Prices Are More Than Expectations

Prices Are More Than Expectations

This week I came across this tweet by @NewRiverInvest:

Breakevens are not inflation expectations (thread)

It explains how implied breakevens from TIPs are not the same as inflation expectations. One of the reasons is because it’s a small market that is easily distorted.

The second reason is more technical. TIPs are actually implicit options. The face value increases with inflation but is floored at par. So if we experienced deflation you’d get your now-even-more valuable USD back. We should presume the TIPs price reflects not just inflation expectations but a premium for the option value.

This is a familiar lesson. Think about volatility risk premiums. Since convexity improves portfolio CAGRs the expected value of owning an option should actually be negative in arithmetic terms. This is why quants will fancily say “implied vol is a biased estimator of realized vol.” It’s overpriced on average but it’s correlation and convexity attributes suggest it is not overpriced in a repeated, compounding framework.

Another demonstration of “price does not equal expectation” is found in correlation itself. Correlation swaps trade at cheaper levels than implied correlation because being short correlation is a concave (ie negatively convex) position. A correlation seller will require an additional risk premia to be short it. A further explanation can be found in my notes.

So whenever you imply an expectation from a price you need to strip out any additional risk premia or preference that is embedded in the price.


This ties in well with Why You Don’t Get Paid For Diversifiable Risks (MoontowerMeta)

2021 Goal: Not Lose To A Kid

Happy New Years all. Even those of you, who like us, celebrate Lunar New Year which is still 6 weeks away. Nobody should feel like they are still left behind in whatever the heck you want to call that last revolution around the sun.

The last few weeks have been a nice break including a week off from work. Our kids spent 2 straight weeks with their cousins and we had a lot of downtime with family. We played lots of games (thanks to my sister for sending Zak Ticket To Ride which was a big hit). Max played chess with an NJ cousin over Zoom…we point the cameras at the board and use the chess grid to announce moves, ie “rook to D4”. We chose not to simply play online because Max is 4 and I think this is a better format for that age.

One fun way to play online is if you use (free) and cast your browser tab to your TV. Then everyone in the room can participate. We did this with some puzzles and all the kids could chime in. It’s  much more social than bending your crooked neck over a small screen. On chrome, just mouse over here:

Yinh is a big goals person. She gets won-the-lotto-level excited from planning her next 13 weeks in the SELF journal. It’s on a technology most of you remember called “paper”. Pronounced with a long “a” sound. (I don’t operate this way, I’m much more of a habit tracker, which might sound similar but is spiritually different and a topic for another time. Or not, I don’t know). Anyway, Yinh led all the older kids in goal-setting exercises and one of Zak’s goals is to beat me in chess in 3 consecutive matches. This of course scared me into adding 15 min a day of chess into my habits to at least delay the inevitable.

So I started by putting myself into the mind of my hunter. I started reading How To Beat Your Dad in Chess (as I searched for the title of that book in Amazon to fetch the hyperlink it auto-completed “how to beat your wife”. Maybe it’s better to just wait for malls to open and buy it at Waldenbooks. Screw you, Amazon). In the intro of the book, I came across a great demonstration of what pattern-recognition skills can look like. They are exceedingly context-dependent. If you are trying to assess how effective a new hire can be or how well your own skills translate to different domains than it’s one of those meta concepts to be aware of.

I wrote a thread about it here including screenshots from the book. (Twitter thread)

Finally, I’ll point you to a little discovery I in Google Sheets.

If you use the following function =CHAR(key) you can generate chess pieces!

For example, =CHAR(9818) will generate a black king.

I discovered this as I take notes in Google Sheets from the book. I got stave Zak off as long as possible. (I actually used this against him last night and yes I’m proud of beating a 7-yr-old. Judge me all you want.)

Holiday 2020 Gift Ideas

Useful gifts

1. A car jump starter (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 gauge.
  • Comes with regular 120v power cord and the 12v that plugs into your car’s ashtray.
  • Comes with multiple needles for filling basketballs or bike tires.

Game Gifts

  • My recs from last year which I continue to enjoy (screenshot)
  • New additions to the collection worth highlighting:
    • Splendor (link)

      A terrific intro to card drafting games that is simple enough for a 6-yr-old but complex enough to satisfy 45 minutes of adult brain jockeying.

    • Hanabi (Link)

      A cooperative game in which everyone except you can see your cards. You must communicate to construct an arrangement of cards based on tacit logic and limited info. 2-5 players. Takes 15 or 20 minutes. It’s pretty popular so you can find it at Target or Walmart and it’s a lot of fun. Feels like a social mind-reading sudoku. It also reminded me of the Two Generals Problem visually presented by Sketchplanations. (Link)

    • For kids learning to count: Hoot Owl Hoot (Link)

      This game is intended to help kids learn to count. A friend of mine who took my rec to play this with his son added a good description of how it feels…”a good intro to backgammon basically”

  • Game book for kids riding the chess boom: How To Beat Your Dad In Chess (Link)

Gifts for Adults Including Yourself

  • AirBnB online experiences (Link)

    A socially-distant way to shake it up, learn something new, and support hustlers who have made major audibles to their small businesses this year. Close friends have raved about a tequila and mezcal cocktail mixing experience they did with a Mexican bar. The owners tell you what you will need beforehand. Makes a great date idea or small group event.

