Best of Moontower 2019

The Top 11

Spinal Tap style here’s the Moontower posts you seemed to like the most based on my proprietary state-of-the-art analytics which I will only tell you about if you get me drunk.

Relationships

Is Loneliness A Downside of Connectedness?
Don’t Ignore the Tambourine

Finance and Economics

The Volatility Drain
The Income Inequality Myth
The Disagreeable Investor

The Scooped Midrange
The Homeownership Fetish
How Expensive Human Poop Saved Us All And How High Prices Are Self Correcting

Mind and Productivity

More Shower Thoughts Please
Memories As A Unit Of Time

Fun

Number Neighbors

References To Bookmark

Here are writeups you may find useful once they are practically relevant for you:

How To Approach Twitter (Link)
Tips to Optimize Your Reading (Link)
The Investment Experts Bookshelf (Link)
Car Lease Math is Not Obvious (Link)
Correlation Is The Key to Investment Portfolios (Link)

Littlewood’s Law in Media

Check this out.

What’s your gut reaction?

If Moontower Musings are doing their job then many of you will have smelled a trap and wondered “well how many cardiologists are there?”

The excerpt was taken from a Slatestar’s post Cardiologists and Chinese Robbers (Link). He discusses parallels in “Chinese robbers”, police brutality, and basically any anomaly that can be summed without context to indicate a trend.

Littlewood’s Law

“In the course of any normal person’s life, miracles happen at a rate of roughly one per month”

Applying Littlewood to the news, Gwern writes:

There will be enough ‘miracles’ that all media coverage of events can potentially be composed of nothing but extreme chance chances, even though it would seem like an ‘extraordinary’ claim to say that all media-reported events may be flukes. Given this, it is important to maintain extreme skepticism of any individual anecdotes or stories which are selectively reported but still claimed (often implicitly) to be representative of a general trend or fact about the world.

Inoculate Yourself

He maintains that your best defense remains standard techniques like critical thinking, emphasizing trends & averages, and demanding original sources can help fight the biasing effect of news.

Here’s an easy trick you can use every day. When you encounter cases where anecdotes are used to paint a picture, instead of jumping to horror, retrain your mind to ask “what is the denominator?”

Unfortunately, connectivity combined with the existence of billions of humans will lead to news which distorts reality. I don’t see any supply-side solution to this. Extremes sell. The human love of narrative is a biological backdoor that media holds a key to. It takes mental effort to be constantly critical. To constantly question how stories are framed. For a mild taxonomy of narrative fallacies and how to spot them Art of Manliness gets you started. (Link)

Gwern has some satirical recommendations for the journos. His intentionally naive belief that news is about signal and not clicks is cute. Some of my favorites:

  • Perhaps in one format, discussion could be weighted similar to a meta-analytic weighting of effect sizes: you are allowed to discuss both anecdotes and studies, but the number of words about an anecdote or study must be weighted by sample size. So if you write 1 page about someone who claims X cured their dandruff, you must then write 100 pages about the study of n=100 showing that X doesn’t cure dandruff. That’s only fair, since that study is made of 100 anecdotes, so to speak, and they are as deserving of 1 page as the first anecdote.
  • A “proportional newspaper” might allocate space by geographic region populations, so there’s a giant void with a tiny little 2-line wire item for Africa, while the (much smaller) USA section requires a microscope.
  • Weight by age: If someone is rereading a 50-year-old essay, that should be given more proportionally more emphasis on a social media stream than a 5-minute old Tumblr post.

 

The Cost of Taking The Bait

The news’ incentives plus our susceptibility to stories strand us in a suboptimal equilibrium. The distortions are insidious and distributed.

How do they darken our world?

1) Healthy skepticism is your best-case scenario

Back to Slatestar’s cardiologist’s example:

If you read Part I of this post and found yourself nodding along, thinking “Wow, cardiologists are real creeps, there must be serious structural problems in the cardiology profession, something must be done about them,” consider it evidence that a sufficiently motivated individual – especially a journalist! – can make you feel that way about any group.

So what are your options?

  • Put no effort into learning how to reason and be an easy mark for charlatans, pseudoscience, ads, politicians.
  • Go to a Penn & Teller show to start a life-long journey into skepticism

Nobody actively chooses to be a sucker, so this is a classic Hobson’s choice. You might not check out P&T but you do try to be critical. So you must find a way to be skeptical without becoming cynical. If my own experience is any indication I’d expect many of you to agree that this is a difficult line to walk.

2) We glorify extremes 

Dr. Oz and the media will highlight whenever a patient appears to benefit from one of his quack remedies. But no story will be written about the patients who did not get better using his tips. Sure that’s frustrating, but by now you are immune to that trick even if the masses are not (given how rich Dr. Oz is I’m pretty sure I’m not underestimating the public here).

But here’s a more speculative cost of glorifying extremes. School shootings. The gun control issue is important, but I’m a seller of it being the entire issue. The social mirroring aspect feels like it is not given enough weight. The question of whether they are contagious, and if so, why and to what extent feels underexplored. Malcolm Gladwell is only a scientist by airport bookstore standards so we know to take him with a heap of salt, but his riot threshold model is worth a peek.

