Is Volatility Back?

On this special episode of the Epsilon Theory podcast, we share an excerpt from a conference call we recorded on February 13 discussing our thoughts on the market selloff earlier in the month. You’ll hear from Christopher Guptill, co-CEO and chief investment officer at Broadmark Asset Management and Dr. Ben Hunt, author of Epsilon Theory.


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The Three-Body Portfolio

Bernard: If knowledge isn’t self-knowledge, it isn’t doing much, mate. Is the universe expanding? Is it contracting? Is it standing on one leg and singing ‘When Father Painted the Parlour’? Leave me out. I can expand my universe without you.

‘She walks in beauty, like the night of cloudless climes and starry skies, and all that’s best of dark and bright meet in her aspect and her eyes.”

  Arcadia, Tom Stoppard

It is a romantic thought, that we might divorce our personal universe from the universe around us. For us investors, maybe that means to hide in a room building an elegant model to work out the true value of a thing. I mean, by itself it’s a complete waste of time…but so romantic!

To make a prairie it takes a clover and one bee,
One clover, and a bee.
And revery.
The revery alone will do,
If bees are few.
To make a prairie”, Emily Dickinson

Since I’m bogarting Ben’s title, I might as well steal his best literary reference, too. The market isn’t necessarily tied to ‘fundamentals’ any more than a prairie is to bees. Revery alone will do, and sometimes it will do for a very, very, very long time.

A true German can’t abide the French,
But he’ll gladly drink their wine.
— Faust, Johann Wolfgang von Goethe

You don’t have to be French to drink their wine, y’all. Being part of the Epsilon Theory pack doesn’t mean buying into narratives. It means understanding that in a market, if it matters to someone, it should matter to everyone. And narratives matter to a whole lot of someones.


Epsilon Theory started from a pretty simple idea. Ben observed that no financial or econometric model can ever fully explain the returns or volatility of financial markets. I don’t think he’ll be too mad if I point out that this wasn’t a particularly novel observation. After all, every statistical model in the world has an error term that basically accounts for this — epsilon.

β + α + ε

Said less vaguely, epsilon is the way in which — as people — investors respond to both financial and non-financial stimuli in various non-random ways. It is an observation that a not insignificant portion of the systematic (i.e. not diversifiable) risk and return in your portfolio is completely divorced from the risks faced by economies and businesses. It is a feature only of the markets and the people who comprise them[1].

Some regard changing perceptions, sentiment and shifting narratives as a source of short-term volatility in securities prices, and little more. Indeed, that is the implication of the old Benjamin Graham trope I disputed in The Myth of Market In-Itself — that the market is a short-run voting machine, but a long-run weighing machine. Sure, sentiment may matter in the short run, but eventually truth will out! I did a fair job, I think, of identifying my issues with that point of view, but as per usual, it was Ben that really got to the heart of the issue. In his latest note, he characterizes the occasional sharp rise in unpredictability of market outcomes — not to be mistaken for volatility — as the result of a Three-Body Problem. You do yourself a disservice if you haven’t read the piece, and probably a greater disservice if you haven’t read the Liu Cixin book of the same title recommended in it. But in short, a three-body problem refers to a system that is solvable not through elegant algorithm, but only through brute-force computation. There is no closed-form solution to predict the future locations of a set of three planetary bodies in a vacuum like, say, the Earth, the sun and the moon.

In most environments, where the purpose of markets is to efficiently and accurately price risk of various uses of capital, those markets tend to behave more or less like two-body systems. The interaction of Planet A (which we’ll call ‘fundamental data’) and Planet B (which we’ll call ‘prices’) is generally predictable. Oh sure, there’s volatility. Remember, not everyone agrees on the starting point and velocity of Planet A — at least, not since Reg FD, anyway. Information takes time to propagate. But we also know that Planet C (let’s call it ‘epsilon’) is sitting out there somewhere. Yet it’s far enough away that its gravity can’t do more than induce short- and medium term distortions in the relationship between A and B. If you knew the truth about the starting positions and velocities of Planet A and Planet B, however, you could develop a formula that would tell you within a pretty fair margin where prices would be down the line.

In this typical state of the world, being a better investor has meant getting better at uncovering the truth about Planet A so that you can predict Planet B’s future location. It’s no wonder that a generation of investors grew up learning about traditional security analysis, the only way investment management is taught in every business school in the world.

Still, everyone from the most well-respected market commentators to the staunchest Graham and Dodd-quoting undergrad recognizes the existence of markets in which Planet C — epsilon — contributes its gravity to the system. Among those periods in which our ability to make predictions on the basis of relationships between fundamental data and securities prices is especially poor, are those we know as bubbles and manias. William Bernstein characterizes these periods as those typified by the “flood of new investors who swallow plausible stories in place of doing the hard math.” He goes on to quote Templeton, admonishing investors, “The four most expensive words in the English language are ‘This time it’s different.’”

Well, guess what? Roll your eyes at the expression to your heart’s content, but I’m telling you what Ben has been telling you for years now:

This Time It’s Different.

It’s not different because people really got it right this time (in ways they missed every other time) about some new technology that’s going to Change The World! Electric cars, cryptocurrency, AI and automation, these may all be fabulous things, and they may well prove to be game-changers for productivity and returns on capital down the line, but if you think any of those things explain current valuations, you’re nuts. You’re also wrong.

It’s different because financial markets are no longer a mechanism for price discovery and the pricing of risk of capital allocation decisions.

Markets have been made into a utility. More to the point, they have been made into a political utility, a tool for ensuring wealth and stability of our political structures. The easing tools we dabbled in to stabilize prior business cycles were brought to bear instead as tools for propping up and expanding financial asset prices. Beyond the direct marginal price impact of the easing itself, central bankers tailored communications policies to create Pavlovian responses to every narrative. Our President tweets about the policy implications when the S&P 500 hits new highs, for God’s sake[2]. This isn’t a secret, y’all. The singular intent of every central banker in the world is to keep the prices of financial assets from going down, and the singular intent of every government that puts those central bankers in power is to ensure that they do so, in order to retain social stability. Sure, there’s a dual mandate. But the mandates aren’t employment and price stability. They’re (1) expanding financial asset prices and (2) effectively marketing the idea of corresponding wealth effects to the public.