  • Booze
    • “Demonslayer” sake (Link)
      This $50 bottle household mainstay is smooth junmai daiginjo available at Whole Foods.
    • Screwball Peanut Butter Whiskey (Link)
      This is an inexpensive bottle which I’ve been mixing with tea and oatmilk for a cozy fireside treat at home.
  • A thought on helping others

    Many people have suffered deeply this year. Even if they have been spared a direct blow from Covid, disruption in social patterns has meant isolation for countless people. In addition, 2020 accelerated the widening spread of tech-forward businesses over service jobs. Throw in a boom in financial assets across the board from bonds to stocks to crypto to gold and the gap between haves and have nots doesn’t relent.

    If you count yourself amongst the fortunate, this is a good year to do the thing you have been meaning to do one day: donate an amount that makes you uncomfortable. Perhaps it’s a cause. Perhaps a person or a group you know who could need the help. Sponsor lessons for a kid who is struggling with distance learning or who can no longer take piano lessons.

    If you get stuck in the “I’ll do this once I research the highest impact place to give” mode of thinking, then you are making perfect the enemy of the good. It’s ok to not mastermind everything. 90% certainty is way past the optimal threshold to make most decisions including this one. Do something good, impulsively. You will help someone else and you will help yourself.

    To help you along consider my simple rule of giving:

    When a friend is raising money for charity always give


    If you are like many other people with good intentions but little free time, you aren’t hanging out in the comments section of effective altruism blogs splitting hairs about which charities are maximizing return per dollar. Some people may even use this as an excuse. “I haven’t done the homework, so I’m not ready to give”. Guess what aspiring philanthropist? You’re not going to do the homework.

    Instead, trust that your friends have done the work since they are putting the effort to raise money. By offering you a chance to give, they are actually doing you a favor. You get to act instead of just meaning to do good. Even if you accidentally give to, over the course of your life you will have maximized area under the curve.

2020 Moontower Investing Writing Highlights

In addition to the newsletter, I took a stab at writing about money and quant topics. The first post I wrote was my only commentary piece. It was the longest piece I’ve written and I published it in January, the day before the first Covid-related selloff. As the year has played out, the post has actually grown in my mind. And that’s not comforting, because it deals with a risk that seems to materializing.

Almost 1 year old and just as relevant to my thinking:

Sacrifice To The Delta Gods (Link)

Here is a selection of my posts which were popular by category:

Options Theory

Lessons From The 50 Delta Option (Link)

Why Option Traders Focus On Vega (Link)

Finding Vol Convexity (Link)

Straddles, Volatility, and Win Rates (Link)

Portfolio Theory

Why You Don’t Get Paid For Diversifiable Risks (Link)

You Don’t See The Whole Picture: The Sun/Rain Example (Link)

How Much Extra Return Should You Demand For Illiquidity (Link)

Mathematical Intuition

Path: How Compounding Alters Return Distributions (Link)

Do Professional Investors Understand Fees (Link)

Making Property Taxes Apple-To-Apples (Link)

Mock Trading Options With Market Makers (Link)

The Metagame Of Investing

The No-Easy Trades Principle (Link)

Dinosaur Markets (Link)

Investing Is Biology Not Physics (Link)

Measurement Not Prediction (Link)

Lessons From The Layup-Corner 3 Spread (Link)

My Personal Investing Wiki (In Progress)

The Moontower Money Wiki (Link)

Why ‘Deserve’ Makes My Skin Crawl

This is a follow up to My Personal Trigger.

Quick Review

If luck is underappreciated then success is overexplained by hard work. Hard work and accountability can get you invited to the party but the tyrannical role of luck is easy to downplay when our minds reconstruct the chain of events that brought us to our champagne moment. This is forgivable. Counterfactuals are written in invisible ink. My essay was a reminder to brush the decoder pen over the story.

Why bother?

There’s practical reasons. For example:

  • Not internalizing the wrong lessons.
  • Not letting poor calibration derail your future.
  • Maintaining a sense of gratitude that can keep you from comparing yourself to others. After all, just as there is always someone smarter, there is always someone luckier (note how smart is often an instance of luckier).

[To argue against myself for a moment, I’ll say that these reasons are not necessarily adaptive. It’s likely that overconfidence can recoup more than its calibration costs by kickstarting a virtuous loop. Advice like “fake it ’til you make it” or “act as if” recruit the power of reflexivity. Humility can be counterproductive.

But here’s the counter to my counter. This strategy is zero-sum. In aggregate terms, if everyone displayed increasing manufactured confidence, society would be left with Trump-level narcissists cancelling each other out in a nitrous gas of collective delusion.]

The largest reason to reject an overdetermined view of success is how it poisons our society’s dialogue. That word deserve triggered my gag-reflex to the poison.

Deserve is a high-stakes concept

The word deserve implies a justification. If you contribute value to society which is proxied by your income, that is its own reward. To layer entitlement above and beyond the already noisy capitalist allocation channel (noisy but the best we got) is to mix the economic notion of value with the value conferred by dignity of being a human.

