Why Do You Invest?

Nick Maggiulli at Of Dollars And Data asks: why do you invest?

Really think about it. My gut response used to be, “to replace my future income,” as I’ve discussed here. However, this response was incomplete. I say incomplete because it seemed too cold and mathematical. It was not based on my personal values. Investing without considering your values is like having the fastest boat in the middle of the Pacific Ocean with no set destination — no matter how fast you go, you will always feel lost. Chasing riches without knowing why you truly want them is a surefire path to lifelong misery.

You might be skeptical, but think of the countless investors who have lost their fortunes, their families, and their freedom pursuing money without purpose. Don’t get me wrong, some of these individuals may have valued the idea of having the most money, but I would guess that they are actually trying to fill a deeper psychological need (i.e. being respected intellectually) instead.

Read the whole thing. This is a foundational issue and will have a dramatic impact on how you view the markets and various investment strategies. I spend a ton of time (arguably too much time) thinking about this.

Why I Invest

#1 – To attain financial independence. Financial independence is a tricky thing to define. For some people that is hanging out and playing a lot of golf. For me, financial independence boils down to “F*** You Money.” That is, having the flexibility to choose when, how and for how much money I am willing to work. I live a pretty minimalist lifestyle and am not located in a high cost of living part of the country. Based on my current budget I think I could live off $36,000/year without substantially compromising my lifestyle. Throw in a couple kids and maybe that moves up somewhat. So I view attaining financial independence as a reasonable goal.

#2 – I love the game. That is, I love investing as a purist. I love doing research, and combining that research with strategy and tactics based on what is going on in the markets. I love that the risk/reward tradeoffs in the markets are always shifting, and that the game is always changing. To me, investing is basically the greatest strategy game ever devised.

Reason #2 is why I write this blog. Reason #2 is also why much of what I write here pokes fun at the investment management business and the financial advice complex.

What passes for “investing” in those contexts is often really just an exercise in “getting market exposure.” If all you are really doing at the end of the day is getting market exposure, you should make sure you are doing it in a cost effective and tax efficient manner. From there you are welcome to run in endless circles debating whether this one particular guy happened to be lucky or skilled in beating the market over a particular trailing 15-year period.

Hence why I find the active versus passive debate so tedious. As my career progresses and my values come into focus I am less and less interested in that discussion. Ultimately, if you are providing financial advice, the “best” thing to do mostly comes down to the specific client you are working with, and that client’s goals and values.

If I know someone’s goals and values, it is easy to go to my investing toolbox and say:

“Well, you are a 22-year old with no debt who inherited $10,000, and you have no particular interest in investing other than ‘putting the money to work’ in an abstract sense, and you are modestly concerned about the price going down ‘a lot.’ Given the circumstances something cheap and simple fits the bill. Here is [an index fund or a low cost, diversified active fund]. Let’s touch base again in a year to see if your circumstances have changed. Life comes at you fast in your 20s.”

Or, conversely:

“Oh, so you are very high net worth, former C-Level executive, and would like to earmark 20% of your portfolio to generate extraordinary capital appreciation. You are hyper-aggressive as an investor and your net worth is such that you’re not going to destroy your legacy if some of this stuff blows up. By the way, it can ALWAYS blow up. There are no guarantees in this world. And going this route will incur higher management and due diligence costs. All that said, to have a snowball’s chance in hell of generating that level of capital appreciation we need to look at private equity, single manager hedge fund investments, maybe a very highly concentrated portfolio of individual stocks.”

Why It Matters

Where you run into real problems is when you build a portfolio out of sync with your values. What happens is that you start doing stupid things as you attempt to “tweak” things to your liking. If you are an advisor and you have a client in the wrong portfolio, the client will eventually fire you. The CFA Level III Curriculum actually teaches a couple of mental models for dealing with this issue.

The first model involves classifying investors into Behavioral Investor Types. There are four main types. Obviously most people share some characteristics of different types but I bet if you are honest with yourself you can sort yourself into one of the four:

Passive Preservers: These are individuals who accumulated wealth primarily through diligent saving, and not through risk taking. A significant portion of their overall net worth may be in the form of defined benefit pensions or social security. Passive Preservers are characterized by risk aversion and low levels of investing knowledge. My mom is a textbook Passive Preserver. The biggest risk for a Passive Preserver like my mom is that she will not take enough risk in her portfolio, and that inflation will erode her wealth in real terms over time.

