-banded armadillo – one of the three state mammals of Texas, because unlike the boring-ass state you live in, Texas gets THREE state mammals. Take that, James Madison and your exquisitely reasoned Federalist Paper 62. Armadillos are remarkable little creatures who followed an unusual and narrow genetic path that has produced some of the strangest land mammals alive today. In addition to its signature armor plating, the armadillo reproduces from an egg which separates into four parts after fertilization. That means that nearly all litters consist of 4 identical creatures of the same sex. What’s more, the implantation of that fertilized egg is typically delayed by the mother by several months to better align with the spring season. Very handy, that.

The armadillo can inflate its intestines to float. It can hold its breath for six minutes to submerge. And that armor really is as tough as we think it is. Tough enough to defeat a .38 revolver. Like its closest cousins, the anteater and tree sloth, the armadillo is a marvel of specialized adaptations. One of evolution’s many weird, slimy miracles.

Also, when an armadillo sees headlights, it gets so terrified that it jumps straight up in the air and gets slammed by a car that would otherwise have passed right over it.

Profiles in Roadkill: Odocoileus virginianus

The armadillo, however, probably isn’t the animal most people (outside of Texas, anyway) think of when they think of victims of automobile-related critter flattenings. In honor of the trek we will take through the beautiful and too-unfairly-maligned state of Mississippi (which is also probably better than your state since it has two state land mammals), it is time we recognize the famousest of roadkill, the white-tailed deer. So common is the sad sight of one of these beautiful creatures along US highways that it causes the otherwise stonehearted, rage-filled American motorist to descend into our country’s unique style of gallows humor. Get well soon, gross deer. Get well soon.

Like the armadillo, evolution has gifted the white-tailed deer with extreme traits that are well-adapted to the challenges it faced during its emergence as a species. First, it is a remarkable jumper. While deer fences tend to be around eight feet tall, the average individual can actually jump somewhat higher than that, in some cases as much as 12 or even 15 feet. Somewhat less when it needs to jump forward and not just up.

Second, probably because of the adaptive benefits of a better field of vision for spotting predators, deer’s eyes are positioned closer to the sides of their head than the front. That means that deer, like many other prey animals, sacrifice binocular vision and depth perception to, you know, get eaten less by things behind them and to their sides. The downside is that it is more difficult for deer to judge distance and the depth of objects in front of them. Incidentally, in addition to being particularly stupid, this is one of the reasons why white-tails don’t always jump over fences they almost certainly could – poor depth perception means that they can’t be sure if they’re going to clear it.

Third, whether because of the need to manage temperatures and heat, to avoid predators, or other reasons they keep to themselves, thank you very much, white-tailed deer are crepuscular, which means they are most active in the twilight hours of dawn and dusk. That adaptation means that their vision is attuned to modest levels of light.

Like the armadillo, the combination of these natural talents has done wonders for making white-tailed deer one of the most successful and widely distributed mammal species in the world.

It also means that when a deer leaps into a road, it spots your distant car in its remarkable peripheral vision, turns its head, is blinded by your headlights because of the attunement of the rods in its eyes to take in more light, and because of its lousy visual acuity and depth perception, can’t make out the closing distance of your vehicle until it’s too late, at which time it leans upon its remarkable leaping abilities so that it can take out your windshield because screw you AND your Volvo.

Profiles in Roadkill: Sciurus carolinensis

Although the deer is the most iconic roadkill animal, it’s not the most common. The most common is the state mammal of one of the most beautiful states in our fair union, but one that admittedly only manages to have a single state mammal, so take my kind words about its trees, mountains and coastlines for the damning faint praise that they are. It’s your time to shine, Interstate 85 and North Carolina.

The 1993 data from an ongoing survey of roadkill (weirdly created for schools as a testing ground for teaching the scientific method) reported just over 750 squirrels in its sample. If anyone is curious, there were only 308 raccoons and 4 coyotes. The noble possum comes in second, at 348. Squirrels are the undisputed kings of roadkill, and yes, the extremely disappointing state mammal of the State of North Carolina. By the way, this really IS disappointing, because North Carolina could have selected one of its many legitimately interesting and endangered/threatened species, like the Carolina Northern Flying Squirrel. The state is also one of the last homes east of the Mississippi for the Townsend’s big-eared bat, which adapted a whispered form of echolocation that probably serves as a countermeasure to the active sonar jamming skills of its primary prey – moths.

