A Man Must Have a Code

The Wire

Mallow: It lacks glamour?

Jael: It lacks mob emotion-appeal.

Mallow: Same thing.

― Isaac Asimov, Foundation

It is the artist’s function not to copy but to synthesize: to eliminate from that gross confusion of actuality which is his raw material whatever is accidental, idle, irrelevant, and select for perpetuation that only which is appropriate and immortal.

― William Ernest Henley, Views and Reviews: Essays in Appreciation

Principal: Mr. Madison, what you’ve just said is one of the most insanely idiotic things I have ever heard. At no point in your rambling, incoherent response were you even close to anything that could be considered a rational thought. Everyone in this room is now dumber for having listened to it. I award you no points, and may God have mercy on your soul.

Billy Madison: Okay, a simple “wrong” would have done just fine.

― Billy Madison (1995)

Homer Simpson as Max Power: Kids, there’s three ways to do things: the right way, the wrong way, and the Max Power way!

Bart Simpson: Isn’t that the wrong way?

Homer Simpson as Max Power: Yeah, but faster!

― The Simpsons, Season 10, Episode 13 “Homer to the Max”

Bunk Moreland: So, you’re my eyeball witness, huh?  So, why’d you step up on this?

Omar: Bird triflin’, basically. Kill an everyday workin’ man and all. I mean, I do some dirt, too, but I ain’t never put my gun on nobody that wasn’t in the game.

Bunk: A man must have a code.

Omar: Oh, no doubt.

― The Wire, Season 1, Episode 7

What is your code?

A few years back I worked at the Teacher Retirement System of Texas. I was responsible for hiring ostensibly sophisticated money managers—hedge funds and others generally regarded as some of the most intelligent people our society has to offer. But the most impressive people I worked with were not London-based portfolio managers but two of my fellow laborers. At a public pension plan in Austin. Go figure.

The first, Dale West, is still probably the most intelligent person I’ve ever worked with, and with my current partners Jeremy Radcliffe and Ben Hunt, would round out my fantasy Bar Trivia team, a list that unsurprisingly overlaps with my do-not-play-poker-with list. (No, in all seriousness, never play poker with Ben Hunt or Jeremy Radcliffe.) A former rising star in the Foreign Service posted in Bucharest, I’m pretty sure Dale was largely responsible for fomenting the overthrow of Ceaușescu, but he maintains that the most exciting thing he did was wire a report back to Washington about the grand opening of the first McDonald’s in Romania. He might also say he was still an undergraduate in Austin at the time. Likely story.

I also had the pleasure of working directly for Chief Investment Officer Britt Harris, one of the wisest men and investors I have known. Britt is a native of the Rio Grande Valley of South Texas, and, like Ben and me he takes peculiar pleasure in the “I’m just a country boy” hustle familiar to all accomplished southern gentlemen. As an investor-cum-philosopher-cum-preacher, Britt was and is famous for imparting that wisdom in particularly pithy turns of phrase—Britticisms, if you will. One such Britticism was the idea that any person who wants to be consistently successful as a human being, and especially as an investor, must have a World View.

In this sense, having a World View means having a center—a core set of philosophies about how the world works, what is objectively true and false, and what actually matters. More importantly, it means internalizing these philosophies so that they are second nature—and so that they become a natural lens through which we judge the world, and which we can describe succinctly to those who ask. It means having a confident view concerning how we come to any measure of knowledge about investing and markets.

To those who have studied philosophy, yes, I’m basically describing an epistemology for markets. But out of respect for the hustle, let’s call it a Code.

Unlike in abstract philosophy, however, developing a complete, fundamental view of the basis of our knowledge about markets is actually not a particularly good use of time and effort. Rationalists might argue for building thorough foundational theories on the underpinnings of human behavior, the resultant evolution of economic and financial systems and how those interact to create trillions of discrete price discovery events. Empiricists might argue instead for an ex-post analysis of price response to various identified factors or stimuli in order to develop a forward-looking framework for similar responses to similar stimuli.

The problem with both approaches is two-fold: first, the forces and individuals that comprise financial markets are far too complex to think we can ever have complete knowledge about what drives them.  Second, even when we can develop acceptable models, humans create massive error terms that we lump into the epsilon of our model, to be ignored and abstracted from. This, of course, is the genesis of Epsilon Theory as a framework for investors.

In the face of overwhelming complexity and the constant exogenous shock of human stupidity, what does it mean, then, to have a World View? What does it mean to have a Code? From my perspective, it means three things:

  1. You have a clear set of investing heuristics that are, by and large, provably true (i.e., what risks will be taken, and why do you believe they will be compensated?)
  2. You have a process for implementing those heuristics and for handling their exceptions (i.e., how do I take those compensated risks?)
  3. You can absorb new facts into your framework without breaking it.

The right way, the wrong way and the Wall Street way

The investment industry has embraced this notion of Codes to varying levels of success.

The best examples are natural, organic expressions of why an investment company was formed in the first place. Dimensional Fund Advisors (DFA), a Texas-based firm (sorry, California) we admire very much, came into existence as a commercial expression of the pioneering work on the value premium by Professors Gene Fama and Ken French. DFA doesn’t claim to have every answer to every question, but they claim to have one or two very big, important answers that matter an awful lot. And they built a firm and a Code around it.