Markets have also rapidly become a social utility, an inextricable part of every contract between governments and the governed. Underfunded pensions and undersized boomer 401(k) accounts mean that ownership of risky assets is not a choice driven by diversification or relative return expectations, but by the fact that it is the only asset they can buy that has any potential of meeting the returns they would need to be adequately funded. Let’s say that you are running a state pension plan that is 65% funded. Your legislature is telling you that no help is coming from the state budget. You and every member of your agency will be fired if you even suggest cutting benefits, if you even have that authority. Your consultant or internal staff just did their new mean reversion-based capital markets return projections, and higher valuations mean projected returns on everything are lower. What’s worse, your funded status assumes returns that are higher than anything on their sheet. You are being presented with a Hobson’s Choice — behind Door #1, you get fired, and behind Door #2, you lever up your stock exposure with an increased private equity allocation. This a brutal position to be in.

And sure, like most markets with bubble-like characteristics, this one has become a utility for psychic value as well. Investors buy Bitcoin on the narrative-driven belief that it is an ‘investment’ in the technology, a way to participate in shifting the economy toward privately negotiated and settled transactions. It isn’t. We’ve all seen the absurd stock charts of companies who did nothing more than add “blockchain” to their names. We’ve observed TSLA, NFLX and CRM continue to trade on earnings reports that provide zero incremental data on business direction or momentum but heroic narratives that the sell side dutifully push out to the masses looking for good stories. If you must own risky assets and those assets don’t have growth, then revery alone will do, if bees are few.

It may comfort us to say that “The market has been divorced from fundamentals for so long, but eventually it must swing back.” And it will. The point of this note, and the point of The Three Body-Problem isn’t to say that it won’t. Planet C will drift away again, and outcomes will look more like what economic and business fundamentals would predict. More like our historical analysis of what drives good, high quality investments. But too many investors are comforting themselves with the stories of the 1990s, of the Nifty Fifty, and the idea that non-fundamentally-driven markets mean return to sanity after five to ten years. But they don’t have to. And because of the utilitization of markets, because of the exit of passive-oriented investors from the price-setting margin of markets, it’s possible that they won’t for a very long time.

This Three-Body Problem isn’t going anywhere for a while.

The Three-Body Portfolio

When I began this Code series at the beginning of 2017, I kicked it off with A Man Must Have a Code, a conversation about why we think that all investors ought to have a consistent way of approaching their major investment decisions. I posited that a code ought to consist of a concise list of Things that Matter, Things that Don’t Matter and Things that Don’t Always Matter (But Do Now). And so my notes have focused on investing principles that I think of as generalized solutions. These are things that I believe are true in both Two-Body and Three-Body Markets:

  1. In I am Spartacus, I wrote that the passive-active debate doesn’t matter, and that the premise itself is fraudulent.
  2. In What a Good-Looking Question, I wrote that trying to pick stocks doesn’t matter, and is largely a waste of time for the majority of investors.
  3. In Break the Wheel, I argued that fund picking doesn’t matter either, and took on the cyclical, mean-reverting patterns by which we evaluate fund managers.
  4. And They Did Live by Watchfires highlighted how whatever skill we think we have in timing and trading (which is probably none) doesn’t matter anyway.
  5. In Chili P is My Signature, I wrote that the typical half-hearted tilts, even to legitimate factors like value and momentum, don’t matter either.
  6. In Whom Fortune Favors (Part 2 here), I wrote that quantity of risk matters more than anything else (and that most investors probably aren’t taking enough).
  7. In You Still Have Made a Choice, I wrote that maximizing the benefits of diversification matters more than the vast majority of views we may have on one market over another.
  8. In The Myth of Market In-Itself (Part 2 here), I wrote that investor behavior matters, and spent a lot of electrons on the idea that returns are always a reflection of human behavior and emotion.
  9. In Wall Street’s Merry Pranks, I acknowledged that costs matter, but emphasized that trading costs, taxes and indirect costs from bad buy/sell behaviors nearly always matter more than the far more frequently maligned advisory and fund management expenses.

In all of these, you’ve gotten a healthy dose of emphasis on getting beta — how we get exposure to financial markets — right. But you’ve seen precious little on alpha — uncorrelated sources of non-systematic, incremental return. Where we dealt with the usual ways in which investors seek out alpha, I have been critical. Maybe even derisive. Sorry, not sorry. There’s a reason:

Even in normal environments, alpha is hard.

Alpha is hard because it’s hard to measure. It’s hard to know if what we’re doing is actually something that adds value, or if we’re being fooled by randomness. We may even just be layering on some other systematic factor, or beta, that is just compensating us for taking additional risk. Every couple of years, someone rediscovers that bond managers tend to “have more persistent alpha”, and a couple of weeks later, someone rediscovers that bond managers just layer on more corporate credit risk than the benchmark. Every couple years, stock-picking strategies go back into vogue — it’s a stock-pickers’ market, they say! Fundamentals matter again! No, they don’t. You’re structurally smaller cap and loaded up on higher volatility names, and when those factors work you feel smart.

Alpha is hard because randomness is an insanely powerful force in the universe and within our industry. Any time I hear a fund manager or financial advisor say, “Look, a 10-year track record like that doesn’t just happen by accident,” every part of me wants to scream, “Yes, it bloody well does, and if there’s anything true and good about mathematics at all, it will happen by accident ALL THE TIME.” I’m not saying that Warren Buffett’s success is an accident, but I am absolutely saying that with as many investors as there are, it is improbable that history would not create Warren Buffett’s track record. We are all looking for a way to increase returns that doesn’t involve taking more risk, and once we’ve gotten all we can out of diversification, believing in alpha is our only choice.

In a three-body market where epsilon exerts its gravity, alpha is not just hard. Finding it emphasizes entirely different types of data and analysis. The whole point of recognizing an increasingly chaotic system is that our confidence in the causal relationships over time and between assets at a point in time drops significantly. Given that tools relying on temporal and cross-asset relationships are the ones we most often use to evaluate investment strategies, it puts us in a bit of a pickle! Sure, there are some exogenous strategies like high-frequency trading that are pretty effective across environments for mechanical reasons. But many of the “time-tested” strategies that work in Two-Body Markets can stop working for a very long time, and the “new” strategies we identify in our in-sample periods can start looking like hot garbage the second we drop them out-of-sample. The search for alpha in this kind of environment — even when it occasionally bears fruit — is time-consuming, expensive, and often leads to unintended risk, cost and diversification decisions that more than offset any positive that they generate. We get a stock pick right, but it is dwarfed by sector effects. We pick the right country to invest in, but get killed on currency. For many investors – for most investors — this means that trying to beat “the market” on an intra-asset class level or at on an inter-asset class level through tactical asset allocation should not be part of their playbook. For these people, I hope the Code to this point is a useful tool. Thanks for reading.

