Friends,
Before the investing jazz, I’m gonna talk aloud about stuff that was bouncing around my parent brain this week.
Wednesday night Yinh came out of the boys’ room and in a hushed tone relayed the 6th grader was feeling down after a bad day. He woke up feeling a bit under the weather (but fine enough to go to school), had a subpar hoops practice, got into a fight with his younger bro (over Halloween masks), his friend was moving to India the next day, and…he was super-stoked about a topic he learned about in Math Academy (interquartile range) but when he told me about it I immediately asked him a question that he didn’t know the answer to deflating whatever good the day had salvaged.
I felt like a total ass. I was 1) out of tune with how the day was treating him and 2) my tone in asking him about the math was out of sync with my message. My intention was curiosity about what he learned but it came out as a challenge or test.
I fumbled. Sometimes you clench the ball too tight.
I have high expectations of effort in 2 categories for the kids:
a) Areas they earnestly want to improve in.
They play soccer for fun but care about getting better at basketball. They create those distinctions. I remind them that getting better doesn’t happen without practice so if you want X and your actions betray you, I’m going to question what you actually want. I try to balance sensibility given their ages without watering down the truth of what being competitive means. Overall, I let their own motivation dictate how hardcore to be about this. I’ll come back to what I mean by this.
b) Things where they are too young to understand the option value of.
I’ll just caveat this with both boys have obvious academic aptitude. If they didn’t, I’d adapt my thinking to what they need as individuals. But since they are capable, I expect them to crush school. You’ll have more choices down the line if you can get yourself onto the equivalent of the honors track. I’m not suggesting this is deterministic — but there’s option value and the easier school work is to a child the cheaper the option premium. Orienting your drive in the direction of your innate strengths is a generally good principle (and possibly underappreciated because the second derivative of that function is opaque but likely convex with respect to success and satisfaction in life).
The flipside of the high expectation is what kids are capable of. I don’t mean this in a purely literal sense. You can search YouTube and find children performing extraordinary feats. Those examples round down to “rare exceptions”. Generally speaking, fulfilling high expectations requires sustained commitment. And sustained commitment relies on motivation. Motivation is a puzzle. What makes some kids (or anyone for the matter) obsessed and others float in the wind? I don’t know those answers but I’ve recently pieced together a partial explanation that bears keeping in mind especially in moments of frustration.
I’ll start with the moments of frustration. Watching my kids waste their time on YouTube Shorts or watching Brawlstars influencers. Nails on chalkboard. Go collect some bugs or build a bike ramp, just turn this crap off. [My nieces and nephews call me Uncle “Nonsense” because I always ask “what nonsense are you watching now?” It’s past the point of meme — my sister’s kids sent me a photo of themselves eating bubble gum flavored ice cream because they know I call it a “nonsense” flavor.]
Sometimes I just wanna yell “go be productive”. But I don’t because that’s not what I really mean — that would be me projecting. That’s my demon, and I don’t want my kids to meet him.
I’ve thought about this a lot. This urge towards productivity. Consider this Paul Graham excerpt I quote in Impedance Mismatch:
What I’ve learned since I was a kid is how to work toward goals that are neither clearly defined nor externally imposed. You’ll probably have to learn both if you want to do really great things.
The most basic level of which is simply to feel you should be working without anyone telling you to. Now, when I’m not working hard, alarm bells go off. I can’t be sure I’m getting anywhere when I’m working hard, but I can be sure I’m getting nowhere when I’m not, and it feels awful.
There wasn’t a single point when I learned this. Like most little kids, I enjoyed the feeling of achievement when I learned or did something new. As I grew older, this morphed into a feeling of disgust when I wasn’t achieving anything. The one precisely dateable landmark I have is when I stopped watching TV, at age 13. Several people I’ve talked to remember getting serious about work around this age. When I asked Patrick Collison when he started to find idleness distasteful, he said:
“I think around age 13 or 14. I have a clear memory from around then of sitting in the sitting room, staring outside, and wondering why I was wasting my summer holiday.”
Perhaps something changes at adolescence. That would make sense.
This line resonates “a feeling of disgust when I’m not achieving anything”. But while that disgust is useful gasoline it has fossil fuel level byproducts and externalities. It’s a tradeoff not an unalloyed virtue. So “go be productive” misrepresents what I really want (which stated simply is to be active in mind or body not numbed into zombie mode. A rule that we enforce poorly is “if you are going to watch YouTube you must search for what you want. You are not allowed to let the algo create the menu or serve the next video”).
But the main reason I restrain the “be productive” message is that it’s inappropriate at their age. Even these psychos that Paul Graham refers to didn’t feel the urge to be productive until 13 or 14. He wonders:
Perhaps something changes at adolescence. That would make sense.
I was listening to Dr. David Yeager on the Huberman podcast (the first time I’ve ever listened to that show believe it or not. Thanks Justin for the heads up, I really enjoyed Yeager’s insights.) and he talks about how puberty coincides with the first time kids really onboard status anxiety. It’s when they become deeply aware of a pecking order or being “popular”. The social dynamics are complex and stressful. It is the first time they start to think of their value in terms of what they can do, or if they are pretty, etc.
