The Tyranny of Optimization

Nature smiles at the union of freedom and equality in our utopias. For freedom and equality are sworn and everlasting enemies, and when one prevails the other other dies […] To check the growth of inequality, liberty must be sacrificed, as in Russia after 1917. Even when repressed, inequality grows; only the man who is below the average in economic ability desires equality; those who are conscious of superior ability desire freedom; and in the end superior ability has its way. Utopias of equality are biologically doomed, and the best that the amiable philosopher can hope for is an approximate equality of legal justice and educational opportunity.

–Will & Ariel Durant, The Lessons of History

When I was younger, I used to believe strongly in what I’ll call “technocratic optimization.” In my view, the Big Problems confronting civilization could be tackled through the decisive application of computational power and human intellect. The idea was that if you got all the smartest people working on all the hardest problems eventually you could solve them. You would discover Truth with a capital T. The rest would take care of itself.

I was a fool to believe this.

Human societies don’t run like giant mean-variance portfolio optimizations, where each individual can be reduced to a personal utility function, then aggregated and mapped to a kind of efficient frontier based on the available resources. Human societies are dynamic systems. These systems are constantly evolving in the face of environmental and social pressures. Whenever we attempt to optimize social and economic systems, our models inevitably end up either overfit or underfit. Hence the abundance of “unintended consequences” that accompany major policy changes.

But here’s the biggest problem with technocratic optimization: even in the best of circumstances, where it’s reasonably self-evident, the mere existence of Truth with a capital T is insufficient motivation for people to change their behavior. As Upton Sinclair famously wrote: “it is difficult to get a man to understand something when his salary depends on him not understanding it.”

So what’s a frustrated optimizer to do?

Well, you can force people to buy into your optimization. Or, you can convince them to buy into your optimization. Or, you can convince them to buy into your optimization by leveraging technology and their behavioral biases (a much better bet than simply relying on the merits of your argument).

If you’re an optimizer, your intellectual journey ends in tyranny.

Russland-Nord, Erschießung von Partisanen

Now, there’s certainly the concentration camp and NKVD firing squad kind of tyranny we’re acquainted with from 20th century history. All very messy. Fortunately, we now have kinder, gentler forms of coercion available to us.

600px-facebook_logo_(square)

The social credit system kind of tyranny, and the fiat news kind of tyranny, for example. Here you’re not staring down the barrel of a gun but rather at a smartphone screen. Here, the trick is not only convincing people to buy into your optimization, but that buying in was their idea in the first place. This is tyranny updated for the 21st century. Much cleaner than putting people up against a wall. Once you start looking for it, you see it everywhere.

So, what’s a reformed optimizer to do?

Personally, I’ve gone back to the Lessons of History, and the collective experience of human civilization. I’ve abandoned the view we should try to engineer “optimal” outcomes for individuals or society. I’ve come to believe that rather than engineer Answers, we should focus on the maintaining and improving the integrity of our Processes: the approximate equality of justice and educational opportunity.

I’ve also abandoned the idea that human civilization progresses on a linear trajectory, or, more precisely, that human civilization can progress along a linear upward trajectory. In reality, things move in cycles and mini-cycles. These cycles are driven not only by changes in the natural world, but also the constant friction generated by individuals and states in competition for power and resources.

Put another way: we oscillate between freedom and tyranny, and between varying levels of equality and inequality over time. This is natural and inevitable (which is not to say it’s “pleasant” or “ideal”). We’ve been fortunate that the general trend over time has been upward. That doesn’t mean we’ll never experience another period of dramatic upheaval and regression a la the Dark Ages.

I believe we should be much more concerned with managing the risks inherent in sudden paradigm shifts such as the French Revolution, Russian Revolution, and the spike in aggressive, authoritarian nationalism that occurred in the 1930s.

In finance nerd terms: mind the tails.

We’re not doing a very good job minding the tails right now. In optimizing for short-term economic growth, our default fiscal policy of every-increasing borrowing and default monetary policy of “plunge protection” (a.k.a The Greenspan/Bernanke/Yellen/Powell/Draghi/Kuroda Put) have provided economic and financial market stability at the expense of political and social stability. One of the most powerful voices in our political discourse today is a freshman rep who is an avowed democratic socialist (whatever that’s supposed to mean). If you can’t see how this relates to the legacy of the financial crisis; the legacy of quantitative easing; the deflationary impact of globalization and technological innovation–well, if you can’t see how all this interrelates, I’m not quite sure what to tell you.

