A Skinner box is a device used to study animal behavior. Its more formal name is “operant conditioning chamber.” It was originally devised by the behavioral psychologist B.F. Skinner. Skinner used his box to study how animals respond to positive or negative stimuli. For example, a rat can be conditioned to push a lever for a bit of food. A dog can be conditioned to salivate whenever a bell rings.
Lest you be inclined to dismiss operant conditioning as silly games played with animals, it’s worth considering that slot machines, video games and social media all make use of operant conditioning to shape our behavior.
The financial markets, too, are a kind of Skinner box.
Do you suppose we believe what we believe about investing because there are immutable laws, similar to physical laws, that govern the price action in markets?
We believe what we believe about investing because we’ve been conditioned to believe it. Much of what we think we “know” about investing is simply rationalized, conditioned behavior (the endless and pointless debate over “lump sum versus dollar cost averaging” is a perfect example–the “answer” is entirely path dependent). We investors aren’t so different from Skinner’s rats, working their little levers for their food pellets. It’s just that we’re after returns instead of snacks.
Below is what an operant schedule of reinforcement looks like.
Bet on Market Factor -> REWARD (GOOD RETURNS, CLIENTS HIRE YOU)
Bet on Momentum Factor -> SMALL REWARD (MAYBE)
Bet on Value, Size, Quality -> PUNISHMENT (BAD RETURNS, CLIENTS FIRE YOU)
The “lesson” here is very clear:
BETA IS ALL THAT MATTERS
BETA IS ALL THAT WORKS
This is what public market investors are being conditioned to believe. And if flows away from active management (particularly low beta strategies) are any indication, the market Skinner box is doing an admirable job. Demand for investment strategies is all operant conditioning, all the time.
Of course, the markets are more complicated than Skinner’s box. Market price action is both the input and output of investor behavior. It’s more like a Skinner box where the collective actions of the rats influence the operant schedule of reinforcement (this is another way of thinking about the concept of reflexivity).
The idea of markets-as-Skinner-boxes is inextricably linked to the idea of market regimes: patterns of correlations for economic variables such as interest rates, economic growth and inflation. It’s also inextricably linked to the idea of the zeitgeist: “the spirit of the age.” The relationship between these processes doesn’t flow so much as interlock. Each process acts on the others.
This visualization isn’t ideal. It implies the interactions are mechanical in nature, and that the result is a straightforward, predictable system. It’s not. In reality it’s much more an interaction of planetary bodies and gravitational fields than clockwork mechanisms of wheels and gears. My friends Ben and Rusty describe this as the three body problem. But imperfect as the above visual may be, it gives you a rough idea of how all this interrelates.
The first self-archetype is merely the subset of James’ blooming, buzzing confusion that we classify into our mind’s “I.” It is extraordinarily hard to redraw this boundary later in life. Hallucinogenic drugs, intense stress, sensory deprivation chambers, or the rigors of meditative practice are usually required.
Freedom’s just another word for nothin’ left to lose.
Kris Kristofferson, “Me And Bobby McGee”
John Patrick Mason: Your “best?!” Losers always whine about [doing their] best. Winners go home and f*** the prom queen.
The Rock (1996)
This is going to be one of those abstract, philosophical posts. Consider yourself warned. However, portions will tie in rather neatly with investing. So you may want to stick around. I’m also going to try to write with as much clarity as possible here, because the concepts I want to explore in this post are fundamentally weird. In order, they are:
Identity functions as a psychic prison.
To have any chance of escaping the psychic prison of identity, we must to cultivate the ability to redraw the boundaries of the self.
Therefore, freedom is, at a fundamental level, the ability to participate as a principal in the process of creative destruction.
Let’s start at the beginning.
The Psychic Prison
There’s a well-known quote from the book (and movie) Fight Club: “the things you own, end up owning you.” The idea is that over time you settle into a pattern of consumption. You stagnate within this pattern. After a while, it is impossible to determine whether you define your pattern of consumption or whether your pattern of consumption defines you.
I’ll take this a step further and suggest the following: the thoughts you think, end up thinking you. That is to say, you think your “self” into existence.
We’ve all met someone who’s chronically negative. That person who’s always put upon, who’s always sick, who’s always short on cash or the victim of sinister forces outside her control. That person who spends her life lurching from one crisis to the next. At times it seems as though she’s the physical manifestation of negativity and misfortune in the world.
It seems that way because it’s true. That person truly is a physical manifestation of negativity and misfortune. While plenty of her misfortunes may well be beyond her control, she’s also co-creator of the misery in her life. She has chosen to define her life with negativity. Now, she may not see this as a choice. (In fact, she almost certainly does not) Stuff just happens to her. But allowing yourself to fall into the posture of a chronic victim is itself a kind of choice.