My own feeling about the rise in shootings is strongly tied to a vague sense of how social media and traditional media feedback on each other which is highly coincident with how modern the epidemic really is. Gladwell’s theory happened to tie it together in a way that made me feel that I wasn’t alone in thinking social dynamics are the biggest driver.

  • I first caught wind of his take from a 10-minute talk at the New Yorker Festival. (Link)
  • If you prefer a 3rd party take on his theory, Derek Thompson gives it his characteristically balanced treatment. (Link)

If you are new to Moontower, you can find my own views about consuming the news here.

Moontower Gift Guide for 2019

It’s the official start of holiday season. I thought this would be a good time to share some of my favorite finds from 2019 including a gift guide in advance of Cyber Monday.

Moontower Gift Guide

Everything in this list is something I have gotten great use out of and found to be reliable. Several of them have been secret Santa gifts I’ve been given. You can’t go wrong buying them for your white elephant exchange or jumping on them if someone else brings it to the party.

1. A car jump starter. I have a VicTsing model (link)

  • Doubles as a high capacity power bank
  • I keep this in my car and have used it many times to give myself a jump without anyone’s help as well as used it to help other motorists. It’s a quicker, easier process than putting 2 cars nose to nose.

2. A 12v/120v power inflator. There are many types to choose from. I have this Bonaire model (link)

  • Set target tire pressure and hit ‘go’. It auto shuts off when the tire is filled. The best part — a digital guage.
  • Comes with regular 120v power cord and the 12v that plugs into your car’s ashtray. I had to use that one on Friday actually.
  • Comes with multiple needles for filling basketballs or bike tires.

3. Asus ZenScreen. My laptop has a 13″ screen but the ZenScreen connect via USB to give you another monitor. (Link)

  • Draws power from your laptop so no need for a separate power supply
  • The included case acts as a stand allowing you position the monitor horizontally or vertically

4. Youtube Premium (Link)

  • I watch more Youtube than I do TV. If you have the same habit, it’s worth the monthly subscription to get rid of the ads. I started paying for it this year and I’m happier for it.

5. Youtube TV (Link)

  • If you are thinking about cutting the cord, I just wanted to share our solution. We switched to Youtube TV in January and we have been happy. It has all the channels we want and there is no lag when you change channel. The lag was always a pet peeve from our Comcast setup. The quality is good and we are saving a little bit of money.

6. Shady Rays Sunglasses (Link)

  • I like their aviator styles. I wrote this summer: I ordered some Aviator style sunglasses from Shady Rays. They are about $60 bucks. If you break or LOSE the glasses up to 2 times they will send you a new pair for the cost of shipping. 

7. A massage gun. I got a Hypervolt (Link)

  • For the person who likes when the masseuse karate chops their back rapidly Street Fighter II- style. They are pricey but if that therapy is your jam, these guns are pretty awesome. Get your kids or partner to do your back. You can do your legs, IT band, etc yourself. There’s 3 intensity settings and it lasts several hours from a single charge.
  • I actually got a knockoff from China for a fraction of the price and it works perfectly. If you are interested and in the Bay Area hit me up and I might be able to help.

8. “Demonslayer” sake (Link)

  • At $50 a bottle this is a treat but it’s very smooth junmai daiginjo. I mentioned a bit about sake from my trip to Japan. (Link)

9. Most practical stocking stuffer

  • White Wizard Spot Remover (Link). We give this to everyone. Takes blood out of white sheets. If you have kids you keep this stuff in a holster. I have no idea if it’s destroying the environment but it’s so good I assume I’m being evil.

10. Games

Boardgames I started playing this year with my 6-year old:

  • Evolution — The Beginning: I wrote about it here
  • Forbidden Island (Link): Simple and fun coop game by the same game designer who brought you Pandemic. The game gets kids to work together and while the replayability for adults is limited there is enough variation in board layout and characters to keep kids engaged. Take about 30 minutes to play and requires no more reading than identifying the names of regions.
  • The Magic Labyrinth (Link): By far the best version of a memory game our household has ever played, No reading required and adults and kids are on equal footing since the game is about trying to remember you and others’ footsteps through a maze with invisible walls. This game was a big hit around here and is one of our favorites to gift since its fun and has few rules to learn.

Boardgames for 10 and up:

  • Settlers of Catan (Link): This was the gateway game that got us into European boardgames 11 years ago. Putting it here because we recently re-discovered it when I took a chance and taught it to Zak. Honestly, unless you are used to playing games for hours it might be a reach for age 6 but I’d feel very comfortable teaching it to an 8-year-old. Teaching someone the rules is the most painful part, but I have yet to meet anyone who did not enjoy playing. Even non-gamers. It’s a gateway game for a reason. While its conflict is economic like Monopoly, it feels less punitive and the entire design is one of the most elegant I’ve seen. Dusting it off was like seeing an old friend and wondering why you let it take so long to connect.
  • Decrypto (Link): A party game like Codenames. Both games are great for teams and so many ages. As word games go Codenames and Balderdash are hall of famers but Decrypto is an instant classic we started playing last Christmas.
  • Acquire (Link): I’m putting this game here even though it’s several generations old. It’s a classic game of M&A and stock ownership using the hotel industry as the theme. Many Moontower readers are finance pros so might appreciate the rec if they didn’t know about it already. It’s in a sweet spot of complexity and has clever market-driven dynamics.
  • A general tip: normal people don’t like reading rule books. Learning rules is best done via Youtube videos. Just search for a tutorial of the game you are interested and use the rulebook as a reference. If you need even deeper rule clarifications I’m 99% confident any question you can think of is covered in relevant BGG forum.

