Moontower #149

Friends,

Last week I took an uncharacteristic adventure into macro which turned out to be my most popular post ever. Not to be all “Thom Yorke hates Creep” since you can only be that sickeningly self-important if you are actually in Radiohead, but come on. I give you what I got every week and all you really want to know is what happens to inflation when the moon is in Taurus.

Seriously, 400 new subs signed up for Moontower after that post which is 10x my normal weekly adds. There are over 4000 subs now which is up 1k in 6 weeks after getting 3000 in 3 years. On one hand, thank you. On the other, be aware that my commercial instincts are trash. As such I will not feed the ducks and you will still find me meandering into macro often. Annoyingly, my most 2nd most popular post ever was also frickin’ macroMarkets Will Permanently Reset Higher (My Sacrifice to the Delta Gods)

Here’s the best 5 seconds of your day.

Moving on.

Over the past few years, I’ve shared a lot of writing about careers and career transitions. Sometimes you know where you want to go and it’s just a matter of putting one foot in front of the other. For others, they sense what they are doing is not the right fit.

This doubt is especially unsettling at the start of a career. It’s easier to pivot when you are younger and opportunity costs are low. Oftentimes it’s just a matter of fighting through the initial discomfort.

I wanted to quit my trading career my first day into it.

I was 22 years old, hapless in my attempts to understand the language of bids and offers ricocheting from the smelly mouths I was standing next to on the Amex trading floor. “Everyone has to start somewhere” is true but hardly consolation when you feel useless. Fetching traders’ lunch was the only time I felt useful. Useful but stupid. I’m in Cafe World on the corner of Trinity and Rector staring at a diagram of where on the plate my boss wanted his Singapore mei fun noodles while lamenting the wisdom of taking on college debt for this privilege.

Fortunately, the initial learning curve for trading isn’t too steep if you are immersed on an exchange floor. I didn’t have to waste much time figuring out if this was a mistake, because it only took a little persistence to get to a place where I could be useful. I became proficient in Excel in less than 2 months. I stopped “offering for” and “bidding at” in less time than that. I could see that my development was in line with my cohort. These clues were helpful because I’ve always felt some suspicion about grit.

I thought grit was overrated.

It wasn’t a buzzword back then, but I always had a feeling that Venkat Rao put into words when he said “hard equals wrong” in Calculus of Grit.

There’s a bit I want to highlight:

School’s failure to reveal most people’s strengths sets their lives on a needlessly masochistic journey.

Venkat explains:

Why? Think of it this way. The disciplinary world very coarsely measured your aptitudes and strengths once in your lifetime, pointed you in a roughly right direction and said “Go!” The external environment had been turned into a giant obstacle course designed around a coarse global mapping of everybody’s strengths.

So there was no distinction between the map of the external world you were navigating and the map of your internal strengths. The two had been arranged to synchronize. If you navigated through a map of external achievement, landmarks, and honors, you’d automatically be navigating safely through the landscape of your internal strengths.

But when you cannot trust that you’ve been pointed in the right direction in a landscape designed around your strengths, you cannot afford to navigate based on a one-time coarse mapping of your own strengths at age 18.

If you run into an obstacle, it is far more likely that it represents a weakness rather than a meaningful real-world challenge to be overcome, as a learning experience.

Don’t try to go over or through. It makes far more sense to go around. Hack and work around. Don’t persevere out of a foolhardy superhuman sense of valor.

It can be difficult to tell when you should persevere vs cut your losses. I offer some thought and links in On GritTo be clear, I think grit is important. But if anything it’s probably more overrated than ever since an airport book was published on it.

In the years since I read that post, I came across an essay that I think is a perfect companion to the grit discussion. The subtext, at least in how I read it, is to orient your heading so it’s downhill. No matter how you read it, it’s a terrific essay. Since it’s commencement season, send it to a recent grad.

✍️How Will You Measure Your Life? (16 min read)
by Clayton M. Christensen

Here are excerpts I like to return to.

On how Clayton responds to advice-seekers…

When people ask what I think they should do, I rarely answer their question directly. Instead, I run the question aloud through one of my models. I’ll describe how the process in the model worked its way through an industry quite different from their own. And then, more often than not, they’ll say, “OK, I get it.” And they’ll answer their own question more insightfully than I could have.

On remembering why you do something at all…

Over the years I’ve watched the fates of my HBS classmates from 1979 unfold; I’ve seen more and more of them come to reunions unhappy, divorced, and alienated from their children. I can guarantee you that not a single one of them graduated with the deliberate strategy of getting divorced and raising children who would become estranged from them. And yet a shocking number of them implemented that strategy. The reason? They didn’t keep the purpose of their lives front and center as they decided how to spend their time, talents, and energy.

Had I instead spent that hour each day learning the latest techniques for mastering the problems of autocorrelation in regression analysis, I would have badly misspent my life. I apply the tools of econometrics a few times a year, but I apply my knowledge of the purpose of my life every day. It’s the single most useful thing I’ve ever learned. I promise my students that if they take the time to figure out their life purpose, they’ll look back on it as the most important thing they discovered at HBS. If they don’t figure it out, they will just sail off without a rudder and get buffeted in the very rough seas of life.

Not everything that matters is good at giving you prompt feedback. If you fail to appreciate this, you chase what’s easily legible at the cost of things that are hard to measure.

Allocation choices can make your life turn out to be very different from what you intended. Sometimes that’s good: Opportunities that you never planned for emerge. But if you misinvest your resources, the outcome can be bad. As I think about my former classmates who inadvertently invested for lives of hollow unhappiness, I can’t help believing that their troubles relate right back to a short-term perspective.

When people who have a high need for achievement—and that includes all Harvard Business School graduates—have an extra half hour of time or an extra ounce of energy, they’ll unconsciously allocate it to activities that yield the most tangible accomplishments. And our careers provide the most concrete evidence that we’re moving forward. You ship a product, finish a design, complete a presentation, close a sale, teach a class, publish a paper, get paid, get promoted. In contrast, investing time and energy in your relationship with your spouse and children typically doesn’t offer that same immediate sense of achievement.

Kids misbehave every day. It’s really not until 20 years down the road that you can put your hands on your hips and say, “I raised a good son or a good daughter.” You can neglect your relationship with your spouse, and on a day-to-day basis, it doesn’t seem as if things are deteriorating. People who are driven to excel have this unconscious propensity to underinvest in their families and overinvest in their careers—even though intimate and loving relationships with their families are the most powerful and enduring source of happiness.

If you want your kids to have strong self-esteem and confidence that they can solve hard problems, those qualities won’t magically materialize in high school. You have to design them into your family’s culture—and you have to think about this very early on. Like employees, children build self-esteem by doing things that are hard and learning what works.

Give me an example…

The lesson I learned from this is that it’s easier to hold to your principles 100% of the time than it is to hold to them 98% of the time. If you give in to “just this once,” based on a marginal cost analysis, as some of my former classmates have done, you’ll regret where you end up. You’ve got to define for yourself what you stand for and draw the line in a safe place.

Be careful how you strive…

Once you’ve finished at Harvard Business School or any other top academic institution, the vast majority of people you’ll interact with on a day-to-day basis may not be smarter than you. And if your attitude is that only smarter people have something to teach you, your learning opportunities will be very limited. But if you have a humble eagerness to learn something from everybody, your learning opportunities will be unlimited. [Me: This is a powerful prescription to make yourself more teachable]: Generally, you can be humble only if you feel really good about yourself—and you want to help those around you feel really good about themselves, too.

His final recommendation…

Don’t worry about the level of individual prominence you have achieved; worry about the individuals you have helped become better people. This is my final recommendation: Think about the metric by which your life will be judged, and make a resolution to live every day so that in the end, your life will be judged a success.

This echoes the wisdom of another late visionary, Michael Crichton:

“If you want to be happy, forget yourself. Forget all of it—how you look, how you feel, how your career is going. Just drop the whole subject of you. People dedicated to something other than themselves are the happiest people in the world.”

It’s a lot of brilliance in a couple of paragraphs:

✍️Happiness (3 min read)
by Michael Crichton


Money Angle

Greeks Are Everywhere

The option greeks everyone starts with are delta and gamma. Delta is the sensitivity of the option price with respect to changes in the underlying. Gamma is the change in that delta with respect to changes in the underlying.

If you have a call option that is 25% out-of-the-money (OTM) and the stock doubles in value, you would observe the option graduating from a low delta (when the option is 25% OTM a 1% change in the stock isn’t going to affect the option much) to having a delta near 100%. Then it moves dollar for dollar with the stock.

If the option’s delta changed from approximately 0 to 100% then gamma is self-evident. The option delta (not just the option price) changed as the stock rallied. Sometimes we can even compute a delta without the help of an option model by reasoning about it from the definition of “delta”. Consider this example from Lessons From The .50 Delta Option where we establish that delta is best thought of as a hedge ratio 1:

Stock is trading for $1. It’s a biotech and tomorrow there is a ruling:

  • 90% of the time the stock goes to zero
  • 10% of the time the stock goes to $10

First take note, the stock is correctly priced at $1 based on expected value (.90 x $0 + .10 x $10). So here are my questions.

What is the $5 call worth?

  • Back to expected value:90% of the time the call expires worthless.

    10% of the time the call is worth $5

.9 x $0 + .10 x $5 = $.50

The call is worth $.50

Now, what is the delta of the $5 call?

$5 strike call =$.50

Delta = (change in option price) / (change in stock price)

  • In the down case, the call goes from $.50 to zero as the stock goes from $1 to zero.Delta = $.50 / $1.00 = .50
  • In the up case, the call goes from $.50 to $5 while the stock goes from $1 to $10Delta = $4.50 / $9.00 = .50

The call has a .50 delta

Using The Delta As a Hedge Ratio

Let’s suppose you sell the $5 call to a punter for $.50 and to hedge you buy 50 shares of stock. Each option contract corresponds to a 100 share deliverable.

  • Down scenario P/L:Short Call P/L = $.50 x 100 = $50

    Long Stock P/L = -$1.00 x 50 = -$50

    Total P/L = $0

  • Up scenario P/L:Short Call P/L = -$4.50 x 100 = -$450

    Long Stock P/L = $9.00 x 50 = $450

    Total P/L = $0

Eureka, it works! If you hedge your option position on a .50 delta your p/l in both cases is zero.

But if you recall, the probability of the $5 call finishing in the money was just 10%. It’s worth restating. In this binary example, the 400% OTM call has a 50% delta despite only having a 10% chance of finishing in the money.

The Concept of Delta Is Not Limited To Options

Futures

Futures have deltas too. If the SPX cash index increases by 1%, the SP500 futures go up 1%. They have a delta of 100%.

But let’s look closer.

The fair value of a future is given by:

Future = Seʳᵗ

where:

S = stock price

r = interest rate

t = time to expiry in years

This formula comes straight from arbitrage pricing theory. If the cash index is trading for $100 and 1-year interest rates are 5% then the future must trade for $105.13

100e^(5% * 1) = $105.13

What if it traded for $103?

  • Then you buy the future, short the cash index at $100
  • Earn $5.13 interest on the $100 you collect when you short the stocks in the index.
  • For simplicity imagine the index doesn’t move all year. It doesn’t matter if it did move since your market risk is hedged — you are short the index in the cash market and long the index via futures.
  • At expiration, your short stock position washes with the expiring future which will have decayed to par with the index or $100.
  • [Warning: don’t trade this at home. I’m handwaving details. Operationally, the pricing is more intricate but conceptually it works just like this.]
  • P/L computation:You lost $3 on your futures position (bought for $103 and sold at $100).
    You broke even on the cash index (shorted and bought for $100)
    You earned $5.13 in interest

    Net P/L: $2.13 of riskless profit!

You can walk through the example of selling an overpriced future and buying the cash index. The point is to recognize that the future must be priced as Seʳᵗ to ensure no arbitrage. That’s the definition of fair value.

You may have noticed that a future must have several greeks. Let’s list them:

  • Theta: the future decays as time passes. If it was a 1-day future it would only incorporate a single day’s interest in its fair value. In our example, the future was $103 and decayed to $100 over the course of the year as the index was unchanged. The daily theta is exactly worth 1 day’s interest.
  • Rho: The future’s fair value changes with interest rates. If the rate was 6% the future would be worth $106.18. So the future has $1.05 of sensitivity per 100 bps change in rates.
  • Delta: Yes the future even has a delta with respect to the underlying! Imagine the index doubled from $100 to $200. The new future fair value assuming 5% interest rates would be $210.25.Invoking “rise over run” from middle school:

    delta = change in future / change in index
    delta = (210.25 – 105.13)/ (200 – 100)
    delta = 105%

    That holds for small moves too. If the index increases by 1%, the future increases by 1.05%

  • Gamma: 0. There is no gamma. The delta doesn’t change as the stock moves.

Levered ETFs

Levered and inverse ETFs have both delta and gamma! My latest post dives into how we compute them.

✍️The Gamma Of Levered ETFs (8 min read)

This is an evergreen reference that includes:

  • the mechanics of levered ETFs
  • a simple and elegant expression for their gamma
  • an explanation of the asymmetry between long and short ETFs
  • insight into why shorting is especially difficult
  • the application of gamma to real-world trading strategies
  • a warning about levered ETFs
  • an appendix that shows how to use deltas to combine related instruments

And here’s some extra fun since I mentioned the challenge of short positions:

Bonds

Bonds have delta and gamma. They are called “duration” and “convexity”. The duration is the sensitivity to the bond price with respect to interest rates. Borrowing from my older post Where Does Convexity Come From?:

Consider the present value of a note with the following terms:

Face value: $1000
Coupon: 5%
Schedule: Semi-Annual
Maturity: 10 years

Suppose you buy the bond when prevailing interest rates are 5%. If interest rates go to 0, you will make a 68% return. If interest rates blow out to 10% you will only lose 32%.

It turns out then as interest rates fall, you actually make money at an increasing rate. As rates rise, you lose money at a decreasing rate. So again, your delta with respect to interest rate changes. In bond world, the equivalent of delta is duration. It’s the answer to the question “how much does my bond change in value for a 1% change in rates?”

So where does the curvature in bond payoff come from? The fact that the bond duration changes as interest rates change. This is reminiscent of how the option call delta changed as the stock price rallied.

The red line shows the bond duration when yields are 10%. But as interest rates fall we can see the bond duration increases, making the bonds even more sensitive to rates decline. The payoff curvature is a product of your position becoming increasingly sensitive to rates. Again, contrast with stocks where your position sensitivity to the price stays constant.

Corporations

Companies have all kinds of greeks. A company at the seed stage is pure optionality. Its value is pure extrinsic premium to its assets (or book value). In fact, you can think of any corporation as the premium of the zero strike call.

[See a fuller discussion of the Merton model on Lily’s Substack which is a must-follow. We talk about similar stuff but she’s a genius and I’m just old.]

Oil drillers are an easy example. If a driller can pull oil out of the ground at a cost of $50 a barrel but oil is trading for $25 it has the option to not drill. The company has theta in the form of cash burn but it still has value because oil could shoot higher than $50 one day. The oil company’s profits will be highly levered to the oil price. With oil bouncing around $20-$30 the stock has a small delta, if oil is $75, the stock will have a high delta. This implies the presence of gamma since the delta is changing.

Games

One of the reasons I like boardgames is they are filled with greeks. There are underlying economic or mathematical sensitivities that are obscured by a theme. Chess has a thin veneer of a war theme stretched over its abstraction. Other games like Settlers of Catan or Bohnanza (a trading game hiding under a bean farming theme) have more pronounced stories but as with any game, when you sit down you are trying to reduce the game to its hidden abstractions and mechanics.

