Beware Helpers Bearing Advice

Warren Buffett has this fantastically understated put-down he uses when he wants to needle investment professionals. He calls them “Helpers” (consultants are “Hyper-Helpers”). It’s a fantastic put-down because it’s simultaneously denigrating and dismissive, without being overtly crass or undignified. The way Buffett writes about Helpers he conjures up images of investment professionals as childlike buffoons. When the GOAT paints a picture of you as a childlike buffoon, there’s really nothing you can do about it.

Trust me, it drives us nuts.

Some day I will write a long post about Warren Buffett, Master of Narrative. There might even be a book in this. We think of Buffett as the greatest investor of all time but he might also the greatest salesperson of all time. He has, after all, sold thousands upon thousands of self-professed contrarians on making an annual religious pilgrimage to Omaha, Nebraska. I think Buffett knows exactly what he’s doing here. And I think he derives great pleasure from it. But that’s a topic for another day.

Here I want to borrow Buffett’s put-down to talk about another kind of Helper: the transactional financial salesperson.

Early in my career, I worked as a loan rep. Specifically, I sold consumer loans. Home equity loans, auto loans, unsecured personal loans and the like. You may not believe it, but this was actually fantastic experience. It was a very safe sandbox in which to learn how deals are structured, how risks are managed (or not managed), and most importantly, how deals are sold.

I was pretty good at selling loans.

If I’d stayed in the position long enough to build up a wider personal network, I think I would have gotten really good at selling loans.

Partly because I didn’t present myself as a person selling loans. I presented myself as a problem solver. There were many cases where I really did help people solve problems, or finance projects that were important to them. But in many cases I was just restructuring their problems. The best example would be the use of a home equity term loan to consolidate credit card debt. By the numbers, it always made sense to do this. It would save people thousands upon thousands of dollars in interest expense, plus term out the debt. Mathematically, you could prove the transaction made sense.

Behaviorally, things were a bit murkier. Because the math only held if the customer stopped racking up credit card debt. Of course, I would explain that to people. I wasn’t a charlatan.

If someone had racked up credit card debt because he used it to finance some kind of one-off project or business venture that went south, then this type of refinancing transaction was a no-brainer. (This setup was rare)

If someone racked up credit card debt because he was outspending his income, it was can-kicking by another name. If his pattern of reckless spending and debt consolidation were to continue, it could eventually end in bankruptcy and the loss of the home. (This setup was more common)

I have no idea how many of these debt consolidation deals worked out for people over time. As a loan rep, my job wasn’t to distinguish between the underlying causes of different individuals’ debt problems. My job was to sell financing solutions to people in need of financing solutions.

This is really just a long-winded way of describing agency problems and information asymmetry. In finance, these issues come up all the time. There’s this meme out there that anyone who does transactional business in finance is necessarily some kind of snake-oil salesman or charlatan. This simply isn’t true. Not all Helpers are looking to rip your face off. But not all Helpers have a fiduciary responsibility to act in your “best interest”, either. I put “best interest” in quotes because, as my home equity refinance example illustrates, it’s not always as straightforward to identify what’s in someone’s best interest as certain people would have you believe.

Transactional business isn’t inherently evil. I do transactional business with people all the time, both personally and professionally. Transactional business can work out quite well for everyone involved.

Where you run into trouble is when you mistake a TRANSACTIONAL relationship for a FIDUCIARY relationship. (See also: It’s Just Business)

If you are the finance director of a small municipality, or the CEO of a small company, and your banker comes to you with an interest rate swap that will “protect you” from interest rate risk, and you are not well-versed in the mechanics of a swaps, then you need to think long and hard about doing that deal. Because ultimately, your banker isn’t compensated to advise you. Your banker is compensated to transact business with you.

I address the finance directors of small municipalities and the CEOs of small companies specifically here because you are often seen as the suckers at the institutional poker table. There is potentially a lot of money to be made Helping you.

With apologies to The Godfather, Part II: you can respect Helpers, you can do business with a Helpers, but you should never trust a Helper.

ET Note: They Live!

They-Live-3

My latest Epsilon Theory note is live. A quick teaser:

If ever you find yourself struggling to keep the difference between Narrative and narrative straight, think of John Carpenter’s 1988 sci-fi action flick, They Live. No doubt it’s a goofy movie. The basic premise will be familiar to anyone who’s seen movies like Dark City or The Matrix. Reality, as we perceive it, is an illusion. But, if you obtain the gift of special sight, you may see the world as it is. In the case of They Live, you put on a pair of special sunglasses only to discover the world is, in fact, controlled by hideous aliens, which use mass media to shape our behavior with subliminal messaging. […]

It’s a wonderful visualization of how symbolic abstraction operates in our world. And who knows, maybe Jerome Powell and Janet Yellen really ARE hideous aliens.

