Two Kinds of People

There are two kinds of people in this world. If you drill down deep enough into someone’s psychology you will find she is hardwired psychologically for either momentum or value (a.k.a trend or mean reversion).

Some Characteristics Of Momentum People

Of the two types of people, momentum people are more sociable. They are innate trend followers. For momentum people, it’s always best to stick with what’s working.

Their business and lifestyle decisions reflect this. “Get while the getting’s good,” is what they think during an economic boom. They prefer to “cut losers and let winners run.”

Momentum people are pro-cyclical. They are fun at parties during boom times. It’s easy to be the life of the party when you are making a lot of money.

Some Characteristics Of Value People

Value people by contrast are a pain in the ass. They are often curmudgeonly and unpopular. This is no accident. Value people are innately contrarian. Mean-reversion underlies a value person’s worldview. For a value person, “things are never as good as you hope, or as bad as they seem.”

A value person’s business and lifestyle decisions reflect this. Value people pare risk and accumulate cash during boom times. They take risk and deploy cash during bear markets.

Value people are counter-cyclical. They are never much fun at parties because they’re always out of phase with the crowd.

Which Are You?

In the end it doesn’t really matter whether you are a momentum or value person. You can succeed in life and business either way (well… assuming you don’t over lever yourself).

What matters is that you recognize whether you are wired as a momentum person or a value person, and that you avoid putting yourself in positions that are a fundamental mismatch for your psychology.

For example, I think I would probably make the world’s worst venture capitalist (spoiler alert: I am a value guy). Not because I would lose money but because it would be hard for me to invest in anything in the first place.

The high base rate for failed venture investments would loom large over every decision. The incessant cash burning would haunt my nightmares.

Our World In Meta-Games

Matryoshka_Russian_politicians
Source: Brandt Luke Zorn via Wikipedia

The world is a complicated place. A good way of attacking that complexity is to view the world as a nested series of games and meta-games.

Ben Hunt at Epsilon Theory wrote an excellent post about meta-games in financial markets a while back, specifically in the context of financial innovation. While I’m going to take a slightly different angle here, his illustration of how a meta-game works is useful as a jumping off point.

It involves the coyotes that “skirmish” with the residents of his town:

What’s the meta-game? It’s the game of games. It’s the larger social game where this little game of aggression and dominance with my wife played out. The meta-game for coyotes is how to stay alive in pockets of dense woods while surrounded by increasingly domesticated humans who are increasingly fearful of anything and everything that is actually untamed and natural. A strategy of Skirmish and scheming feints and counter-feints is something that coyotes are really good at. They will “win” every time they play this individual mini-game with domesticated dogs and domesticated humans shaking coffee cans half-filled with coins. But it is a suicidal strategy for the meta-game. As in literally suicidal. As in you will be killed by the animal control officer who HATES the idea of taking you out but is REQUIRED to do it because there’s an angry posse of families who just moved into town from the city and are AGHAST at the notion that they share these woods with creatures that actually have fangs and claws.

For simplicity’s sake, I’m going to write about four interrelated layers of “games” that influence financial markets. Imagine we are looking at a set of Russian nesting dolls, like the ones in the image at top, and we are working from the innermost layer out. Each successive layer is more expansive and subsumes all the preceding layers.

The layers/ games are:

1. The Security Selection Game

2. The Asset Allocation Game

3. The Economic Policy Game

4. The Socio-Political Power Game

Each of these games is connected to the others through various linkages and feedback loops.

Security Selection

This is the most straightforward, and, in many ways, the most banal of the games we play involving financial markets. It’s the game stock pickers play, and really the game anyone who is buying and selling assets based on price fluctuations or deviations from estimates of intrinsic value is playing. This is ultimately just an exercise in buying low and selling high, though you can dress it up any way you like.

While it often looks a lot like speculation and gambling, there is a real purpose to all this: price discovery and liquidity provision. The Security Selection Game greases the wheels of the market machine. However, it’s the least consequential of the games we will discuss in this post.

Asset Allocation

Asset Allocation is the game individuals, institutions and their financial advisors play as they endeavor to preserve and grow wealth over time. People often confuse the Security Selection Game with the Asset Allocation Game. Index funds and ETFs haven’t helped this confusion, since they are more or less securitizations of broad asset classes.

At its core, the Asset Allocation Game is about matching assets and liabilities. This is true whether you are an individual investor or a pension plan or an endowment. Personally, I think individual investors would be better served if they were taught to understand how saving and investing converts their human capital to financial capital, and how financial capital is then allocated to fund future liabilities (retirement, charitable bequests, etc). Unfortunately, no one has the patience for this.