Now, obviously some of the reason so many squirrels become double-thumps in the road is because – despite my efforts as a kid with a BB-gun – there are a lot of squirrels. But that’s kind of the point. There are a lot of squirrels because squirrels are a very successful species. Part of why they are a very successful species is because they are very successful at avoiding predation, mostly by hawks and other birds with a taste for tree-rat.  Part of the reason they are so successful at avoiding predation is that they adapted an instinctive tendency to run in seemingly random zig-zag motions that involve unpredictable changes in both speed and direction. Very good defense against a hawk flying at high speed toward a fixed point.

Not so much against a speeding teenager driving his mom’s Yukon.

All three of these animals are incredibly successful and still growing their geographic footprint. All three are incredibly well-adapted to the challenges that they faced over the course of their evolution. All three are well-prepared for the challenges they face in most of their daily lives. All three get dead real quick when their evolutionary strengths are transformed into circumstantial weaknesses.

Part of the reason I wrote this, the second note in this series, was to make you look at that hilarious and morbid roadside pizza party deer. That and to pursue some tortured analogy to compare you, dear reader, to roadkill. But there’s an important investment lesson here, too: Survival is the only way we measure the success of an adaptation, and the species that treats past adaptations as timeless and universal – as laws of physics – will go extinct.  

The trick is in knowing what, among all the things we do as investors, reflects timeless and universal principles, and what reflects our adaptation to states of the world which will change. It’s not always easy to tell the difference.

Timeless and Universal Principles

For my part, I think timeless and universal principles of investing must be either tautologies or generalized reflections of human behavior. Heuristics which are based on states of the world (e.g. I like this asset class because it is cheap, I favor this sector because of its growth characteristics, I’m concerned about this country because of higher-than-usual geopolitical risk) don’t really fit. Philosophies which are driven by views on the superiority of certain constructs (e.g. asset classes, instruments, etc.) are similarly ephemeral. I think there are really four timeless and universal principles, and we’ve written about each before:

  1. Over very long periods, you will generally be paid based on the risks an average investor (including all of his liquidity sensitivities, his investment horizons, etc.) would be taking if he made that investment [1]. – Whom Fortune Favors
  2. We must be supremely confident that we have information about the returns on various investments to justify decisions which reduce the diversity of our sources of return.You Still Have Made a Choice
  3. Humans have evolved to demonstrate preferences for certain types of investments and returns. Those preferences – and the fact that other humans will shrewdly seek to exploit those preferences – will influence returns.The Myth of Market In Itself
  4. Taxes, fees and transaction costs will reduce returns.Wall Street’s Merry Pranks

I think it’s a good framework. You may not, in which case you should replace it with what you think these rules are. Or y’know, by sending me an email telling me how stupid I am. Both are fine. But identifying these rules means acknowledging that all of our other philosophies are either successful adaptations OR new things we’re trying out because we are guessing they will be better suited for some future state of the world. After all, if we’re going to update our Bayesian estimates, we’ve got to have some kind of experiment.

It isn’t hard to identify beliefs and strategies that look well-adapted over the last decade, by which I mean investment strategies whose reputations have survived. Structurally owning more assets in U.S. financial markets looks well-adapted during this age of the world. So has owning more stocks in technology companies. Believing that there is no need for an investor to have a financial adviser seems like a very well-adapted trait. Aversion to any strategies which try to pick which securities will outperform. Keeping things simple with a 60/40 portfolio of stocks and bonds. Leveraged strategies. Aversion to, skepticism about and usually derisive attitudes towards hedge funds. Those of us who saw what worked in 2009 and 2010 and stuck with it as the new normal probably have a pretty confident assessment of some of our adaptations. More than a few of us and our clients have adopted some of the above as heuristics – our rules of thumb around which we generalize our investment beliefs into process.

What does treating well-adapted-looking traits like permanent states of the world look like? Below is one innocuous-looking example from social media marketing. I’ve removed any author’s name to protect the innocent.

There are good principles in here. But look at these more closely to see temporarily well-adapted traits creep in. A decade of dominance from US stock markets and low volatility has created a world of investors who now think that saying “keep things simple” and “avoid excessive diversification”, which are smart-sounding dog whistles for “just buy US large cap ETFs”, is timeless and universal advice. It’s not. And it’s going to get a lot of investors hurt.

Unfortunately, the memeability of common sense! advice like this is is exactly how an adapted trait evolves into a species-defining characteristic. Survival and reproduction. And then extinction.