But for those who know they won’t be content with that very adequate outcome, I’ll do my best to talk about alpha strategies that I think can work in a Three-Body Market. That means identifying the likelihood of success of various analytical security and asset class selection strategies. It also means giving you my perspective on what edge (ugh, I know) would even conceivably look like in a fund manager. As we close the door on 2017, I also close my series on The Things That Matter and The Things that Don’t Matter. As we open the door on 2018, look forward to a new series on the Things that Don’t Always Matter (But Do Now).

Together, I think they’ll provide a pretty good roadmap for the Three-Body Portfolio. But I mean, even if they don’t, at worst you’ll get to read horror stories of terrible fund managers, so what have you really got to lose?

From Texas, my best wishes for a prosperous New Year to you and yours.

PDF Download (Paid Subscription Required): http://www.epsilontheory.com/download/15758/

[1] I know some will pipe in that this is just part of beta. This is mathematically true in that systematic sources of risk are what we mean when we say ‘betas’, but anyone reading this who pretends not to understand that what we’re talking about is a specific component of systematic risk that tends to be understated in favor of econometric and financial variables is a filthy pedant.

[2] Actually, he tweets about the Dow hitting new highs, because of course he refers to the Dow.

Make America Good Again

On episode 26 of the Epsilon Theory podcast, we welcome back Rusty Guinn, our executive vice president of asset management, to talk about political markets — a topic just as important to Ben as capital markets. Be sure to also check out the companion pieces to this podcast: “Always Go To the Funeral,” “Sheep Logic,” and “Before and After the Storm.”


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Failure to Inflate

On episode 25 of the Epsilon Theory podcast, we’re joined by Peter Cecchini, Chief Market Strategist, Head of Equity Derivatives and Cross-Asset Strategy at Cantor Fitzgerald, to discuss one of his recent notes, “Failure to Inflate.” As Peter writes, “The theories that guide monetary policy fail to explain why growth and inflation remain so low in developed economies.” Tune in to hear why this is and what might bring about higher inflation.


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The Myth of Market In-Itself: Things That Matter #3, Pt. 1

That space and time are only forms of sensible intuition, and hence are only conditions of the existence of things as phenomena; that, moreover, we have no conceptions of the understanding, and, consequently, no elements for the cognition of things, except in so far as a corresponding intuition can be given to these conceptions; that, accordingly, we can have no cognition of an object, as a thing in itself, but only as an object of sensible intuition, that is, as phenomenon — all this is proved in the analytical part of the Critique; and from this the limitation of all possible speculative cognition to the mere objects of experience, follows as a necessary result.

Immanuel Kant, The Critique of Pure Reason (1781)

I know, diving right into 18th-century German metaphysics is a real crowd-pleaser. But this is just a bunch of fancy words to say that we can never know the fundamental truth of a thing independently from our perceptions and experience. It’s the realization that makes Kant probably the most indispensable of the great thinkers. Doubly so for Epsilon Theory. We desperately want to believe that with enough information and analysis, we can know the true value of something. There is an almost mythological belief in the market as the mechanism through which we uncover that truth. The rest of the world will realize that we are right, and then we will make money. But the ‘true value’ of a thing — the market in-itself — isn’t something we can know. We observe value only through price, a measure based on our collective subjective experience.

Is there any hiding of the character of an apple-tree or of a geranium, or of an ore, or of a horse, or of a man? A man is known by the books he reads, by the company he keeps, by the praise he gives, by his dress, by his tastes, by his distastes, by the stories he tells, by his gait, by the motion of his eye, by the look of his house, of his chamber; for nothing on earth is solitary, but everything hath affinities infinite.

— Journals of Ralph Waldo Emerson, June 7, 1860

Still, just because there isn’t a knowable intrinsic value to an investment, no investment in-itself, it doesn’t mean we can’t know anything about it. The people who form the market and apply their sensible tuition to these things have affinities infinite. Some of those affinities can be observed or inferred. This is the soul of the Narrative Machine writ large.

Run a BBW Tumblr blog and forget the password

I may be speaking too soon but this is a disaster

Like old people in modern sneakers

I saw Book of Mormon with a congregation of true believers

milo, “In Gaol”, a toothpaste suburb (2014)

As investors, it is very tempting to get so caught up in our own tribe of investing — our style, our philosophy — that we sit in a state of constant bemusement of other investors, sure that everyone is going to come around to our point of view on the value of something eventually. That congregation of true believers we can’t believe are watching a parody of their beliefs can stick around for a long, long time, folks. Over a sufficiently long period, being wrong about value but right about price can become indistinguishable from being right about value.

Empathy, evidently, existed only within the human community, whereas intelligence to some degree could be found throughout every phylum and order including the arachnida.

Philip K. Dick, Do Androids Dream of Electric Sheep (1968)

I’ll admit it. At any given time around our Houston office, there are four TVs tuned to CNBC. Don’t ask me why. Or at least don’t expect a satisfactory answer.

If pressed, I would tell you that it’s important to know what a voice that speaks through thousands of televisions in similar offices around the world is saying, even if it’s a meal of empty calories. After all, Epsilon Theory is about stories. Stories, those who tell them, and those who, in listening, respond. Some of those stories are powerful myths, timeless and universal, others virtuously or nefariously cultivated for a singular place in space and time. And some of them — including most of what you hear on financial television — are vapid and worthless.

A story linking six months of a presidency to the returns of a stock market at the same time. A story linking August returns to calendar years that end with the number 7. A story that “stocks slipped on the news” of a development in investigations of Russian collusion with no evidence of relationship other than that the two things happened on the same day. Oh look, oil fell on “profit-taking.” Linking a down day in U.S. markets to one of a million macro factors that moved that day. We say the stock moved “on this news” or “on that news” when, if we’re really being honest with ourselves and each other, we know that all of these stories are stupid and wrong. Deep down we know that we have no earthly clue why our investments go up and down every day, much less moment to moment, and we’re just grasping for answers. Stories. And boy, are people ready to give us some.

It’s a problem. And it’s a problem we can’t ignore, because our investment decisions communicate views about our expectations even if we don’t intend it. We don’t get to say that “it’s OK” not to understand what moves markets, because every day we are all making bets that say we do. Sure, we have all sorts of explanations for why investments should rise in value. We should be paid for taking risk. We should own something valuable if it continues to grow its earnings. We should be able to trust the fact that risky investable assets have produced positive returns over almost any long-term horizon for the last several centuries.

But the distinction between understanding why we ought to be paid for owning something and understanding how that manifests itself in changes in securities prices is not just academic. It is fundamental, and it sits squarely in Epsilon Theory’s wheelhouse. In the same way that Ben bastardized Gresham’s Law, I’m going to steal from Friedman:

Investment returns are always and everywhere a behavioral phenomenon.

