A Skinner box is a device used to study animal behavior. Its more formal name is “operant conditioning chamber.” It was originally devised by the behavioral psychologist B.F. Skinner. Skinner used his box to study how animals respond to positive or negative stimuli. For example, a rat can be conditioned to push a lever for a bit of food. A dog can be conditioned to salivate whenever a bell rings.
Lest you be inclined to dismiss operant conditioning as silly games played with animals, it’s worth considering that slot machines, video games and social media all make use of operant conditioning to shape our behavior.
The financial markets, too, are a kind of Skinner box.
Do you suppose we believe what we believe about investing because there are immutable laws, similar to physical laws, that govern the price action in markets?
We believe what we believe about investing because we’ve been conditioned to believe it. Much of what we think we “know” about investing is simply rationalized, conditioned behavior (the endless and pointless debate over “lump sum versus dollar cost averaging” is a perfect example–the “answer” is entirely path dependent). We investors aren’t so different from Skinner’s rats, working their little levers for their food pellets. It’s just that we’re after returns instead of snacks.
Below is what an operant schedule of reinforcement looks like.
Bet on Market Factor -> REWARD (GOOD RETURNS, CLIENTS HIRE YOU)
Bet on Momentum Factor -> SMALL REWARD (MAYBE)
Bet on Value, Size, Quality -> PUNISHMENT (BAD RETURNS, CLIENTS FIRE YOU)
The “lesson” here is very clear:
BETA IS ALL THAT MATTERS
BETA IS ALL THAT WORKS
This is what public market investors are being conditioned to believe. And if flows away from active management (particularly low beta strategies) are any indication, the market Skinner box is doing an admirable job. Demand for investment strategies is all operant conditioning, all the time.
Of course, the markets are more complicated than Skinner’s box. Market price action is both the input and output of investor behavior. It’s more like a Skinner box where the collective actions of the rats influence the operant schedule of reinforcement (this is another way of thinking about the concept of reflexivity).
The idea of markets-as-Skinner-boxes is inextricably linked to the idea of market regimes: patterns of correlations for economic variables such as interest rates, economic growth and inflation. It’s also inextricably linked to the idea of the zeitgeist: “the spirit of the age.” The relationship between these processes doesn’t flow so much as interlock. Each process acts on the others.
This visualization isn’t ideal. It implies the interactions are mechanical in nature, and that the result is a straightforward, predictable system. It’s not. In reality it’s much more an interaction of planetary bodies and gravitational fields than clockwork mechanisms of wheels and gears. My friends Ben and Rusty describe this as the three body problem. But imperfect as the above visual may be, it gives you a rough idea of how all this interrelates.
This is a short-and-sweet post meant to get some thoughts down and possibly provide a (small) public service. In my line of work I’m involved in a bit of direct private equity investing. The typical acquisition target is a Main Street USA business with EBITDA somewhere between $500,000 and $2,000,000. These are profitable businesses but slow growers. We’re talking mid-single digit revenue growth here.
These businesses are worth something like 3x to 5x EBITDA (subject to negotiation, of course). It’s rare that the seller is financially sophisticated. The sale of the business is probably the only such transaction he or she will complete in a lifetime. So setting realistic expectations around pricing is one of the most important things to cover early in the process. If someone thinks he’s going to get a 10x multiple on one of these things it’s best to walk away early rather than waste everyone’s time and energy.
There’s a common argument unsophisticated sellers trot out to make the case for a higher valuation. It’s this:
What about my IP and intangible assets? Surely they’re worth something. You should be assigning more value to those things!
No purchaser takes this argument seriously. The fact of the matter is that value has been assigned to the IP and intangible assets. It’s in the earning power of the business.
Put another way, when you buy an operating business you don’t buy the tangible assets (property and equipment) separately from everything else. Same with intangibles. The costs and benefits associated with both tangible and intangible assets are loaded into the cash flow profile of the business. You don’t double-count them.
