The End Of The Beginning

4

“Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.”

—Winston Churchill

I have not written much since the coronavirus outbreak blew up. Not because I’m not thinking about things. I simply haven’t had much to say. I have no unique perspective to add regarding epidemiology or public health policy. Sometimes the best thing to do is simply hang back and reflect. This post contains some thoughts on where we’ve been, and where we might be headed.

One indisputable consequence of this pandemic is that we have quickly transitioned from a disinflationary or even (I would argue) mildly stagflationary regime to a deflationary economic regime. The duration of this new regime is an open question. Policymakers, particularly on the monetary side, have reacted as expected. They did MOAR. And they will continue to do MOAR to backstop financial markets, so long as they deem it necessary.

Unsurprisingly, this has done wonders for financial assets. Particularly duration-sensitive assets such as long bonds and growth equities.

Some dominant themes/narratives I think we will grapple with as this evolves:

The transformation of financial markets into political utilities is complete. It has always been a mistake to assume markets are a prefect reflection of the real economy. Now, markets are probably less a reflection of the real economy than ever before. A consequence of MOAR is that markets (or at least pockets of them) have seemingly become completely untethered from the real economy. There are sensible reasons for this, of course. Ultra-low discount rates. The fact that solvent businesses with liquidity to draw on should not see long-term impairment of value as a result of the virus, etc. But as with the financial crisis, policy geared toward owners of financial assets has been implemented quickly and decisively. Much more decisively than policy geared toward vulnerable small businesses and their employees. This will likely have social and political consequences.

We are all MMTers now. Government deficits will never matter again. Well, at least not unless/until an inflationary bill is acknowledged as having coming due. Central Banks are explicitly engaged in debt monetization. This is mainstream. It is accepted. Yes, there are a different flavors of it. There is the progressive flavor, with its Green New Deals and job guarantees. Then there is the “fiscally conservative” flavor, with its tax cuts and its endless promises of shrinking government (government is never shrunk in a material way, ‘natch). I’m not interested in arguing over whether this dynamic is right or wrong at this point. All I care about is acknowledging is that it IS. Because it matters. It matters a lot.

Politics is going to get nastier. The United States government is now explicitly in the business of choosing winners and losers in the economy. As usual, owners of financial assets have been selected as winners. As usual, those who do not own financial assets are deemed losers. I expect the long-simmering political conflict between Capital and Labor to further intensify as a result. Political rhetoric will become more extreme. Politicians will become more ridiculous. Congress will become even less effective (difficult to imagine such a thing is possible, I know). Fun times.

Investment-wise, it’s going to be MOAR of the same. Outside of the obligatory post-recession bounce, there will not be mean reversion in value versus growth factor performance. Long duration growth bets will continue to perform well, because there is no opportunity cost to making them. I suspect that long duration bonds will also continue to perform well in the short-term, against all odds. Because I believe we will test negative interest rates here in the US before we test higher interest rates. And convexity is a thing people seem determined to refuse to understand.

But how does it all end? I see a few very different endings to this story. The first, of course, is some kind of inflationary or stagflationary regime triggered, in part, by relentless monetary easing. But people like me have been worried about this for a long time. And it’s never shown up. A second possibility is that some kind of transformational technological innovation on the order of the internet allows us to return to much higher trend growth rates. This would be ideal. Perhaps the darkest scenario is that the political conflict described above spirals completely out of control, and we get to live through a reprise of the 1930s and 1940s.

This is not a very hopeful post. It is not hopeful because I do not have a very positive outlook on the macroeconomic and political trends of the day.

That said, this is also not an argument for bearish positioning in a portfolio. If you follow me on the Twitter, you may recall my exhortation to “dare to be smart enough to be dumb.” Flexibility is key here. I can forgive people (myself included) for not grasping how monetary policy would impact financial market behavior post-2008. That mistake is less forgivable today. In my opinion, it is nigh on impossible to invest today without accounting for the gravitational pull of monetary and fiscal policy.

To be perfectly explicit, as things stand today:

Quantitative value (owning cheap things because they are cheap) is at best a tactical trade.

