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:

  1. Aren’t constraints on our behavior necessary to some extent to have a functional society?
  2. 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.

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)

godfatherii_tom_frank

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).

When Obnoxious Salespeople Attack

A couple days ago I listened to one of the worst investment pitches I have ever heard. Its manifest awfulness had nothing to do with the investment strategy on offer and everything to do with the presenter.

My colleagues and I endured approximately half an hour of some guy literally shouting at us about how great this fund was and how the fund’s investments have averaged 24% IRRs. The presenter paced like a caged animal for the duration of his monologue, punctuating the pitch with exclamations of “got it, people?!” and “okay, people?!”

I imagine this is kind of what it was like listening to Mussolini speak publicly (if Mussolini had been a real estate guy, anyway). Browbeating prospects into submission was the cornerstone of this guy’s sales process. Not a good look.

Of the myriad varieties of aggressive salespeople, aggressive financial salespeople are probably the most hazardous to your wealth. They are almost always selling you something pro-cyclical and frequently there is financial leverage on top of the cyclicality. (Where do you think the 24% IRRs come from?) This is stuff with significant go-to-zero risk. Caveat emptor.

Nonetheless, I’m fascinated by the psychology of aggressive salespeople. They are okay at making money but in my personal experience at least pretty lousy at hanging on to it. I think that has to do with pro-cyclicality, willingness to take on lots of leverage and a general predisposition toward gambling. These guys live like Thanksgiving turkeys.

turkey_happiness_graph
Source: Attain Capital via ValueWalk

Early in my career I had a number of colleagues who spent time in subprime lending. One of them described how at the peak of the cycle the reps would all be driving sports cars. Then when the cycle rolled over tow trucks would show up to repo the cars as the reps defaulted on their auto loans, same as their customers. You would think people in the subprime lending business would have a better grasp of the credit cycle. But you would be wrong.

To me this is further anecdotal evidence that pro-cyclicality and herd behavior are hard-wired into human nature. But it doesn’t make listening to obnoxious salespeople any easier.

The Many Flavors Of Dumb

Lack of intelligence (“book smarts”) = “Dumb”

Lack of “street smarts” = “Dumb”

Lack of “emotional intelligence” = “Dumb”

Unwillingness to define a circle of competence = “Dumb”

Inability to define a circle of competence = “Dumb”

Overestimating your own intelligence = “Dumb”

Overestimating the impact of intelligence on outcomes = “Dumb”

Believing intelligence translates into control of outcomes = “Dumb”

There are many dimensions to intelligence. Yet we tend to talk about intelligence in a reductive way. As if it is somehow straightforward to separate the world into the “smart” and the “dumb.” By the standard of raw IQs the folks on Wall Street responsible for creating synthetic CDOs circa 2006 were frighteningly intelligent. Look what they wrought.

People with low IQs tend not create really bad outcomes. At least not at the level of society at large. People with low IQs are rarely put in a position where they have that much power and influence.

Really bad outcomes result from “smart” people overestimating their intelligence. They result from “smart” people mistakenly believing being “smart” allows them to control outcomes in complex systems. And they result from “smart” people being coerced into doing dumb things by warped incentive systems.

Some examples (not comprehensive):

Literally every financial crisis.

The Titanic.

Literally every speculative bubble.

World War I.

The Challenger explosion.

Tobacco companies.

The Hindenburg.

Love Canal.

Badly cooked dinners.

Different Priorities, Different Portfolios

So I pushed out my big behavioral finance/investing values post last week only to discover today that Morgan Housel is riffing on the same themes. He writes:

[W]e rarely recognize that most investment debates – debates that literally make markets – are just a reflection of people making different decisions not because they disagree with each other, but because they view investing with a different set of priorities.

If you’re trying to maximize risk-adjusted returns you have no idea why someone would buy a 10-year Treasury bond with a 2% interest rate. But the investment probably makes perfect sense to Daniel Kahneman. Paying off your mortgage with a 3% tax-deductible interest rate is probably crazy on a spreadsheet but might be the right move if it helps you sleep at night. Trading 3X leveraged inverse ETFs is financial suicide for some and a cool game for others. Long-term investors who criticize day traders bet on football games because it’s fun. People who scream at you for over-allocating into REITS buy six-bathroom homes for their four-person family. The flip side of Daniel Kahneman is the billionaire who risks his valuable reputation to gain money he doesn’t need. Have you been on Twitter? People see the world differently.

Two rational people the same age with the same finances may come to totally different conclusions about what’s right for them, just as two people with the same cancer can pick radically different treatments. And just as medical textbooks can’t summarize those decisions, finance textbooks can’t either.

This isn’t just about differences in risk tolerance.

People who work in finance underestimate that watching markets go up and down isn’t intellectually stimulating for most regular people. It’s a burden. And even if they can technically stomach investment risk, the added complexity robs bandwidth from other stuff they’d rather be doing. The opposite is true. Claiming your investment product is entertaining is usually the refuge of those who can’t point to performance. But it’s crazy to assume that many people don’t find investing incredibly entertaining – so much so that they rationally do nutty stuff regardless of what it does to their returns.

Everyone giving investing advice – or even just sharing investing opinions – should keep top of mind how emotional money is and how different people are. If the appropriate path of cancer treatments isn’t universal, man, don’t pretend like your bond strategy is appropriate for everyone, even when it aligns with their time horizon and net worth.

Here are some areas where I think personal values and priorities will play a significant role in your view of optimal portfolio construction:

Definition of risk. Do you define risk as volatility (“prices going up and down a lot”), or as permanent impairment of capital (“realizing losses in real dollar terms”)?

Definition of performance. Are you focused on absolute performance (“I want to compound my capital at 10% annually”) or performance relative to a benchmark index (“I want to outperform the S&P 500”)?

Tax sensitivity. Are you someone who will spend $1.05 to save $1.00 in taxes based on “the principle of the thing?” Or are taxes just something you have to deal with if you want to make money?

People who use volatility as their risk measure, focus on relative performance and are extremely tax sensitive tend to gravitate toward passive investing strategies. Those who define risk as permanent impairment of capital, focus on absolute performance and are less tax sensitive might favor a more active approach.