Back in the day, the long/short hedge fund I co-managed was part of a larger long-only asset manager. Their biggest strategy was US mid-cap value, and it was well staffed with a bevy of really sharp analysts and PMs. But the firm also had a $4 billion US large-cap strategy that was managed by all of two people – the firm’s co-founder as PM, plus a single analyst position that was something of a revolving door … people would come and go all the time in that seat.
The solo analyst’s job, as far as I could tell, was basically to go to investor conferences and to construct massive spreadsheets for calculating discounted cash flow models for, like, Google. And sure, Google would be in the portfolio, because Google MUST be in a large-cap portfolio, but it had nothing to do with the literally hundreds of hours that were embedded in this sixty page spreadsheet. I mean … if the firm’s co-founder/PM spoke with the analyst more than once per week about anything, it was an unusual week, and there’s zero chance that he ever went through this or any other spreadsheet. Zero.
Now to be clear, I think the firm’s co-founder was a brilliant investor. This guy GOT IT … both in terms of the performance of portfolio management and the business of asset management. But here he was, managing a $4 billion portfolio with one ignored analyst, and it was working just fine.
And here’s my koan-version:
A portfolio manager was doing a fine job managing a $4 billion stock portfolio.
A single analyst worked under him, coding up elaborate fundamental models of portfolio companies. The portfolio manager never spoke to the analyst, nor reviewed the models he created.
Over the years, many analysts came and went. It was always the same story with them. But the portfolio continued on in the same way. It was working just fine.
“A knowledge of cheating methods and the ability to detect them is your only protection against dishonest players in private games. It is for this reason that the most ethical, fastidiously honest card games are those in which the players are top notch gamblers, gambling operators, gambling-house employees and card sharpers. When they play together the game is nearly always honest. It has to be, because they play in an atmosphere of icy distrust, and their extensive knowledge of the methods of cheating makes using their knowledge much too dangerous. They do not cheat because they dare not.
In a money card game patronized by men and women who know little or nothing about cheating techniques, the odds are 2 to 1 that a card cheater is at work.”
John Scarne, Scarne’s New Complete Guide to Gambling (1986)
I came down with some horrible, vaguely flu-like illness recently. Happily, this at least coincided with the arrival of a print copy of Scarne’s New Complete Guide to Gambling. It’s more of a reference text than something you’d read cover to cover. What impressed me most as I leafed through its 800-plus pages was Scarne’s obsession with cheating. In addition to a full sub-section on methods for cheating at card games, nearly every discussion of a game includes a section on common methods for cheating. Rigged games, it seems, are the default state of the universe.
Scarne’s dismissal of carnival wheels is typical of both his logic and wit:
If you want to play carnival wheels for fun, you would be smart to consider that 25% to 50% of the money you wager on each spin is a donation; when you reach the total amount you wish to donate—quit playing.
As you’d expect, in addition to cheating, Scarne was fairly obsessed with edge. Of poker strategy, he writes:
There is one big secret, a Poker policy which, if put to use, will not only make you a winner at your next session but at most of them. It’s a policy that is practiced religiously by the country’s best poker hustlers. It is the only surefire rule that wins the money. It’s a simple rule: Don’t sit in a Poker game with superior players.
There are plenty of ways to apply this rule to investing. It’s well-worn ground in the context of the active/passive debate. I’ve got little to add there. So let’s talk about another application. Let’s talk about deals. Specifically, let’s talk about the “democratization” of deals—how increasingly, private equity and credit strategies are being pitched to wealthy individuals and their financial advisors as important, if not essential, additions to portfolios.
I’m hardly a low complexity, liquid asset teetotaler when it comes to portfolio construction. I happen to believe private market deals offer a rich opportunity set for value-added portfolio management by skilled professionals.
Why? Because we’re talking about a relatively inefficient, illiquid market where the participants are allowed to act on inside information. A real poker game. A wild west poker game, even. I suspect John Scarne would feel right at home at the helm of a PE or VC shop.
And wouldn’t you know it, the dispersion of returns for non-core real estate, private equity and venture capital managers is immense.
What is the single most important thing that separates a top quartile manager from a bottom quartile manager?