We already understand that luck plays a major role in outcomes. To impose additional notions of entitlement is double jeopardy for the unlucky and a gratuitous rounding up for the winners. One’s relationship with the word deserve simultaneously reveals and informs their sense of justice.

From deserve to justice

Justice is the prosocial construct that forms the basis of cooperation. Cooperation is the basis for the rise of our feeble species. When we inject the word deserve into our transactions we dilute the importance of justice, weakening its potency in times when it’s actually needed. Don’t cry wolf.

We must protect justice from the vagaries of chance. Regrettably when we start to pretend that hard work determines outcomes, we fall trap to its flipped fallacy — failure means you did not work hard. This creates a backdoor for chance to slip into the justice process using the deserve key. We substitute a stochastic variable with a deterministic variable, then compound the error by having that dictate your metaphysical worth.

The bitter recipe:

  1. A complex process such as success is overdetermined as simple cause and effect.
  2. The seductive logic of determinism justifies one’s destiny. A loser is blamed, and the winner glorified.
  3. The word deserve is imported as a seal of the outcome’s authenticity.
  4. Justice becomes a product of the outputs instead of the inputs.

What you deserve bleeds into politics

I believe your position on the luck-determinism continuum influences your sense of justice. And what we deem to be just dictates our allies. Therefore the role of luck is endemic to one’s political beliefs.

In the US, views are shoehorned into an overly compressed blue-red binary. I prefer to think of our politics across a gradient. Please indulge my caricatures of how determinism manifests in our politics as we move from left to right. If everyone is insulted, I am doing this right.

The Barbell of Determinism

Extremely Progressive

The progressive version of deterministic success is embodied by a rentier class and its bro-ish “fail sons”. Meanwhile, a baby born across the tracks is sentenced to an entrenched underclass, institutionally conspired against, and should be read Rage Against The Machine lyrics every night so she can “know her enemy”. This is the initial-conditions-as-fate story.


If you believe outcomes have a major random component you will want to attenuate extremes which are complex processes and the most influenced by luck. The idea of a progressive tax system within reason will make sense. Healthcare for those with pre-existing conditions is basic fairness. We accept that everyone is entitled to a free education, and that a terrible accident should not bankrupt you. The notion of self-made is tempered by an appreciation that being born in a hospital was a privilege to begin with. If most Americans are moderate (debatable) then reasonable people are free to argue whether we turn the knobs to 4,5, and 6s instead of 10s (or 11s if you are a Spinal Tap fan).

Extremely conservative

Unlike the progressive for whom determinism means the seeded value predicts the terminal value, the conservative sees the terminal value as the rightful outcome of a deterministic process. You deserve what you get. Rich people are smart and poor people are lazy.

The noisy channel between justice and politics

I am reasonably confident that one’s sense of determinism drives their sense of justice. But the channel by which it influences one’s politics is far noisier. Just consider the role of self-interest in politics.

It’s reasonable to argue that conservative politics has more to do with self-interest than a sense of justice or determinism. The majority of high earners are indeed Republican [pause for the bushy-tailed 20-somethings in tech to fact check that]. Considering Democrats outnumber Republicans in general, this is especially meaningful on a normalized basis. 

Then there’s the obvious wrinkle of low-earning conservatives opposed to redistribution. Why would they vote against their self interest? I’d speculate that this can possibly be rationalized by a correlation between ‘religious-determinist’ and “everything happens for a reason”. [I’m in the deep end of the pool with that.] 

I’m trying to connect dots between how people infer the role of luck to their sense of justice to their personal politics. Self-interest confounds that process. I know because I wrestle with my own dissonance. Luck influences so much of my own view of justice. So the word deserve shook me because it cut to the heart of the contradictions I wrestle with. If I have outpunched my weight that’s a tribute to randomness. Thank heavens that’s possible. But then I’m left to wonder:

  • What is the duty that comes with that good fortune?
  • If guilt creeps in, should it?
  • Scaling up, what is the responsibility of lucky people in general?
  • If luck evens out in aggregate should we even bother to mitigate its effects on the individual level?
  • Are these questions totally off the mark?


One of my favorite economists, Russ Roberts, recently published a piece that helped me clarify my own feelings. His post, Do I Deserve What I Have, is broken up into 3 parts:

Part I: Argues that he does not deserve his standard of living.

it can be argued that much if not all of my material success comes from things I had no part in — who my parents were, the rise of the internet, the importance of economists these days and so on.

Part II: Intending to equalize material outcome would be counterproductive

Pure socialism would likely make poor people poorer…[it] would make most if not all people worse off relative to the status quo.

Part III: If success is undeserved, what does that prescribe for practical policy?

I want to tackle the harder question that I avoided in part II. Sure, pure socialism is a bad idea for large societies of millions of strangers, but doesn’t the logic of part I — the acceptance that my standard of living is in some fundamental way unearned — justify what I will call Gentle Socialism — a dramatically larger redistributive effort than what we currently have in America?