That’s why Investor Behavior is #3 on our list of Things that Matter.

Knowledge and Information

I know we all know this, but from time to time it bears repeating: until it defaults, matures or is called, the price of every security in the world is ultimately driven by two — and only two — things:

  1. Who is willing to pay the most to buy the thing, and
  2. Who is willing to accept the least to sell the thing.

That’s it. A lot of applied behavioral economics IS flawed and less rigorous than it ought to be, but at the risk of giving Taleb the vapors, any argument for how prices are determined and, thus, how returns are generated that ignores investor behavior isn’t just weak. It’s objectively wrong.

Now, while there really aren’t any strong-form efficient market guys out there with skin in the game (i.e., outside of academia) anymore, there are still a lot who think about markets as being generally efficient, by which they mean that the market generally does a good job of pricing available information. This is actually a pretty fair point of view. To believe otherwise is to take a dim view of the value of markets as a mechanism for expressing the aggregated will of individuals. That ain’t me. I was and will always be a Hayekian at heart. Since we’ve decided it’s now acceptable to terminate employees for expressing wrongthink, I’ve started firing anyone who doesn’t see my copy of The Road to Serfdom and slam it down on the conference room table, shouting, “THIS is what we believe!” à la Maggie Thatcher.

The problem with most interpretations of information, however, is that fundamental data alone isn’t information in any real sense that matters. Facts about a company only become information when they are passed through the perceptions and preferences of the people who are participating in determining the security’s price. There is no objectively ‘right price’ for a security based on the available information about its business, its assets, its prospects or its profitability, because there is no objective sense in which changes in any of those things ought to result in changes in prices. There is only a price which reflects how that information is viewed through the collective lens of individuals or groups of individuals who participate in that market.

Now while two people functionally determine the current price of any security, the movement of prices in that security from that level are also influenced by a much larger group who are willing to buy for a little bit less than the guy setting the bid price, and those who are willing to sell for a little bit more than the guy setting the ask price. Those who’ve made those views explicit are part of the so-called order book, an actual group of people willing to buy and sell at certain prices. Greater is the group of individuals who haven’t explicitly put a line in the sand at all, but who do have a view that they have an interest in expressing. They are paying attention to the stock. Far, far larger still is the universe of investors and assets who are paying no attention to the security at all and play little to no role in its pricing, even if they own the thing. You can imagine it looking something like the below — a little bit of money is willing to trade close to the current bid-ask spread, and increasing amounts if you’re willing to sacrifice.

Source: Salient 2017. For illustrative purposes only

Again, excluding terminal events for a security — like its default, retirement, maturity or being called away — there are only two ways for a security to change in price:

  1. Someone who had an explicit or implicit view in the “order book” — a blue or red bar from the above chart — changes their mind about the price at which they would buy or sell.
  2. Someone who didn’t have a view before decides to express a view.

Many of the things we do to trade, like a market order or most common trading algorithms, cross the spread in order to find a trading partner. In other words, as the day wears on, a lot of the people who thought they’d only sell for $75.10 — but need to sell — end up saying that they’d take less. Those folks are making the price move by changing their mind about the price at which they’d buy or sell. In other situations, maybe we get a call from a client who needs money for a down payment for house. It’s a big, liquid stock, so we put in a market order. We take $74.90 for our shares despite having not expressed a view on price before that, and everyone else in the market tries to figure out why.

So why do these people change their mind? Are they, in fact, responding to the stimuli that financial TV suggest? Did a barrel of oil really just trade up by 15 cents because investors changed what they were willing to pay as a result of North Korean sabre rattling? Other than major sources of observable volatility — earnings, corporate actions and the like, and often even then — if anyone tells you they know, they are probably lying to you. All we know, because it is a tautology, is that it is absolutely a reflection of human behavior (which includes, mind you, the behaviors incorporated on the front-end of a systematic trading strategy or implicit in a trade execution algorithm). That doesn’t mean that people can’t make money off price movements over this horizon — plenty of stat arb and high-frequency trading firms do exactly that, albeit in different ways. But over the very short run, the drivers of market movement are noisy and overdetermined, meaning that there are more factors driving that noise than there is noise. They are also nearly impossible to generalize, other than to say that they are reflections of the behaviors of the individuals who caused them.

The great investor Benjamin Graham famously characterized his views on the matter in this way. “In the short run,” Graham said, “the market is a voting machine, but in the long run, it is a weighing machine.” This is a popular view. But with respect due to Mr. Graham, it is also wrong. Since I’ve bastardized and restated the words of one financial genius already, let’s make it two:

In the very short run, the market is a voting machine.

In the short run, the market is a voting machine.

In the long run, the market is a voting machine.

The Long-Run Voting Machine

There’s a contingent of people reading this who are probably saying to themselves, “Wait a minute. What about a bond? Every time I receive my coupon I book some return. Every day I get closer to maturity, and I can predict pretty accurately how a bond trading at a premium or discount is going to converge to par.” The implication of that argument is that while fundamental characteristics of an investment may only technically manifest themselves in some terminal event, they are effectively still very predictive because we can have a high degree of confidence around them for some types of investments. In other words, maybe sentiment is a bigger predictor for risky securities than it is for securities where the return is coming from predictable cash flows.

This is true.

If you intend to hold something to maturity, or if you hold an investment that is reliably paying enough cash flow to repay you over a reasonable length of time, all else being equal, the variability in the price attached to your investment and its returns, and the behaviorally driven component of those returns, ought to be lower. This is one of the reasons why we tend to buy and hold bonds in our client accounts to maturity. Yet, even here, your compound returns are going to be influenced by investor behaviors outside of that bond — you have to reinvest those coupons at rates determined by individual actors influencing prevailing interest rates, after all.

The other, more common argument — this is the Graham argument — is that these behaviorally driven features of markets are, even for investments in riskier parts of the capital structure like credit or equity, temporary noise on the path toward convergence of the investment’s price with its value. Investors have historically found comfort in the idea that the voting machine will someday converge to the weighing machine — that one day, everyone else will come to the conclusion that I have about this company and value it like I do.