But this isn’t a note about your Friendly Neighborhood Central Bankers, or even how symbolic abstraction can be weaponized to sell you a new refrigerator. This is a note about how symbolic abstraction is used to shape your investment behavior. Both your behavior and your clients’ behavior.

Click through to Epilson Theory to read the whole thing.

I’m quite pleased with the way this note turned out. Even more so because this is an instance where a little editorial input went a long way toward improving the final product. Some ideas more or less show up on the page fully formed. Others require a bit of workshopping. Still others end up being workshopped, killed and then harvested for their vital organs. I’m glad this one not only survived, but flourished!

Gluttons For Punishment

If you’re a longtime reader, you may recall my little hypothesis about active mutual fund manager and hedge fund performance. The aggregate performance of active mutual fund managers and hedge funds will not, and cannot, improve while Market factor performance dominates everything else. You’ll certainly have individual managers perform well here and there. But in the aggregate, performance versus long-only benchmark indexes will remain unimpressive.

If you’re wondering exactly what the hell it is I’m talking about here, compare the pre-financial crisis and post-financial crisis periods on the below chart.

4Q18_3YR_Trailing_FACTORS
Data Source: Ken French’s Data Library

And just for fun, here’s another chart, focused on the last five years or so:

4Q18_Trailing_Factor_Returns
Data Source: Ken French’s Data Library

If there’s one thing you should take from this post, it’s this: the market is conditioning you to be fully invested and in particular to be long US equity market beta. We can certainly debate the “whys” and “hows” of this (for instance, how it’s the stated policy goal of our Friendly Neighborhood Central Bankers to keep us allocated to equities for the long run). But as a practical matter, if you’re overweight US stocks, particularly large cap US stocks, you’re receiving positive reinforcement. If you’re underweight US stocks, particularly large cap US stocks, you’re receiving negative reinforcement. And god help you if you’ve been significantly overweight small cap value stocks or ex-US stocks over the last couple of years. If so, you’re being subjected to corrective shock therapy.

I don’t say this to make value judgments.

I say this to explain what’s driving investment decisions all over the United States, and indeed the world. I say this to contextualize why the most common conversation I have with investors of all types lately seems to be: “why do we own foreign stocks, anyway?”

If you’re the kind of person who likes to extrapolate historical return data to make asset allocation decisions, all the data is screaming for you to be fully invested in US large cap stocks. You’d be a complete idiot to do otherwise. Perhaps you’ve told your financial advisor this. Perhaps you’ve fired your financial advisor over this.

And you know what? You might be right.

In my own humble opinion, the number one question confronting anyone allocating capital right now is whether or not this market is “for real.” If it is, and you decide to fight it, either as a private individual or as a professional investor, you’re toast. But if this market isn’t “for real”–if it’s all just an artifact of easy monetary policy, and you decide to “go with the flow”, and it all unwinds on you, then you’re also toast.

In thinking about my own portfolio, what I want is to develop a financial plan offering me a decent chance of hitting my goals while assuming as little risk as possible. Those of you well-versed in game theory, such as my friends over at Epsilon Theory, would call this a minimax regret strategy

Notice I wrote “financial plan” and not “investment portfolio” above. From a pure portfolio perspective, you’re facing a no-win scenario. You have to handicap whether, when and how the whole QE-as-permanent-policy project comes undone. This is nigh on impossible. Investors have been trying and failing to do this for at least a decade now. When faced with a no-win scenario, your best strategy is to change the conditions of the game. In order to do that, you first have to understand the game you’re playing.

We investors and allocators like to believe we’re playing the investment performance game.

We’re not.

We’re playing the asset-liability matching game.

Investment performance only matters inasmuch as it helps us match assets and liabilities. You probably don’t need to “beat the S&P 500” to fund your future liabilities. You can probably afford to take less market risk. And investment performance is hardly the only lever we can pull here. We can increase our savings rates. We can decrease our spending. We can allocate some of our capital to the real economy, instead of remaining myopically focused on increasingly abstracted, increasingly cartoonish financial markets. We can start businesses that will throw off real cash flow, and own real assets.