Some Codes are willed into being by visionaries. The most famous such example is probably Bridgewater Associates, which is famous for discussing the “timeless and universal” principles that they believe underpin both the economy and financial markets. Above even these market-oriented principles, Bridgewater leans upon the principles established by Ray Dalio over many years, now compiled into a 100+ page tome. Not everyone may agree with all of the principles, but it is hard not to admire their Code and especially their commitment to it.

One family office in Ohio we think highly of has so embraced the importance of the processes that put their Code into action that firm policy dictates a regular verbatim reading of these policies and procedures as a group—aloud!

Most of the industry is less inspiring. I’ve met with hundreds of hedge funds, private equity funds, equity, fixed income and credit managers over the last decade as an allocator. Unfortunately, this experience provides very little to dispel the popular conception of Wall Street as being populated by charlatans or, worse, salesmen. Unfortunately, an entire mythology has formed around the ability of due diligence or manager selection teams to pluck out the good fund managers from the bad through huge checklists, data requests and face-to-face meetings where you can “look them in the eye” to find out whether they’re good or bad people and good or bad investors.

It’s all nonsense.

The sad reality – or the happy reality, for road-weary due diligence professionals – is that 90% of evaluating a fund manager can be boiled down to a single question: “How and why do you make money?”

When you ask this question, a fund manager with a Code’s eyes will light up. The one without will pause and give you a quizzical look. “What do you mean?” He was prepared to tell you about his investment philosophy. He was prepared to tell you about his investment process – he had the funnel graphic and everything! He was prepared to tell you which five names added the most to his P&L that quarter. He was prepared to tell you about the sector he moved from 2% to 4% overweight.

What he wasn’t prepared to do is tell you why any of that matters.

Rather than adopting a Code, individual investors, financial advisors and investment firms alike tend to try to define themselves by either a formal stated philosophy or some informal self-applied label of the type of investor they are. Invariably these descriptions are banal and infinitely transferable to the point of irrelevance.

I die a little bit inside when a fund manager tells me that his investment philosophy is something to the effect of, “We believe that our rigorous bottom-up, fundamental analysis process coupled with prudent risk management will allow us to produce above average risk-adjusted returns.” This kind of statement is the surest sign that a fund manager has absolutely no idea what he is doing that will actually make money, in addition to being a sign that he is probably spending half his day in committee meetings. That is, coincidentally, the only decision-making structure that could come up with such a ridiculously incoherent investment philosophy.

Slightly more frequently, the fund manager expresses his philosophy by communicating how he sees the world differently from everyone else by seeing it just like everyone else. “Wall Street is just focused on the next quarter—our philosophy is that we will win by having a longer-term perspective.” I might consider this a lovely Code if every other equity fund manager in New York hadn’t said the same thing to me earlier that week.

Often the response isn’t an attempt at philosophy but a reference to the size of a research team (i.e., look at our cube farm of disaffected millennials pretending to work on a dividend discount model while they look for tech jobs!), as if there were some self-evident transfer coefficient between headcount and returns.

In perhaps the most common case, the investor eschews the more formal philosophy statements in favor of the simply applied label, such as, “I’m a value investor.” This, of course, is another way to say that you like to buy things you think are cheap because you expect them to be more expensive later. In other words, you are an investor. Congratulations, your certificate is in the mail, and meetings are every other Thursday at the VFW hall. The number of fund managers who think this is an adequate description of how they generate returns, perhaps self-lauding their own simplicity in light of the perceived difference in the way everyone else sees the world, is absolutely staggering.

What does a code look like?

And yet the problem with these isn’t that they are bad philosophies. Okay, that’s part of the problem. But the real problem is that even if they were good, they wouldn’t be useful. And they aren’t useful because they aren’t measurable and because they don’t provide any mechanism for decision-making. In our view, to be successful a Code should be explicit in highlighting four key beliefs:

  1. The things that matter.
  2. The things that don’t matter.
  3. The things that don’t always matter, but which matter now.
  4. The process and tools you’ll use to focus on what matters and dispense with what does not.

It really is that simple. In future pieces, I will walk through my Code – our Code – in hopes that it will help to apply the principles of Epsilon Theory. And I promise—no funnel charts.

Okay, maybe a few funnel charts.

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The Art of the Probe

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Slade: How the hell did you know I didn’t have the king or the ace?
Lancey Howard: I recollect a young man putting the same question to Eddie the Dude. “Son,” Eddie told him, “all you paid was the looking price. Lessons are extra.”
― “The Cincinnati Kid” (1965)

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There are only two great movies about poker — Rounders, which everyone knows, and The Cincinnati Kid, which no one knows. Steve McQueen is the Kid and Edward G. Robinson is the Old Pro, Lancey. When I was a younger man, I rooted for the Kid. Today … I’m pulling for Lancey all the way.

Slade: Six stacks, is that right, Shooter?
Shooter: Six.
Slade: Well, we’ve been playing 30 hours… uh, that rate, six thousand, that makes roughly, uh, $200 an hour. Thank you for the entertainment, gentlemen. I am particularly grateful to Lancey, here; it’s been a rewarding experience to watch a great artist at work. Thank you for the privilege, sir.
Lancey Howard: Well now, you’re quite welcome, son. It’s a pleasure to meet someone who understands that to the true gambler, money is never an end in itself, it’s simply a tool, as a language is to thought.
“The Cincinnati Kid” (1965)

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Money is to gambling as a language is to thought. What a line!