Roberts comes to the same conclusion I have:

Accomplishments explain results; they don’t justify them 

You may have worked hard and that explains your outcomes but this is not the same as justifying them. It has nothing to do with deserve. That is a judgement beyond our provision.

I’ll be honest, Robert’s brainstorms in Part III left me unsatisfied. But even that is revealing. The celestial questions of justice and randomness are larger than the man-made constructs we have to hold them. There is going to be loss.

[I often think political leanings reflect your tolerance for Type I vs Type II errors. For example, convicting an innocent person vs letting a felon walk.]

Personal Commentary

By now, you can see why the word deserve makes my skin crawl. It beckons justice in realms for which it is unfit. 

Luck is often summarized by “being born on 3rd base”. But there are many forms of luck. Just look at a sprinter’s physique. They are not like you. It’s not fashionable to say so, but there are Beth Harmons out there. This is not cause for despair, but celebration. Author Fredrik DeBoer explains why beautifully:

The other possibility is the one that Malcolm Gladwell and, well, the entirety of our culture want you to believe: that it’s all just hard work. People who seem incredibly talented simply worked hard and had perseverance. And specifically they worked harder and had more perseverance than you. If individual talent is a hoax and that all that is required to excel is the expression of will, that may be a more just world in some useless Platonic sense, and a world of more open possibility. But God, it is also a bleak world, one where all of us ordinary people are not just punished through our lack of access to supreme talent, but where we deserve it, where we not only fail to accrue the tangible benefits and psychic rewards of genius, we are presumptuous to ask for them thanks to our failures of will. Is this better?

Well, there’s no need to be consequentialist: I think some people are just good at things for reasons we can’t comprehend, that they have won a cosmic lottery and enjoy the fruits. I don’t think we live in a tidy moral universe where cause follows effect so simply or with such moral convenience. The people I’m critiquing would no doubt agree that our lives are everywhere buffeted by chance, but they can’t take that last crucial step. They can’t see that we get lucky and unlucky literally as we are being made.

My Privilege

Like many second gen Americans, my parents came to the US in the 1970s. Penniless. That means I am extremely lucky.

Imagine not just being born in the richest country in the world, but the positive selection bias of having parents who rejected the familiarity of their language, cultures and homes to be here. 

That I was born in 1978, just before the dawn of a 40 year and counting bull market, means that even when I’m still the waters around me lift me higher.

My parents emphasized education. They sacrificed to send me to Catholic school. They made this bet not knowing that the gap between haves and have nots would widen along the education axis. If it was a good bet on their part, I’m the lucky beneficiary. But this luck is invisible if I just think to myself “I did good in school, therefore I deserve X”.

It would be impossible to list all the invisible sources of luck. (I’ve been in 2 crazy car crashes and had 4 concussions by the time I was 12. Every other source of luck is incidental to the fact that I’m even here)

At a society level, appreciating the role of chance is ultimately about empathy. It’s the recognition that you could have hatched from an egg anywhere in the world in any time in history. Our policies should not amplify the extremes of cosmic dice but instead balance them. 

On a me level, the best I can hope for is not to be right and justified. It’s not for my kids to be right and successful. But it’s to honor life and consequences. To share good luck, not because I have to, but because I could have had bad luck. And when life’s inevitable unfairness strikes to not look around and find everyone arguing over what they deserve.

My Personal Trigger

Five years ago, the first summer we had in our then new home, we threw a big pool party for Yinh’s family. Yinh’s mom is the eldest of twelve. There were a lot of people. Lots of kids. Uncensored kids. Yinh and I were chatting with a group of middle schoolers when one of them just let it fly:

“Are you rich? What do you do?!”

It’s the Bay Area. Having a pool means you are rich in the same way I thought a classmate was rich if they had the G.I. Joe Aircraft carrier in 1985. Still we were standing there. I looked at Yinh with the it’s-your-family-you-take-it look. She said something about if you work hard you can have a nice house one day. Boilerplate response. Acceptable.

But of course wrong.

When we stepped away I shared my thought. These kids’ parents work hard. We know that. The kids know that. Kids are smart and these kids will wonder rightly, “Then where’s my pool?”

They deserve a complete answer. They should know how exceptional their parents are for overcoming every English-guarded obstacle on their way to starting a nail salon. They should know that they have a golden chance to outdo their parents. That education is going to be the most likely path. These realities are easy to explain because they are not just true but constructive. What’s absent is the thing that always sucks to explain: luck is a tyrant.

Fundamental Attribution Error

You know this concept from Psych 101. We ascribe success to our ability and failures to bad luck. It’s not news that we flatter ourselves. Luck looms larger than the due we give it even when it’s acknowledged.

Some underappreciated aspects of luck:

  • Less control than we think

We are what Scott Adams calls “moist robots”. Our actions can be programmed by hacking the way our brains make associations. This underlies various forms of therapy, advertising, and persuasion. Anyone who has read Cialdini’s Influence is nodding. I was chatting with Drew this week and he presented a simplified example of path dependence:

The Spotify algorithm isn’t mirroring my own deeply personal taste so much as its mirroring what was on alternative rock radio in the 90s

Since familiarity breeds fondness, the reinforcing loops of our lives are more beholden to initial conditions than we feel comfortable admitting.