Identifying the line between timeless principles and adaptations gets even harder over very long periods. 30 years. 50 years. Owning more bonds than our timeless principles might otherwise recommend. Relying on those same bonds to be diversifying against stocks. Knowing that commodities are not really investable, that real assets should just be a personal asset. Trusting that risky assets will always generate positive returns over a long enough horizon. As periods get longer, our confidence that our heuristics are not situational adaptations, but timeless and universal principles, grows.

All of this is Roadkill thinking. Oh, we may not get run over right away. It may never happen – during our investment lifetimes, anyway. We may go quietly in our sleep like so many armadillos, convinced that we adapted to survive cars just because we never got run over. But believing that the strategies we developed are timeless and universal strategies just because they’ve worked for us during our careers so far, or because they have worked for others for what feels like a very long period of time, is Roadkill thinking.

This first kind of Roadkill thinking is of the Type 1 error variety I mentioned earlier – false positives when identifying timeless and universal truths about markets.

Type 2 errors in Roadkill thinking are usually the more pernicious. It’s easy to think that the solution to our fears that an investment environment may be changing is to be creative, to throw a bunch of ideas at the wall, because that’s what we think adaptation looks like. And it is, in a way. But while adaptation through (mostly) random mutation works at the species level, at the individual level, it is literally murder. If our adaptive strategy is trying to time the turn in value or the market top, we will probably fail individually. If our adaptive strategy is to hold a quarter of our portfolio in cryptocurrencies to insulate us against what’s next, we will probably fail individually. If our adaptive strategy is to drain the swamp by…sorry, lost my train of thought, there. And sure, our failures will inform and improve the odds of success of other investors at large. A fat lot of good that does us. There’s a reason why coyotes with no skin in the game are so drawn to fields where they can promise disruption, new ideas, and high risk/high reward opportunities: because they share in all the upside of the aggregate while subjecting us to the risk of individual ruin along the way.

What does matter is that pursuit of these strategies often comes at the explicit or implicit expense of the ideas that really are permanent. We have finite dollars and finite attention, and our attempts to do something about environments that confuse us are usually distractions. In the same way that we’re probably all Coyotes from time to time, I think we’ve got a lot of Roadkill in us, too. I certainly do, anyway. There’s no extricating it from our nature, but as with so many things, simply acknowledging it goes a long way toward being mindful of its influence:

  1. Roadkill doesn’t know what its timeless and universal investment principles are.
  2. Roadkill doesn’t discern between temporarily effective adaptations and timeless principles.
  3. Roadkill randomly tries new adaptations even when they violate timeless and universal principles.

If we would not be Roadkill – or worse, food for coyotes – we would do well to subject our priors to constant challenge. What assumptions are we making about our investments, intentionally or unintentionally? What priors are built into our portfolio construction and investment selection methodologies? Are they always true, or maybe artifacts of an environment or industry convention?

For my part, were I sitting on an investment committee during a period of slowing in population growth, after a sustained long-term rally in multiple types of risk assets, following an extended period of falling interest rates, in the face of historically significant household and government debt, with increasing abstraction sitting between valuations and value, I would hold very loosely to all but my core principles. During every regular review, I would subject my conventions – sectors, style definitions, benchmarks, asset class definitions, risk measurement methodologies, and the like – to scrutiny.

More to the point, when we write about Narrative, we write in part because we believe that Common Knowledge about investment strategies and investable assets is part of what makes them work. This is our theory, and not a fact, but I think that Narrative analysis can inform earlier, less individually risky attempts at adaptation as environments change. Big if true. And I think it is.

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We had a little fun at North Carolina’s expense, but it’s a wonderful state and a wonderful place with a lot of people that are hurting – and will be hurting – for a long time. From my experience with Hurricane Harvey in Houston, there are few organizations that do as much good as the United Way. If you can, consider giving now to the United Way of Coastal Carolina. Or if you want to make amends for laughing at the balloon deer, the Outer Banks SPCA and the Dare County Animal Shelter will be in desperate need of help over the next few weeks.

[1] This is, incidentally, why I am not one of those who thinks that volatility is a terrible ex ante way of thinking about risk. If price sensitivity matters to individual investors – and it does – it matters to how the return investors will demand for taking that risk, even if that perception is completely irrational and they should be thinking about “permanent impairments to capital” or some other phrase that has survived because it sounds clever in marketing materials. My experience with investor behavior also tells me that unrealized returns often become realized when they’re big, negative numbers.