Economic policy will hamper mean reversion.

Trends are our friends for the foreseeable future. Not all of them are likely to be positive. But forewarned is forearmed.

05/20 Permanent Portfolio Rebalance

Despite the strong rally in April the portfolio came in above the 12% volatility guardrail in April (upside volatility counts as much as downside volatility). Each individual asset is above the 12% threshold (though gold not by much). Cash needs to move to a 20% weight. To do this I will trim from everything but gold.

New weights:

NTSX – 29%

GLD – 25%

VIESX – 13%

JOHIX – 13%

Cash – 20%

Which means the underlying allocation is approximately:

S&P 500 – 27%

Laddered Treasury Bonds – 18%

Gold – 25%

EM Small Cap – 13%

Ex-US Dm Large Cap – 13%

Cash – 20%

(98% notional exposure)

I remain quite pleased with year-to-date performance. The interesting thing about this recent signal is that it is de-risking the portfolio after a strong rally. As mentioned above, volatility as a measure does not discriminate between up and down moves. It is just showing you the sea is choppy. The intuition here is very simple. You de-risk when the seas reach a certain level of roughness, even if the most recent moves happen to have been up.

2004_pp_performance
Source: Demonetized Calculations

 

Just A Flesh Wound

Black_Knight_Holy_Grail

Despite some tense moments, the leveraged permanent portfolio has held up pretty well through the recent market turmoil. With the announcement of unlimited Fed liquidity support, I added a decent chunk of gold exposure back to the portfolio. This was another discretionary decision. However, the rationale was consistent with the philosophy underlying this strategy. At the time, I believed that the Fed’s policy interventions would do much to end liquidation behavior and, hopefully, reduce correlations across equities, bonds and gold.

Today, the portfolio is:

~29% S&P 500 Futures

~18% ex-US Developed Market Equity

~17% ex-US Emerging Market Small Cap Equity

~26% Gold

~19% Laddered Treasury Bond Futures

~5% Cash

(~110% notional exposure)

Over the standard 1-year lookback period, this puts me just below the 12% volatility threshold that would trigger adding more cash. So, in the absence of the resumption of indiscriminate liquidation behavior in financial markets, this will be my allocation through the next rebalance check.

Year-to-date, performance is a bit worse than a standard 60/40 allocation. This is consistent with the behavior that a backtest of this type of strategy exhibited during the depths of the financial crisis (another period when “all correlations went to 1”). Note that in the below chart, the Morningstar Large Cap index has replaced the S&P 500. For some reason, S&P 500 returns are slow to pull through this tool now. The differences between the two indexes should be minimal, however.

 

200401_pp_performance1
Source: Demonetized calculations

Of course, my implementation of this strategy uses a global equity allocation. A fully-invested US-only variant (50/50 NTSX/GLD) would have finished March down only 7% or so year-to-date.

I’ve written before that there are endless variations of this kind of strategy. Personally, I am (perhaps irrationally) biased toward longer lookback periods and a more globally diversified equity allocation. However, I would not argue that those are necessarily optimal. Indeed, I am leaning more and more toward my friend @breakingthemark‘s compelling case for shorter lookback periods and more frequent rebalancing checks.

Nonetheless, I am pleased with how this strategy has performed since I first implemented it. The balance of upside participation with downside protection has been excellent. In addition to its standalone performance, it was able to serve as a source of liquidity when markets became especially dislocated in March, which I used to add to the aggressive, discretionary sleeve of my overall allocation.

I would never argue that this is a “perfect” investment strategy (there is no such thing). However, I think its recent behavior validates it as a very straightforward, DIY solution that even small investors can easily implement. I have no idea what the future may bring in terms of financial market performance. But I am very excited to see how the leveraged permanent portfolio holds up.