Friendly Followers: Friendly Followers chase fads (and thus performance). They tend to buy high and sell low, and rationalize those decisions in hindsight. The main risk to a Friendly Follower is that he whipsaws his net worth into oblivion over time by constantly buying high and selling low. Friendly Followers often display acute Fear of Missing Out (FOMO).

Independent Individualists: If you are reading this blog, I suspect you are an independent individualist (or at least have that streak running through you). Great! We share the same behavioral investor type. I hardly need to tell you that for us, making up our own minds is paramount. If someone tries to force feed us instructions, we will push back. Our greatest asset as investors is our predisposition toward contrarian thinking. However, as a fellow Independent Individualist I will tell you our greatest weakness is confirmation bias. Once we make up our minds, we tend to seek out information confirming our views and spend less time and energy considering evidence that may contradict them. This can lead us to overlook or downplay certain risks.

Active Accumulators: Active Accumulators have generated significant wealth via risk taking. These individuals tend to be entrepreneurs, business owners and senior executives. They are extremely aggressive and confident investors (their confidence is rooted in their past business successes). Active Accumulators tend to take too much risk, in too concentrated fashion. They also tend to discount the impact of randomness on investment outcomes. The biggest risk for an Active Accumulator is that he (yes, they tend to be men) blows up his portfolio with a concentrated bet. On the flipside, their risk tolerance can also allow them to win big when they are right.

Now when you think about these types, you can probably get an idea of who is more suited to passive investing versus active. The CFA Institute material has a nice diagram that ties it all together:

CFA_Behavioral_Types — Source: CFA Institute

The trick is to tailor your investment program to your behavioral type. Now, on occasion you will have a situation where someone’s biased preferences cause him to do things that put his standard of living at significant risk. In that situation you have to evaluate the level of risk to decide whether to attempt to moderate the behavioral bias or simply adapt the portfolio to the bias. Which leads to the second model:

CFA_Modify_vs_Adapt — Source: CFA Institute; SLR stands for Standard of Living Risk

The more emotionally driven your behavior, and the lower your standard of living risk, the more flexibility you have to adapt the investment strategy to your behavioral type.

Of course, understanding your values and behavioral type also helps in the selection of a financial advisor if you go that route. Different behavioral types need different things out of an advisor:

Passive Preservers need a counselor.

Friendly Followers need a teacher.

Independent Individualists need a sounding board and/or devil’s advocate.

Active Accumulators need a sparring partner and/or punching bag.

Variant Perception

I listen to a lot of investor calls and I spend a lot of time meeting with investment managers all across this great land of ours. Something I have noticed over time is how much time and energy some people waste loudly proclaiming their agreement with consensus.

For example, various permutations of the statement: “tax cuts are supportive of corporate earnings.”

No. Freaking. Kidding. Why are we still talking about this? Is there any actionable insight whatsoever in that statement?

As an investor I am interested in hearing where someone differs from consensus. This is where you are going to distinguish yourself. If your goal is simply to piggyback on the wisdom of the crowd you ought to own a bunch of index funds. That is, after all, the underlying premise of index investing: no one can consistently outguess the market. Put another way:

MARKET PRICES ALREADY REFLECT THE CONSENSUS VIEW

Of course, it is hardly a secret that much of what passes for market commentary is in fact just thinly-veiled marketing copy. Here’s the template (key phrases italicized):

Fund Company: A Scary Thing is happening in the markets, or might happen soon. This might Make The Prices Go Down. But if you do this Other Thing you may improve your chances at A Financially Secure Retirement and be able to fund your Children’s College Education. Oh, BTW we happen to have a product that does The Other Thing. Check out the performance. We are in the top quartile of our Morningstar peer group since inception.

Alternatively:

Fund Company: Someone Is Making A Lot of Money doing A Certain Thing. Now, we know some people say That Certain Thing is a little long in the tooth. However, our analysts are telling us there is plenty of room left to run [shows chart of forward earnings estimates without mentioning that forward earnings estimates are notoriously unreliable]. Oh, BTW we happen to have a product that does That Certain Thing. Check out the performance. We are in the top quartile of our Morningstar peer group since inception.

Personally, I read market commentary as meta-texts.

When a fund company writes about A Scary Thing, that is a cue that a certain area of the market is viewed as risky. And if a lot of fund companies are writing about A Scary Thing, and are in agreement about the level of Scariness, there is a decent chance assets exposed to the Scary Thing can be bought at a discount.

Why? Fund companies don’t like to own assets that threaten their business (read: management fees). So they don’t bid the prices up. Similarly, Fund companies like to own popular things. Why? Because popular things attract investor flows (read: larger management fees). So prices get bid up to unsustainable levels. There is an inherent tension in the investment management business between what is good for the business and what is good for investment results.