Video Game

  • We just discovered Portal : Bridge Constructor (Link). Available on many platforms including iOS and Android. We are playing it via Xbox Game Pass which has 3 months for a $1 intro rate which gives you access to tons of free games. If you liked Lemmings growing up you will dig this game. The whole house is addicted to structural engineering principles now.

11. Finally, a rec I received from Twitter — Storyworth memoirs (Link)

  • Our knowledge of our parents before we are born is very limited. If you have ever asked them to recount their stories, you may have left the conversation wishing it was written down. And that’s just for the stuff they thought of when they were on the spot or during that evening around the table. Storyworth is a service which prompts them every day with a question that they answer and at the end of the year you can get physical and/or digital copies. I’m sure the efficacy of this depends a lot on your parent’s bandwidth, willingness, and literacy but I thought the concept was worth surfacing here. I actually think they should have a version for family recipes!

Your Portfolio Intuition Is Poor

Summary and takeaways from Bridge Alternatives’ Portfolio Intuition (Link)


Intuition Test

Assume:

  • Your current portfolio has 5% return and 15% volatility for a Sharpe ratio of .33
  • You want to allocate 10% of your portfolio to a prospective asset
  • You want to maximize the Sharpe ratio of the resulting portfolio

Choose between A1 and A2

A1 A2
Return 4.00% 4.00%
Volatility 7.96% 46.04%
Correlation -.20 -.20

Unsurprisingly, most people prefer A1 since it has the same attributes as A2 with 1/6 the risk.

Now let’s run the numbers 

Expected return of the new portfolio is the same whether we choose A1 or A2:

Volatility of the new portfolio if we choose A1:

Sharpe ratio of original portfolio = .33

Sharpe ratio when we add A1 = .049/.13363 or .3667

The Sharpe ratio improved by about 10%

Now what is the Sharpe ratio if we add A2 instead of A1.

First, we must compute the volatility. Go ahead, plug and chug…

That’s right, the volatility is the same!

The volatility of the new portfolio is the same whether we add A1 or A2 which means the new combined portfolio has the same improvement to Sharpe whether we add A1 or A2. This is true despite A2 having a far worse Sharpe than A1! It is counterintuitive because portfolio math and the role of correlation is not intuitive.

To see why, look at the formula for portfolio volatility:

Let’s zoom in on the last 2 terms which come from adding the second asset:

Plot of change in overall portfolio volatility vs volatility of prospective asset (A1 or A2)

As we increase the asset’s risk, the first term grows exponentially, and the second term shrinks linearly (remember, the correlation is negative). It turns out that, at least temporarily, the shrinking effect from the negative correlation outweighs the exponential term.

There are 2 observations to note once you are done reeling from the bizarre impact of correlation.

  1. When adding a negatively correlated asset to a portfolio its risk must be incredibly high before it starts to degrade the Sharpe ratio of the final portfolio.
  2. Notice how, at least until we hit the vertex, if we move from left to right, representing an increase in risk, we’re actually reducing return. Put differently, if we added risk and didn’t reduce return we’d deliver more than a 10% improvement; risk has a positive payoff here, which is very cool. There is a significant range where we are reducing the prospective assets’ Sharpe and actually reducing the volatility of the new portfolio.

More Preference Tests

B1 B2 C1 C2 D1 D2
Return 10.54% 3.57% 9.33% 6.50% 6.43% -2.64%
Volatility 20.00% 20.00% 27.50% 12.50% 10.00% 40.00%
Correlation .80 -.20 .40 .40 .50 -.60

Most people agree:

  • B1 was slightly preferred to B2. For the same risk, B1 delivers much more return, though B2’s correlation is better.
  • C2 was preferred. It’s Sharpe is higher (about 0.52 versus about 0.34).
  • D1 was preferred to D2. D1’s Sharpe ratio is much higher. D2’s return is negative

The punchline, of course, is that every one of these assets improves the Sharpe of the portfolio by the same 10%. Your intuition would tell you would prefer a portfolio in the upper left green box since those assets have the best Sharpe (risk/reward), so it is probably uncomfortable to learn that the final portfolio is mathematically indifferent to all of these assets.

Correlation Is The Key

Here’s the same plot relating these equivalent portfolios by their respective correlations

As the correlation drops (corresponding to lines of “cooler” coloring), less return is required to deliver the same 10% improvement!

While Sharpe ratios are “mentally portable”, they are shockingly incomplete without being tied to correlation. To create a compact formula which links Sharpe ratios with correlation, it is helpful to view indifference curves.

Indifference Curves

RRR= Sharp Ratio of prospective asset
RRRb = Sharp Ratio of original portfolio

If Relative RRR > 1 the Sharpe of the prospective asset is greater than the Sharpe ratio of the original portfolio

The indifference curve represents an equivalent tradeoff between Sharpe ratio and correlation for various mixing weights. For example, the light green line assumes you will allocate 20% of the original portfolio to the prospective asset.