You Had One Job


ots more where this came from on Of course I think these pix and this meme are hilarious. But then I start to think about whether or not alternative investment strategies have done their job. I start to think about what that job is. And I go hmmm …

Whenever you are about to find fault with someone, ask yourself the following question: What fault of mine most nearly resembles the one I am about to criticize?

― Marcus Aurelius, “Meditations” (180 AD)

esar Millan, dog whisperer. The show can be silly, but I’m a fan. If you want to boil his advice down into one phrase, it’s this: every dog needs a job.

It’s true for the pack, and it’s true for the portfolio.

I know he doesn’t look like much, but Karnak is the most powerful superhero of them all. His ability? To see the flaw in all things. That includes death and philosophies. That includes himself. When he’s not begrudgingly saving the world, Karnak spends most of his time staring at blocks of stone.

One of Karnak’s flaws is that he can’t lead. No one follows a man who sees exactly what’s wrong with you. But he’d make a great short-seller.


Again. Sadder than was. Again. Saddest of all. Again.

William Faulkner, “The Sound and the Fury” (1929)

How often have I lain beneath rain on a strange roof, thinking of home.

William Faulkner, “As I Lay Dying” (1930)

Memory believes before knowing remembers.

William Faulkner, “Light in August” (1932)

The past is never dead. It’s not even past.

William Faulkner, “Requiem for a Nun” (1951)

A Great Rabbi stands, teaching in the marketplace. It happens that a husband finds proof that morning of his wife’s adultery, and a mob carries her to the marketplace to stone her to death.

There is a familiar version of this story, but a friend of mine — a Speaker for the Dead — has told me of two other Rabbis that faced the same situation. Those are the ones I’m going to tell you.

The Rabbi walks forward and stands beside the woman. Out of respect for him the mob forbears and waits with the stones heavy in their hands. ‘Is there any man here,’ he says to them, ‘who has not desired another man’s wife, another woman’s husband?’

They murmur and say, ‘We all know the desire, but Rabbi none of us has acted on it.’

The Rabbi says, ‘Then kneel down and give thanks that God has made you strong.’ He takes the woman by the hand and leads her out of the market. Just before he lets her go, he whispers to her, ‘Tell the Lord Magistrate who saved his mistress, then he’ll know I am his loyal servant.’

So the woman lives because the community is too corrupt to protect itself from disorder.

Another Rabbi. Another city. He goes to her and stops the mob as in the other story and says, ‘Which of you is without sin? Let him cast the first stone.’

The people are abashed, and they forget their unity of purpose in the memory of their own individual sins. ‘Someday,’ they think, ‘I may be like this woman. And I’ll hope for forgiveness and another chance. I should treat her as I wish to be treated.’

As they opened their hands and let their stones fall to the ground, the Rabbi picks up one of the fallen stones, lifts it high over the woman’s head and throws it straight down with all his might. It crushes her skull and dashes her brain among the cobblestones. ‘Nor am I without sins,’ he says to the people, ‘but if we allow only perfect people to enforce the law, the law will soon be dead — and our city with it.’

So the woman died because her community was too rigid to endure her deviance.

The famous version of this story is noteworthy because it is so startlingly rare in our experience. Most communities lurch between decay and rigor mortis and when they veer too far they die. Only one Rabbi dared to expect of us such a perfect balance that we could preserve the law and still forgive the deviation.

So of course, we killed him.

– San Angelo, “Letters to an Incipient Heretic”

Orson Scott Card, “Speaker for the Dead” (1986)

It takes a village to manage a portfolio. Or a country. Discipline to maintain process. Flexibility to tolerate deviance … err, I mean tracking error. We need better Rabbis. Who we don’t kill.


In all cases, not only in the two which we have analyzed, recovery came of itself. But this is not all: our analysis leads us to believe that recovery is sound only if it does come of itself. For any revival which is merely due to artificial stimulus leaves part of the work of depressions undone and adds, to an undigested remnant of maladjustment, new maladjustment of its own which has to be liquidated in turn, thus threatening business with another crisis ahead. Particularly, our story provides a presumption against remedial measures which work through money and credit. For the trouble is fundamentally not with money and credit, and policies of this class are particularly apt to keep up, and add to, maladjustment, and to produce additional trouble in the future.

Joseph Schumpeter, “Depressions: Can we learn from past experience” (1934)

Schumpeter famously wrote that his personal goals were to be the smartest economist in Europe, the finest horseman in Austria, and the most accomplished lover in Vienna. He judged these to be equally difficult and equally praiseworthy achievements. I think he overrated the whole economist thing.