The objective is to use the least resources (whether those are turns/actions, physical resources, money, etc) to maximize the value of your decisions. Mapping those values to a strategy to satisfy the win conditions is similar to investing or building a successful business as an entrepreneur. You allocate constrained resources to generate the highest return, best-risk adjusted return, smallest loss…whatever your objective is.

Games have mine a variety of mechanics (awesome list here) just as there are many types of business models. Both game mechanics and business models ebb and flow in popularity. With games, it’s often just chasing the fashion of a recent hit that has captivated the nerds. With businesses, the popularity of models will oscillate (or be born) in the context of new technology or legal environments.

In both business and games, you are constructing mental accounting frameworks to understand how a dollar or point flows through the system. On the surface, Monopoly is about real estate, but un-skinned it’s a dice game with expected values that derive from probabilities of landing on certain spaces times the payoffs associated with the spaces. The highest value properties in this accounting system are the orange properties (ie Tennessee Ave) and red properties (ie Kentucky). Why? Because the jail space is a sink in an “attractor landscape” while the rents are high enough to kneecap opponents. Throw in cards like “advance to nearest utility”, “advance to St. Charles Place”, and “Illinois Ave” and the chance to land on those spaces over the course of a game more than offsets the Boardwalk haymaker even with the Boardwalk card in the deck.

In deck-building games like Dominion, you are reducing the problem to “create a high-velocity deck of synergistic combos”. Until you recognize this, the opponent who burns their single coin cards looks like a kamikaze pilot. But as the game progresses, the compounding effects of the short, efficient deck creates runaway value. You will give up before the game is over, eager to start again with X-ray vision to see through the theme and into the underlying greeks.

[If the link between games and business raises an antenna, you have to listen to Reid Hoffman explain it to Tyler Cowen!]

Wrapping Up

Option greeks are just an instance of a wider concept — sensitivity to one variable as we hold the rest constant. Being tuned to estimating greeks in business and life is a useful lens for comprehending “how does this work?”. Armed with that knowledge, you can create dashboards that measure the KPIs in whatever you care about, reason about multi-order effects, and serve the ultimate purpose — make better decisions.


Last Call

✍️Notes From C.Thi Nguyen Interview About Games and Society (14 min read)

This is a re-post from one of my favorite all-time interviews.

C. Thi Nguyen received his Ph.D. in philosophy from the University of California, Los Angeles. He is currently associate professor of Philosophy at the University of Utah. He has written public philosophy for venues such as Aeon and The New York Times, and is an editor of the aesthetics blog Aesthetics for Birds. He was the recipient of the 2020 Article Prize from the American Philosophical Association. His recent book is Games: Agency as Art.

But here’s the most fun part:

Nguyen’s Board Games: so many recommendations

I’ve played several of these. The list and descriptions are glorious.

 

Stay groovy!


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Moontower #148

Here’s a rarity for this letter. Let’s play macroeconomics.

I don’t usually write about “macro” because it feels like astrology. You can look at any bit of data (the “current thing” as they say on the internet is inflation) and see it molded to be the cause or result of whatever axe a speaker is trying to grind. People who just learned what inflation was on Tuesday have incorporated it into their pre-existing worldview so seamlessly that by Friday their updated narrative is more coherent than ever.

Macro is the raw material for story-telling. For marketing. It’s a political battering ram for both sides. But macro is a ball of yarn. The discourse that’s consumable is reduced so much to aid absorption that the logic, by necessity, ends up sounding unassailable. It must. The logic is solving for convenience. Not understanding.

So I don’t write about it because I don’t think it’s especially useful. It’s more likely to give you brainworms by beefing up your priors. It will calcify hunches into commandments when the evidence only merits “things to learn more about”.

“Buy Potatoes”

While I don’t write about macro, I’m hardly immune to the animal urge to read about it and pretend I understand how the world works. My mind’s sentry just keeps me from taking it too seriously. [I suspect the sentry has saved me many times and cost me many times and I can’t tell if it’s worth the free rent it gets in my head. The question is moot, since I can’t evict it anyway. It’s like SF up in there.]

My first macro boner happened (was searching for the right verb here and “happens” is the most fitting action word to apply to boners) while reading Michael Lewis’ Liar’s Poker when I was 21. When Michael was a junior salesperson on the Salomon trading desk, he was taken under the wing of a senior trader named Alexander:

The second pattern to Alexander’s thought was that in the event of a major dislocation, such as a stock market crash, a natural disaster, the breakdown of OPEC’s production agreements, he would look away from the initial focus of investor interest and seek secondary and tertiary effects.

Remember Chernobyl? When news broke that the Soviet nuclear reactor had exploded, Alexander called. Only minutes before, confir mation of the disaster had blipped across our Quotron machines, yet Alexander had already bought the equivalent of two supertankers of crude oil. The focus of investor attention was on the New York Stock Exchange, he said. In particular it was on any company involved in nuclear power. The stocks of those companies were plummeting. Never mind that, he said. He had just purchased, on behalf of his clients, oil futures. Instantly in his mind less supply of nuclear power equaled more demand for oil, and he was right. His investors made a large killing. Mine made a small killing. Minutes after I had persuaded a few clients to buy some oil, Alexander called back.

“Buy potatoes,” he said. “Gotta hop.” Then he hung up. Of course. A cloud of fallout would threaten European food and water supplies, including the potato crop, placing a premium on uncon taminated American substitutes. Perhaps a few folks other than potato farmers think of the price of potatoes in America minutes after the explosion of a nuclear reactor in Russian, but I have never met them.

But Chernobyl and oil are a comparatively straightforward example. There was a game we played called What if? All sorts of complications can be introduced into What if? Imagine, for example, you are an institutional investor managing several billion dollars. What if there is a massive earthquake in Tokyo? Tokyo is reduced to rubble. Investors in Japan panic. They are selling yen and trying to get their money out of the Japanese stock market. What do you do?

Well, along the lines of pattern number one, what Alexander would do is put money into Japan on the assumption that since everyone was trying to get out, there must be some bargains. He would buy precisely those securities in Japan that appeared the least desirable to others. First, the stocks of Japanese insurance companies. The world would probably assume that ordinary insurance companies had a great deal of exposure…

If you are 21 years old today, how can you not hear “buy potatoes” and not think of trading as Settlers of Catan? Trading is the ultimate boardgame. It’s just that now, an algo sweeps all the call offers on Brent futures before Alexander finishes reading the headline. [Actually, the market-makers’ streaming call offers have a “panic” setting that gets triggered if they get hit on more than couple related strikes at a time and pull their co-located quotes before they get picked off by the news-reading algo. So prices can gap to something closer to fair value on very little trading volume. The graveyard of backtesting signals that don’t appreciate this would occupy every blade of grass on the planet if it were a physical place].

The blessing and curse of our frontal lobes is a desire to understand how the complex world works. Macro brings the romance of chess to investing. It lures mandate-dodging pros and tourists alike with scalable p/l if you can:

a) make accurate predictions

and

b) identify mispriced lines with respect to those predictions.

In reality, it’s more like 3-card Monte where you have no chance of guessing where the card is and if you get lucky the reward is the false confidence to wager more next time. [I highly recommend the Wikipedia for 3-card Monte. The analogy of “marks” and “shills” to the finance marketing machine writes itself].

My personal relationship with macro is as follows:

  1. I’ve got some mental model of how things work
  2. Stuff happens — none of it was predicted by that model
  3. Backfit new models to explain the strange stuff
  4. Repeat

Seriously, the meme never stops giving.

With that, in this week’s Money Angle, I’m going to go full-Tobias [narrator: you never go full Tobias] and share some macro takes I found resonant in explaining the past several decades.


Money Angle

Since this is macro story-telling I’d consider this entertainment. I’m just picking a story that feels right. These are the re-factored views of Lyn Alden and Cem Karsan.

In Lyn’s March newsletter, we start by rewinding the clock.

  1. The globalized labor arbitrage begins


    Starting in the early 1980s, China began to open its economy to the rest of the world. And then starting in the early 1990s, the Soviet Union collapsed and its various former states also began to open their economies to the world. This combination brought a massive amount of untapped labor into global markets within a rather short period of time, which allowed corporations to geographically arbitrage their operations (a.k.a. offshore a big chunk of their labor force and various facilities) to take advantage of this. This was disadvantageous to laborers and tradespeople in developed markets, and advantageous to executives and shareholders, particularly in the US where we shifted towards massive trade deficits in the 1990s. But it did also help hundreds of millions of people rise out of abject poverty in these developing countries, and created hundreds of millions of new global consumers for those global brands as their wealth grew. China experienced a massive increase in the average standing of living, and so did many former Soviet states.

  2. Bean counters then optimized on the back of this arbitrage

    All sorts of management approaches regarding “lean manufacturing” and “just in time delivery” became popular among corporations and MBA programs during this era. Some of these had their roots in the early 20th-century manufacturing revolution (via Ford, Toyota, and others), but they were basically rediscovered, expounded upon, and brought to a new level in the 1980s, 1990s, and 2000s across the entire manufacturing sector.

    Moontower readers will recognize the MBA mindset of selling options. Engineers build beyond spec, or “overengineer”. Biologists know our redundant kidney is an insurance policy.

    We constantly trade slack for efficiency as Moloch whistles by. The balance between efficiency and slack (or efficiency and fairness for that matter) is hard to find. So we can count on overshooting until the “gotchas” show themselves.

    Of course, this was somewhat of an illusion. Companies basically traded away resilience in favor of efficiency, while pretending that there was minimal downside, and yet this type of approach only works under a benign global environment. Outside of the Middle East and a few localized regions around the world, the 1980s through the 2010s was generally a period of limited war as far as supply chains were concerned, with significant global openness and cooperation. Extremely efficient and highly complex supply chains, with limited redundancy or inventory, could thrive in this stars-aligned macro environment. Any company not playing that game would be less efficient in this environment, and thus would be out-competed.

  3. As we enter a new regime, comparisons to recent history are breaking

    Going forward, any back-tests about inflation or disinflation that only go back twenty or thirty years are practically useless. This whole 1980s-through-2010s disinflationary period (with one substantial cyclical inflationary burst in the 2000s) was during a backdrop of structurally falling interest rates and increasing globalization, with the sacrifice of resiliency for more efficiency. The world is now looking at the need to duplicate many parts of the supply chain, find and develop potentially redundant sources of commodities, hold higher inventories of everything, and in general boost resilience at the cost of efficiency.

  4. The 1940s as the reference point

    I’ve been making a macroeconomic comparison between the 2020s and the 1940s for nearly two years now, and the similarities unfortunately continue to stack up. For the most part, I was referring to monetary and fiscal policy and the long-term debt cycle for that comparison, with charts like this that my readers are quite familiar with by now.

    This unusually wide gap between inflation and interest rates is one of the key reasons I regularly compare the 2020s to the 1940s (rather than primarily the 1970s, despite some other similarities there), and I have been making that comparison for nearly two years before the gap became as wide as it is now.

    Since debt was so high in the 1940s (unlike the 1970s where it was low), and the inflation was driven by fiscal spending and commodity shortages in the 1940s (rather than a demographic boom and commodity shortages as in the 1970s), the Fed held interest rates low even as inflation ran hot in the 1940s (unlike the 1970s where they raised rates to double-digit levels).

  5. Will Russia’s latest adventure hasten the broader movement to diversify away from USD reserves?

    Diversification of global reserves and payment channels into a more multi-polar reserve currency world, with a renewed emphasis on neutral reserve assets. Much like how COVID-19 accelerated the practice of remote work, I think Russia’s war with Ukraine and the associated sanction response by the West will accelerate that diversification of global reserves and payment channels…In a world where official reserves can be frozen, some degree of reserve diversification would be rational for most countries to consider, and as investors, we should probably expect this to occur over time. This is especially true for countries that are not strongly aligned with the United States and western Europe.

  6. The conundrum facing US policymakers

    Unfortunately for the Fed, the US economic growth rate is already decelerating, and basically the only way to reduce supply-driven inflation with monetary policy is to reduce demand for goods, which is recessionary.

    Credit markets are already weakening, the Treasury market is becoming rather volatile and illiquid, and the Fed has ended quantitative easing. The Fed is likely to continue monetary tightening until financial markets get truly messy, at which point they may reverse course to the dovish side yet again.

    Stagflationary economic conditions are inherently hard for central banks to deal with; stagflation is somewhat outside of their expected models. In fact, the Fed might end up being forced to tighten liquidity with one hand and loosen liquidity with the other hand.

    This is another reason why countries may shift towards gold and other commodities for a portion of their official reserves. Not only can fiat reserves (bonds and deposits) be frozen by foreign countries that issue those liabilities, they also keep getting devalued with interest rates that are far below the prevailing inflation rate because debt levels are too high to raise rates above the inflation level.

We now shift to Cem Karsan. In an interview with Hari Krishnan, Cem discusses how policy in the aftermath of the GFC is misunderstood. This is important because policy is changing, and if you failed to interpret the effect of policy in the last decade, you may be caught flat-footed as the policy changes.

I don’t want to be subtle about the potential problem.

Popular investment strategies have been fit to recent decades. Roboadvisors, 60/40, “model portfolios” and target-date funds are now the default. Once you tell an advisor your age and risk tolerance they strap you into an off-the-shelf glide path and go looking for their next client. And it’s hard to fault them. They have no edge in the alpha game. 60/40 and similar approaches are low-cost, commoditized solutions that allow an advisor to (correctly) not spend time stock-picking. With fee compression in advisory, FAs can defend their net profits by outsourcing the investing portion of the job while focusing on planning and sales. To further cement their incentives, the prisoner’s dilemma of advisory means they can’t stray too far from popular asset allocation prescriptions because the advisors are the one short tracking error volatility.

Lyn believes the macro world is changing sharply. Cem has been beating this drum for the past year at least. Let’s see what he says.

  1. Monetary policy came to dominate because it’s relatively free from political stand-offs

    My mental model of macro involves essentially monitoring the Fed (ie monetary policy) and then fiscal policy. We’ve essentially had one of those two major pipes sealed shut for 42 years. Our founding fathers in the US created a system that was purposely made to not change laws quickly or easily. That was fine until the economy became more dynamic and quicker. Congress decided they couldn’t act quickly enough to economic crises. So they created the Federal Reserve but they wanted to control its mandate, to not give it broad latitude. So they created a clear mandate of price stability and maximum employment, and only gave them one tool, — monetary policy. Essentially, there’s only been one game in town because the only way things would ever get past from a fiscal perspective is in a crisis. The monetary solution was faster, so monetary policy has been the only game in town for 42 years.

  2. The nature of loose monetary policy is to encourage investment

    Monetary policy is free-market economics, right? It is empowering nature to go about and, and create kind of optimal outcomes. From a growth perspective, that is GDP-maximizing. We have created a technological revolution, almost unintentionally, but by being monetary policy supply-side dominant. We’ve created the Ubers and Amazons and Tesla’s of the world, companies that never would have existed in previous periods because they wouldn’t have had the cash flow to survive. But infinite cash flow ultimately led to longer duration bets. And this is why growth has outperformed value because cash flows haven’t mattered when money is free. If there’s no need to make money, the need is to capture market share and get bigger, to ultimately make money in the long run. You send money to corporations, corporations make more money. Ultimately, that leads to more globalization. If you send money to corporations, what is the corporation’s mandate, by definition, they have to maximize profitability, maximizing profitability means lowering costs of their goods, right and capturing more market share. So that’s the power of competition.

