The Juicy Stuff Doesn’t Hit The Pit

New Substack recommendation: The Old Rope by @varianceswap

Here’s a fun excerpt from the latest issue:

Real estate in the private market exists in between the two preceding applicable stock market concepts: you want to buy quality, and you want to buy it at the price you’d buy distressed assets at. But you’re okay just buying quality- after all the private market real estate investor needs to find an asset to 1031 exchange within 45 days of a sale. Readily available dirt-cheap bankruptcy-remote leverage from commercial lending operations provides the private real estate investor with a nearly-government-guaranteed reasonable return. Buy quality and stay rich (never pay taxes).

Because private market commercial real estate is private, rarely do these quality assets sell at generous prices to counterparties outside of the “boys’ club” or in-network, off-market participants for whom favors have already been traded, country club memberships have been synched, and alumni events have been planned. This is what I would call the System 1A of real estate investing. This is where common misconceptions occur with real estate: generalist laymen see these slam-dunk transactions and the seemingly risk-free returns generated from them. They observe “dumb people” getting rich not knowing these people are actually repeat-players in a multi-generational game. They play nice with each other to stay in the club and stay rich.

Damn, this brought me back to some of the cronyism in the trading pits. On the NYMEX/COMEX floor brokers were also allowed to be traders. They could trade for their own accounts, but they were not allowed to trade against their own flow. Well, if you can imagine the incentive, you can imagine the outcome.

Here’s the scene: market makers stand in a pit while brokers run their business out of surrounding booths. The booths were the phone banks outside the pit where broker clerks would talk to the “upstairs” customer. If a juicy market order, especially one without a lot of risk or deltas such as a tight vertical spread or butterfly, there was a silent feeding frenzy. Sal couldn’t trade against his own flow, but knew that Tony would get him “next time”. You know, like a running bar tab. Better yet, maybe your sister starts her own brokerage competing (cough) for the same flow.

If a 100 lot of butterflies traded in the pit for a credit (you heard that right…the meat of a butterfly trading over the wings) you can safely deduce that several hundred lots never made it to the pit.

It’s worth reprinting the last line of that excerpt:

They observe “dumb people” getting rich not knowing these people are actually repeat-players in a multi-generational game. They play nice with each other to stay in the club and stay rich.

And if resentment to this old word order wasn’t high enough, we had the experience of watching some of these “dumb” people who owned several, sometimes tens of seats on the exchange, receive nearly $10mm a pop for them when the exchange demutualized.

[Side note: I worked for a SIG at the time who owned a bunch of seats. They made a bonanza buying NYSE seats before the stock exchange went public so they were ready for the same trade ahead of the NYMEX IPO. One of our assistant traders spent most of his time going to the admin office in the building to find the bid/ask on seats and get the color on who was looking to buy or sell. Probably didn’t take much more than regular coffee and donuts to keep in the office clerk’s good graces. On a personal note, I got some shares as part of the seat lease agreements that SIG had to (probably begrudgingly, since prop firms are ruthless maximizers) give to the people whose names were actually on the lease. The IPO priced at $59 bucks but the NMX shares opened on the first day at $120. I sold the opening print along with many other traders. It was a free $25,000 or so. The stock closed at $152 that first day so I left a lot on the table, but even worse was that my mind’s comparison monster left me feeling sour. A lot of folks down there became generationally rich.

And if they were smart, took the money and ran. It was a countdown to the end of floor trading.

[Extra salt in the wound — there was some arrangement where you had to sell your free shares through Merrill (I think) and they charged like a $500 brokerage fee. And yes, this was 2006, not 1966.]

Enough story time. Go read The Old Rope. The second post I’d read is:

Fake Life, True Wealth (2 min read)

When Crypto Grifters Do Econ

Crypto is simultaneously fascinating and frustrating. The frustrating part of watching “number go up”, has been watching:

a) legalized grift and pumping. This can range from sewer-dwelling spammers to podcast-darling VCs who spout new-age word salad and clever analogies from the same set of sci-fi books.

b) newly flush financial tourists speaking like experts on matters of investing and economics. A charitable classification of this group is honest but not yet competent. Their confidence is just “beer muscle” (I realize this would hit harder if I wrote it 9 months ago, but just look at a 3-year chart of BTC and it holds as long as you don’t know the difference between time-weighted and dollar-weighted returns).

The “a” group knows who they are. They can jump off a bridge. Incompetence is one thing, but being smart and dangerous gets you negative respect and a forever loss of trust in my book. (There is a path to redemption: you can always donate your dirty gains to charity and unwind the Bay Area home price increases you spurred with the fiat you exchanged for bags of coal. If your eventual attempt at penance is nothing more than a “ReformedVC” Substack where you litany all the “story-telling” and “narrative-building” persuasion tactics you employed it isn’t gonna make the @ladder_is_kicked_crypto_is_my_only_hope Twitter anon feel any better.)

The “b” group, if they care about learning, should read:

Economic Misconceptions Of The Crypto World (8 min read)
by Noah Smith

It explains 2 important economic concepts:

  • Cash is not savings
  • Scarcity doesn’t necessarily create value

Noah is an economist so I’ll let his post explain those ideas but I’ll add a bit that seems intuitive to me for no other reason than I’ve played Monopoly. The fact that the money supply grows whenever you pass GO is a clue. This is totally unacademic so feel free to correct me:

Money’s primary purpose is liquidity — to reduce transactional frictions. The money supply needs to increase with the population.

Imagine an island economy with coconuts, hut-building labor, and surf instructors…they could use seashells as a medium of exchange to solve the double coincidence of wants problem. If the seashell supply were fixed, then as the economy grows the seashells would be deflationary (meaning everything of value in the economy would go down in value relative to the seashells). And crucially, liquidity would dry up. Money would not fulfill its promise of facilitating trade because islanders would horde seashells.

When the population grows there is more supply and demand for goods and services. Population growth means economic growth. GDP increases. (Note that for GDP per capita to grow, which is what we ultimately desire to raise standards of living, productivity needs to grow. For example the ability to grow more coconuts with the same labor. We call that agriculture.)

BTC ultimately has a fixed supply. It’s like the seashells. If the technology known as “money” is useful because it creates frictionless transactions, aka liquidity, then a fixed supply is a counterproductive design.

[I’ve heard people argue against this by saying BTC is divisible into tiny amounts.

<Headscratch emoji>

Brb, lifting a 4-slice pizza so I can cut it into 8s and sell it to you for a profit.]

To be complete, BTC’s scarcity can make it a store of value even if it’s not great as a form of money. Cash is a store of value, but only temporarily, and that’s ok because, well, read Noah’s article.

(One last parenthetical from me…gold and silver are somewhat divisible and scarce. They maintain some collective acceptance as money. They have also been stores of value. But they have satisfied these roles as “stores of value” and “money” in uneven ways. I can’t buy bread with silver at the store. Its volatility in dollar terms is much higher than the annual standard deviation of CPI and as long as I need to convert silver to USD to buy stuff, this volatility spread matters. As a store of value, gold and silver real returns have beaten inflation on the centuries time scale, but since your life is lived in decades there’s a lot of tracking error. Unless you’re a cat, the experience of your life happens once so you need to decide how problematic that tracking error is.)

Commodities As Risk Transfer Markets

  • 5 Ideas by Eric Crittenden on the Mutiny Investing Podcast (11 min read)
    by Moontower

    I jotted a few notes from this terrific conversation between Eric Crittenden of Standpoint and my friend Jason Buck of Mutiny.

    If you read CTA (especially trend-following CTAs) decks about why trend-following works in commodities you will hear stories that sound like:

    • taking the other side of hedgers
    • markets have behavioral biases like anchoring which cause futures to underreact on breakouts

    These are reasonable claims. I traded commodity options for most of my career and a lot of flow is in fact constrained (ie forced and price-insensitive) due to hedging covenants attached to financing arrangements for new projects such as plants and wells. The behavioral bias argument sounds good but I’m not sure to what extent biases like that cancel out (just replace “extrapolators” for “greed” and “mean-reversioners” for “fear”).

    Overall, I think commodity markets are basically zero-sum. They make sense as diversifers because they can act as an inflation hedge at times. But because inflation is diabolically hard to hedge in isolation, I’d expect futures markets to have negative expected returns after fees and taxes (note the similarity to insurance. It’s negative expected return but still makes sense as a diversified and hedge when you consider compounded returns at the portfolio level). The pre-fee/tax return is probably random depending on the term-structure.

    Yet, Eric and Jason’s discussion framed the problem in a way I hadn’t thought of which is more of a risk transfer service. Since the demand to transfer risk is not static the curve shapes and positioning will be key determinants of which way the edge presents itself.

    If CTA positioning is inversely correlated with physical hedger positions you’d expect positive edge. I found this provocative because one of the trades I liked to look for was actually betting against the CTAs but in an asymmetrical way. If CTA’s were all-out long coffee futures (for example the Commitment of Trader’s Report, aka COT, showed that as a percentage of open interest managed money length was in the 100th percentile) then I’d like to look for cheap put skew to buy. My reasoning was that CTAs are actually weak hands in the sense that they just follow price, so if there was a sharp reversal in the market they’d rush for the exits together. CTAs often use similar signals (breakouts or moving averages for entries and stops for exits) so they tend to have correlated flows.