To continue with our poker game analogy, in the larger cap areas of public markets you can be reasonably certain the cards have been dealt fairly. Deal flow isn’t an issue there. In private markets, it’s just the opposite. Private markets are about card sharping. Pickup stacking. Riffle stacking. False shuffling. Nullifying the cut. Bottom dealing. There’s a reason certain big firms’ shticks are recruiting a vast army of consultants and partners, many of whom who operate at the nexus of government and business. There’s far too much money at stake here to leave these things to chance.
I have a friend who did a tour as a White House Fellow. Believe me when I tell you the deck is stacked. The big PE shops and consultancies are masters of the riffle stack.
So where does that leave us?
We can either learn to see the angles, or we can decline to play. When it comes to deals, there are plenty of hands not worth playing.
To take a simple example, let’s think about interval funds. These are private equity and credit deals packaged in a mutual fund-like wrapper that can more easily be sold to mass affluent clientele. The pitch is that you, or your financial advisor, can access the private equity “asset class” with more favorable liquidity terms, 1099 tax reporting, and so on. “Private markets for the rest of us,” so to speak.
What’s not to like?
I’ve had the opportunity to discuss these with a couple investment banker types. I always ask the same question: “How can we know the sponsors aren’t just dumping all their worst deals into these retail vehicles as an excuse to charge fees on the assets?”
The answer always comes back: “You can’t.”
And as anyone who’s ever invested in anything even remotely illiquid well knows, favorable liquidity terms are just, like, someone’s opinion. Read the docs! If stuff ever hits the fan, you’ll be gated and locked up like everyone else. No one cares about liquidity when times are good. Everyone wants liquidity when times are bad. The more desperately you want out, the more likely you are to find yourself trapped. This is a timeless axiom of risk management.
Oh, and there’s always the matter of performance evaluation. Deals are sold on the basis of IRR, but “you can’t eat IRR” (it doesn’t measure cash-on-cash returns). So remember to compare IRR to MOIC, and on top of that to look at everything in the context of your original capital commitment, ’cause there’s an opportunity cost to committed capital. You can go on and on with this stuff. We haven’t even gotten to trends for deal multiples, or the dispersion of those multiples across across market segments, or the leverage and coverage levels for those deals, or what any of that might mean for prospective returns…
…so, yeah, there are lots of angles in private markets.
How do you learn to spot them?
The same way you learn to gamble. By playing. By getting fleeced. By losing money. Scarne again:
After twelve hours of gambling, Fat the Butch found himself a $49,000 loser, and he quit because he finally realized something must be wrong with his logic. He was, later, part owner of the Casino de Capri in Havana, and when I told him it would need 24.6 rolls to make the double-six bet an even-up proposition, and that he had taken 20.45% the worst of it on every one of those bets, he shrugged his massive shoulders and said, “Scarne, in gambling you got to pay to learn, but $49,000 was a lot of dough to pay just to learn that.”
I’m not saying you shouldn’t play this game.
I’m saying if you choose to play, you better play to win, and you better be ready to take some hard knocks along the way. DO NOT DABBLE NAIVELY. Because the folks pitching you deals, and their competitors, are definitely playing to win. Winning is their business. I’m not talking narrowly about generating attractive net returns for investors. I’m talking about fee revenue and carried interest. Fee revenue and carried interest are the metagame here. And there’s far too much money at stake to leave that outcome to chance. Regardless of your net returns as an investor.
Since this is a Scarne-inspired note, I’ll give him the last word:
When you play cards, give the game all you’ve got, or get out; not only is that the one way on earth to win at cards, it’s the only way you and the rest of the players can get any fun out of what ought to be fun. You can’t play a good hand well if your mind’s on that redhead down the street or the horses or your boss’s ulcers or your wife’s operation. When you don’t remember the last upcard your opponent picked and you throw him the like-ranked card which gives him Gin, it’s time to push back your chair and say, “Boys, I think I have another engagement.”
I revisited some of George Soros’s writing on reflexivity over the weekend (thanks Ben Hunt!). In doing so, I realized my initial reading, years ago, had been extremely superficial. Back then, I focused on feedback loops as amplifying the usual cognitive and emotional biases we point to in investment writing. Things like confirmation bias and loss aversion and overconfidence. This reading of Soros wasn’t necessarily wrong. But it was narrow and incomplete.