The best investment managers think of the portfolio first and then the business. They are willing to run a smaller business to preserve returns. This is not a trivial thing. Particularly for someone with a strong track record. So, as always, #notallfundcompanies applies.

I leave you with these exhibits from Kevin Martelli:

MartekQ — Source: Martek Partners via MicroCap Club

MartekA — Source: Martek Partners via MicroCap Club

A Simple Quantitative Analysis of Buffett’s Hedge Fund Bet

(This material was originally written for an entirely different context. However, the subject came up in casual conversation recently and I thought it was worth revisiting. Warren Buffett’s bet with a fund of funds firm has gotten a lot of press but little in the way of rigorous analytical treatment. That’s a shame in my view as the bet is a good jumping off point for a discussion of portfolio construction)

Sadly, there is not enough data (and doesn’t sound like there ever will be enough released publicly) to do a rigorous performance attribution for the funds of funds featured in the bet. But I did want to comment on a topic that stuck out to me, inspired by this passage:

The compounded annual increase to date for the index fund is 7.1%, which is a return that could easily prove typical for the stock market over time. That’s an important fact: A particularly weak nine years for the market over the lifetime of this bet would have probably helped the relative performance of the hedge funds, because many hold large “short” positions. Conversely, nine years of exceptionally high returns from stocks would have provided a tailwind for index funds.

Instead we operated in what I would call a “neutral” environment. In it, the five funds-of-funds delivered, through 2016, an average of only 2.2%, compounded annually. That means $1 million invested in those funds would have gained $220,000. The index fund would meanwhile have gained $854,000.

Without more detail on how the funds of funds were allocated, it is difficult to confirm whether or not the market environment was actually “neutral” for them. I also believe at least one of the funds succeeded in creating some value despite trailing the index on an absolute basis.

Remember sitting in math class wondering why you would ever need to know to calculate things like standard deviation and correlation? Well, here is an opportunity to put all those seemingly wasted Stats classes to use.

With the help of some basic statistics we can build a simple attribution model to assess whether the hedge fund managers added value, as well as their risk exposures relative to the index fund.

Buffett_Bet_Stats — Source: Berkshire Hathaway 2016 Annual Report; Demonetized Calculations

I will not bore you with the specifics but trust me when I say we can use the annual return data from the Berkshire letter to calculate betas for all of the funds of funds. And since we can calculate betas, we can get an idea of how exposed the hedge fund portfolios were to the same systematic (read: market) risk factors as the index.

T-Bills, for example, have a beta of 0. This makes intuitive sense because T-Bills are not exposed to the same market risks as the stocks in the S&P 500. The S&P 500 Index fund has a beta of 1 to itself, which also makes intuitive sense because it is exposed to exactly the same market risks.

So what about the hedge funds?

Well, as is evident in the above table there are a range of betas, from .41 for FoF A to .69 for FoF E. We can use the betas to evaluate whether the managers trailed the market simply because they were less exposed to the market in a period whether the market did rather well (I would disagree with Mr. Buffett’s assertion that 2012 to 2016 have been “neutral” years for the market), or because the managers themselves destroyed value.

This one is a simple calculation. You simply multiply the beta by the index fund’s average return for the period:

FoF A = .41 * 9.1 = 3.71

FoF B = .55 * 9.1 = 5.00

FoF C = .53 * 9.1 = 4.82

FoF D = .65 * 9.1 = 5.91

FoF E = .69 * 9.1 = 6.28

The multiplication gives you the return you should expect from a hypothetical investment that does nothing more or less than match the hedge fund’s beta to the index. Compare this number to the actual average fund returns to get a rough idea of whether the manager has added or subtracted value on top of that.

For the funds in the table, most of them performed rather poorly even by this measure. As Buffet writes in his letter, this is because the managers weren’t able to add enough value to offset expenses, and on top of that probably made some mistakes. It is hard to say without knowing more about how the portfolios were built. We could expand our attribution model to try and get a more granular picture, but that is a topic for another day.

There is one exception among the funds. FoF C appears to add value. We can see this via the above comparison and also comparing its Sharpe ratio to the Sharpe ratio for the index fund. Note that FoF C delivered 67% of the return of the index with 65% of the volatility.