The Asset Allocation Game is incredibly influential because it drives relative valuations across asset classes. As in Ben Hunt’s coyote example, you can simultaneously win at Security Selection and lose at Asset Allocation. For example, you can be overly concentrated in the “best” stock in a sector that crashes, blowing up the asset side of your balance sheet and leaving you with a large underfunded liability.

I sometimes meet people who claim they don’t think about asset allocation at all. They just pick stocks or invest in a couple of private businesses or rental properties or whatever. To which I say: show me a portfolio, or a breakout of your net worth, and I’ll show you an asset allocation.

Like it or not, we’re all playing the Asset Allocation Game.

Economic Policy

The Economic Policy Game is played by politicians, bureaucrats, business leaders and anyone else with sociopolitical power. The goal of the Economic Policy Game is to engineer what they deem to be favorable economic outcomes. Importantly, these may or may not be “optimal” outcomes for a society as a whole.

If you are lucky, the people in power will do their best to think about optimal outcomes for society as a whole. Plenty of people would disagree with me, but I think generally the United States has been run this way. If you are unlucky, however, you’ll get people in power who are preoccupied with unproductive (yet lucrative) pursuits like looting the economy (see China, Russia, Venezuela).

The Economic Policy Game shapes the starting conditions for the Asset Allocation Game. For example, if central banks hold short-term interest rates near or below zero, that impacts everyone’s risk preferences. What we saw all over the world post-financial crisis was a “reach for yield.” Everyone with liabilities to fund had to invest in progressively riskier assets to earn any kind of return. Cash moved to corporate bonds; corporate bonds moved to high yield; high yield moved to public equity; public equity moved to private equity and venture capital. Turtles all the way down.

A more extreme example would be a country like Zimbabwe. Under Robert Mugabe the folks playing the Economic Policy Game triggered hyperinflation. In a highly inflationary environment, Asset Allocators favor real assets (preferably ones difficult for the state to confiscate). Think gold, Bitcoins and hard commodities.

This is no different than Darwin’s finches evolving in response to their environment.

Do you suppose massive, cash-incinerating companies like Uber and Tesla can somehow exist independent of their environment? No. In fact, they are products of their environment. Where would Tesla and Uber be without all kinds of long duration capital sloshing around in the retirement accounts and pension funds and sovereign wealth funds and Softbank Vision Funds of the world, desperate to eke out a couple hundred basis points of alpha?

Insolvent is where Uber and Tesla would be.

In general, western Economic Policy players want to promote asset price inflation while limiting other forms of inflation. There are both good and selfish reasons for this. The best and simultaneously most selfish reason is that, to a point, these conditions support social, political and economic stability.

However, the compound interest math also means this strategy favors capital over labor. This can create friction in society over real or perceived inequality (it doesn’t really matter which–perception is reality in the end). We’re seeing this now with the rise of populism in the developed world.

The Sociopolitical Power Game

Only the winners of the Sociopolitical Power Game get to play the Economic Policy Game. In that sense it is the most important game of all. If you are American, and naïve, you might think this is about winning elections. Sure, that is part of the game. But it’s only the tip of the proverbial iceberg.

This game really hinges on creating and controlling the narratives that shape individuals’ opinions and identities. If you are lucky as a society, the winners will create narratives that resemble empirical reality, which will lead to “progress.” But narratives aren’t required to even faintly resemble reality to be effective (it took me a long time to understand and come to grips with this).

You could not find a more perfect example of this than President Donald Trump. People who insist on “fact checking” him entirely miss the point. Donald Trump and his political base are impervious to facts, precisely because Trump is a master of creating and controlling narratives.

Ben Hunt, who writes extensively about narrative on Epsilon Theory, calls this “controlling his cartoon.” As long as there are people who find Trump’s narratives attractive, he will have their support. Facts are irrelevant. They bought the cartoon. (“I just like him,” people say)

It’s the same with Anti-Vaxxers. Scientific evidence doesn’t mean a thing to Anti-Vaxxers. If they cared even the slightest bit about scientific evidence, they wouldn’t exist in the first place!

I’m picking on Trump here because he is a particularly prominent example. The same can be said of any politician or influential figure. Barack Obama. Angela Merkel. JFK. MLK. I think MLK in particular is one of the more underrated strategists of the modern era.