Screenplay by Ring Lardner, Jr., one of the Hollywood 10 who refused to be rats for the House Un-American Activities Committee in McCarthy days. Lardner was blacklisted and sentenced to a year in prison for contempt of Congress.

True courage comes at a heavy price. Some will be willing to pay that price over the next four years.

And some won’t.

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[Shooter’s wife Melba is altering a jigsaw puzzle piece with a nail file]
Shooter: Melba, why do you do that?
Melba: So it’ll fit, stupid.
Shooter: No, I’m not talking about that. What I’m asking is … do you, uh, have to cheat at everything?
Melba: At everything?
Shooter: Yes. At … solitaire. I’ve yet to see you play one game of solitaire without cheating.
Melba: So what?
Shooter: Look, you’re just cheating yourself, don’t you understand? You’ll be the loser, no one else but yourself! … You’ve ruined the puzzle, now, that doesn’t go in there.
[She forces the altered piece into place]
Melba: Does now.
“The Cincinnati Kid” (1965)

I’ve known more than a few economists who had more than a little Melba in them. Quants, too. That’s Ann-Margret as Bad Girl Melba, by the way, and Karl Malden as the cuckolded Shooter. ‘Nuff said.

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Daring ideas are like chessmen moved forward. They may be beaten, but they may start a winning game.

― Johann Wolfgang von Goethe (1749 – 1832)

A gambit risks a pawn for advantage later in the game. The word is derived from the Italian gamba (leg), from a wrestling move with a similar sacrifice.

In chess as in life — the only way to defeat a gambit is to accept it.

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Berlin is the testicles of the West. Every time I want the West to scream, I squeeze on Berlin.

Nikita Khrushchev, 1963

Without wishing to trade hyperbole with the Chairman, I do suggest that he reminds me of the tiger hunter who has picked a place on the wall to hang the tiger’s skin long before he has caught the tiger. This tiger has other ideas.

John F. Kennedy, 1961

Sieges and blockades are game theory in practice, on both sides of the wall.

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Photo of North Vietnamese General Giap, taken during the siege of Dien Bien Phu in 1954. In anticipation of a full-scale assault, the French took up positions (marked in green on the map) on a series of fortified hills. Rather than attack en masse, however, Giap set up artillery positions east and north of the French fortifications and wore the French down with artillery fire combined with constant probing skirmishes. In investing, I always try to think: WWGGD?

I’ve written a lot about The Common Knowledge Gamehere, here, and here – because it’s the game of markets, i.e., it’s the central contribution of game theory to understanding how markets work. I’ve also written a lot about new technologies and new perspectives – here, here, and here – that help us see The Common Knowledge Game in action. Today I want to take a different cut at this topic: how can you be a better game-player? What are some specific strategies one can adopt to play the game of markets more effectively?

There’s a concept in poker that’s a useful introduction to what I want to talk about. It goes by lots of different names, but I’ll call it The Probing Bet. The idea is that you make a raise or otherwise take the initiative in a signaling interaction because, as you’ll hear time after time if you talk to good poker players, you need to find out “where you stand” in that particular hand. The betting behavior of the other poker players sitting around the table from you is like the betting behavior of the other investors sitting around the market from you: it’s over-determined, which is a $10 word that means there are far more possible explanations of what actual cards might be driving that betting behavior than are required to explain the behavior fully (see “The Unbearable Over-Determination of Oil” for an investment example).

In other words, there might be six different basic card combination categories that an opponent might hold, each of which — if you were playing that hand — has some percentage likelihood of prompting you to duplicate that opponent’s betting behavior. But if you add up those percentage likelihoods across the six different categories, you get a number way higher than 100%. As a result, if you’re trying to reverse engineer in your mind what cards your opponent might be holding, it’s really difficult to come up with anything interesting or informative. It’s difficult and not terribly fun, so most poker players don’t even try. Most poker players only play their own hand. Period. They know their own hand’s strength in an absolute or non-strategic sense, and they know what cards need to show up for them to have a really killer hand. But that’s all they really know, so their betting behavior is directly connected to the non-strategic strength of their hand, coupled with some loose sense of whether they want to play “tight” (bet per the book odds of hitting that killer hand) or “loose” (bet more than the cards justify in an absolute sense in order to set up a bluff or maybe just get lucky).

The average poker player is fascinated by his own cards. Every deal unlocks a world of seemingly endless potential, and almost all of the mental energy at a typical poker game is consumed by thoughts of “how am I going to represent my hand to my opponent?” In sharp contrast, precious little mental energy is spent asking “how can I learn more about how my opponent is representing his hand?”, even though the latter question is FAR more useful to answer. Why more useful? Because just as you are fascinated by your cards, so is your opponent fascinated by his cards. In a game of ubiquitous self-absorption, even a little bit of other-awareness goes a really long way.