Marsellus: The thing is, Butch, right now you got ability. But painful as it may be, ability don’t last. And your days are just about over. Now that’s a hard motherfn’ fact of life, but that’s a fact of life you’re gonna have to get realistic about. See, this business is filled to the brim with unrealistic motherf’rs. Motherf’rs who thought their ass would age like wine. If you mean it turns to vinegar, it does. If you mean it gets better with age, it don’t. Besides, Butch, how many fights do you think you got in you anyhow? Two? Boxers don’t have an Old Timers Place. You came close but you never made it. And if you were gonna make it, you would have made it before now. [holds out the envelope of cash just out of Butch’s reach] You’re mine, dig?
Butch: It certainly appears so.
“Pulp Fiction” (1994)

Like boxing and organized crime, our business is filled to the brim with unrealistic motherf’rs.

This is the line that haunts me: if you were gonna make it, you would have made it before now.

The Hunt family has three dogs, each with a distinct job. The German Shephard’s job is to protect. The Sheltie’s job is to herd. The Golden’s job is to love. Each dog is very good at its job, sometimes in an annoying way (particularly the Sheltie), but they’re oh-so happy with what they do well, and it fits our entire family dynamic. There are sacrifices we make for having this particular pack, like we can’t have any other dogs drop in for a visit or else the German Shephard might eat them, but the positives far outweigh the negatives. We’re a solid pack, and there’s nothing quite like that feeling of knowing that the dogs are there for you and you for them, and that the entire Hunt family — human and dog alike — is stronger not just in fact but in spirit for giving ourselves over to the pack.

It’s the same with investment portfolios. Every dog needs a job, and every investment does, too. No single dog can be all things to all people, and neither can a single investment. Nor can any pack of dogs accomplish anything and everything you like. The biggest mistake people make when they get a dog is trying to make the dog fit into the life they wish they led, rather than the life they actually lead. You better know thyself before you get a dog, much less a couple of dogs, and it’s exactly the same thing with making an investment. But if you get it right … man, there’s nothing better. Like a confident pack, a confident portfolio provides both strength in fact, as well as — and this is the part I bet you’re missing right now and the focus of this note — strength in spirit.

In my experience, most people don’t particularly like their portfolios, much less get a lift from them. They tolerate their portfolios. They may be pleased enough with the performance, but they don’t get a psychic boost from their portfolios. They don’t enjoy the confidence and strength of spirit that a solid pack or a solid portfolio can provide. And before you say that this really doesn’t matter to you, that so long as your portfolio performs up to a certain standard you couldn’t really care less whether it provides any “psychic strength” or any such mumbo-jumbo hogwash, let me stop you to say that you’re not just wrong, you’re completely wrong. In truth, the only thing that matters to you about your portfolio is its psychic reward, the positive way it makes you feel.

Now don’t misunderstand me. Performance is part of that psychic reward, usually the biggest part. But in the same way that the Economic Machine is part of a larger social phenomenon that I call the Narrative Machine, in the same way that Newtonian physics is part of a larger set of natural laws called Einsteinian physics, in the same way that Game Theory is part of a larger intellectual construct called Information Theory, so is “performance enjoyment” part of a larger behavioral attitude toward our portfolios. I first wrote about all this in Epsilon Theory with “It’s Not About the Nail” and “It’s (Still) Not About the Nail”, and it’s high time I picked up on this thread as part of the current “Anthem!” series.

The place where I see the greatest dissatisfaction or lack of spirit in most portfolios is in the allocation to alternative strategies. Most model portfolios that come down from on high at the big wealth management firms suggest that alternative strategies should be anywhere from 10-20% of a portfolio. But in fact most actual portfolios for actual clients have a small fraction of the recommended allocation, say 3-4% at most. Why the disconnect?

To answer that question, let me start by telling you what the answer is not. The answer is NOT that financial advisors or professional investors need more “education” about the virtues of an alternatives-heavy portfolio. I think that this focus on “education” is the single most tone-deaf and semi-condescending aspect of the business of modern investment management, which I suppose is a pretty bold statement given the sheer number of tone-deaf and semi-condescending things in our line of work. But there you go. I see it every day. Another email, another webinar, another white paper, another earnest effort to “educate” financial advisors about alternatives, with, let’s be honest, the unspoken implication that you are kinda stupid if you don’t have a heaping plate of alternatives in your portfolio.

