ET Note: Hyakujo’s Fox

(Disclosure: This is another one of those philosophical posts that (optically, at least) has nothing to do with finance or investing. If you’re just here for the finance stuff you’ll probably be happier skipping it)

I’ve been slow to post on the blog lately. Partly because I moved houses recently, and partly because any remaining creative bandwidth had been eaten up by the idea for my most recent Epsilon Theory note.

Teaser:

Recently, a friend and I were texting about the meaning of life. (what? you and your friends don’t text regularly about the meaning of life?) My friend wrote that in the end, all you can really do is carry your cross to the finish line. I quite like this. It cuts right to the heart of the issue. There are no Answers. There is only Process. I did suggest adding an inscrutable Zen twist, however. My version:

In the end, all you can really do is carry your cross to the finish line. Except there is no finish line, there is no cross, and there is no you.

Read the whole thing at Epsilon Theory.

Must be something in the water lately as I discovered (only after my ET note was written) this Ribbonfarm post by Jacob Falkovich dealing with the “self” and cognition. The money shot:

When the part of your brain that monitors itself notices repeated patterns of thought it creates a high-level model called “self” that it can use for prediction. “I” am interpreting the sound as a stick hitting a woodblock. “I” suffer when in pain. “I” think of everything in terms of predictive processing. And “I” will likely continue to do so in the future.

But when a thought or interpretation arises that can’t be predicted from the habits of my mind, there is no reason to assign it to a consistent thinking “self”. The thoughts I’m used to thinking are mine, but the novel ones could be anyone’s or no one’s.

Have you ever had a random transgressive thought (or even a transgressive dream) that disturbed you? I certainly have. What’s disturbing about the experience is that some horrible idea originated within you. Some horrible idea that’s destabilizing to your conception of self. A “residual” in the predictive model for thought patterns.

Every religious tradition acknowledges the existence of these residuals. Broadly speaking, they’re sins. What differs across religions is how you treat them. In the Catholic tradition I was raised in, there is a whole guilt complex built up around our inherently sinful nature (it’s a bit less apparent in the kinder, gentler, post-Vatican II Catholicism I was raised with than the hellfire and brimstone Catholicism of my parents’ generation). Residuals represent corruption. To cleanse yourself of their taint, you seek absolution through confession and penance.

Zen takes a different view of the residuals. Among other things, it teaches you to see them for what they really are: random noise in your thought patterns. The Zen response to transgressive thought is simply to acknowledge it. Observe it the way you might observe a passing cloud. It will pass.

This is not at all to argue that the Zen tradition is “superior” to the Catholic tradition. It is, however, why I think Zen philosophy resonates more with me than the Catholic doctrine of my youth.

What I’ve found to be most challenging about Zen is squaring it with morality. Indeed, one of the most common reactions to my ET note was: I liked this but isn’t the message still that ‘nothing really matters’?

A true Zen master (which I am most definitely not) would whack us over the head with a stick for asking that question. Not only is it the wrong question, it is an irrelevant question. It is a question only a “deluded” mind stuck in a dualistic thought pattern would ask.

There is no good. There is no evil. The enlightened mind is beyond good and evil.

But doesn’t that mean you can justify anything?

Again, it’s the wrong question. Only a deluded mind requires an intellectual basis for moral action. Likewise, only a deluded mind would interpret “beyond good and evil” as “license to burn, rape and pillage.”

Put another way: even in religious traditions where a framework for determining “right” from “wrong” is made explicit, people still sin. Literally all the time. Hell, the Catholic Church I was raised in pretty much institutionalized the protection of child rapists. That fact doesn’t invalidate Catholic religious doctrine by any means. All religious institutions are flawed and corrupt to one degree or another, precisely because they are run by fallible humans. But it goes to show that a clear framework for moral behavior isn’t The Answer. To my eye, it’s not even half The Answer.

I conclude with a Zen story that addresses these “substance versus form” issues related to morality and moral action. It is one of my favorites.

Tanzan and Ekido were once traveling together down a muddy road. A heavy rain was still falling.

Coming around a bend, they met a lovely girl in a silk kimono and sash, unable to cross the intersection.

“Come on, girl” said Tanzan at once. Lifting her in his arms, he carried her over the mud.