This forms part of the story for a vast range of investment styles. For the investor who speaks the language of growth, it is indispensable. He is saying, explicitly or implicitly, “I believe this company will grow faster than other investors expect. When I’m right, the price will converge to the value implied by the higher earnings.” For the intrinsic value or quality investor (I’m talking to you, too, Holt, EVA, CFROI wonks), it is an even stronger impulse. He believes that a company’s ability to deploy its current assets and reinvest at higher rates than the market expects (or for a longer time than the market expects) forms a value that is essentially the stock-in-itself. That’s kind of what intrinsic means, isn’t it? Frankly, it is the multiples-driven value investor who approaches the question with the keenest awareness of behavioral influences on prices. He’s comfortable implying that investors tend to do a bad job of knowing which companies ought to be worth a lower multiple of their earnings/assets/cash flow, and that enough time will cause the outperformance of the cheap company to be recognized and rerated. Or maybe just the increase in earnings will cause investors to apply the same multiple to create a higher value. There is, at least, the self-awareness of behavior’s fickle influence.

In each of these cases, the investors recognize that the market is a noisy, behaviorally complicated voting machine in the short run. This is why when you meet with a fund manager, they will always always always tell you that the rest of the market is looking at the next quarter’s earnings, while they stand alone at the top of the mountain, summoning the courage to weather short-term storms in favor of long-term outcomes. They’re very brave. Lots of people have been talking about it. But in each of these cases, the reality is that other than significant sources of real cash flow distributions (i.e., not stock buy-backs or debt pay-downs, for fans of the “Shareholder Yield” concept), the convergence of the voting machine to the weighing machine can take a very, very, very long time. And it may never happen, for the forces that will cause it to take place are themselves behavioral in nature! Somebody’s gotta say they’re willing to buy your stock at that price, and that somebody is either a person or a computer programmed by a person.

If the market wants to convince itself that Amazon can and will someday raise its prices to generate actual profits, and that they will then use those profits to bestow untold trillions of dollars (or maybe bitcoins, by the time this actually happens) in dividends on its loyal investor base, it can do it for a very, very, very long time. If you do not think Amazon can manage to preach this narrative to its investor base for another 10, 25 or even 50 years, you are dead wrong.

Do you think I’m arguing against value investing? Against fundamental research? Because I’m not. Not even a little bit. OK, maybe a little bit in the case of most fundamental research. What I am arguing is that when these approaches work, they still work because of the lens of preferences and experience that those who participate in the pricing of the investment bring to the table with them. ANY criticism of “behavioral” methods of investing must also be a criticism of fundamental ones, because they both include assumptions about how humans will respond to something.

This has a lot of implications:

For asset owners and allocators: How much time and effort do you spend thinking about who else owns the investment? Who else might want to own it if some bigger thing happens in the world? To that investor’s situation? To the investment or company itself? Compare that to the amount of time you spend sifting through macro data, research reports and constructing models. If you’re like most of us, you’re spending <5% of your time and resources on the former and 95% on the latter. That’s a mistake.

For fund selectors: Spend more time developing theses about managers who — through intuitive or quantitative techniques — seek to understand what drives the behaviors of other investors (or non-investor influencers of securities prices), rather than simple security-based or macroeconomic analysis.

For all investors: Always keep in mind how prices are determined when you think about how certain trends and events may impact markets and your portfolio. Think about how regulation-driven moves toward passive instruments may change price-to-value convergence. Think about how an increase in private equity dollars may influence or change price-to-value convergence in public markets. Think about what behaviors a low global growth environment could induce on the part of financial advisors, institutions and individuals as they participate in the price-setting process.

OK, so how do we do all this? If the Market In-Itself is a myth, how do we adjust our thinking?

There is no mathematical proof that solves this conundrum for us, because we can’t know people’s full motivations, preferences and exogenous influences. We do not know what investors or traders are paying attention to, except by observing the results after-the-fact and coming up with stories to attach to those analyses. Even if we could, many of these behaviors are emergent properties of the market in the aggregate, meaning that the way people behave isn’t nearly as independent of the path or state of the overall market as we’d like it to be. The market is a complex system.

What we can do is recognize what we recognize about every other aspect of society: that these motivations, preferences and exogenous influences on our behavior are reflected in the tribes we select and the language we speak. We may not be able to observe specific behaviors in action, but we can understand a lot about investors by observing, for example, the sell side. Not because they have anything useful to say (sorry), and not even because we think that they somehow reflect the consensus about a fundamental fact about a company. Because the sell side is telling us who their customers are. The feedback mechanisms of industry conventions, of style boxes, of terminology and language that our fellow investors adopt — these, too, all tell us a great deal about investor behaviors. They can also give us insight — incomplete insight, but insight nonetheless — into things like sustained low volatility, limited liquidity, the rationale for the existence of behavioral premia like momentum, value and low volatility, and how they go through sustained periods of weak or strong performance.

And that’s exactly where we’re going in Part II: the languages and tribes of investing and how they can help us understand the behavioral drivers of the Long-Run Voting Machine.

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Does It Fly, Really?

On episode 22 of the Epsilon Theory podcast, we’re in Las Vegas at the 2017 EQDerivatives conference. Both Dr. Ben Hunt and our guest, Devin Anderson, managing director in equity derivative sales at Deutsche Bank, were speakers at the event this year. In a nod to David McCullough’s 2015 book, The Wright Brothers, this episode explores whether the ubiquitous ideas floating around finance today actually have wings and can fly.

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And They Did Live by Watchfires: Things that Don’t Matter #4

Oliver Bird

There are two kinds of stories we tell our children. The first kind: once upon a time, there was a fuzzy little rabbit named Frizzy-Top who went on a quantum, fun adventure only to face a big setback, which he overcame through perseverance and by being adorable. This kind of story teaches empathy. Put yourself in Frizzy-Top’s shoes, in other words.

The other kind: Oliver Anthony Bird, if you get too close to that ocean, you’ll be sucked into the sea and drowned! This kind of story teaches them fear. And for the rest of their lives, these two stories compete: empathy and fear.

Oliver Bird, Legion, Chapter 4 (2017)

Skinner: What are you doing in here?
Linguini: I’m just familiarizing myself with, you know, the vegetables and such.
Skinner: Get out. One can get too familiar with vegetables, you know!
— Ratatouille (2007)

It’s four in the morning, and he finds himself drawn to a hotel and casino that has been out of style for thirty years, still running until tomorrow or six months from now when they’ll implode it and knock it down and build a pleasure palace where it was, and forget it forever. Nobody knows him, nobody remembers him, but the lobby bar is tacky and quiet, and the air is blue with old cigarette smoke and someone’s about to drop several million dollars on a poker game in a private room upstairs. The man in the charcoal suit settles himself in the bar several floors below the game, and is ignored by a waitress. A Muzak version of “Why Can’t He Be You” is playing, almost subliminally. Five Elvis Presley impersonators, each man wearing a different colored jumpsuit, watch a late-night rerun of a football game on the bar TV.

