Moontower #45

Friends,

99th percentile.

That’s what it takes to get into the “gifted and talented” program. The specific tests may differ by state but the goal of this tool is universal. To detect an elite mix of mental alloy in K thru 12th graders. Verbal, quantitative, and visual reasoning. My friends’ 4th-grader just got accepted into the program. It didn’t surprise me, he’s a smart kid across the board.

What follows after he gets the news of his acceptance is surprising. It involved his 2nd-grade sister who missed the score cutoff. She doggedly chased down the advice of her friends who did get in. “How do I prepare so I can get in too?”

(my head explodes)

I’m not sure how much time you spend with 2nd-graders but this is 99th percentile behavior of a different breed.

Grit

This is one of those buzzy social science ideas that took off like 2018 cannabis IPOs. Like ‘10,000 hours’ or ‘growth mindset’, ticker GRIT got too far ahead of its fundamentals because the story was so disruptive — talent doesn’t matter if we can just instill stick-to-it-iveness. Angela Duckworth is credited with popularizing “grit”. A simple web search will enumerate the exaggerated claims (here’s a screen of my summary of David Epstein’s measured critique of the studies).

Let’s not be too harsh.

Consider the price of BYND. It’s down 50% from its peak. It’s still trading for a price that affirms durable importance. It’s forgivable if our ability to measure that value is low-resolution. The same goes for grit. The scantron score can accurately identify talent in math and reading. But this 2nd-grade girl reminds us that “not everything that counts can be counted”.

That fact makes life more fun anyway. Anything easily measured will be correctly priced. Alpha resides in what is illegible.

The Calculus of Grit

While we approve of grit when we see it, there is a difference between being persistent vs just stupid. Sometimes it’s obvious. Like if you’re 5’9 and want to play in the NBA. You should direct your #MambaMentality elsewhere. But you have no doubt faced times when it was a close call to give up vs carry on. When is grit bad strategy?

Venkat Rao has written a contrarian take on the idea of grit. He advocates for taking the path of least resistance.

He explains:

• How school’s failure to reveal most people’s strengths sets their lives on a needlessly masochistic journey.

Why? Think of it this way. The disciplinary world very coarsely measured your aptitudes and strengths once in your lifetime, pointed you in a roughly right direction and said “Go!” The external environment had been turned into a giant obstacle course designed around a coarse global mapping of everybody’s strengths.

So there was no distinction between the map of the external world you were navigating and the map of your internal strengths. The two had been arranged to synchronize. If you navigated through a map of external achievement, landmarks, and honors, you’d automatically be navigating safely through the landscape of your internal strengths.

But when you cannot trust that you’ve been pointed in the right direction in a landscape designed around your strengths, you cannot afford to navigate based on a one-time coarse mapping of your own strengths at age 18.

If you run into an obstacle, it is far more likely that it represents a weakness rather than a meaningful real-world challenge to be overcome, as a learning experience.

Don’t try to go over or through. It makes far more sense to go around. Hack and work around. Don’t persevere out of a foolhardy superhuman sense of valor.

• If the one size-guide you have been equipped with is not in sync with your strengths you will bash your head against a wall in vain. You need to figure out your path, not trust the guide you were given. This requires introspection. Once you recognize this, logic will point you to an unfashionable conclusion: hard equals wrong.

If it isn’t crystal clear, I am advocating the view that if you find that what you are doing is ridiculously hard for you, it is the wrong thing for you to be doing. I maintain that you should not have to work significantly harder or faster to succeed today than you had to 50 years ago. A little harder perhaps. Mainly, you just have to drop external frames of reference and trust your internal navigation on a landscape of your own strengths. It may look like superhuman grit to an outsider, but if it feels like that inside to you, you’re doing something wrong.

This is a very contrarian position to take today. “

“Exhortation is pointless. Humans don’t suddenly become super-human just because the environment suddenly seems to demand superhuman behavior for survival. Those who attempt this kill themselves just as surely as those dumb kids who watch a superman movie and jump off buildings hoping to fly.

It is the landscape of your own strengths that matters. And you can set your own, completely human pace through it.

The only truly new behavior you need is increased introspection. And yes, this will advantage some people over others. To avoid running faster and faster until you die of exhaustion, you need to develop an increasingly refined understanding of this landscape as you progress. You twist and turn as you walk (not run) primarily to find the path of least resistance on the landscape of your strengths.

The only truly new belief you need is that the landscape of disciplinary endeavors and achievement is meaningless. If you are too attached to degrees, medals, prizes, prestigious titles and other extrinsic markers of progress in your life, you might as well give up now. With 90% probability, you aren’t going to make it. It’s simple math: even if they were worth it, as our friend Friedman notes with his characteristic scare-mongering, there simply isn’t enough to go around”

• The path of least resistance does not mean lazy. Or easy. He calls you to consider your efforts in the framework of his 3 Rs: reworking, referencing and releasing. Depending on your goals or field these words may mean different things but they are the blueprint for excellence.