Ekido did not speak again until that night when they reached a lodging temple. Then he no longer could restrain himself. “We monks don’t go near females,” he told Tanzan, “especially not young and lovely ones. It is dangerous. Why did you do that?”

“I left the girl there,” said Tanzan. “Are you still carrying her?”

ET Note: On The Great Jihad And Other Possible Futures

My latest note for Epsilon Theory is about possible futures. And Dune.

One of the recurring images in the book is what we in finance know as a probability tree. In the world of Dune, if you are at least a little bit psychic, and you amplify that psychic ability with a generous helping of hallucinogenic “spice,” you can catch a glimpse of the branching probability tree that is the as-yet-unrealized future.

Here in the investment and financial advice businesses, we, too, seem to have reached an evolutionary crossroads. I don’t claim to know exactly what the industry will look like in ten or twenty years. But like Dune‘s protagonist, Paul Atreides, I think I can peer through the haze of a spice trance to glimpse some of the branching possibilities.

Click through to Epsilon Theory to read the whole thing.

I got a lot of great feedback on this note. In reflecting on it, there are a couple points I wish I’d articulated or emphasized more explicitly.

Non-Linearity In Causal Relationships

The imagery of a probability tree used in the note is oversimplified. In reality, discrete paths do not lead inevitably to particular futures with such-and-such probabilities. Rather, events exert a kind of gravity on one another. (See: The Three Body Problem) For example, if MMT were to become the fiscal policy paradigm adopted by our fiscal policymakers, it wouldn’t “automatically” mean that X, Y, and Z would follow as consequences. Rather, the “gravity” of this event would shift the positioning of events in probability space.

A “better,” but more conceptually challenging way of thinking about this is in terms of the light cone used in special and general relativity.

A detailed exploration of the light cone concept is beyond the scope of this post (A Brief History of Time by Stephen Hawking offers a good, in-depth introduction if this topic piques your interest). For simplicity’s sake I’ll rip the relevant principles regarding causality straight from the light cone Wiki:

Because signals and other causal influences cannot travel faster than light (see special relativity), the light cone plays an essential role in defining the concept of causality: for a given event E, the set of events that lie on or inside the past light cone of E would also be the set of all events that could send a signal that would have time to reach E and influence it in some way. For example, at a time ten years before E, if we consider the set of all events in the past light cone of E which occur at that time, the result would be a sphere (2D: disk) with a radius of ten light-years centered on the position where E will occur. So, any point on or inside the sphere could send a signal moving at the speed of light or slower that would have time to influence the event E, while points outside the sphere at that moment would not be able to have any causal influence on E. Likewise, the set of events that lie on or inside the future light cone of E would also be the set of events that could receive a signal sent out from the position and time of E, so the future light cone contains all the events that could potentially be causally influenced by E. Events which lie neither in the past or future light cone of E cannot influence or be influenced by E in relativity.

As events “fire” in space-time, they dynamically shape the geometry of possible futures. Of course, when we think about this in the context of politics, geopolitics, or economics, it is important to acknowledge that events/signals “fire” with different levels of intensity–they create proportionally greater or lesser perturbations in probability space.

If someone were to shoot me dead tomorrow it would not even cause a ripple in global probability space. The event would really only impact probability space in a way that is localized to me and my immediate personal connections. Maybe my local community.

If the President of the United States were to be shot dead, however, the event would “shock” global probability space. A much wider range of possible futures are impacted, distorted, and/or brought into play, and on a much larger scale.

The concept of “blowback” is interesting to consider in this context. The term is used in the intelligence community to describe unintended consequences resulting from covert ops. For example, you arm and train some Islamic fundamentalist religious groups to fight communism during the Cold War. Decades later, the same fundamentalists are using their arms and training to commit terrorist attacks against you. Blowback results from our inability to precisely forecast changes in the geometry of probability space.

We are not Paul Atreides.

And for what it’s worth, if you’ve read Dune: Messiah, you know that even Paul’s prescient vision lets him down in the end.

Some Thoughts On Permabearishness

On a completely unrelated note, I think it’s worth making a few comments on bearishness and permabearishness in particular. If you are not familiar with the term “permabear,” it refers to someone who is constantly calling for the end of the world and therefore refuses to put capital at risk in the equity markets, or is chronically short equities. Sometimes people mistake me for a permabear because I spend a lot of time thinking and writing about economic and investment risks.