  • Respect for counterfactuals

You’ve seen me commiserate with Andy Weir’s Egg. Well, one of the greatest Magic The Gathering players of all-time, Jon Finkel, echoes the ovarian lottery idea.

I think I’m a bright guy, but I’m also aware of how much of my success has been luck. I was born a white man to upper middle class parents in the wealthiest country the world has ever known. I had a very specific set of skills that are easily translatable into money in our current society, but would have been far less useful for most of human history. The game I got obsessed with happened to grow and expand into the enormous thing magic has become, and it just so happens that I was actually good at it. So basically, I don’t think I have an edge in everything at all. I think I had a couple specific intellectual skills and it just so happens that they’re most obvious in the games that all the smart people I know also play, so it makes me look more talented than I really am. (Interview transcript)

In no era in history has brawn mattered so little as it does today. This should humble most of us desk jockeys.

  • The bell curve of luck

    On Tyler Cowen’s podcast, Jordan Peterson comments on an unlucky and meaningful segment of the population:

    The American military decided a couple of decades ago that it was illegal to induct anybody into the armed forces who had an IQ of less than 83. That’s an unbelievably important thing to know because that’s about 10 percent of the population.

    You’ve got to understand what this means. It means that a very large organization that’s desperately hungry for manpower, especially under circumstances of extreme crisis, is unwilling to accept 10 percent of the population because they have determined — after 100 years of doing absolutely everything they possibly could to the contrary — that there isn’t a single thing that they can train someone like that to do that’s not counterproductive.

Success is overdetermined

If life were totally random, the opposite would be determinism. From one perspective a cast die is random. But from another the toss trajectory and speed, the material and that of the landing surface, the position of the moon, and the imperceptible rotation of the Earth about it’s axis are as predictable as equations.

No serious person invokes a Hari Seldon-esque mapping of inputs to outputs but millions of people will agree with this:

The implication is that success can be explained. I’m not picking on Pomp, Yinh’s response to the children was similarly overdetermined by x = hard work. Yinh and Pomp can both be interpreted charitably. They presented a required condition as a sufficient condition. The worst crime here is incompleteness.

The danger is when the incomplete knowledge gets inverted. When we start to believe you are NOT successful because you did NOT work hard. As if the world adhered to a model without a giant error term.

The downstream effects of this logic are profound. “Everything happens for a reason” gives way to the just-world delusion. Via Wikipedia, this fallacy asserts:

that a person’s actions are inherently inclined to bring morally fair and fitting consequences to that person; thus, it is the assumption that all noble actions are eventually rewarded and all evil actions eventually punished.

This determinism is the basis of victim-blaming. If you are poor you must have done something to deserve it.

My trigger

Yinh gave me permission to share this story:

Years ago, after 6 especially hardworking months in her new job she wanted to buy herself a timepiece (aka, a watch). This would be a non-event except for what she said and how I reacted. She said, “I deserve it”.

Boom, mushroom cloud.

The word split me in half like a bolt of lightening. Deserve. Biggest argument we ever had. “What does “deserve” have to do with anything?!” I raved. What does the word even mean? Yinh grew up with nothing. She was succeeding and she wanted a treat. I had no objection to indulgence. But to justify it was to bury good people alive. It was the closest I felt to what I imagined religion feels like to true believers. I needed Yinh to convert. To a non-deserver.

Today we joke about the story. I even told the story of my “trigger word” to a friend this week when she suggested I go to Guitar Center with her husband to to take advantage of the sales. “Buy a new guitar, you deserve it”, she said. This time I just laughed. I find the word just as bothersome, but I’ve been dealing with it. The issue is the same one that made me correct Yinh about the kids. The same thing that made me clip Pomp’s tweet.

In my next post, I’ll share why the word deserve makes my skin crawl. You can decide how crazy or wrong I am. Or maybe you will think of the word differently.

Part II: Why ‘Deserve’ Makes My Skin Crawl

Measurement Not Prediction

Morgan tweeted a fun question today

It’s a provocative exercise to reduce investing to a single law. There are many thoughtful responses. It’s a healthy opportunity to consolidate your core beliefs about investing.

Twitter has exposed me to many ideas that I’ve re-mixed with my own experience. That process may uncover universal truths. It has helped form new beliefs, challenged old beliefs, and improved my understanding of some beliefs. I maintain a notebook of these beliefs.

There are 3 categories:

  1. Current Priors
    Examples: Long term bonds offer poor risk/reward or demographics are slow moving drivers of growth rates
  2. Beliefs Graveyard
    Examples: Profit margins should mean revert, printing money leads to inflation, more risk equals more reward
  3. Evergreen Beliefs
    I have publically shared these on my wiki.

I have recently added another to my “current priors”. It’s a belief that has underpinned my trading style for 20 years but I was only able to name it recently. Why? Because it only revealed itself in relief to what other people think investing is about. By observing how people think about investing, I’ve noticed my current prior is not widely obvious:

Investment edge is about measurement not prediction.