    [This echoes Lyn’s discussion of globalization]

    Remember Moloch’s main trick for fanning unhealthy competition, is to reduce our values to narrow optimizations. When an institution is highly specialized its incentives become perverse from a society-level purview.

    Let’s see why.

  3. Monetary policy didn’t appear to have side effects because the Fed’s narrow mandate failed to consider wider signs of economic vitality

    If you look at incentives, you’ll see the results. The incentives have been to these two simple ideas of price stability and maximum employment. Greenspan realized that the economy had somewhat changed. And that more monetary policy wasn’t causing inflation. It took the natural rate of unemployment down from 6% to 4%. And kept doing more monetary policy, which led to the tech bubble. Without having to worry about inflation their mandate was basically maximum employment. If that’s the case, right? Why wouldn’t you just do more, it’s a free lunch, right. And so the world has had a free lunch now, for 40 years, interest rates have gone lower and lower. Maximum employment has been more and more sticky at the lower end.

    But there was a catch. And it wasn’t the Fed’s job to address it. (In fact, you could argue that thru the “wealth effect” the catch was intended.)

  4. It’s not really the Fed’s fault. The problem is they didn’t have a mandate for inequality, or a lot of other issues.

    The Fed is permitted to neglect growing gaps in equality. These gaps finally caught up to us during Covid, but this time the government responded. We ran a giant fiscal deficit with PPE loans, extended unemployment benefits, direct transfer payments, rent moratoriums, and general forgiveness. Support for these measures was broad enough to get them passed.

    But perhaps the most important result was the recognition that inequality itself is stark. The keyboard class just hummed along on Zoom, often getting paid more, while having less opportunities to spend. They built up massive savings which if I didn’t know better seems to be conspicuously spent on house overbids and jerking the ladder up with renewed and unprecedented force.

    Let’s turn to Cem’s framing of inequality and why it’s a value we cannot ignore.

    Ultimately this goes back to Socrates. Do you give the best violin players the best violins? Or do you give the worst violin players the best violins? At the end of the day, we’ve given the best violin players the best violins. And Socrates would argue that that’s what you should do, because it creates infinitely beautiful music. But there are a bunch of violin players that don’t get to make music anymore. So we start talking about inequality about 10 years ago, and it’s really built up in five years, and COVID accelerated that trend. Again, all of a sudden, COVID happens. We get that populist kind of reaction, which had been building, what created Donald Trump and created Bernie Sanders. This is not a political statement. The world has become more populist, because of this inequality that’s essentially been created by monetary policy for two generations. And so now the fiscal response is where we are.

    This policy shift is noteworthy for investors. Especially if you have mistaken beliefs about how loose monetary policy affects supply and demand. In the aftermath of the GFC, with the monetary spigot open, the consensus was it would lead to broad inflation.

    Cem offers a counterintuitive explanation that fits what we actually witnessed since the GFC.

  5. The important difference between fiscal and monetary policy — fiscal is inflationary. Monetary, counterintuitively is not.

    This whole thing is important in terms of the pipes and how everything works. That fiscal policy piece that’s been sealed shut for 40 years now has $12 trillion in fiscal policy. $12 trillion in Fiscal policy is an order of magnitude in real terms bigger than the New Deal. It is about the same size as the new deal when adjusted for the size of the economy. The New Deal filled a hole over a decade, which was called the Great Depression. This is not the Great Depression. We spent about one and a half trillion of that $12 trillion, there’s about $10 trillion still in the pipe to come, and we’re about to reopen.

    So it is not a surprise that we are having inflation. Fiscal policy has a velocity of one, it goes directly into people’s pockets, sometimes even more with things like infrastructure spending. Monetary policy has a velocity of almost zero, it goes directly to “Planet Palo Alto”. And Palo Alto creates new technologies. They’re sophisticated, futuristic people. They provide new self-driving cars and things getting delivered to your doorstep. They create supply. That’s the thing that people don’t understand — monetary policy actually increases supply, it does not increase demand. And so it is deflationary.

  6. The role of the Fed today

    When the Fed was created, the economy was very different. It was dependent on labor. The trickle-down effects of a laborer getting paid more was enough to counteract those inflationary supply effects. That is no longer the case. So ultimately, the Fed has a mandate, which is completely unreasonable — to control price stability. With supply-side economics, the only way that they can control this ultimately is to pull back. And slow capital markets decrease via the wealth effect. Ultimately, there’s a significant lag, so they are not in a position to ultimately control inflation without bringing down markets.

Cem is saying that raising rates is a blunt tool. It’s a monetary solution to a fundamentally non-monetary problem because it only works on one side of the ledger. Demand. Rate hikes can only reasonably expect to slow the economy by decreasing demand. It doesn’t address the main problem which is a lack of supply to absorb the demand. In fact, it aggravates it. If you believe inflation is a purely monetary phenomenon this is a belated prompt to unlearn that.

How I relate this to MMT

MMT discourse gets lambasted because it appears irresponsibly profligate. Consider the Investopedia definition of modern monetary theory:

Modern Monetary Theory (MMT) is a heterodox macroeconomic framework that says monetarily sovereign countries like the U.S., U.K., Japan, and Canada, which spend, tax, and borrow in a fiat currency that they fully control, are not operationally constrained by revenues when it comes to federal government spending.

Critics of MMT read that as “these crazy MMTers think you can print as much money as you want and spend it”.

This is a strawman. MMT supporters think it’s not useful to think a government is like a household that has to pay its debt back. This isn’t because they are irresponsible. It’s because they recognize that any discussion of whether a certain amount of debt is reasonable, depends on what it is backed by. Debt is neither good nor bad. Its merit depends on what is productive assets back it.

So an MMTer believes you can run a deficit (so government expenditures do not need to be matched with revenues) as long as the expenditures lead to investments in productive capacity. In other words, is the spending creating projects and jobs that will generate a real return? This is hardly unfamiliar logic. When students enroll in medical school, their loans are collateralized by the expectation of increased earnings power that comes with getting “M.D.” after your name. Constraining their current ability to spend by their current earnings would be a horrible loss of economic efficiency.

MMT is deeply focused on inflation

In the MMT world, inflation is a serious topic because a highly inflationary environment is evidence that the spending was not wise. Inflation is a test.

I direct you to my notes on Jesse Livermore’s Upside Down Markets paper on the mechanics of inflation:

Jesse, in a nod to Adam Smith’s invisible hand, calls the inflation the”invisible fist”. The requirement to return principal and interest to a lender constrains the expansion of credit and therefore spending power. Unproductive spending will lead to the destruction of financial wealth. If I borrowed money for a lemonade stand but then spent it on a vacation, my deficit spending will have created new financial wealth for the system, but it won’t have created any new real wealth. I won’t receive future cash flows to repay the loan.

The first place where the invisible fist will destroy financial wealth will be on my personal balance sheet. I originally accounted for the business as a new financial asset that offset the new liability that I had taken on. If that new financial asset never comes into existence, or if it turns out to be worthless, then it’s going to get written off. I’m going to end up with a new liability and nothing else—a negative cumulative hit to my net worth. The next place where the invisible fist will destroy financial wealth will be on the lender’s balance sheet. The loan will get defaulted on. In a full default, the lender will suffer a hit to his financial wealth equivalent in size to the financial wealth that I added to the balance sheets of the people that I bought the vacations from. The lender will experience an associated decrease in his spending power, compensating for the increase in spending power that my unproductive vacation expenditures will have conferred onto those people. In the end, the total financial wealth and spending power in the system will be conserved. The invisible fist will not allow them to enjoy sustained increases, since the real wealth in the system—its capacity to fulfill spending—did not increase. In this way, the invisible fist will prevent an inflationary outcome in which the supply of financial wealth overwhelms the supply of real wealth.

One of the leading MMT theorists, Stephanie Kelton, explains that, if anything, the MMT crowd takes inflation more seriously than mainstream economics. This makes sense if inflation, not the size of the deficit, is the true cause for concern.

In We Need to Think Harder About Inflation, she writes:

It’s the typically cavalier way of thinking about inflation that has come to dominate mainstream economics. Keeping a lid on inflation is the central bank’s job, not something Congress, the White House, or anyone else really needs to waste time thinking about. If inflation accelerates above some desired target, the Fed will knock it back down by tightening monetary policy. Easy peasy. (Unless, of course, the Fed “falls behind the curve,” allowing “inflation expectations to become unanchored” and other mumbo-jumbo.)

All you really need is an “independent” central bank that is deemed “credible” by market participants, and you can sit back and relax. There’s a one-size-fits-all way to deal with any inflation problem. To dial inflation down, simply dial up the overnight interest rate. You might throw in some “forward guidance” to help shape “inflation expectations” but that’s really still about managing inflation via adjustments in the short-term interest rate…

It’s this sort of cavalier attitude and reverence for monetary policy that troubles me. We’re supposed to accept—as a matter of faith—that the central bank can always handle any inflation problem because mainstream economics says so?

The “invisible fist” today

So have we plowed too much money into unproductive projects? Have we overpaid for the projects and startups? The market tries to sort the question out every day.

In keeping any sense of proportion we should recognize that crypto is a tiny portion of the overall economy. But as a metaphor, it poses an interesting question. Have we dumped too much money into cat gifs, figuratively speaking? Are a few becoming insanely rich while society holds the bag?

I’m partial to Michael Pettis’ idea of the bezzle. In Minsky Moments in Venture CapitalAbraham Thomas explains how bezzle conditions emergeThe key insight is that high prices create a positive feedback loop because prices themselves tell you something about risk. High prices signify safety. This is a paradox because a high price is also an asymmetric risk to reward. The paradox tends to resolve itself abruptly:

One way to understand Minsky cycles is that they’re driven by the gap between ‘measured risk’ and ‘true risk’.

When you lend money, the ‘true risk’ you take is that the borrower defaults3. But you can’t know this directly; instead you measure it by proxy, using credit spreads. Credit spreads reflect default probabilities, but they also reflect investor demand for credit products. A subprime credit trading at a tight spread doesn’t necessarily imply that subprime loans have become less risky (though that could be true); the tight spread may also be driven by demand for subprime loans. Measured risk has deviated from true risk.

Similarly, when you invest in a startup, the ‘true risk’ that you take is that the startup fails. But you can’t know this directly; instead you measure it by proxy, using markups. Markups reflect inverse failure probabilities (the higher and faster the markup, the more successful the company, and hence the less likely it is to fail — at least, so one hopes). But markups also reflect investor demand for startup equity. Once again, measured risk has deviated from true risk.

During Minsky booms, measured risks decline. During Minsky busts, measured risks increase. The flip from boom to bust occurs when the market realizes that true risks haven’t gone away.

Squaring all of this with my own priors

We started with Lyn and Cem’s analysis of how we got to today. If the world de-globalizes many of the deflationary headwinds that convolved with loose monetary policy will reverse. The new regime would be inflationary. How inflationary is anyone’s guess. Is the floor for the foreseeable future 2%, 4%, higher?

If bubbles pop and bezzles recede, would that make inflation worse as we discover that spending was wasted and economic supply did not grow where it needed to (ahem housing and energy)?

Or will deflation come roaring back as drawdowns push wealth effects in reverse and higher borrowing costs on huge loan balances crowd out future growth?

My prior is torn between:

a) inflation will fall in a way that surprises people. Low inflation is actually the default because wealth inequality acts as what I call an “inflation heat sink”. Here’s my explanation using the boardgame Monopoly:

Unfortunately, if you think inflation is going to fall the trade is probably not to buy treasuries since real rates are already quite negative. The related insight is more concerning. Bonds can keep falling as inflation falls and nothing would be glaringly mispriced. Ouch, 60/40.

and

b) Stimulative fiscal policy is inflationary in the short-run (and in the long-run if the spending is unproductive) and while fiscal policy is highly political, neither party is afraid to run big deficits at this point anymore.

If inflation accelerates (or at least fails to abate) it’s not clear what investments it would be good for. People like to promote real estate as an inflation hedge. Given the low affordability already built into prices, outpacing real rates is hardly a given. Maybe that’s where you lose the least? What inflation expectations are already embedded in commodity prices? How to invest for inflation from current prices is a hard problem.

Unwinding imbalances

I tend to believe Lyn and Cem’s story about how the forces that brought us to today are unwinding. If we have spent the past 40 years building a giant imbalance between capital and labor this reversal is ultimately a good thing. But it’s not going to make capital happy. If you have been an outsize winner for the past decade, you’re probably going to moan about it when the imbalance narrows (hey it’s understandable that we respond to marginal changes to our situation, but it’s not reasonable to miss the big picture that prior wins have been out of proportion to contribution). What was given to you easily by the Fed’s support of high duration bets, can be taken away. Don’t expect sympathy.

The most direct way to correct the imbalance would be to heavily tax high earners and the rich but it’s not politically viable. But there’s a backdoor. The combination of fiscal stimulus, especially if done in a progressive way, will bolster the economy while we raise interest rates. The net effect will offset labor’s pain in an economic slowdown. But it will still be inflationary since we are supporting demand (by giving $$ to those who actually spend it) while constraining supply (by raising hurdle rates on capital expenditures). To a rich person invested in growth and expensive real estate, this will feel like stagflation as labor’s slice of the pie increases relatively while demand for the rich person’s assets slows (opposite of how loose monetary conditions created inflation for homes and stocks but not labor and importable goods). It would be a shadow progressive tax using inflation to take back financial wealth while creating conditions for lower-wage earners to keep up with the price of goods and services.

No matter how the economic picture unfolds, the theme that feels alive under the surface is imbalance. It doesn’t matter that the average American lives better than a 16th-century king. We relentlessly compare and that’s never going to stop. The imbalance matters. We have accumulated massive amounts of debt. If the debt isn’t truly backed by the collective wealth of the individuals who make up the economy, eventually a catalyst will shatter the illusion that we can continue rolling it over.

Mechanically, that debt is of course backed by the sum of our assets. But when push comes to shove, how is it apportioned? What is the fair attribution? Do our anti-trust laws and tax policy divide the risk and rewards fairly (whatever that means from an equitable and efficiency perspective)? It’s not as easy as saying “the market gets this right”. The rules are political. Power is not accorded solely due to merit (whatever that means). So sure, the debt is backed by our assets, but good luck calling the loans back in.

I recently re-watched Ray Dalio’s How The Economic Machine Works. I assigned it to some young teens who are trying to learn about the economy. The video shows how the macroeconomy is built up from everyday transactions. A loan (ie credit) is one such transaction. The credit cycle is endemic to the economy itself. Dalio overlays the short-term credit cycle (small squiggles) on the long-run cycle.

(credit: the hatchfund.com)

The end of long-term debt cycles are times of massive upheaval. Historically this has meant violence, currency devaluations, and victors dividing the spoils regardless of who was previously listed as a creditor.

Dalio, uses a highly understated word for this adjustment. Deleveraging. The default process (whether outright or via inflation) is redistributive. Politics determines the winners and losers. It’s always been give and take. But we need to keep talking.

If we cannot find a way to cooperate, the problem of imbalance and feelings of injustice don’t just disappear.

Redistribution finds a way.


Addendum

I realize MMT is a polarizing topic. I have a cursory understanding of it, so feel free to correct me: I think the core insight that a government doesn’t need to run like a household is correct mechanically. The problem is how the debt is allocated to the citizens in the form of taxes and transfer payments. So from a policy point of view, I don’t know if MMT frameworks lead to effective practical policy. Effective is always a matter of debate and depends on your constituency’s perspective. In that sense, MMT is no different than any other framework that claims to have good reasons for how it grows and splits the pie.