What you need to whittle down an over-determined behavior is The Probing Bet, something out of the ordinary that intentionally puts capital at risk in order to narrow down the likely range of hands your opponent might hold. The Probing Bet isn’t designed to represent or signal anything about your hand (which right there makes it a foreign concept to the vast majority of players). It’s a bet designed to get more information about your opponent’s hand and the way he plays it, and it’s something you might do regardless of what cards you have in your hand. Importantly, The Probing Bet in and of itself has a negative expected return. There’s no such thing as a free lunch, and that’s as true in poker as anywhere else. If you want more information, you have to pay for it, and the cost is the potential loss of The Probing Bet. You should gladly pay that cost, however, if the additional information garnered from The Probing Bet increases the expected return of the entire deal (or future deals!) by an even greater amount.

You can find the concept of The Probing Bet in every classic game. In chess, it’s the gambit, the intentional risking of a pawn that accepts a limited loss in the short term to win a more valuable positional advantage over the entire course of the game. When offered a gambit, you’re damned if you do and damned if you don’t. If you don’t accept the offered pawn, you don’t get the piece and you lose the positional advantage anyway. But if you do accept the pawn, your degrees of freedom going forward are sorely limited. On balance, when offered a gambit you have to take it. Chess is a game of informational initiative, and playing a gambit grabs that initiative with both hands. At a cost.

You similarly find the concept of The Probing Bet in every game of nations, and it’s here that we can start making the connection (please!) to the game of markets. I know this sounds weird, but I’ve always found international maritime law to be a place where the game of nations gets crystalized in really interesting ways. Why? Because international law in general is just a short cut to equilibrium outcomes that you’d otherwise need to fight a war to arrive at — which is to say that international law is, in a very real way, MADE of game theory — and maritime law in particular has seen thousands of years of every imaginable strategic interaction in a clean and ordered way. So bear with me as I shift the metaphor from poker to naval blockades and the role of non-belligerent neutral parties. Trust me, there’s a decent payoff here.

Let’s say you’re Neutral Nation and you want to send a ship full of wheat across the ocean to Market Nation and sell it there. You’re one of many neutral nations and you don’t have a huge combatant navy, just lots of cargo ships and lots of wheat to sell. Unfortunately, Market Nation is at war with Banker Nation. Now you don’t have a dog in that fight; all you want to do is make money. But before you send your ship on its merry way, you are informed by Banker Nation’s ambassador that they have declared a blockade on Market Nation, that the list of contraband materials includes wheat, and that they are asserting the right to stop, search, and seize any neutral ships headed for Market Nation carrying such contraband. What do you do?

For a blockade to be valid under international law, two conditions must be fulfilled. First, it must be communicated to you, which in this case it clearly was (interestingly, it doesn’t have to be communicated directly, but can be understood to have been communicated “through the notoriety of the fact”, which is a fancy way of saying Common Knowledge). Second — and this is the important part — it must be an effective blockade for it to be legally binding on you, the neutral party. In other words, Croatia can’t declare a neutral party-binding blockade on Italy because it doesn’t have enough warships to cover all of the Italian ports and make that blockade effective. So if Banker Nation is some weakling, you have every right to say that you don’t recognize their blockade as effective, and any action they might take against your ships will be treated as an illegal seizure and a potential act of war. In game theory we would call this a trivial case, in that the game play is obvious — you and every other neutral country ignore the “blockade” and it collapses immediately.

But let’s say that Banker Nation has a decent-sized navy, maybe even a large navy. Let’s say that Banker Nation is able to put a warship or two around most of Market Nation’s ports most of the time. Is that an effective blockade? Banker Nation will represent that it is. Banker Nation and its ambassadors will tell you that they have an impenetrable wall of warships covering every square inch of Market Nation’s coastline. You know that this isn’t true, but you don’t know how true it is. When they say that they have an effective blockade, are they covering 100% of the ports 80% of the time? 60% of the ports 60% of the time? Does their coverage ratio go up over time? Down? Whatever the port coverage ratio might be, is that enough for you to consider the blockade “effective” and keep your cargo ships at home? The problem you face as Neutral Nation is the same problem faced by The Cincinnati Kid: the statement “my blockade is effective” is as over-determined as an opening bet in a game of Five Card Stud. You don’t know what cards Banker Nation is really holding.

So here’s what you don’t do as Neutral Nation. You don’t send cargo ship after cargo ship sailing blindly to Market Nation in the hopes that a few of them will slip through. You don’t fight the Fed Banker Nation! But what’s also a mistake is to accept the efficacy of Banker Nation’s blockade as a permanent state of the world or just on their word, even though that’s what most neutral countries will do.

So what DO you do? Let’s put this (finally!) in the context of an actual investment scenario. The ECB has famously said that they will do “whatever it takes” to keep the euro system intact. They have proclaimed unlimited resolve to purchase government and corporate debt to accomplish their goals. They have, to stick with the naval warfare metaphor, announced an effective blockade of fundamental market pressures associated with the common currency and the sovereign debt of currency bloc members. Would the Spanish 10-year bond trade 90 basis points tighter than the U.S. 10-year bond if the ECB weren’t patrolling the waters of sovereign rates markets? Please.