Punched In The Face

MikeTyson

I had never expected the leveraged permanent portfolio concept to be tested so dramatically, so soon after beginning this experiment. The speed of the coronavirus-induced drawdown in financial markets has been absolutely breathtaking. Truly a punch in the face. Through 3/20/20, my leveraged permanent portfolio has drawn down materially, though to a lesser extent than global equities. It has performed much like a 60/40 portfolio in these conditions, though much of this is actually attributable to the inclusion of ex-US equity in the allocation (a US-only variant would be down about 10%).

 

200320_pp_performance
Source: Demonetized calculations as of 03/20/20*

In the midst of the chaos, I made an important discretionary decision last week. I liquidated the entire GLD position and took it to cash well ahead of the next monthly rebalancing check (due 4/1/20).

Market conditions had deteriorated significantly, and there was a period where essentially all financial assets had become correlated (equities, Treasuries, gold). This increase in correlations is THE existential threat to the permanent portfolio and in my view it MUST be managed. There are basically two ways of doing this: 1) hedge, or 2) take a portion of the portfolio to cash. I opted for #2, and liquidated both the gold and a small residual emerging markets equity position.

Current allocation (based on a full lookthrough of NTSX’s exposures):

33% Cash

27% S&P 500 Futures

18% Laddered Treasury Futures

17% Large Cap ex-US Equity

16% Small Cap ex-US Equity

(78% notional exposure; 60% notional equity exposure)

There is an argument for reducing exposure further. For example, my Twitter friend @breakingthemark runs a somewhat similar strategy with a weekly rebalancing cadence, which has delivered extremely impressive performance. His strategy is tuned to respond more quickly to crashes, and is currently at 60% cash. I expect at 4/1/20 I will be adding more cash, as well as rebalancing some equity exposure back into gold.

 

* Differences between the total (time-weighted) and personal (dollar-weighted) returns are attributable to the timing of trades, as well as the fact that I reduced the overall size of this portfolio to opportunistically redeploy capital into my “lottery ticket” portfolio bucket during this period.

Silver Linings

The nice thing about big selloffs is that the lower the market goes today, the higher your future returns go for tomorrow. We have 4Q19 Fed Z.1 data now, which means I can try to roundabout ballpark S&P 500 returns for the next 10 years. As of 12/31/19 this estimate was 2.43%. After making some (very) rough adjustments for recent market moves, it has increased to 7.66% today.

200320estsp500

With interest rates as low as they are, and the possibility of negative rates looming on the horizon, I think a 700+ bps equity risk premium probably merits some buying, somewhere. DON’T GO ALL-IN. It is very possible things get worse before they get better. My own strategy has been to focus on the shares of companies that seem inordinately dislocated based on poor liquidity conditions. This is particularly evident in small cap stocks. In the US, these stocks had drawn down approximately 50% prior to the last couple days’ bounce.

Pulling the trigger on these things is not a trivial thing to do. It is uncomfortable knowing that you could be catching falling knives. I am not arguing that people are stupid for being cautious here.

I am, however, arguing that if you have liquidity (also far from trivial), and are willing to be a provider of liquidity in a dislocated market, there are spots where you can be compensated quite well for doing so. In small cap land, there are stocks trading at double-digit discounts to announced, all-cash takeout offers. This makes very little economic sense. Is Google going to bail on its FitBit acquisition because of the coronavirus? Probably not.

Admittedly, my truest investing self is “bottom-feeding contrarian.”

Right now, I think it makes sense more than ever to put money to work in a concentrated, “lottery ticket” portfolio alongside a more conservative core.

02/20 Permanent Portfolio Rebalance

Finally, some action!

If you are reading this blog you probably know that February was a wild month in the financial markets. So how did the leveraged permanent portfolio fare?

My verdict is “good, not great.”

0220_pp_performance
Source: Demonetized calculations

In the last rebalance post I asked the question: how does this portfolio break?

Answer: correlations go to 1 in a crisis.

Ironically (the markets do have an uncomfortable habit of throwing this stuff right back in your face), this is precisely what we saw in February in terms of the relationship between equities and gold. GLD finished the month down slightly. However, the monthly number obscures a sharp selloff that occurred in the last couple days of the month. Why did it happen?