The great personal dividend of MMT is how it popularized the sectoral balances approach to understanding the economy. Similar to Dalio’s video, it views the economy as a collection of small transactions. Since every buy is someone else’s sell, we can use a giant T account of credits and debits to understand the economy from basic accounting. Those credits and debits flow through the household, government, corporate and “foreign sectors”. Economists associated with this approach include Godley, Pettis, Kalecki, and Levy.

To demonstrate the power of this lens, I encourage you to read Jesse Livermore’s Upside Down Markets paper. It completely reshaped my understanding of macro into something that I believe is closer to reality. Whenever I hear a macro argument, I at least try to place it within the sectoral balances framework to see if it is at least self-consistent. The advantage of basic accounting identities is they are identities. They are tautologically true and that’s a useful razor for an initially evaluating an argument.

Jesse’s paper is a beast. Many people won’t read a 40k word paper. I encourage everyone to read this one. While it’s a dense exploration of timely macroeconomics ideas, Jesse’s rare ability to tackle the complexity in an approachable, step-by-step progression is an amazing opportunity to learn.

Having said that, I realize many people still won’t read the paper. So I decided to try my hand at creating this explainer. I completely re-factored it to turn it into a personal reference. You can use it too:

✍️Moontower Guide To Jesse Livermore’s Upside Down Markets (link)


Be groovy to the mom’s out there!

-K

Moontower #147

I exhausted my writing energy in this week’s Money Angle, so today you get a grab bag.

🏫Schoolhouse.world (check it out)

This is the latest initiative by Sal Khan (definitely a hero). It’s a peer-to-peer live tutoring service focused on HS math and test prep. If we know anything about KhanAcademy then we can expect this is just the beginning.

Schoolhouse.world is a platform for free, peer-to-peer tutoring–where anyone, anywhere can receive live help, build their skills, and pay it forward by becoming a tutor themselves.

I happened to be browsing the list of donors to KhanAcademy and was heartened to see how bipartisan it was. Their mission transcends our differences.

Elon’s Giant Package (12 min read)
by @ranjanxroy

Some background before reading Ranjan’s post.

Earlier this week Matt Levine wrote:

Twitter is a strange company; it has enormous influence on politics and culture but is not great at making money. It has a lot of power as a venue of public discussion, and there is a lot of debate among Twitter’s employees and users, and among politicians and regulators, about how it should use that power. Elon Musk certainly cares about this stuff, and has explicitly said that he wants to buy Twitter not for economic reasons but for “free speech.”

The narrative is “free speech”, but I’m personally a bit skeptical because my impulse is buying Twitter seems more coherent as Elon:

1) secures distribution. It’s like marketing capex that also happens to have vanity value.

And it makes sense for things that have vanity value to be uneconomic. Indulge me:

2) wants cover to diversify from TSLA shares. If Twitter is run like a “clown car that crashed into a goldmine” then presumably it has potential upside independent of vanity.

Ranjan’s mini-grand theory on what Elon’s up to with Twitter was resonant with my prior. After reading that, consider something I’ve mentioned before. Portfolio theory asserts that things which don’t make sense in isolation can be brilliant when paired with the right strategy or synergistic buyer. Especially today. It’s spelled out further in:

Portfolio Theory And The Invisible Option On Hobbies (7 min read)

Twitter is more useful to Elon than anyone else on Earth. Whether it’s useful enough to him to justify the price is another matter, but it’s not shocking that he’d be the most justifiable high bid for it.

Let’s end with some housing talk. I think comparisons to 2007 are off base. Lending standards are tighter and people are flush with cash right now. It’s not to say I’m bullish exactly, but I think the downside in nominal terms is fairly contained. I suspect RE will be dead money in real terms for a while but then again, everything might be. It could be the tallest midget for the foreseeable future. I’m also the ass who sold his house in late 2020 so maybe discount everything I just said by 200%.

Read Calculated Risk instead:

Don’t Compare the Current Housing Boom to the Bubble and Bust (4 min read)
by Bill McBride


Money Angle

In the past few years, I’ve written several posts about option greeks.

If you are familiar with them, you know my goal is to explain things like you are 5 years old (well more like 12…my kids don’t know how an option works yet). I struggle to read technical finance papers because I’m, like a human being and stuff. I assume others feel that way about option greeks.

My latest post occured to me as I was falling asleep Tuesday night, so I spent Wednesday in a fever of writing that reminded me why I don’t write technical posts all the time. Even a concept I feel very comfortable with took about 10 hours to write about.

Check it out:

Moontower On Gamma (15 min read)

Gamma is a concept that maps perfectly to acceleration in physics which is an intuitive and familiar concept we encounter in daily life. We can use that analogy to see why p/l is the same idea as “distance traveled”. From there, it’s delightful to see why option profits have a squared term.

If you want the krisnotes with less of the math:

Just a reminder, I maintain the Moontower Volatility Wiki with the help of the online nerd community. It’s a collection of resources for quant finance with a focus on options. I curate what goes into it, but it’s a community effort ultimately:

👽Moontower Volatility Wiki


Last Call

I’ve been following and chatting with Adam Butler and his teammates Rodrigo Gordillo and Mike Philbrick from ReSolve Asset Management for a while. They are a super-smart, thoughtful group of guys that I learn from. They asked me to come on their show which could have been very intimidating (these guys talk to people with way more things figured out than I ever will), but they made me feel comfortable enough to just riff.

I sound like a meatball. You can take the kid outta Jersey but, well let’s just say I prefer to hide behind print for a reason. It’s mostly stories with some risk managment ideas sprinkled in.

ReSolve Riffs on Exploring Life Under The (Option) Surface (YouTube)

If you prefer audio only (you don’t have to watch me gesture like a crackhead) here’s the Spotify link.

Moontower #146

Friends,

Last week I hinted at a framework for deciding what to pursue if you started with a blank sheet of paper.

Before I continue, I want to briefly address headspace. As we travel through life there are periods where we are head down with specific outcomes in mind. It could be printing money at your job, training for a marathon, building a business, surviving residency, or writing a thesis. Whether consumed by a grueling grind or a creative fever, it’s not the time for introspection.

Don’t interrupt momentum in between checkpoints. Even if it’s a slog, be gracious for the conviction. It’s a gift that comes and goes. Don’t squander it. Just like true learning, personal progress is uncomfortable. Ron Burgundy said it best — “it’s a deep burn”. The only way is through.

Conversely, if you are at a checkpoint, looking for your next sprint, you’re in explore mode looking for your next exploit. I don’t love the word exploit here but it’s a classic framing of the problem (see my notes on an interview with AI researcher Brian Christian). Part of that search is self-search. “Why” overtakes “how”. If this is where you find yourself, I hope this essay offers a perspective to turn over in your mind. If you are full speed ahead on your current jam, you can skip ahead to today’s Money Angle.

Otherwise, let’s make our way toward the framework.

It comes from a meatspace friend who I admire for a brutal amount of intent in how he lives. He’s not an online guy but has one of the Tim Urban visuals from The Tail End printed out in his office. I have an offline in-law who has the number of weekends he has left with his kids on the front page of his digital dashboard. Besides being impressed with Tim Urban’s reach, I’m struck at how conscious these people are about time. I remember listening to an interview with investor Chris Cole where he talks about the watch he wears — it counts the days until his expected actuarial death.

Personally, I don’t feel compelled to inhabit this level of morbidity, but I can appreciate its life-affirming focus. If they sound quasi-extreme, it’s only because it’s easy to take time for granted. But you can’t put more sand in an hourglass1.

Acknowledge Your Agency

Complacency is a warm blanket. It soothes and coddles. Until you get itchy. Then it becomes the very source of your discomfort. Once you notice, you can’t get it off fast enough.

Agency is choosing which discomfort you want to confront. Fear or complacency. Fear of what? I don’t even want to type it out because it sounds ridiculous, but here it goes:

You are afraid of your own potential.

It still sounds ridiculous. So why indulge the thought? Two reasons.

  1. If it’s true, then finding out has an outrageous expected value in terms of fulfillment.

    I doubt fulfillment is a destination. It’s more of the feeling of pushing against something and having it push back in a way that makes you feel like you are alive. That you are in a conversation with existence rather than just watching it.

  2. Others have this thought as well. And that’s a clue that it could be real and worth confronting.

As evidence of this second thought, I strongly urge you to read the entirety of Nat Eliason’s short post:

✍️Shadow Careers and Unembracing Failure (4 min read)

I want to zoom in specifically on the back half of the post (boldfaced is mine):

We should want to work on things where failing terrifies us. If you feel nothing when a relationship ends, why were you in it in the first place? If you wouldn’t be devastated by failing to succeed at your mission, what kind of mission are you spending your limited years pursuing?

It’s a bit lofty, sure, but it provides a useful heuristic. Assuming your basic needs are met it might not be worth working on anything where you aren’t terrified of failing. If you know a project is going to succeed, or you’d be fine if it failed, then it’s not a true calling for you.

There’s a concept I think about from time to time, that hell would be meeting the person you could have been. Who you could be if you ignored the shadow careers, the side quests, the failures you were okay with.

Imagining that person can often be helpful. You’ll almost immediately fill in certain gaps, probably related to what you’re most insecure about. What would you expect them to say they did? What would they tell you they accomplished that would make you immediately overcome with self-loathing at your own shortcomings?

I know my answers, and I bet you do too. It’s not fun to think about, but it is certainly useful. Most of us are in shadow careers. Shadow careers are the defaults. We have to spend some time imagining that person, seeing what they could say that would make us the most embarrassed, to start to tap into a potential level of fulfillment we’re passing up for what’s easy.

“What happens when we turn pro is, we finally listen to that still, small voice inside our heads. At last, we find the courage to identify the secret dream or love or bliss that we have known all along was our passion, our calling, our destiny.”

And lest it gets confused, achieving these secret dreams won’t bring any lasting happiness. Finding the right challenge to struggle against, though… that’s a game you can play for life.


Framework

So back to the “framework” I keep mentioning. Its purpose is to take our ridiculous premise and map it to target opportunities. We want to find the “right challenge to struggle against”.

To do that, we find the overlap of 3 concepts:

  • Constraints
  • Terms
  • Worldview

Constraints

These are your “must-haves”. For example, your endeavor must satisfy or have an acceptable chance of satisfying your financial and geographic needs. You must account for your family’s needs. It sounds straightforward because these are conversations you should have already had but it’s worth checking assumptions. If you define your constraints too narrowly you will rob yourself of paths. This step carries the risk of guiding the Ouija board right back to where you are now by making it the only choice.

Terms

This is similar to constraints but more aspirational. These map to “nice to haves” but without the “take it or leave it” air of negotiability that phrase carries. There’s urgency here. If your terms are not serious goals, why bother with this exercise in the first place?

What’s an example of a term?

A basic example is genuinely liking what you do. Being excited to work. Another example is defining how much time you spend with your kids. Imagine what you want that to look like. This is not easy because “time with kids” is a complicated idea. Some parts of it are a drag. This is not a time to let guilt define your terms. We all have different levels of patience. Some parents prefer their kids in smaller doses than others. It’s ok. Be honest with yourself.

If this reflection isn’t mentally or emotionally demanding you are not doing it right. At the same time, there needs to be flexibility. We don’t have perfect track records of predicting what we want.

Worldview

This one is a doozy because it’s something I’ve only started thinking about in the past few years directly. And some part of that is because I didn’t realize it was ok to have worldviews. Or maybe I just didn’t find it useful to be anything other than agnostic about everything. This has been gradually changing. While I’m not interested in spelling my worldviews out, you can spot some of them by reading between the lines of this letter every week.

Still, I want to be more concrete about what worldview means. I will share my friend’s as an example. He was happy to lay them out for me (and if any local friends are reading this there’s a decent chance they can figure out who it is. He lives it.)

His life and work place an emphasis on 3 aspects of life that he never tires of exploring. To him, they hold the keys to human flourishing.

  1. Culture/Identity
  2. Community
  3. Learning

His hobbies and businesses orbits these three ideas. It’s not an accident. His ethnicity and religion are visibly different than what you typically find growing up south of the Mason-Dixon line as he did. He spent time touring the world as part of a band you likely know. These experiences shaped his worldview. His most recent startup was born out of things he was already doing with his 3 kids. Prior businesses were born out of community building.

Wordviews, like terms and constraints, are deeply personal. I only shared the ones above for example. Your own views can be miles apart. This pluralism is the basis for both bonds and frictions. This leads to an interaction between the three concepts. Your terms or constraints may preclude you from exposure to certain worldviews. The truth is there are some worldviews you are never building a bridge towards.

But the stakes aren’t always that high. We make compromises.

You can spend 8-10 hours a day unaligned with your collaborators’ views or doing work out of sync with your own views. If your choices are limited, your tolerance for this might be high. It’s a tough spot to be in. If you are fortunate enough to have options then a sense of alienation will gradually gnaw at you. You might tolerate it. You might rationalize. You’ll definitely compartmentalize.

Until a point.

The cost of that self-alienation builds. I once had a colleague, older than me, both seasoned and successful who quit because dealing with brokers all day (in a prior gig he purely focused on electronic trading) affected him negatively. He couldn’t compartmentalize. “I’m not who I want to be when I’m here”. I will never forget when he left. If I were 25, I would have thought “what a soft thing to say… suck it up”. Instead, I have profound respect for his choice. I suspect it cost him a lot of money.

You may believe it’s a luxury to adhere to your values. The logic reminds me of how Milton Friedman theorized that racism would be self-correcting because if a bigot chose to not sell products to or hire from a segment of the population the bigot would hurt themselves. I think Friedman was wrong because he was assuming that dollars were the sum of our values. Similarly, your values might cost you dollars, but your soul feels the cost when you ignore your values.

[That reminds me — one of my worldviews is that accounting is super important. Because what we measure gets managed, accounting is actually the art of representing the full picture of costs and benefits. Since decisions in all aspects of life are downstream of accounting, we need to measure better. We need holistic accounting. If your heart and body “disagree” with an outcome that was supposed to make you happy, I suspect your decisions fell out of a narrow accounting framework.

So I lied. I did share a worldview.]

Ok, this is getting long and I’m feeling pedantic. I mentioned last week that I’m still working through stuff. I know this might all sound a bit pompous and snowflakey. I’ll never apologize for snowflakism (another worldview in there probably). But I also appreciate that many people are dutiful without overthinking. Life can sometimes feel like a parade of sterile transactions that pay the bills. There’s grace in just being reliable. The older I get the more inspired I am by the unsung elders who just get it done without too much introspection. There’s tremendous beauty in that and they don’t even realize it.

But this essay is for those trying to sleep in an itchy blanket. It’s warm but you’ll never rest.

Living is risk. Your potential is indeed fearsome. March straight into it if you want to live.

“When in doubt, have a man come through a door with a gun in his hand.”

-Raymond Chandler’s advice to writers who get stuck


Further reading:

✍️How to Pick a Career That Actually Fits You (60 min read)

This is another Tim Urban classic. He penned it in 2018. In a pensive weekend, while Yinh was at Coachella I actually printed out the worksheets and worked though them while I streamed the festival on YouTube. I forgot the name of the post but was able to search for it according to how I remembered it — as the “octopus” model.

The resources at the end are also worth checking out, especially 80,000 Hours. Tim describes it as:

dedicated to helping young, high-potential people make big career choices—is an awesome resource. The site is run by super smart, thoughtful, forward-thinking people, and can be digested in video or book format in addition to on their site.