Here is Sean McElwee, creator of #AbolishICE, commenting to the FT on effectively crafting and propagating narratives:

“You make maximalist demands that are rooted in a clear moral vision and you continue to make those demands until those demands are met,” said Mr McElwee. “This is an issue where activists have done a very good job of moving the discussion of what has to be done on immigration to the left very quickly.”

If you want to get very good at the Sociopolitical Power Game, you have to be willing to manipulate others at the expense of the Truth. It comes with the territory. Very often the Truth is not politically expedient, because our world is full of unpleasant tradeoffs, and people would prefer not to think about them.

I have been picking on the left a lot lately so I’ll pick on free market fundamentalists here instead. In general it is not a good idea to highlight certain features of the capitalist system to the voting public. Creative destruction, for example. In Truth, creative destruction is vital to economic growth. It ensures capital and labor are reallocated from dying enterprises to flourishing enterprises. Creative destruction performs the same function wildfires perform in nature. Good luck explaining that to the voters whose changing industries and obsolete jobs have been destroyed.

Because of all this, many people who are very good at the Sociopolitical Power Game are not actually “the face” of political movements. These are political operatives like Roger Stone and Lee Atwater, and they are more influential than you might think.

The Most Important Thing

There is a popular movement these days to get back to Enlightenment principles and the pursuit of philosophical Truth. I’m sympathetic to that movement. But I’m not sure it really helps you understand the world as it is.

In the world as it is, people don’t make decisions based on Truth with a capital T. In general, people make decisions based on: 1) how they self-identify; and 2) what will benefit them personally. Rationalization takes care of the rest.

When have you heard an unemployed manufacturing worker say, “yeah, it’s a bummer to be out of a job but in the long run the aggregate gains from trade will outweigh losses like my job”?

In the world as it is, people operate much more like players on competing “teams.” They want their team (a.k.a tribe) to win. They are not particularly concerned with reaching stable equilibria across a number of games.

And that tribal competition game is probably the most important meta-game of all.

Monopoly Money

I predict we are going to hear a lot more about Modern Monetary Theory (MMT) in the next few years. I am not particularly happy about it, but I think it is the way the cookie will crumble.

To the extent the hard left wing of the American political spectrum has coherent economic principles they are grounded in MMT. And it is the hard left and right wings of the political spectrum that have the momentum these days.

Here’s the gist of MMT:

Governments that issue their own currencies are not budget constrained. In other words, government spending is not constrained by tax revenues. As long as a government issues its own currency, it can run perpetual budget deficits of any size. A sovereign currency issuer can’t go bankrupt. The MMT people are actually right about this, and in my view this is what lends MMT a superficial degree of credibility. Because the MMT people can point to deficit hawks and say, “The Rich are lying to you!” which is a message that sells.

Since they are not budget constrained, governments can spend whatever is necessary to ensure maximum employment and an arbitrarily high standard of living for the population. To the extent tax revenues fall short of the required spending, the government will simply run a deficit. Under MMT, you really can have your cake and eat it. The government need only decide everyone is entitled to as many cakes as he wants. In fact, the only reason we don’t have MMT today is nasty, greedy Elites perpetuate the myth of balanced budgets the keep the huddled mass of The 99% in check. That’s the MMT view, anyway.

Sure, you can get down into the weeds on any number of operational details. But the above is all you really need to know to get to grips with MMT.

Why MMT Is A Bad Idea

The MMT people are absolutely correct that a sovereign government that issues its own currency cannot go bankrupt. That doesn’t mean MMT “works,” or is a particularly good idea.

Two reasons spring readily to mind:

Even with fiat money, inflation remains a constraint on government spending. A government can spend as much as it wants, as long as someone is willing to hold its liabilities (a government liability is always an asset to someone else). Yes, in theory this amount is still unlimited. The Bank of Japan, for example, has printed an extraordinary amount of money with hardly a whiff of inflation. Ultimately, the amount of money a government can print is limited by its credibility. Fiat money is a faith-based system.

When people lose faith in government liabilities (a.k.a money), they abandon them for stores of value like land, gold, bitcoin, whatever. Hyperinflation results as people try to unload their monopoly money as quickly as possible while it still has some purchasing power. I remember reading stories about Zimbabwe’s hyperinflation in the mid-2000s. Prices would rise so fast people would take the bus to work in the morning but wouldn’t be able to afford a ticket on the way home.

