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.
The Lessons of History is a distillation of the key themes of the longer work. It’s the cliffs notes for The Story of Civilization.
As you read, a couple of key premises emerge: 1) history is a competitive evolutionary process, and 2) that process is cyclical.
A key driver of these cycles is the tendency for market systems to create wealth inequality over time. There isn’t anything nefarious about that. I don’t read it as a pejorative, either. It’s just the way things work. Mostly because wealth, when managed properly, compounds over time. It’s not just compound interest I’m talking about here. It’s economic opportunity more generally.
The Durants sum this up in a single, beautiful little paragraph (my favorite in the whole book):
We conclude that the concentration of wealth is natural and inevitable, and is periodically alleviated by violent or peaceable partial redistribution. In this view all economic history is the slow heartbeat of the social organism, a vast systole and diastole of concentrating wealth and compulsive recirculation.
An entire chapter on socialism follows. “[H]istory so resounds with with protests and revolts against the abuses of industrial mastery, price manipulation, business chicanery, and irresponsible wealth,” the Durants observe. “These abuses must be hoary with age, for there have been socialistic experiments in a dozen countries and centuries.”
One example, from China:
Wang Mang (r. A.D. 9-23) was an accomplished scholar, a patron of literature, a millionaire who scattered his riches among his friends and the poor. Having seized the throne, he surrounded himself with men trained in letters, science, and philosophy. He nationalized the land, divided it into equal tracts among the peasants, and put an end to slavery. Like Wu Ti, he tried to control prices by the accumulation or release of stockpiles. He made loans at low interest to private enterprise. The groups whose profits had been clipped by his legislation united to plot his fall; they were helped by drought and flood and foreign invasion. The rich Liu family put itself at the head of a general rebellion, slew Wang Mang, and repealed his legislation. Everything was as before.
The relationship between free market capitalism and socialism is cyclical. It’s a yin and yang type of deal. When inequality under capitalism causes enough friction, and social cohesion decays enough, people gravitate toward the utopian promises of socialism. Then, as the socialist system ossifies under the dual pressures of complexity and inefficiency, it becomes vulnerable to unexpected shocks. Eventually, people overturn the socialist system and return to free market capitalism. The cycle begins again.
The last bit of the book is devoted to the idea of “progress.” If all history is cyclical, does progress actually exist? If so, how do we measure it? I won’t spoil it for you, since this last chapter does a nice job of tying everything together.
Who Should Read This Book?
Literally everyone should read this book. It is a short read, easy to follow and relevant to every human being on the planet. This is the type of “Big Idea” book that helps you see the world as it is, rather than how you want to see it.
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.
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 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.
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.
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.
Golf is a weird game. Playing well is actually fairly demanding physically (assuming you are walking). It requires core strength and good hand-eye coordination. But what makes golf truly weird is the mental dimension. Sure, all sports have a mental dimension. But golf is especially mental. If your head is not right, you will play terribly.
Every Shot Must Have A Purpose, by Pia Nilsson and Lynn Marriott, is described early on as “a life philosophy, not merely a golf instruction book.” It is therefore relevant for anyone engaged in any complex and mentally demanding endeavor (read: investing). Given the nature of this blog, I’m going to focus on the broader relevance of the ideas in the book.
There are a handful of Big Ideas in this book:
Focus on process, not outcome
Learn to bring yourself from heightened emotional states back to neutral
Trust your swing. It is your signature.
All of this is relevant for investors. Even the part about trusting your swing. I’ll take them in reverse order.
Trust Your Swing
On trusting your swing, Nilsson and Marriott write:
If you can hit the shots you want under pressure, your swing is working. What is important is to make up your mind what swing you believe in, and to have the discipline not to abandon that belief because of a bad round or two. To be in “search-and-scan” mode never works over time. Find your swing, trust it, and stay committed to it.
For the investor, your “swing” is your investing discipline. It is the value creation mechanism(s) that will compound the value of your capital over time.
Classical Ben Graham value investing is a swing form. Munger and Buffett-style value investing is a swing form. Momentum investing is a swing form. All of these swing forms “work” because they are fundamentally sound in terms of economic principles and investor behavior. Just like the golf swing “works” because it is grounded in the laws of physics.
What does not work very well is trying to time different styles to chase “what’s working” at a given point in time. This is the equivalent of trying to rebuild your golf swing from scratch after every round where you score poorly. Both are a recipe for poor future performance.
Bring Yourself Back To Neutral
It is fun to take a pitching wedge from 90 yards out and land a perfect strike six feet from the pin. When you hit a shot like that, you literally get high. But when you chunk a five iron thirty-five yards from a perfect lie in the middle of the fairway, you crash.
Experiencing wild emotional swings is not a recipe for consistent golf.
Likewise in investing, you get high when a stock doubles in three months. You crash when a name halves on some seemingly random exogenous event.