    Now, percentiles are risky inputs to trades. If something is in the 100th percentile today and goes up tomorrow that is the new 100th percentile. But I was betting in a risk-contrained way. Instead of shorting, I was buying puts (and again only if the skew surface presented attractive pricing…the qualitative and quantitative both need to line up, and even then an idea like this is a small edge and small part of a broader portfolio).

    Here is a pertinent excerpt from the interview (bold is mine):

    Jason Buck: You said three return sources, so eliminate the three return sources that you believe you have?

    Eric Crittenden: So, I feel like there’s capital formation markets, like stocks and bonds, which are kind of a one-way street, the risk premia is kind of a one-way street. I mean, the bulk of the risk premia is your long stocks. The futures, whether it’s metals, grains, livestock, energy, these are risk transfer markets and risk transfer markets are different than capital formation markets. I feel like risk transfer markets, you need to be symmetrical, you need to be willing to go long or short, because they’re a zero-sum game. They have term structures, so they’re factoring expectations, storage costs, cost of carry, all that stuff. And then there’s the risk-free rate of return, which used to be a great way to kind of recapture inflation, it’s not so much anymore.

    [Eric continues…]

    This is an important concept to me, because it goes to the point of why I do what I do, or why I think that macro trend-oriented approaches expect a positive return over time, because the futures markets are a zero-sum game or actually, a negative-sum game after you pay the brokers, and the NFA fees, and all that stuff. So, in a negative-sum game, you better have a reason for participating. For you to expect to make money, you better be adding something to that ecosystem that someone else is willing to pay for, because somebody else has to mathematically lose money in order for you to make money. So, in studying the futures markets, and I’ve been on both sides, I’ve been on the corporate hedging side, I’ve been on the professional futures trader side.

    I believe I understand who that somebody is, that has deep pockets, and they’re both willing and able to lose money on their future’s position. A trend-oriented philosophy that’s liquidity weighted is going to be trading opposite those people on a dollar-weighted basis through time. It does make sense that they would lose money on their hedge positions, I mean, in what world would it make sense for people who hedge, which is the same thing as buying insurance, to make money from that? It makes no sense, that would be an inverted, illogical world. So, anyone who’s providing liquidity to them should expect some form of a risk premia to flow to them. It’s just up to you to manage your risk, to survive the path traveled, and that’s what trend following is. I don’t know why that is so controversial, and more people don’t talk about it, because I couldn’t sleep at night if I didn’t truly believe that what we’re doing deserves the returns that we’re getting.

    Jason Buck: CTA trend followers, or whatever, just they don’t really know how they make money. They’re like, “It’s trending, it’s behavioral, it’s clustering, it’s herd mentality, and that’s how we make money.” You’ve accurately portrayed it as these are risk-transfer services, speculators make money off of corporate hedgers. But the only thing I would push back, and I’m curious your take on this, is like you said, zero-sum game or negative-sum at the individual trade level. But when we look more holistically, those corporate hedgers are hedging their position for a reason, and it’s likely lowering their cost of capital for one of the exogenous effects. So, my question always is, is it really zero-sum or negative-sum, or is it positive-sum kind of all the way around? In a sense that the speculator can make money offering these risk transfer services that the hedgers are looking for that liquidity, and then the hedgers are also… If we look at the rest of their business, they’re hedging out a lot of their risks, which can actually improve their business over time, whether that’s cost of capital, structure, or other exogenous effects.


    Eric Crittenden: Absolutely, I wish I had… You did record this, so I’m going to steal everything you just said. In the future’s market, it’s negative-sum. If you include the 50% of participants that are commercial hedgers, it’s no longer zero-sum. But most CTAs, and futures traders, and futures investors don’t even concern themselves with what’s going on outside the futures market. So, but if you pull that in and look at it, you can see, or at least it’s clear to me, we’re providing liquidity to these hedgers. They’re losing some money to us, and the more money they lose to us, the better off their business is doing, for a variety of reasons. Tighter cash flows, more predictable cash flows results in a higher stock price, typically. But you brought one up that almost no one ever talks about, and that is if they’re hedged, their cost of capital, the interest rate that they have to pay investors on their bonds is considerably lower. Oftentimes, they end up saving more money on their financing than they lose on their hedging, and they protect the business, and they make Wall Street happy at the same time, so who’s really the premium payer in that? It’s their lenders. So, by being a macro trend follower in the future space, the actual source of your profits is some bank that’s lending money to corporations that are hedging these futures. So, it’s the third and fourth order of thinking, and you can never prove any of this, which is great, because if you could prove it, then everyone would do it, and then the margins would get squeezed.

  • More commodities stuff:
    • I created a Twitter list to follow commodities folk. I’ll add to it as I learn of more accounts that fit. (Twitter list)
    • The CME has a great tool for charting and studying the CFTC’s COT report. You will need to sign up for their free QuikStrike suite of analytics.

5 Ideas by Eric Crittenden on the Mutiny Investing Podcast

Mutiny founder and host Jason Buck’s introduction:

In this episode, I talk with Eric Crittenden, Founder and Chief Investment Officer of Standpoint, an investment firm focused on bringing all-weather portfolio solutions to US investors. Eric plays an active role in the firms’ research, portfolio management, product innovation, business strategy, environments and client facing activities. He believes using an all-wealth approach is the most effective way to prepare for a wide rage of market environments, while producing meaningful investment returns with limited downside risk.

Eric has over 20 years experience researching, designing, and managing alternative asset portfolios on behalf of families, individuals, financial advisors, and other institutional investors. Eric and I talk about circuitous paths with multi-year dead-end rabbit holes, simplicity can be the ultimate sophistication, what clients want, what’s wrong with the investing industry, and strategy scaling.

Episode link

All bold emphasis is mine.


  1. Investing opens your mind

    Jason Buck: Well, like you said, you don’t have to be overly prescient to talk about negative oil or negative interest rates. What I’ve always loved about macro trend is that you just follow price, right? And so if price goes negative, you just keep following it negative if that’s the direction of the trend. You don’t have to have any global macro narrative. And that’s the point, is you’re just offsetting narratives and people love narratives, so they didn’t like the idea that you said it could potentially go negative. You weren’t calling for it. You’re like it’s just within the realm of possibility. And I wonder, do you think that following trends for so long just opens up your mind that anything’s possible?

    Eric Crittenden: I think doing the research around it and seeing what actually happened. I mean, you can see with your own eyes what happened historically, like the sugar trade in the 1980s, where the price was below the cost of production. And the price didn’t actually go any lower, but you made a boatload of money being short because of the contango and the futures curve. Right? So today, you fast forward to today, and I talk to emerging CTAs or people that want to start trading their own account, they’ll do the same thing over and over. It’s always the same thing. They come up with all these filters to filter out trades and they say, “Well, if the price is too low, it won’t go short. If the price is too high, it won’t go long.” Well, okay, so one of these days you’re going to experience this phenomenon, and the greatest trade of the decade will be the one that your filter filters out.

  2. Breakouts vs moving averages

    I looked at many, many different ways to measure and identify a developing trend, and what I found, and you know this, is that they all basically pick up on the same thing. They’re just different ways of measuring the same thing. It’s like if there’s a wave coming in and you’re in Santa Barbara and you’ve got a guy from Hawaii and a guy from Oregon and a guy from California, and one guy says it’s four and a half feet, the other one says it’s five feet, and the other one says it’s four, they’re all measuring the same thing, they’re just doing it the Hawaiian style or the Oregon style or whatever.
    So there’s not a lot of benefit from diversifying your entry/exit style, moving average crossover, breakout. There’s a whole bunch of different styles. That being said, you could develop a strategy that uses a moving average crossover that doesn’t have a lot of … in other words, they’re not all created equal.

    I like breakouts. So I’m kind of in the minority there. I like breakouts because they’re pure trigonometry. They’re just triangles, essentially. And you know the price that would force you to get in, and then your stop-loss is some other price, and you know what that is. And you know what both of those prices are every single day. And that means you can calibrate your risk. You can lean on that. We call that the risk range. So I know approximately how much risk I’m taking to market because I know what both of those prices are. When it comes to a moving average crossover, I don’t know what price is going to force those two moving averages to crossover without doing some really advanced, or not advanced but tedious math to come up with a bunch of different scenarios about how they might crossover in the future. So because they all basically pick up on the same thing, but the breakout approach is very clean from a risk management perspective, I gravitate towards that, and I didn’t see a lot of benefit from diversifying meaningfully beyond what I’m already doing when it comes to entries. [Kris: This is resonant with what I saw at a fund that ran a breakout trend strategy.]

  3. Approach to risk management depends on whether you come from the relative vs absolute return crowd

    Jason Buck: Is like CTAs have always been pointing out, or macro trends specialists, have always pointed out that this is what actually matters is your aggregate drawdown risk, not your volatility metric. But that just doesn’t seem to translate well to everybody else, and everybody still seems to care most about sharp ratios versus max drawdown.