There is an important difference between spending a lot of time and energy thinking about risk and refusing to put capital at risk, or being chronically short equities.

Why do permabears exist? Some are cynical charlatans who are permabears because they make a living as permabears. Other permabears get one bearish call right and it leads them down a path of perpetual bearishness as a result of overconfidence in their own prescient vision (there is a Dune reference for everything).

In my view, the core failing of permabears is confirmation bias. They become so myopically focused on justifying their perpetually bearish stance that they lose sight of the fact that you don’t actually make much money (any money?) as a permabear.

The core tenets of my personal investment philosophy these days are the following:

Minimax Regret > Utility Maximization
Create Convexity

My affinity for barbell-type portfolios is the result. Rather than create “muddy” blends of fixed income and equity, strive for a convex risk/return profile. Use some method (simple annuity, permanent portfolio, T-bills) to create a kind of “floor” for a portfolio. Then take the remainder of your capital and place your high risk, high reward, high convexity bets. The goal is to create and maintain an asymmetrical risk/reward profile. Skewed to the upside, obviously.

To summarize:

It is not okay to be a permabear. In fact it is dumb to be a permabear.
It is okay to be a nervous bull.
It is okay to view the world through the lens of minimax regret instead of utility maximization (though you must acknowledge potential opportunity costs).

ET Note: Every Shot Must Have A Purpose

My latest note for Epsilon Theory is a golf lesson we can apply to our portfolios.

The most grievous portfolio construction issues I see inevitably seem to center on basic issues of strategy and commitment. Particularly around whether a portfolio should be built to seek alpha or simply harvest beta(s).

You don’t have to shape your shots every which way and put crazy backspin on the ball to break 90 in golf. Likewise, not every portfolio needs to, or even should, strive for alpha generation.

There are few things more destructive (or ridiculous) you can witness on a golf course than a 20 handicap trying to play like a 5 handicap. And it’s the same with portfolios. For example, burying a highly concentrated, high conviction manager in a 25 manager portfolio at a 4% weight. Or adding a low volatility, market neutral strategy to an otherwise high volatility equity allocation at a 2% weight.

Click through to Epsilon Theory to read the whole thing.

ET Note: The Life Aquatic

My latest for Epsilon Theory is about surviving and thriving in a highly financialized world. What’s financialization?

Financialization is all about using financial engineering techniques, either securitization or borrowing, to transfer risk. More specifically, financialization is about the systematic engineering of Heads I Win, Tails You Lose (HIWTYL) payoff structures.

In business, and especially in finance, we see this playing out everywhere.

Debt-financed share buybacks? HIWTYL.

Highly-leveraged, dropdown yieldcos? HIWTYL.

Options strategies that systematically sell tail risk for (shudder) “income”? HIWTYL.

Management fee plus carry fee structures? HIWTYL.

Literally every legal doc ever written for a fund? HIWTYL.

There are two ways to effectively handle a counterparty that has engineered a HIWTYL game: 1) refuse to play the game at all, 2) play the game only if you have some ability to retaliate if your counterpaty screws you. Legal action doesn’t count. The docs and disclosures are written to be HIWTYL, remember?

(aside: corporate borrowing can be viewed as management selling put options on a company’s assets. I’ll leave it to you to consider what that might imply about government borrowing)

You need to be in a position to hurt your counterparty for real.

You need to be in a position to hurt your counterparty economically.

A friend (who is not in finance) recently asked me about the relationship between the sell-side and the buy-side. His question was basically this: is the purpose of investment banking just to rip fee revenue out of people by whatever means necessary even if it involves deliberately misleading them to screw them over?

My answer is that the sell-side’s purpose is simply to facilitate transactions. For investment bankers, that means raising capital or advising on M&A deals or whatever. For sell-side research groups it means driving buy and sell transactions.

The sell-side does not exist to make you money.

You can do business with the sell-side. You can even respect the sell-side. But you should never trust the sell-side. The same goes for pretty much all business relationships. Especially transactional relationships.

We poke fun at the sell-side around here, but what we’re poking fun at is just the sell-side’s Buddha nature. The zen master Shunryu Suzuki described Buddha nature thusly:

“If something exists, it has its own true nature, its Buddha nature. In the Parinirvana Sutra Buddha says, “Everything has a Buddha nature,” but Dogen reads it in this way: “Everything is Buddha nature.” There is a difference. If you say, “Everything has Buddha nature,” it means Buddha nature is in each existence, so Buddha nature and each existence are different. But when you say, “Everything is Buddha nature,” it means everything is Buddha nature itself.”