So why would I want to own FoF C instead of the index when it underperforms on a cumulative basis? Well, maybe I want an “equity-like” return with less risk (read: better risk-adjusted performance). And why would I want that? Maybe it aligns better with my risk tolerance or my goals as an investor (I may need a screwdriver instead of a hammer based on a particular problem I am trying to solve in a portfolio). Not everyone defines risk as permanent impairment of capital, and not everyone can withstand mark-to-market volatility. Also, there are very few investors who truly have a “long term” investment horizon.

How do you know if your horizon is truly long term?

If the market closed tomorrow and you could never trade again, would you keep the same portfolio? If so, you are truly a long term investor.

Most of us don’t meet that criteria, because we will need to draw down our portfolios to some extent to fund various living expenses somewhere over the next couple of decades. The point is this: if you are underperforming the broad market because you have made a conscious decision to be less exposed to the market, that’s not necessarily a problem. It depends on the bill of goods you’ve advertised to your investors.

Of course, I also might outperform the index at times simply by avoiding large drawdowns in periods of market stress. However, with a low net exposed fund I would definitely not hang my hat on absolute outperformance versus the index over a long time period.

What Is The Point Of All This, Exactly?

Warren Buffett is perhaps the most misunderstood personality in finance. Though he may look the part, he is not simply some kindly old billionaire dispensing pearls of wisdom to the unwashed masses (he certainly excels at cultivating that image).

Warren Buffett is a value investor and should be viewed through that lens. If he finds value in an investment opportunity, he will pay for it. Even if it is nominally “expensive.” He admits as much in this very investor letter, writing:

And, finally, let me offer an olive branch to Wall Streeters, many of them good friends of mine. Berkshire loves to pay fees – even outrageous fees – to investment bankers who bring us acquisitions. Moreover, we have paid substantial sums for over-performance to our two in-house investment managers – and we hope to make even larger payments to them in the future.

To get biblical (Ephesians 3:18), I know the height and the depth and the length and the breadth of the energy flowing from that simple four-letter word – fees – when it is spoken to Wall Street. And when that energy delivers value to Berkshire, I will cheerfully write a big check.”

How do you reconcile this with his advice for other investors to index?

Warren Buffett knows most people, including a fair number of professionals, are profoundly awful at identifying good investments and good investment managers. He also may or may not believe that the trend toward indexing actually improves the opportunity set for a genuinely skilled investor (read: himself). That last bit is just idle speculation on my part.

In my view Buffett’s stance has more to do with his belief that most investors simply do not have a good understanding of how to identify “value,” whether in the context of an individual stock or an investment manager. He is also smart enough to realize most investors don’t need outperformance to achieve basic financial goals like funding their kids’ educations or saving for retirement. Cheap beta exposure (a.k.a “being in the market”) will get the job done.

For these investors there is little value to be had pursuing an active investment program, which they will almost certainly botch chasing 1, 3 and 5-year trailing performance numbers, all the while paying the higher cost of active management.

Put another way: these investors are better at wielding a hammer than a screwdriver.

Jack Bogle’s Secret To Success

(from a CFA Institute interview)

Q: Because you have been so successful, let me ask you this: What is the secret to success?

Bogle: People often ask me what the secret to success is, and I say, “I absolutely have no idea.” In fact, I don’t use the word success. But I think it has something to do with working a little harder and a little longer than everyone else on whatever job you are given or task you are doing. Do a better job on it than everyone else, and the rewards will come. From this perspective, at least, the secrets to success are not very mysterious.

Some people will never have passion for anything because that is the type of person they are. Being yourself is very important. This is true whether you are dealing with your associates or your clients because people can spot a phony a mile away.

Figure out who you are, and try to follow a career that fits with who you are. Woodrow Wilson wrote a book titled When a Man Comes to Himself. I came into myself, to be honest, when I was probably 11 years old. I figured out who I was and what I wanted to do in life very early–too early, you could argue. Most people start to get a good sense of who they are probably in their early 20s, some in their 30s or 40s, and some never. Some people never get to know who they are.

People need to ask themselves, “Am I the kind of person I want to be? Am I filling a role in life, in the community, and in society that I want to fill? Am I comfortable in my own skin? Where does being a good spouse and parent fit in with a career?” People should consider all those kinds of things.

Investing Is Not Gambling But It Sure Can Look Like It

I often meet people who conflate investing and gambling. Their confusion is understandable. There are many similarities between gambling and investing, but also important differences. As with most complex topics the devil is in the details.

How Investing And Gambling Are Similar

Both investing and gambling are exercises in decision-making under uncertainty. In both activities one places bets (takes positions) based on one’s appraisal of future expected value. Critically, both gambling and investing outcomes are subject to randomness. These are probabilistic activities. And therefore in both investing and gambling, it is difficult to disentangle luck and skill.