It’s not that any of these “educational” efforts are wrong. They speak the truth, albeit a bloodless, overly scientificized truth. But the truth is also that financial advisors have had a poor experience with alternative investment strategies, and once burned twice shy. Why burned? Because A) they’ve been pushed onto financial advisors as some sort of wonder dog that can be all things to all portfolios, and B) they’ve been pulled into portfolios by financial advisors who were thinking more about the portfolio and clients that they wish they had rather than the portfolio and clients that they actually have.

epsilon-theory-you-had-one-job-november-4-2016-scrappy-dooI’m not going to spend a lot of time on point A because it’s obviously egregious and I see this changing for the better in my conversations with financial advisors. They are still inundated with semi-condescending “educational” materials from every possible source, but at least the content of those materials today is a lot more even-handed about the specific job that alternative strategies can perform in a portfolio, as opposed to promising the investment equivalent of Scrappy Doo, Scooby’s far more competent crime-fighting nephew. Pro tip: if you’re offered a walking, talking dog to fill out your pack, you should hold onto your wallet.

Its point B that I think is a bit less obvious and one that needs more explication. Basically I think what’s happened is that a lot of financial advisors and serious investors believe they know the job that alternatives can help provide for a portfolio — diversification — and they really want that for their portfolio. But they set themselves up for failure, where the alternative strategies in their portfolio don’t FEEL satisfying even if the performance is okay, in two important ways.

First, they’re mistaking a quality of the portfolio — diversification — for a job of an individual investment. Asking an investment to provide diversification is like asking a dog to provide pack stability. It’s just not within their power to do this. Portfolio diversification and pack stability emerge from the proper organization and job assignment of the individual members of the portfolio or pack, not the other way around. If someone tells you that their alternative strategy is “a diversifier”, your question should be “Relative to what?” if you’re in a generous mood, something a little more snippy if you’re not. The question you need answered is what job does the strategy perform in your portfolio. How should I expect it to behave under what conditions? Then you can decide for yourself how that job fits with the other jobs your other investments are doing. Then you can evaluate this potential new member of your pack in a non-alienated fashion, focusing on its fit within the whole rather than its standalone attributes.

Second, they’re judging this alternative strategy versus that alternative strategy on the basis of standalone historical performance, alienated from the psychological meaning that the overall portfolio composition — the pack — plays in their client’s or their own life. Alternative strategies in this conception are a line item in the portfolio, a tasty-looking dish that one orders from a 10-page diner menu, a beautiful exotic dog breed that one reads about in The New York Times Style Magazine.

Odds are that you’ll be disappointed with that exotic dog, through no fault of the dog and actually, through no fault of yours. Odds are that you’ll be disappointed with that fancy alternative strategy, similarly through no fault of the strategy or you. Why? Because human rationality is based on Bayesian decision-making, a $10 phrase that means we make up our minds as we go along and new information comes our way. Maybe that dog is, in truth, perfect for you and your life. But maybe it’s not. I mean, you got all excited about the breed from an article you read in the NYT Style Magazine. Are you crazy? Maybe that alternative strategy is a perfect diversifying complement for your portfolio. But maybe it’s not. I mean, you got all excited about the fund because the manager sounded really smart. Really? Did you really make THAT mistake again?

My point is that we start any standalone investment from a position of self-doubt, and from a Bayesian perspective it takes a lot of evidence before we come to any conclusion as to whether we made a good original decision or not. Even then our conclusions are never final or definitive in a Bayesian approach, because there’s always a chance that new information will come to light that shifts our opinion. Moreover, the qualities of portfolio diversification and pack stability take quite a bit of time to emerge. If you think you see these qualities right off the bat, or conversely you think you see something that shows this is a disaster, you’re usually mistaken. In fact, with both dogs and alternative investment strategies, by the time you’ve received enough information to judge for sure whether or not you’ve actually got a “good one” or a “bad one”, it’s almost always too late to make a switch or do anything differently about it. Put it all together, and we stay in this position of self-doubt on an effectively permanent basis.