If that’s a bit too inscrutable for your taste, consider the fable of the scorpion and the frog:

A scorpion asks a frog to carry it across a river. The frog hesitates, afraid of being stung by the scorpion, but the scorpion argues that if it did that, they would both drown. The frog considers this argument sensible and agrees to transport the scorpion. The scorpion climbs onto the frog’s back and the frog begins to swim, but midway across the river, the scorpion stings the frog, dooming them both. The dying frog asks the scorpion why it stung the frog, to which the scorpion replies “I couldn’t help it. It’s in my nature.”

ET Note: The Funnel

My latest for Epsilon Theory:

Lately I’ve been thinking about the mechanics of fiat news. By now we know what fiat news is: the presentation of opinion as fact. We know what fiat news looks like (pop on over to Vox and skim a few stories). But lately I’m more and more interested in how fiat news works.

The metaphor I like best is the medieval wolf trap.

Click through to Epsilon Theory to read the full piece.

Metastability

My latest Epsilon Theory note is about the metastability of social systems.

A social system remains metastable as long as there is a reasonably broad consensus regarding its core values and mythology. Without this consensus, metastability weakens. Put another way: first-order threats to social stability, such as isolated riots and street crime, are risks that lie in the body of the distribution of outcomes, both for individuals and society. Metainstability is a higher-order threat. The risks associated with metainstability lie in the tails of the distribution. They fall under the broad category heading of Really Bad Stuff and include things like:

violent revolution

war

property expropriation

Back to the Ants and the Grasshopper. Would it behoove the Ants to share a bit of food with the other insects to shore up the metastability of the forest’s social system?

You can read the whole thing at Epsilon Theory.

Metastability is a rich concept to explore. I didn’t spend a lot of time defining metastability in my ET piece, but I find it worthwhile to look at the concept through the lens of elementary calculus.

If you’re reading this blog, you’re probably familiar with the differentiation of the simple quadratic function f(x) = x^2. The first derivative (a.k.a “instantaneous rate of change”) of f(x) = X^2 is 2x. The second derivative of f(x) = x^2 is just the derivative of 2x, the constant, 2. This, in turn, can be interpreted as the “instantaneous rate of change” for the function f(x) = 2x.

So you can see there’s some mathematical intuition behind that old saw, “change is the only constant.” It’s rates of change all the way down.

These concepts show up in finance all the time. In fixed income, there’s an inverse relationship between bond prices and yields. The first derivative of this function is a bond’s duration. The second derivative is its convexity.

With an option, the payoff depends on the price of the underlying relative to the strike price at expiration. The sensitivity of the option’s price to changes in the price of the underlying is the first derivative of this relationship. This is the option’s delta. The second derivative of this relationship, the sensitivity of the option’s delta to changes in the price of the underlying, is the option’s gamma.

(homework: consider the CAPM or any other linear factor model of financial asset returns in this context)

Anyway, on to metastability.

Take a society at any given point in time.

Social stability is its first derivative. Social stability is the instantaneous rate of change for society’s consensus values and norms.

Metastability is the second derivative. Metastability is the rate of acceleration (or deceleration) of changes in social stability.

In the language of options traders, social stability is society’s delta. Metastability is society’s gamma. Unfortunately for society, it’s generally short gamma. Which is just a fancy way of saying change is dangerous. Change stresses human social systems. The greater the magnitude of social change, and the faster the rate of change accelerates, the greater the stress on the existing social order.

Want to destroy social order in a hurry?

Lose a big war. That typically gets the job done.

Of course, this also invites the question, how would you strengthen social metastability?

By cultivating shared values and mythology.

The most common negative responses to my ET piece were comments along the lines of “the ants shouldn’t have to ‘share’/the Grasshopper should have to ‘earn’.” That’s a fine point of view. But it’s only a first-order look at the issue. Heck, from a first-order perspective, I completely agree. But that says nothing about metastability. I wish I’d made this a bit more explicit in the original post, but I did elaborate in the comments.