When Soros writes about reflexivity, he isn’t just arguing cognitive errors made by market participants cause prices to diverge from the objective reality of the fundamentals in self-reinforcing feedback loops. He’s arguing the fundamentals are often, if not always, themselves subjective realities.
But since you got here through the blog, you also get some bonus content. Note that if you continue reading, things will get conceptual, abstract, philosophical, and maybe a little weird. Consider yourself warned. If you’re not interested in that kind of thing you can safely skip the rest of this post.
My ET note is about subjective reality in the context of financial markets. At the very end, it alludes to the fact that reflexivity and subjective realities influence all social systems. Politics. Geopolitics. Economics. It’s all reflexive. The Big Idea is this: reflexivity is what drives the cyclicality we observe throughout history. Reflexivity is why we appear to learn from history and yet are doomed to repeat it.
It’s important to understand that when Rao writes about Sociopaths, he’s not writing narrowly about serial killer wannabes. He’s writing about people who want to know The Truth. Specifically, Sociopaths want unmediated access to the Truth, because they (rightly) suspect other people have a vested interested in obscuring or distorting it for their own ends. The Beginner Sociopath is vaguely aware of Narrative. In pursuit of Truth she begins unmasking reality–ripping away Narrative abstractions.
Over to Rao:
As the journey proceeds, Sociopaths progressively rip away layer after layer of social reality. The Sociopath’s journey can be understood as progressive unmasking of a sequence of increasingly ancient and fearsome gods, each reigning over a harsher social order, governing fewer humans. If morality falls by the wayside when the first layer is ripped away, other reassuring certainties, such as the idea of a benevolent universe, and predictable relationships between efforts and rewards, fall away in deeper layers.
With each new layer decoded, Sociopaths find transient meaning, but not enduring satisfaction.
Much to their surprise, however, they find that in the unsatisfying meanings they uncover, lie the keys to power over others. In seeking to penetrate mediated experiences of reality, they unexpectedly find themselves mediating those very realities for others. They acquire agency in the broadest sense of the word. Losers and the Clueless delegate to them not mere specialist matters like heart surgery or car repair, but control over the meanings of their very lives.
So in seeking to unmask the gods, they find themselves turning into the gods.
When they speak, they find that their words become imbued with divine authority. When they are spoken to, they hear prayerful tones of awe. The Clueless want to be them, Losers want to defer to them.
Once the Sociopath overcomes reality shock and frames his life condition as one defined by an absence of ultimate parental authority, and the fictitious nature of allsocial realities, he experiences a great sense of unlimited possibilities and power.
Daddy and Mommy are not here. Anything is possible, and I can get away with anything. I can make up any sort of bullshit and my younger siblings will buy it.
The sense of freedom is one I like to describe as free as in speech, and as in lunch.
Free as in speechdescribes the Sociopath’s complete creative freedom in scripting social realities for others. Cherished human values are merely his crayon box.
Free as in lunchdescribes the Sociopath’s complete freedom from accountability, in his exercise of the agency ceded to him by the Losers and Clueless, via their belief in the reality of social orders.
Non-Sociopaths dimly recognize the nature of the free Sociopath world through their own categories: “moral hazard” and “principal-agent problem.” They vaguely sense that the realities being presented to them are bullshit: things said by people who are not lying so much as indifferentto whether or not they are telling the truth. Sociopath freedom of speech is the freedom to bullshit: they are bullshit artists in the truest sense of the phrase.
What non-Sociopaths don’t recognize is that these aren’t just strange and unusual environmental conditions that can be found in small pockets at the tops of pyramids of power, such as Lance Armstrong’s racing team, within a social order that otherwise makes some sort of sense.
It is the defaultcondition of the universe. The universe is a morally hazardous place. The small pockets of unusual environmental conditions are in fact the fictional realities non-Sociopaths inhabit. This figure-ground inversion of non-Sociopath world-views gives us the default perspective of the Sociopath.