I don’t know that anyone knows for sure (if any of you are traders or market makers with special insight, please leave a comment!). My personal hypothesis is that this was a function of investors rebalancing portfolios, taking down gross exposure and getting margin calls. Gold in particular has had a tremendous run over the last 8 months or so. Since I started running this portfolio, GLD is up 23%, while the S&P 500 has returned 2.77% and the BBgBarc Aggregate Bond Index nearly 9%.

Portfolios with a static allocation to gold are probably overweight it. And if you need to sell something for whatever reason, what makes the most sense to sell?

This is the kind of “real-world” trading activity that takes correlations to 1 in a crisis environment. And this portfolio is certainly vulnerable to it, as we saw in February (albeit to a relatively mild degree). It’s why volatility and trend are used as overlays for risk management.

Incidentally, the one-year lookback I use didn’t flag a need to add cash to the portfolio.* A one-month lookback would have, with trailing one-month volatility of about 15%. Equity exposure would have been trimmed to add the cash, with most equity market segments having crashed through their 200-day moving averages in February.

Why do I not use a one-month lookback? Originally, I did. However, I became concerned that such a short lookback period might be too sensitive to very short-term shocks, whereas the strategy is intended as a strategic allocation more geared toward navigating changes in market regimes.

Candidly, I’m not sure this is the right decision.

But we’ll see.

 

* Astute readers may notice that the portfolio weights in this update differ slightly from those in the previous update. There are two reasons for this. First, I trimmed and rebalanced an overweight to ex-US equity exposure that had crept in. Second, yesterday I sold some of the gold and NTSX exposure to make some purchases in my individual stock portfolio. If you’ve been following these updates since the beginning you may recall that I pair this strategy with a concentrated, high-risk, 10(ish) stock equity portfolio.

The Tip Jar

In an ironic twist, I am experimenting with monetizing a blog called Demonetized. I have added a tip jar to the site. It will either display at the top right of the sidebar or the bottom of the list of posts, depending on the size of your device screen. It is marked with a charming little vector graphic of a piggy bank. Which is meant to represent my piggy bank.

piggy_bank

I have a couple reasons for taking this step:

First and foremost, it would be nice to make more money.

Second, even a minimal amount of tips will help defray the (admittedly low) cost of site upkeep.

Third, I am interested in experimenting a bit with “business models” (that is being overly generous here) that might work well for my particular skill set. This blog is not, and never will be, paywalled in any way. But, candidly, I have considered launching something that would lend itself to some kind of subscription model. The tip jar is simple test of whether people think my work might be worth paying for.

Comments/suggestions/irate feedback welcome.

01/20 Permanent Portfolio Rebalance

With January over I ran the latest leveraged permanent portfolio rebalance check. Still in good shape from 12% volatility limit perspective. Relative performance versus the S&P 500 has diminished since 4Q18 rolled off the lookback period. But it remains quite strong versus a Global 60/40 comp.

Actual realized performance from my implementation:

2001_pp_performance

January is an interesting month because it demonstrates the diversifying power of uncorrelated assets (gold, Treasury futures in NTSX) in the face of macroeconomic event risk. In this case, coronavirus.

Recall that the whole purpose of this approach is to be insulated from unexpected macroeconomic or geopolitical shocks without having to predict anything. So far we’ve had two out-of-backtest opportunities to test this: 1) trade war anxieties in August 2019, and 2) coronavirus. In both instances, the strategy has performed as expected.

Which I suppose raises an interesting question: how would you “break” this strategy?

The strategy breaks if equities, Treasuries and gold become highly correlated in a period of sharply negative performance. It is difficult to imagine what would cause correlations to change in this way. I tend to believe it would be some kind of end of the world scenario such as nuclear war, suspension of private property ownership, or zombie apocalypse. I’m not sure portfolios can or should be built with such extreme scenarios in mind.

But anything is possible.