You can’t destroy risk. You can only transform it.

That insight is in short supply among technocratic optimizers.

Are Structured Products Trash?

oscar_the_grouch

I am not a fan of structured products.

For those of you who haven’t wasted hours of your life ruminating on the pros and cons of financial engineering, structured products are sold to investors as a custom package of risk exposures.

For example, you might buy a note that promises a guaranteed minimum value and potential upside participation in an equity index’s return. This is equivalent to being long a zero coupon bond and a call option on the underlying index.

Or, you might buy a reverse convertible that pays a fat yield in exchange for exposing you to downside equity risk. In this case you are long a bond and short a put (you are shorting volatility).

Here’s my beef with structured products:

  • They’re expensive.
  • Most banks are better than you and me at pricing options. The deck is stacked against us (this is not to be confused with the common misconception that the bank is on the other side of the trade when you buy a structured product–issuers hedge out their exposures).
  • Because structured products are such profitable products for banks, they have fat commissions attached to them and are often foisted on unsuspecting retail investors who have no idea what they own. For example, it’s easy to sell Yield! to unsophisticated clients (and some sophisticated ones, too).
  • Oh, by the way you’re an unsecured creditor of the bank, which is one of those things that doesn’t matter until suddenly it matters, and then it’s the only thing that matters.

Before I wrote this post, I solicited some feedback from folks on Twitter. I wanted to know: do you see any legitimate uses for these products? The responses I received boiled down to the following:

  • It can be difficult for individuals and institutions to replicate their desired exposures directly in the options market for structural reasons or due to governance constraints.
  • At times, banks screw up on pricing, or there’s an opportunity to put a trade on that’s so attractive it justifies getting your face ripped off on pricing (as one individual put it: “an obviously suboptimal implementation [may be] the best available implementation”).

Taking this all into consideration I’ll modify my stance on structured products somewhat. If you are good with options, and are able to decompose these structures to judge whether the embedded options are cheap or expensive, it may make sense to dabble in structured products. I certainly don’t begrudge anyone a clever way to make a buck. In fact, it warms the heart to know clever people have made a few bucks beating Wall Street at its own game.

Likewise, if the design of your portfolio absolutely, positively requires options exposure, and structured products are the only way to access that exposure, perhaps it makes sense.

But I suspect most of us are better off without them.

Mirror, Mirror

spock-star-trek-mirror-mirror

Captain James T. Kirk: What worries me is the easy way his counterpart fit into that other universe. I always thought Spock was a bit of a pirate at heart.

Mr. Spock: Indeed, gentlemen. May I point out that I had an opportunity to observe your counterparts here quite closely. They were brutal, savage, unprincipled, uncivilized, treacherous–in every way splendid examples of homo sapiens, the very flower of humanity. I found them quite refreshing.

Captain James T. Kirk [to McCoy]:  I’m not sure, but I think we’ve been insulted.

Star Trek, “Mirror, Mirror” (1967)

As any sci-fi nerd who reads this can likely attest, “Mirror, Mirror” is one of the best known Star Trek episodes. It’s an Alternate Universe story, with the all-too-common “transporter malfunction” serving as catalyst (aside: if transporter tech is invented in my lifetime I will never, ever use it). In the Mirror Universe, the Federation is instead the Terran Empire. Imagine all the worst impulses of the Roman emperors, applied on a galactic scale.

In Terran society, only the strong survive. Don’t like your boss? Kill him. You simply take what you want through violent force. Women. Resources. Power. It’s pure Social Darwinism.

A fairly horrifying way to organize social and economic activity, when you really stop and think about it. Imagine being tortured in the Agonizer Booth every month you underperform the S&P 500. Many of us would be on intimate terms with the Agonizer Booth by now.

But as Mr. Spock observes at the end of the episode, the Terrans are just an exaggerated expression of basic human nature. The kinder, gentler humans of the Federation share the same basic impulses. They have the same capacity for cruelty and violence.

They’re us. We’re them.

It’s the same in our relationships with our investment managers. Many of their failings, real and imagined, reflect our own weaknesses and failings, both as individuals and allocators.

