First, a giant thank you for reading this letter. This is Moontower’s 3-year anniversary. This week the 3,000th subscriber joined. Thank you to the 45 people or so who agreed to read that very first issue.
Writing online allowed me to unlock myself in ways that I couldn’t without your support. So truly, thank you.
Ok friends, let’s proceed.
This week, I published the sequel to There’s Gold in Them Thar Tails.
It begins with a recap of part 1:
- We saw that an explosion of choice whether it’s a job or college applicants, songs to listen to, athletes to recruit has made selection increasingly difficult.
- A natural response is to narrow the field by filtering more narrowly. We can do this by making selection criteria stricter or deploying smarter algorithms and recommendation engines.
- This leads to increased reliance on legible measurements for filtering.
- Goodhart’s law expects that the measures themselves will become the target, increasing the pressure on candidates to optimize for narrow targets that are imperfect proxies or predictors of what the measure was filtering for.
- Anytime we filter, we face a trade-off between signal (“My criteria is finding great candidates”) and diversity. This is also known as the bias-variance trade-off.
- Diversity is an essential input to progress. Nature’s underlying algorithm of evolution penalizes in-breeding.
- In addition to a loss of diversity, signal decays as you get closer to the extremes. This is known as tail divergence. The signal can even flip (ie Berkson’s Paradox).
- The point where the signal noise overwhelms the variance in the candidates is an efficient cutoff. Beyond that threshold, selectors should think more creatively than “just raise the bar”.
Part 1 ends with a discussion of strategies for selectors and selectees.
Part 2 extends the discussion with what tail divergence says about life and investing.
✍️There’s Gold In Them Thar Tails: Part 2 (24 min read)
It’s a long post including footnotes, but there is a large section about options trading that will only appeal to masochists.
The post roadmap:
- We begin with the challenge of scaling our moral intuitions up to an age where our ethics must be explicitly coded. AI and automation require making species-level questions less rhetorical.
- The prescription is humility. The simple math of regression shows this as correlations break down or invert in the extremes. The CAPM to Hedging post was actually a diversion that ended up being a stand-alone post as I was writing the tiny math section in Part 2.
- From there we move into trading and investing strategies to exploit our misunderstanding of extremes. 2 words: respect path. We start with a story of a famous investor/governor who stubbornly didn’t respect path.
- We then talk about familiar path-respecting approaches to investing: care with leverage, appreciating “rebalance timing luck” (hugs to@choffstein) and finally thinking about path vs terminal value.
- This opens the door to a discussion of trade expressions and the need to map them tightly to our isolated trade premises. I use options to demonstrate 3 path-aware approaches: static, dynamic, combined.
- The combined approach is touched on briefly. It’s technical but not complicated and lends itself more to a video (maybe one day). It’s also an example of why it’s useful to understand option structures and the basic arbitrage relationships.
- Then we move to general investing styles that respect path: venture and “gorilla” investing. They both know what they don’t know about extreme outcomes and construct strategies that are robust to that reality.I’m not an expert in those approaches but was drawn to their common link of manufacturing convexity. Convexity is not volatility or leverage. It’s the slope of your p/l steepening in the direction of the market because your position size changes.
When your signals are weak as they are for extreme outcomes, you want to preserve convexity into the unknown. If you can do that, you can funnel wider. This can be higher yielding than tuning your signals harder.
- Review and concluding remarks — Happy prospecting!
Money Angle
Speaking of Corey Hoffstein:
“when assets are expensive, make assets,” they said.
cc @cobie pic.twitter.com/QKCNm2BGRd
— Corey Hoffstein 🏴☠️ (@choffstein) January 18, 2022
His tweet brought my attention to @cobie and his masterful description of psychology.
I also appreciated Josh Brown’s take on the sell-off in so-called growth or momentum names. Here’s an excerpt from Jan 31’s It’s not over yet.
I’m less interested in the real-time action. Focus the evergreen psychology instead:
Where do bounces come from in a midst of a correction?
Sometimes it’s just that stocks have fallen too far for sellers to want to keep selling. This isn’t bullish. In fact, this type of bounce can suck people back in by creating the appearance that the worst is over. Growth stocks in particular. Because belief dies hard and enthusiasm for cutting edge technologies fades slowly, not suddenly. Which mean the give-up process is long and drawn out – even after a stock is cut in half sometimes the worst is still yet to come. The slow bleed after is often worse than the initial shocking drop that preceded it.