    Eric Crittenden: I think in the securities world, stocks, bonds, mutual funds, it’s historically been a relative game rather than an absolute game. In a relative game, anytime you sell, you’re putting yourself into a position to get left behind. If you get left behind, it’s game over for you, everyone loses confidence in you. Futures guys, derivatives guys, live in a very different world or grew up in a very different world where it’s all about survival. Some of these guys are using leverage and quite a bit of it, so it really was essential that they control the amount of risk they’re taking. So, and when CTAs is drone on, and on, and on about risk management, it drives advisors crazy, because they don’t even really know what you mean when you say that.

    [Kris: I’m biased but I agree with this from my life as a derivatives trader. Risk management is the #1 focus, but I had never thought about why the beta world might not think that way]

    It’s not that important in their world, because a balanced portfolio of stocks and bonds, it’s more important to not manage risk, because you don’t want the taxes, you don’t want the turnover, and you don’t want to get left behind. You can look at these psychological studies, and I’ve had people tell me it’s okay to be down 50% once every 10 years, as long as the market’s down 45, or 50, or 55%, I won’t lose my clients. But if I manage my risk along the way, the way you guys do, and I’m up 20 when the market’s up 25, and then the next year I’m up six when the market’s up 11, it’s game over for me. That’s unfortunate, but that’s how it is in the securities industry. So, but when you’re looking at alternatives, and in particular all-weather investments, frame the right way, that all goes away.

  4. “All weather” and uncorrelated risk premia

    Dalio coined that term or made it popular and he sometimes will say, “You need upwards of 16 uncorrelated return streams,” do you think that’s even possible?

    Eric Crittenden: No, it’s not, and I like Dalio, I like his writings, I modeled a lot of what we do off of what their firm did in the ’80s. So, I have a lot of respect for what he achieved, and how he did it, the how is very important. That being said, anyone with a plain vanilla copy of Excel can use a random number generator and realize that three uncorrelated variables are pretty much all you need to be the best money manager out there. So, I don’t know where the 21’s coming from. I’ll tell you hit on something though that there’s only one thing in this world that actually that I’m jealous of right now. There’s one risk premia out there that I can’t source, but it would be so valuable if I could.  So, I’m really just getting three, and I feel like that’s all we need, it’s the best I can do. I think it solves a lot of problems for people, but there’s one more out there that I think is big and sustainable, but you can’t get it from Phoenix, Arizona, and that is the market-making style risk premia. Where you need economies to scale, you need poll position, co-locate your servers, you got to be big, and have a solid network. You got to be basically like Amazon or Costco, where you can just muscle your competitors out of the way. You’re like, “Nope, get out of here, this is my real estate, and I’m doing…” It would be so valuable, but there’s just no way we could pull it off.

    Jason Buck: You said three return sources, so eliminate the three return sources that you believe you have?

    Eric Crittenden: So, I feel like there’s capital formation markets, like stocks and bonds, which are kind of a one-way street, the risk premia is kind of a one-way street. I mean, the bulk of the risk premia is your long stocks. The futures, whether it’s metals, grains, livestock, energy, these are risk transfer markets and risk transfer markets are different than capital formation markets. I feel like risk transfer markets, you need to be symmetrical, you need to be willing to go long or short, because they’re a zero-sum game. They have term structures, so they’re factoring expectations, storage costs, cost of carry, all that stuff. And then there’s the risk-free rate of return, which used to be a great way to kind of recapture inflation, it’s not so much anymore. We can get into that later on, it’s a fascinating time to be managing money, because there’s a huge gap between inflation and risk-free. But, historically speaking, those are the three that I think makes sense, especially in the context of an all-weather portfolio that uses futures to get its commodity and derivative exposure, because it leaves a lot of cash lying around. So, to go source that risk-free rate of return costs you nothing, there’s no opportunity cost, because you were going to be sitting on that cash anyways.

    When I look at all the different risk premium on this computer or the one behind me, historically, I see those three blending together more beautifully, and there’s other ones out there, they just don’t move the needle for me. Things that are related to real estate, credit, they just all have that same trap door risk that the equity market has when the equity market’s going down. So, and then the rest of the time they’re expensive, they’re tax inefficient, they’re illiquid, and then they disappear on… Sometimes they get crowded, I mean, they just cause more problems than they solve. That’s how I feel about corporate bonds, credit, all that stuff. I mean, I wish there was something there, I know other people strongly feel that there is, but I’ve looked at the data until my eyes are blurry, for decades, and I don’t see it.

  5. Capital formation vs risk transfer markets

    This is an important concept to me, because it goes to the point of why I do what I do, or why I think that macro trend oriented approaches expect a positive return over time, because the futures markets are a zero-sum game or actually, a negative-sum game after you pay the brokers, and the NFA fees, and all that stuff. So, in a negative-sum game, you better have a reason for participating. For you to expect to make money, you better be adding something to that ecosystem that someone else is willing to pay for, because somebody else has to mathematically lose money in order for you to make money. So, in studying the futures markets, and I’ve been on both sides, I’ve been on the corporate hedging side, I’ve been on the professional futures trader side.

    I believe I understand who that somebody is, that has deep pockets, and they’re both willing and able to lose money on their future’s position. A trend oriented philosophy that’s liquidity weighted is going to be trading opposite those people on a dollar-weighted basis through time. It does make sense that they would lose money on their hedge positions, I mean, in what world would it make sense for people who hedge, which is the same thing as buying insurance, to make money from that? It makes no sense, that would be an inverted, illogical world. So, anyone who’s providing liquidity to them should expect some form of a risk premia to flow to them. It’s just up to you to manage your risk, to survive the path traveled, and that’s what trend following is. I don’t know why that is so controversial, and more people don’t talk about it, because I couldn’t sleep at night if I didn’t truly believe that what we’re doing deserves the returns that we’re getting.

    Jason Buck: CTA trend followers, or whatever, just they don’t really know how they make money. They’re like, “It’s trending, it’s behavioral, it’s clustering, it’s herd mentality, and that’s how we make money.” You’ve accurately portrayed it as these are risk-transfer services, speculators make money off of corporate hedgers. But the only thing I would push back, and I’m curious your take on this, is like you said, zero-sum game or negative-sum at the individual trade level. But when we look more holistically, those corporate hedgers are hedging their position for a reason, and it’s likely lowering their cost of capital for one of the exogenous effects. So, my question always is, is it really zero-sum or negative-sum, or is it positive-sum kind of all the way around? In a sense that the speculator can make money offering these risk transfer services that the hedgers are looking for that liquidity, and then the hedgers are also… If we look at the rest of their business, they’re hedging out a lot of their risks, which can actually improve their business over time, whether that’s cost of capital, structure, or other exogenous effects.

    Eric Crittenden: Absolutely, I wish I had… You did record this, so I’m going to steal everything you just said. In the future’s market, it’s negative-sum. If you include the 50% of participants that are commercial hedgers, it’s no longer zero-sum. But most CTAs, and futures traders, and futures investors don’t even concern themselves with what’s going on outside the futures market. So, but if you pull that in and look at it, you can see, or at least it’s clear to me, we’re providing liquidity to these hedgers. They’re losing some money to us, and the more money they lose to us, the better off their business is doing, for a variety of reasons. Tighter cash flows, more predictable cash flows results in a higher stock price, typically. But you brought one up that almost no one ever talks about, and that is if they’re hedged, their cost of capital, the interest rate that they have to pay investors on their bonds is considerably lower. Eric Crittenden: Oftentimes, they end up saving more money on their financing than they lose on their hedging, and they protect the business, and they make Wall Street happy at the same time, so who’s really the premium payer in that, it’s their lenders? So, by being a macro trend follower in the future space, the actual source of your profits is some bank that’s lending money to corporations that are hedging these futures. So, it’s the third and fourth order of thinking, and you can never prove any of this, which is great, because if you could prove it, then everyone would do it, and then the margins would get squeezed.

    [Kris: As a commodity options trader, this framing is spot on. I was typically trading with flow that was constrained or price-insensitive. Corporate hedgers must hedge because of the covenants in their loan financing. I had never thought about the edge being spilled in the option market is coming from the lenders ultimately! I guess if we follow that logic even deeper it’s the bank shareholders that are giving up expectancy by requiring less loan defaults and it’s an open question as to whether the hedging activity is worth the lower cost of capital at the bank share level]

15 Ideas From Morgan Housel’s Interview with Tim Ferriss

Morgan Housel is one of my favorite finance writers who happened to make it to the mainstream with his massive hit book Psychology of Money. It’s a book I like to gift people even though I haven’t read it myself. That probably sounds weird, but I’ve read almost every blog post he’s written in the past 5 years and cite his writing in my newsletter constantly. I am just bad better at buying books than reading them. My nightstand has more than 50 books on it. That’s not a typo, it’s a problem (since I moved to CA I read about 5 books per year which is about 1/3 of what I used to back when I had an NYC subway commute).

Anyway, Morgan is great and his big-time interview with Ferriss is worth the 3 hour listen (transcript).

Here are 15 parts I felt like sharing. Bold is my own emphasis.