Observations

  • As the weight allocated to the asset increases (the lines move upward, from green to purple), the asset must be more performant in order to do no harm; it must be better relative to the portfolio. Put differently, as the role played by the asset increases, more is required of it, and that sounds about right.
  • A less performant asset, ie one with a worse Sharpe ratio than the original portfolio can compensate with low or negative correlations

Getting Practical

The investor’s natural question when evaluating a new asset or investment is:

“What is required from an asset (in terms of return, risk and correlation) in order to add value to my portfolio?”

With math that can be verified in the paper’s appendix we find a very handy identity:

This equality describes what’s required, in an absolute bare-minimum mathematical sense, of a prospective asset in order to do no harm. 

How to use it

For a given prospective Sharpe ratio, you very simply compute the maximum correlation the new asset can have to be accretive to the portfolio. For example, if the prospective asset has a Sharpe ratio of .10 and the original portfolio has a Sharp ratio of .40 then the prospective asset requires correlation no greater than .25 (ie .10/.40).

For a given correlation, you can compute the minimum required Sharpe ratio of the new asset to improve the portfolio. If the correlation is .80 and the original portfolio has a Sharpe ratio of .70 then the prospective asset must have a Sharpe ratio of at least .56 (ie .80 x .70).

Insights and Caveats

  • Correlation is best understood as a sort of performance hurdle. For assets exhibiting low correlation, less is required of their standalone performance (i.e. return over risk), all else equal.
  • Prospective assets with a Sharpe ratio greater than the original portfolio are always additive.
  • If you happen to find a truly zero-correlation asset it will be additive as long as it has positive returns. And as we saw with asset D2, a negative Sharpe Ratio asset can be additive if it has a negative correlation!
  • This cannot be used to somehow rank prospective assets. It can only serve as a binary filter: yes or no. This might feel like a real limitation. Sharpe ratios are absolutely rankable. They are measurements of the same unit (risk). But as we’ve shown in this paper, those rankings are not indicative of their true value within the context of a portfolio. Making decisions based only on return and risk is like ranking runners based on their times without asking how far they ran. It doesn’t make sense. If you take away one thing from this paper, this should be it!

My Own Conclusions

  • Correlations make portfolio math extremely unintuitive.
  • Negative and low correlations can make poor or losing stand-alone investments great additions to a portfolio. The implications for the diversifying power of low or negative-yielding assets are significant. Bonds, cash, commodities, gold.
  • Highly volatile assets with a negative correlation are tamed and even subtractive to the total risk of a portfolio.
  • While the importance of low or negatively correlated assets is well known it’s possible it remains underappreciated.

Further reading

Breaking The Market’s outstanding post Optimal Portfolios For Two Assets

You will learn:

  • How to mix assets by comparing their geometric returns.
  • Correlation’s effect on portfolio construction is not linear.
    • The closer correlations are to 1 the more they impact the recommended mix.
    • Negative correlations are deeply valuable in portfolio construction, adding to the long term return. Positive correlations are harmful, limiting the benefit of diversification.
    • The mixing range for the geometric returns is the combination of each asset’s variance, expanded or contracted based on the correlation between the two assets.
    • Negative correlation is wonderful.

Tool

You can save your own copy here

You can also play with the numbers directly below

Moontower Thanksgiving 2019

This letter started with a discussion of cosmic luck. There are 7 billion people in the world. You have about a 1 in 6 chance of being born into the “developed” world. My gratitude starts there.

I didn’t quite catch the heads required to end up in the crib of a median American family but I got something more valuable. Parents who love me and cared about my future.

They met here in the US but they are both from Cairo and they were not in the US long before meeting one another and having me in 1978. As all immigrants must, they navigated a strange land and a strange language. One of my favorite bits of family lore is how weird they thought the spaghetti sauce was in the US. They thought Americans’ taste buds were broken. Turned out my grandpa was buying ketchup.

In my spoiled existence today it’s hard to imagine what they went through and with so little. And yet despite the odds, I was given great opportunities and have had amazing luck:

  •  I’m 6’1
  • My parents are hard-working and my mom was especially demanding. She worked in treasury ops at banks when I was growing up. I was sorting fixed income traders’ mail when I was 16 thanks to her. I commuted from Hazlet, NJ to Manhattan at 5am in my summers to work. I got paid $16/hr in the 90s.
  • I have thus far dodged serious illness. I survived 2 serious car crashes before age 21 (at age 13 I had the experience of seeing and touching my right shinbone before I had even realized what happened). My apartment building burned down my junior year of college. Everyone has crazy experiences. That you are still around to have them has nothing to do with merit. Blind luck.

Speaking of college one of the most influential moments in my life was my choice to go to Cornell. My mother had always pushed me and spoke of this place Cornell before I was even in HS. When I visited the campus, I immediately loved it and applied early decision to maximize my chance of getting in. When I did get in, she and I were over the moon. But in a moment of major doubt and looking at the cost, I hesitated. You see Rutgers would have been a full academic scholarship. Cornell was gonna cost close to 30k per year. I didn’t want to saddle my mother with any more burden. She had already shouldered the bills of a private Catholic all-boys HS (CBA in Lincroft). And when she couldn’t afford it, she begged the school to let me attend without paying. She never gave up and it worked. They graciously made an exception for part of my tuition.