Professionals: let’s not kid ourselves. It is better to be lucky than skilled.

Another reason investing resembles gambling is that many people exhibit a preference for lottery ticket-like “investments.” Penny stocks and cryptocurrencies are excellent examples. People like to buy lottery tickets because the downside is small and well-defined, while the theoretical upside is very large. They say: “I’m just going to put $100 in BTC or this marijuana penny stock and maybe it goes up 100x.”

However, these individuals do not realize that many lottery ticket-like investments are, like lotteries themselves, negative expectation propositions. For example, some penny stocks and cryptocurrency ICOs are in fact fraud schemes with zero probability of success over the long run. Which brings us to…

How Investing And Gambling Are Different

Almost all casino games and lotteries are negative expectation games. That is, the odds are rigged against the players (in mathematical terms: the probability-weighted value of the payouts is less than zero). Were this not the case, neither lotteries nor casinos would last very long!

A casino underwrites risk in a similar way to an insurance company. Broadly speaking, the goal is to price risk in such a way that the insurance losses (gambler wins) will be more than offset by the insurance premium income (gambler losses) over long time periods.

In casino games, risk is priced such that if you play for an arbitrarily long period of time (let’s call it 1,000 years) you are all but certain to lose everything you bet. In other words, casino payouts are set so they do not adequately compensate gamblers for the riskiness of their bets. This is “the house edge.” In the United States, we actually use these negative expectation games as a regressive tax on the poor and uneducated, in order to fund certain social programs. You read a lot about social justice these days but one idea you don’t hear much is to outlaw lotteries!

Below is a table showing the house edge for various craps bets from the Wizard of Odds. As you can see, the best advice you can give to any craps player is to limit her bets to pass/don’t pass, taking the odds when the point is set (one of the best bets in the casino!), and maybe a place bet on the 6 or 8 to keep things interesting.

Craps_House_Edge — Source: Wizard of Odds; Second column is House Edge; Third column is standard deviation or “bankroll volatility”; Note that expected value and standard deviation (volatility) are also building blocks of Modern Portfolio Theory!

Investing, on the other hand, may or may not be a negative expectation game. Historical data leads us to believe investing is a positive expectation game (at least in the aggregate). If you have ever worked with a financial advisor, you have probably been told something to the effect that “in the long run the market always goes up” before being shown a chart like this one as “proof:”

jpm_ex_market_returns — Source: J.P. Morgan Asset Management

However, by naively extrapolating from historical data we are subject to the problem of induction. To make the issue more concrete, consider Nassim Taleb’s graph of a Thanksgiving turkey’s happiness:

turkey_happiness_graph — Source: Attain Capital via ValueWalk

The turkey doesn’t realize it until it’s too late, but she is playing a negative expectation game. So are volatility shorts…

…and certain hedge fund managers…

Small wonder so many people believe investing, like gambling, is a negative expectation game. Indeed, it is entirely possible the long-run expected value of all our 401(k)s is $0.00. Try arguing to a Russian government bond holder circa 1917 that markets always go up over the long run!

So like the turkey, we will have to wait and see.

The Notion Of The US Total Market Portfolio Is Redundant And Really Kind Of Silly

Today I am going to channel my inner Cliff Asness and demonstrate why it is more or less irrelevant whether you own a Total US Market index fund or an S&P 500 index fund. Intuitively, the reason for this is straightforward:

Since a Total US Market index fund is market capitalization weighted, it is dominated by the largest companies. The largest US companies are all included in the S&P 500. Hence, S&P 500 stocks drive the overwhelming majority of the return of the total market portfolio.

If you trust me, you can stop reading here. If you would prefer to see some supporting data, read on. Fair warning: it gets wonkish rather quickly.

Statistical Evidence

I used Portfolio Visualizer to run regressions on two widely held index funds using the Fama-French Three Factor Model. The model fits the index funds extremely well as evidenced by the respective R^2 values of 99.7% and 99.99% (this means the model explains over 99% of the variation in returns over the time time period analyzed). One regression was for VTSMX and the other for VFIAX. Below is the output:

VFIAX_Regression — Source: Portfolio Visualizer

VTSMX_Regression — Source: Portfolio Visualizer

The key numbers are in the Loading column. Do a quick visual compare/contrast. See how they are almost identical? That is because at the end of the day, when you own the market portfolio, most of your money is invested in S&P 500 stocks (you can verify this using the actual portfolio holdings if you want).