A big man in a light gray suit sits at the man in the charcoal suit’s table, and, noticing him even if she does not notice the man in the charcoal suit, the waitress, who is too thin to be pretty, too obviously anorectic to work Luxor or the Tropicana, and who is counting the minutes until she gets off work, comes straight over and smiles. He grins widely at her, “You’re looking a treat tonight, m’dear, a fine sight for these poor old eyes,” he says, and, scenting a large tip, she smiles broadly at him. The man in the light gray suit orders a Jack Daniel’s for himself and a Laphroaig and water for the man in the charcoal suit sitting beside him.

“You know,” says, the man in the light gray suit, when his drink arrives, “the finest line of poetry ever uttered in the history of this whole damn country was said by Canada Bill Jones in 1853, in Baton Rouge, while he was being robbed blind in a crooked game of faro. George Devol, who was, like Canada Bill, not a man who was averse to fleecing the odd sucker, drew Bill aside and asked him if he couldn’t see that the game was crooked. And Canada Bill sighed, and shrugged his shoulders, and said. “I know. But it’s the only game in town.” And he went back to the game.

— Neil Gaiman, American Gods (2001)

I had a dream, which was not all a dream.
The bright sun was extinguish’d, and the stars
Did wander darkling in the eternal space,
Rayless, and pathless, and the icy earth
Swung blind and blackening in the moonless air;
Morn came and went—and came, and brought no day,
And men forgot their passions in the dread
Of this their desolation; and all hearts
Were chill’d into a selfish prayer for light:
And they did live by watchfires…
— George Gordon, Lord Byron, Darkness (1816)

A Year Without Summer

In 1816 — 200 years ago — much of the world was experiencing a “Year without Summer.” We now know this was a result of the 1815 eruption of Mount Tambora, a volcano on the sparsely populated Indonesian island of Sumbawa, an eruption which sent some 38 cubic miles of rock, ash, dust and other ejecta into the atmosphere. For reference, that’s roughly 200 times the volume of material ejected in the eruption of Mount St. Helens, but only a tenth or so the size of the Lake Toba explosion off Sumatra that some researchers believe caused one of the most perilous bottlenecks in human genetic history.

At the time in 1816, the world didn’t know the cause. Well, except for maybe the people living on Sumbawa. The effects, on the other hand, couldn’t be missed.

In New England, the clouds of ash that blocked the sun led to remarkable drops and extraordinary variations in temperature and precipitation. In the Berkshires, there was a deep freeze in May. It snowed in Boston as late as June 7. Cornfields in New Hampshire were ruined by frost on August 14. The Dartmouth College campus was blanketed by snow as late (early?) as September. It caused as near a true famine as the U.S. has ever experienced. Hardy crops — some strains of wheat, potatoes and the like — got most of the nation through the year, as did a culling of wild game that likely came as a bit of an unpleasant surprise to the squirrels, hogs and possums that were usually spared a place on the American table.

The situation was not much better in Western Europe, where average temperatures fell as much as 3-4°C. On the British Isles, failed wheat and potato crops meant famine for much of Ireland, Wales and Scotland. Germany had food riots. And in Switzerland, where Lord Byron was in residence with Shelley, the constant rain and cold led each to create a great deal of poetry, which, depending on your opinion of early romanticism, was either more or less catastrophic than the torrential rains that accompanied it. Under the circumstances, it is not surprising that Byron was inspired to write about the heat death of the universe some 35 years before Lord Kelvin proposed it rather more formally (and perhaps less melodramatically).

Byron’s poem, Darkness, envisions a world in which the sun has been extinguished, in which morning never comes. In this time of desperation, the world is literally tearing itself apart. Palaces are ripped to pieces for firewood, forests are set alight and people gather “round their blazing homes” just so they can see their own hands, and the faces of their family and friends. Everything the world has built is pulled apart piece by piece in search of a solution to the problem of darkness.

The stories we tell about such times of desperation tend to fall into the two archetypes Jemaine Clement’s character describes in Legion: stories of fear and stories of empathy. Byron gave us a story of fear. Empathy stories, on the other hand, follow the usual trope of necessity as the mother of invention. But even this is often just a fear story with a different outcome, not uncommonly summoning a sort of deus ex machina. Luke listening to Obi Wan’s disembodied voice instead of the computer as he aims his last shot at the Death Star. Gollum showing up to bite off Frodo’s ring finger and take a dive into Mt. Doom, saving the hobbit from the now too-strong temptation to wear the ring and return it to Sauron. And maybe there’s a story where Byron’s humanity finds a real solution to the coming darkness instead of tearing their homes and businesses apart looking for something else to burn.

The investment environment we face is not so dire as all this, but it does feel a bit grim, doesn’t it? Market returns have continued to defy the odds, but the data, our consultants, our advisors, our home offices and our instincts are telling us that the combination of demographic slowing, stagnant productivity, limited debt capacity, low rates and high valuations isn’t going to end well. Or at a minimum, we remain optimistic but confused. I’m sure we’ve all asked or heard clients and constituents asking us, “What the hell do we invest in when everything is expensive and nothing is growing?” In this call to action, are we successfully turning this into an empathy story? Or are we just ripping apart our homes for tinder so that it looks like we are doing something?

When it’s hard to see what’s two feet ahead of our own noses, when the game feels rigged, sometimes it feels like we have no choice but to stay at the table and play. After all, it’s the only game in town. And so instead of walking away and taking what the market gives us, we tweak, we tilt, we “take chips off the table,” we “go all in” and we hack, hack, hack at the beams and joists of our own homes for the great bonfire.

This bias to action is a road to ruin. That’s why the endless tweaking, trading and rebalancing of our portfolios takes spot #4 on our list of Things that Don’t Matter.

Of Priuses and Passive Investors

In 2011 a group of researchers at Berkeley examined an age-old question: are rich people driving expensive cars the asshats we all think they are? The findings? Yes, indeed they are! The study found that drivers of expensive cars were three times more likely than drivers of inexpensive cars to fail to yield to pedestrians at crosswalks requiring it, and four times more likely to go out of turn at a stop sign. The team performed similar tests in other non-traffic areas (e.g., cheating at games of chance, etc.) that arrived at the same conclusion, and furthermore identified that simply making people believe that they were part of the 2% Club made them behave more rudely.