epsilon-theory-you-had-one-job-november-4-2016-bruce-willisIt’s what I call The Curse of (Some) Talent, and it’s one of the most pernicious aspects not only of investing, but of the human condition. It’s embodied in Butch, the Bruce Willis character in Pulp Fiction, a boxer who’s a pretty good fighter but is now getting a little long in the tooth. As Marsellus Wallace, the crime boss who bribes Butch to take a dive, says, “if you were gonna make it, you would have made it before now.” Butch has (some) talent, enough to become a professional fighter. But he doesn’t have enough talent to really succeed, to really make it big. I recognize Butch in myself, which is what makes this scene so haunting. Here I am, 52 years old, sitting in a hotel room far away from home on another business trip, writing this note. If I was gonna make it, wouldn’t I have made it before now? I recognize Butch in all the really smart portfolio managers I know, each of whom runs what seems like a really interesting strategy that for whatever reason hasn’t made them a Master of the Universe. If they were gonna make it, wouldn’t they have made it before now? Clearly they have (some) talent. Do they have enough to be an individual star? And if that’s what I need from them or if that’s how I’m evaluating them, then how in the world do I muster up the confidence to take the chance that they do? How in the world do I maintain the confidence to keep them in my portfolio when the winds of chance blow against me or them, something that will always happen at some point?

I think that most financial advisors or serious investors know exactly what I’m talking about here, and this is why most of them are waaaay under-allocated to what investment “science” and their model portfolios and their own voices inside their heads tell them should be their “proper” allocation to alternative strategies. If we’re evaluating these strategies on a standalone, line-item basis, plagued by the self-doubt inherent in Bayesian decision-making and the other-doubt inherent in the Curse of (Some) Talent, then the mystery isn’t why current allocations to alternatives are so low at 3-4%, but why they’re so high!

So here’s what I think is a better way to think about portfolio construction, one that puts not only alternative strategies but ALL strategies in their proper place, which is in service to the pack. That’s your responsibility, too, by the way. The pack always comes first.

Step One. Every investment in the portfolio must have a job, meaning that we expect each investment to do certain things under certain circumstances. This means that we have to imagine what those future circumstances might be. Here are two scenarios that I think we should wrestle with.

  1. The Long Gray Slog: a continuation of the current investment status quo, where central banks continue to squelch the volatility out of markets in their continuing efforts to turn markets and the entire macro-economy into political utilities. Business cycles and bear markets are effectively outlawed, but the imposition of a floor also imposes a ceiling. It’s 1% GDP growth and zero on your savings and flat to slightly up markets just as far as the eye can see.
  2. Fire & Ice: a political event that sets the global economy on a new deflationary leg down, which in turn creates a global credit freeze and liquidity concerns at systemically important European banks. This is Ice. But central banks of the modern ilk refuse to back down, unleashing a wave of bank nationalizations, negative interest rates, and helicopter money drops of various sorts, all designed to force asset prices higher by sheer dint of printing and distributing vast quantities of fiat currencies. This is Fire. You don’t get the Fire without the Ice, and I need strategies that can survive both.

Step Two: Now that we’ve identified the scenarios we think we might face, we need to figure out what sort of portfolio can survive or thrive under these circumstances. How do we do that? By immersing ourselves in the stories of investors who survived and thrived during Long Gray Slogs or Fire & Ice scenarios of the past. By developing a sense of empathy for what it felt like to invest during, say, the 1930s or the 1970s or (for the younger crowd) the 2000s. This is how we figure out what sort of pack supports the life we want to live when confronted by these circumstances. This is how we figure out what strategies — in complement with each other — can create that pack with strength of spirit as well as strength of performance.

We gain this sense of empathy in two ways. We talk to old-timers (for much of my audience, that’s anyone older than 40), and we read. We read a lot. We read biographies. We read memoirs. We read old newspapers and old magazines, as much primary material as we can. We read and we talk, not in the modern cynical way of gotcha and tsk-tsk and eye-roll, but in older ways of trying to understand the WHY and the FEEL, not just the WHAT and the FACT. It’s a Faulknerian effort of trying to understand the past on a visceral level, such that it’s part of the living us and not “the past” at all. Empathy means putting yourself in someone else’s shoes, and it’s one of the hardest, least taught skills in the modern age of narcissism and self-absorption. But it’s also one of the most important. I hire history majors.

What strategies have I found that perform specific, useful jobs in these scenarios? Keep in mind that this is for a portfolio that works for me and my family and the life we’ve chosen. We’re not like everyone. We live out in the woods in Fairfield County, CT. We homeschool our kids. We have sheep and goats and horses. Your kids will have a blast when they visit, but if you bring over your dog, it might be killed by our dogs. Just kidding on that last one. Kind of.

On the Long Gray Slog side, for me it’s basically what’s worked for the last several years, strategies that either harvest global betas in a cheap, efficient, preferably volatility-controlled way, or strategies that “play the player” in a trend-following or discretionary way. Especially the discretionary stuff, but then again I’m a discretionary global macro kind of guy. That’s who I am. Also, in a more or less permanently low growth world, any sort of secular growth and real cash flows from real economic activity is something to be treasured. See my “Hobson’s Choice” and “Cat’s Cradle” notes for more.