Why are there so many overly diversified, low tracking error portfolios out there? The dominant methods allocators use to evaluate performance incentivize the construction of overly diversified, low tracking error portfolios.

Why do so many bottom-up managers dabble in macro tourism? Allocators have unrealistic expectations for how true bottom-up portfolios should perform during broad market selloffs.

Why does it feel like so little money is managed with an emphasis on “real world” cash flow generation by “real world” businesses? Because the dominant models for asset allocation are based on abstracted baskets of securities.

Why is does it feel like so much money is managed in a short-term, overfitted fashion? Clients want 200% upside capture and 0% downside capture, and they want it “consistently.”

Our flaws and biases as allocators manifest themselves in our managers’ portfolios. They’re amplified by the intense pressure that comes with managing other people’s money. We end up in a kind of nightmarish feedback loop. The more pressure a manager is under during a period of underperformance, the worse that feedback loop gets. The more exaggerated our flaws and biases become as they’re translated into security selection and portfolio construction.

I sometimes often laugh at the silly conversations I have with capital intro people and third party marketers. They’ll say things like: “Fund X was actually up in December 2018! You should really take a look.” As if that, on its own, is somehow a meaningful data point.

But I shouldn’t laugh.

I shouldn’t laugh because I made them this way. Me, and others in seats like mine. Ultimate responsibility for the pervasive absurdity in the investment management business lies with us. We not only tolerate it, but actively encourage it. We encourage it with our peer group rankings and tracking error parameters and quarterly performance evaluations, not to mention our fear and greed.

I’ve always loved Wes Gray’s take on this, using a poker metaphor:

On the other side of the table is an institutional poker player, hired by wealthy investors, to play poker as best as possible. This poker player is a pure genius, mathematically calculates all probabilities in her head, and knows her odds better than anyone. Now imagine that our super player, as a hired gun, has a few limits. “We need you to maintain good diversification across low numbers and high numbers. We also want to see a sector rotation between spades, aces, and clubs. Don’t take on too much risk with straights and flushes, stick to pairs like the market does…” No one would ever play poker like this. But in finance, this is how people play.

They’re us. We’re them.

Mirror, mirror.

We’re All Selling Something

I received a couple questions on my last post from a commenter, and I felt they had enough heft to them that they could form the basis for a follow-up post. Note that I’ve paraphrased a bit for brevity. Since all this leans heavily on Ben and Rusty’s work over at Epsilon Theory, I want to make sure to give them a shout-out up front.

But with all that said, let’s jump in!

Where in this same environment do you place Narrative?

It’s all Narrative. No, seriously. There are multiple layers of narrative abstraction operating in that last post.

The post itself is Narrative–an allegory likening a period of medieval history to a challenging market environment for many asset management businesses.

Active Management! as referenced in the post is also an abstraction. There’s wide dispersion of performance across fundamental active managers–particularly for what we call “hedge funds.” Some funds were up well over 20% in 2018. Some were down more than 30%. Likewise, not every discretionary active shop is at death’s door. Active Management! carries negative connotations around fees and performance. But I could point to plenty of funds in the real world that bear little resemblance to Active Management! as debated in the media and with clients.

Risk Parity! Algos! and Indexers! as commonly referenced by struggling investment managers are similar abstractions of real things.

Finally, the film The Seventh Seal is an abstraction of a real historical period.

How these abstractions function in a semiotic sense is perhaps best explained in this Epsilon Theory post. To quote Rusty directly: “[m]ost symbols we encounter are powerful shorthands, and their meaning differs based on our unique and shared experiences.”

Active Management! has a different symbolic meaning to me as an allocator than it does to a hedge fund manager who returned 25% in 2018 and has been closed to new capital for a couple years on the back of an enviable track record. However, that manager and I both have a shared understanding of what active discretionary management means in a literal sense.

This is all just a long winded way of illustrating that Narrative is everywhere. You can no more escape Narrative as a human being than you can escape oxygen. At best you can be aware of Narrative, and how we all use narrative abstraction and symbolic representation to model the world around us.

Which brings me to the next question.

What do you think of the idea that as you build a company/organization/following you inevitably become a powerful missionary for that tribe?