The thoughts you think, end up thinking you.
You are the co-creator of your lived experience.
If you find yourself attracted to value investing, and you come to identify strongly as a “value investor,” in addition to whatever financial returns you generate that identity probably gives you a sense of meaning and maybe even a sense of community or belonging (if you don’t see Berkshire Hathaway’s annual meeting as a form of religious pilgrimage I’m really not sure what to tell you). Your value investor identity also frames your worldview a certain way. It limits your worldview in certain ways. This can be a liability, if your value worldview is fundamentally misaligned with the prevailing market regime. In this case your identity may well turn out to be a form of maladaptation.
A static identity locks you into particular patterns of thought and behavior. These patterns are relatively straightforward for others to identify and exploit, whether in business, politics or investing.
This lock-in is what I mean by psychic prison.
Escaping The Psychic Prison
Escaping the psychic prison of identity is straightforward but not easy. All you have to do is redraw the boundaries of your identity.
This lies at the heart of zen practice, adjacent to the idea of non-attachment. After years of practice, a zen master might be able to completely erase his attachment to self–a process that might trigger a complete mental breakdown for someone unprepared for the experience. What might this feel like? Having not experienced the feeling of complete dissolution of self, I’m hardly qualified to describe it.
Fortunately, complete dissolution of the self isn’t required to break out of the psychic prison of identity. All that’s needed is the ability to consciously rewrite the boundaries of identity.
Meditation is one way to practice this. Another is acting.
Our value investor might begin working on his escape from the limiting aspects of that identity by play-acting at growth or momentum investing. This doesn’t mean completely abandoning the tenets of value investing. It merely means cultivating the ability to view the world through someone else’s eyes. It’s merely about wearing the mask of a growth investor. At least to start, anyway.
The things you own, end up owning you.
The thoughts you think, end up thinking you.
The masks you wear, end up wearing you.
Ultimately, there’s no difference between you and the masks you wear. You are the masks you choose to wear. For some this is a frightening possibility to consider. Particularly from a metaphysical perspective. However, it’s also empowering.
Remember, you get to choose the masks you wear. That’s the point of this post.
The Nature Of Freedom
True freedom is freedom from an arbitrary or externally defined definition of self. It’s engaging in the process of creative destruction.
Personal freedom is engaging in creative destruction at the level of the self. Economic freedom is engaging in the process of creative destruction in the external world. When I say engage in I mean engage inas a principal, as a force acting on the world around you. Like it or not, we’re all subject to the process of creative destruction. The difference between freedom and slavery is agency.
This is the reason I included that quote from The Rock at the start of this post. It cuts to the very heart of what it means to be free. Free people manifest their will in the world around them. Losers whine about doing their best.
The archetype of the chronically negative loser described at the beginning of this post is especially grim. Here is a person who cannot even rise to the level of whining about doing her best. All she can do is whine about being a victim.
By contrast, by this definition, Frederick Douglass was probably freer as a slave than most nominally “free” people are today. It’s not an accident that one of Douglass’s most famous sayings is the statement that “knowledge is the pathway from slavery to freedom.” There is a reason slave owners did not want their slaves to learn to read.
In this spirit I’ll close with an excerpt from Douglass’s speech, “Self-Made Men,” which I recommend you read in its entirety.
I am certain that there is nothing good, great or desirable which man can possess in this world, that does not come by some kind of labor of physical or mental, moral or spiritual. A man, at times, gets something for nothing, but it will, in his hands, amount to nothing. What is true in the world of matter, is equally true in the world of the mind. Without culture there can be no growth; without exertion, no acquisition; without friction, no polish; without labor, no knowledge; without action, no progress and without conflict, no victory. A man that lies down a fool at night, hoping that he will waken wise in the morning, will rise up in the morning as he laid down in the evening.
Faith, in the absence of work, seems to be worth little, if anything. The preacher who finds it easier to pray for knowledge than to tax his brain with study and application will find his congregation growing beautifully less and his flock looking elsewhere for their spiritual and mental food. In the old slave times colored ministers were somewhat remarkable for the fervor with which they prayed for knowledge, but it did not appear that they were remarkable for any wonderful success. In fact, they who prayed loudest seemed to get least. They thought if they opened their mouths they would be filled. The result was an abundance of sound with a great destitution of sense.
It’s a bit hard for me to believe but I’ve apparently published 200 posts on this blog since I started writing it in September 2017. When I got this notification it prompted some introspection. I went back to my very first post, Zen & The Art of Investment Research. There I articulated a hazy vision for the ideas I wanted to explore here, writing:
Some people will argue there are compliance procedures like departmental firewalls to prevent conflicts of interest from influencing analysts’ recommendations. To which I would respond with The Golden Rule: He Who Hath The Gold, Maketh The Rules.