But at the same time, the ECB is facing extraordinary and escalating pressure on the home front — the politics of member states and their willingness to participate in a common currency system that clearly has big winners (Germany) and big losers (Italy). 2016 was rocky enough from a political perspective, but 2017 shapes up to be a real doozy, with elections in France and Germany and probably Italy … the three sine qua non countries of the eurozone. As the home front deteriorates, the ECB is going to be hard-pressed to maintain its fleet of announced balance sheet expansion programs, much less the mythical dreadnaughts of the OMT program and other super-warships that are supposedly waiting in the wings should the blockade start to fail. Draghi and the rest of Banker Nation will never admit the deterioration in the cards that they hold, but we know it’s happening. What we don’t know is how bad the deterioration actually is. What we don’t know is what has to happen before Common Knowledge shifts from “yes, the blockade is effective so don’t even try to act against the ECB” to “no, the blockade is no longer effective so let’s go do what we’ve gotta do to protect our capital and make some money if the euro isn’t going to make it.”

What we do know, however, is how the Common Knowledge Game works. We know that we need to watch for a Missionary statement — typically from a status quo-breaking politician — that creates new Common Knowledge in opposition to the old Common Knowledge. We know that we need to watch for how this Missionary statement is repeated and amplified (or not) by other Missionaries — other politicians, famous investors, prominent journalists, etc. We know that this war of beliefs and memes is every bit as fierce as a war of bullets, and that it isn’t just difficult, but is impossible to predict the winning belief through traditional econometric analysis (in the lingo, it’s a multiple-equilibrium game).

Since we can’t predict where we’re going to end up in the Common Knowledge Game (and I really can’t emphasize this point strongly enough … the past is a terrible predictor of the future when it comes to multiple-equilibrium games), we have to constantly assess where we are as the game unfolds. How do we do that? By making occasional Probing Bets. By placing capital at risk to see “where we stand” in the strategic dynamic of the game of markets. By experiencing the reaction of the ECB and other investors, large and small, to a potential volatility catalyst like an Italian election.

Some investors make big Probing Bets. They’re called Bond Vigilantes, and they’ve been cowering in the tall grass since 2012 when Draghi proclaimed “whatever it takes”. But they’re still there, biding their time. Just wait. In 2017 they’ll be back. Many of these game players are Missionaries themselves, and they pack an extra punch in the game-playing as a result.

But you don’t need to be a hedge fund Master of the Universe to make a Probing Bet, although maybe we should take the capitalization off and call these probing bets. You just need to get in the game. I’d like to tell you that you can figure out where we are in the euro game by watching from the sidelines and letting others place Probing Bets, but I can’t. My strong belief is that you have to live an investment before you can gain useful information from the experience. And it’s got to be a high enough cost so that you pay attention. As Old Pro Lancey would say, you can’t just pay the looking price. Does it have to be a cost in actual dollars and cents? No, although that’s a really good attention-grabber. The real price you must pay for a probing bet is even more precious than money — time. That’s the price that most of us find hardest to pay, which is why I think it makes all the behavioral sense in the world to couple it with real money. No one uses the free gym in an apartment complex.

And now for the big finish. I’ve used a macro trade (the ECB and what’s in store for the euro) as my example of the useful role of probing bets and the investment managers who play those cards, because that’s the investment arena that I play in. The exact same logic applies to ALL investment arenas and ALL active managers. What’s the big mistake that investors are making with their single-minded and headlong pursuit of passive investment strategies in the form of ETFs, index funds, and the like? Passive strategies give you ZERO information about the strategic gameplay of markets. Passive strategies, by definition, cannot make a Probing Bet. Passive strategies, by definition, will be the last to know when the state of the world has changed and will be the slowest to adapt. A portfolio composed of passive strategies is like the average poker player who just plays his own hand in a strategic vacuum. That can work out fine if you’re dealt nothing but great cards, a lot less well if you’re not.

That’s not to say that all active managers are effective information-seekers or strategic game-players. In fact, I think it’s fair to say that many, if not most, active managers and active investors are so-so game-players because they confuse caution with wisdom. It’s one thing — a perfectly reasonable thing — to create a cautious portfolio through low gross exposure or high levels of cash if your belief is that markets are more likely to go down than up AND you are placing probing bets to see if the market dynamic is somewhere other than where you think it is, i.e., more positive than you believe. And it’s also a perfectly reasonable thing to be all-in with your portfolio if your belief is that markets are likely to keep rocking AND you are placing probing bets to see if the market dynamic is somewhere other than where you think it is, i.e., more negative than you believe. What’s not so reasonable, I think, but I see every day (and I recognize from time to time when I look in the mirror!) is to take a big risk with a portfolio (and a high level of cash IS a big risk for a portfolio), without allocating a commensurate portion of my risk budget towards going the other way, towards gaining more information about how competing players are playing their hand, towards challenging my beliefs with real dollars and precious time.

And that, in a nutshell, is the best advice I’ve got for any game, whether it’s the game of poker, the game of chess, the game of nations, or the game of markets: act strongly on your beliefs, but don’t hold your beliefs strongly. That’s the cornerstone of Adaptive Investing.

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Rounders

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Mike McDermott: In “Confessions of a Winning Poker Player,” Jack King said, “Few players recall big pots they have won, strange as it seems, but every player can remember with remarkable accuracy the outstanding tough beats of his career.” It seems true to me, cause walking in here, I can hardly remember how I built my bankroll, but I can’t stop thinking of how I lost it.
– “Rounders” (1998)

I know it’s crooked, but it’s the only game in town.
– Canada Bill Jones (c. 1840 – 1880), described as “the greatest three-card monte sharp to ever work the boats”, on being told by his partner George Devol that a Faro game in Cairo, Illinois was rigged.