Now, the MMT people will argue the government can use taxation to “mop up” excess liquidity and maintain price stability. Maybe it can. Maybe it can’t. Personally I am skeptical. Regardless…

…MMT would require a massive government apparatus to administer. Let’s call this apparatus Gosplan. Under MMT, Gosplan does the following:

  • Decides on the appropriate standard of living for all citizens
  • Calibrates government spending and money creation to meet that standard of living
  • Allocates labor between the private and public sectors via a job guarantee program
  • Sets tax policy in such a way as to maintain price stability without upsetting the rest of the apple cart

Simple, right? What could possibly go wrong?

I suspect things would ultimately go about as well as they have with every other centrally planned economy in history. (spoiler: not very well)

The Enduring Appeal Of MMT

Sadly, I fear MMT will continue to get traction. It is an easy sell. Under MMT, there needn’t be any scarcity. Gosplan will ensure full employment, price stability and a fantastic standard of living. If you dare to dream, you can make it real. It’s the perfect economic platform for the populist left. If I were a hard left politician, I would be out flogging MMT at every opportunity. “Cake for everyone!” I would tell the euphoric crowds. “One for having and one for eating!”

Like socialism more broadly, MMT appears to offer a convenient “out” from some of the nastiness and brutishness of the human condition. As Will and Ariel Durant wrote in The Lessons of History:

[T]he first biological lesson of history is that life is competition. Competition is not only the life of trade, it is the trade of life–peaceful when food abounds, violent when the mouths outrun the food. Animals eat one another without qualm; civilized men consume one another by due process of law.

In theory, MMT is attractive because it eliminates certain economic risks that individuals face, allowing them to live more dignified lives. That’s an admirable goal. But here’s the thing. Risk can never be destroyed. The best you can do is lay it off on someone else. And that’s exactly what MMT would do.

Sure, MMT might nominally eliminate unpleasantness like unemployment and poverty. But the underlying risk of economic imbalances wouldn’t be reduced. Imbalances would just shift around. Most likely they would reappear in the form of supply/demand mismatches, like shortages and surpluses of certain goods, and, eventually, serious inflationary pressure.

Update (09/13/18): In response to some responses I received on this post, and as a reflection of related conversations, I wrote a brief follow-up post. The follow-up makes it clearer my views of MMT have more to do with human behavior, incentives and risk management. This portion is particularly relevant:

Politicians are always and everywhere incentivized to run deficits and print money. Hand politicians a license to run deficits of arbitrary size and they will print and print and print. This isn’t left versus right political thing. This is a human nature thing.

Under MMT, it would be up to self-interested politicians and their appointed bureaucrats to ensure we don’t end up with hyperinflation. Self-interested politicians and appointed bureaucrats hardly have an unblemished track record when it comes to economic management.

Macroeconomics For Lazy Pragmatists

A friend asks:

I’m interested in your thoughts on how you would look at [macroeconomic] fundamentals [for international investing]. Presumably that would involve (among other things) looking at the top industries that drive the national economies?

This question inspired me. Now, I am not a “macro guy” and I am definitely not an academic. I am mostly concerned with understanding the handful of key drivers that might impact a given investment. So if you are a pedant you can quit reading now. You’re not going to find anything to like about this.

Have all the pedants left now?

Great. Before we get in to economic fundamentals it’s worth specifying the high level variables that shape every investment environment:

  • Economic growth prospects & fundamentals
  • Rule of law / protection of property rights
  • Asset valuations

The ideal investing environment is one with strong economic fundamentals; where the rule of law is upheld; and where cheap valuations are cheap. The stars will almost never align in this way, if for no other reason that if the first two variables are looking good, you are going to have to pay up for assets. But that’s the dream, anyway.

This post will focus on the first bullet: economic growth prospects and fundamentals.

The Most Important Things

Before we go any further, I need to emphasize that investing is not as simple as saying: “oh GDP growth looks good so it’s a good time to invest.” In fact, there is essentially zero correlation between GDP growth and stock market performance. What macro analysis helps you do is assess the drivers and risks associated with an economy. When you consider those drivers and risks in relation to valuations, you can use them to help formulate and/or evaluate various investment cases.

Seth Klarman said it best: every asset is a buy at one price, a hold at another price, and a sell at another.

Note that all of this is addressed toward folks who are thinking of investing with a fundamental view over a multi-year time horizon. If you are trying to swing trade currencies you will need to look at the world very differently. (And good luck with that, by the way)

Some of you might say, “well I will be a contrarian and just push money into bombed out economies where stocks trade on single-digit PEs and mean reversion will do the heavy lifting.” That’s all well and good. But if you really think this way I would expect to see a not-insignificant exposure to places like Russia, Brazil and Turkey in your portfolio today.

Otherwise quit kidding yourself. You are a phony.