Money Angle

I liked this post by Morgan Housel:

✍️How People Think (29 min read)

He explains:

This article describes 17 of what I think are the most common and influential aspects of how people think.

It’s a long post, but each point can be read individually. Skip the ones you don’t agree with and reread the ones you do – that itself is a common way people think.

My obsessive need to consolidate and refactor required transposing his list to this one (I re-titled them all for compression):

1) Tribalism

2) We only see the tip of icebergs

3) All probability gets represented as yes or no

4 and 5) We expect trees to grow to the sky (which leads us to overreaction)

6) We are surprised when geniuses disappoint us

7) Unhealthy competition makes us short-sighted. The antidote is extending the horizon to create space.

8) Stories FTW

9) Complexity sells

10) Motivated reasoning is the rule

11) Experience is the raw material for empathy

12) Heisenberg makes us poor self-evaluators. Seek other’s input

13 and 16) Innumerate about extremes [compounding & inevitably of rare occurrences ie the birthday problem]

14) Simple but not easy

15) When imagining change we fail to consider the full context [for example when you are younger you imagine being older as your current life with grey hair but you don’t consider the mental and emotional evolution that comes with aging]

17) Idealism is seductive but counterproductive often leading to isolated demands for rigor

I want to zoom in on #7. It’s our child-eating friend Moloch again. I covered him several times this year:

Recall how Moloch symbolizes the tendency to overoptimize on a single value to the detriment of all others, swallowing everyone in its unhealthy path.

I tend to be pretty laid back in general. For better or worse, I tend to be a satisficer rather than a maximizer. A charitable interpretation of that trait (there are non-charitable ones too but I’m the host of this here party at the Moontower) is I appreciate ergodicity. See Luca Dellanna’s What Is Ergodicity? for a quick explanation that word.

But it turns out, humans likely grok the idea in their DNA. In fact, this appreciation forms the basis of pushback against some of the cognitive bias research, especially loss aversion. Contrived behavioral economics experiments assume agents maximize single-trial expected value instead of median expectancy. What behavioral economists label as design flaws are more of Chesterton’s Fence to protect you from self-destruction in the name of maximization. The expected value of saved seconds from jayrunning across the street might be positive. But you only need one ill-timed fall to negate the sum of those optimized moments.

So when I say that “slack” is the answer to Moloch, it has nothing to do with being lazy. It’s appreciating that any one trial is just a single draw in a repeated strategy and the merits of the strategy cannot be graded on isolated outcomes.

Since we are on the topic of behavioral economics, there is another common knock against cognitive bias research.

Via Notes From Todd Simkin On The Knowledge Project:

Shane points out a paradox in cognitive science. Knowing our biases doesn’t seem to help us overcome them.

Todd concurs:

It is definitely true that it is sort of descriptive of the past. A lot of these heuristics and biases are things that we can see when we after we’ve already identified that a mistake has been made. And we say, Okay, well, why was the mistake made? Say, oh, because I was anchored, or because of the way the question was framed, or whatever it might be, we have a really hard time seeing it in ourselves.

But we know the cure for this. I wrote:

This is a topic the brilliant Ced Chin has studied in depth. Ced told me that the literature suggests the only way cognitive bias inoculation works is via group reinforcement. I told him that was exactly the cultural DNA when I was at SIG which makes me believe there is a lot of value in being aware of bias. Anytime you replayed your decision process, it was a cultural norm to point out where in the process you were prone to bias.

Todd reinforces Ced’s conclusions:

We have a really easy time seeing when someone else is making that type of stupid mistake. A big part of our approach to education is to teach people to talk through their decisions, and to end to talk about why they’re doing what they’re doing with their peers, the other people on their team. If we can do that real-time, that’s great. Often in trading, you don’t have that opportunity, because things are just too immediate. But certainly, anytime things have changed. If you’re doing things differently, it’s a really good time to turn to the traders around you. And the quantitative researchers around you and the assistant traders and your team and say, Hmm, it looks like all the sudden Gamestop is a whole lot more volatile than it was a week ago. Here’s how I’m positioning for this trading. What do you guys think? And have someone say, oh, it seems like you’re really anchored to last week’s volatility. If things have changed that much, you need to move much more quickly than you’re moving right now.So you don’t realize that you’re anchored, that’s the whole nature of being anchored, is that you don’t recognize the outsized importance that the anchor has on your decision, but somebody else who’s a little bit more distant from it can. So if we’re good at encouraging communication, then we’re going to be really good at getting other people to help improve your decision process.

I add:

There it is. The key — communication. It’s not some magic formula. Even after I left SIG I spent my whole career working with SIG alum. This culture and these types of communications happen all day on the desk. Despite the common perceptions of “trading”, I have always found it to be a team game and communication skills are paramount.

Todd expands:

I know that you are fond of pointing out that you are the sum of the five people that you spend the most time with. So if the people that you’re spending the most time with are your co-workers who are thinking about trading the same way you are, then maybe you’re going to combine the same types of errors, it’s certainly better than then trying to act on your own. But even better is if you have a culture that rewards truth-finding, as opposed to rewarding action. If nobody feels personally attacked, because of somebody else pointing out their error, but instead feels like we together have now done more to get closer to, to some truth to the better way to act or the you know, the more accurate, fair value of this asset that we’re trading, then everybody feels like it’s a win. And they will therefore encourage the involvement of the people around them.

If you work in a Molochian, credit-stealing environment you face a prisoner’s dilemma as to whether you even want to even correct others’ biases. (I suspect this gets worse as the fiefdoms that emerge in large hierarchies rot the spirit from the inside). Teamwork and its antecedent, alignment, are devilishly hard, but critical because they hold the key to improving decisions.

When Shane asks what the most important variables are for being a better decision-maker, he expects Todd might say “probabilistic thinking”. But Todd did not hesitate with his answer:

Talk more is number one, that beats probabilistic thinking. That beats sort of anything else. Truth-finding is being able to bring in other people in the decision process in a constructive way. So finding good ways to communicate, to improve the input from others. Thinking probabilistically I think is definitely a very, very important piece of trying to diagnose what works by trying to think of where where things fall apart, where people fail. The other place that people fail is falling in love with their decision process and not being open to being wrong. So an openness to feedback to finding disconfirming information to actively seeking out disconfirming information, which is really uncomfortable. But that I think is the other piece that is super important for being a good trader.

If I were to try to be a prop trader from my pajamas, I’d form a Discord channel of sharp, open-minded, truth-seeking, humble, teachable teammates before I even opened a brokerage account.

Trading is not a single-player game.

You need honest mirrors. Not the ones you find in fancy dressing rooms.

Stay groovy squad

Moontower #145

Friends,

Soooo…getting back into the groove after vacation has been a failure. Been hard to conjure any productivity. While I was in Hawaii, I left my phone in the room most of the time. Was nice to mostly unplug. But vacation is fantasyland and then you come home. Instead of building on a healthy habit, I gave myself permission to guiltlessly hang out on Twitter as if I earned something. My history of swallowing a pint of ice cream after the rare cardio session is ample warning that in my personal constitution no good deed goes unpunished.

The upshot of all this?

Instead of having some tidy, prepared essay I’m gonna just overshare about life today. If you’re here for nerd stuff feel free to skip ahead to Money Angle, no hard feelings.

Ok. So there was a Twitter thread where a friend and a stranger were talking about me. The stranger was asking the friend why a portfolio manager (don’t mind me as I adjust my imaginary tie) would share insight about trading publicly. The tone, insofar as one can detect tone in text, was “traders shut up and trade, grifters teach”.

It’s not the first time I’ve seen something like that and I usually let it slide. I suspect I normally don’t get too much suspicion directed at me because it would be really hard to fake 21 years of prop trading with a massive sample size of daily trades and then write about risk and options in a way that other verified pros find value in. This is not me defending myself. This is you, beloved readers, especially the professional peers amongst you who are so supportive.

But this particular conversation did spark a reaction in me because it was a friend that was stuck in some isolated thread trying to defend me. So I chimed in to give him a break.

This is how I think about my writing about trading:

If you are a pro options trader reading me, then I’m reinforcing what you already know. Sometimes the articulation gives you a vocabulary that clarifies your thinking. I’m not turning over new rocks, but if I scramble them a bit, you may see something new.

If you are a novice trader/investor, you are learning things that are table stakes for the risk-taking side of the industry. The decision-making principles are not secrets. You can find any number of sources to learn from. People prefer to be communicated to in different ways. I’m just one of those many ways.

I would never write about secrets while I was working. I chose to write about the meta. The website is literally called MoontowerMeta. So if you are not violating any policies, you’re not exposing info that your friends use to make money, and you can still find angles that are helpful to readers then you have value to share. Aspiring writers sitting on trading desks, that’s your cue.

[An aside that is gonna trigger some set of people: I could hand over all my professional dashboards and tools, and it wouldn’t make a difference. You won’t get the same results. Experience, discipline, and creativity are not something you can take from another. And they are foundational to a discretionary strategy. Think about this from a game-theoretic point of view. If I could codify (I tried and couldn’t) what I did, then it would be easy to prove the edge. The strategy would then be automated and be oversubscribed or its owners would never sell it to an investor. The fact that it’s discretionary and cannot be proven except by its eventual outcomes means an investor must always worry that I’m full of shit. But that’s also why there’s some middle ground where I want outside funding and investors are willing to fund it. If a purely automated, systematic strategy is a money-printing machine you’ll never see it. And if you do, its legibility will be its eventual downfall as it gains assets]

Still, a big question remains —why share? The stranger was hinting that I had an ulterior motive. Like maybe I had flamed out and was setting up my next job. There’s some truth to that but not in the way he insinuated. (The last year of my career was my best and it was not even close.)

I decided to tweet a thread on why I share. To do that I needed to back up and explain the decision process behind quitting.

The bizarre result was the thread went totally viral. I also realized the way I wrote it must have made people think I just quit. Tsk, tsk. If they were subbing to Moontower they know that is old news. If you didn’t receive this letter in your email don’t make that mistake:

Subscribe.

Before I quit trading, I framed the decision: I’m 43 yrs old. I can stay, make more $$, racing for 10 more years. Or I can leave now, while I have energy, reasonable health and less ageism against me to work towards something that I’m not in a race to get over.

It will take some time to figure out my next step but since my kids are 5 and 8, it’s a great time to take time. When I start my second professional life, it won’t be a race. It’s something I can do til I drop dead.

I’ve written about my lack of interest in any conventional retirement (I don’t play golf, I like to work and write with my free time as long as it’s on my terms). So a sustainable journey reduces my need for a large nest egg to carry through many non-working years. (I also put little trust in market returns as an arbiter of my financial destiny so I’m conservative about how long I need to work). If you know you can work say 20 years longer than if you raced in a finance career, then a lot of pressure is relieved.

Suddenly leaving isn’t so risky.

2 other points:

1. If I stayed I’d be in the same boat at 53 years old. What do I do with myself? I’d have more money, but also so what. Money is not an issue if you are happy working (and you don’t crave caviar every meal)

2. If I’m wrong, I can always get a finance job. It won’t pay what I used to make because the seniority you have with people you know for a long time is a special sort of trust and goodwill. I had a long leash (in finance speak that probably earns you 2 years of underperformance cushion).

I prefer not to take my mortality for granted and when you are in your 40s it becomes far more real. When you receive a phone call instead of a text out of the blue your pulse quickens a bit. I don’t obsess about $ like I did even 10 years ago and definitely not like 20 years ago. I didn’t grow up with it, but have fought the urge to see it as a security blanket catch-all for every kind of anxiety.

Scarcity mindset is adaptive when you are young and broke, because the scarcity can be quite real. The mindset is protection. Like a 40d put. But as you earn, that put becomes further OTM. You are going to be ok. No need to pay theta in the form of suboptimal decisions because you feel the need to service that put as if it’s 40d when it’s really 1 delta.

Everyone gotta do what they gotta do. But if you are unhappy with your fancy job, that’s on you. There are no excuses for that. It’s understandable to feel otherwise but I do believe you need to work through that. It’s really hard to develop a healthy relationship with $. I’m trying to get better at it all the time. Because I have to. It’s not wise to do a job you don’t want to do to allay irrational fears of being broke.

Twitter is a tool for relationships and to spread proof of work. I did one thing for 21 years. When I try to do something else I’m a major underdog. I’m not going back to school. I don’t enjoy school. My online presence is like a proof of work, so when I try to convince someone to take a chance on me in a new field I can show something that looks like a resume to someone that’s open-minded. If you wonder about my incentives on Twitter, I’m being open about it: relationships, proof of work, & optionality in distribution.

There it is. I tweet and write to “find the others” and to make myself marketable to future collaborators and clients. I don’t know if that makes it any less “ulterior” if it’s not in pursuit of a trading gig (if I was going to stay in trading I already had a ridiculous seat. There are not a lot of places to go unless I was going to be a founder, but I have no interest in that. Trying to be an emerging manager is institutional masochism. Respect to my friends on that journey. I love it for them. Not for me. I know enough to never say never, but my mindset is far away from that and I’m not getting any younger.)

This thread went viral because it struck a nerve with so many people. I’m a size 150 bid on how many DMs, texts, emails, and requests for phone calls I received. Many were just extending support but many wanted to discuss their own crossroads.

If you are curious, the replies to the thread are the less vulnerable versions of private messages.

Some made similar leaps in the past, some are in the midst of such a leap, some just starting to hear the whispers from their inner selves, and some were younger people with enough maturity to already anticipate how they might feel in their 40s. It was weirdly overwhelming to get such a candid glimpse of people’s feelings.

I’m happy to discuss any aspect of all this if any of you feel that’s what you need. I had many conversations before making my final decision. One of my local friends is a serial entrepreneur a decade removed from corporate America. He’s similar in age, with a family, and is particularly thoughtful about aligning who he is with his work. Over the course of several hangouts and long morning hikes I came to understand his framework. And parts of it were foreign in interesting ways. I never considered thinking about the problem the way he does. It unlocked thoughts within me but even now I’m still processing it. It’s a bit painful to think through because you need to be so honest with yourself. If you are not rattled, you’re doing it wrong. But I knew he understood me, just based on the questions he asked. In the next week or two, I’ll discuss the framework as well as what I’m thinking about most these days.

Since it’s Twitter, a number of trolls who must hate-follow me said it was a mid-life crisis as if I was defective. I suppose I am. In many ways, it would be easier to have just stayed in my job. But if there’s a defect I’d rather take over from the autopilot and intentionally try to go to the right destination than accidentally land in the wrong one with no fuel left in the tank.


Resources

In the public domain, the 2 friends I found especially helpful were Paul Millerd and Khe Hy.

Paul’s book, Pathless Path, which came out in January is going to be canon on this topic. My notes and review are here. I’ll even buy you a copy if you want. Paul is kind and brilliant. He’s had so many discussions with others on these topics that chatting with him is like plugging yourself straight into a current of flowing wisdom.

Khe’s path was extremely resonant because he was in the same field (in fact long after he left finance I learned that he was in meetings 20 feet from where I was standing in my office). Khe’s writings make him one of the OGs about thinking about our relationships with ourselves and our careers. He has successfully navigated the long path from corporate America to a business that sustains both his clients’ and family’s needs. For the better part of a decade, his writing has put you in the sidecar. I’ve plugged his work at every opportunity because it’s outstanding and he’s the kind of giving soul you love to see crush it. The next cohort of his $10k Work Bootcamp starts in a few weeks. The testimonials are ridiculous and I’m not surprised. He’s taken everything he’s learned and combined it with easy-to-use technology to turn you into a high-leverage weapon. Give it a look hereIt’s 100% free.