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David Howard: We’re up!
Linda Howard: We’re still down.
David Howard: How down?
Linda Howard: Down.
David Howard: How down is she?
Desert Inn Casino Manager: Down.
Desert Inn Casino Manager: You’re a nice guy. You make me laugh. But our policy is: we can’t give your money back.

– “Lost in America” (1985) 

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Boredom is the conviction that you can’t change … the shriek of unused capacities.
– Saul Bellow, “The Adventures of Augie March” (1953)


Anything becomes interesting if you look at it long enough.

– Gustave Flaubert (1821 – 1880)


She wanted to die, but she also wanted to live in Paris. 

– Gustave Flaubert (1821 – 1880)

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To me, at least in retrospect, the really interesting question is why dullness proves to be such a powerful impediment to attention. Why we recoil from the dull…surely something must lie behind not just Muzak in dull or tedious places but now also actual TV in waiting rooms, supermarkets’ checkouts, airport gates, SUVs’ backseats. Walkman, iPods, BlackBerries, cell phones that attach to your head. This terror of silence with nothing diverting to do. I can’t think anyone really believes that today’s so-called ‘information society’ is just about information. Everyone knows it’s about something else, way down.

– David Foster Wallace, “The Pale King” (2011)

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Carl:  This is crazy. I finally meet my childhood hero and he’s trying to kill us. What a joke.
Dug: Hey, I know a joke! A squirrel walks up to a tree and says, “I forgot to store acorns for the winter and now I am dead.” Ha! It is funny because the squirrel gets dead.

– “Up” (2009)

I’m a good poker player. I know that everyone says that about themselves, so you’ll just have to take my word for it. I’m also a good stock picker, which again is something that everyone says about themselves. At least on this point I’ve got a track record from a prior life to make the case. But I don’t consider myself to be a great poker player or a great stock picker. Why not? Because I get bored with the interminable and rigorous discipline that being a great poker player or a great stock picker requires. And I bet you do, too.

To be clear, it’s not the actual work of poker playing or stock picking that I find boring. I could happily spend every waking moment turning over a new set of cards or researching a new company. And it’s certainly not boring to make a bet, either on a hand or a stock. What’s boring is NOT making a bet on a hand or a stock. What’s boring is folding hand after hand or passing on stock after stock because you know it’s the right thing to do. The investment process that makes a great poker player or a great stock picker isn’t the research or the analysis, even though that’s what gets a lot of the attention. Nor is it the willingness to make a big bet when you believe the table or the market or the world has given you a rare combination of edge and odds, even though that’s what gets even more of the attention. No, what makes for greatness as a stock picker is the discipline to act appropriately on whatever the market is giving you, particularly when you’re being dealt one low conviction hand after another. The hardest thing in the world for talented people is to ignore our mental “shriek of unused capacities”, to use Saul Bellow’s phrase, and to avoid turning a low edge and odds opportunity into an unreasonably high conviction bet simply because we want it so badly and have analyzed the situation so smartly. In both poker and investing, we brutally overestimate the edge and odds associated with merely ordinary opportunities once we’ve been forced by circumstances to sit on our hands for a while.

As David Foster Wallace puts it so well, “the really interesting question is why dullness proves to be such a powerful impediment to attention.” Why do we increasingly suffer from a “terror of silence” where we use electronic information devices to fill the void? Why are most of you reading this note with at least one TV screen showing CNBC or Bloomberg within easy viewing distance? How many of us are bored to tears with the Fed’s Hamlet act on raising rates, and yet have been staring at this debate for so long that we have convinced ourselves that we have a meaningful view on what will transpire, even though it’s a decision where we have zero investing edge and unknowable risk/reward odds. I’m raising my hand as I re-read this sentence.

The biggest challenge of our investing lives is not finding ways to process more information, or even finding ways to process information more effectively. Our biggest challenge is finding the courage to focus on what matters, to admit that more or quicker information will not help our investment decisions, to recognize that our investment discipline suffers mightily at the hands of the impediment of dullness. Because let’s be honest… the Golden Age of the Central Banker is a really, really dull time for a stock-picking investor. I’m not saying that the markets themselves are dull or that market price action is boring. On the contrary, this joint is jumping. I’m saying that stock pickers are being dealt one dull, low conviction hand after another by global Central Banks, even though they’re forced to sit inside a glitzy casino with lots of lights and sounds and exciting gambling action happening all around them. We have little edge in a Reg-FD public market. We have at best unknowable odds and at worst a negatively skewed risk/reward asymmetry in a market where policy shocks abound. And yet we find ways to convince ourselves that we have both edge and odds, making the same concentrated equity bets we made back in happier times when idiosyncratic company fundamentals and catalysts were actually attached to a company’s stock price. Builders build. Drillers drill. Stock pickers pick stocks. We can’t help ourselves, even if the deck is stacked against us here in the only game in town.

Investment discipline suffers under the weight of dullness and low conviction in at least four distinct ways here in the Golden Age of the Central Banker.