The Fire & Ice scenario is perhaps a little more contentious, but only because we’ve been living so completely in the Long Gray Slog for the past few years. My take on Fire & Ice is pretty simple. I want as close to direct ownership as possible of real assets with real cash flows. My definition of real assets is pretty broad, including not just the obvious choices like infrastructure and real estate, but also intellectual property and gold. Yes, I know that gold doesn’t have intrinsic cash flows. Neither does an insurance policy (which is what gold is against central bank error), and I like insurance. A lot of people are fans of Bitcoin and other cryptocurrencies for a Fire & Ice scenario. I’m not (you can read my views here). Basically I’m looking for maximum resiliency, what Nassim Taleb would call antifragile, in the jobs I want my portfolio holdings to perform in a Fire & Ice scenario. And remember, in my scenario, Fire comes last and it can go on and on. Bond holders beware. This is where the right discretionary calls on global macro, particularly on the short side where you get the timing right on long-volatility bets, can make a career. This is when you want Karnak on your team.

epsilon-theoryyou-had-one-job-november-4-2016-the-atlanticAs an aside … well, not so much of an aside, because it’s central to the Epsilon Theory effort … this embrace of empathy and the true lessons of the past is exactly what our central bankers are NOT doing. I put a long quote by Joseph Schumpeter at the start of the note just to show that there have been some other really smart people in the past who suffered through really similar macro-economic situations and looked carefully at empirical evidence and came to diametrically opposed conclusions on what monetary policy should and shouldn’t do as a response. What we are told today is the Truth with a capital T in regards to monetary policy is nothing of the sort. It’s a particular sort of truth, an ex cathedra pronouncement by cultists like Ben Bernanke and his academic acolytes, cherrypicking historical data about the U.S. in the ‘30s or Japan in the ‘90s that fits their tautological world view and rejecting the rest, brooking no dissent. It’s a mongrel pack of policies that provides neither strength in fact nor strength in spirit to the citizens it’s supposed to support and protect. That’s a lot of mixed metaphors, but you get my point. And my disgust. Just remember that Greenspan used to be lauded as a hero, too. Today not so much. Today he’s the man who knew, as in the man who knew better. Okay, rant concluded for today.

Step Three: So I know what sort of portfolio I want for the sort of future scenarios I might encounter. I know what jobs I need filled in that portfolio and I’ve got a sense of the strategies that can best do those jobs. Now how do I choose between specific strategies or managers or what have you? How do I avoid that whole Curse of (Some) Talent thing? Here’s what I’m not doing. I’m not evaluating historical track records, projecting those into the future in some sort of crystal ball, capital markets return prediction effort, and then rolling those individual calculations up into some aggregate portfolio projection. I think that’s nuts. Instead, I’m asking whether the manager has a clear idea of what makes the strategy work (or not). What is the job that the manager performs and under what conditions does he or she perform it? Then I evaluate those claims in a Bayesian way. The most important evidence: did the manager do this job before? As advertised and for realz, not in a backtest. What was the investor experience within that prior job performance? How did it feel? Almost as important from a Bayesian perspective, does the manager have a stable, visible process? Does the process impose a discipline of sticking to the principles of the strategy come hell or high water, while also handling uncertainty and deviation in a calm and intellectually rigorous way? That’s how I judge real talent, the talent that ultimately matters most, in others and in myself. Fortune is fickle, even for the most talented. Experience and process never is.

The hardest part about Step Three is saying no to a talented manager, a good Rabbi for the strategy he administers, because the strategy doesn’t do the required job for the portfolio you actually have, as opposed to the portfolio you wish you had. In truth, that’s the hardest part about this entire process, the monomaniacal focus on what’s best for the portfolio as a whole, given the challenges it might face in the future. But in the same way that we require (or should require) discipline in our managers, we should absolutely require that discipline in ourselves as financial advisors or serious investors. It’s what creates a confident client/advisor relationship, it’s what creates a confident investor/manager relationship, it’s what turns any collection of individuals, man or beast, into a well-functioning pack.

Ultimately, that’s what we’re after here. The protection of the pack. It’s been the human animal’s source of strength, in both fact and spirit, for a couple of hundred thousand years now. I think we’re going to need it over the next few years, too.

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