Over at Verdad Capital, Dan Rasmussen revisits their “Bubble 500” list of overpriced growth stocks, originally created in the Summer of 2020. It’s filled with money-losing companies working in exciting areas of technology such as electric vehicles and gene editing therapy and so on. Needless to say, this list of bubble stocks has gotten absolutely destroyed year-to-date, after having run straight up in Verdad’s face through the middle of 2021. Dan explains two very important things in his update this week: The first is that sell-offs for growth stocks differ from sell-offs for value stocks in one very important way:
This breakdown is significant, especially for growth stocks. Remember, growth stocks trend, and value stocks mean revert. The psychology is simple. People hear about a hot stock that’s gone up 3x, they buy some, it goes up 2x, they buy more: the whole attraction of buying a hot growth stock is the historic return trajectory. Value stocks are the opposite: you do well buying them when they’re down…
This idea is counterintuitive – that some stocks actually become worse buys as they are falling to lower prices, but the explanation is psychological, not financial. Stocks trading at excessive valuations require a fan base to sustain their share prices. That fan base is often a bandwagon-jumping melange of traders and investors who are attracted to recent gains. Yes, they’ll latch onto the fundamental story, but the fact that the stock has been and currently is going up is the main thing. When the stock breaks, so too does the fandom. And when the fan base moves on to greener pastures or runs out of money, a new fan base will not form for this stock with its chart in decline. Broken growth stocks become orphans. There is no natural place for them to find a home.
Momentum is a divergent strategy while “value” is a mean-reverting strategy. Several years ago the research team at OSAM published edifying papers on how these approaches work. I wrote a summary here:
✍️ Notes on OSAM’s Factors from Scratch (6 min read)
Value works by fading overreaction. Momentum is attributed to underreaction. In a name trending higher, the sellers are discounting the substance of new information too aggressively. In dork world, we call this anchoring. If you pay attention to “anomalies” you may recognize the concept of post-earnings drift as an acute example of anchoring. Wikipedia even has an entry for it.
Fear or FOMO in markets cuts both ways. On the way down, we fear a loss of wealth. On the way up we fear social embarrassment — we aren’t keeping up with our neighbors. We are caught between self-preservation and shame. I wonder if being part of the herd is any consolation on the way down while everyone loses. Or is this just another miserable psychological asymmetry inseparable from speculation?
Anyway, I don’t have much to add. Investing requires you to be honest about your desires, constraints, and emotional tolerance. If you can get honest with yourself, you can initiate a plan that you can stick to. You want to avoid ad-hoc decisions with the bulk of your savings (I’m not gonna poo poo on gambling with 1 or 2% of your wealth, especially if it suppresses wider risk-seeking behavior. Agustin Lebron’s Laws of Trading has a provocative section about “risk set points” that operate like weight set points. If your life becomes too dull in one way you spice it up in another and vice versa. Maybe Alex Honnold’s portfolio is all in bonds 🤷🏽).
Oh and just a quick observation that you can ponder in the context of those flashy, earningless momentum stocks. If you start at $1 and double 6x you get to $64. If the stock drops 50%, you’ve only erased 1 halving.
Be careful knife catching.
From My Actual Life
I wrote this 1 year ago but I’m reprinting it with updated ages. I flew into NYC on St. Patrick’s day this week, 6 years after this story. I spent yesterday at my nephew’s birthday in NJ.
St. Patrick’s Day now reminds me of a story that is now 6 years old…
March 17, 2016. I flew into NYC for a 36-hour business trip. I was hopping around the city meeting with bank derivative sales desks. Routine relationship maintenance. I planned poorly. I was late to every meeting since you can’t cross 5th Ave during the St Patty’s parade.
Anyway, that evening I was at dinner as a client. When I went to the restroom I checked my phone. My family chat was blowing up.
My sister just had a baby.
I hadn’t told my east coast fam I was in NYC because it was just a quick trip. But right then, I called my mom in NJ and stunned her with the knowledge that I was an hour away in NYC.
When I returned to the table, I excused myself from dinner, hopped on a bus to my childhood house in Hazlet, borrowed my mom’s car and drove down to Jersey Shore Medical Center.
It was close to midnight.
When I walked into the hospital room I’ll never forget my sister’s look of ‘what are you doing here?’
I got to meet my new nephew, spent an hour chatting with my sis and her husband, and made it back to NYC with enough time to grab my bags and get back to JFK.
Since then, St Patrick’s Day has meant much more than day drinking.
Happy 6th birthday to my nephew!