This is further underscored by Portfolio Visualizer’s performance attribution analysis:

Regression_Attribution — Source: Portfolio Visualizer

In the attribution table, SMB means “the return you got from investing in smaller companies” and HML means “the return you got from investing in “cheap” (value) stocks versus “expensive” (growth) stocks. The total market fund earned basically no return from exposure to small companies over this time period, while the value/growth stock exposures are so similar as to be irrelevant.

Conclusion

The market cap weighted total US market portfolio does not provide a meaningful exposure to small company stock returns (or a meaningful tilt to value or growth stocks–a non-issue for the purposes of this post).

Put another way, in statistical terms, the total US market index behaves nearly identically to an S&P 500 index fund.

For people who are knowingly overweight US large cap stocks in the form of the S&P 500, I’ve got nothing to argue with you over. This bet has worked out pretty well over the last couple of decades. Maybe it will keep working (there are a lot of great businesses in the S&P 500). Maybe it won’t keep working (a lot of those companies are richly valued). Anyone who claims he can handicap future market returns with any degree of accuracy is an idiot or a liar (possibly both).

For people who are naively overweight US large cap stocks in the form of the S&P 500, I have this to say: like it or not you have made a bet on a particular market segment. Admittedly, these are high quality companies and the underlying revenue sources are globally diversified. However, the valuation risk is not necessarily very well diversified. Something like 20% of the portfolio is invested in FANG stocks (that’s an off-the-cuff number).

My point here is not to say definitively that the S&P 500 is a bad place to be invested. No one knows what the next 30 years will look like.

Rather, I am making a philosophical point about asset allocation. Namely, when you “passively” allocate assets predominantly to a market cap weighted US total market portfolio, you have implicitly made an active decision to concentrate your risk exposure in US large cap stocks. Only about 50% of global equity market capitalization is located in the US. If you truly believed in the logic behind a capitalization weighted total market portfolio, you would obtain all your equity exposure via something like ACWI.

However, I have yet to meet anyone who does this. Or any financial advisor who recommends it.

Why?

(a good subject for another post)

“The Last, Best Order”

There is a neat post on Redfin’s blog. It is the CEO’s “IPO diary.” Read the whole thing for a fascinating look at the process from the inside. A couple of sections really resonated with me:

Masters of the Universe
In other ways too, the roadshow had the feel of a bygone era. For example, almost everyone on the buy-side we met that week was a man: in one group lunch, all 24 of the portfolio managers in attendance were male. We may have met more portfolio managers who were Israeli special forces veterans than women. I asked our bankers how long it would take the first one to kill me with his bare hands.

Almost all of them took notes on tablets. Some of them tried to look up as you spoke, but with their eyes focused on nothing except the numbers in their head. They weren’t just capturing the highlights of a meeting; it was a nearly verbatim transcription of what we’d said, so we could be held accountable for it later. Information in every form is the currency of Wall Street, and drops of it never seem to fall on the floor.

Chess with Bobby Fischer
Most of the fund managers were exotically, obviously smart. Except for one person who fell asleep in a meeting, none of the fund managers we met was anyone I’d want to be on the other side of a trade with, buying what he sold, or selling what he bought. This is what I realized I had been doing my whole life as an E-Trade stock-picker; it had been like challenging Bobby Fischer to a game of chess. I spent a long time that first week trying to judge whether it made sense to have so many brilliant people decide where our society allocates capital, as opposed to making cars or software or hospitals.

The Last Ideology-Free Realm
What impressed me most about these people was their willingness to change their minds. No one in our society seems to change her mind about Donald Trump or Hillary Clinton based on a new fact, but a fund manager on the wrong side of a bad trade has to change her mind in a moment or lose her job. This is why investing is the world’s last ideology-free realm. It would be easier to accept the premise that our society can’t agree on one version of the truth anymore, about whether temperatures are rising or the economy is growing, except that’s exactly what happens when every public company reports its earnings every quarter. You can believe what you want to believe, but not with a million dollars on the line.

And, perhaps most interesting to me:

The Last, Best Order
One of my favorite meetings was with a Scottish fund manager in San Francisco. His firm was known for buying only a few stocks, and holding each for as long as a decade. In a hotel meeting room with enough prospectuses, pitchbooks, cookies, fruit, cheeses, crackers and popcorn for 30 people, he came in alone. And rather than rattling through twenty or thirty questions about our metrics, he just asked me why I ran the company.