I do believe it’s inevitable that anyone who builds any kind of substantial following or customer base will become a missionary to his tribe. Particularly if he’s someone who uses mass communication tools to reach an audience (for example by blogging). As I explored above, effective mass communication more or less demands a certain level of abstraction. Otherwise it’s difficult to effectively convey shared meaning across a wide audience.

In that sense, we’re all selling something.

Though it may be dangerous to start throwing around terms like “good missionary” and “evil missionary” in this post, here’s how I think about distinguishing between them.

A “good missionary” acts and communicates in good faith. To lean on Rusty’s framing from the ET note linked above, the good missionary treats others as principals. The good missionary respects our autonomy of mind.

An “evil missionary” is an instrumentalist. The evil missionary neither acts nor communicates in good faith. Rather, the evil missionary weaponizes Narrative to transform others into agents. The evil missionary does not respect our autonomy of mind.

The most important thing is for us to think critically about the information we consume. Look for narrative abstractions. Look for symbols. Be mindful of how they’re being used.

This stuff is everywhere. Ultimately, we’re all selling something.

Including me.

Mortification of the Flesh

seventh-seal-the-1957-007-flagellants

Jöns: What’s that rubbish there?

Painter: People think the plague is a punishment from God. Crowds wander the land lashing each other to please the Lord.

Jöns: Lashing each other?

Painter: Yes, it’s a horrible sight. You feel like hiding when they pass.

Jöns: Give me a gin. I’ve had nothing but water. I feel as thirsty as a desert camel.

Painter: Scared after all?

The Seventh Seal

The Seventh Seal is a film about the silence of God. It’s set in medieval Europe, during the Plague and the Crusades. The protagonist, the knight Antonius Block, spends the film looking for signs of God’s existence. He stalls Death with a now-iconic game of chess.

They just don’t make ’em like this anymore, folks. We’re too clever for movies that take religion so seriously. So literally. It’s all too earnest for The Age of Snark.

Anyway, as much as it’s about Antonious Block’s existential crisis, The Seventh Seal is about medieval European society’s response to the apocalyptic destruction wrought by the plague. And boy, it ain’t pretty. Inquisitors burn witches. Charlatan theologians prey on the weak and the naive. Flagellants wander from town to town, putting on bizarre religious displays.

Observing a procession of flagellants, Block’s squire mutters:

Is this what we offer to modern men’s minds? Do they really believe we will take all of this seriously?

As investors, we too wrestle with God’s silence. It’s not war or plague that shakes our faith but changes in the structure and behavior of financial markets. How do we respond?

Inquisitors burn witches.

Charlatan theologians prey on the weak and the naive.

Flagellants put on bizarre religious displays.

In many circles–particularly those of the fundamental discretionary persuasion–there has emerged a kind of millenarian cult mindset. We endure this suffering to purge our sins. To mortify the flesh. When The Great Reckoning arrives, the Algos and the Indexers and the Risk Parity Heretics shall be cast into the flames. And we, The True Investors, shall emerge from the hellfire unblemished, as did Buffett after the Dot Com Bubble.

Make no mistake. This is religion. Yes, the sermon comes with charts. There will be CAPE charts. There will be Value/Growth dispersion charts. There will be Active/Passive cycle charts. But these charts aren’t science. They’re religious icons.

As we begin meeting with clients, investment managers and management teams in 2019, I’d encourage us all to look at the arguments and data we’re being presented though this lens.

How much of what’s passed off as “analysis” is, in fact, religious fanaticism clothed in the language and trappings of science?

How much of what’s passed off as “analysis” is, in fact, religious art?

How often, when we laud “conviction,” are we just promoting the mortification of the flesh?

The Maginot Mentality

hochwald_historic_photo

A military commander may approach decision with either of two philosophies. He may select his course of action on the basis of his estimate of what the enemy is able to do to oppose him. Or, he may make his selection on the basis of what his enemy is going to do. The former is a doctrine of decision based on enemy capabilities; the latter, on enemy intentions. The doctrine of decision of the armed forces of the United States is a doctrine based on enemy capabilities. A commander is enjoined to select the course of action which offers the greatest promise of success in view of the enemy capabilities.

–R. Duncan Luce and Howard Raiffa, Games And Decisions: Introduction & Critical Survey

A recent Epsilon Theory note has me thinking on how we play the various games and meta-games that touch our lives. Specifically, how often we dismiss our opponents and competitors as stupid, ignorant, or subject to behavioral biases and constraints we’ve miraculously managed to transcend.