She had a one-tracked mind. Give her son a chance.

In the end, she convinced me with a plan I could bear. Cornell offered 1/3 of the cost in a need-based grant that she wrote many letters for every year. She and I would split the remaining cost equally. I’d pay my share with loans and my summer job earnings. She believed Cornell was going to mean more opportunities.

She had a one-tracked mind. Give her son a chance.


If you simulate my life 100x over I probably don’t end up with the professional luck I’ve actually enjoyed in 90-95 of those sims. I punched above my intrinsic gifts. But I have respectable outcomes in most of those sims because of who my mom is. Sure I had to meet her part of the way with effort but ultimately she gave me the best chance.

I’m thankful for being born in America and that my family fought their way to get here. I’m fortunate to grow up in a home that taught me how to fish even though it didn’t have much fish to give me. I’m not very interested in politics but if I had to say, I’m a lot more liberal than my parents. But something I would agree with them on…when I watch politicians fan the flames against the rich on what I feel are extremely exaggerated claims about what income inequality really is I recoil.

The prosperity of the United States and the possibility to push yourself or your kids into a better life has been calling to foreigners for over a hundred years. Anecdotes are not data. But having seen enough people from humble roots succeed beyond their expectations, makes me thankful I live where those anecdotes are not outliers. Billionaires are outliers. Kids from Hazlet or Newman, CA (Yinh’s hometown) who end up in our shoes are very much part of the real distribution.


if there is a devil he wants you to compare yourself to your neighbor. It’s that simple. It’s his most effective trick. And it’s subtle. Don’t pay attention to his whispers.

This Thanksgiving I’m grateful for all the luck it took for me to be able to sit in a warm house, with wifi and the time to write this. To have my children fed and asleep in bed (they’re in my bed tonite the rascals) and for my wife to be peacefully passed out while watching TV. There’s a lot of heads that had to come up to be here but it all started with a chance to play.

Enjoy your loved ones this Thanksgiving and much love from me. As always, thanks for reading.

Longitudinal Studies > Snapshot Studies

Longitudinal studies described by Roberts are very difficult while snapshot comparisons are relatively much easier to implement. But even the longitudinal studies are done on wide demographic cohorts. You may be interested in a much narrower subset of people. For example the children of decamilionaires, the class Kylie was born into.

The way to do a study like that would probably be a Bayesian experimental design. For example you’d take the base rates from the broader longitudinal studies and adjust them for the specific reference class you are studying. A statement that sounds like “how did children born in the 1980s do given they had access to a PC or given they grew up in Beverly Hills?” The conditions after the word “given” comprise the reference class.

In Kylie’s case, what was the right reference class? What’s the relevant condition? Being a decamillionaire to start? What about her IG followers? Not all decamillionaires enjoyed her fame. What about the fact that she became a billionaire so quickly?

The critical observation: experimental design has an enormous impact on the results of studies that show up in our feeds that then spread like truth at happy hour. A poorly constructed design or reference class has downstream effects that can swamp the conclusions.

A recurring Moontower theme is the world is messy, be critical of tidy takes. Alas, don’t despair, here are some guides and concepts to keep in mind.

Making Better Comparisons

One of my favorite researchers Michael Mauboussin wrote a guide to making better comparisons. Since all non-split second decisions require conscious comparison we can all do better by getting meta about the process. Mauboussin decomposes the steps and highlights pitfalls that await along the way. The link to the pdf and my summary notes can be found here.

Simpson’s Paradox

We learned how easy it can be to overreach for conclusions from snapshot data. Russ Roberts pointed out the danger of averaging averages — Simpson’s Paradox. It states that the change in the average is not the same as the average of the changes. When I interviewed at Susquehanna coming out of college, one of the questions was a perfect example of the paradox, even if I didn’t know the term for it back then.

The question: If batter A has a better batting average than batter B for the first half of the season AND batter A has a better batting average for the second half of the season, is it possible for batter B to have a better batting average for the whole season?

The answer.

Life expectancy example

In 1900, life expectancy was about 47 for a US male. Does that mean you were middle-aged by the time you left college? Of course not. If you made it to 22 years old there was a good chance you’d live well into your 60s or older. Life expectancy is extremely sensitive to infant mortality rates. In 1900, infant mortality was around 20%. Today it’s closer to .5%.

Society 1:

Infant mortality = 30%
Survivors who make it past infancy live to 80
Life expectancy = .20 x 0 + .80 x 80 = 64 years old

Society 2:

Infant Mortality = .5%
Survivors who makes it past infancy live to 80
Life expectancy = .005 x 0 + .995 x 80 = 79.6 years old

Without tracking the lives of people, the snapshot of life expectancy can make people jump to all types of silly conclusions about the 2 periods. When we study longitudinally we would have seen that someone who makes it to 32 is still far from middle-aged.

The Income Inequality Myth?

Blind luck matches your unborn spirit to a physical baby body on Earth. The spirit didn’t audition for the part. Where you arrive? To whom? In what century? Blind, dumb luck.  But the second the baby opens her eyes her conditions and her genes interact. A unique trajectory unfolds.

Repeat this process billions of times across geography and history. Interject randomness, a magical insight or a stray bullet. Watch as outcomes diverge just as a narrow river flows down a hill, widens at the mouth, then spreads into a vast ocean.