I found myself talking about my older brother, who had died just before I became Redfin’s CEO, and the feeling I had then that my life so far hadn’t made the world a much better place. He asked me about whether Redfin’s sense of mission would survive our public offering. He didn’t write much down. His order was one of the last, and the best, to come in.

My aspiration as an investor is to be that “last, best order.” There’s a reason I classified this post under Finance, Investing, Learning and Values. There is some real insight here.

Practicing Objectivity

They say there is nothing new under the sun and so when I started thinking more deeply about philosophy, The Meaning of Life, etc. a few years ago I should not have been surprised to find myself drawn to a philosophy developed over 2000 years ago!

I am of course talking about stoicism. I encourage everyone to at least read up on stoicism. The Daily Stoic is a good starting point. The site provides quite a bit of content that is useful for introspection or reflection.

Today I encountered this quote from the philosopher Epictetus:

Don’t let the force of an impression when it first hit you knock you off your feet; just say to it: hold on a moment; let me see who you are and what you represent. Let me put you to the test.

This is something to meditate on as an investor as well as an individual. As you go about your day, think of all the people and ideas you dismiss out of hand.

Are you dismissive about these people and ideas based on reasoned thinking? Or are you just making snap decisions for convenience?

How many people and ideas do you write off each day for no reason other than that they offend your preconceived notions of how the world works?

When you think about things this way, you will quickly discover surprisingly little of what you believe is reasoned from first principles. This isn’t something to be ashamed of! In fact it is intensely liberating. It means that life is not a test you pass or fail. Rather it is unknown territory for exploration. Life is an adventure, and you are the hero! What is more exciting than that?

A Comment on Cuba’s Biotech Sector

I was fascinated by this naked capitalism post on Cuba’s biotechnology sector: https://www.nakedcapitalism.com/2018/03/cuba-became-biopharma-juggernaut.html

This is not something we hear about in the US (you could probably write a whole book about that–may I suggest the title Ad Hominem: A Fallacy of Irrelevance?). I do not know very much about Cuba, and I know virtually nothing about the Cuban healthcare system. I do, however, have a close friend who has:

(1) worked as a practicing surgeon

(2) worked in healthcare policy here in the US

(3) visited Cuba and observed the Cuban healthcare system in action (though not the biotech sector)

I reached out to him for an opinion, and he replied with the following:

Cuba has an inexpensive system that delivers reasonably good outcomes. I thought the article was a little light on examples for exactly how the government’s control of pharmaceutical R&D delivers better outcomes. Costs are lower, in part, because they have a more favorable regulatory environment. They are also lower because the government probably maintains a single, narrow drug formulary for the entire country. With one formulary, they are able to regulate the number of drugs in each class. After all, do we really need 9 options for a medicine that gives old guys an erection? Less choice, but lower costs. You see examples of this here with Medicare Part D formularies preferred drugs.

The other question is whether they incentivize and reimburse drugs based on value. Many economists here have called for a more explicit determination of value when determining drug prices. Pharma companies can charge whatever they want for a medicine that may be no better or more effective than one that already exists, but may be within a lucrative class of medicines. Certain really important drug classes, like antibiotics, are underdeveloped in the U.S. because they are not likely to make much money, even during their exclusive patent rights period. If Cuba funded drug classes based on need and anticipated value, that would be quite smart. Some left-leaning folks have called for government to take this role here. Unclear how that would work in practice.

I am not trying to put a stake in the ground here. However, I was intrigued by both the original article and the comment and thought others might feel the same.

A Tangent

Just because some aspect(s) of the Cuban healthcare system may work well or promote decent outcomes does not imply:

Communism or socialism are superior economic systems to capitalist, market-based systems
The Cuban economy as a whole functions efficiently (or even “decently well”)
The economic deprivation and restricted personal freedoms of the Cuban system are acceptable tradeoffs for a healthcare system that produces some decent outcomes

(you get the idea)

A Mental Model For Politics

Politics is the process by which tribal groups negotiate the distribution of power and resources in a society. A tribal group may identify strongly with a particular philosophy. However, conflating politics with philosophy (“values”) is a muddy way of viewing the underlying drivers of political conflict. It took me a long time (about 15 years) to realize this.

I now realize there are two dimensions to tribal politics:

The competitive dimension (the political process itself). This is essentially a strategy game. Because it is a strategy game, effective political operatives (Lee Atwater) needn’t actually concern themselves with “correct” policy or philosophy. Their role is simply to “win”–that is, secure power and resources for the tribal group they serve.
The philosophical dimension (the inner lives of tribal group members). This is the process by which tribal group members construct their identities, bond with one another and develop a shared vision of how power and resources should be allocated across society. Tribal group members may or may not develop their identities through a rigorous process of reasoning from first principles. That depends largely on the mental complexity of each individual.