We don’t have to remain fully invested at all times. We don’t have to be 100% net long and unhedged with the capital we do have invested.

We don’t have to be gluttons for punishment.

The Confidence Meter

If you are anywhere near as strange a person as me, you spend a lot of time thinking. And not only thinking, but thinking about thinking (whether any good ideas actually come out of this process is a discussion for another time). Over the years I’ve become more and more interested in epistemology. Is there a such thing as Truth with a capital T? If so, how would we know if we found it? How can we better manage the Bayesian updating of our priors?

Personally, as far as epistemology is concerned, I come down on the side of fallibism. Whether fallibism is, or should be, applicable to moral questions lies beyond the scope of what I write about here. But when it comes to our beliefs about economics, geopolitics, and investing, I think fallibism is an eminently sensible position.

Now, it’s important to distinguish between fallibism and nihilism.

Nihilism is extreme skepticism in the existence of Truth.

Fallibism is extreme skepticism in the provability of Truth and in the methods we use to arrive at Truth. (See also: The Problem of Induction; The Trouble With Truth)

For a fallibist, acquiring knowledge is a relentless, grinding process of formulating conjectures, challenging them, adjusting them, discarding them, and so on. It never ends. By definition, it can’t end. So if you’re bought-in on fallibism, you need to seek out people and ideas to challenge your priors.

This is not fun. In fact, we as humans pretty much evolved to do the opposite of this. For most of our history, if you were the oddball in the tribe you risked being exiled from the group to make your way in a harsh and unforgiving world, where you would likely die miserable and alone (albeit rather quickly), without the consolation of having passed along your genetic material.

The Confidence Meter is a little mental trick I use to mitigate my evolved distaste for challenging my priors, as well as my evolved distaste for being wrong. It’s something I think about when I want to judge how tightly to grip an idea (such as an investment idea). It also helps interrupt emotional thought patterns around certain ideas. For fans of Kahneman, I use it to interrupt System 1 and activate System 2.

The Confidence Meter (A Stylized Example)

the_confidence_meter

At 0% confidence, I shouldn’t even be making a conjecture. At 0% confidence, I should just be gathering information, and soaking it all in without an agenda. (Not always easy)

At a toss-up, I could make a conjecture and support it with evidence, but I wouldn’t put anything at risk. 

At 75% confidence and greater, a willingness to bet money on the outcome implies a sound grasp of the theory underlying my idea, as well as the empirical evidence. It also implies I have a sound grasp of the arguments and empirical data challenging my position.

Using this framework, how many of your beliefs do you suppose merit a >=75% confidence level?

For me, it’s a very small number. To the extent I’m >=75% confident of anything I believe, it’s elementary, almost tautological stuff, like how you make money investing.

The empirical data around the impact of the minimum wage on unemployment? Meh.

The relationship between marginal tax rates and economic growth? Meh.

That doesn’t mean I don’t have beliefs about these things. I’m just leaving an allowance for additional dimensions of nuance and complexity. Particularly when we’re inclined to look at relationships in linear, univariate terms for political reasons. The world is a more complex place than that admittedly powerful little regression model, Y = a + B(x) + e, would lead us to believe.

The Confidence Meter helps me keep that in perspective.

The Ministry Of Love: A Play In One Act

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(We open on a nondescript, windowless room. A FUNDAMENTAL INVESTOR sits strapped into a GROTESQUE TORTURE CHAIR. The torture chair is designed to inflict the physical, psychological and financial pain of enduring a short squeeze on its occupant. An ECONOMIST dressed in an ordinary suit addresses the investor)

ECONOMIST: I would like to begin by emphasizing we have invited you to this Continuing Education Session in the spirit of educational goodwill. Here at the Ministry, we work not for money, but out of love. Our love for you. Our love for your fellow investors. Our love for the financial markets and the global macroeconomy. Now, we shall begin today’s session by reviewing some simple concepts. What is a financial market?

INVESTOR: A financial market is where buyers and sellers– (mid-sentence, the Investor convulses in pain, letting out a guttural sound that is half-grunt and half-scream)

ECONOMIST: –Already we are starting off on the wrong foot. A financial market has nothing whatsoever to do with buyers and sellers. A financial market is a wealth creation mechanism for individuals and thus societies. Now, what do you suppose a market should do over time?

INVESTOR: It depends– (again the Investor convulses in pain)

ECONOMIST: Incorrect. The correct answer is RISE. A financial market RISES over time. Can you tell me why?