Our opponents and competitors may indeed be stupid, ignorant, and subject to behavioral biases and constraints we’ve miraculously managed to transcend. But basing business and investment decisions on this characterization is bad strategy.

History is rich with examples. In the first world war, for example, Britain badly underestimated Ottoman resources and fighting spirit, at the Dardanelles and again at Gallipoli.

A common variation on this mistake is refusing to adapt to changes in our opponents’ capabilities, or changes in the payoffs and estimations shaping the game. This may arise out of hubris and ignorance. More often it’s a result of institutional inertia and constraints. We sometimes call this the “man with a hammer” problem.” When the only tool we’ve got is a hammer, every problem is either a nail, or analogous to a nail.

In the case of France in the run-up to the second world war, economic and political constraints mired the country in a defensive posture. In fact, geopolitical reality demanded a decisive, proactive strategy. As Kissinger writes in Diplomacy:

French policy grew increasingly reactive and defensive. Symbolic of this state of mind was that France began to construct the Maginot Line within two years of Locarno–at a time when Germany was still disarmed and the independence of the new states of Eastern Europe depended on France’s ability to come to their aid. In the event of German aggression Eastern Europe could only be saved if France adopted an offensive strategy centered on its using the demilitarized Rhineland as a hostage. Yet the Maginot Line indicated that France intended to stay on the defensive inside its own borders, thereby liberating Germany to work its will in the East.

In the investing game, we build Maginot Lines all the time. We’re building and extending Maginot Lines whenever we embrace and promote appealing narratives in a way that reinforces rigid and inflexible thinking.

Discretionary active managers build Maginot Lines with narratives about index funds distorting valuations and ETFs as weapons of mass destruction.

Bogleheads build Maginot Lines with narratives about the greedy asset managers and efficient markets.

Financial advisors build Maginot Lines defending various fee structures with endless sniping and virtue signaling around what compensation structure makes someone “a true fiduciary.”

The Maginot Mentality is a kind of strategic solipsism. It assumes our opponents and competitors will play to our strengths and weaknesses. Or, perhaps, they’ll play according to some caricature we’ve drawn of their own strengths and weaknesses. It’s bad strategy, all around.

Mostly, the Maginot Lines we build for ourselves are symbols. Sure, they can be real enough. All those forts and gun emplacements along the Franco-German border were certainly real enough. They even impacted strategic decision making. But our opponents aren’t obligated to act according to the caricature we’ve drawn. They can choose another axis and mode of advance–one that plays to their true strengths and weaknesses.

Sound strategic thinking assumes they will.

Why I Write

Since more people are reading and commenting on what I’ve written here lately, I’m moved to reflect on why exactly I do this. So here are some reasons I write:

I write as an outlet. I’m a bit of a crazy person. I start thinking about things and sometimes I literally can’t stop thinking about them until I write them out of my head. Even if no one ever read a single word I’d written, I think I’d have to keep on writing or lose my mind. This is the main reason I write.

I write to solidify and clarify my thinking. The posts on this blog fall on a spectrum somewhere between random thoughts jotted in a notebook and a more polished series of research notes (though they’re definitely closer to random thoughts jotted in a notebook). My writing on this blog tracks the evolution of my views over time.

I write (publicly) to “talk” with others who are writing and thinking about my areas of interest. Where I sit in the investment business, daily life has relatively little to do with better understanding the whys and hows of financial markets. It’s more about gofer tasks in support of the gathering and retention of assets. We spend a lot of time producing silly charts looking at random noise from different angles, because for the most part clients don’t want the truth. For all their faults, the internet and platforms like Twitter are “marketplaces of ideas” where we can think, analyze and discuss without every idea immediately being subordinated to internal politics.

I write to “own my record”, even if I choose to do it anonymously for now. Because, as Rusty Guinn writes here:

if you want to avoid the life of a professional bullshit artist or a life resigned to charlatanry, the secret is not to hide in an introverted shell trusting that your good work will out. The secret – if we can truly call it that – is to act boldly while cultivating an unceasing, insatiable, transparent willingness to consider all the ways you might be wrong.

I’m not holding myself up as a shining example of the above. But it’s definitely an aspirational goal.

Finally, and most importantly, I write because I enjoy it.