First, just as there’s a winner on every poker hand that you sit out, there’s a winner every day in the markets regardless of whether or not you are participating. The business risk of sitting out too many hands weighs heavily on most of us in the asset management or financial advisory worlds. We can talk about maintaining our investment discipline all we like, but the truth is that all of us, in the immortal words of Bob Dylan, gotta serve somebody. If we’re not telling our investors or our board or our CIO that we have high conviction investment ideas … well, they’re going to find someone else who WILL tell them what they want to hear. And for those lucky few of you reading this note blessed with access to more or less permanent capital, I’ll just say that the conversations we have with ourselves tend to be even more pressuring than the conversations we have with others. No one forces me to “make a play” when I have a middle pair and a so-so kicker, but I’ve somehow convinced myself that I can take down a pot just because I’ve been playing tight for the past hour. No one forced Stanley Druckenmiller – one of the truly great investors of our era – to top-tick the NASDAQ bubble when he bought $6 billion worth of Internet stocks in March 2000. Why did he do it?

So, I’ll never forget it. January of 2000 I go into Soros’s office and I say I’m selling all the tech stocks, selling everything. This is crazy at 104 times earnings. This is nuts. Just kind of as I explained earlier, we’re going to step aside, wait for the next fat pitch. I didn’t fire the two gun slingers. They didn’t have enough money to really hurt the fund, but they started making 3 percent a day and I’m out. It is driving me nuts. I mean their little account is like up 50 percent on the year. I think Quantum was up seven. It’s just sitting there.

So like around March I could feel it coming. I just … I had to play. I couldn’t help myself. And three times during the same week I pick up a phone but don’t do it. Don’t do it. Anyway, I pick up the phone finally. I think I missed the top by an hour. I bought $6 billion worth of tech stocks, and in six weeks I had left Soros and I had lost $3 billion in that one play. You asked me what I learned. I didn’t learn anything. I already knew I wasn’t supposed to do that. I was just an emotional basket case and couldn’t help myself. So maybe I learned not to do it again, but I already knew that.

If living in the NASDAQ bubble can make Stan Druckenmiller convince himself that stocks trading at >100x earnings were a high conviction play only a few months after selling out of them entirely, what chance do we mere mortals have in not succumbing to 6-plus years of the most accommodative monetary policy in the history of man?

Second, every facet of the financial services industry is trying to convince you to play more hands, and we are biologically hard-wired to respond. I don’t have a good answer to Wallace’s question about why we all fear the silence and all feel compelled to fill the void with electronically delivered “information”, but I am certain that the business models of the Big Boy information providers all depend on Flow.So you can count on the “information” that we constantly and willingly beam into our brains being geared to convince us to join the casino fun. My favorite character in the wonderful movie “Up” is Dug the dog, who despite his advanced technological tools is a prisoner of his own biology whenever he hears the signal “Squirrel!”. We are all Dug the dog.

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Third, Central Bankers have intentionally sown confusion in our ranks. Like the barkers on CNBC and the sell-side, the Fed and the ECB and the BOJ and the PBOC are determined to force us into riskier investment decisions than we would otherwise choose to make. This is the entire point of extraordinary monetary policy over the past 6 years! All of it. All of the LSAPs, all of the TLTROs, all of the exercises in “Communication Policy” … all of it has been designed with one single purpose in mind: to punish investors who choose to sit on their hands and reward investors who make a bet, all for the laudable goal of preventing a deflationary equilibrium. And as a result we have the most mistrusted bull market in history, a bull market where traditional investment discipline was punished rather than rewarded, and where any investor who hasn’t been totally hornswoggled by Fed communication policy is now rightly worried about having the policy rug pulled out from underneath his feet.

Or to make this point from a slightly different perspective, while there is confusion between the concepts of investing and allocation in the best of times, there is an intentional conflation of the two notions here in the Golden Age of the Central Banker. The Fed wants to turn investors into allocators, and they’ve largely succeeded. That is, the Fed doesn’t care about your picking one stock over another stock or one sector over another sector or one company over another company. They just want to push you out on the risk curve, which for the vast majority of investors just means buying stocks. Any stock. All stocks. This is why the quality bias that most investors have – preferring solid management, strong balance sheets, and good cash flow generation to their opposites – has been largely immaterial as an investment factor (if not an outright drag on investment returns) over the past 6 years. If the King is flooding the town with easy credit, the deadbeat tailor will do relatively better than the thrifty mason every time. But try telling a true-believer that quality is just an investment factor, no more (and no less) privileged than any other investment factor. Honestly, I’ll get 50 unsubscribe emails just for writing this down.

Fourth, our small-number brains are good local data relativists, not effective cross-temporal or global data evaluators. Okay, that’s a mouthful. Translation: the human brain has evolved over millions of years and human society has been trained for tens of thousands of years to make sense of highly localized data patterns. Humans are excellent at prioritizing the risks and opportunities that they are paying attention to at any moment in time, and excellent at allocating their behavioral budget accordingly. It’s why we’re really good at driving cars or, in primate days of yore, surviving on the Serengeti plains. But if asked to compare the risks and rewards of a current decision opportunity with the risks and rewards of a decision opportunity last year (much less 10 years ago), or if asked to compare the opportunity we’ve been evaluating for months with something less familiar, we are utterly flummoxed. It’s not that we can’t remember or think on our feet, but there is an overwhelming attention and recency bias in human decision-making. That’s fine so long as we share the market with other humans, much less fine when we share the market with machine intelligences that excel at the information processing tasks we consistently flub. Whether it’s trading or investing, humans are no longer the apex predator in capital markets, but we act as if we are. 