INVESTOR: Earnings– (another convulsion)

ECONOMIST: WRONG AGAIN! A market rises because a market MUST rise over time. It is a tautology that a market must rise. I am beginning to suspect your misconceptions about our financial system are more fundamental than I had initially believed. I shall endeavor to correct this. (The Economist pauses briefly, as if switching to a new script in his head) Tell me, why should someone invest?

(The Investor hesitates)

ECONOMIST: Go on. I am genuinely curious.

INVESTOR: To earn a return on capital.

ECONOMIST: Yes. To earn a return on capital. And why should an investor prefer bonds, to say, cash?

INVESTOR (hesitant): Higher returns.

ECONOMIST: Yes, quite right. And why should an investor prefer stocks to bonds?

INVESTOR: Higher returns.

ECONOMIST: And WHY do you suppose stocks should return more than bonds or cash over time?

INVESTOR: As compensation for the incremental risk associated with taking the most junior position in a capital structure, with only a residual claim on cash flows and assets.

ECONOMIST: Yes, very good. And how does an investor decide whether he is being compensated fairly for taking the most junior positions in capital structures, instead of owning bonds?

INVESTOR (after a long pause): Relative valuations.

ECONOMIST: And what determines relative valuations?

INVESTOR: Investor preferences– (this time the convulsion is extra long and painful)

ECONOMIST: Now we’ve arrived at the crux of our misunderstanding. You investors only BELIEVE you determine relative valuations across asset classes. You are so absorbed in your own brilliance, in your petty little security selection games and benchmark arbitrage games and sales and marketing games that you COMPLETELY AND UTTERLY FAIL to see the world AS IT IS. In reality, WE determine relative valuations. The Federal Reserve. The European Central Bank. The Bank of Japan. In nature, it would be as though we controlled the force of GRAVITY. Investors do not “determine” anything. They merely RESPOND to our influence as it manifests itself in the world. Can you tell me, whence we derive this incredible power?

INVESTOR (for the first time, calm and self-assured): You control the supply of money.

ECONOMIST: Not only the SUPPLY of money, but the PRICE of money. Said another way, we control the price of RISK. You investors can no more escape our influence on the price of risk than you can escape the force of gravity. Excellent. (The Economist is obviously delighted with this progress) Now that we’ve reached this understanding, we shall practice with a brief exercise. What is a reasonable return on Treasury bills?

INVESTOR: Depending on inflation–(a brief zap of pain)

ECONOMIST: Incorrect. Let us try again. What is a reasonable rate of return on Treasury bills?

INVESTOR: I need to know–(a longer convulsion ensues)

ECONOMIST (sighs): Again, what is a reasonable rate of return on Treasury bills?

INVESTOR (desperate; frustrated): I DON’T KNOW! Just tell me what you want to hear!

(This is the longest zap of the torture device yet, and when it ends the Investor is little more than a blubbering pile of mush)

ECONOMIST (to the audience): A reasonable rate of return on Treasury bills is whatever OUR models say it should be. A reasonable rate of return on Treasury bills is whatever WE want it to be. WE decide whether you should prefer bonds to bills, or stocks to bonds. WE decided whether you should be incentivized to hold cash or spend it with reckless abandon. WE decide whether the market should rise or fall. Only deciding whether the market should rise or fall is no decision at all. The market rises over time because it MUST rise over time. That the market rises over time is a tautology.

(Abruptly, the stage goes black)

(Scene change)

(Slowly, the lights come up. The Investor is seated at his desk, working. He is on a client call, holding his phone up to his ear. He is flanked by an enormous plasma TV, showing Neel Kashkari being interviewed on CNBC)

Investor (smiling broadly): Well, of course the market goes up over time, Mister and Missus Smith. The market pretty much HAS TO go up over time. It’s basically a tautology. (He pauses momentarily, listening) Of course! Happy to explain…

(Fade to black)

ET Note: Kobayashi Maru

I suspect I have some significant reader overlap with Epsilon Theory, but for those of you who aren’t also ET readers (you should be, btw), I was recently invited to contribute to the site. Perhaps needless to say, I jumped at the opportunity. I’m excited to join Ben, Rusty, Peter, Neville and David on a platform offering some of the most unique perspective out there on politics and investing. For now, I expect to contribute approximately one note every three weeks, and to cross-post the links to those notes on this site.

My first note went live Tuesday afternoon. It’s titled “Kobayashi Maru”, and it’s about how in a no-win scenario, the best strategy is to change the conditions of the game.