You may quote me chapter and verse from a compliance manual. I do not care what is written in someone’s compliance manual. In practice, if ever there is a dispute between a profit center like an investment banking group and a much smaller profit center (or, god forbid, a cost center) like a research group the profit center will win out every time.
Examining applications of The Golden Rule throughout history and contemporary events is part of what this blog will be about. This blog will also be about exploring the way the world works, through the lens of The Golden Rule, without needing to worry about where we end up and whether our conclusions might cost us our jobs.
One of the things that drew me to investment research is that in its purest form, it provides clears incentives, both positive and negative, for intellectual honesty, regardless of whether something makes you uncomfortable ideologically.
I think I’ve done a pretty good job executing on that vision over the last year and a half, though my reading and writing have gradually drifted from “pure” finance and economics to more of a focus on narrative abstraction, and how narrative abstraction is used to shape financial markets (not to mention our world). I expect this to continue to be my focus for the foreseeable future.
Something I’ve spent more and more time thinking about lately, especially as Demonetized has attracted a (very small) audience, is what I want this blog to be.
One thing I’ve decided it will not be is a business. Will I potentially write other things that I’ll attempt to sell? Yes. But this blog will remain Demonetized (actually more like un-monetized). I’ve got two major reasons for this.
First, this blog doesn’t lend itself to monetization. Maybe some affiliate links. But the writing itself isn’t the kind of (shudder) “content” that works as a product.
Second, I want this blog to be a place where I can follow my interests as they evolve over time.
Something I’ve observed studying narrative is that if you’re a public intellectual, and you make a living as a public intellectual, you essentially become locked into a particular shtick over time. This isn’t necessarily grifting (though it can be). It’s a function of the fact that your followers customers sketch out mental models of you over time. These models aren’t robust. They’re brittle. They fuel what my friends at Epsilon Theory call the game of you: “mirror” or “rage” engagements.
What brings out the real emotion and the real confusion is when a mirror engagement goes awry. It’s also confusing when a rage engagement goes against type and agrees with you on something, but the reaction isn’t upsettedness … it’s boredom. The emotion when a mirror engagement goes against type is much more pronounced, much more urgent. It’s a betrayal.
Not a big betrayal. Not a personal betrayal. Not (usually) a permanent betrayal. It’s not even a Heel Turn, to use the pro wrestling phrase, when a Baby Face (a good guy) flips the script and becomes a Heel (a bad guy) in some shocking plot twist.
No, it’s more like when your favorite sitcom has a “very special episode” where they deal with some social issue du jour in a “serious” fashion that of course you find cringe-worthy. That’s not what you want from Three’s Company!
When you’ve got a dedicated audience (or maybe an anti-audience, if you tend to attract rage engagements), the audience isn’t drawn to you (a complex individual who is likely to change over time), but rather a cartoon of you (a sketch that’s appealing on the basis of prospective mirror or rage engagements). It’s this cartoon that’s brittle. Evolve your views and interests “against type” and you risk breaking the cartoon. You risk losing your audience. Not to mention your revenue.
This incentivizes stagnation.
And stagnation is the opposite of what I’m trying to achieve here.
So over time I will go where curiosity takes me, albeit with an emphasis on ideas connected to finance, economics and geopolitics.
Maybe I’ll pause to reflect again in another couple hundred posts.
Lately I’ve been thinking about the mechanics of fiat news. By now we know what fiat news is: the presentation of opinion as fact. We know what fiat news looks like (pop on over to Vox and skim a few stories). But lately I’m more and more interested in how fiat news works.
The metaphor I like best is the medieval wolf trap.
This is a short-and-sweet post meant to get some thoughts down and possibly provide a (small) public service. In my line of work I’m involved in a bit of direct private equity investing. The typical acquisition target is a Main Street USA business with EBITDA somewhere between $500,000 and $2,000,000. These are profitable businesses but slow growers. We’re talking mid-single digit revenue growth here.
These businesses are worth something like 3x to 5x EBITDA (subject to negotiation, of course). It’s rare that the seller is financially sophisticated. The sale of the business is probably the only such transaction he or she will complete in a lifetime. So setting realistic expectations around pricing is one of the most important things to cover early in the process. If someone thinks he’s going to get a 10x multiple on one of these things it’s best to walk away early rather than waste everyone’s time and energy.
There’s a common argument unsophisticated sellers trot out to make the case for a higher valuation. It’s this:
What about my IP and intangible assets? Surely they’re worth something. You should be assigning more value to those things!