Money Angle

One of the best threads I’ve seen in a while. It’s important because it shows how betting strategies vary based on your goals.

In the basic version, the “Devil’s Card Game” is constrained by the rule that you must bet your entire stack each time.

You can maximize:

  1. expectation
  2. utility (in the real world Kelly sizing is the instance of this when utility follows a log function)
  3. the chance of a particular outcome.

At the end of the thread, we relax the bet sizing rules and allow the player to bet any fraction of the bankroll they’d like. This is a key change.

It leads to a very interesting strategy called backward induction. In markets, the payoffs are not well-defined. But this game features a memory because it is a card game without replacement. Like blackjack. You can count the possibilities.

The thread shows how the backward induction strategy blows every other strategy out of the water.

If we generalize this, you come upon a provocative and possibly jarring insight:

The range of expectations simply based on betting strategies is extremely wide.

That means a good proposition can be ruined by an incompetent bettor. Likewise, a poor proposition can be somewhat salvaged by astute betting.

I leave you with musings.

  1. Is it better to pair a skilled gambler with a solid analyst or the best analyst with a mid-brow portfolio manager?
  2. How confident are you that the people who manage your money would pick the right betting strategy for a game with a known solution?

    Maybe allocators and portfolio managers should have to take gambling tests. If analytic superiority is a source of edge, the lack of it is not simply an absence of one type of edge. It’s actually damning because it nullifies any other edge over enough trials assuming markets are competitive (last I checked that was their defining feature).


From My Actual Life

We went to the Kaanapali region of Maui for Spring Break with 4 other families.

We ended up hanging out with 13 total families that we knew, nearly half were totally random encounters. With so many friends around, the kids didn’t notice mom and dad drank their 529s in the form of Mai Tai’s.

Fun bit: this pic was taken from the backyard of a friend’s place that also has quite the poker room. The friend was renting it from a certain celeb who liked to host card nights well attended by professional athletes and…Woody Harrelson.

#goals

(If you need any recommendations let me know. Also, with rental cars so expensive Turo was the way to go for many of us.)

Stay groovy!

Moontower #144

[I’m touching down in Maui this morning with my family for Spring Break. I won’t open the laptop this week so Moontower will be off next Sunday.]


Friends,

It’s been a crazy “Q1” as the suits say (seasonal references that favor fiscal orbits over solar ones still can’t escape the “time is a flat circle” vibe. A semantic loss all around, well-played all of us). In keeping with my Spring Break, I’ll re-post links to the more popular articles I wrote in the past few months in case any new or old readers want to catch up. There won’t be new content in the next 2 weeks.

Drawing Better Outcomes From Fat-Tailed Distributions

✍️There’s Gold In Them Thar Tails: Part 1 (13 min read)

✍️There’s Gold In Them Thar Tails: Part 2 (24 min read)

A meta-comment about the process of writing these. The thinking behind the posts was heavily inspired by Rohit Krishnan’s Spot The Outlier. When I first read his article, I knew it was deeply insightful but I struggled to fully grok it. I saved it in my task dashboard so I would re-visit it occasionally. By keeping it top of mind, I was more primed to “see” it in the wild. There was a back and forth between exposing myself to the post, following his references, and trying to reason about it in the context of what I already knew. This brings me to an encouraging point (I think). Understanding an idea you don’t get fully get is often just a matter of repetition broken up by rests and just enough space in your RAM to give your attention filter a chance to see it around you. It’s a mix of focused and diffuse thinking.

I imagine some readers are thinking “Kris, that post was not hard to understand…you’re supposed to be an options trader?!” I found it hard, what can I say. The journey to comprehend it (at least enough to write a few thousand words on it) is more encouraging than the distress of being dense in the first place. Which is a roundabout way of saying to understand something just keep trying from different angles. Give yourself rest. And trust in repeated exposure. I hope that advice helps next time you try to bang a concept into your skull. Fluid intelligence peaks in your 20s so knowing how to learn requires believing that you can. I’m 100% sure you can.

If you enjoyed this ensemble of concepts (finding outliers, Berkson’s Paradox, correlation breakdown in the extremes), I encourage you to read another treatment that adds to and reinforces the conversation:

✍️ Searching for outliers (22 min read)
by @benskuhn

The post is about better decision-making in fat-tailed distributions. Since they exist in many real-world matters, you should care. The end of the post has good recommendations while the beginning helps you differentiate between thin and fat-tailed distributions.

Some highlights:

  • As the dating example shows, most people have some intuition for this already, but even so, it’s easy to underrate this and not meet enough people. That’s because the difference between, say, a 90th and 99th-percentile relationship is relatively easy to observe: it only requires considering 100 candidates, many of whom you can immediately rule out. What’s harder to observe is the difference between the 99th and 99.9th, or 99.9th and 99.99th percentile, but these are likely to be equally large. Given the stakes involved, it’s probably a bad idea to stop at the 99th percentile of compatibility. This means that sampling from a heavy-tailed distribution can be extremely demotivating, because it requires doing the same thing, and watching it fail, over and over again: going on lots of bad dates, getting pitched by lots of low-quality startups, etc. An important thing to remember in this case is to trust the process and not take individual failures, or even large numbers of failures, as strong evidence that your overall process is bad.
  • Often, you’ll have a choice between spending time on optimizing one sample or drawing a second sample—for instance, editing a blog post you’ve already written vs. writing a second post, or polishing a message on a dating app vs. messaging a second person. Some amount of optimization is worth it, but in my experience, most people are way over-indexed on optimization and under-indexed on drawing more samples.
  • This is similar to how venture capitalists are often willing to invest in the best companies at absurd-seeming valuations. The logic goes that if the company is a “winner,” the most important thing is to have invested at all and the valuation won’t really matter. So it’s not worth it to the VC to try very hard to optimize the valuation at which they invest.

Finally, I can offer an example sitting right under everyone’s nose: choosing which books to read. In How to Read: Lots of Inputs and a Strong Filter, Morgan Housel writes:

The conflict between these two – most books don’t need to be read to the end, but some books can change your life – means you need two things to get a lot out of reading: Lots of inputs and a strong filter…A good reading filter is more art than science. You’ll have to find one that works for you. The bigger point is that the highest odds of finding the right piece of information comes from inundating yourself with information but very quickly being able to say, “that ain’t it.”

The Moloch Series

You cannot unsee the god of unhealthy competition.

✍️Don’t Look Up, It’s Moloch (10 min read)

Once you feel sufficiently Moloch-pilled you need the serum:

✍️Putting Moloch To Rest (7 min read)

To reinforce the cure (again, repetition folks) see this quirky and enjoyable post:

✍️ Slack (4 min read)
by Zvi Mowshowitz

Zvi’s writing has an almost poetic cadence and sticky phrasing. His blog is a minimalist rabbit hole. He’s in the Magic: The Gathering Hall of Fame and a former market maker so I’m probably biased towards his kind of geekery.

Self-improvement

✍️Lessons From Susquehanna (5 min read)

Todd Simkin’s interview re-hashed a collection of deeply influential ideas regarding learning and communication from my professional career

✍️Being A Pro And Permission To Be Serious (12 min read)

Discipline and earnestness feel quaint in the theater of memes modernity hyper-manufactures. Don’t fall for it.

Hedging

✍️From CAPM To Hedging (16 min read)

Ideas in this post:

  • Variance is a measure of dispersion for a single distribution. Covariance is a measure of dispersion for a joint distribution.
  • Just as we take the square root of variance to normalize it to something useful (standard deviation, or in a finance context — volatility), we normalize covariance into correlation.
  • Intuition for a positive(negative) correlation: if X is N standard deviations above its mean, Y is r * N standard deviations above(below) its mean.
  • Beta is r * the vol ratio of Y to X. In a finance context, it allows it allows us to convert a correlation from a standard deviation comparison to a simple elasticity. If beta = 1.5, then if X is up 2%, I expect Y to be up 3%
  • Correlation is symmetrical. Beta is not.
  • R2 is the variance explained by the independent variable. Risk remaining is the volatility that remains unexplained. It is equal to sqrt(1-R2).
  • There is a surprising amount of risk remaining even if correlations are strong. At a correlation of .86, there is 50% unexplained variance!
  • Don’t compute robotically. Reason > formulas.

✍️If You Make Money Every Day, You’re Not Maximizing (28 min read)

Part stories and part technical discussion of how to think about reducing risk.


Money Angle

Finance Guilt

I’ve said several times that finance is really just code. Like software, it’s an abstraction skin pulled over physical features. One can feel a bit disembodied if their formulation of the world for 8-12 hours a day are prices. Prices that collapse all of human enterprise, from the dirt under its fingernails to the sunrises and sunsets between now and some expiration date, into some Excel number format.

Just as software intermediates for less, financial innovation lowers the cost of go-betweens. In finance, the things went-between are people paying to offload risk to people looking to get paid for warehousing risk. In software and finance, skimming a tiny bit of rent on those transactions is lucrative.

How good or bad we can feel about the degree of skimming depends on how much surplus is created versus the higher friction model. The value of information liquidity is fairly obvious so Google enjoyed a positive reputation for at least its first decade in business. Meanwhile, finance feels like a constant barrage of “what did Wells Fargo do now?” or words that rhyme with Fonzi. People outside finance can be excused for having a dim, albeit biased, view of the profession since nobody reports on people doing an honest job.

With that in mind, I leave you with Mitchell’s understandable question:

Here’s my quick response:

Agustin’s response:

I’ll wrap with a footnote from a recent post:

The slicing and dicing of risk is finance’s salutary arrow of progress. Real economic growth is human progress in its battle against entropy. By farming, we can specialize. By pooling risk, we can underwrite giant human endeavors with the risk spread out tolerably. People might not sink the bulk of their net worth into a home if it wasn’t insurable. Financial innovation is matching a hedger with the most efficient holder of the risk. It’s matching risk-takers who need capital, with savers who are willing to earn a risk premium. Finance gets a bad rap for being a large part of the economy, and there are many headlines that enflame that view. I, myself, have a dim view of many financial practices. I have likened asset management to the vitamin industry — it sells noise as signal. But the story of finance broadly goes hand in hand with human progress. It might not be “God’s work” as Goldman’s boss once cringe-blurted, but its most extreme detractors as well as the legions of “I wish I was doing something more meaningful with my life” soldiers are discounting the value of its function which is buried in abstraction. Finance is code, so if software is eating the world, financialization is its dinner date.


Last Call

December 1984:

✍️The Day Los Angeles’ Bubble Burst (4 min read)

Now:

✍️Is the Housing Market Broken? (4 min read)
by Ben Carlson

See y’all in 2 weeks!

Mahalo

Moontower #143

Friends,

This week I published the longest post I’ve ever written. It’s long because it was liberal with stories. This is the long-winded story I used to introduce the concept of hedging.


If You Make Money Every Day, You’re Not Maximizing

This is an expression I heard early in my trading days. In this post, we will use arithmetic to show what it means in a trading context, specifically the concept of hedging.

I didn’t come to fully appreciate its meaning until about 5 years into my career. Let’s start with a story. It’s not critical to the technical discussion, so if you are a robot feel free to beep boop ahead.

The Belly Of The Trading Beast

Way back in 2004, I spent time on the NYSE as a specialist in about 20 ETFs. A mix of iShares and a relatively new name called FEZ, the Eurostoxx 50 ETF. I remember the spreadsheet and pricing model to estimate a real-time NAV for that thing, especially once Europe was closed, was a beast. I also happened to have an amazing trading assistant that understood the pricing and trading strategy for all the ETFs assigned to our post. By then, I had spent nearly 18 months on the NYSE and wanted to get back into options where I started.

I took a chance.

I let my manager who ran the NYSE floor for SIG know that I thought my assistant should be promoted to trader. Since I was the only ETF post on the NYSE for SIG, I was sort of risking my job. But my assistant was great and hadn’t come up through the formal “get-hired-out-of-college-spend-3-months-in-Bala” bootcamp track. SIG was a bit of a caste system that way. It was possible to crossover from external hire to the hallowed trader track, but it was hard. My assistant deserved a chance and I could at least advocate for the promotion.

This would leave me in purgatory. But only briefly. Managers talk. Another manager heard I was looking for a fresh opportunity from my current manager. He asked me if I want to co-start a new initiative. We were going to the NYMEX to trade futures options. SIG had tried and failed to break into those markets twice previously but could not gain traction. The expectations were low. “Go over there, try not to lose too much money, and see what we can learn. We’ll still pay you what you would have expected on the NYSE”.

This was a lay-up. A low-risk opportunity to start a business and learn a new market. And get back to options trading. We grabbed a couple clerks, took our membership exams, and took inventory of our new surroundings.

This was a different world. Unlike the AMEX, which was a specialist system, the NYMEX was open outcry. Traders here were more aggressive and dare I say a bit more blue-collar (appearances were a bit deceiving to my 26-year-old eyes, there was a wide range of diversity hiding behind those badges and trading smocks. Trading floors are a microcosm of society. So many backstories. Soft-spoken geniuses were shoulder-to-shoulder with MMA fighters, ex-pro athletes, literal gangsters or gunrunners, kids with rich daddies, kids without daddies). We could see how breaking in was going to be a challenge. These markets were still not electronic. Half the pit was still using paper trading sheets. You’d hedge deltas by hand-signaling buys and sells to the giant futures ring where the “point” clerk taking your order was also taking orders from the competitors standing next to you. He’s been having beers with these other guys for years. Gee, I wonder where my order is gonna stand in the queue?

I could see this was going to be about a lot more than option math. This place was 10 years behind the AMEX’s equity option pits. But our timing was fortuitous. The commodity “super-cycle” was still just beginning. Within months, the futures would migrate to Globex leveling the field. Volumes were growing and we adopted a solid option software from a former market-maker in its early years (it was so early I remember helping them correct their founder correct the weighted gamma calculation when I noticed my p/l attribution didn’t line up to my alleged Greeks).

We split the duties. I would build the oil options business and my co-founder who was more senior would tackle natural gas options (the reason I ever got into natural gas was because my non-compete precluded me from trading oil after I left SIG). Futures options have significant differences from equity options. For starters, every month has its own underlyers, breaking many arbitrage relationships in calendar spreads you learn in basic training. The first few months of trading oil options, I took small risks, allowing myself time to translate familiar concepts to this new universe. After 6 months, my business had roughly broken even and my partner was doing well in gas options. More importantly, we were breaking into the markets and getting recognition on trades.

[More on recognition: if a broker offers 500 contracts, and 50 people yell “buy em”, the broker divvies up the contracts as they see fit. Perhaps his bestie gets 100 and the remaining 400 get filled according to some mix of favoritism and fairness. If the “new guy” was fast and loud in a difficult-to-ignore way, there is a measure of group-enforced justice that ensures they will get allocations. As you make friends and build trust by not flaking on trades and take your share of losers, you find honorable mates with clout who advocate for you. Slowly your status builds, recognition improves, and the system mostly self-regulates.]

More comfortable with my new surroundings, I started snooping around. Adjacent to the oil options pit was a quirky little ring for product options — heating oil and gasoline. There was an extremely colorful cast of characters in this quieter corner of the floor. I looked up the volumes for these products and saw they were tiny compared to the oil options but they were correlated (gasoline and heating oil or diesel are of course refined from crude oil. The demand for oil is mostly derivative of the demand for its refined products. Heating oil was also a proxy for jet fuel and bunker oil even though those markets also specifically exist in the OTC markets). If I learned anything from clerking in the BTK index options pit on the Amex, it’s that sleepy pits keep a low profile for a reason.