Why Macro Matters

I talk to a lot of investors who say “we’re bottom-up stock pickers” as if the macroeconomic environment somehow has no impact on their portfolios. I am not sure if these people are genuinely delusional or if this is just something they are used to putting in their pitch decks and have come to recite by rote without thinking.

If you genuinely believe this I think you are reckless at best and a complete idiot at worst. Of course the macroeconomic environment matters. At the very least it shapes the opportunity set.

We also do people a huge disservice by teaching them economics as if it’s physics. Not only is it obnoxiously intimidating but it lends economics a false sense of precision. I believe we should really teach economics using an ecological framework. Macro fundamentals define our economic habitat. There is often a feedback loop between macro fundamentals and investor behavior. If you can develop actionable insights into that feedback loop, you can make a lot of money.

So what we’re really doing with macro analysis is trying to understand our habitat. Thinking about it this way de-emphasizes making point estimates of future economic growth, which are notoriously inaccurate.

What Does a Healthy Habitat Look Like?

In the natural world, we can evaluate the health of an ecosystem based on its values. Here are some ecosystem values courtesy of the EPA:

Ecosystem_Values
Source: EPA.gov

Economies can be evaluated along similar lines:

  • “Biotic Resources” (Demographics)
    • Is the labor force growing?
    • Is the labor force becoming more or less productive?
    • How educated and innovative is the labor force?
  • “Biodiversity” (How Diversified Is The Economy?)
    • Is economic activity highly concentrated in particular industries? If so, what are their characteristics?
    • Is there a diverse array of financial market participants providing ample liquidity? Or are markets fragmented and illiquid?
  • “Energy & Nutrients” (How Is The Economy Financed?)
    • What does national income look like?
    • Is there a current account deficit? If so, is the country heavily dependent on external debt?
    • Where is the economy in the credit cycle?

More Energy & Nutrients

I want to spend a little more time on “Energy & Nutrients” as this is where many of the traditional textbook macro concepts come into play. More importantly, when this area of the ecosystem gets squirrelly, really nasty outcomes tend to result. Financial crises and deep depressions and hyperinflations and such.

Let’s start with the classic GDP identity:

GDP = Government Spending + Consumer Spending + Investments + (Exports – Imports)

More commonly written as:

GDP (or Y) = G + C + I + (X-M) 

Most of this is pretty self-explanatory, but the X – M term bears further scrutiny. This term is also called the “current account.” If it is positive you are net exporter (trade surplus) and if it is negative you are a net importer (trade deficit). Negative current account balances must be financed somehow. Countries do this either by selling claims on their assets to foreigners or by drawing down foreign currency reserves.

You can decompose and rearrange this identity in various ways. I’m not going to spend a bunch of time doing that here. You can find plenty of resources online. For now just trust me when I say the current account is equal to the difference between investment and domestic savings.

This is a critical concept because there are three and exactly three ways to finance private investment (a.k.a economic growth): 1) out of consumer savings, 2) with a current account (trade) surplus, 3) debt and equity issuance.

There is a school of thought among certain individuals that trade deficits are always and everywhere evil. That issue lies well beyond the scope of this post. What’s more relevant is the potential for dangerous imbalances to build up inside economies dependent on external financing. Dangerous imbalances are the stuff of financial crises, political revolutions and sovereign defaults.

The Example of Egypt

The Egyptian economy is a disaster.

For much of the recent past Egypt was dependent on direct foreign investment and tourism for foreign currency to fund its current account deficit (Egypt imports significant quantities of food and fuel). These sources of financing dried up following the country’s 2010 revolution and ensuing political turmoil, draining foreign currency reserves, driving up government debt levels and ultimately forcing a devaluation of the Egyptian pound (which is pegged to the dollar in a futile valiant effort to maintain price stability).

Egypt_Current_Account
Source: Trading Economics
Egypt_FX_Reserves_USD
Source: Trading Economics
Egypt_Govt_Debt_GDP
Source: Trading Economics

Essentially, the Egyptian government printed money to finance economic activity. Naturally, this resulted in a dramatic spike in inflation.

Egypt_Inflation
Source: Trading Economics

Needless to say this is a fragile ecosystem (spoiler: most developing economies are). That doesn’t mean all Egyptian securities are automatically bad investments. However, it has direct implications for the kind of margin of safety you should demand when considering an investment.

You will notice I haven’t said anything about the domestic credit cycle. That’s because I’m not going to bang on about the credit cycle here when I can just have you watch Ray Dalio explain it in a slick YouTube video.