  1. Who’s the greatest investor of all time?

    It doesn’t seem like a hard question to answer. It should be an analytic answer, it’s just like a number who’s had the best performance, but then you can split this different ways. So who is the wealthiest investor of all time? That answer is Warren Buffett. Who’s the greatest investor of all time in terms of like long term average annual returns? It’s Jim Simons by a mile. And like it’s not even close. Warren Buffett’s long term average annual returns are about 21 percent per year. Jim Simons’ are like 66 percent per year after his ridiculous fees. He’s like in a different universe, but Warren Buffett is like way wealthier. And Jim Simons is like a deca-billionaire himself. And to say like he’s not as rich sounds crazy, but to parse out the reason that Warren Buffett has earned one third of the returns, but he’s like 10 times as wealthy, is because Warren Buffett has been investing for 80 years.

    And so even though he’s not the greatest investor of all time in annual returns, he has so much endurance in terms of what he’s done that by a mile. He’s the wealthiest, which to me, that gets into a really interesting point, which is how do you become a great investor? And most people when they hear that, what they think of is like, how can I earn the highest returns? What are the highest returns that I can earn this year and over the next five years, and over the next 10 years. And that’s not bad, that can be a great thing to do. But to me, if the goal is to maximize the dollars that you have, just like what’s the way that maximize the amount of dollars I accumulate over the course of my life. Then the answer to that question, the huge majority of the time is not earning the highest returns.

    It’s what are the best returns that you could earn for the longest period of time, which usually aren’t the highest returns that are out there because maybe you can double your money this year, but can you do that for 50 years in a row? Like probably not, but could you earn 10 percent annual returns for 50 years? Yeah, you can totally do that and generate an enormous sum of wealth. All compounding is, is returns to the power of time, but time is the exponent. So that’s to me what you want to maximize and that’s why Warren Buffett is in my mind, and it seems like an easy answer, the greatest investor of all time, even though his returns are probably not even in the top 20 percent of annualized returns among professional investors.

  2. Investors Morgan admires besides Buffet

    John Bogle, who started Vanguard, I think is probably the most admirable because it was so selfless what he did.

    A lot of people don’t even know this, Vanguard is owned by the people who own Vanguard Mutual. There’s no Vanguard shareholders. There’s no profits. There’s no dividends that are played to the owners. Vanguard was made for the benefit of the people who own the ETFs, the people who own the mutual funds and John Bogle did not make that much money for himself because of that. And you could almost think that Vanguard’s low fees, all of that is — the amount that you saved in fees is money that could have gone to John Bogle and John Bogle’s estate that didn’t. He’s like this undercover philanthropist of finance that I really admire just because there’s so few other people like that.

    And I think someone like James Simons, who we mentioned earlier. I think in every field, there’s only one person who’s claimed a fame, who’s competitive advantage is “I’m smarter than everyone else”. In tech, for 20 or 30 years, that person was Bill Gates, and I think in finance for the last 20 or 30 years, that person has been James Simons. The only person in the field who can say, if you ask them the question, “What is your competitive advantage?” They can say, “I’m just smarter than everyone else.” Only one person can say that, and it’s James Simons. If you look at what Renaissance Technology has done and just the results that they’ve accumulated and the consistency of what they’ve done, it’s like LeBron James times Michael Jordan times Tiger Woods to the power of Mikaela Shiffrin. It’s just such a different universe compared to what anyone else has done that it’s just, it’s astounding to watch.

  3. Admiration but not copying

    So I think most of the people who I really admire as investors, it’s more that I admire just how they’ve lived their lives, and their general life philosophies, and their investing philosophies stems from that. That’s true for Buffett as well. Actually, there’s an interesting thing about Buffett, which is that it was so easy to admire him and still is. But when the book The Snowball came out, which is a biography written about Buffett by an author named Alice Schroeder, and it came out, I want to say 2009, something like that. It really makes clear the case that Buffett has not lived a perfect life by any means. And in a lot of instances, his family life has been a disaster. I think that’s the right word to use. It’s kind of rude to say that, but I think it’s really true. In some ways, it’s good to hear that, that like everyone puts their pants on one leg at a time in the morning. Everyone is human. Everyone deals with the ups and the downs of living a life. And that he’s a human.

    And also that a lot of the reason that his family life was troubled at times is because he was, had a singular devotion in life, which was picking the best stocks and everything else came second to that. Everything from his family on down came second to that, in a way that a lot of people, including myself at one point said, “I want to be Warren Buffett. I want to be the next Warren Buffett.” But then you read about what it took to get there, and I’m like, “No, I want to stay 10 miles away from that.”

    …In The Making of an American Capitalist, and I read this decades ago, but the story that really stuck out to me and I’m probably getting this wrong, but someone on the internet will correct me. I remember his meeting, Warren’s routine was to work at the office and then come home and basically just walk straight upstairs, and begin reading like S-1 filings or annual reports of one type or another, quarterly reports. And that was his routine.

    And one day, he came home after work and I want to say his son, but one of his kids was like splayed out at the bottom of the stairs and had clearly like fallen down the stairs, and he just stepped over this child and walked up to his office to read reports. Like it didn’t even register to attend to his child.

    That’s a really important insight to learn is that a lot of these people who you admire, the reason that you admire them is they’re so successful, and that success that they had had enormous costs associated with it that are easy to ignore. And when I look at that, it’s like, I can look at pieces of Buffett’s life that I admire and pieces of Jim Simons’ life that I admire, but I don’t want to be them. Because that mega success had so many costs attached to it that I want to avoid in my life. That’s been an important observation too, for me.

  4. Compounding

    [Kris note: A reminder that geometric growth is N² and exponential growth is 2ᴺ…compounding deals with exponential growth. For example, if you grow at 10% per year for 30 years you end up with 1.10³⁰ = 17.4]

    The math behind it is 99 percent of his wealth was accumulated after his 50th birthday and 97 percent came after his 65th birthday, which is a really obvious thing. If you think about how compounding works, like it’s always in the extreme later end of year, is that the numbers just start getting ridiculous. Compounding is just like, it’s just like, it starts slow and then it’s boring. And for 10 years it’s boring, for 20 years it starts to get pretty cool. And then 30 years you’re like, wow. And then 40, 50 years, it’s like, holy, like it just explodes into something incredible. There’s a friend of mine named Michael Batnick, who its explained compound growth, I think the most easy way to comprehend, which is, if I ask you: “What is eight plus eight plus eight plus eight?” you can figure that out in your head in three seconds, like anyone can do that.

    That’s no problem. But if I say, “What is eight times eight times eight times eight times eight?” Like, your head’s going to explode trying to think about it. All compounding is never intuitive. And that’s why, if we look at someone like Buffett, we in the financial industry have spent so much time trying to answer the question: how has he done it? And we go into all this detail about how he thinks about moats and business models and market cycles and valuations, which are all important topics. But we know that literally 99 percent of the answer to the question, how has he accumulated this much wealth, is just that he’s been a good investor for 80 years. It’s just the time. And if Buffett had retired at age 60, like a normal person might, no one would’ve ever heard of him. He would’ve been like one of hundreds of people who retired with a couple hundred million bucks and like moved to Florida to play golf.

    He never would’ve been a household name. He would’ve been a great investor, of course, but there’s a lot of great investors out there. The only reason he became a household name is just his endurance and his longevity, that’s it. And that’s why if you go back to like, even the late 1990s, not that long ago, Warren Buffett was known within circles. Like within investing circles, people knew who he was. He didn’t become a household name until the early and mid-2000s, which is that’s when the compounding took his net worth to become worth 20 billion, 50 billion, a hundred billion where he is right now. It’s just the amount of time he’s been doing it for.

  5. Tim describes the letter Morgan wrote to his son while the boy was still a child

    “You might think you want an expensive car, a fancy watch, and a huge house. But I’m telling you, you don’t. What you want is respect and admiration from other people, and you think having expensive stuff will bring it. It almost never does — especially from the people you want to respect and admire you.”

    Here’s the paragraph that stuck out to me:

    “When you see someone driving a nice car, you probably don’t think, ‘Wow, that person is cool.’ Instead, you think, ‘Wow, if I had that car people would think I’m cool.’ Do you see the irony? No one cares about the guy in the car. Have fun; buy some nice stuff. But realize that what people are really after is respect, and humility will ultimately gain you more of it than vanity.”

    Now the last sentence has some counter examples maybe. But the point that we rarely look at the person in the cool car and say, “Wow, that person must be cool.” Rather, we apply it to ourselves is I think a very profound observation.

    …Morgan adds:

    I was a valet at a high-end hotel in Los Angeles. So I was in my early 20s and there were people coming in in Ferraris and Lamborghinis and Rolls-Royces, like the whole thing. And it dawned on me one day that when those cars pulled in, that I had really admired, I’m a car guy, I love that. Never once did I look at the driver and say, “That guy is cool.” What I did is I imagined myself as a driver and I thought people would think I’m cool. And this was like, I was in my early 20s, but I’m just thinking like that was my first kind of light bulb into how wealth works, that everyone thinks that they want to be the driver, but no one actually is paying attention to the driver.

    They’re imagining themselves. People think about themselves way more than they think about other people. But we all think that everyone’s looking at us, I think that’s like a universal thing. Everyone thinks like, oh, this person’s looking at me, they’re impressed with me. By and large they’re not, they’re thinking about themselves and how other people might want to be impressed with them.