I decided it was worth a closer look. We brought a younger options trader from the AMEX to take my spot in crude oil options (this person ended up becoming a brother and business partner for my whole career. I repeatedly say people are everything. He’s one of the reasons why). As I helped him get up to speed on the NYMEX, I myself was getting schooled in the product options. This was an opaque market, with strange vol surface behavior, flows, and seasonality. The traders were cagey and clever. When brokers who normally didn’t have business in the product options would catch the occasional gasoline order and have to approach this pit, you could see the look in their eyes. “Please take it easy on me”.

My instincts turned out correct. There was edge in this pit. It was a bit of a Rubik’s cube, complicated by the capital structure of the players. There were several tiny “locals” and a couple of whales who to my utter shock were trading their own money. One of the guys, a cult legend from the floor, would not shy away from 7 figure theta bills. Standing next to these guys every day, absorbing the lessons in their banter, and eventually becoming their friends (one of them was my first backer when I left SIG) was a humbling education that complemented my training and experience, illuminating some ways of thought that would have been harder to access in the monoculture I was in (this is no shade on SIG in any way, they are THE model for how to turn people into traders, but markets offer many lessons and nobody has a monopoly on how to think).

As my understanding and confidence grew, I started to trade bigger. Within 18 months, I was running the second-largest book in the pit, a distant second to the legend, but my quotes carried significant weight in that corner of the business. The oil market was now rocking, with WTI on its way to $100/barrel for the first time, and I was seeing significant dislocations in the vol markets between oil and products. This is where this long-winded story re-connects with the theme of this post.

How much should I hedge? We were stacking significant edge and I wanted to add as much as I could to the position. I noticed that the less capitalized players in the pit were happy to scalp their healthy profits and go home relatively flat. I was more brash back then and felt they were too short-sighted. They’d buy something I thought was worth $1.00 for $.50 and be happy to sell it out for $.70. In my language, that’s making 50 cents on a trade, to lose 30 cents on your next trade. The fact that you locked in 20 cents is irrelevant.

You need to be a pig when there’s edge because trading returns are not uniform. You can spend months breaking even, but when the sun shines you must make as much hay as possible. You don’t sleep. There’s plenty of time for that when things slow down and they inevitably will. New competitors will show up soon enough and the current time will be referred to as “the good ole’ days”. Sure enough, that is the nature of trading. The trades people do today are done for 1/20th the edge we used we used to get. That’s not fully explained by falling costs. That’s progress of human knowledge and returns to scale.

I started actively trading against the pit to take them out of their risk. I was willing to sacrifice edge per trade, to take on more size (I was also playing a different game than the big guy who was more focused on the fundamentals of the gasoline market, so our strategies were not running into one another. In fact, we were able to learn from each other). The other guys in the pit were not meek or dumb. As I said earlier, they were bright. Many simply had different risk tolerances because of how they self-funded and self-insured. My worst case was losing my job, and that wasn’t even on the table. I was transparent and communicative about the trades I was doing. I asked for a quant to double-check what I was seeing.

This period was a visceral experience of what we learned about edge and risk management. It was the first time my emotions were interrupted. I wanted assurance that the way I was thinking about risk and hedging was correct so I could have the fortitude to do what I intellectually thought was the right play.


Money Angle

The rest of the post gets into a proper discussion of hedging:

What Is Hedging?

Investopedia defines a hedge:

A hedge is an investment that is made with the intention of reducing the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting or opposite position in a related security.

The first time I heard about “hedging”, I was seriously confused. Like if you wanted to reduce the risk of your position, why did you have it in the first place.? Couldn’t you just reduce the risk by owning less of whatever was in your portfolio? The answer lies in relativity. Whenever you take a position in a security you are placing a bet. Actually, you’re making an ensemble of bets. If you buy a giant corporation like XOM, you are also making oblique bets on GDP, the price of oil, interest rates, management skill, politics, transportation, the list goes on. Hedging allows you to fine-tune your bets by offsetting some of the exposures you don’t have a view on. If your view was strictly on the price of oil you could trade futures or USO instead. If your view had nothing to do with the price of oil, but something highly idiosyncratic about XOM, you could even short oil against the stock position.

Options are popular instruments for implementing hedges. But even when used to speculate, this is an instance of hedging bundled with a wager. The beauty of options is how they allow you to make extremely narrow bets about timing, the size of possible moves, and the shape of a distribution. A stock price is a blunt summary of a proposition, collapsing the expected value of changing distributions into a single number. Imagine a typical utility stock that trades for $100. Now imagine a biotech stock that is 90% to be worth 0 and 10% to be worth $1000. Both of these stocks will trade for $100, but the option prices will be vastly different.1

If you have a differentiated opinion about a catalyst, the most efficient way to express it will be through the options. They have the most urgent function to a reaction. If you think a $100 stock can move $10, but the straddle implies $5 you can make 100% on your money in a short window of time. Annualize that! If you have an even finer view — you can handicap the direction, you can score a 5 or 10 bagger allocating the same capital to call options only. Conversely, if you do not have a specific view, then options can be an expensive, low-resolution solution. You pay for specificity just like a parlay. The timing and distance of a stock’s move must collaborate to pay you off.

So options, whether used explicitly for hedging or for speculating actually conform to a more over-arching definition of hedging — hedges are trades that isolate the investor’s risk.

The Hedging Paradox

If your trades have specific views or reasons, hedging is a good idea. Just like home insurance is a good idea. Whether you are conscious of it or not, owning a home is a bundle of bets. Your home’s value depends on interest rates, the local job market, state policy. But also on some pretty specific events. Your house value depends on “not having a flood”. Insurance is a specific hedge for a specific risk. In The Laws Of Trading, author and trader Agustin Lebron states rule #3:

Take the risks you are paid to take. Hedge the others.

He’s reminding you to isolate your bets so they map as closely as possible to your original reason for wanting the exposure.

You should be feeling tense right about now. “Dude, I’m not a robot with a Terminator HUD displaying every risk in my life and how hedged it is?”.

Relax. Even if you were, you couldn’t do anything about it. Even if you had the computational wherewithal to identify every unintended risk, it would be too expensive to mitigate2. Who’s going to underwrite the sun not coming up tomorrow? [Actually, come to think of it, I will. If you want to buy galactic continuity insurance ping me and I’ll send you a BTC address].

We find ourselves torn:

  1. We want to hedge the risks we are not paid to take.
  2. Hedging is a cost

What do we do?

Before getting into this I will mention something a certain, beloved group of wonky readers are thinking: “Kris, just because insurance/hedging on its own is worth less than it’s actuarial value, the diversification can still be accretive at the portfolio level especially if we focus on geometric not arithmetic returns…rebalancing…convexi-…”[trails off as the sound of the podcast in the background drowns out the thought]. Guys (it’s definitely guys), I know. I’m talking net of all that.

As the droplets of caveat settle the room like nerd Febreze, let’s see if we can give this conundrum a shape.

Reconciling The Paradox

This is a cornerstone of trading…

Edge scales linearly, risk scales slower

Continue reading:

✍️If You Make Money Every Day, You’re Not Maximizing(28 min read)


From My Actual Life

A month ago I started tutoring elementary school students in math. These kids are in vulnerable communities that were hit extra hard by the impact of remote learning. They are one or more grades behind standards.

One-on-one instruction is effective but a luxury. The non-profit always needs more volunteers. Without volunteers, this cannot happen.

The organization offers training before you start as well as all the supplies you need. There are opportunities to teach in-person for reading and remote for math.

If you live in CA you can help!

You only need to get your fingerprints done for a background check and be willing to commit 30 minutes a week. You can do more if you like. I do 2 sessions a week with a second-grader and a third-grader. You don’t need to be “good” at math. If you can count backward from 10 to 5, you already know things that these kids need help with. Seriously.

Ping me if you are interested. This will give you time to get your background check and training (training is just a few hours).

The next sessions will be summer and then the return to school in the fall.

Moontower #142

First, a giant thank you for reading this letter. This is Moontower’s 3-year anniversary. This week the 3,000th subscriber joined. Thank you to the 45 people or so who agreed to read that very first issue.

Writing online allowed me to unlock myself in ways that I couldn’t without your support. So truly, thank you.


Ok friends, let’s proceed.

This week, I published the sequel to There’s Gold in Them Thar Tails.

It begins with a recap of part 1:

  1. We saw that an explosion of choice whether it’s a job or college applicants, songs to listen to, athletes to recruit has made selection increasingly difficult.
  2. A natural response is to narrow the field by filtering more narrowly. We can do this by making selection criteria stricter or deploying smarter algorithms and recommendation engines.
  3. This leads to increased reliance on legible measurements for filtering.
  4. Goodhart’s law expects that the measures themselves will become the target, increasing the pressure on candidates to optimize for narrow targets that are imperfect proxies or predictors of what the measure was filtering for.
  5. Anytime we filter, we face a trade-off between signal (“My criteria is finding great candidates”) and diversity. This is also known as the bias-variance trade-off.
  6. Diversity is an essential input to progress. Nature’s underlying algorithm of evolution penalizes in-breeding.
  7. In addition to a loss of diversity, signal decays as you get closer to the extremes. This is known as tail divergence. The signal can even flip (ie Berkson’s Paradox).
  8. The point where the signal noise overwhelms the variance in the candidates is an efficient cutoff. Beyond that threshold, selectors should think more creatively than “just raise the bar”.

Part 1 ends with a discussion of strategies for selectors and selectees.

Part 2 extends the discussion with what tail divergence says about life and investing.

✍️There’s Gold In Them Thar Tails: Part 2 (24 min read)

It’s a long post including footnotes, but there is a large section about options trading that will only appeal to masochists.

The post roadmap:

  1. We begin with the challenge of scaling our moral intuitions up to an age where our ethics must be explicitly coded. AI and automation require making species-level questions less rhetorical.
  2. The prescription is humility. The simple math of regression shows this as correlations break down or invert in the extremes. The CAPM to Hedging post was actually a diversion that ended up being a stand-alone post as I was writing the tiny math section in Part 2.
  3. From there we move into trading and investing strategies to exploit our misunderstanding of extremes. 2 words: respect path. We start with a story of a famous investor/governor who stubbornly didn’t respect path.
  4. We then talk about familiar path-respecting approaches to investing: care with leverage, appreciating “rebalance timing luck” (hugs to@choffstein) and finally thinking about path vs terminal value.
  5. This opens the door to a discussion of trade expressions and the need to map them tightly to our isolated trade premises. I use options to demonstrate 3 path-aware approaches: static, dynamic, combined.
  6. The combined approach is touched on briefly. It’s technical but not complicated and lends itself more to a video (maybe one day). It’s also an example of why it’s useful to understand option structures and the basic arbitrage relationships.
  7. Then we move to general investing styles that respect path: venture and “gorilla” investing. They both know what they don’t know about extreme outcomes and construct strategies that are robust to that reality.I’m not an expert in those approaches but was drawn to their common link of manufacturing convexity. Convexity is not volatility or leverage. It’s the slope of your p/l steepening in the direction of the market because your position size changes.

    When your signals are weak as they are for extreme outcomes, you want to preserve convexity into the unknown. If you can do that, you can funnel wider. This can be higher yielding than tuning your signals harder.

  8. Review and concluding remarks — Happy prospecting!

Money Angle

Speaking of Corey Hoffstein:

His tweet brought my attention to @cobie and his masterful description of psychology.

I also appreciated Josh Brown’s take on the sell-off in so-called growth or momentum names. Here’s an excerpt from Jan 31’s It’s not over yet.

I’m less interested in the real-time action. Focus the evergreen psychology instead:

Where do bounces come from in a midst of a correction?

Sometimes it’s just that stocks have fallen too far for sellers to want to keep selling. This isn’t bullish. In fact, this type of bounce can suck people back in by creating the appearance that the worst is over. Growth stocks in particular. Because belief dies hard and enthusiasm for cutting edge technologies fades slowly, not suddenly. Which mean the give-up process is long and drawn out – even after a stock is cut in half sometimes the worst is still yet to come. The slow bleed after is often worse than the initial shocking drop that preceded it.

Over at Verdad Capital, Dan Rasmussen revisits their “Bubble 500” list of overpriced growth stocks, originally created in the Summer of 2020. It’s filled with money-losing companies working in exciting areas of technology such as electric vehicles and gene editing therapy and so on. Needless to say, this list of bubble stocks has gotten absolutely destroyed year-to-date, after having run straight up in Verdad’s face through the middle of 2021.  Dan explains two very important things in his update this week: The first is that sell-offs for growth stocks differ from sell-offs for value stocks in one very important way:

This breakdown is significant, especially for growth stocks. Remember, growth stocks trend, and value stocks mean revert. The psychology is simple. People hear about a hot stock that’s gone up 3x, they buy some, it goes up 2x, they buy more: the whole attraction of buying a hot growth stock is the historic return trajectory. Value stocks are the opposite: you do well buying them when they’re down…

This idea is counterintuitive – that some stocks actually become worse buys as they are falling to lower prices, but the explanation is psychological, not financial. Stocks trading at excessive valuations require a fan base to sustain their share prices. That fan base is often a bandwagon-jumping melange of traders and investors who are attracted to recent gains. Yes, they’ll latch onto the fundamental story, but the fact that the stock has been and currently is going up is the main thing. When the stock breaks, so too does the fandom. And when the fan base moves on to greener pastures or runs out of money, a new fan base will not form for this stock with its chart in decline. Broken growth stocks become orphans. There is no natural place for them to find a home.

Momentum is a divergent strategy while “value” is a mean-reverting strategy. Several years ago the research team at OSAM published edifying papers on how these approaches work. I wrote a summary here:

✍️ Notes on OSAM’s Factors from Scratch (6 min read)

Value works by fading overreaction. Momentum is attributed to underreaction. In a name trending higher, the sellers are discounting the substance of new information too aggressively. In dork world, we call this anchoring. If you pay attention to “anomalies” you may recognize the concept of post-earnings drift as an acute example of anchoring. Wikipedia even has an entry for it.

Fear or FOMO in markets cuts both ways. On the way down, we fear a loss of wealth. On the way up we fear social embarrassment — we aren’t keeping up with our neighbors. We are caught between self-preservation and shame. I wonder if being part of the herd is any consolation on the way down while everyone loses. Or is this just another miserable psychological asymmetry inseparable from speculation?

Anyway, I don’t have much to add. Investing requires you to be honest about your desires, constraints, and emotional tolerance. If you can get honest with yourself, you can initiate a plan that you can stick to. You want to avoid ad-hoc decisions with the bulk of your savings (I’m not gonna poo poo on gambling with 1 or 2% of your wealth, especially if it suppresses wider risk-seeking behavior. Agustin Lebron’s Laws of Trading has a provocative section about “risk set points” that operate like weight set points. If your life becomes too dull in one way you spice it up in another and vice versa. Maybe Alex Honnold’s portfolio is all in bonds 🤷🏽).

Oh and just a quick observation that you can ponder in the context of those flashy, earningless momentum stocks. If you start at $1 and double 6x you get to $64. If the stock drops 50%, you’ve only erased 1 halving.

Be careful knife catching.


From My Actual Life

I wrote this 1 year ago but I’m reprinting it with updated ages. I flew into NYC on St. Patrick’s day this week, 6 years after this story. I spent yesterday at my nephew’s birthday in NJ.