More specifically, it’s about discretionary active management and the way ESG investing is sold to investors and financial advisers.

And, obviously, it involves a Star Trek analogy.

kobayashi_maru

The Haunter of the Dark

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Source: Jens Heimdahl via Wikipedia

I had never heard the name NYARLATHOTEP before, but seemed to understand the allusion. Nyarlathotep was a kind of itinerant showman or lecturer who held forth in public halls and aroused widespread fear and discussion with his exhibitions. These exhibitions consisted of two parts—first, a horrible—possibly prophetic—cinema reel; and later some extraordinary experiments with scientific and electrical apparatus. As I received the letter, I seemed to recall that Nyarlathotep was already in Providence…. I seemed to remember that persons had whispered to me in awe of his horrors, and warned me not to go near him. But Loveman’s dream letter decided me…. As I left the house I saw throngs of men plodding through the night, all whispering affrightedly and bound in one direction. I fell in with them, afraid yet eager to see and hear the great, the obscure, the unutterable Nyarlathotep.

–H.P. Lovecraft

Nyarlathotep (try saying that 10 times fast!) was inspired by a dream. Lovecraft dreamed his friend Samuel Loveman wrote a letter encouraging him to see the “itinerant showman”:

Don’t fail to see Nyarlathotep if he comes to Providence. He is horrible—horrible beyond anything you can imagine—but wonderful. He haunts one for hours afterwards. I am still shuddering at what he showed.

Nyarlathotep is a perversion of the Wizard! archetype: a twisted incarnation of the mad scientist futurist.

In the Cthulhu Mythos, Nyarlathotep serves the Great Old Ones. He’s a kind of messenger. The guys over at Epsilon Theory would call him a Missionary. In fact, Nyarlathotep is the archetypical Evil Missionary. He most definitely does not respect our autonomy of mind. The notion of pathetic, insignificant humans exercising autonomy of mind and spirit would be utterly incomprehensible to him. To Nyarlathotep, we’re no more worthy of autonomy of thought and feeling than cockroaches. Typically, whenever one of Lovecraft’s unfortunate protagonists encounters him, the result is either insanity or death.

Nyarlathotep’s nature is never entirely clarified in Lovecraft’s fiction. Some commentators think of him as a lesser god, subordinate to the Great Old Ones. My preferred interpretation is that Nyarlathotep isn’t a discrete being with his own conscious will, but rather the manifestation of the Elder Gods’ power and influence in our world. He’s a vessel for the Old Magic. For Dark Magic. He channels the Elder Gods’ power for their cults here on Earth.

But Nyarlathotep isn’t simply a purveyor of cosmic horror. No, he’s also a purveyor of science. Scientism, to be precise. Nyarlathotep’s special blend of scientism is occult magic, gussied up in the trappings of science and technology, with some religiosity thrown in for good measure. It’s occult scientism.

So what the hell does any of this have to do with economics, geopolitics, or investing?

Well, once you start looking for Nyarlathotep, and his particular brand of occult scientism, you’ll see him everywhere. I made a snarky nerd joke about Nyarlathotep at Davos on Twitter the other day, and received a rather evocative reply:

nyarlathotep_tweet

Indeed. And we see his handiwork everywhere.

It’s the Gaussian Copula.

It’s eugenics and racial pseudioscience.

It’s Soviet collectivized agriculture.

It’s esoteric securitizations of risky assets and byzantine structured products.

It animates the Chinese social credit system; the Intellectually Superior Davos Man; the Cult of MMT-Enabled Economic Management; the Cult of Supply-Side Economics; the Divine Order of the Ever-Wise and Benevolent Central Banker; the erstwhile Caliphate of the Islamic State; the Malthusian Society of Self-Loathing Climate Warriors.

Occult scientism is powerful stuff. It combines the memetic power of symbolic abstraction with a veneer of scientific (“rational”) credibility, then underscores it all with religious fervor. Occult scientism topples governments. It launches revolutions, wars and genocides. It shapes our perception of our world and ourselves in a way that scientism and religion, taken in isolation, cannot. When we encounter it, we’re transfixed.

He is horrible—horrible beyond anything you can imagine—but wonderful. He haunts one for hours afterwards. I am still shuddering at what he showed.

Wherever our most powerful missionaries congregate, look carefully for Nyarlathotep and his miracles. He may not be preaching front-and-center, but he’s almost certainly there, lurking in the shadows, whispering in the dark.