The distinction between prediction and measurement

Predicting means you make a probability-weighted opinion of future states of the world. This is typically built up from logic and reasoning.

Measurement is counting. Usually with an intent to rank. The idea is simple but not easy. Accounting is an entire field devoted to trying to create a meaningful picture of a business by normalizing quantities across industries.

These are of course not mutually exclusive activities. Measurement is done in current time and then projection leads to predictions. The prediction eventually becomes a point in the past, gets counted, and iteratively fed into the next projection.

Yet when I say edge is about measurement not prediction I am very much emphasizing the importance of measurement over prediction. There is just a single prediction underlying the entire framework:

Over time, cheap stuff outperforms expensive stuff.

But there is so much to measure. Once you accept this, your gaze shifts from the future to the present. The focus becomes finding the variables that matter, harvesting and cleaning data, and normalizing across markets. Every one of these steps leaves tremendous opportunity for creativity, discretion, and disagreement.

Why do I make this distinction?

There are many ways to skin a cat (don’t linger on that too long, it’s an expression better left unexamined).

Your cornerstone beliefs depend heavily on the path your career has taken. There are activist investors who use their rights to influence outcomes. Thematic investors concentrate their portfolio around a vision of the future (AI, crypto, cannabis, clean energy). They are the epitome of crystal ball predictors wagering their money and time. These strategies are high risk-reward with long feedback loops.

But I came into the investing world from the nearly the opposite angle. The market-making side. I see trading as the role of the house in a casino. That means diversifying over a wide range of discrete edges and not letting any single bet risk putting you out of business. Rapid feedback loops and large sample sizes. The focus is on operationalizing and measurement. In options, if you do not understand volatility time you cannot compare implied vols across markets. There’s only one major prediction: 1 If I measure cheap and expensive correctly it will pay off as surely as the casino gets paid.

If the distinction isn’t clear consider this story from Andrew Tsai about his internship at Susquehanna (disclosure: I worked there for 8 years after college). He recounts a company outing to a dog track:

I’m sitting next to one of the partners and I’m looking at the sheet of all the races, and he’s like “How are you gonna bet?” I respond, “Well, I’ve never really done this before but this dog looks like he’s got a good track record and he’s been running strong lately.”

The guy looked at me like I was a complete idiot.

He’s like, “What are you talking about, ‘How is this dog doing?’”

Andrew is perplexed. Well, isn’t that kind of what we’re talking about.

The partner starts to explain, Look at the relative value of this dog and that dog.

Tsai’s confusion was at the heart of prediction vs measurement. The partner didn’t have any opinion about the dog’s chances. He was just looking for mispriced lines. Which is another way of saying, “I don’t know what is going to happen but these prices are self-contradictory compared to the future state of the world.”

Yes, there’s some embedded prediction there, but the framing is very different from wondering which dog is feeling extra feisty.

Measurement — simple but not easy.

If you normalize correctly then the cheap and expensive are just colors on a heatmap. In options, you must normalize vols, time, funding, and any parameter you believe drives pricing. Your feedback loops are punctuated by expiration cycles where the asset’s distribution needs to be settled. That’s the beauty of options. My friend Jeff explains this beautifully with respect to futures markets in his interview with Corey Hoffstein. Expirations force a convergence of truth. Manage risk, learn, repeat.

Exporting the logic to fundamental investing is outside my practical experience, but I can see the complexity of the problem. Consider stocks. As perpetual claims on future earnings, they have durations that vary with market discount factors. Today, fundamental investors feel like the ref (aka discount factor & interest rates) has tacked 90 minutes of extra time to the soccer match as earnings are amortized from ever further into the future.

I’m even more daunted when I consider wrangling fundamental parameters. A superficial process doesn’t distinguish between a value stock and a value trap. Even deeper, there’s a big difference between a stock whose cheapness reflects a low forward ROIC vs a stock that’s cheap because the market knows its inventory is overvalued.

From the outside, it appears that quant approaches to stock-picking come from the measuring camp. Yet commoditized approaches are likely frustrated by naïve measurement practices or practices that do not truly scale. So long as reading the fine-print in financial statements is labor-intensive and dependent on judgement, stock-picking will be an opportunity for analysts at the pinnacle of the art of measuring.

In addition to understanding business, there’s an adjacent skillset of understanding finance. In this thread by @10kdiver, we can see how stock based compensation can obscure the cap structure of a company. Any valuation estimate downstream from this analysis will be sensitive to how this impact is normalized across stocks’ dilution paths.

Selling a differentiated depth of knowledge in both finance and industry is easier than actually possessing it. So it makes sense to have a high bar when faced with someone claiming to have both.

A focus on measurement and agnosticm

I’m probably one of the few individuals who has ever leased on a seat on the Amex, NYSE, NYMEX, COMEX, and NYBOT/ICE (so every exchange in NYC. You are welcome to view this as a demerit as well).