    [Kris note: I describe this effect as the “bad hair day”. The ratio of people noticing someone else’s hair is messy divided by people mentally derailed by their “bad hair day” is indistinguishable from zero]

  6. Purpose of wealth

    I think if there is a universal trait of money that’s true for like not a hundred percent of people, but let’s say 90 percent of people, is that, what people really want in life is independence and autonomy. I think no matter where you’re from, what you do, your aspirations are, that’s a common denominator. That people just want to wake up every morning and do what they want to do on their own terms. And whether they’re able to do that, whether they can actually do that today, or that’s a goal. I think that’s a universal trait among people is just independence and autonomy. And so to the extent that we can use money to gain that, to gain independence and autonomy, that is, I think, as close as it comes to a universal want and thing that we can use money for. The interesting thing to me is that among huge numbers of people, educated people, financial professionals, the purpose of money is to buy stuff. It’s to accumulate more stuff, bigger house, nicer car, whatever it might be, which is great.

    I love all that stuff too. But to me, the most powerful thing that money can do and the most universal benefit that it can bring us is systematically overlooked, like using it for independence and autonomy is so overlooked. And that to me has always been kind of a sad thing that we are so accustomed and attuned to just wanting to use our money, whatever money that we have, whatever savings that we have, to go out and buy more stuff when we could be using it for freedom and autonomy. And then when you come to a period like in March and April 2020, or October 2008, when millions of people lose their jobs and you see during those periods, like the early day of COVID, how many people are just on the razor’s edge of insolvency. And it does not take them much, one or two weeks of unemployment to be in a really bad financial spot, whether that’s for an individual or a small business, it does not take them much to be thrown over the edge.

    And you realize how dependent so many people are on their jobs, their salaries, their theirs customers in a short period of time. And there’s just not a lot of room for error throughout most of the world. And I think for the huge majority of people, not everyone, but for the majority of people, there could be a lot more. And the reason that they don’t want to have more savings is because to them, the knee jerk reaction is “Why would I just keep my money in the bank or even invest it? Like, the purpose of money is to go out and buy more stuff to enjoy my life.”

    I get that, I understand it, but it’s usually once every five or 10 years that people realize how important independence and autonomy is. And having that wealth that you have not spent, having the money that you haven’t spent that was just lying around doing nothing, becomes the most valuable thing in the world when it lets you gain control of your time and just wake up every morning and say, “I can do whatever the hell I want today.”

    I want to wake up every morning and hang out with my kids and I want them to be happy and I want to do it on my own schedule. If it’s a Wednesday morning and I don’t want to work, then I’m going to sit on the couch all day and watch Netflix. And if it’s a Sunday and I got a good idea, I’m going to spend all day working. It’s all my own schedule on my own time, whatever I want to do. It’s that independence and autonomy.

    Tim Ferriss: Can you not do that right now?

    Morgan Housel: Yes. Yeah, I can. There was a point when I couldn’t and that’s why I feel like I’m pretty happy, and I feel like I’ve done a decent job of doing that. Now I do have, as a lot of people would, a tendency to be like, “Oh, what if I got that Porsche? What if we got the bigger house? What if we did this? What if we did that?” And it’s fun to think that because I love nice cars, I love all of that. It’s just so easy to realize. There was a great quote that I love that’s, “The grass is always greener on the side that’s fertilized with bullshit.” I think that’s really what it is. That’s the accurate phrasing of that well-known quote, and I think that’s really what it is. The idea that all that nicer stuff is going to make you necessarily happier, I think is just so easy to disprove.

    Especially once you’ve experienced a little bit of it yourself and that actually what is going to make people happy is that independence and autonomy, that once I remind myself of that, I’m like, okay. And then the game of earning more just becomes a game, it’s less about like, oh, if I have more money, I’m going to be happier. No, if my net worth is 10 X what it is today, I’m not going to be any happier. That was not true at one point in my life, but I think it’s true today, it’s probably true for you right now, it’s true for a lot of people listening. And therefore you can admit that a game is fun and a game is fun to play, but just admit that it’s a game and it’s actually not going to make you happier.

  7. Risk is personal

    The takeaway from that is most investing debates, where people are arguing with each other, is this a risk? Is that a risk? Should I buy this stock? Is the market going to go up next week? By and large, those debates are not actually debates. It’s people with different risk tolerances and different time horizons talking over each other, talking over one another. And that’s why. I think to me, the most important part about risk is that the definition is different for everyone. My definition’s going to be different from yours, which is different from anyone else who’s listening.

    And it’s not because we disagree with each other. It’s just because we’re different people, with different goals and different ages and different family situations, etc. And so, risk is a very personalized calculation for everyone whether that’s in investing or other areas of your life.

    [Kris: I always say that if you need $1mm tomorrow, the biggest risk is not flying to Vegas and betting 500k on red]

  8. “Tails drive everything” demonstrated without math

    Tim: Am I recalling correctly that a bulk of his career returns came from concentration in GEICO? Am I getting that right?

    Morgan Housel: That’s true. The last page of Benjamin Graham’s book, The Intelligent Investor, tells us little tale about an investor who earned basically his entire career success off of one investment. And that one investment broke every rule that this investor had laid out. And then kind of in the last paragraph on the last page of his book, he says, “By the way, that investor is me.”

    And if you look at Benjamin Graham’s track record, his career track record is incredibly good. And if you remove GEICO, it’s average. And like I mentioned, GEICO by Graham’s own saying, breaks every rule that he just laid out in that book to buy it. And so that’s a really interesting thing is like, not only was it one company, but it’s a one company that broke all the rules. So if you’re reading that book and looking for rules to follow, like by definition, you are not going to achieve Benjamin Graham’s success.

    And so, I think that’s really telling, and I don’t know what the takeaway from that is. If you could say, “Well, then clearly he’s just lucky.” If all of the success was due to one company that broke the rules, you could say, he’s just lucky.

    The other thing you could say is that’s just how capitalism works. And that’s true for Buffett. It’s true for a lot of people. That if they make a hundred investments, you’re going to make the huge majority of your money on probably five of them. That’s true for anyone. That’s even true if you’re investing in an index fund. That within the index, most of the games are going to come from five percent of the companies that you invest in. That’s always the case.

    I think it just kind of changes how people view success though. Like if your view of success is that every stock that Warren Buffett or Chamath or Jim Chanos or all these big name investors, that every time they make an investment, then it’s clear that, that company’s going to be a winner.

    And that’s just not how this success plays out at all. That even among the top names, the best investors over time, the majority of the picks that they make do not do very well. And the reason that they’re so successful is because one or two or maybe five investments they’ve made are ultra home runs. People associate that with venture capital. That’s how it works in NVC. But it’s actually true in all stages of investing.

    The stat that I’ll share with you here is that if you look at the Russell 3000 index, which is an index of large public stocks in the United States, over time, from I think, 1980 to 2010, 40 percent of the stocks in this large cap, like mom-and-pop index, 40 percent of the companies went out of business, not merged, not BAPA, but they went bankrupt, 40 percent of them.

    But the index did very well because seven percent of components were huge winners. It was like Amazon, Microsoft, Netflix, those companies. So even in a boring old index fund, almost half the companies are going to go out of business. But you’ll still do well because a few do very well. And so that was true. And I think the more successful you are, the more you see that.

    Even at a company like Apple or whatnot, what percentage of Apple success is the iPhone? It’s enormous. But they’ve experimented with dozens of different products over time. Amazon has experimented with the Fire Phone, which is a total flop, and they’ve done things in music which were flops. They’ve done all these flops, but they’ve also done Prime and AWS, which matters more than anything else. So almost anywhere you look, you will see that a tiny number of activities, apply for the majority of success. And it’s so hard to wrap your head around that when you’re trying to emulate these people who you look up to and admire.

  9. Safety net vs fuel approach to inheritance

    I’m quoting Buffett again, I don’t want to do this ad nauseam for the whole podcast, but he has a great quote on wealth where he says he wants to leave his kids enough money that they can do anything, but not so much money that they could do nothing — I think that’s really the key. And that’s how I think about my own kids who are very young, but when my wife and I think, how do we want to use whatever savings that we have to benefit them? Giving them a safety net, but not a fuel is a — that’s what my parents did for myself and my siblings, I always knew — when I was a teenager and in my early 20s, I always knew they would be there if I fell on my face and they would — I would never just completely fail, I’d never be homeless, I would never — they would always catch me, but they were never going to be a fuel. They’re never just going to give me money just to make my life better, that was never going to be the case.

  10. Against optimization

    Even if you look at the periods that in hindsight we think were the greatest that existed, which for most Americans is the 1950s and the 1990s, that’s what we remember as the golden age of prosperity and happiness and peace. Even if you look at those periods, like in the 1950 people were high, kids were doing nuclear bomb drills under their desks, and there was a lot of pessimism and negativity. Even if we know in hindsight, it was great at the time, by and large, they did not know that maybe it was good economically, but there was a lot to be worried about in the 1950s. Same in the 1990s, which we today it’s like, oh, the booming 1990s, the bull market. But even people forget in 1994 there was a big interest rate calamity where a bunch of bond interest rates rose and then the stock market crashed.

