Moontower #207

2 quick thoughts:

1. I spoke to a quant investing club at Cal this past week. Lots of seniors in the room so the one bit of advice I wanted to make sure I left them:

   Optimize for learning when choosing your first job. 2 components to this:

   a) Mind your inputs

   Specifically, surround yourself with the best people you can both in terms of character/courage and ability). Your environment will shape you (tyrannically so — its incentives, values, and culture will be absorbed) so make sure you are deliberate in choosing one.

   b) Get to having real responsibility as fast as possible

   Responsibility = risk and risk accelerates learning. A little more responsibility than you think is appropriate will stretch you — if you want to rise to that you likely will. If you don’t feel stretched, even if you’re making good money, the human capital part of your ledger is being docked. Rest-and-vest attitudes are deceptively expensive in the long run — don’t ever adopt one in your 20s and 30s (and probably not after that either).

2. Paul Bloom, from his chat with Russ Roberts, on chosen suffering:

   I think there’s a wise point there, which is: one of the — it may be the major theme of my book — is about the importance of chosen suffering. I have a very different opinion about unchosen suffering, we can talk about that. The importance of choosing suffering as part of a good life is, I think, the projects that make life worth living involve suffering. We often know this ahead of time. And, having kids is such an example. For one thing having kids, at least for me–maybe I’m prone towards anxiety–is really an experiment in feeling mild dread for the rest of my life. Loving such fragile creatures–and they remain fragile even into their 20s — it is like there is a hangman’s noose sitting around your neck all the time. And then they will separate from you. If you do it right, if you are lucky, and if you do it right, these creatures that you love and devoted your life to, will leave you. And, actually, if you do it right they will think a lot less about you than you will think about them, because they’re into their own lives. It’s such a perverse project. And I think it’s a very human one.

   Russ Roberts: Yeah. I agree with that, obviously. What you said reminds me of a quote I heard from Elizabeth Stone. It’s the following: ‘Making the decision to have a child–it is momentous. It is to decide forever to have your heart go walking around outside your body.‘ I thought that captured the kind of anxiety you’re talking about there.

   [Kris — choosing responsibility is a form of chosen suffering. But it’s so obviously a privilege. I am tediously dramatic about this — the kids and I were bringing in the garbage bins to the tune of their whining and I banged them over the head with “you should be happy you get to do this…would you rather not have legs and not be able to be helpful?” I wish I uttered a more sensitive example on the spot but that’s what happened.]

Money Angle

I added another post to this Moontowermoney.com series:

Checkpoint: Risk Tolerance (moontowermoney.com)

Full post:

In a Word About Goals and Risk is unavoidable. Let’s get to the good news, we established 2 cornerstone axioms:

Risk is personal

If you need ransom money by Friday betting your savings on a hand of blackjack or borrowing cash from a loan shark become prudent alternatives in light of your singular goal.

On the other hand, a comfortable person who risks what they need for something they merely want is setting themselves up for failure. Even if the gamble pays off, that decision pattern eventually catches up with them.

Doing the inner work to distinguish “need to haves” from “nice to haves” is a personal exercise. Looking over the fence at your neighbor leads to miswanting and disappointment. We cannot fully see what practical and mental constraints others have that lead to their choices. You must ruthlessly “do you”.

A bright side of personal investing is that it is solitaire. You do not need to worry about competitors the way professional investors do. Professionals are compared to benchmarks which introduces tracking error risks (”why are you only up 8% when the SP500 is up 11%?”) and path dependency. Employees are more likely to browse LinkedIn job boards when you don’t keep up, which aggravates your competitive position further.

💡The personal investor is unburdened by the expectations of others

Risk is unavoidable

Examples of this reality:

• If you don’t invest your cash its purchasing power will erode. In the past 100 years, cash has lost >95% of its value. Not investing is surrendering to an inevitable, maybe slow, but quite inevitable loss.

• If you do invest, you open yourself to the possibility of a faster loss. This is true in both nominal and real (ie adjusted for inflation) terms. In the 21st century alone we’ve seen sharp drawdowns from the Dot Com bubble, the 2008 GFC, and the covid pandemic in 2020. Drawdowns of these magnitudes, while rare, are inevitable and part of the investing experience. As Meb Faber shows, this is true even in real terms:

• The trade-off between “failing fast” and “failing slow” shifts as you age. If you lose 40% of your assets at age 24 you have your whole adult life to recover. If you’re in your 60s such a sharp loss could impair your standard of living throughout retirement. This is commonly referred to as sequence of return risk. It’s the basis of “glide paths” that slip your investment mix from higher to lower risk holdings as you age.