Non-Sociopaths, as Jack Nicholson correctly argued, really cannot handlethe truth. The truth of an absent god. The truth of social realities as canvases for fiction for those who choose to create them. The truth of values as crayons in the pockets of unsupervised Sociopaths. The truth of the non-centrality of humans in the larger scheme of things.
When these truths are recognized, internalized and turned into default ways of seeing the world, creative-destruction becomes merely the act of living free, not a divinely ordained imperative or a primal urge. Creative destruction is not a script, but the absence of scripts. The freedom of Sociopaths is the same as the freedom of non-human animals. Those who view it as base merely provide yet another opportunity for Sociopaths to create non-base fictions for them to inhabit.
Regardless of how I qualify it in advance, the word Sociopath carries with it decidedly negative connotations. But again, Sociopaths as described here are not inherently evil. Rao only tangentially touches on the difference between Good Sociopaths and Evil Sociopaths. Here it is: Good Sociopaths choose to adhere to some kind of moral code. Evil Sociopaths choose to live in a state of amorality.*
I’ll expand on this slightly.
The Evil Sociopath embraces nihilism as a license to treat others as playthings. Most often Evil Sociopaths do this through legal means, for example under the cover of business and financial dealings. Others do it through criminal activity, or by playing manipulative games within their personal relationships. And yes, a very small minority of Evil Sociopaths go the serial killer route.
The Good Sociopath, on the other hand, rejects nihilism as a license to treat others as playthings. Critically, this is not because there is some fundamental, verifiable Truth out there affirming an underlying moral order. Instead it’s because, for whatever reason, Good Sociopaths find the thought of embracing nihilism repulsive. The Good Sociopath chooses to believe other people are worthy of some level of dignity.
I have been annoyingly consistent in highlighting the word choose here just to emphasize that we’re dealing with subjective reality. Social systems are reflexive. Facts and small-t truth do exist, but to Sociopaths they’re negotiable.
In the immortal words of Don Draper: “if you don’t like what’s being said, change the conversation.”
And the Sociopath/Missionary is free to do so.
Free as in speech.
Free as in lunch.
* For another pop culture reference that may make this more concrete, the first season of HBO’s True Detective is pretty explicitly about Rust Cohle’s Sociopath journey, and how he and various and sundry other Sociopaths cope with “reality shock.”
Warren Buffett has this fantastically understated put-down he uses when he wants to needle investment professionals. He calls them “Helpers” (consultants are “Hyper-Helpers”). It’s a fantastic put-down because it’s simultaneously denigrating and dismissive, without being overtly crass or undignified. The way Buffett writes about Helpers he conjures up images of investment professionals as childlike buffoons. When the GOAT paints a picture of you as a childlike buffoon, there’s really nothing you can do about it.
Trust me, it drives us nuts.
Some day I will write a long post about Warren Buffett, Master of Narrative. There might even be a book in this. We think of Buffett as the greatest investor of all time but he might also the greatest salesperson of all time. He has, after all, sold thousands upon thousands of self-professed contrarians on making an annual religious pilgrimage to Omaha, Nebraska. I think Buffett knows exactly what he’s doing here. And I think he derives great pleasure from it. But that’s a topic for another day.
Here I want to borrow Buffett’s put-down to talk about another kind of Helper: the transactional financial salesperson.
Early in my career, I worked as a loan rep. Specifically, I sold consumer loans. Home equity loans, auto loans, unsecured personal loans and the like. You may not believe it, but this was actually fantastic experience. It was a very safe sandbox in which to learn how deals are structured, how risks are managed (or not managed), and most importantly, how deals are sold.
I was pretty good at selling loans.
If I’d stayed in the position long enough to build up a wider personal network, I think I would have gotten really good at selling loans.
Partly because I didn’t present myself as a person selling loans. I presented myself as a problem solver. There were many cases where I really did help people solve problems, or finance projects that were important to them. But in many cases I was just restructuring their problems. The best example would be the use of a home equity term loan to consolidate credit card debt. By the numbers, it always made sense to do this. It would save people thousands upon thousands of dollars in interest expense, plus term out the debt. Mathematically, you could prove the transaction made sense.