It’s the age when kids start bands. We know why they do that. And it’s not to “be productive.” But achievement is a byproduct. Ambition is a natural solution to status anxiety.
Meanwhile elementary school kids are beautifully unaware. Some kids wanna score a hattrick and some are picking daisies. But there’s room for everyone. Their lives are pre-achievement. Open exploration. No judgement. It’s a small window.
How dare I shorten it?
For their whole lives, others are gonna size them up. These boys’ thoughts will whisper “what are you bringing to the table?”. They don’t need extra pressure from me. They don’t need another form of love that comes with strings attached. The world’s love comes with enough conditions.
They’ll need guidance. They’ll be things they can’t forsee because they are unforseeable. But there will also be things they can’t foresee because they’re inexperienced. We can help with that. There will be useful resources and opportunities they didn’t even know were possibilities. We can help with that. There will be questions of reality. Like what it takes to learn. What it means to have integrity. How to model decision-making. We can help with all that.
But we are not here to create pressure. Or fear. I want them to face fear. I don’t want to generate it. The world will do that for free.
If I killed the enthusiasm for what Zak learned in math, I’m doing something wrong. I’m grateful Yinh told me, because like him, I’m learning and we will get better. Puberty is gonna be a trip.
The day after the bad one was uplifting.
I was traveling. Yinh texted me that the younger one was struggling with Math Academy and extra frustrated because the older one who he idolizes crushed his quiz.
But…the older one coached and brought him around and excited again.
Like any set of brothers they can be 2 cats in a bag (they were the night before), but it makes it that much sweeter when they get each other’s backs. This particular instance made me especially proud because I’m relentlessly on their ass about being patient (go slow to go fast) in learning and with each other so any indication that they hear me is a win.
Yinh was blown away at how Zak was so calm and methodical breaking down Max’s difficulty into manageable steps. I’ve had his friends say the same thing about how he helps them. Being patient and helpful because everyone learns at a different pace is an explicit and modeled value at home. But a lot of what you want to instill doesn’t transmit so it’s worth celebrating the small win.
Yinh captured the moment when cooler heads prevailed:
Money Angle
🚀Announcement🚀
Ricki Heicklen is hosting another Quantitative Bootcamp in Berkeley from Nov 6th through 10th.
When you sign up, there’s a field to check that indicates you were referred by Moontower giving you a $150 discount.
Also, I’ll see you there…I’m attending at least one of the days!
To learn more about Ricki and the BootCamp check out my post A Jane Street Alum Teaches Trading
Sign up here.
[If you attend the bootcamp in November I’ll throw in a 15% discount to a moontower.ai subscription.]
Note that the course price goes up tomorrow🕛
On the investing front there is an absolute explosion of new ETFs being listed every month.
Dave Nadig gave a presentation for Kitces.com and summarized the key points in:
The ETF Market: A Zine (14 min read)
A few notable takeaways:
- ETFs have become a behemoth of $10 Trillion in assets across some 4,000 products.
- That growth has come largely at the expense of traditional active equity mutual funds, although the worst of that outflow seems to have abated a little. As every asset manager on the planet finds a way into the ETF market, the “horse race” between mutual funds and ETFs matters less and less.
- Traditional Mutual Funds will exist forever thanks to 401ks, or until someone rewrites the entire US retirement system.
- The industry is on a massive product development binge, launching 650 ETFs this year so far with an open/close ratio of 3:1.
- Over 40% of industry revenue comes from products that aren’t cheap beta.
- There are more ETF Brands now then there were ETF Tickers 20 years ago
The post is directed at financial advisors but hands-on individual investors should certainly read it.
And if you’re interested, there is even a “how to launch your own ETF” discussion including a link to Corey Hoffstein’s tutorial.
One of the comments describes the post well:
A wonderfully-written, comprehensive, and refreshing time piece about the real story of ETFs for all – pro’s or not!
All this financial, umm, innovation does get a little chuckle from me (levered exposure to individual stocks? Really? It’s like ghost of single stock futures haunting your watchlist).
The chuckle:
I’m not the only wiseguy feeling this way. This wiserobot is less lazy than me in its skepticism:
The thread continues…
Shorting all this nonsense (uncle nonsense reporting for duty) vs going long whatever it’s trying to replicate directly is a labor-intensive way to effectively pay yourself the embedded management fees. But the feasibility is predictably undermined by borrow costs.
But as a trader, it’s a useful reflex to:
- Observe the growth of “product” incentivized by fees and lowered barriers to entry
- Expect a bunch of trash to be launched with the logic of “it’s a call option on asset gathering”
It can inspire trade ideas from a place of maximal interpretability — you can’t launch all this stuff and expect none of it to be steaming hot turds.
Dave even warns you about what’s coming to the crap carousel:
I have been asked about getting private equity and credit into ETFs every single week this year so far. I’ll just put the marker down here again: this is a bad idea. YES, it is the case that we have broken market capitalism so badly that the majority of what we would recognize as actual capital allocation and risk taking happens privately. NO, that is not a good thing, and it does not mean we should shove all that private capital into daily-liquidity structures like ETFs.