My favorite discovery from the research was the odd outlier they discovered: the moderately priced Toyota Prius. Fully one third of Prius drivers blew by intrepid Berkeley grad students (taking a night off from throwing trash cans through the windows of some poor Wells Fargo branch, perhaps) who stepped into a busy crosswalk for science. This put it very near the top of the tables for rudeness. Most of you will recognize this as our old friend moral licensing: the subconscious tendency to feel empowered/entitled to do something bad, immoral or indulgent after having done something to elevate our estimation of our own value. The Prius owner has earned the right to drive like a jerk, since he’s saving the world by driving a hybrid car, after all. Alberto Villar of Amerindo Investment Advisors, who was the largest opera donor since Marie Antoinette, could easily justify stealing his clients’ money to make good on charitable pledges. Of course I can eat that Big Mac and large fries when I sneak over to the McDonald’s across the street from our San Francisco office — I ordered a Diet Coke, after all.

And so on behalf of insufferable hipsters, fraudulent philanthropists and Big Mac dieters everywhere, I would like to extend a gracious invitation to our club: ETF investors who pride themselves on being passive investors while they tactically trade in and out of positions over the course of the year.

Now there’s a lot of old research protesting too much that “ETFs don’t promote excessive trading!” A cursory review of news media and finance journals will uncover a lot of literature arguing exactly that, although the richest studies are several years old now. You’ll even find some informing you that leveraged ETFs aren’t being abused any more. Those of you who are closest to clients, are you buying what the missionaries are selling on this one?

I hope not.

Even when some of the original studies were published (most of which said that mutual funds were held around three years on average, while ETFs were held about two-and-a-half years), it was plainly evident to anyone who works with consumers of ETFs that basing claims on the “average” holding behavior was a poor representation of how these instruments were being held and traded. The people with skin in the game who weren’t selling ETFs were aware that holders fell by and large into three camps:

  1. The long-term holders seeking out market exposure,
  2. The speculators trading in and out of ETFs to generate additional returns, and
  3. The increasingly sad and depressing long/short guys shorting SPY to hedge their longs, telling the young whippersnappers stories from a decade ago about “alpha shorts” before yelling for them to get off their lawn.

Source: Morningstar. For illustrative purposes only.

The mean holding period in the old research was still pretty long because Group 1 was a big group. I think that it was also because a lot of the ETF exposure that Group 2 was swinging around was in smaller, niche funds or leveraged ETFs. Both of these things are still true. They’re also becoming less true. A few weeks ago, Ben Johnson from Morningstar published this chart of the ten largest ETFs and their average holding period. There’s all sorts of caveats to showing a chart like this — some of the causes of ETF trading aren’t concerning — but if SPY turning over every two weeks doesn’t get your antennae twitching, I’m not sure what to tell you.

There are a lot of reasons to believe that we are lighting our houses on fire with the almost comically active use of “passive” instruments, and trading costs are one of them. Jason Zweig wrote an excellent piece recently highlighting research from Antti Petajisto on this topic. Petajisto’s work in the FAJ estimates that “investors” may be paying as much as $18 billion a year to trade ETFs. Zweig, perhaps feeling rather charitable, concedes that as a percentage of overall trading volume, this number isn’t really all that high. And he’s technically correct.

But who cares about trading volume, at least for this discussion, which isn’t really about the liquidity of the market? If — as so many investors and asset managers are fond of saying — the ETF revolution is but a trapping of the broader active vs. passive debate (insert audible yawn), we should really be thinking of this in terms of the asset size of the space. And in context of the $3 trillion, give or take, that is invested in ETFs, $18 billion is a LOT. It’s 60bp, which would be a lot even if it weren’t impacting investors who often make a fuss over whether they’re paying 15bp or 8bp in operating expenses.

And then there’s taxes. Now, actively managed strategies, especially those implemented through mutual funds, have plenty of tax issues and peculiarities of their own. But the short-term gains taxable investors are forcing themselves into by timing and day-trading ETFs are potentially huge.  If we assume, say, a 6% average annual portfolio return, the investor who shifts 100% of his return from long-term gains into short-term gains is costing himself 60-120bp per year before we consider any time value or compounding effects of deferring tax liabilities. Given that the largest ten ETFs all have average holding periods of less than a year, this doesn’t seem to be all that inappropriate an assumption.

The growing Group 2 above, our day traders — oops, I mean, our “passive ETF investors” — may be giving away as much as 1.2%-1.8% in incremental return. Those fee savings sure didn’t go very far, and the direct costs of all this tinkering may not even be the biggest effect!

Every piece of data on this topic tells the same story: when we try to time our cash positions to have “ammo to take advantage of opportunities,” when we decide a market is overbought, when we rotate to this sector because of this “environment” that is about to kick off, when we move out of markets that “look like they’ve gotten riskier,” when we get back in because there’s “support” at a price, we are burning down our houses to live by watchfires.

There are two ways in which we as investors do this, one familiar and one less so.

Of Clients and Crooked Card Games

First, the familiar. We stay in the crooked game because it’s what’s expected of us. It’s tempting to think of the desire, this inclination toward constant “tactical” trading as an internal impulse. A response to boredom or, perhaps, an addiction to certain of the chemical responses associated with winning, with risking capital, even with losing. I think that’s probably true for some investors. I know that when I sat in an allocator’s seat, when I heard a portfolio manager tell me he had “fallen in love with the market” when he was six years old and started trading options with his dad when he was 10, I didn’t see that as a particularly good thing. One can get too familiar with vegetables, you know.

But just as often, the impulse to stay in the game is external, and that pressure usually comes from the client. I’m empathetic to it, and it’s not unique to our industry.

Have you ever sent a document to a lawyer and gotten no comments back? Have you ever visited a doctor and gotten a 100% clean bill of health with no recommendations? Have you ever taken your car to a mechanic and had them tell you about just the thing you brought it in for? Have you ever consulted with a therapist or psychiatrist who didn’t find something wrong with you, even if they had the bedside manner to avoid using those exact words? It isn’t just that those folks are being paid for the additional services they’re proposing. There is a natural feeling among professional providers of advice that they must justify their cost to their clients even if the best possible advice is to do nothing.