Wrapping Up With Helpful Framings

By now we have laid out the nature of markets as well as the investing “problem”. The strategy we employ needs to be well-matched to our risk tolerance. Investment returns are carrots for us to take risk and solve our “problem”. There is no way to fully remove risk from a strategy but we can imagine a frontier of strategies that require lesser units of risk for the same potential reward. For example, if a fair coin flip offered 2-1 odds then this is a great investment. But if you bet all your money on it you turn this great investment into one that is not worth the risk since losing all your money is not an acceptable outcome.

💡We want to avoid strategies that are inferior with respect to our goals

Our tolerance for risk is a personal function of our emotions and our stated goals. Financial advisors try to match their approach to a client’s risk appetite with questionnaires such as the Grable & Lytton Risk Assessment (link). A common though cynical take is such gauges are more about covering their liability than actually zeroing in on risk tolerance. A charitable view is that asking someone to predict how they’d feel if their account lost 25% is a doomed exercise from the start. We are not Vulcans capable of such reasoned foresight.

When it comes to goals, the problem is more tractable, especially for near-term objectives. If you are saving for a down payment on a house in the next few years, you can compare your savings rate to the fluctuations of your account to decide how much risk is reasonable. If you have $450k saved for a $500k down payment and you are able to save $25k per year, then if you took no risk you are about 2 years from affording a home. If you invest the $450k in BTC you could lose many years worth of savings in a single swoop. You should match your the riskiness of your investments to what you consider a “need to have” vs a “nice to have”. A common sense approach is a robust balance between being simple enough and effective enough.

When it comes to personal finance, optimization suffers from garbage-in, garbage-out problems. The idea is not to make perfect the enemy of the good. It’s to find an approach that mostly works that you can stick to. It is easy to get bogged down in FIRE-esque micro-budgeting or dazzled by promises of easy money in rental properties or option selling. But before you even consider an investing strategy, it’s critical to establish your goals for both your wealth and your time. If eeking out an extra 1% on a $500k portfolio takes 100 hours, you are working for $50/hr with no guarantee that you are focused on the right levers.

2 qualitative frameworks that can help define your investment mission:

• Jeff Bezos’ regret minimization framework Imagine you are old or at your funeral looking back in time. What did you want to give the world or your family? What would you regret not having done? The idea is simple — don’t take risks that close those doors. Structure your life so you can take the risks that open those doors. The key to this is defending your aspirations with a mix of personal courage plus resistance to distraction and comparison.

• Venkatesh Rao’s fixed point futurism This is the antidote to the inherent spreadsheet nihilism of efficiency, optimization, and “paper-clip maximization”. It is deeply personal.
  • Fixed-point futurism is related to the idea of inventing the future rather than predicting it…It’s simple: don’t make plans, choose fixed points. Choose one thing to make true, force to be true, about the future. Something that is likely to be within your control, no matter how the future plays out. Something that isn’t rationally derived from something else more basic, but is sort of arbitrary and self-defining. It sounds silly, but it’s really amazing how such small assertions of personal agency, far short of putting a “ dent in the universe ” can magically make life feel more meaningful. You’re arbitrarily using your life to declare that futures, where you wear blue shirts, are better than ones in which you don’t. Many people intuitively do fixed-point futurism. In fact, in the U.S ., the so-called American Dream has historically been based on the standard fixed point of homeownership. As in, “no matter what happens in the future, I’ll be a homeowner. ” A way to understand fixed-point futurism is to think of it as a priceless commitment. No matter what happens, and no matter what else goes wrong or off-the-rails in weird ways, you’ll make sure one thing goes really, really right, even if you have to go crazy making sure it does. The nice thing about fixed-point futurism is that you don’t have to worry about tradeoffs. You don’t have to constantly revisit cost-benefit analyses. You don’t have to worry about competing priorities. The fixed point is priceless, so you can commit to it without knowing lots of important things about the future.
  • This type of thinking says “I’m going to play in a band even if there’s no reward. I just want to do it”. It could mean taking an insurance policy knowing that no matter what your kids will have X even if it’s not as “smart” as self-insuring the future via a separately managed investment account. A reckless person can use fixed-point thinking to rationalize poor decisions, but overly analytical people can benefit from pulling their noses out of Excel to think more approximately. The whole “it’s better to be roughly right, than precisely wrong” thing.

🔗Learn More

• Newfound Research’s Failing Slow, Failing Fast, and Failing Very Fast (Link)

• Nick Maggiulli’s A Change in Perspective (Link)

• Alpha Architect’s Even God Would Get Fired As An Active Manager (Link)

• Venkatesh Rao on Fixed Point Futurism (Link)

Money Angle For Masochists

I knocked out Euan Sinclair’s Positional Option Trading in a few hours which is to say much of it overlapped with my own knowledge. It takes the approach professionals start with but adapts it to the constraints of retail (you probably aren’t delta-hedging for example).