So what’s an investor to do?

I can sum it up in one deceptively simple sentence: You take what the market gives you.

It’s deceptively simple because it implies a totally different perspective on markets than most investors (or allocators, frankly) bring to bear. It means approaching markets from a position of humility, i.e. risk tolerance, rather than from a position of hubris, i.e. return expectations. It’s all well and good to tell your financial advisor or your board or yourself that you’re “targeting an 8% return.” That’s great. I understand that’s your desire. But the market couldn’t care less what your desire might be. I think it’s so important to stop focusing on our “expectations” of the market, as if it were some unruly teenager that needs to get its act together and start doing what it’s told. It’s madness to anthropomorphize the market and believe that we can control it or predict its behavior. Instead, we need to focus on what we CAN control and what we CAN predict, which is our own reaction to what a stochastically-dominated social system like the market is going to throw at us over time. Tell me what your risk tolerance is. Tell me what path you’re comfortable walking. Then we can talk about the uncorrelated stepping stone strategies that will make up that path to get you where you want to go. Then we can talk about sticking to the path, which far more often means keeping risk in the portfolio than taking it out. Then we can talk about adaptively allocating between the stepping stone strategies as the risk they generate today differs from the risk they generated in the past. Maybe you’ll get lucky and one of the strategies will crush it, like US equities did in 2013. Excellent! But aren’t we wise enough to distinguish allocation luck from investment skill? I keep asking myself that rhetorical question, but I’m never quite happy with the answer.

You know, there’s this mythology around poker tournaments that the path to success is a succession of all-in bets where you “read” your opponent and make some seemingly brilliant bluff or call. I’m sure this mythology is driven by the way in which poker tournaments are televised, where viewers see a succession of exactly this sort of dramatic moment, complete with commentary attributing deep strategic thoughts to every action. What nonsense. The goal of great poker players is NEVER to go all-in. Going all-in is a failure of risk management, not a success. I’m exaggerating when it comes to poker, because the nice thing about poker tournaments is that there’s always another one. But I’m not exaggerating when it comes to investing. There’s only one Nest Egg (“Lost In America” is by far my favorite Albert Brooks movie), and thinking about investing and allocation through the lens of risk tolerance rather than return expectations is the best way I know to grow and keep that Nest Egg.

Taking What The Market Gives You has specific implications for each of the four ways in which the Golden Age of the Central Banker weakens investor discipline.

1) For the business risk associated with maintaining a stock-picking discipline and sitting out an equity market that you just don’t trust … it means taking complementary non-correlated strategies into your portfolio, as well as strategies that have positive expected returns but can make money when equities go down (like trend-following strategies or government bonds). It rarely means going to cash. (For more, see “It’s Not About the Nail”)

2) For the constant exhortations from the financial media and the sell-side to try a new game at the market casino … it means taking what you know. It means taking what you know the market is giving you because you have direct experience with it, not taking what other people are telling you that the market is giving you. Here’s my test: if I hear a pitch for a stock or a strategy and I find myself looking around the room (either literally or metaphorically) to see how other people are reacting to the pitch, then I know that I’m being sucked into the Common Knowledge Game. I know that I’m at risk of playing a hand I shouldn’t. (For more, see “Wherefore Art Thou, Marcus Welby?”)

3) For the communication policy of the Fed and the soul-crushing power of a risk-free rate that pays absolutely nothing … it means taking stocks that get as close as possible to real-world economic growth and real-world cash flows in order to minimize the confounding influence of Central Bankers and the game-playing that surrounds them. There’s nowhere to hide completely, as the volatility virus that started with the end of global monetary policy coordination in the summer of 2014 will eventually spread everywhere, but there’s no better place to ride out the storm than getting close to actual cash flows of companies that are determined to return those cash flows to investors. (For more, see “Suddenly Last Summer”)

4) For the transformation of the market jungle into a machine-dominated ecosystem … it means either adopting the same market perspective as a machine intelligence through systematic asset allocation strategies, or it means focusing on niche areas of the market where useful fundamental information is not yet aggregated for the machines. In either case, it means leaving behind the quaint notion that you can do fundamental analysis on large cap public companies and somehow gain an edge or identify attractive odds. (For more, see “One MILLION Dollars”)

One final point, and it’s one that seems particularly apropos after watching some bloodbaths in certain stocks and sectors over the past week or two. Investor discipline isn’t only the virtue of great investors when it comes to buying stocks. It’s also the virtue of great investors when it comes to selling stocks. I started Epsilon Theory a little more than two years ago in the midst of a grand bull market that I saw as driven by Narrative and policy rather than a self-sustaining recovery in the real economy. For about a year, I got widespread pushback on that notion. Today, it seems that everyone is a believer in the Narrative of Central Bank Omnipotence. What I find most interesting, though, is that not only is belief in this specific Narrative widespread, but so is belief in the Epsilon Theory meta-Narrative … the Narrative that it is, in fact, Narratives that drive market outcomes of all sorts. My hope, and at this point it’s only a hope, is that this understanding of the power of Narratives will inoculate a critical mass of investors and allocators from this scourge. Because the same stories and Narratives and low conviction hands that shook us out of our investment discipline on the way up will attack us even more ferociously on the way down.

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