Thus, mental complexity is a key input to this model:

Socialized minds simply adopt an identity consistent with their surroundings.
Self-authoring minds go a step further and build their own identity.
Self-transforming minds go a step even further and work to develop a meta-understanding of tribal group dynamics, in order to integrate that into a more “complete” mental model of how the world works.

To make that more concrete:

The socialized mind says: “Everyone in my town and my workplace supports Political Party A. Political Party A is the place to be. I am A.”
The self-authoring mind says: “I identify with aspects of Political Party A, but also Political Party B. Furthermore, I believe in X, Y and Z based on my education, life experience and vision for what I want to achieve in life. I combine these inputs to formulate my own identity, views and goals. I am a C.”
The self-transforming mind says: “I am a C, but it is possible (in fact likely) that my views as a C are incomplete, inaccurate, or oversimplified. I must leave room to modify these views over time. Over the years I will likely transform from a C to a D, to an E, and so on as I constantly integrate new learnings into my mental model of the world.”

Morgan Housel provides a good example of how a self-transforming mind views tribal politics:

Everyone belongs to a tribe and underestimates how influential that tribe is on their thinking. There is little correlation between climate change denial and scientific literacy. But there is a strong correlation between climate change denial and political affiliation. That’s an extreme example, but everyone has views persuaded by identity over pure analysis. There’s four parts to this:

Tribes are everywhere: Countries, states, parties, companies, industries, departments, investment styles, economic philosophies, religions, families, schools, majors, credentials, Twitter communities.

People are drawn to tribes because there’s comfort in knowing others understand your background and goals.

Tribes reduce the ability to challenge ideas or diversify your views because no one wants to lose support of the tribe.

Tribes are as self-interested as people, encouraging ideas and narratives that promote their survival. But they’re exponentially more influential than any single person. So tribes are very effective at promoting views that aren’t analytical or rational, and people loyal to their tribes are very poor at realizing it.

Psychologist Geoffrey Cohen once showed Democratic voters supported Republican proposals when they were attributed to fellow Democrats more than they supported Democratic proposals attributed to Republicans (and the opposite for Republican voters). This kind of stuff happens everywhere, in every field, if you look for it.

It should be obvious by now why most political debates among individuals go nowhere:

Most individuals debating politics do not clearly distinguish between the strategy game dimension and the philosophical dimension. This is important. A genuine philosophical debate is a complex and mentally taxing endeavor requiring concentration and a high level of openness. The goal of a philosophical debate is to pursue Truth, not to “win.” What we call political “debate” is almost always strategy and tactics masquerading as philosophy.
Socialized minds are simply not capable of engaging in genuine philosophical debate. They do not possess the requisite level of mental complexity (though they certainly can develop it). You will never change a socialized mind with evidence and argument. You need look no further than the comments section of a website for evidence of this.
Self-authoring minds are more than capable of engaging in lively philosophical debate. However, they tend to grasp their mental models rather tightly (after all, these are intelligent, highly motivated individuals we are talking about). This can be perceived as either stubborn, obnoxious or even courageous, depending on the observer. As mentioned above, genuine philosophical debate is exhausting. Most people do not want to put the energy into engaging in genuine philosophical debate. Don’t waste your time trying to debate political philosophy with people who aren’t interested in working hard at the process!
From a distance, self-transforming minds can seem devoid of logical consistency. This is especially true from the perspective of a socialized mind, for which maintaining an identity consistent with the tribal group is of paramount importance. This is because self-transforming minds are explicitly aware not only of the need to develop mental models, but of the need to adjust them. This can make it difficult for them to relate to the more static worldviews of self-authoring and socialized minds (and vice versa). Others may view a self-transforming mind as an untrustworthy waffler.

To conclude, here is a little checklist for thinking about politics:

Be explicit about the dimension you are analyzing:
- Strategic Dimension?
- Philosophical Dimension?
When analyzing the strategic dimension, do not conflate “values” with strategy and tactics. This will allow you to reason more clearly.
If you are analyzing the philosophical dimension, account for mental complexity.
If you are involved in a political discussion, try to understand the level of mental complexity the other part(ies) are operating at. This will lead to richer, more fulfilling conversations. On the other end of the spectrum, it will clue you in on when it might make sense to simply disengage.
If you want to do deep, truthful, political analysis, you need to integrate both the strategic and philosophical dimensions.