Let’s start with a question from Twitter:
If you had to our your whole net worth into a single company right now (public or private), what would you pick?
Berkshire Hathaway is not allowed as an answer pic.twitter.com/ruCjbC6bZO
— Patrick OShaughnessy (@patrick_oshag) March 4, 2022
This is a provocative question. Patrick was clever to disallow Berkshire.
As I was working on the second part of There’s Gold In Them Thar Tails, I got distracted by that tweet.
My Reaction To The Question
I don’t know anything about picking stocks. I do know about the nature of stocks which makes this question scary. Why?
- Stocks don’t last forever
Many stocks go to zero. The distribution of many stocks is positively skewed which means there’s a small chance of them going to the moon and a reasonable chance that they go belly-up. The price of a stock reflects its mathematical expectation. Since the downside is bounded by zero and the upside is infinite, for the expectation to balance the probability of the stock going down can be much higher than our flawed memories would guess. Stock indices automatically rebalance, shedding companies that lose relevance and value. So the idea that stocks up over time is really stock indices go up over a time, even though individual stocks have a nasty habit of going to zero. For more see Is There Actually An Equity Premium Puzzle?.
- Diversification is the only free lunch
The first point hinted at my concern with the question. I want to be diversified. Markets do not pay you for non-systematic risk. In other words, you do not get paid for risks that you can hedge. All but the most fundamental risks can be hedged with diversification. See Why You Don’t Get Paid For Diversifiable Risks. To understand how diversifiable risks get arbed out of the market ask yourself who the most efficient holder of a particular idiosyncratic risk is? If it’s not you, then you are being outbid by someone else, or you’re holding the risk at a price that doesn’t make sense given your portfolio choices. Read You Don’t See The Whole Picture to see why.
My concerns reveal why Berkshire would be an obvious choice. Patrick ruled it out to make the question much harder. Berkshire is a giant conglomerate. Many would have chosen it because it’s run by masterful investors Warren Buffet and Charlie Munger. But I would have chosen it because it’s diversified. It is one of the closest companies I could find to an equity index. Many people look at the question and think about where their return is going to be highest. I have no edge in that game. Instead, I want to minimize my risk by diversifying and accepting the market’s compensation for accepting broad equity exposure.
In a sense, this question reminds me of an interview question I’ve heard.
You are gifted $1,000,000 dollars. You must put it all in play on a roulette wheel. What do you do?
The roulette wheel has negative edge no matter what you do. Your betting strategy can only alter the distribution. You can be crazy and bet it all on one number. Your expectancy is negative but the payoff is positively skewed…you probably lose your money but have a tiny chance at becoming super-rich. You can try to play it safe by risking your money on most of the numbers, but that is still negative expectancy. The skew flips to negative. You probably win, but there’s a small chance of losing most of your gifted cash.
I would choose what’s known as a minimax strategy which seeks to minimize the maximum loss. I would spread my money evenly on all the numbers, accept a sure loss of 5.26%. The minimax response to Patrick’s question is to find the stock that is the most internally diversified.
This led me to write a post launching into the basics of regression, correlation, beta hedging and risk. Especially the concept of “risk remaining” which contains practical and surprising intuition.
It is a topic that affects traders and investors. It also ties back poignantly to the ideas of tail divergence I’m writing about in part 2 of There’s Gold In Them Thar Tails.
The little detour involves math but I move slowly and try to offer footholds of intuition along the way.
[Trying to simply difficult topics is absolutely my intention. If I’m writing over your head, I’m doing something wrong. Tell me. Help me help you.]
Here you go:
✍️From CAPM To Hedging (16 min read)
I recently read Laws Of Trading by Agustin Lebron. It’s exceptional.
Here’s my review. There’s a link with my notes at the end.
If I ran a trading firm this would be Day 1 reading. After finding out where the bathroom is and filling out your W-4, you would be handed this book and told to finish it by tomorrow. After 1 year on the job, you are required to re-read it. There are many sentences in this book that serve as somewhat off-hand or connecting, but are deeply insightful. The kinds of things that would not be perceived by a novice but veterans will recognize they are reading something by a deeply experienced professional. As a veteran of options trading, I found this feature makes the book transcend being informative into being delightful. Trading is the art of decision-making turned into a high-rep game. It requires:
- multi-level thinking
- sound epistemology
It is deeply intertwined with technology, math, and economic reasoning. This book is an instant classic. The rules in the book are reductions of vast, hard-fought institutional knowledge and the leading edge of thinking about risk. The author combined his training and experience at Jane Street, a legendary quant trader and market-making firm, with a broad intellectual acumen. Both his engineering background and affinity for liberal arts and philosophy come through to create a guide that transcends a single discipline. Personally, reading this book left me with nostalgia as the type of thinking was the water I swam in when I was at SIG (Jane Street’s lineage traces to SIG alumni who became under-the-radar legends themselves). My second personal feeling is, “damn, I wish I wrote that book.” Except I couldn’t. The author is an elite synthesizer with a nuanced comprehension for coding, organizational behavior, interviewing, and data analysis.
My notes are below. They are sparse compared to the depth of insight crammed into 250 pages. Every chapter covers a “rule”, situates that rule in the context of finance, then applies it to decisions all people face in the course of life.
✍️Notes on The Laws Of Trading (Notion.MoontowerMeta)
I’ve watched this a lot. What a natural.
Bursting with his dad's charm https://t.co/OqEVjerQB7
— Kris (@KrisAbdelmessih) March 7, 2022