No purchaser takes this argument seriously. The fact of the matter is that value has been assigned to the IP and intangible assets. It’s in the earning power of the business.
Put another way, when you buy an operating business you don’t buy the tangible assets (property and equipment) separately from everything else. Same with intangibles. The costs and benefits associated with both tangible and intangible assets are loaded into the cash flow profile of the business. You don’t double-count them.
My latest Epsilon Theory note is about the metastability of social systems.
A social system remains metastable as long as there is a reasonably broad consensus regarding its core values and mythology. Without this consensus, metastability weakens. Put another way: first-order threats to social stability, such as isolated riots and street crime, are risks that lie in the body of the distribution of outcomes, both for individuals and society. Metainstability is a higher-order threat. The risks associated with metainstability lie in the tails of the distribution. They fall under the broad category heading of Really Bad Stuff and include things like:
Back to the Ants and the Grasshopper. Would it behoove the Ants to share a bit of food with the other insects to shore up the metastability of the forest’s social system?
Metastability is a rich concept to explore. I didn’t spend a lot of time defining metastability in my ET piece, but I find it worthwhile to look at the concept through the lens of elementary calculus.
If you’re reading this blog, you’re probably familiar with the differentiation of the simple quadratic function f(x) = x^2. The first derivative (a.k.a “instantaneous rate of change”) of f(x) = X^2 is 2x. The second derivative of f(x) = x^2 is just the derivative of 2x, the constant, 2. This, in turn, can be interpreted as the “instantaneous rate of change” for the function f(x) = 2x.
So you can see there’s some mathematical intuition behind that old saw, “change is the only constant.” It’s rates of change all the way down.
These concepts show up in finance all the time. In fixed income, there’s an inverse relationship between bond prices and yields. The first derivative of this function is a bond’s duration. The second derivative is its convexity.
With an option, the payoff depends on the price of the underlying relative to the strike price at expiration. The sensitivity of the option’s price to changes in the price of the underlying is the first derivative of this relationship. This is the option’s delta. The second derivative of this relationship, the sensitivity of the option’s delta to changes in the price of the underlying, is the option’s gamma.
(homework: consider the CAPM or any other linear factor model of financial asset returns in this context)
Anyway, on to metastability.
Take a society at any given point in time.
Social stability is its first derivative. Social stability is the instantaneous rate of change for society’s consensus values and norms.
Metastability is the second derivative. Metastability is the rate of acceleration (or deceleration) of changes in social stability.
In the language of options traders, social stability is society’s delta. Metastability is society’s gamma. Unfortunately for society, it’s generally short gamma. Which is just a fancy way of saying change is dangerous. Change stresses human social systems. The greater the magnitude of social change, and the faster the rate of change accelerates, the greater the stress on the existing social order.
Want to destroy social order in a hurry?
Lose a big war. That typically gets the job done.
Of course, this also invites the question, how would you strengthen social metastability?
By cultivating shared values and mythology.
The most common negative responses to my ET piece were comments along the lines of “the ants shouldn’t have to ‘share’/the Grasshopper should have to ‘earn’.” That’s a fine point of view. But it’s only a first-order look at the issue. Heck, from a first-order perspective, I completely agree. But that says nothing about metastability. I wish I’d made this a bit more explicit in the original post, but I did elaborate in the comments.
Actually, as far as metastability is concerned, in the fable’s base case involving the ants and a single grasshopper, it’s perfectly fine to just let the grasshopper starve. A moral philosopher might challenge that view, but the moral philosophy of this is a whole other issue.
In fact, you can easily imagine the Ayn Rand version of my “extended edition,” where all the insects are strict utilitarians. Here there’d be no need for any “metastability insurance” because of a strong consensus around libertarian utilitarian values as the organizing principles for society.
Likewise, you can imagine a Scandinavian “extended edition” where all the insects are social democrats or whatever. That society may have a very different set of consensus values and an entirely different level of metastability.
This is what I’m driving at when writing about metastability as a reflexive process, and why the social contract is necessarily something that’s negotiated. The obnoxious, twenty-five cent word for this process would be “dialectic.” Outside of relatively small, culturally homogenous communities, it becomes increasingly difficult to establish a strong consensus around values. The example of Prussia used in the post is a prime example. The Prussian “solution” to the problem of forging consensus around shared values at scale was to bind cultural identity to the state. It worked pretty well. Too well, in fact.
Anyway, for the purposes of this post I’m not concerned at all with whether libertarian or social democratic values are inherently superior. I’m more concerned with the idea that at the scale of a large, technologically advanced nation-state, maintaining social metastability is a balancing act across different constituencies.
I think I will likely have more to say on this subject in future posts.