To Conclude: A Brief Note On Currencies

I picked the Egypt example above because of the currency component. Currency is an important wrinkle in international investing. There are lots of different approaches to currency valuation but longer term investors should mostly be focus on the idea of purchasing power parity. All else equal, a basket of goods in Country A should cost the same as an identical basket of goods in Country B.

In the real world all else is not equal. Namely: inflation. So if inflation is 2% in Country A and 10% in Country B, we would expect Country B’s currency to depreciate by 8% relative to Country A.

Purchasing power parity tends to hold up pretty well over long time horizons. In the short term, however, divergences can be significant. For our purposes the important thing to recognize is that a country’s national income and balance of payments have a direct impact on the inflation rate. Inflation differentials are important variables to consider when making international investments, because they influence the currency component of the investment return, which can be significant.

How Much Is Enough?

Money is a funny thing. As a unit of exchange it is the raw material for consumption (or, if you prefer, the deferral of consumption). We express who we are through our spending. It’s no surprise then that the answer to “how much is enough?” varies wildly from person to person. But really what it boils down to is an optimization problem.

Contrary to what people think, the hard thing about answering “how much is enough?” is not calculating a dollar amount. The hard thing is deciding what constraints to apply to optimization. Once you do that, the calculations pretty much fall into place on their own.

At a high level, we are looking at the following function (let’s call it the Enough Function):

Enough = Present Value of (Future Lifestyle Spending + Future Basic Needs Spending + Desired Margin of Safety)

Obviously you can disaggregate each component (Basic Needs Spending would break down into line items like “Housing” and “Essential Food”). For the purposes of this post I’ve opted for brevity.

In principle optimizing the Enough Function is pretty straightforward. In practice people find it difficult for a couple of reasons. For one, most people live like sheep. They follow the examples set by advertisers, movies, TV shows and the people around them.

We can partly blame evolution for this. A million years ago if you didn’t fit in with the rest of your tribe you would be ostracized and could look forward to dying cold, hungry and alone. We are a long way from those days and yet our evolutionary programming dies hard. Most people have not spent much time thinking what actually gives their lives meaning. So they look for meaning elsewhere.

On a more mundane level, quantifying a margin of safety can also be tricky. There is just no way to gain absolute certainty. Margin of safety is best addressed with scenario analysis, which is beyond the scope of this post. In fact, for people who are totally lost when it comes to this stuff, a good reason to hire a professional financial planner is to delegate the analytical work to someone with expertise.

I don’t have a position on whether it’s “better” to live frugally or not. If we’re looking at the continuum of spending patterns, with Mustachianism on the frugal end and Kardashian-esque conspicuous consumption on the other, I suspect most people plot somewhere in the muddy middle.

Personally, I tilt a little more toward the frugal end of the spectrum. The main reason for this is that most of the things I enjoy doing (reading, writing) are not particularly expensive pursuits. But do I think people who want to drive nice cars and live in big houses and spend lots of money on clothes and jewelry are “doing it wrong?” No. Their Enough Functions are just optimized for a different set of constraints.

The Root Of All Most Financial Problems

Financial problems result from mismatches in the optimization of the Enough Function and the financial resources at hand.

It is okay to make a ton of money and live the high life. It is not okay to make very little money and live the high life. Unless you are optimizing for a crushing debt load and eventual bankruptcy, of course. Fortunately, if you find yourself in this position there are a couple levers you can pull: spend less or make more money.

Like I wrote above, this stuff is really simple in principle. The challenge comes in the implementation, but it’s mostly a challenge of self-discipline (on the spending side) and hard work (on the income side).

The Trouble With Truth

A friend and I have been having a running conversation about the “post-truth era” and bias in the media. This post is an attempt to pull the ideas from those conversations together into a kind of mental model.

Essentially there are three issues in play here: epistemic uncertainty (the problem of induction), cognitive biases and incentive systems.

The first two help explain why otherwise intelligent and well-meaning people can come to inhabit echo chambers when they otherwise seek to reason objectively. Incentive systems then reinforce the sub-optimal behavior of well-meaning people and assist opportunists and charlatans in spreading outright falsehoods.

This post is not meant to address opportunists and charlatans as their motives are things like wealth, power and ideological fanaticism. For these individuals the truth is simply an inconvenient speed bump along the road to power. Rather, I am interested in how the uncertainty inherent in scientific reasoning leaves openings for multiple truths and seemingly contradictory bodies of evidence.

Epistemic Uncertainty

How can we know a thing is true in the first place? That seems like a good place to start.

