The Tyranny of Optimization

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

–Will & Ariel Durant, The Lessons of History

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

I was a fool to believe this.

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

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

So what’s a frustrated optimizer to do?

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

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

Russland-Nord, Erschießung von Partisanen

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

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

So, what’s a reformed optimizer to do?

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

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

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

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

In finance nerd terms: mind the tails.

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

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

That insight is in short supply among technocratic optimizers.

Why I Write

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

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

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

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

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

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

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

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

You Can’t Borrow Conviction

palumbo_callahan_barlow
Source: David Palumbo

“Nowhere left to go,” Barlow murmured sadly. His dark eyes bubbled with infernal mirth. “Sad to see a man’s faith fail. Ah, well…”

The cross trembled in Callahan’s hands and suddenly the last of its light vanished. It was only a piece of plaster that his mother had bought in a Dublin souvenir shop, probably at a scalper’s price. The power it had sent ramming up his arm, enough power to smash down walls and shatter stone, was gone. The muscles remembered the thrumming but could not duplicate it.

[…] And the next sound would haunt him for the rest of his life: two dry snaps as Barlow broke the arms of the cross, and a meaningless thump as he threw it on the floor.

[…] “It’s too late for such melodrama,” Barlow said from the darkness. His voice was almost sorrowful. “There is no need of it. You have forgotten the doctrine of your own church, is it not so? The cross… the bread and wine… the confessional… only symbols. Without faith, the cross is only wood, the bread baked wheat, the wine sour grapes.”

–Stephen King, ‘Salem’s Lot

Whenever the market falls, you start to see symbol-waving. This famous Charlie Munger quote about equity drawdowns, for example:

If you’re not willing to react with equanimity to a market price decline of 50% two or three times a century you’re not fit to be a common shareholder, and you deserve the mediocre result you’re going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations.

This is core doctrine for the Church of Value Investing. It works for Charlie because Charlie has Faith. Unfortunately, many of us who wave the symbols of Buffett and Munger in the face of Scary Things do not, in fact, have Faith. We fancy ourselves members of the Church of Long-Term, Buy & Hold Investing when times are good. But when things go bump in the night, we find ourselves waving cheap plaster crosses at the drawdown monster.

barlow

And it works about as well for us as it did for Father Callahan.

So we make arbitrary changes to what are meant to be long-term asset allocations designed to capture structural risk premia. We fiddle with exotic alternative strategies we don’t properly understand. We sell to cash without any idea how we’ll convince ourselves to buy back in. We seriously damage our chances of achieving our long-term objectives.

This chart?

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Source: CRSP

This chart is a plaster cross. I show it specifically because it’s the most common exhibit financial advisors use to harp on “a long-term view” in client presentations.

But if you don’t believe equities should earn a structural premium over gold or T-bills or credit over very long periods of time, this chart will do nothing whatsoever to help you when your equity holdings halve. Same if don’t believe your portfolio has enough of a liquidity buffer to withstand a lengthy drawdown. You will waver. The drawdown vampire will snap your plaster cross and eat you.*

How do you build Faith?

Honestly, I had only the vaguest idea how to answer that question, so I punched it into Google and found this article (no idea what The Living Church of God might be–link isn’t an endorsement). Suggestions include:

Prove what you believe (or try to, anyway).

Study what you believe.

Endure the trials that arise as you go.

Because ultimately, there are no shortcuts to Faith.

Faith is a Process, not an Answer.

You can’t borrow conviction.

 

 

*Yeah, I know Barlow doesn’t actually kill Father Callahan in ‘Salem’s Lot. ‘Salem’s Lot purists can extend the metaphor and imagine the drawdown vampire turning them into unclean market-timers, doomed to wander the earth for all eternity with low returns and even less credibility.

Pity The Fools

Pity the babies of 1987 and 1990, then, who left school or university around the time that Lehman Brothers collapsed in 2008. Sending around a CV in the middle of the greatest financial crisis since their grandparents were born cannot have been a whole lot of fun.

That’s Tim Harford writing in the FT. As one of those babies of 1987, I can assure you it was indeed hell to send out resumes in the middle of the greatest financial crisis since my grandparents were born.

There are a lot of good articles out there about how your lived experience in markets and the world shapes your behavior. Here’s an especially good one from Morgan Housel.

So how did the financial crisis shape me?

Mainly, it made me paranoid.

It taught me talk is cheap.

It taught me no one’s entitled to a happy ending.

It taught me that money talks and bullshit walks.

It taught me you can do business with people who wield power and influence, you can respect people who wield power and influence, but you should never trust people who wield power and influence.

Most of all it taught me that at the end of the day, the only things you should count on are your skills and your character.

Don’t get me wrong. People can be wonderful. I’ve benefited from the support of many individuals who took an interest in my career development over the years. I will always and ever be grateful for the opportunities they offered me. Particularly in the early days, when I was a poorly-credentialed career changer with the wrong resume.

But here’s the thing about people. You can’t control their behavior any more than you can control the macroeconomy.