By the end of my floor trading life, I leased (believe me I wish I owned) seats on all 3 exchanges in the NYMEX building at 1 North End Avenue. I was a ghost who would migrate from pit to pit based on where the action was. I learned the specific dynamics of several markets including oil, gas, precious metals, and soft commodities. Yet, I only dove into fundamentals deep enough to understand the major “gotchas” (usually squeeze mechanisms and bottlenecks) and seasonality trends. The Slovic study on horse bettors who were given more info than they needed showed that the extra data increased their confidence faster than their accuracy. And as you’ve heard, “It’s not what you don’t know that kills you, it’s what you know for sure that ain’t true.”

Find the variables that matter and ruthlessly tune. Normalization within and across these markets became the focus. I was a microcosm of the firms I had worked for. The specifics of a market needed to be learned to be fed up into a more bird’s eye view. Then it was a matter of sorting cheap and expensive. At no point did I have an opinion on underlying price. I’m a donkey. I just look for mispriced point spreads. Yes context matters, but as much as possible, I held an end goal of feeding normalized parameters into a framework to see what pops out.

Today, I remain skeptical of thematic and fundamental approaches. The former because it relies on prediction. For fundamental approaches, I’d like to see how a manager shortens the feedback loops. How they can map the variables they focus on to outcomes. Ideally variables that bounce around so there is trading opportunity and sample sizes. If this process lacks iteration it cannot improve. It just starts to look like thesis investing.

My bias (again, views are path-dependent and I am clearly giving my experience lots of weight) is towards agnostic, opportunist type of investors. Folks that are normalizing lines rigorously to find the mispriced horse. No allegiance to asset class or sector. When I talk to a manager I want to know what kind of metrics they look at, why those metrics matter, how they know if they still matter, and what short cycles they study to inform the metastability of their framework.

You are either a casino or a tourist. So if you claim you can count cards I need to be convinced they are countable. Can you measure?

YIMBY Paradoxes

All sensible policies must contend with trade-offs between equality and efficiency. There’s a tension between between optimal resource allocation and, well, basic fairness. Textbooks call it positive vs normative economics. Progressive taxation, honors classes, pre-existing conditions. These topics are neck deep in these trade-offs.

Housing Policy Cage Matches

Housing policy debates are a pure form of this polarity between economic and social fairness. Unfortunately, these debates become charged cartoons pitting Nextdoor superposters who pay $500/yr in property taxes on their 5 bdrm peninsula homes against tech-worshipping YIMBY Nudgers.

It’s understandable that housing discussion dispenses with nuance. There’s no room for hedged statements when you have a book to talk. And everyone has a book to talk. Especially near expensive cities where the stakes are high because shelter is either your largest expense or biggest “investment”.

Even if I pretend that incentives don’t dominate your stance, housing is still going to be a charged issue. Humans value proximity to one another. And shelter is known as an “excludable good”. You physically cannot stand on the GPS coordinates that my body occupies. We should always expect the means of allocating proximity to a nucleus of human activity, ie cities, to be a rilesome topic.

More Of A Puzzle

I’ve recently become a renter again, but I’ve bounced back and forth between owning and renting for the past 15 years. The only thing I have allegiance to is telling people they should not organize their life around trying to own because “it’s something an adult is supposed to do” or “rent is throwing away money” (see my post The Homeownership Fetish).

Still, when you live in the Bay Area, you cannot avoid the NIMBY/YIMBY discourse that surrounds you. I’ve always struggled to form a coherent opinion on it as any extreme stance capsizes the efficiency/equality ship while a sensible middle stance is a paradox in practice (and in practice is what matters).

I recently discovered a post that articulated the pudding of contradictions that is housing debate better than I understood them. The bummer is its conclusion is basically a shrug. Something I’ve come to accept about shrugs is they usually mean range of policies that reasonable people can agree to is fairly wide. The good news is we can feel more confident dismissing strong views. The sanguine news is that the local maxima is not a single point but a line of unsatisfying compromises.

On to the post (thanks to Taylor for sending it)…

Home Is Where The Cartel Is (Interfluidity)
Steve Randy Waldman

On the contradiction…

  • There is a fundamental contradiction at the heart of housing capitalism. We encourage people to take on highly leveraged, undiversified exposure in homes with promises that they are good “investments”, meaning they will increase or at least retain their values over time. We also claim that housing is a consumption good that should be efficiently provided, a good for which competitive markets should expand supply to drive prices down to a technologically declining marginal cost of production. Housing cannot be both of those things at once. Much of the work we have to do if we wish to increase housing supply is to deemphasize the housing-as-investment narrative in favor of housing-as-consumption-good.
  • If you buy a home in San Francisco today, the last thing you want to happen is for the housing affordability problem to be solved next year. Residential property is expensive in power cities because it includes the capitalized value of the large incomes streams one can earn from accepting tenants.

On homeowners ironic position as anti-capitalists…

  • Existing homeowners bought into particular neighborhoods in large part because of their “character”, which includes nice-sounding things like walkability or “charm”, as well as not-so-nice-sounding things like access to exclusionary education. “Zoning reform” is an anodyne way to describe an expropriation of those customary rights. It amounts to diminishing residents’ ability to preserve or control the evolution of their neighborhoods, in order to challenge the exclusivity on which the value of existing neighborhood amenities may be based.

On the YIMBY case…

  • Housing supply constraints are to blame for high rents in powerhouse cities, and may constitute an important drag on productivity growth and a cause of macroeconomic stagnation.