Actually, as far as metastability is concerned, in the fable’s base case involving the ants and a single grasshopper, it’s perfectly fine to just let the grasshopper starve. A moral philosopher might challenge that view, but the moral philosophy of this is a whole other issue.

In fact, you can easily imagine the Ayn Rand version of my “extended edition,” where all the insects are strict utilitarians. Here there’d be no need for any “metastability insurance” because of a strong consensus around libertarian utilitarian values as the organizing principles for society.

Likewise, you can imagine a Scandinavian “extended edition” where all the insects are social democrats or whatever. That society may have a very different set of consensus values and an entirely different level of metastability.

This is what I’m driving at when writing about metastability as a reflexive process, and why the social contract is necessarily something that’s negotiated. The obnoxious, twenty-five cent word for this process would be “dialectic.” Outside of relatively small, culturally homogenous communities, it becomes increasingly difficult to establish a strong consensus around values. The example of Prussia used in the post is a prime example. The Prussian “solution” to the problem of forging consensus around shared values at scale was to bind cultural identity to the state. It worked pretty well. Too well, in fact.

Anyway, for the purposes of this post I’m not concerned at all with whether libertarian or social democratic values are inherently superior. I’m more concerned with the idea that at the scale of a large, technologically advanced nation-state, maintaining social metastability is a balancing act across different constituencies.

I think I will likely have more to say on this subject in future posts.

ET Note: The Grand Inquisition

Below is the teaser for my latest Epsilon Theory note. The piece is a meditation on freedom, through the lens of Dostoyevsky’s parable, “The Grand Inquisitor”:

The Nudging State and Nudging Oligarchy believe they are giving us a gift: Freedom from Choice.

Except that it is neither a gift nor freedom in any sense. Rejecting it isn’t always easy and it isn’t always costless. But it’s the only choice for anyone who would be free.

Click through to Epsilon Theory to read the whole thing.

There’s an idea embedded in this note, related to the specific mechanism through which the Nudging State engages in social engineering, which is worth making more explicit. I’ve written around the edges of it before on this blog, in The Tyranny of Optimization, when I wrote:

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.

What I’m describing here is what my friends at Epsilon Theory call “fiat thought.” These are thoughts and behaviors you believe are your own, though in reality they’ve been engineered by the Nudging State and the Nudging Oligarchy to promote some policy or behavior.

How do you test for fiat thought?

Ask why.

“Why do I believe [whatever]?”

For fiat thought, the answer is always some permutation of “because someone told me so.” Maybe that’s a politician. Maybe it’s a business leader. Maybe it’s a public intellectual or “thought leader.” Maybe it’s a go-to media outlet (or several). Bottom line is you won’t have a principles-based reason for believing whatever is at issue.

Having your thoughts replaced with fiat thought is perhaps the purest form of slavery I can imagine. It’s like being transformed into a pod person, except you don’t even realize the transformation is taking place. In fact, to the extent you notice the transformation at all, you’ll believe it was your own idea. This is the nature of “choice architecture.” It’s a kind of rigged game–a simulation of free will.

In reading some of the responses to my note, there are a couple common threads:

Aren’t constraints on our behavior necessary to some extent to have a functional society?
Most of the folks who serve the State do not have malicious intentions and are sincerely doing the best they can to balance tradeoffs when making policy.

These are both excellent points. I totally agree with both of them.

Constraints on our behavior and incentive systems are terms we negotiate as part of the social contract. The negotiation process is ongoing and dynamic. It never ends. An important aspect of freedom is the ability to participate in the negotiation process as a principal. “Nudgers” do not treat us as principals. Nudgers treat us as biological systems to be engineered.

ET Note: Kobayashi Maru

I suspect I have some significant reader overlap with Epsilon Theory, but for those of you who aren’t also ET readers (you should be, btw), I was recently invited to contribute to the site. Perhaps needless to say, I jumped at the opportunity. I’m excited to join Ben, Rusty, Peter, Neville and David on a platform offering some of the most unique perspective out there on politics and investing. For now, I expect to contribute approximately one note every three weeks, and to cross-post the links to those notes on this site.

My first note went live Tuesday afternoon. It’s titled “Kobayashi Maru”, and it’s about how in a no-win scenario, the best strategy is to change the conditions of the game.

More specifically, it’s about discretionary active management and the way ESG investing is sold to investors and financial advisers.

And, obviously, it involves a Star Trek analogy.