    And then in 1998 a big hedge fund went out of business and almost took the whole global economy down with it. There was a lot to worry about during these periods, so how do you protect yourself from that? How do you actually become buy and hold? I think there’s one thing to do here, there’s a friend of mine named Carl Richards, who’s a financial advisor, and he has a quote where he says, “Risk is what is left over when you think you’ve thought of everything.” And I think that’s the definition of risk is whenever we’re done planning and forecasting, everything that’s left over that we haven’t thought about, that’s what risk actually is. And the takeaway from that, the actual practical takeaway is that if you are only planning for risks that you can think about and you can envision and you can imagine, then 10 times out of 10, you’re going to miss the biggest risk that actually hits you.

    The biggest risk is always something that nobody sees coming, including something like COVID where it’s actually not fair to say no one saw it coming, but by and large — it’s like in financial circles, not a single investor in 2019 in their economic outlook had a viral pandemic as something that they were worried about, not a single one, or 9/11, or Lehman Brothers going bankrupt, all the big events that actually mattered, it’s pretty much true to say no one saw them coming. I think that’s generally true. And therefore, the takeaway is you have to have a level of savings in your asset allocation that doesn’t make sense. You have to have a level of conservatism that seems like it’s a little bit too much. That’s the only time that you know that you are prepared for risks that you cannot envision.

    And if you are only prepared for what you can imagine, again, you’re going to miss the biggest risk every single time. Whenever people look at my asset allocation, if I share that with them, it looks a little bit too conservative and they say, “Ah, you could be taking a little bit more risk,” and they’re right. I probably could, but I want to be prepared for the risks that I can’t imagine, or the risk that is possible but I don’t want to even think about it, it’s too painful to think about. That’s the only time that you can be prepared for the surprises in life. And I think most people, not all investors, but the majority of investors are not conservative enough. And I know whenever I say that they shake their head like, “Come on. Why don’t you want to take risk?” And once a decade you learn why, once a decade. Whether it’s COVID, or 9/11, or 2008, once per decade, you’re like, “Oh, okay, I get it now. I didn’t see this coming. It was a calamity and I either ground myself into the floor and I got wiped out, or I had a little bit of extra savings that got me through.” So that’s how I think about how to stay in the game in a long term history where history is a constant chain of surprises. That’s the only way to do it.

  11. Framing: Understanding when volatility or pain is a “fee or a fine”

    The way that I’ve phrased it in the book was “understanding the difference between a fee and a fine,” which seems like they’re really similar but there’s a very important difference which is, a fine means you did something wrong like, “Shame on you, here’s your speeding ticket. Don’t do it ever again, you’re in trouble.” And a fee is just a price of admission that you paid to get something better on the other side. Like you go to Disneyland, you pay the fee, and then you get to enjoy the theme park. You didn’t do anything wrong, it’s just that’s the fee.

    I think if you could situate your life to where you view a lot of the ups and downs, not all of it, but a lot of the volatility in investing, a lot of the volatility in your career, as a fee instead of a fine, then it just becomes a little bit more palatable. And when the market falls 30 percent, it’s not that you enjoy it, you don’t think it’s fun, but you’re like, “Okay, I understand this is the fee that I have to be willing to pay in order to do well over a long period of time.” Most investors don’t do that. When their portfolio falls 30 percent, they say, “I fucked up. I did something wrong. I clearly made a mistake. And how can I make sure this never happens again?” And that’s the wrong way to think about it. And I think if you view it as a fee instead of a fine, it’s just much more enjoyable. It’s much more realistic to deal with.

    Now, I said earlier that there are some areas in life where it’s like that. If you’re talking about a death in the family, a divorce, there’s things that’s like, “No, that’s not — that’s just a straight negative.” Like no silver lining to some of these things in life so I want to be careful at parsing that. But particularly investing, the huge majority of the pain that people go through and put themselves through is just the fee for earning superior returns over time. And if you’re not willing to pay that, then you’re probably not going to get the reward on the other side. And that’s why you can see so many people who at the first experience with being uncomfortable in investing with a loss, they view it as they screwed up and then they want out. They want to move on to something else.

    And of course, they’re not going to get the rewards over time. Nothing in life is going to give you those rewards for free. There’s a cost to everything. And just identifying what the cost is then realizing that the cost is not on a price tag, you’re going to pay for it with stress and anxiety, and dopamine, and cortisol, like that’s how you pay for these things, I think that’s the only way to deal with those big ups and downs.

  12. The optimal amount of bullshit

    You had Stephen Pressfield on your show, and he was talking about a time when he lived in a mental institution. He was not a patient himself, but he lived there and he starts talking to all these people. And he made this comment that a lot of the common denominators of these people who lived in a mental institution was they were not crazy, they just could not handle or put up with the bullshit of life. They just couldn’t deal with it. And that was kind of why they ended up in the mental institution. And he said all these people were the smartest, most creative people who he had ever met, but they couldn’t put up, they had no tolerance for the bullshit of the real world. And that to me, just brought this idea that there’s actually an optimal amount of bullshit to deal with in life. If your tolerance for bullshit is zero, you’re not going to make it at all in life…

    I listened to that [interview] and it was like, “Oh, see, these people could not function in the real world because they had no tolerance for bullshit.” The second step from that is, there is an optimal amount of bullshit to put up within life. And that was where this article, “The Optimal Amount of Hassle,” came from.

    And I remembered I was on a flight many years ago and there was this guy in a pinstripe suit who let everyone know that he was a CEO of some company, and the flight was like two hours delayed, and he completely lost his mind. He was dropping F bombs to the gate agents and just completely making an ass of himself because the flight was delayed. And I remember thinking like, “How could you make it this far in life and have no tolerance for petty annoyance, like a delayed flight?”

    And I just think like there’s a big skill in life in terms of just being able to deal with some level of bullshit, and a lot of people don’t have that. There’s another great quote that I love from FDR, who of course was paralyzed and in a wheelchair. And he said, “When you’re in a wheelchair and you want milk but they bring you orange juice instead, you learn to say, ‘That’s all right.’ and just drink it.” And I think that just having the ability to put up with that kind of stuff is, I think, really important and often lost in this age where we want perfection. We want everything to be perfect, and it never is.

    [Kris: I have a good friend who is insanely smart and well-traveled (top 1% in both categories of everyone I know). He has a  brother who is not conventionally successful and I’ve asked him about what that brother is like. His brother is also very well-traveled in part to choosing a life in the armed forces. But my friend has also described is brother as also extremely smart. But he’s incapable of tolerating the b.s. that defines the ladder-climbing world. The military life is simple in the ways he prefers. It has always stayed with me, that my friend quite explicitly described his brother as being unwilling to suffer bullshit. I really think about this a lot (too much if I’m being honest), since I often feel that “getting ahead” is really just climbing sedimentary layers of compressed bullshit.]

  13. The durability of value investing with a lower case “v”, not the investment category

    Value investing will always work in terms of, if you buy an asset for less than it’s worth, you’ll probably do pretty well over time. But the actual formulas that you use to determine value, those have always evolved and always changed. And formulas that people use, whether it’s price to book value, the P/E ratio. Whatever formula it is that may have worked at one period of time, those always evolve. That’s always been the case. I think it always will be the case that there will be people that will be stubbornly attached to the metrics and the formulas and the valuation techniques that worked perfectly in the previous era that now outdated and outmoded.

  14. Incentives

    If I was selling products by commission, if I was a financial advisor selling by commission, I would probably be much more into active investing and active strategies than I am right now. I think because I’m not a financial advisor, I’m not giving people advice, I can just view it as an outsider and be like, well, this is what makes sense to me so that’s what I’m going to do.

    Whereas I know that if I was in the trenches so to speak and had to make a living doing this, I know I would’ve very different views about what strategies you should pursue. And I know that the strategies that I would lead towards would be higher fee higher commission. I just think that’s the reality of it. Most people who work in finance are good, honest, noble people. Not all of them, but most of them are. But to the extent that is bad advice that gets perpetuated, I really just think it comes down to the incentives that are in the industry. The perfect example of this is that the only firm that’s really been able to make a good business out of selling passive funds is Vanguard and they’ve done it by becoming a nonprofit. That’s the only way that you can do it. You can’t make a good business out of selling the lowest fee funds that are out there. You just can’t do it. So I know that if I had a different compensation structure, I would think differently as an investor.

  15. I couldn’t help mentioning this section. Do what you will with it

    Tim Ferriss: Yeah. I am going to try to find this. There it is. It is a tweet from Jason. So a few years ago, Naval Ravikant and I were having a conversation on the podcast and he talked about the asymmetric costs of offense and defense in a world where drones are weaponized. Meaning if you have a drone or a bunch of tiny drones that are weaponized, and this is being developed all over the world, of course. You have sophisticated attacks where they can be coordinated with software to say all land on a given tank and explode at once. They can be used in more ad hoc, improvised ways.