On the YIMBY pro-market framing…

  • “Market urbanists” present themselves as capitalist deregulators but I think they can be described with equal accuracy as radical redistributionists.

On the futility of this framing…

  • Homeowners understand their actions not as monopolizing the housing market but as protecting their homes and neighborhoods from the market. Telling people to think of their homes as a commodity upon which market forces should be brought to bear in order to ensure production of housing services at competitive prices is obtuse. People purchase property, rather than renting, largely to gain security and control, to escape the vicissitudes of the market. The worst place to emphasize “deregulation”.
  • People experience individual not aggregate outcomes, and individual outcomes are usually riskier than aggregate incomes. it is rationally hard to persuade individuals to consent to policy changes that, in aggregate terms, would meet a return-to-risk hurdle but at an individual level might not. When market urbanists point to how much more productive and awesome the city as a whole might become, they are missing this point.

How misunderstanding rent-control exacerbates the already poor framing…

  • If you frame your solution as being about “freeing markets”, you are likely to oppose rent control on naive and misleading Econ 101 grounds. Price controls, you have been taught, create scarcity, by eliminating the incentive to produce up to the market-clearing quantity…In the prosperous cities where we perceive housing crisis, market-rate housing is already priced at levels that would attract further development, if only the polity could be persuaded to allow it. New construction is market-rate housing: It is almost never subject to rent controls. The existence of rent controls on older buildings does suggest a danger that housing built today might someday be placed under rent controls too, sure. But that risk is already priced into market-rate development. If market-rate apartments sell for substantially more than their physical cost of replacement, then the market deems the risk of future value-impairing rent regulation to be sufficiently small, or sufficiently distant, or the present demand for housing to be sufficiently acute, as to cover that risk. The Econ 101 case against rent controls only holds if the threat of controls prevents the market value of newly produced rentable properties from substantially exceeding the cost of development after regulatory hurdles have been overcome. This is not what we observe in real life. Impaired prices are simply not the binding constraint on new development.
  • Market urbanists unnecessarily make enemies of a critical constituency, tenants in rent-stabilized apartments who have extraordinarily much to lose.

Ending with a shrug…

  • I don’t advocate trying to impose price ceilings on existing market-rate housing. That would be an expropriation at least as unfair and politically challenging as eliminating zoning restrictions. Plus, maximizing the quantity of housing supplied cannot be our sole, overriding objective. There is much to be said for encouraging “neighborhood capital” production, incentivized in part by the prospect of rising home values, as a means of increasing quality of life and sheer aesthetic joy, despite the “NIMBY-ism” it rationally provokes. There are trade-offs.
  • Urban housing is a really hard problem. We’ll need lots of inspiration. That economics textbook might help a little, but don’t try to use it as a cookbook.

Notes on Trading Volatility: Correlation, Term Structure, and Skew

Trading Volatility: Correlation, Term Structure, and Skew
Colin Bennett

The book is a broad reference on basic option theory, dispersion, and exotic options. It includes practical insight into managing a hedged book with a focus on correlation, term structure, and skew.

In addition its appendix includes the following topics and more:

  • a taxonomy of historical vol computations including and how they rank on “bias” and “efficiency”
  • shadow greeks
  • cap structure arbitrage theory

It’s an outstanding reference so I took notes. For public sharing I re-factored them by topic and tied some back to my own investment writing.

You can find these edited notes in my public Notion page. (Link)

Vol Premium [Partial] Justification

I’m about halfway through Colin Bennet’s terrific book Trading Volatility, Correlation, Term Structure and Skew (pdf).

Bennet is (or was) the Head of Quantitative Derivatives Strategy at Santandar. The book sits in a very sweet spot. It has lots of practical insights into managing vol portfolios and the mechanics of both vanilla and exotic options, var, and vol swaps. I’ll likely do a full post summarizing the takeaways I appreciated most, but in the meantime I thought to share this blurb about the oft-referred VRP (vol risk premium).

Just because implied vols trade over realized does not mean they are mispriced:

[To be fair the author asserts they still are. More importantly, you should read ch. 3 of the book to see how he decomposes the premium to systematic risk and pure vol demand premia.]

I wrote something similar a few weeks back:

Index options should be “overpriced”.

The question is how much premium do they deserve. If stocks warrant a risk premium over the RFR it’s because their systematic risk cannot be hedged. Index options must conceptually inherit this premium otherwise there would an arb in portfolio allocation.

An index option, held delta neutral, gets paid as correlations in the marketplace increase. It literally makes money when systematic risk embodies.

A standard for deciding if puts are expensive: Its price should have enough premium in it that by buying a put, if delta hedged, that you would actually have basis risk. In other words, it’s premium should make it uncertain that you would actually make money in a sell-off. If your argument is that it’s expensive in a vacuum (perhaps as a comparison to realized vol) then what if it was only 1% premium to realized? That sounds like a bargain for something that hedges the risk that, like, the whole world has. This isn’t news to most investors or anyone who understands portfolio construction and the beauty of neg correlations. It’s just another instance of my sun/rain example.