The combinations are infinite and we can’t help but wonder what variables along the way cause which outcomes. Consider the life of an attractive woman. I’m ready to non-ironically play the violin for exceptionally pretty girls. Why? Because I can’t imagine how they must navigate all the distorting signals they receive, an excessive quota of creepers they’re going to attract (in addition to desirable mates), the baggage they might have incurred in the process, and the feedback loops that sweep them up. It’s easy to see how arrows of causality rarely point in one direction. Every blessing rides with its own curse.

How does this relate to income inequality? 

In order to study how people arrive at different outcomes you must follow the same people around and only then do you have a chance to disentangle the interaction of their qualities from their conditions. You must track the water as it travels from peak to basin. If you just sample the water in the starting and ending locations you have no chance of uncovering whys and hows.

The discourse on income inequality makes exactly this mistake. Everyone is familiar with a graph that looks something like this:

If you Google image search “income inequality” you will be bombarded with charts like this showing that the rich’s share of income has increased relative to the poor and median. While it’s true that the bucket of people considered “rich” now earn even more than the bucket called “poor” over time, these studies are all based on snapshots. And they make great kindling for outrage, attention, and political thrust. They sell like steroids at the Jersey Shore.

But it also masks the good news. Regrettably, good news doesn’t have a natural buyer.

Like the Kylie Jenner problem, that chart tells us absolutely nothing about one’s chance of climbing or falling through the ranks. That is the question we really care about. Russ Roberts writes:

What the snapshots show is that the rich today are richer than the rich of yesterday. If rich people are the same people as yesterday, then one’s class determines one’s fate. But if they are not the same people, the snapshots tell you that the dispersion of income has increased. That may or may not bother you, but it doesn’t necessarily mean that there is a distinct group called “the rich” who are capturing all the gains while the rest of us tread water.

A Much Rosier View

In his outstanding essay (link), which I’d go far as to call a PSA, Roberts shows the most dramatic claims by the pessimists that no one is making progress other than the rich are wrong.

1) Distortions in the snapshot methods conspire to make inequality look much worse than it really is.

You can’t use two snapshots to conclude that only the rich have made progress. It’s possible that everyone from the earlier snapshot has actually gotten richer and then been replaced by different people whose incomes will also rise. The people in the snapshots are not the same people. 

Immigration, divorce, and marriage rates all distort measure of progress. Roberts creates this easy-to-follow video showing how snapshot math can make it appear that the poor are doing worse even when everyone’s income doubles!

In this diagram captured from the video he creates a hypothetical to demonstrate how divorce rates impact snapshots.

Imagine 5 quintiles with 2 families in each bucket. Every person earns the same amount. 30 years later we take another snapshot and every individual’s income doubles but half the families divorce resulting in 5 more households. Now when you look at the quintiles it appears the top 2 quintiles benefitted at the expense of everyone else, yet in this example every person in society is benefitting equally from the stronger economy.

Immigration and marriage rates will reveal similar effects.

2) Longitudinal studies > snapshot studies

Roberts emphasizes the biggest problem with the pessimistic studies is that they rarely follow the same people to see how they do over time.

The data crunchers at DQYDJ, a leading site for income studies, make similar warning when viewing data that is not longitudinal:

You can not draw any conclusions about the performance of individual households from this data. Households in certain income brackets move up or down the income spectrum, but the data as presented doesn’t give any history or hint of movement. The only fair way to draw conclusions about the performance of last year’s households is with repeat surveys given to the same subjects.
3) The American dream is alive and well

Roberts reveals encouraging conclusions when you look at the results of longitudinal studies. Many are summarized in this video.

The pessimistic story based on comparing snapshots of the economy at two different points in time misses the underlying dynamism of the American economy… When you follow the same people over time, the largest gains over time often go to the poorest workers; the richest workers often make no progress.

4) What it actually looks like when “the ladder has been pulled up”

Nassim Taleb observes social mobility in the US vs Europe:

Static inequality is a snapshot view of inequality; it does not reflect what will happen to you in the course of your life

Consider that about ten percent of Americans will spend at least a year in the top one percent and more than half of all Americans will spend a year in the top ten percent. This is visibly not the same for the more static –but nominally more equal –Europe. For instance, only ten percent of the wealthiest five hundred American people or dynasties were so thirty years ago; more than sixty percent of those on the French list were heirs and a third of the richest Europeans were the richest centuries ago. In Florence, it was just revealed that things are really even worse: the same handful of families have kept the wealth for five centuries.

You do not create dynamic equality just by raising the level of those at the bottom, but rather by making the rich rotate –or by forcing people to incur the possibility of creating an opening.

The way to make society more equal is by forcing (through skin in the game) the rich to be subjected to the risk of exiting from the one percent

Or, more mathematically

Dynamic equality assumes Markov chains with no absorbing states

Our condition here is stronger than mere income mobility. Mobility means that someone can become rich. The no absorbing barrier condition means that someone who is rich should never be certain to stay rich.
Pulling from a NYTimes op-ed, this tweet maintains that economic rotation remains alive and well in the US.

Final Takeaway

As you get bombarded this election season with discussion of income inequality, remember, the snapshot view you are being fed is:

a) politically useful

and

b) doesn’t answer the question you care about: what are the prospects for me and my loved ones?