And that is why we set a volatility threshold for the portfolio. If pairwise correlations between equities, Treasuries and gold go to one, and the world has not ended, we would almost certainly see a sharp spike to overall portfolio volatility. At 12% portfolio volatility, we would effectively begin to be “stopped out” of risk assets, and would have to add cash to bring the portfolio back below the 12% max volatility threshold. In theory, if the world were truly turned upside down, this would give us the opportunity to re-allocate to other asset classes that are “working” in the new regime.

Notes On Metarationality

Recently I had something of a revelatory experience. I went down the rabbit hole with David Chapman’s Meaningness. Here I found a robust framework that clarified and systematized ideas that I’ve recently been exploring in a more abstract way. I am not exaggerating when I say that David’s work has saved me maybe a decade of thinking and writing. This post reflects on those ideas.

 

Modes of Meaning

One of the things that resonated with me most strongly when exploring Meaningness was the progression of “modes of meaning” it describes:

Choiceless: Prior to about 1700, meanings were essentially fixed, either by God or nature. This had the advantage of being simple and unambiguous. It had the significant disadvantage of being obviously wrong.

Systems: Broadly speaking, it took a few hundred years of religious conflict to overthrow the Choiceless mode of meaning. We killed God and tried to replace Him with systems. Capitalism. Marxism. Facism. All of these systems failed to provide a comprehensive and internally consistent system of meaning and social organization. Real-world implementations of fascism and marxism essentially culminated in genocidal wars of aggression. A bastardized version of capitalism has survived to the present day, but only by sacrificing comprehensiveness and internal consistency (every developed nation state I can think of has implemented some socialist welfare programs).

Countercultures & Subcultures: We responded to the failures of the Systematic Mode through the countercultures. Broadly speaking, the two countercultures were hippie and evangelical. Because these countercultures lacked sufficient nuance to accommodate the diverse identities of their participants, they were ultimately superseded by smaller scale subcultures. Boomers most closely identify with the countercultures. Subcultures are more of a Gen X phenomenon.

Atomization: The fundamental inability of subcultural niches to provide breadth and depth of meaning, as well as advanced technology, have brought us to the atomized mode. Chapman writes:

As culture and society atomize, it becomes impossible to maintain a coherent ideology. Religions decohere into vague “spirituality,” and political isms give way to bizarre, transient, reality-impaired online movements. Decontextualized, contradictory, intensely-proclaimed religious and political “beliefs” displace legacy systems of meaning. These are not beliefs in an ordinary sense, but advertisements of personal qualities and tribal identification. The atomized mode generates paranoia, because without the systematic mode’s “therefores,” its structure of justification, there are no memetic defenses against bad ideas.

Atomized politics abandons the outdated convention that political arguments should make sense. Occupy, the Tea Party, ISIS, the “tumblr SJW” and “alt-right” social media movements, and the 2016 American Presidential campaign ignored “therefore” in favor of claims that were false and absurd, but not duplicitous, because they were not intended to be believed—just reacted to for their intense emotional impact.

I am recapping these ideas here because they are fundamental to my own updated mental models of society, religion and politics. For example, my mental model for politics post from a couple of years touches on related ideas. What I’ve lacked till now, and what David Chapman has spent years creating, is a robust and comprehensive framework for exploring all of this (I intend to apply these models to certain trends in investing in future posts).

 

Metarationality in the Atomized Mode

Like me, David does not believe in Answers. He believes in Process. The way forward in the atomized mode is with metarationality.

A self-described rationalist might try to apply Bayesian reasoning as an ordering principle for life. Bayesian reasoning is certainly hyper-rational. But if your only tool is a hammer you will think of every problem as a nail.

A metarationalist recognizes that Bayesian reasoning is only effective for addressing certain kinds of problems. The metarationalist carries a big toolbox. The hammer has its uses. But sometimes a screwdriver or ratchet wrench is the tool for the job. Sometimes unconventional combinations of tools and materials are required to solve certain problems. The experienced craftsman does not arrive at these solutions through systematic reasoning but through experience, intuition, and experimentation.

A rationalist evaluation of the capitalist, marxist and fascist systems might conclude that capitalism is “the best” (or “least bad” system).