Behaviorally, things were a bit murkier. Because the math only held if the customer stopped racking up credit card debt. Of course, I would explain that to people. I wasn’t a charlatan.
If someone had racked up credit card debt because he used it to finance some kind of one-off project or business venture that went south, then this type of refinancing transaction was a no-brainer. (This setup was rare)
If someone racked up credit card debt because he was outspending his income, it was can-kicking by another name. If his pattern of reckless spending and debt consolidation were to continue, it could eventually end in bankruptcy and the loss of the home. (This setup was more common)
I have no idea how many of these debt consolidation deals worked out for people over time. As a loan rep, my job wasn’t to distinguish between the underlying causes of different individuals’ debt problems. My job was to sell financing solutions to people in need of financing solutions.
This is really just a long-winded way of describing agency problems and information asymmetry. In finance, these issues come up all the time. There’s this meme out there that anyone who does transactional business in finance is necessarily some kind of snake-oil salesman or charlatan. This simply isn’t true. Not all Helpers are looking to rip your face off. But not all Helpers have a fiduciary responsibility to act in your “best interest”, either. I put “best interest” in quotes because, as my home equity refinance example illustrates, it’s not always as straightforward to identify what’s in someone’s best interest as certain people would have you believe.
Transactional business isn’t inherently evil. I do transactional business with people all the time, both personally and professionally. Transactional business can work out quite well for everyone involved.
Where you run into trouble is when you mistake a TRANSACTIONAL relationship for a FIDUCIARY relationship. (See also: It’s Just Business)
If you are the finance director of a small municipality, or the CEO of a small company, and your banker comes to you with an interest rate swap that will “protect you” from interest rate risk, and you are not well-versed in the mechanics of a swaps, then you need to think long and hard about doing that deal. Because ultimately, your banker isn’t compensated to advise you. Your banker is compensated to transact business with you.
I address the finance directors of small municipalities and the CEOs of small companies specifically here because you are often seen as the suckers at the institutional poker table. There is potentially a lot of money to be made Helping you.
With apologies to The Godfather, Part II: you can respect Helpers, you can do business with a Helpers, but you should never trust a Helper.
My latest Epsilon Theory note is live. A quick teaser:
If ever you find yourself struggling to keep the difference between Narrative and narrative straight, think of John Carpenter’s 1988 sci-fi action flick, They Live. No doubt it’s a goofy movie. The basic premise will be familiar to anyone who’s seen movies like Dark City or The Matrix. Reality, as we perceive it, is an illusion. But, if you obtain the gift of special sight, you may see the world as it is. In the case of They Live, you put on a pair of special sunglasses only to discover the world is, in fact, controlled by hideous aliens, which use mass media to shape our behavior with subliminal messaging. […]
It’s a wonderful visualization of how symbolic abstraction operates in our world. And who knows, maybe Jerome Powell and Janet Yellen really ARE hideous aliens.
But this isn’t a note about your Friendly Neighborhood Central Bankers, or even how symbolic abstraction can be weaponized to sell you a new refrigerator. This is a note about how symbolic abstraction is used to shape your investment behavior. Both your behavior and your clients’ behavior.
I’m quite pleased with the way this note turned out. Even more so because this is an instance where a little editorial input went a long way toward improving the final product. Some ideas more or less show up on the page fully formed. Others require a bit of workshopping. Still others end up being workshopped, killed and then harvested for their vital organs. I’m glad this one not only survived, but flourished!
(We open on a nondescript, windowless room. A FUNDAMENTAL INVESTOR sits strapped into a GROTESQUE TORTURE CHAIR. The torture chair is designed to inflict the physical, psychological and financial pain of enduring a short squeeze on its occupant. An ECONOMIST dressed in an ordinary suit addresses the investor)
ECONOMIST: I would like to begin by emphasizing we have invited you to this Continuing Education Session in the spirit of educational goodwill. Here at the Ministry, we work not for money, but out of love. Our love for you. Our love for your fellow investors. Our love for the financial markets and the global macroeconomy. Now, we shall begin today’s session by reviewing some simple concepts. What is a financial market?