Broadly speaking, we can reason deductively or inductively. Deductive reasoning is a process that arrives at a “logically certain conclusion.” Deductive reasoning is what you do in math class. The beauty of mathematics, which I did not properly appreciate as a kid, is that it is about the only discipline where you can know with certainty when you are right. Your conclusion must follow inevitably from your premises. It cannot be otherwise.

Inductive reasoning, on the other hand, takes specific observations and then infers general rules. Importantly, the scientific method is a form of inductive reasoning. All of the social sciences, including economics, utilize inductive reasoning. Inductive reasoning is subject to the so-called “problem of induction.” Namely: inferences are not “logically certain.”

The classic example involves swans. For a long time people believed all swans were white. This was an inference based on the fact that in every recorded observation of a swan, the swan had been white. Critically, this did not prove all swans were white. In order to prove all swans were white, you would have to observe every swan in existence, every swan that had ever existed, and every swan that ever would exist. That is of course impossible. And in fact, as soon as someone discovered a black swan (in Australia in 1697), the inference that all swans were white was immediately proven false.

That’s not to say the inference was a bad one. It was perfectly reasonable given the available data. You see how this presents issues for science, and any other truth-seeking endeavors. Even “good science” is often wrong.

If you have spent any time reading scientific research, you are familiar with the way hypotheses are formulated and tested. It is never a question of “true or false.” It is a question of “whether the null hypothesis can be rejected at such-and-such a confidence interval.”

What confidence interval is appropriate? The gold standard is 95% (a.k.a. within two standard deviations of the mean, assuming normally distributed results). However, there is a healthy debate over where that threshold should be set.

The probabilistic nature of induction results creates epistemic uncertainty. In that sense, there is no post-truth era. There has never really been an era of truth, either. Science has never really given us truth. It’s given us inferences, some of which have withstood many years of repeated testing (evolution, Newton’s laws, etc.), and to which we’ve assigned extremely high levels of confidence. In other words: we are pretty damn sure some things are true. Sure enough we can do things like send satellites out of our solar system. But it’s still not logical certainty.

In other areas, science has given us inferences where confidence levels are much lower, or where there is significant debate over whether the inference if of any significance at all. Many scientific studies don’t replicate.

The point of this is not to argue we should junk science or inductive reasoning. It’s to show how even if two parties use scientific reasoning in good faith and with the exact same methodology, they might arrive at different conclusions. How do you resolve the conflict?

To function properly, the scientific method requires friction. Replication of results in particular is critical. However, when we layer on cognitive biases and political and economic incentives, scientific inqiuiry and other inductive reasoning processes become distorted.

Cognitive Biases

Humans are funny creatures. Our brains evolved to deal with certain specific problems. It was not that long ago that the issues of the day were mainly things like: “can I eat this mushroom without dying?” and “that animal looks like it wants to eat me.”

Evolution did not optimize human brains for analyzing collateralized loan obligations.

I am not going to rehash the literature on cognitive biases here. If you are interested in a deep dive you should read Thinking, Fast and Slow, by Daniel Kahneman. Rather, I want to mention one bias in particular: confirmation bias.

Instead of looking for evidence that their inferences are false, people look for evidence that confirms them. The Wiki for confirmation bias calls it “a systematic error of inductive reasoning.” There is a saying among quants that if you torture data long enough it will say whatever you want it to. These days we have more data than ever at our fingertips, as well as new and exciting torture methods.

Importantly, confirmation bias does not represent a conscious decision to lie or deceive. People who consciously manipulate data to support a hypothesis they know ex ante to be false are opportunists and charlatans. We are not concerned with them here.

People aren’t evil or stupid for exhibiting confirmation bias. They just do. Intelligent people have to be especially careful about confirmation bias. They will be extra unconsciously clever about it.

You can probably see how combining this with inductive reasoning can be problematic. It creates a situation where everyone has “their” facts. What’s more, most people involved in research and reporting operate within incentive systems that encourage confirmation bias rather than mitigate it.

Incentives

If people tend to seek out information confirming their views, it is only logical that media businesses pander to that tendency. The media business is first and foremost an attention business. Either you have people’s attention or you don’t. If you don’t, the subscribers stop paying and the advertisers don’t want to be on your platform and pretty soon you are out of business. It behooves you to serve up the kinds of stories your readers like reading, and that align with their worldviews.

Likewise academics face their own pressures to conform with peers. Academic departments are subject to the same power games and politics as corporate boardrooms. Reputation matters. Particularly given the importance of tenure to young faculty. Also, if you are an academic star who has built a 40-year reputation on the back of a particular theory, how much incentive do you have to want to try and poke holes in that? If you think these dynamics don’t impact behavior, you don’t know very much about human behavior.