You can see my notes:

Positional Option Trading by Sinclair (Moontower)

I want to direct your attention, especially to these 10 points (emphasis mine):

1. “Option pricing models don’t really price options. The market prices options through the normal market forces of supply and demand. Pricing models convert the market’s prices into parameters.”
2. If we pay the wrong implied volatility level for an option, we might still make money, but we would have been better off replicating the option in the underlying.
3. Risk premiums versus inefficiencies discussion from chapter 2

   [Kris: I appreciate how Sinclair attempts to categorize each source of edge as either a risk premium or inefficiency. He’s also candid about the difficulty in categorizing some of them, but the thought process is useful to observe for understanding what kind of evidence he needs to sort the edge.]

   1. A risk premium is earned as compensation for taking a risk. If the premium is mispriced, it will be profitable even after accepting the risk. A risk premium can be expected to persist, as the counterparty is paying for insurance against the risk.
   2. In contrast, inefficiency is a trading opportunity caused by the market not noticing something. An inefficiency will last only until other people notice it.
   3. Differentiating a risk premium from an inefficiency can be challenging.
4. Behavioral explanations can be used as part of a checklist for why an inefficiency might exist. For example, together with historical data and a theory of underreaction, one can have enough confidence that post-earnings drift is a real edge. The data suggests the trade, but the psychological reason gives a theoretical justification.
5. In the long term, values are related to macro variables such as inflation, monetary policy, commodity prices, interest rates, and earnings. These change on the order of months and years. Worse still, they are all codependent. A better way to think of market data might be that we are seeing a small number of data points that occur a lot of times. This makes quantitative analysis of historical data much less useful than is commonly thought. [Kris: This is the old “Thinking in N not T” where we recognize that samples drawn from the same regime reduce N. This is also why I think the concept of attractor landscapes is important.]
6. Calendar spreads have a similar payoff diagram to a butterfly at the expiration of the front-month option. [Kris: This intuition can guide one’s thinking about how the skew in the front month relates to the slope of the term structure]
7. A method for choosing the strike to sell [Kris: paraphrasing Sinclair in my own lingo: choose the strike that has the greatest dollar premium to a flat vol surface (as opposed to the highest vol, which will correspond to a low premium option)
8. Despite views to the contrary, skew trades are not particularly useful for speculating on the movement of the implied skew itself. The fluctuations in implied skew are dwarfed by the effects of stock movement and the level of implied volatility. [Kris: I’ve said this before and strongly agree. Sinclair offers a math justification based on the order of magnitude comparing Greeks]
   1. Skew trades might make more sense with longer-dated options that have more vega and less gamma, but the skews are also more stable. It’s possible to make money with this trade, but the edge is likely overwhelmed by noise.
   2. Ratio trades have all the same problems mentioned with skew trades and are an even worse vehicle for trading. An idea that isn’t very good to start with. [Kris: In my opinion, risk reversals and ratio spreads are “path trades” and should be framed as bets on spot/vol correlation. In fact, a great demonstration of this point is the challenge of calibrating your delta in the presence of strong spot/vol correlation. Actually, buying the ratio to sell the single skewed option, which will have a higher skew premium in dollar, not vol, terms could be a better expression of the skew trade!]
9. Stops don’t just stop losses. They drastically change the shape of the return distribution and can lower the average return. Adding stops won’t transform a losing strategy into a winning strategy. The only reason that we would add a stop is that we prefer the shape of the stopped distribution.
10. A position should be exited when we are wrong. Sometimes this will coincide with losing money. In this case, a stop is harmless. But sometimes losing money corresponds to situations for which we have more edge. Here, a stop is actively damaging and contrary to the idea behind the strategy. [Kris: Fully agree and why I believe in risk rules that are independent of P/L for option trading. Instead, focus on ex-ante risk shocks].

From My Actual Life

I’m introducing the boys to the first 2 Terminator movies and they are into it (we are about halfway through the first movie. We put them to bed last night right after Arnold removes his eye and dons the Gargoyle shades for the first time).

I was curious about what the internet thought of how age-appropriate these movies are (they’re not) and got a nice chuckle about one reviewer reminding readers that Terminator was an “Eighties R” — which means a “hard R”.

In the olden days, getting a VHS from the rental shop (pre-Blockbuster) is one of those memories that I can trace the footsteps of. When I was in first grade a friend slept over and my mom rented Terminator for us to watch. My youngest is in 2nd grade. He hasn’t looked away once from the screen. Which reminded me that I’ve gotten more squeamish as I’ve gotten older.

To bring things around from today’s open, nobody has ever had more responsibility resting on his shoulders than this annoying kid:

Stay groovy ☮️