A metarationalist critique recognizes that each system contains elements of truth. The capitalist system recognizes that the “free” interaction of market participants is a more robust system for allocating resources in a society than centralized economic planning. The marxist system recognizes that the “efficient” or “robust” allocation of resources can nonetheless threaten social cohesion. The fascist system recognizes the attractiveness of fixed meanings and idealized forms (modernism and postmodernism have always been the twin-headed nemesis of fascist movements).

The challenge rationalism faces in the atomized age is the tendency to think of systems in discrete or static terms. Yet all systems are “obviously” inadequate. Metarationality is fully at ease with the notion that elements of capitalism and marxism can be deleted, combined, edited and remixed in ways that more accurately model reality, regardless of whether the resulting system is ideologically or logically consistent. Metarationality accepts the inevitability of internal inconsistencies in any “real world” (especially social) phenomena. The Meaningness term for this is “patterned nebulosity.”

Some may read this post as an argument that a metarational worldview is somehow superior or transcendant. There is no such thing as transcendance. I would argue a metarational worldview offers a higher resolution view of reality than a strictly rational worldview, and certainly a choiceless worldview. But a metarationalist is still human, with human cognitive, emotional and moral weaknesses.

Metarationalists eat, breathe, shit and bleed like everyone else.

There is an interesting parallel here with elements of Buddhist philosophy. A common misconception is that Enlightenment == Transcendence. A more correct understanding is that Enlightenment == Acceptance, or Enlightenment == Equanimity. Likewise, Non-Dualism =/= Monism (“All Is One”).

One thing I have seen repeatedly is the conflation of metarationality with nihilism or existentialism. Candidly, my own personal views have verged on existentialist at times, before the distinction became clear to me. Meaningness explores these distinctions in depth, but a simple summary is as follows:

Eternalists argue meaning is fixed.

Existentialists argue meaning is subjective.

Nihilists argue meaning is nonexistent.

Metationalists argue meaning is nebulous.

Meaning exists. But meaning is also insubstantial. Like a mist, or a cloud. When you get up close to it, it has a tendency to evaporate.

 

Some Personal Reflection

In Meaningness, David hypothesizes that that it is easiest for STEM people to make the transition to rationality and then metarationality.

For the most part, you have to have a thorough understanding of how to work within systems before it’s feasible to step up and out of them, to manipulate them from above. There are other routes to mastering systematic rationality—through experience as a manager in a bureaucratic organization, for instance—but this curriculum will assume a STEM background.

The minimum requirement might be an undergraduate STEM degree; but research experience at the graduate level may be needed. You have to have seen how many different systems work, and—more importantly—how they fail. At the undergraduate level, you are mainly shielded from the failures, and systems get presented as though they were Absolute Truth. Or, at least, they are taught as though Absolute Truth lurks somewhere in the vicinity, obscured only by complex details. Recognizing that there is no Absolute Truth anywhere is a small downpayment on the price of entry to meta-systematicity.

That may already have set off warning bells. Woomeisters and postmodernists say things like that—and if you think they are horribly wrong, I agree!

I don’t disagree with David’s view here. Frankly, it is a pain in the ass to come at this from a non-STEM background. I say that with some confidence, because it was what I did, personally. My undergraduate degree was in the wooiest of woo: English (Writing). I had to do quite a bit of remedial STEM (mainly TM work) work to get a reasonable handle on systems thinking. And I will likely only ever be a mediocre systems thinker at this point.

David goes on to write:

By system, I mean, roughly, a collection of related concepts and rules that can be printed in a book of less than 10kg and followed consciously. A rational system is one that is “good” in some way. There are many different conceptions of what makes a system rational. Logical consistency is one; decision-theoretic criteria can form another. The details don’t matter here, because we are going to take rationality for granted.

Meta-systematic cognition is reasoning about, and acting on, systems from outside them, without using a system to do so. (Reasoning about systems using another system is systematic, and meta, but not “meta-systematic” in this sense.) Meta-rationality, then, is “good” meta-systematic cognition. Mostly I use the terms interchangeably.