Closer to home for this blog, at hedge funds and mutual funds analysts often receive bonuses based on how their ideas perform once they are in a portfolio. But what if you are the analyst covering a weak opportunity set? The right thing to do is throw up your hands and say, “everything I am looking at sucks.” But if you go that route you can look forward to no bonus and possibly being fired. So instead you will sugar coat the least bad ideas and try to get them into the book.

Putting It All Together

So here we have it, from start to finish:

  • Many forms of “knowing,” including the scientific method, are forms of inductive reasoning. Inductive inferences are subject to uncertainty and potential falsification. This means there is always an opening for doubt or contradictory evidence. We accept certain scientific principles as true, but they are not actually logical certainties. Truth in the sense of logical certainty is not as common as many people think.
  • Due to cognitive biases, especially confirmation bias, people distort the process of scientific inquiry. Rather than seek information that could falsify their existing beliefs (the correct approach), they seek out information that confirms them. People have “their facts,” which they can back up with evidence, which in turn creates multiple, plausible versions of “the truth.”
  • Economically, media companies are incentivized to appeal to peoples’ cognitive biases. The economics of media incentivize a continuous feedback loop between content producers and consumers. Academics and other researchers are also incentivized to confirm their beliefs due to issues of reputation, professional advancement and compensation.

Mental Model: Time Dilation

Time dilation is a consequence of relativity in physics. Put simply: individuals moving at different speeds perceive time differently. The most extreme example of this would be someone moving at the speed of light versus a stationary observer. For the person traveling at the speed of light, time measured from the point of view of the stationary observer would appear to have stopped.

Crazy, right?

Take a moment and allow that to sink in. It is pretty wild to think about. It took me two passes through A Brief History of Time before I felt like I had a decent handle on the concept.

Below is a fun animation to help illustrate.

Nonsymmetric_velocity_time_dilation
Time dilation illustrated. The motion inside each “clock” represents the perceived passage of time from the blue clock’s perspective. Source: Wikipedia

In financial markets, we experience our own form of time dilation. A high frequency trader experiences time differently than Warren Buffett. Here the relative velocity we are concerned with isn’t physical motion, but rather the velocity of activity in a portfolio of financial assets. The more you trade, the slower time moves for you.

Below are two charts for AAPL, one for the last trading day and one for a trailing 1-year period. All the price action depicted in the first chart is imperceptible on the second.

AAPL_1_Day
Source: Google
AAPL_1_Year
Source: Google

This idea of time dilation presents significant challenges for investment organizations.

The first challenge is the friction it creates between stated investment horizons and performance measurement. It is tough to manage money to a three or five-year horizon if your investors are measuring performance monthly. With that kind of mismatch, stuff that wouldn’t seem significant over three or five years starts to look significant (in a way, it is). And so you are tempted to “do stuff” to keep your investors happy.

While you should be focused on the “signal” from annual reports, you get bogged down in the “noise” of quarterly fluctuations in earnings. Or, god forbid, daily and weekly newsflow. Unless you are a proper trader, nothing good ever comes of focusing attention on daily and weekly newsflow.

Also, since people pay money for investment management, it is easy for them to mistake large volumes of activity for productive activity. Yet, just because you “do a lot of stuff” doesn’t mean your results will be any better. In fact, plenty of empirical evidence argues the opposite. The more “stuff” you do, the worse your results will be.

Here is an example of market time dilation from Professor Sanjay Bakshi. Years ago he executed a “very cool” arbitrage trade involving Bosch stock for a triple digit IRR. That’s an objectively fantastic result. And yet, Prof Bakshi readily admits to missing the forest for the trees. Why? He was operating on a different time horizon.

bakshi_bosch
Source: Professor Sanjay Bakshi

You can judge whether someone truly has a long term mindset based on how he feels about being “taken out” of a stock in a merger or buyout. Long-term thinkers don’t like to be taken out of their positions! They would rather compound capital at 20% annually for 30 years than have a 100% return in a single year.

They all explain this the same way: there aren’t that many businesses capable of compounding value at 20% annually for 30 years. When you find one you should own it in size. Selling it should be physically painful. Only phony long term thinkers are happy about getting taken out of good businesses.

Now, that’s certainly not the only way to make money in the markets. The trick isn’t so much finding “the best way” to make money as it is genuinely aligning your process with your time horizon. This is not a trivial thing. Particularly if you manage other people’s money.