INVESTOR: A financial market is where buyers and sellers– (mid-sentence, the Investor convulses in pain, letting out a guttural sound that is half-grunt and half-scream)
ECONOMIST: –Already we are starting off on the wrong foot. A financial market has nothing whatsoever to do with buyers and sellers. A financial market is a wealth creation mechanism for individuals and thus societies. Now, what do you suppose a market should do over time?
INVESTOR: It depends– (again the Investor convulses in pain)
ECONOMIST: Incorrect. The correct answer is RISE. A financial market RISES over time. Can you tell me why?
INVESTOR: Earnings– (another convulsion)
ECONOMIST: WRONG AGAIN! A market rises because a market MUST rise over time. It is a tautology that a market must rise. I am beginning to suspect your misconceptions about our financial system are more fundamental than I had initially believed. I shall endeavor to correct this. (The Economist pauses briefly, as if switching to a new script in his head) Tell me, why should someone invest?
(The Investor hesitates)
ECONOMIST: Go on. I am genuinely curious.
INVESTOR: To earn a return on capital.
ECONOMIST: Yes. To earn a return on capital. And why should an investor prefer bonds, to say, cash?
INVESTOR (hesitant): Higher returns.
ECONOMIST: Yes, quite right. And why should an investor prefer stocks to bonds?
INVESTOR: Higher returns.
ECONOMIST: And WHY do you suppose stocks should return more than bonds or cash over time?
INVESTOR: As compensation for the incremental risk associated with taking the most junior position in a capital structure, with only a residual claim on cash flows and assets.
ECONOMIST: Yes, very good. And how does an investor decide whether he is being compensated fairly for taking the most junior positions in capital structures, instead of owning bonds?
INVESTOR (after a long pause): Relative valuations.
ECONOMIST: And what determines relative valuations?
INVESTOR: Investor preferences– (this time the convulsion is extra long and painful)
ECONOMIST: Now we’ve arrived at the crux of our misunderstanding. You investors only BELIEVE you determine relative valuations across asset classes. You are so absorbed in your own brilliance, in your petty little security selection games and benchmark arbitrage games and sales and marketing games that you COMPLETELY AND UTTERLY FAIL to see the world AS IT IS. In reality, WE determine relative valuations. The Federal Reserve. The European Central Bank. The Bank of Japan. In nature, it would be as though we controlled the force of GRAVITY. Investors do not “determine” anything. They merely RESPOND to our influence as it manifests itself in the world. Can you tell me, whence we derive this incredible power?
INVESTOR (for the first time, calm and self-assured): You control the supply of money.
ECONOMIST: Not only the SUPPLY of money, but the PRICE of money. Said another way, we control the price of RISK. You investors can no more escape our influence on the price of risk than you can escape the force of gravity. Excellent. (The Economist is obviously delighted with this progress) Now that we’ve reached this understanding, we shall practice with a brief exercise. What is a reasonable return on Treasury bills?
INVESTOR: Depending on inflation–(a brief zap of pain)
ECONOMIST: Incorrect. Let us try again. What is a reasonable rate of return on Treasury bills?
INVESTOR: I need to know–(a longer convulsion ensues)
ECONOMIST (sighs): Again, what is a reasonable rate of return on Treasury bills?
INVESTOR (desperate; frustrated): I DON’T KNOW! Just tell me what you want to hear!
(This is the longest zap of the torture device yet, and when it ends the Investor is little more than a blubbering pile of mush)
ECONOMIST (to the audience): A reasonable rate of return on Treasury bills is whatever OUR models say it should be. A reasonable rate of return on Treasury bills is whatever WE want it to be. WE decide whether you should prefer bonds to bills, or stocks to bonds. WE decided whether you should be incentivized to hold cash or spend it with reckless abandon. WE decide whether the market should rise or fall. Only deciding whether the market should rise or fall is no decision at all. The market rises over time because it MUST rise over time. That the market rises over time is a tautology.