That the rich today are richer than the rich of yesterday is a very different finding than that the rich are getting all the gains. Too many economists have treated these as identical. The snapshot approach does not capture the impact of economic growth on people’s material well-being or provide evidence that the rich or the poor are static categories no one ever escapes. [While none] of these studies is decisive, [what they] show is that the economic growth of the last 30–40 years has been shared much more widely than is generally found in the cross-section studies that compare snapshots at two different times, following quintiles rather than people.

Extra credit question I have for the finance-minded

Are low real interest rates actually progressive by flattening the compounding effect of wealth. Asked differently: do low rates of return in markets make being rich less of an absorbing barrier?

How Many Coin Flips to Be Kylie Jenner?

Imagine. You’re a zygote hanging out in the fancy airport lounge of the cosmic ether. Chatting with other unborns while sipping a mimosa and charging your phone.  Meanwhile on Earth, a couple bails early from a holiday party and Lyfts it home. The couple will soon be asleep but not before the ancient power of wine and nature take its course.

The loudspeaker in the cosmic airport lounge summons you. Next thing you know, you’re en route to sit in a uterine waiting room until Labor day.

Who Will I Be Born To?

Let’s say you start flipping a coin on the flight. How many heads in a row you flip determines whose house you go to. No heads at all? Ouch. Your soon-to-be-mother is struggling to keep a job while her baby daddy stands before a judge for domestic violence.

Flip a single head and you arrive at the median net worth household. You got two parents and statistically speaking .5 siblings.

Flip 3 in a row and you’ll get some overachieving parents who are going to spend the next 5 years wondering if they should ‘redshirt’ in kindergarten since your birthday is right on the cut-off and if your the oldest kid in the class you’ll be better at sports and blah, blah, blah, blah…You’ll probably be in the safest car seat and your parents the life of the party I’m sure.

Now, what about 11 heads in a row? Jackpot. You are being dropped into a Calabasas mansion to an ambitious family that knows how to wring clicks from the genetic advantages securely stored in your carry-on. In an era where anyone can get Warhol’s “15 minutes” but not a minute more, this family knows how to get their 15 years (and counting).

This table approximates the household a zygote headed for America can fall into. (I cobbled it together from 2016 DQYDJ data).

Enter Kylie Jenner

After selling a stake in her cosmetics brand she is now worth $1.2 billion. Here’s context:

First off, let’s just get one indisputable fact out of the way: Team Kylie Jenner has built a remarkable business. It posted revenues of $200m last year, and is on track for Ebitda margins of 25 per cent this, all while growing 40 per cent. For reference that’s more Ebitda than Uber, Lyft and Peloton made in the last quarter. Combined. (Link)

Then this guy:

The internet has been arguing over whether she is “self-made”. Just check out the comments.

People can’t wait to discount the success of people who “start on third base”. People like to drink Haterade. That’s old news. But it does bring up an interesting question. How likely or unlikely was such an outcome based on where she came from? After all, her half-brother Rob shared many of the same advantages.

What would be the equivalent level of success for somebody who started in a regular household? Well, let’s see. We can use the table to see how many heads in a row it would take Kylie to become a billionaire from her roots. Her silver spoon roots place her somewhere between decamillionaire and centimillionaire. From there, it’s about 7 heads in a row to billionaire. Translating that to a person born into the median net worth home, that’s the equivalent of Mary Smith rising to become the richest person at their HS if not their whole school. A 99.9 percenter.

Using that logic, you can still see just how unlikely it was to pull off what she did. You can lessen it since it wasn’t impossible from the get-go but there’s lots of things that impress us even if they aren’t impossible. Throw in the fact that regression to the mean shows most rich kids remain outshined by their illustrious parents. Meanwhile, Kylie blew them out of the water (financially speaking).

Dissonance

You’re skeptical. “Wait a minute, Kris, you can’t use the raw odds of being born into a certain household to estimate the probability of moving higher through the ranks? When Kylie gets her last name she also gets a weighted coin.”

Congratulations. You have just discovered a major flaw in the income equality conversation dominating the nation. In this week’s Money Angle we’ll see why.

Optimize Your Reading

In 1974 a researcher named Paul Slovic studied professional horse bettors. He let them each choose 5 pieces of information to make their predictions. Whatever they wanted from an extensive database. Horse’s age, jockey weight, etc. The bettors could each have a custom list of 5 variables.

The bettors turned out to be nearly 2x as good as chance in predicting winners 17% vs 10% since there were 10 horses running. Furthermore, the betters assigned a 19% confidence to their bets suggesting they were also well-calibrated.

As betting rounds continued, the bettors were allowed more pieces of information culminating in a final round where a bettor was allowed 40 variables.

What happened? Access to more variables had no effect on their accuracy but doubled their confidence. (Source: Adam Robinson interview)

1. Humans struggle to process too many sources of information effectively.

Psychologists and common sense suggest we simply can’t hold too much in our working memory. Since storage is upstream to processing it feels safe to conclude we can’t integrate too many variables in our reasoning.