How many times have you hit your tee shot into the trees and then, in a fit of anger, tried to do too much with your second shot and ended up making a triple bogey? The disappointment with the drive leads you to attempt to erase the poor shot with one swing. And we all know how that works out. More often than not, a gamble is greeted with a ball clunking off a tree or remaining in the rough.
The frustrating thing is that on many of those occasions, when you looked back at the round you wondered why you didn’t just pitch back to the fairway and settle for a bogey–or maybe a one-putt par. Anger opens the door to a variety of mistakes: bad decisions, hesitant swings, rushed tempo, and even not seeing the line to the target clearly.
Consistent performance starts internally, with how you regulate your emotions. The goal isn’t to become a robot impervious to emotion. I don’t think such a thing is possible. And even if it is, it’s certainly not healthy. The goal is that whether you hit a good shot or a bad shot (whether an investment is a winner or a loser) you are able to bring yourself back to a neutral state of focus, where your attention is on executing the shot in front of you.
Focus On Process, Not Outcome
One of the reasons golfers–professionals as well as recreational players–can’t take their games from the range to the course is that, in the current practice culture, they are two different experiences. Just as we try to unify the mental with the mechanical aspects of the game, we also must try to erase the line between practice and playing. We want to teach you to play when you practice and practice when you play. In the end, it all has to be about executing golf shots with total commitment when it matters most. To do this you have to learn that playing needs to be a process focus and not score focus.
It’s not that different in investing. Particularly in situations where you have to make a buy/sell/hold decision under pressure. Thinking about the score (returns) doesn’t do any good here. If anything, you’ll fall victim to the disposition effect.
Who Should Read This Book
Anyone trying to improve her golf game should read this book. Investors and other professionals who golf (regardless of skill level–I think I am a 25 handicap) can also benefit from applying these concepts to areas outside the game. I would not recommend the book to non-golfers, as it’s hard to relate if you haven’t struggled through learning the game or fought through some difficult rounds.
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
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.
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).
Essentially, the Egyptian government printed money to finance economic activity. Naturally, this resulted in a dramatic spike in inflation.
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.
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.
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).
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.
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.”
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.
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.
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.
One of my favorite bits of life advice comes from Mark Cuban. A couple of years ago, Business Insider wrote a brief piece on his view that surprisingly few people are willing to put in the effort to gain a knowledge advantage in their fields. I remember it to this day, because it is consistent with much of my experience in the working world.
“I remember going into customer meetings or talking to people in the industry and tossing out tidbits about software or hardware,” he writes. “Features that worked, bugs in the software. All things I had read. I expected the ongoing response of: ‘Oh yeah, I read that too in such-and-such.’ That’s not what happened. They hadn’t read it then, and they still haven’t started reading it.”
Cuban says that despite a minimal background in computers, he was outperforming so-called experts in the field simply because he put time and effort in. It’s why, he writes, he still allocates a chunk of his day to reading whatever he can to gain an edge in the businesses he’s involved in.
“Most people won’t put in the time to get a knowledge advantage,” he writes.
Another quote that sticks in my head along these lines (I don’t recall exactly where I heard this, and it’s possible I’ve fused a couple different quotes together):
“If you aren’t passionate about what you’re doing, don’t ever make the mistake of competing with someone who is. You will lose every time.”
Ray Dalio’s Principles is two books in one. It is half autobiography and half instruction manual for living a meaningful life, both at home and at work. This book is more about philosophy, personal values and self-improvement than financial markets. Supposedly Dalio is working on a second book about investment principles, however.
For those who may be unfamiliar with Ray Dalio, he is the founder of Bridgewater Associates, one of the most successful investment firms of all time. Bridgewater more or less invented risk parity strategies with its All Weather Fund.
What I did not realize until reading this book was that Dalio went through an extremely difficult period in the early 1980s, where he was on the edge of bankruptcy in the wake of a bad macro bet. This experience informed much of his personal development, and it shows in the book.
The essence of Principles comes through in the following lines:
There is nothing more important than understanding how reality works and how to deal with it. The state of mind you bring to this process makes all the difference. I have found it helpful to think of my life as if it were a game in which each problem I face is a puzzle I need to solve. By solving the puzzle, I get a gem in the form of a principle that helps me avoid the same problem in the future. Collecting these gems continually improves my decision making, so I am able to ascend to higher and higher levels of play in which the games gets harder and the stakes become ever greater.
All sorts of emotions come to me while I am playing and those emotions can either help me or hurt me. If I can reconcile my emotions with my logic and only act when they are aligned, I make better decisions.
The book lays out a model for living a meaningful life, however you choose to define “meaningful.”
Who Should Read This Book
There is something here for everyone, regardless of whether you have any interest in Ray Dalio, Bridgewater Associates or financial markets. You could skip the autobiography and go straight to the principles themselves if you prefer, though I felt they were more impactful with the autobiographical details in mind.
Investment nerds will enjoy delving into he history of Bridgewater from Dalio’s point of view, as well as some high level insight into Bridgewater’s investment process and culture.