It’s Just Business

“Your father did business with Hyman Roth, your father respected Hyman Roth, but your father never trusted Hyman Roth.” – Frank Pentangeli, The Godfather, Part II

Frank Pentangeli is one of my favorite characters from The Godfather movies. He’s a lovable, old-fashioned gangster struggling to eke out a living in a brutal and cynical world. Frank’s fatal flaw is that he’s not smart enough to see all the angles. He never fully grasps how completely he’s at the mercy of forces much larger and more powerful than himself. He clings to a code of honor that seems increasingly outmoded as the plot evolves.

And so, it’s fitting that when Pentangeli finally goes out near the end of Part II, it’s not because someone whacks him. It’s because Tom Hagan convinces him the only way to salvage his honor and dignity is to off himself. The scene is one of the best in all three movies.

In Epsilon Theory speak, Frankie Five Angels is a lousy player of the metagame. (h/t to Epsilon Theory for inspiring this post, btw)

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Despite Frank’s obvious flaws, his acute sense of personal honor was useful when it came to judging the character of his business partners and counterparties. His most famous line (quoted above) is a testament to the fact you can always choose to do business with someone at arm’s length. Trust is not a prerequisite for a mutually beneficial business relationship.

So it is with the sell-side.

We do business with the sell-side. We respect the sell-side. But we should never, ever, under any circumstance trust the sell-side.

I was moved to reflect on this after another one of those “market outlook” meetings where a “portfolio specialist” (a salesman with his CFA designation) from a big asset manager comes and talks to you about how the next recession is at least a couple years away* and sure there some risks but nonetheless the fundamentals are sound. Oh and by the way have you looked at leveraged loan funds lately?

Sure, leveraged loan covenants suck, and the space is red hot, and investors will get burned eventually. But there’s still a couple years left in the trade.

Sure, high yield looks like a crap deal on a relative basis, but on an absolute basis there’s still a supportive bid for yield from foreign buyers.

Sure, this stock trades rich, but our analysts can see a path higher from here.

How many times have you heard this stuff? Or stuff that rhymes with this?

Our relationship with the sell-side should always and everywhere be a transactional relationship. But the goal of every great salesman is to turn a transactional relationship into a personal relationship. Personal relationships bring with them all kinds of social conventions and obligations. Unless you’re a complete sociopath, it’s nigh on impossible to behave in a transactional manner once a business relationship turns personal.

That doesn’t mean you can’t go to lunch with the sell-side.

It doesn’t mean you can’t use research from the sell-side.

It means you should never, ever under any circumstance allow yourself to believe the helpful guy or gal from the sell-side you have lunch with once a quarter is truly on your side of the table, always and everywhere with your best interests in mind.

If you do this, and you choose to trust these people instead of merely transacting business with them, you will eventually discover that they do not, in fact, sit on the same side of the table as you. They do not, in fact, suffer like you when the bill of goods they’ve sold you blows up.

And it’ll cost you.

*The next recession is always at least a couple years away.

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).

I Don’t Know

I think of myself as a reasonably intelligent person. I like to imagine myself as an independent thinker who is reasonably well-read. So for a long time, it was nearly impossible for me to say “I don’t know.”

I think there were several contributing factors here. Youthful arrogance (it seems young people chronically overestimate their competency); ambition (“it is good for my development and career prospects to be seen as capable and intelligent”); anxiety (“if I cop to ‘not knowing’ I am admitting I am not as smart and well-read as I line to think”).

These days I try to make “I don’t know” my default answer.

Charlie Munger models this behavior well. I read a transcript of the most recent Daily Journal Meeting, and it’s littered with stuff like this:

Question 2: My question relates to BYD.  Given that you’ve successfully invested in commodities in the past, how do you view investing in things such Cobalt, Lithium, and Helium as technologies of the future?

Charlie: Well I’m hardly an expert in commodity investing, but certainly cobalt is a very interesting metal.  It’s up about 100% from the bottom.  And it could get tighter, but that’s not my game. I don’t know much about…I haven’t invested in metals in my life much.  I think I bought copper once with a few thousand dollars.  I think that’s my only experience.

And this:

Question 8: Your thoughts on the valuation of software companies like Apple, Facebook, Google, Amazon, Alibaba.  Are they over-valued, potentially under-valued, too early to tell?

Charlie: Well my answer is I don’t know. (laughter) Next question. (laughter)

There are a couple of important benefits that come with a willingness to say “I don’t know.”

The first is that it helps combat conformation bias. Of all the behavioral biases, the one I suffer most from is confirmation bias: a tendency to seek out only information that confirms my (usually contrarian) view. Openly admitting “I don’t know” helps me maintain a more open mindset, and to loosen my grip on my ideas. If you get too entrenched in a position you risk developing what Dealbreaker jokingly refers to as “Ackmania.” Or some new strain of it, anyway.

Also, when you say “I don’t know” in conversation with someone else, you leave them an opening to teach you something new. No only that, but you are likely to develop a deeper relationship with that person. People love to talk about themselves and their areas of expertise.

Now, I am still more than willing to hypothesize about different things. Sometimes, for entertainment purposes, I even frame these hypotheses as statements of facts. But in my mind they are still just hypotheses.

Because most of the time I just don’t know.