2. Excessive information can lead to false confidence.

Humans are slaves to narratives, most of which are not rigorously tested. In Moneyball, old school scouts thought having a six-pack was predictive of a player’s success. This might be true if you are choosing from random people and have no other info. But when you are looking at a narrowed pool of baseball players, the sight of impressive abs loses its weight relative to the information file that was used winnow the candidates in the first place. The excess info can not only distract us from our proven model but, and this is diabolical, increase our confidence.

Implications for Reading

When reading to learn, as opposed to entertainment, search for the books that matter. The lessons that generalize. The handful of variables that do most of the explaining.

Probabilistically speaking, the non-fiction you picked up at Hudson News in Terminal 3 is best used to lined a birdcage.  The canon that has stood the test of time gives you perspective. You need perspective to judge. Perspective shifts in increments, while the latest study simply gets written over. A draft better off never seen.

Instead of filling your brain with the facts most likely to expire, let’s optimize our reading time.

What to read

Bill Gates has called Charlie Munger, Warren Buffet’s partner at Berkshire Hathaway, the “broadest thinker he’s ever met.” Heavily influenced by Ben Franklin and his almanac, “Poor Charlie’s Almanack is a collection of Charlie Munger’s best advice given over 30 years, in the form of 11 speeches given as commencement addresses and roundtable talks.” Allen Cheng’s notes are outstanding and sectioned by topic. (Link)

While I prefer to be cautious when drawing lessons from outliers such as Munger, his emphasis on multidisciplinary learning bears repeating.

By collecting a broad range of mental models you can more effectively pattern-match phenomena in one discipline with more general phenomena that you may have discovered in a different field. Farnum Street describes 109 handy mental models to add to your repertoire. (Link)

How will they help?

1. Improve your analysis and more importantly predictions

Many phenomena are just instances of a more general one. To analyze the phenomena at hand, we can study how the general one usually plays out. The general one will have a long history and wider sample set to draw from. Consider a hardware store and a candy shop. They seem very different but both are straightforward examples of brick and mortar retail. The underlying business principles are going to be more similar than the difference between Skittles and a chainsaw. In essence, we are collapsing many data points into the ones that mattered. Rather than study every type of brick and mortar we can reference our mental model for how brick and mortar businesses work. Remember the horse bettors. Isolate the information that matters.

2. Avoid misdiagnosing a problem 

When you are too narrow, you are the proverbial hammer to which everything looks like a nail.

Example in action

According to The Power of Mathematical Thinking, there was a year in which North Dakota had the lowest cancer rate and South Dakota had the highest. Explain how that can happen.

Reveal the answer

 

Where To Start

To get a start or reboot of a personal multidisciplinary education Naval Ravikant offers suggestions:

  • Stick to science and the basics
  • Generally, read the things that people agree on: “The longer something has been in print, the longer it will remain in print and the higher value it is.” What Nassim Taleb calls the “Lindy Effect”.
  • Read lots of microeconomics (NOT macroeconomics)

I’ve offered my own advice in the past. Avoid the news and information with a short half-life. (Link)

How to Read

There are different types of reading which depend on your intent. If you are not reading for entertainment or scanning for a specific piece of info, then you are reading for understanding, retention, and reuse. Mortimer Adler describes analytical and synoptical reading. (Link)

You must read actively which takes effort if you expect to absorb the information for later use. Some techniques for doing this include:

  • State what a chapter or book is about with the utmost brevity.
  • The Feynman technique — “the best way to learn anything”. (Link)

Reading Experiments 

  1. Cedric Shin’s Land and Expand strategy for fully conquering a topic. It assumes you are too tired to read difficult topics after a long day at the office. (Link with my highlights)
  2. The “Barbell”. Nassim Taleb and Marc Andreesen focus on very short term and very long term expiring information. Think social media and classic books.
  3. Dave Perell plunges into “atemporality
    • For days or weeks at a time, I will escape the present moment and only consume content published in a different decade. For example, if I want to learn about the 1970s, all my media consumption will consist of books, videos, and interviews published in the 1970s. By doing so, I’ll embody the mindset of people in a bygone era and gain new perspectives on the here and now. (Link)

Reading Recs From the Pros

This week I asked about 25 people from my network of portfolio managers, CIOs, and independent investors for the books which have most impacted how they think about risk-taking, investing, and trading. Here’s the Investing Pro’s Library (Link).

Besides books, the web is teeming with analysis and discussion in finance. It wasn’t always this way. 20 years ago when I started at Susquehanna in the options and ETF world there the best places to learn online were not blogs. They were forums. You could come across brilliant gamblers and traders on sites like 2+2 and Wilmott. Fast forward to 2019 and you can gain a substantial education in finance if you follow the right authors. The problem is no longer discovery but curation.

Here’s my short list of who you can’t miss today:

For breaking down high finance topics:

Matt Levine
Byrne Hobart

Quantitative Investing

Philosophical Economics
Econompic
Newfound
O’Shaughnessy Asset Management 
Alpha Architect
Convexity Maven

Susquehanna’s Raise Your Game

Valuation

Musings on Markets by Aswath Damodaran

General Investing

Of Dollars and Data
Movement Capital
Morgan Housel
Michael Mauboussin

History

Investor Amnesia
American Business History

A more extensive list of blogs to follow can be found on my site. Note that this is only a subset of all the feeds I think are worth subscribing to. If anybody is interested in that giant list, just reach out.