St. Patrick’s Day now reminds me of a story that is now 6 years old…

March 17, 2016. I flew into NYC for a 36-hour business trip. I was hopping around the city meeting with bank derivative sales desks. Routine relationship maintenance. I planned poorly. I was late to every meeting since you can’t cross 5th Ave during the St Patty’s parade.

Anyway, that evening I was at dinner as a client. When I went to the restroom I checked my phone. My family chat was blowing up.

My sister just had a baby.

I hadn’t told my east coast fam I was in NYC because it was just a quick trip. But right then, I called my mom in NJ and stunned her with the knowledge that I was an hour away in NYC.

When I returned to the table, I excused myself from dinner, hopped on a bus to my childhood house in Hazlet, borrowed my mom’s car and drove down to Jersey Shore Medical Center.

It was close to midnight.

When I walked into the hospital room I’ll never forget my sister’s look of ‘what are you doing here?’

I got to meet my new nephew, spent an hour chatting with my sis and her husband, and made it back to NYC with enough time to grab my bags and get back to JFK.

Since then, St Patrick’s Day has meant much more than day drinking.

Happy 6th birthday to my nephew!

Moontower #141

Let’s start with a question from Twitter:

This is a provocative question. Patrick was clever to disallow Berkshire.

As I was working on the second part of There’s Gold In Them Thar TailsI got distracted by that tweet.

My Reaction To The Question

I don’t know anything about picking stocks. I do know about the nature of stocks which makes this question scary. Why?

  1. Stocks don’t last forever

    Many stocks go to zero. The distribution of many stocks is positively skewed which means there’s a small chance of them going to the moon and a reasonable chance that they go belly-up. The price of a stock reflects its mathematical expectation. Since the downside is bounded by zero and the upside is infinite, for the expectation to balance the probability of the stock going down can be much higher than our flawed memories would guess. Stock indices automatically rebalance, shedding companies that lose relevance and value. So the idea that stocks up over time is really stock indices go up over a time, even though individual stocks have a nasty habit of going to zero. For more see Is There Actually An Equity Premium Puzzle?.

  2. Diversification is the only free lunch

    The first point hinted at my concern with the question. I want to be diversified. Markets do not pay you for non-systematic risk. In other words, you do not get paid for risks that you can hedge. All but the most fundamental risks can be hedged with diversification. See Why You Don’t Get Paid For Diversifiable Risks. To understand how diversifiable risks get arbed out of the market ask yourself who the most efficient holder of a particular idiosyncratic risk is? If it’s not you, then you are being outbid by someone else, or you’re holding the risk at a price that doesn’t make sense given your portfolio choices. Read You Don’t See The Whole Picture to see why.

My concerns reveal why Berkshire would be an obvious choice. Patrick ruled it out to make the question much harder. Berkshire is a giant conglomerate. Many would have chosen it because it’s run by masterful investors Warren Buffet and Charlie Munger. But I would have chosen it because it’s diversified. It is one of the closest companies I could find to an equity index. Many people look at the question and think about where their return is going to be highest. I have no edge in that game. Instead, I want to minimize my risk by diversifying and accepting the market’s compensation for accepting broad equity exposure.

In a sense, this question reminds me of an interview question I’ve heard.

You are gifted $1,000,000 dollars. You must put it all in play on a roulette wheel. What do you do?

The roulette wheel has negative edge no matter what you do. Your betting strategy can only alter the distribution. You can be crazy and bet it all on one number. Your expectancy is negative but the payoff is positively skewed…you probably lose your money but have a tiny chance at becoming super-rich. You can try to play it safe by risking your money on most of the numbers, but that is still negative expectancy. The skew flips to negative. You probably win, but there’s a small chance of losing most of your gifted cash.

I would choose what’s known as a minimax strategy which seeks to minimize the maximum loss. I would spread my money evenly on all the numbers, accept a sure loss of 5.26%. The minimax response to Patrick’s question is to find the stock that is the most internally diversified.

This led me to write a post launching into the basics of regression, correlation, beta hedging and risk. Especially the concept of “risk remaining” which contains practical and surprising intuition.

It is a topic that affects traders and investors. It also ties back poignantly to the ideas of tail divergence I’m writing about in part 2 of There’s Gold In Them Thar Tails.

The little detour involves math but I move slowly and try to offer footholds of intuition along the way.

[Trying to simply difficult topics is absolutely my intention. If I’m writing over your head, I’m doing something wrong. Tell me. Help me help you.]

Here you go:

✍️From CAPM To Hedging (16 min read)


Money Angle

I recently read Laws Of Trading by Agustin Lebron. It’s exceptional.

Here’s my review. There’s a link with my notes at the end.

If I ran a trading firm this would be Day 1 reading. After finding out where the bathroom is and filling out your W-4, you would be handed this book and told to finish it by tomorrow. After 1 year on the job, you are required to re-read it. There are many sentences in this book that serve as somewhat off-hand or connecting, but are deeply insightful. The kinds of things that would not be perceived by a novice but veterans will recognize they are reading something by a deeply experienced professional. As a veteran of options trading, I found this feature makes the book transcend being informative into being delightful. Trading is the art of decision-making turned into a high-rep game. It requires:

  • multi-level thinking
  • sound epistemology
  • discipline
  • self-awareness
  • self-honesty
  • alignment
  • humility
  • curiosity
  • competitiveness
  • collaboration
  • creativity
  • comparing

It is deeply intertwined with technology, math, and economic reasoning. This book is an instant classic. The rules in the book are reductions of vast, hard-fought institutional knowledge and the leading edge of thinking about risk. The author combined his training and experience at Jane Street, a legendary quant trader and market-making firm, with a broad intellectual acumen. Both his engineering background and affinity for liberal arts and philosophy come through to create a guide that transcends a single discipline. Personally, reading this book left me with nostalgia as the type of thinking was the water I swam in when I was at SIG (Jane Street’s lineage traces to SIG alumni who became under-the-radar legends themselves). My second personal feeling is, “damn, I wish I wrote that book.” Except I couldn’t. The author is an elite synthesizer with a nuanced comprehension for coding, organizational behavior, interviewing, and data analysis.

My notes are below. They are sparse compared to the depth of insight crammed into 250 pages. Every chapter covers a “rule”, situates that rule in the context of finance, then applies it to decisions all people face in the course of life.

✍️Notes on The Laws Of Trading (Notion.MoontowerMeta)


Last Call

I’ve watched this a lot. What a natural.

Moontower #140

Friends,

I’m in SoCal again this weekend visiting with family and getting a couple nights away with Yinh.

I didn’t get around to publishing part 2 of how to think about finding opportunities in the extremes of the distribution. For background see last week’s There’s Gold In Them Thar Tails: Part 1.


This week I’ll share a thought I jotted down after reading a rousing post by scientist Michael Nielsen. Hopefully, this is a dose of local, actionable inspiration.

✍️ Unlock One Another: The Right Compliment At The Right Time (6 min read)

This post is not science. It’s not rigorous. It is a simple belief, both self-evident and load-bearing. Itself the proof of its premise because believing it is my own generative force.

Stated as I see it:

The closest thing we have to a perpetual motion machine is inspiration.

  1. Inspiration creates its own energy for action.
  2. Action creates information.
  3. Information generates inspiration.

Repeat.

A finance-dork way of saying this is inspiration is the cheapest source of capital.

One of the ideas economist Tyler Cowen is recognized for comes from his short post, The high-return activity of raising others’ aspirations, where he writes:

At critical moments in time, you can raise the aspirations of other people significantly, especially when they are relatively young, simply by suggesting they do something better or more ambitious than what they might have in mind.  It costs you relatively little to do this, but the benefit to them, and to the broader world, may be enormous.

This is in fact one of the most valuable things you can do with your time and with your life.

I’m interested in education and how people learn. There’s nothing more invigorating than the moment of empowerment in a child’s eye when they realize “they can”. As a parent, my proudest moments are the goofy smiles on the boys’ faces when they found themselves able to do what they didn’t think they could. Swim their first lap, add in their head, not panic when they got stuck on a zipline (my 7-year-old was calmer than I would have been).

Learning is the receipt you get for courage.

Courage is virtue. It takes courage to see clearly. To empathize. To put aside your preconceptions. To not give into malformed ideas about yourself or others without a challenge. To face your insecurities. To step outside your comfort zone.

I’m as fallible as the next person but I try to live in a way that takes what Cowen says seriously. It’s something I try to keep top of mind especially when I can feel my patience fray. That’s when I need to recruit that belief the most. This is part of being charitable. Giving people credit for wanting to be better. Sometimes a jerk is just a jerk. But sometimes a jerk is someone who wants to be better but doesn’t know how. They are scared but don’t know it. Behind that defense mechanism is an insecure soul that once crawled on all fours, just like you. I don’t want to let go of the rope until the last second when it’s clear they want to take me over the cliff with them. Sometimes I do. I can’t live up to my own ideals.

But I and all of us must continue to try. Noah Smith, a writer and professor, explains why (emphasis mine):

I think our society has moved a huge amount in the direction of meritocracy — of being open to talent. I think we’re really good at that at this point. But I think our pursuit of meritocracy has caused us to neglect a few important things. One is ambition; the people whose talent we discover are the people who come to us, who shove their talent in our faces, because their parents instilled drive and ambition and confidence in them. But there are a lot of talented people out there whose abilities never get discovered because no one ever told them they should aim high, or because they didn’t have parents to push them, or because they simply lacked confidence. My brother-in-law grew up poor in a trailer park, no one in his family had ever been to college. But my sister instilled him with a little more ambition, and he just graduated from a top law school. Without the luck of meeting my sister, he might still be in a trailer park! So our system is so focused on setting up these tournaments for ambitious people that we fail to go out and nurture the ambition of people who have undiscovered talent...A successful society rests on a broad foundation of human capital; it does not place all its hopes on a thin sliver of genius. I see too many people in Silicon Valley — both liberals and conservatives — tacitly accept the notion that only a few people have real potential. And maybe that’s because venture-funded software is such a winner-take-all market. I don’t know. But that’s not the attitude that will bring this country a broad industrial renaissance or social revitalization.

Scientist Michael Nielsen offers an idea anyone can borrow. Nielsen contends that if you give specific compliments to people instead of generic platitudes you are capable of doing far more good than you think. It kicks off a spiral of inspiration in its target. It can validate what they think they are good at, a source of energy that pays off 10-fold as they lean even harder into their gifts. And if that recipient didn’t realize they had some special gift in the first place? You just hit’em with a defibrillator. They just gasped to life.

And maybe. For the first time.

I leave you with his essay. It hit hard because my love language is compliments and since I’m not special I assume it is for many people. It’s a simple thing you can do for others. It takes being present. A dash of vulnerability. And a few words.

On Volitional Philanthropy (a short essay!)

by Michael Nielsen

T. E. Lawrence, the English soldier, diplomat and writer, possessed what one of his biographers called a capacity for enablement: he enabled others to make use of abilities they had always possessed but, until their acquaintance with him, had failed to realize. People would come into contact with Lawrence, sometimes for just a few minutes, and their lives would change, often dramatically, as they activated talents they did not know they had.

Most of us have had similar experiences. A wise friend or acquaintance will look deeply into us, and see some latent aspiration, perhaps more clearly than we do ourselves. And they will see that we are capable of taking action to achieve that aspiration, and hold up a mirror showing us that capability in crystalline form. The usual self-doubts are silenced, and we realize with conviction: “yes, I can do this”.

This is an instance of volitional philanthropy: helping expand the range of ways people can act on the world.

I am fascinated by institutions which scale up this act of volitional philanthropy.

Y Combinator is known as a startup incubator. When friends began participating in early batches, I noticed they often came back changed. Even if their company failed, they were more themselves, more confident, more capable of acting on the world. This was a gift of the program to participants [1]. And so I think of Y Combinator as volitional philanthropists.

For a year I worked as a Research Fellow at the Recurse Center. It’s a three-month long “writer’s retreat for programmers”. It’s unstructured: participants are not told what to do. Rather, they must pick projects for themselves, and structure their own path. This is challenging. But the floundering around and difficulty in picking a path is essential for growing one’s sense of choice, and of responsibility for choice. And so creating that space is, again, a form of volitional philanthropy.

There are institutions which think they’re in the volitional philanthropy game, but which are not. Many educators believe they are. In non-compulsory education that’s often true. But compulsory education is built around fundamental denials of volition: the student is denied choice about where they are, what they are doing, and who they are doing it with. With these choices denied, compulsory education shrinks and constrains a student’s sense of volition, no matter how progressive it may appear in other ways.

There is something paradoxical in the notion of helping someone develop their volition. By its nature, volition is not something which can be given; it must be taken. Nor do I think “rah-rah” encouragement helps much, since it does nothing to permanently expand the recipient’s sense of self. Rather, I suspect the key lies in a kind of listening-for-enablement, as a way of helping people discover what they perhaps do not already know is in themselves. And then explaining honestly and realistically (and with an understanding that one may be in error) what it is one sees. It is interesting to ask both how to develop that ability in ourselves, and in institutions which can scale it up.

[1] It is a median effect. I know people who start companies who become first consumed and then eventually diminished by the role. But most people I’ve known have been enlarged.

Note, by the way, that I work at Y Combinator Research, which perhaps colours my impression. On the other hand, I’ve used YC as an example of volitional philanthropy since (I think) 2010, years before I started working for YCR.


Money Angle

The Moontower Money Wiki is a project to help people who don’t know how to invest their savings. I plan to turn these write-ups into a series that starts with the “nature of investing” and holds their hand through implementation. The final form of the series is TBD. Maybe in-person lectures, exercises, videos. I don’t know how this will unfold.

Right now I’m just interested in helping people think better about investing. The first step of that is to help people unlearn the garbage they are bombarded with because of FOMO, punditry, and “democratization” apps laced with dopamine.

Investing is not about “engagement”. It’s actually brain damage if you cannot anchor yourself to goals and plans. People are not wired to navigate random number generators, so we need to form a qualitative basis for why we invest in the first place and how investing actually leads to returns.

Many readers here are sophisticated, so it will be beneath them. Yet, I want to make something even HSers can understand. When I complete a post for it, I will share them in this letter. It takes me longer than I’d like to get anything done so I won’t venture a guess on how often I’ll publish one.

So after all that blathering here’s the most recent write-up:

✍️The Challenge Of Outperformance (Link)

 

   

Last Call

Today is also an opportunity for global inspiration.

Our friend Tina and her organization All Hands And Hearts are procuring buses to evacuate children from Ukraine to Poland which is accepting refugees with open arms.

Every little bit helps. Every bus they procure can make many runs back and forth. 300 kids per run. The money is being used for buses, diapers, food and water.

Re-tweet to spread the word as well.

 

I just have to shout fellow fintwitter, Jessica. Mostly known for shitposting (and math wizadry when she feels like it), Jess is absolutely boss when it’s time for action.

From My Actual Life

The world feels big and scary. Everyone deals with it in their own ways. For better or worse, I keep my focus on what I think I can handle but try to do my best within that narrow aperture.

A few personal thoughts I had this week.

Yinh reminds me that you can’t have all the things at the same time. Matthew McConaughey (you should listen to the Greenlights audiobook or see my takeways from his commencement speech…Wooderson’s self-help advice stands with the best) recognizes that as well. He recommends “checking in” with each category intermittently to see how well you are tracking compared to where you’d like to be. It’s inevitable that you will lag in various categories at various times. A smattering of conscious effort, even if contrived, can keep you from orphaning a category you once told yourself matters.

Stay groovy!