The money currently trapped in private markets is desperate for liquidity so it can invest back into greener deals where there’s more profit runway. That money will push, and push, and push until it finds a new pile of money to sell to. Don’t fall for it. Be super skeptical.
Money Angle For Masochists
Markku Kurtti is an engineer in the telecom world. His outsider quant take on portfolio construction is beautifully derived and intuitive.
I strongly recommend his interview with Corey Hoffstein:
🎙️Diversification is a Negatively Priced Lunch (Flirting with Models podcast)
His blog is also outstanding. I’ll point you to this post in particular:
How much skill a concentrated stock picker needs to beat a diversified benchmark? (17 min read)
I summarize key findings below (with the aid of an LLM). The “Moontower highlights” are direct quotes from my kindle.
The central theme:
For a stock picker to successfully manage a concentrated portfolio, they must generate sufficient alpha to overcome the inherent risks and volatility associated with fewer holdings.
Supporting points:
1) The Balance Between Concentration and Diversification
Concentrated portfolios inherently carry more risk due to idiosyncratic variance, or the unique risks associated with individual stocks. To overcome this risk, stock pickers need to generate enough alpha to offset the “variance drag” — the reduction in expected growth rate caused by high volatility.
🟡Moontower highlight: “Portfolio construction of a skilled stock picker is a compromise between enhancing alpha by concentration and mitigating idiosyncratic variance drag by diversification.”
2) Importance of Consistent Skill and Alpha Requirements by Stock Size:
Different types of stocks require varying levels of alpha to beat the benchmark. Larger, more stable stocks typically require less alpha than smaller, more volatile stocks. Consistency in skill is crucial, as erratic performance increases the minimum alpha required to compensate for the higher risk.
🟡Moontower highlight: “Assuming perfectly consistent stock picking skill over time, 10-stock big stocks portfolio has historically required roughly 0.5 percentage point (pp) annualized alpha, small stocks ~1pp and micro-caps ~2pp. High E/P, E/B, Mom and B/P styles, in the universe of all stocks, have required roughly ~1pp and low E/P, E/B, Mom and B/P styles north of ~2pp. Low E/P style (smallish growth stocks with low profitability) have required the highest 2.55pp alpha.”
3) Risk of Concentration Without Skill
Concentration magnifies returns but also heightens risks. Without genuine stock-picking skill, a concentrated portfolio becomes increasingly likely to underperform over time. The document cautions against relying too heavily on concentration to boost returns without sufficient alpha.
🟡Moontower highlight: “But concentration is risky. If you concentrate and don’t have genuine stock picking skill, time will be your enemy.”
4) Circle of Competence and Style Diversification
The post emphasizes the value of investing within one’s “circle of competence” — areas where the investor has the most knowledge or advantage. However, it also warns that focusing exclusively on a single style exposes investors to style risk.
5) Predictability of Variance Drag Over Return
Idiosyncratic variance drag, the penalty for concentrating in fewer stocks, is more predictable than expected returns.
🟡Moontower highlight: “Idiosyncratic variance drag differences are easier to predict than expected return differences. It is therefore safer to increase diversification, which reliably decreases minimum alpha requirement, than to increase portfolio concentration to enhance uncertain alpha.”
🟡Moontower reference: The idea that volatility is more predictable than returns is a foundational principle in portfolio management. See Know Nothing Sizing
6) Lottery Preference in High Variance Styles
Some investors are attracted to high-idiosyncratic-variance stocks with potential for lottery-like returns leading to lower forward-looking returns.
🟡Moontower highlight: “Some investors may prefer stocks that may pay off big and this is exactly what idiosyncratic variance delivers: large dispersion of returns among individual stocks.”
🟡Moontower reference: See A Recipe For Overpaying for a succinct explanation by Chris Schindler.
7) Takeaway on Diversification for Risk Management: Diversification not only reduces variance drag but also lessens reliance on unpredictable alpha.
🟡Moontower highlight: “Our take away is that idiosyncratic variance drag is much more predictable than expected return. More generally, it is easier to predict variance than mean return. It is therefore safer to diversify more as it will reliably bring down idiosyncratic variance drag compared to concentrating more in a hope of higher alpha.”
It’s a love letter to diversification mixing words and math. For what it’s worth, at SIG Jeff Yass also called diversification a free lunch.
I’m partial to my Sun/Rain example in You Don’t See The Whole Picture which is an even stronger statement — you are incinerating money by not diversifying but if you evaluate yourself by “resulting” you won’t see it. That’s because the highest bid for risk is the most efficient at absorbing it. This is deeply true in the derivatives world. In the broader investment landscape it’s confounded by info asymmetry, principal-agent conflict, and the comfort of (perceived) safety in herding.
If you want to get deeper into this idea see the back half of the moontower guide:
🟰Understanding Risk-Neutral Probability (link)
But be aware…”diversification always means having to say you’re sorry” since something is always losing.
And sometimes almost everything loses. This was Wednesday. Eww.
Stay Groovy
☮️
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