The result is that the crooked card game usually takes three different forms, which, in addition to all the fees and tax impact discussed above, may add risk and harm returns for portfolios in other ways as well:

  • The Cash Game: When investors feel concerned about the timing of their entry into markets, the direction of markets, upcoming events, or some other factor and temporarily sell investments and go to cash, they’re playing the Cash Game. I recently had a meeting with an intermediary who had recently launched a system to integrate all client holdings (including accounts held away). Their initial run identified average aggregate cash positions of more than 15%!
  • The PerformanceChasing Game: I’ve talked about this ad nauseam in prior notes. We investors find all sorts of vaguely dishonest ways to pretend that we aren’t just performance-chasing. It doesn’t work, and a goodly portion of the damage done by tinkering and “tactical” moves is just performance-chasing in guise, even if we are high-minded enough to pretend that we’re making the decision because “the fund manager changed his process” or euphemistically inclined enough to say the investment “just wasn’t working,” whatever that means.
  • The In-Over-Our-Heads Game: Still other games are essentially designed to “fleece the odd sucker,” causing investors to seek out hedges and interesting trades to take advantage of events and “low cost” insurance for portfolios. As a case study, please take a gander at the size and volume of instruments and funds tracking the VIX. Please look at the return experience of holders of those various instruments. It’s not the vehicles themselves that are flawed, but the way in which these markets prey on misplaced expectations of investors that they know when insurance is cheap or expensive. As a quick test: if you can’t define gamma without looking it up on Investopedia, you probably shouldn’t own any of these instruments, much less be flopping in and out of them. This concept is broadly transferable to a variety of things investors do to “hedge” — buying S&P puts, buying short ETFs, etc.

I know I’m not treading new ground here. Borrowing from the work done in a thorough survey on the literature that itself concludes a 1.0% impact from the ways in which investors trade in and out of funds, the figures are pretty consistent. The folks over at Dalbar concluded in 2016 that investors in equity mutual funds underperformed equity indices by 3.5% over the last 20 years, 1.5% of which they attribute to “panic selling, exuberant buying and attempts at market timing.” Frazzini and Lamont previously estimated 0.85%. In 2007, Friesen and Sapp said 1.56%. We’ve got something for hedge fund investors, too.

You’ve heard this story before. So why am I telling you this?

Because when I meet or speak with investors, I often worry that when they think about dominant narratives and observations about human behaviors, they are focused on identifying tradable trends and signals. In rare cases, that is a worthwhile endeavor. And we’ve made no secret that we’re spending a lot of time thinking about the Narrative Machine — after all, if we believe that investors systematically make mistakes that cost them returns and money, it should be possible to identify ways to capitalize on the actions taken by others.

But far more often, the message from the analysis of prevailing narratives is to back away from the table. Investors I’ve spoken to in the past few years have heard a voice of caution against rotating away chunks of portfolios that by all rights ought to be invested in bonds based on flimsy rationale like, “rates couldn’t possibly get lower!” I’ve likewise cautioned against haphazardly fleeing equity markets into cash on the basis of historically high valuations, perceived political turmoil and the like. There will come times where it may be right to make strong positive observations on opportunities for tactical allocations, but as in all decisions we make when investing, it is imperative that we be aware that the hurdle for staying at the table to play the only game in town is very high. Our skepticism about opportunities to play it should be extreme.

Of Bambi and Battle Tanks

Since I’m advising you to be skeptical, I’ll forgo the apocryphal (it’s real to me, dammit!) story I was going to tell at this point in my little piece. I was going to tell you a story my brother told me once about a high school classmate, an M1A1 Abrams tank and a whitetail deer. It is apparently not normal in polite company to discuss the disintegration of adorable animals, and so I won’t unless you buy me a drink (Lagavulin and water, please). What I will do is highlight that the often-overlooked pitfall of the tinkering mentality is the tendency to use very big tools to accomplish very small things, for which the intended aim is almost always overwhelmed by the unintended consequence. Pointing a 120mm smoothbore cannon at a tiny animal isn’t going to shrink the explosion it causes. Likewise, pointing a major change in risk posture or asset allocation at an event we’re a bit nervous about isn’t going to change the fact that we’ve made a change to some very fundamental characteristics of the portfolio.

This happens all the time.

In the last year, I’ve met with advisors, allocators and investors convinced of the inexorable, unstoppable, indomitable rise of interest rates who exited their government and investment-grade bond portfolios — in many cases, the only remnant of their portfolio standing against them and a downturn in risk assets — in favor of higher yielding equity portfolios that wouldn’t be as exposed to the environment they expect. I’ve seen investors leaving passive equity allocations in favor of concentrated private deals because they are concerned about the broader economy’s impact on stocks. I’ve seen investors switch asset classes because they didn’t like the manager they were invested with.

There may be reasons for some of those views, and in some cases even for acting on them. But I am always concerned when I see changes like that unaccompanied by consideration of the magnitude of the unintended consequences: are we still taking the right amount of risk? Are we achieving adequate diversification? As we close out the list of Things that Don’t Matter, I look forward to publishing our list of things that actually DO, because these questions play prominently. There is hope. There are things we can do, and most of them will run contrary to our instincts to take rapid, “nimble” action in our portolios.

Within that thread of hope, a plea first to readers who prefer poetry: that we feel disillusioned or confused about the outcomes for markets does not mean we ought to be more active, more nimble in modifying our asset allocation, however good and wise those things sound when we say them to ourselves and our clients. All the data tell us that we are likely to find ourselves warming our hands at a watchfire before long. To those who prefer poker: you don’t have to play the game. It is OK to step away from the table, walk back to the elevator bank and call it a night, to take what the market gives us.

Make no mistake: the alternative is worse. It’s an expensive alternative. It’s often a risk-additive alternative. It’s a tax-producing alternative. It’s an alternative that frankly most of us just aren’t in a position to successfully execute. There is a reason that most global macro and GTAA hedge funds hire traders who have success in individual markets, even individual types of trading strategies within individual markets. It’s because being able to effectively determine when to switch among managers, among asset classes and among drivers of risk and return is very, very hard. The data bear this out, and no matter how hard we feel like we have to do something, it won’t change the fact that lighting our house on fire isn’t going to make the sun come back.

Understanding the dominant impact of narratives in markets today doesn’t mean abandoning our well-designed processes and our work determining asset allocation, risk targets and portfolio construction in favor of a haphazard chasing of the narrative-driven theme for the day. It means that human behavior and unstructured forms of information should — must — increasingly play a role in the structure of each of those processes in the first place.

After all, all investing is behavioral investing. Anyone who tells you different is either incompetent, selling something or both. One of the most pointless such behaviors — our unquenchable desire to act — nearly completes our list of the Things that Don’t Matter.

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1999 v2.0

On episode 21 of the Epsilon Theory podcast, Dr. Ben Hunt is joined by Brad McMillan, CFA, CAIA, the chief investment officer at Commonwealth Financial Network®. Brad graciously hosts us at Commonwealth’s headquarters in Waltham, Massachusetts. Ben and Brad talk about their mutual love for Terry Pratchett, narrative causality, the French elections, and how technology is changing the financial advisory business.

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