    But I’ve been tracking this space because a number of my friends are involved. Some of them design and manufacture predator drones, for instance. So a drone that would kill or capture other drones, and they use netting that is shot out like Spider-Man to catch drones and they’re used by different major league sports franchises, because that’s a non-trivial threat to say an arena would be drone attacks. And Jason has a tweet, this is from December 7th, 2021. “Saudi Arabia is running out of the ammunition to defend against drone and missile attacks from rebels in Yemen…” I can’t pronounce, the Houthi it might be, I’m sure I’m pronouncing that incorrectly, ” …rebels in Yemen is appealing to the US and its Gulf and European allies for a re-supply.” This is in The Wall Street Journal and the lead, or at least the teaser sentence that I see presented by Wall Street Journal, is, “Saudi Arabia’s defense against the rebels’ drones pits $1 million missiles against $10,000 ‘flying lawn mowers.’” In quotation marks.

    Morgan Housel: I remember that. Yeah. That’s a great way to phrase the problem that you’re dealing with and who has the edge here? It’s crazy.

    Tim Ferriss: Yeah. The future of warfare is here. Not to beat poor William Gibson’s quote to death, but the future’s already here, it’s just not evenly distributed. But this is something that I’ve been watching very closely because the potential consequences and the implications are so terrifying. So not to end on that, but I only saw that tweet today from Jason and it served as a reminder to me that I think in a year, particularly with the technological development cycles that we’re seeing, how compressed they are, and the innovations that we’re seeing from drone manufacturers. I recently had some interactions with the newer drones and drones with flir technology and infrared tracking capabilities. It is incredibly impressive. Compared to drones from even 18 months ago, they are worlds apart. It is shockingly impressive.

    Morgan Housel: Here’s what’s scary to me about that too, is that when the nuclear bomb came about, there was obviously fear that this is the future of war and knock on wood, fingers crossed, it has not since 1945. Because the consequences of a nuclear war are so catastrophic, that everyone who has them up until this point has said it’s not worth using them because the consequences are so severe. I almost think drone war is the opposite where it’s like there’s no skin in the game, you’re not sacrificing any soldier’s lives. You’re sacrificing civilian lives, of course, on the other side. But there’s so little skin in the game and it’s so easy to just flip these things up in the air and go for it, that it makes starting a war, progressing a war so much easier than it’s ever been. It’s the opposite of what happened with nuclear war over for the last 80 years.

    Tim Ferriss: Yeah. If people want to make an attempt at looking around some corners, also from a technical perspective with respect to AI and cyber warfare, highly recommend listening to my recent podcast with Eric Schmidt, it is mind-boggling. What else? I think that within a year we will have things like GPT-3 at a point where we can generate probably, I would say within a year might be aggressive, but within 18 months, with figures who have enough audio on online that you can really deep fake effectively. You’ll have synthetic interviews with people alive and dead that are convincing enough that they can’t be distinguished from live interview. I could see that being graspable in the next 12 to 18 months.

    Morgan Housel: And that just torpedoes trust even more than it’s ever been. You hear a quote from Tim Ferriss, and you’re like, “That’s probably not even Tim, so I don’t even take it serious anymore.” There’s no trust anywhere.

    Tim Ferriss: Election cycle 2022. It’s going to be exciting.

    Morgan Housel: I got my son in Oculus for Christmas and there’s a thing where you can do a tour of the White House with Barack and Michelle. It was filmed back then. And just sitting at a table in VR, having a conversation with Barack Obama, it was so shockingly realistic. And you know where that’s going, the VR headsets that we have 10 years from now are going to make this look like a complete joke. If you mix that with the ability to deep fake, we’re heading into a world that’s going to be so wild.


    Kris: As I was pulling insights from the transcript this was a timley news event:

Structuring Shorts

Don’t Get Squozen: How to structure equity shorts for max profit and min risk of ruin (14 min read)
by Brent Donnelly

Brent’s free Substack series on trading concepts is terrific. The title doesn’t bury the lede. It’s a great discussion of shorting. But this post really stood out because of the decision tree it lays out for how and when to consider using options. I also added the post to the Moontower Volatility Wiki.

I’ve written a bunch on shorting and using options for directional reasons. Please read Brent’s post if you care about this stuff. If you feel like hearing my written voice after that, you can learn more about these topics here:

  • Shorting In The Time Of ShitCos (8 min read)
  • The difficulty with shorting and inverse positions (2 min read)
  • The Gamma Of Levered ETFs (8 min read)
  • Structuring Directional Option Trades (8 min read)
  • How Options Confuse Directional Traders (8 min read)
  • Using The TSLA Price Endgame To Understand Options (12 min read)

I’ve been reading J. Paul Getty’s How To Be Rich: His Formulas which is a collection of essays that was first serialized in Playboy magazine at the behest of Hef in the 1960s. I like the way Getty writes and I liked learning about how he amassed his fortune in oil but it’s not a book I’d say rush out and read. I picked it up from the Getty Museum gift shop because it was short and I knew nothing about him.

Anyway, you’ll recall Moloch was a heavy theme of this newsletter at the beginning of the year. I just liked this:

More Mauboussin

I enjoyed, as I always do, an interview with Professor Michael Mauboussin. For those, with a trading slant, he is the academic that best bridges mainstream investing concepts (like stock-picking) with the decision and game theory concepts that derivatives firms focus on. It’s value investing concepts married to the pari-mutuel discourse traders are used to.

Reflections on the Investing Process with Michael Mauboussin (47 min read)
Interview by Frederik Gieschen via theManual by Compound

My excerpts and notes:

  1. Most investors act as if their task is to figure out a stock’s value and then to compare that value to the price. Our approach reverses this mindset. We start with the only thing we know for sure — the price — and then assess what has to happen to realize an attractive return…The most important question in investing is what is discounted, or put slightly differently, what are the expectations embedded in the valuation?
  2. Question: Unlike other competitive fields like sports, feedback and coaching is more challenging in investing. The rudiments that lead to success seem more poorly defined and the field has more randomness (esp if investment horizons for individual investments span significant portions of an individual career).

    One quality that’s important in investing is curiosity and ability to learn and improve and adapt over time. You wrote recently an interesting piece on feedback and how people and organizations can learn and improve. What was your key takeaway from that paper?

    One of the things that I have always observed is that in most fields, timely and quality and accurate feedback tend to improve performance. If you’re a tennis player or a musician, you’re likely to have a coach, even if you’re an elite participant, you’re likely to have a coach to help you in that process. The investment management industry is an industry that draws a lot of really smart people. The remuneration is attractive and so forth. It’s a very competitive, interesting field. It’s remarkable in the sense that feedback is very difficult to attain. In the long run it’s portfolio performance and so on. But in the short run it’s very, very difficult to do.

    The question is, are there any mechanisms to give ourselves quality feedback? That got me going back to the very top. If you study, for example, Phil Tetlock’s work on Superforecasting. Tetlock, a psychologist at the University of Pennsylvania participated, this is probably a decade ago, in a forecasting tournament that was sponsored by the defense department. And they invited people to participate on their team and they found that 2% of them, one in fifty were so-called superforecasters, people making really good forecast that were way beyond what chance would dictate. And they decompose what those people were doing. But if you talk to Phil and you say, well, what is the key? He’s like, well, you gotta get the right people. That’s the key, that’s the first starting point.

    So I opened the piece by talking about what are the right qualities that we would look for as investors? We drew on that superforecasting literature. We also drew on this idea of rationality quotient by Keith Stanovich. I think that’s very powerful work. Stanovich has made this really interesting, and I think provocative, claim that there’s a distinction between IQ intelligence quotient and what he calls rationality quotient, which is the ability to make good decisionsAlong with some of his colleagues he developed a specific test to measure rationality. And if you look at the subcomponents of that test, it seems really consistent with what we would care about as investors.

  3. Question: What is practice in investment management? The other interesting question is, in every domain elite performers tend to practice. Every sports team practices, every musician practices, every comedian practices. What is practice in investment management? How much time should we be allocating to that?

    The individual

    It’s a fundamentally interesting question. What you’re doing is taking yourself essentially offline in order to be more effective when you come back online. That’s what I’m going to say is practice or training. And there are lots of interesting questions that come out of that, topics like skill transfer. If I teach you to be a great poker player or backgammon player or chess player, are those skills going to map over to you as you are in your investing seat?

    The organization

    The second big thing we studied was how people are embedded in organizations. It’s lovely to think that you’re doing all these things by yourself and you’ve got the right attributes and so forth. But the question is once you’re in an organization, does the organization enhance your ability to make decisions or does it detract? The work on this is quite clear that when you’re working in a team, you want to get different points of view. And the biggest problem in teams and organizations typically is that dissenting views tend to get squashed

    Feedback

    Then the last part is the feedback. To bring this back full circle, what we argue is when you have an investment thesis to buy or sell something, that means you believe you’re going to generate an excess return, or there’s a mispricing in the market. And you’re going to have a thesis and that thesis should have sub-components to it that will allow us to create a scoring system. The most common of these or known of these is called a Brier Score. Brier himself was a meteorologist. So you can imagine this was developed first for meteorologists who obviously are predicting rain or sunshine with certain probabilities. And then they observed the outcomes very quickly, to see if they’re right or wrong. So that helps them get better calibrated.