(Abruptly, the stage goes black)
(Slowly, the lights come up. The Investor is seated at his desk, working. He is on a client call, holding his phone up to his ear. He is flanked by an enormous plasma TV, showing Neel Kashkari being interviewed on CNBC)
Investor (smiling broadly): Well, of course the market goes up over time, Mister and Missus Smith. The market pretty much HAS TO go up over time. It’s basically a tautology. (He pauses momentarily, listening) Of course! Happy to explain…
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.
Captain James T. Kirk: What worries me is the easy way his counterpart fit into that other universe. I always thought Spock was a bit of a pirate at heart.
Mr. Spock: Indeed, gentlemen. May I point out that I had an opportunity to observe your counterparts here quite closely. They were brutal, savage, unprincipled, uncivilized, treacherous–in every way splendid examples of homo sapiens, the very flower of humanity. I found them quite refreshing.
Captain James T. Kirk [to McCoy]: I’m not sure, but I think we’ve been insulted.
—Star Trek, “Mirror, Mirror” (1967)
As any sci-fi nerd who reads this can likely attest, “Mirror, Mirror” is one of the best known Star Trek episodes. It’s an Alternate Universe story, with the all-too-common “transporter malfunction” serving as catalyst (aside: if transporter tech is invented in my lifetime I will never, ever use it). In the Mirror Universe, the Federation is instead the Terran Empire. Imagine all the worst impulses of the Roman emperors, applied on a galactic scale.
In Terran society, only the strong survive. Don’t like your boss? Kill him. You simply take what you want through violent force. Women. Resources. Power. It’s pure Social Darwinism.
A fairly horrifying way to organize social and economic activity, when you really stop and think about it. Imagine being tortured in the Agonizer Booth every month you underperform the S&P 500. Many of us would be on intimate terms with the Agonizer Booth by now.
But as Mr. Spock observes at the end of the episode, the Terrans are just an exaggerated expression of basic human nature. The kinder, gentler humans of the Federation share the same basic impulses. They have the same capacity for cruelty and violence.
They’re us. We’re them.
It’s the same in our relationships with our investment managers. Many of their failings, real and imagined, reflect our own weaknesses and failings, both as individuals and allocators.
Why do so many bottom-up managers dabble in macro tourism? Allocators have unrealistic expectations for how true bottom-up portfolios should perform during broad market selloffs.
Why does it feel like so little money is managed with an emphasis on “real world” cash flow generation by “real world” businesses? Because the dominant models for asset allocation are based on abstracted baskets of securities.
Why is does it feel like so much money is managed in a short-term, overfitted fashion? Clients want 200% upside capture and 0% downside capture, and they want it “consistently.”
Our flaws and biases as allocators manifest themselves in our managers’ portfolios. They’re amplified by the intense pressure that comes with managing other people’s money. We end up in a kind of nightmarish feedback loop. The more pressure a manager is under during a period of underperformance, the worse that feedback loop gets. The more exaggerated our flaws and biases become as they’re translated into security selection and portfolio construction.
I sometimes often laugh at the silly conversations I have with capital intro people and third party marketers. They’ll say things like: “Fund X was actually up in December 2018! You should really take a look.” As if that, on its own, is somehow a meaningful data point.
But I shouldn’t laugh.
I shouldn’t laugh because I made them this way. Me, and others in seats like mine. Ultimate responsibility for the pervasive absurdity in the investment management business lies with us. We not only tolerate it, but actively encourage it. We encourage it with our peer group rankings and tracking error parameters and quarterly performance evaluations, not to mention our fear and greed.
On the other side of the table is an institutional poker player, hired by wealthy investors, to play poker as best as possible. This poker player is a pure genius, mathematically calculates all probabilities in her head, and knows her odds better than anyone. Now imagine that our super player, as a hired gun, has a few limits. “We need you to maintain good diversification across low numbers and high numbers. We also want to see a sector rotation between spades, aces, and clubs. Don’t take on too much risk with straights and flushes, stick to pairs like the market does…” No one would ever play poker like this. But in finance, this is how people play.