One field I draw on is the empirical psychology of adult development, as investigated by Robert Kegan particularly. This framework describes systematic rationality as stage 4 in the developmental path. Stage 5 is meta-systematic. However, as far as I know, no one from this discipline has applied the stage theory to STEM competence specifically. Empirical study of cognitive development in graduate-level STEM students would be helpful, but in the absence of that I’m working from a combination of first principles, bits of theory taken from many apparently-unrelated disciplines, anecdata, and personal experience.

According to this framework, there is also a stage 4.5, in which you lose the quasi-religious belief in systems, but haven’t yet developed the meta-systematic understanding that can replace blind faith. Stage 4.5 leaves you vulnerable to nihilism, including ontological despair (nothing seems true), epistemological anxiety (nothing seems knowable), and existential depression (nothing seems meaningful). It’s common to get stuck at 4.5, which is awful.

An odd benefit of coming at this in reverse is that I suspect it makes the transition from Stage 4 to Stage 5 thinking easier. One of the (few) advantages of a modern humanities education is that if you approach it in the correct mindset it gets you comfortable swimming in a sea of ever-shifting meanings. In fact, you even do this fairly systematically. The entire process of obtaining a humanities degree consists of processing data through a particular analytical lens.

The major disadvantage of a modern humanities education is, of course, that most systems of meaning you’re taught operate at extremely high bullshit-to-truth ratios. This is exacerbated by the fact that many of the professors teaching you these systems of meaning are not themselves metasystematic thinkers, but rather True Believers with political and social axes to grind. Valuable opportunities to cultivate meta-systematic thinking are thus wasted.

Quick Thoughts On Geopolitical Risk

Most nation states are fairly rational actors. Iran. North Korea. Even Libya under Qaddafi and Iraq under Saddam. These are not the kinds of regimes I would like to live under. But they are not irrational in their foreign policy agendas, either. Don’t mistake what a head of state says for what that state will actually do. Even the most vile, tyrannical regimes are first and foremost concerned with self-preservation. It isn’t in their interest to start wars they can’t win.

What they are solving for is the optimal mix of shenanigans to maximize geopolitical power and domestic prestige while minimizing existential risk. If you are the kind of person who thinks only OTHER countries operate this way, you have a lot to learn about geopolitics.

But.

Sometimes rationality does not prevail in international relations. Or, for idiosyncratic reasons (see WWI), what appears to be a series of rational actions when taken in isolation ultimately leads to an irrational outcome.

Hence, in my view we tend to overestimate the frequency of severe geopolitical shocks and underestimate the severity of the shocks that will inevitably occur. In other words, we are really, really bad at handicapping expected values related to geopolitical risk.

The obvious lesson?

QUIT TRYING TO PREDICT GEOPOLITICAL SHOCKS AND IGNORE ANYONE WHO CLAIMS TO BE ABLE TO PREDICT THEM.

Now, I enjoy reading foreign policy think-pieces as much as the next guy. Maybe even more than the next guy. (Fun Fact: Many moons ago I took the FSOT. At the time, you took the exam and wrote the essays separately. I passed the exam but promptly failed the essay section. In retrospect, I was almost certainly disqualified for ideological unreliability) Anyway, the way to read a foreign policy think-piece is as a scenario–a scenario that might play out in a grand strategy game like Hearts of Iron. This is essentially a speculative activity (the parallels with investment research should be obvious). The fact of the matter is that this stuff is useful for getting you to think about a range of possible futures and strategic options. It is NOT useful for actually predicting the future.

In practical terms, the way you manage geopolitical risk is with hedges and rules-based guardrails. Personally, I’d rather ignore geopolitical risk all together than make predictions based on subjective probabilities.

This is relatively simple, process-over-outcome and OODA loop stuff. There are dozens, if not hundreds of ways to adapt a portfolio to geopolitical risk without predicting anything. And 99.99% of what’s written about geopolitics is trash, anyway. Per the above, that’s kind of the point.

The challenge here isn’t identifying the right tools, or even understanding the tradeoffs they entail.

The challenge is shot commitment.