Last week I wrote that markets would move from pillar to post up until the election, and this week I thought it might be useful to revisit the origin of that phrase. The expression was originally ‘from post to pillar’, and it referred to the practice of whipping some miscreant on a post and then moving them over to a pillory for display to a jeering crowd. Here’s someone in a pillory. Not sure if he’s been soundly whipped or not.
I suppose I can’t say that this is what “the market” feels like these days, what with the S&P 500 having its best week in months last week, and the QQQ having its best week in forever. But I do think this is what it feels like to have a view on the market or the election these days. Maybe you’ve already been whipped soundly for that view and maybe you haven’t. But anyone with a view has got to be feeling locked in a pillory. Anyone with a view has got to be worried that a whipping is just around the corner.
Three weeks ago, the common knowledge – what everyone knows that everyone knows – was that a Constitutional crisis was inevitable and that more stimulus was impossible. Last week, the common knowledge was that a “blue wave” was inevitable and that not only was more stimulus on the way, but it could easily be MOAR stimulus. This week … I dunno … it feels like we’re recognizing that the entire world is going to hell in a new Covid-wave handbasket. Next week … well, next week I’m expecting the aliens to land. Or for the large hadron collider at CERN to make contact with a parallel universe. Actually, that last bit is not a joke.
What we’re dealing with here in October 2020 is not risk. It’s uncertainty.
Decision-making under risk is something we’re all very practiced at. All of expected-utility theory, all of portfolio theory – ALL of it – is based on decision-making under risk, where probabilities and outcomes are knowable.
Decision-making under uncertainty, on the other hand, is something we have very little practice at (thank goodness!) and even fewer tools and theories. But there is a strategy that works. From the Epsilon Theory note Once in a Lifetime …
The decision-making strategy designed specifically for uncertainty is Minimax Regret.
Minimax Regret was invented (or at least formalized) in 1951 by Leonard “Jimmie” Savage, one of the founding fathers of what we now call behavioral economics. Savage played a critical role, albeit behind the scenes, in the work of three immortals of modern social science. He was John von Neumann’s right-hand man during World War II, a close colleague of Milton Friedman’s (the second half of the Friedman-Savage utility function), and the person who introduced Paul Samuelson to the concept of random walks and stochastic processes in finance (via Louis Bachelier) … not too shabby! Savage died in 1971 at the age of 53, so he’s not nearly as well-known as he should be, but his Foundations of Statistics remains a seminal work for anyone interested in decision-making in general and Bayesian inference in particular.
As the name suggests, the Minimax Regret strategy wants to minimize your maximum regret in any decision process. This is not at all the same thing as minimizing your maximum loss. The concept of regret is a much more powerful and flexible concept than mere loss, because it’s entirely subjective. But that’s exactly what makes the strategy human. That’s exactly what makes the strategy real when the ultimate human chips of living and dying are on the table.
Minimax Regret downplays or eliminates the role that probability distributions play in the decision-making process.
Minimax Regret doesn’t calculate the odds and the expected utilities over multiple rolls of the dice. Minimax Regret says forget the odds … how would you FEEL if you rolled the dice that one time and got snake-eyes?
More technically, Minimax Regret asks how would you feel if you took Action A and Result 1 occurs? What about Result 2? Result 3? What about Action B and Result 4, 5, or 6? Now out of those six potential combinations of action + result, what is the worst possible result “branch” associated with each action “tree”? Whichever action tree holds the worst possible result branch … well, don’t do THAT. Doing anything but THAT (technically, doing the action that gives you the best worst-result branch) is the rational decision choice from a Minimax Regret perspective.
The motto of Minimax Regret is not Know the World … it’s Know Thyself.
Because when faced with an uncertain event, where you only have one roll of the dice on a probabilistic event, that’s all we can know.
We are only given the world once. Usually that’s not a big deal from an investing standpoint, because the possible parallel universes aren’t that far apart in their market consequences. Over the next three weeks (and maybe longer than that!), the fact that we are only given the world once is a very big deal indeed.
My advice over this span … pay less attention to what the world is telling you about the future, and more attention to what your gut is telling you about yourself. Knowing yourself and your maximum regret does NOT necessarily mean playing it safe. I know lots of investors for whom playing it safe IS their maximum regret. What it means is just that – know thyself – and if you’re managing other people’s money – know them, too – and avoid action trees that hold the worst possible result branch given that knowledge.
Just do that, and this will all be over soon enough, even if it feels like being in a pillory right now. Minimize that maximum regret and you’ll live to fight (and invest) another day. No matter what parallel universe we end up in!