    To have a Brier score you only need three things. You need an outcome that we can agree upon, within a time period that we are finite, with some probability. And if you have those three things, you’re in business to calculate a Brier score. And so my argument is break down your thesis and put it into some Brier score ready predictions. Again they’re embedded there. You just have to surface them and start to keep track. And this doesn’t have to be on a public score board or anything like that, you can just do this for yourself. But what I find is the very discipline of writing those things down will force you or compel you to think more about them and to think more deeply about them. For example, if you’re assigning probabilities, you’re going to immediately start searching for base rates.

    [The analogy to my post on post-mortems is obvious: Being A Pro And Permission To Be Serious]

  4. The importance of a team in calibrating

    [I’m always emphasizing that trading is a team sport contrary to the perception that it’s some genius alone in a basement who plays the drums to rest his mind.]

    Question: What is an elite team, why are they special? And did you learn anything about how to create one?

    Tetlock and his colleagues, when they did the Good Judgment Project, this forecasting tournament, they did a lot of really interesting things. They would say, well, if we train people well, will it help them or not. If we put them in teams, will it help them or not. And they have controls for everything, so they can compare it to what the other outcome would’ve been.


    Discoveries included:

    • training esp if you focus on base rates works
    • Teams added value relative to even those individuals who were trained.


    3 important features for effective teams:

    Size


    There’s a guy named Richard Hackman, but he was an organizational psychologist most recently at Harvard, who made it like basically a life’s work of the study and found that the optimal team’s size was four to six. He also found that if you were going to make a mistake, three would be preferable to seven. Four to six seems to be the sweet spot. Hackman didn’t really study investment organizations. He studied all sorts of organizations. This is something that’s important for us to think about because it tends to be human.


    Diversity


    Types of diversity

    Social: Age, race, gender, ethnicity, etc

    Cognitive: what makes an individual unique (training, experience, personality) Now I think one can make the case very seriously and quite rigorously that social category diversity contributes to cognitive diversity, but it is cognitive diversity that we’re after.

    Values: The third type of diversity is values diversity. You might think about it as a sense of purpose, and on that you actually want to be low. We want a common mission, even if we are of very different background, we’re pulling in the same direction

    Managing the team

    In most organizations, there are people thinking things that are different than what’s going on around them. But they’re not going to say it. Leaders of teams often stymie this process by indicating what they believe. Here is the leader, he or she leans into one sort of solution, one sort of decision, and everybody else falls into line in the investment or in business.

    It’s truly rare to have consensus. If you have consensus, you should be asking what the heck is going on…The onus here is on the leader. The leader of that group has to make sure that he or she is surfacing alternative points of view, making sure that their people are expressing those views in an independent fashion.

    [This section pairs well with Notes From Todd Simkin On The Knowledge Project specifically the section about a culture of “truth-finding”.]

  5. Implication of fundamental law of active management

    The fancy formula is “information ratio equals the information coefficient times the square root of breadth.” In plain words, it says excess returns are a function of skill times opportunity set. If an investor hopes to generate some sort of an excess return, you might use that as a guideline to break down the fundamental law of active management and ask if they’ve got the components in place.

    Components

    • Information coefficient is a measure of skill. If you project something, does it come true? It’s a measure of calibration in your skill, but you can also break that down in terms of batting average and slugging.

      This goes back to our conversation about Druckenmiller. Batting average is a measure for every 100 investments you make, what percent go up, literally just go up versus what go down. So we’re measuring that. And then slugging is how much money you make when you make money versus how much money you lose when you lose money. And of course you can have a low batting average if you have a very high slugging rate. If you have a low slugging rate, then you need a high batting average. I’d want to understand exactly how they’re thinking about that and that ratio.


      For example, if you have a low batting average, just slightly over 50, and you have very low slugging, you need a lot of opportunities. As a consequence, those are organizations where people have to be constantly churning for new ideas. By contrast, if you have an organization that says, we’re going to be relatively concentrated, we want a high batting average, and we want an even higher slugging average. They’re going to have to find gems of ideas, but they’re not going to find a ton of them. Then just making sure that everything seems to be aligned.

    • Breadth is the other one. One of the ways we measure breadth practically is through the concept of dispersion. How much variation is there in stock price returns. You want to know the dispersion of the asset class in which that investor is participating, and to see if the dispersion is sufficiently large for them to express their skill, and whether that dispersion is widening or narrowing. So that’s one way to have a systematic way to break down what a particular investment process looks like. And then you’re going to focus on the people.

      [Mauboussin has written extensively on when active management makes the most sense: when the dispersion of returns provides an opportunity for skill to reimburse its costs.

      See:

      Looking for Easy Games How Passive Investing Shapes Active Management (CSFB Research)

      Understanding Skill A Paradox Plus Qualitative and Quantitative Approaches (CSFB Research)

      You can find a repository of Mauboussin’s papers here. ]

The Benefit Of Betting Culture

I piggybacked a thread about betting culture in the trading world. It’s not just degen performance art. It’s how you practice calibration.

The thread discusses how this looks in a real-world context and how it relates to trade expression. But for those who have a quota on how many clicks they’ll spare on a Substack I’ll reproduce the difference between 2 popular bet types:

First, suppose someone says they can get drive to some destination in 30 minutes. You overhear the convo and are incredulous. You blurt “I’ll buy 30 minutes” meaning you think they are underestimating travel time.

If the person wants to stand on their assertion, you’ll trade. They will be short 30 minutes, you’re long 30 minutes. It’s common to establish the bet style. Futures style or over/under style

Futures style would be something like $1 per minute. So if the commute takes 27 minutes the original bragger who shorted 30 minutes makes $3.

The second style is over/under (or binary). In this case, it’s assumed the seller is selling 50% probability. Like selling a contract at 50 that can settle to 100 maximum. So the loss is capped. It’s a pure probability bet. You could adjust the odds in a negotiation by saying “hey let’s trade at 40% probability” which means the seller is laying 3-2 (ie 60 to 40).

Because the loss is capped, the difference between these bet styles depends on the distribution of the proposition. In a travel problem, there’s skew to the upside since absent teleportation there’s a lower bound to how long the commute takes.

But the upside is almost unbounded…the person could get in an accident on the way. More realistically there could be a bad accident that causes traffic and turns a 30 min commute into 60 min. So the seller faces more risk selling 30 futures style vs over/under style.

That means they should pad the price they are willing to short at. Say 35 minutes futures style or be willing to trade 30 minutes over/under style.

Over/under bets are focused on the median. Futures-style are more concerned with the mean. The more skew in the bet, the more the prices will diverge.

The Success Paradox

I was going to write about how to measure implied skew. The post would also have been a nice demonstration of why I write about options stuff in the first place (hint: it’s not because I think you should be trading options). You would walk away from the post excited by a new insight but rattled because it would crack a door you’d definitely prefer to keep closed.

The anticipation is a tad cruel because I’m going to table that post for next time. I didn’t feel like breaking up today’s letter with nerd stuff.

Dazed and Confused transpires over the last day of school. Randy “Pink” Floyd ain’t doing homework in the moontower and I’m not gonna be the cruel teacher who’s gonna put your mind in problem set mode.

Instead, I give you one of my favorite videos. Watch it through to the end. It’s worth it.

As tensions go, it presents one of the most difficult tensions an intellectually honest person needs to contend with. I’ve come to the same conclusion its author does — the “Success Paradox” cannot be resolved without some controlled self-deception1.

You will recognize the same thinking in this 2-part series:

✍️ My Personal Trigger (5 min read)

✍️Why ‘Deserve’ Makes My Skin Crawl (8 min read)

I’ve always been sensitive to the “success paradox”. It informs my politics. My worldview. It’s why I find Freddie deBoer’s views on education impossible to look away from. (I will be writing more about learning in the back half of this year. You can expect Money Angle to get some of that treatment in the context of investing as well.)

For now, watch the video. At worst, you are introduced to a beautiful YT channel.

Investing Q&A With Khe and Kris

Money Angle

This week my friend Khe asked me to join him for a Q&A on investing basics as a way to give some extra value to his Rad Reads community. In this letter and my blog, I write a lot about wonky finance stuff. Despite my best efforts to simplify the brain damage, I realize it’s not exactly basic.

This session was basic and I enjoy taking a shot at helping people learn the essentials. The feedback on this session was glowing and kind:

This is such good information because you’re going through all the things that I read, all the little bits and pieces, and you’re saying, “Well, this is not why this works.” This is very logical, and it makes a lot of sense. I really love how you got deeper into what you’re teaching and saying, to explain how things are not what some people are touting them to be. There’s so many examples here.

You can watch the replay:

🎬Investing Fundamentals With Khe and Kris (1 hour)

📝Transcript (Otter.AI)

This was the list of resources I shared for novice investors to learn:

Introductory

My Favorite Investing Blogs To Learn

Favorite Advanced Blogs

Professors

Following Along On A Regular Basis

  • Matt Levine’s daily Money Stuff column (Link)Apply your knowledge and learn how to think from Wall Street’s supreme writer. His supremacy is a fact.
  • Kyla Scanlon (Substack)
  • Link roundups: Abnormal Returns (Link)