I’ve read the essay a few times over the years. The advice is resonant. Since Rao’s writing style might be an acquired taste I’ll share the link with my highlights. (Link)

Jerry Seinfeld (look, I’ve already told you I basically memorized SeinLanguage so you’ll need to endure these references) has some life efficiency hacks. Always put the bowl away with a spoon. If you ever find yourself needing a bowl without a spoon cross that bridge when you come to it. When you bend over to make your bed and tuck in the corners, stay bent over at the waist as you move from one side to the other. The seconds add up.

Taylor Pearson’s The Subtle Art of Reaching Your Potential could be the efficient, practical companion guide to Rao’s Calculus of Grit. He explains when to substitute the 80/20 rule for 10,000 hours. We all have the same 24 hours. The essay will help you discern how to allocate your time. (Link with my highlights)

The Money Angle

I recently described markets as biology not physics in recognition of how players adapt. Let’s discover 2 more opaque examples and their causes.

1) Structured products

Historically your bank would happily sell you an investment note which guarantees your principle (insofar as you are ok with your bank’s credit risk) and earns you a return which is linked to return of an equity index. To manufacture this investment product the bank would invest in bonds and a portion of the interest income would be directed to buy call options on the index. There are more shortcuts they use to create the product (for example, the investor typically doesn’t capture the dividends which are a significant portion of the expected return), but the important thing to understand is these notes require enough interest income to finance the call options. With interest rates near zero in most of the world, banks have had to get more…creative.

To keep these notes promising attractive rates of return, the issuers buy insurance against a sell-off from the investors. Not explicitly of course. Instead they embed a feature that “knocks” your note out and exposes you to the losses if the reference index falls far enough. Yes, the prospectus spells this out. But for whatever reason, retail investors fail to wonder why an investment product can offer seemingly attractive returns in a low risk-free rate environment. They continue to gobble them up, not realizing they are self-financing these returns by underwriting catastrophic risk.

Here’s where it gets interesting. Since interest rates have never been this low and the aging developed nations have never been this large, there is unprecedented demand for these notes. These products are intensely popular in Asia and Europe (a friend once quipped you could buy them at a 7-11 in Italy. I want to believe this because it sounds so ridiculous so I refuse to fact-check it). The issuing banks, who are not in the business of taking directional or outright volatility risk, must recycle the optionality that these notes spit off. The associated option flows from these popular products are correspondingly massive.

From a “market is biology” perspective, it’s useful to remember that anybody using historical data to make their case may not be fully appreciating that our current landscape includes a bunch of dormant, non-linear payoffs that kick in only when the market has already made a large down move. An extreme analogy would be like comparing NFL wide receivers through time without noticing that they got rid of pass interference rules.

Although the bulk of these notes have historically been tied to Asian indices like Korea, they are becoming increasingly linked to the SP500. Will the tail wag the dog? Let options fund manager Benn Eifert explain on his latest appearance on the Bloomberg Odd Lots episode titled How To Create Havoc In The U.S. Options Market. (Link)
2) How corporate governance responds to the age of passive indexing
Consider these points taken from Farnum Street Investment’s latest letter. (Link)

• In 1965, the CEO-to-worker pay ratio was 20-to-1. By 2018, it had jumped to 278-to-1. How did pay structures get so lopsided? Shouldn’t someone have stepped in? Yes, someone should have stepped in: the owners of the companies. But if you’re a passive index holder, you abdicated that responsibility to Vanguard, Blackrock, State Street or Fidelity. It wasn’t a custodian like Vanguard’s job to mind the henhouse. It was the job of the owners of the company.

Hard Truth: If you own an index fund, you waive your right to complain about CEO compensation.

• In 2019, Lyft went public. With the increased transparency of SEC filing, it was discovered the company had 46 million restricted stock units (RSU) outstanding. RSUs are a way to incentivize employees, but they can become a big bill for owners. In the case of Lyft, the RSUs would cost owners $2-4 billion, depending on the IPO price. This represented a 20-25% ownership stake of the company being granted to employees. Corporations who grant extravagant stock options do so at the expense of the owners. There are no free lunches.

Hard Truth: If you own an index fund, you waive your right to complain about option dilution.

• From 2008-2017, the pharmaceutical giant Merck distributed 133% of profits back to shareholders via dividends and share buybacks. Yes, they paid out more than they took in. Those resources could have gone toward research, saving lives, and the next blockbuster drug. The strategy seems obviously shortsighted. How come no one stepped up to tell them to think long term? Analysis initiated by SEC Commissioner Robert Jackson Jr. revealed that in the eight days following a buyback announcement, executives on average sold five times as much stock as they had on an ordinary day. Management is effectively cashing out at the owners’ expense when they know the price will be supported by internal buybacks. How come no one is stopping them?

Hard Truth: If you own an index fund, you waive the right to complain about myopic corporate strategy and share buybacks.

• Sir Winston Churchill once said, “Capitalism is the worst economic system, except for all the others.” That remains true, but proper capitalism requires thoughtful stewards, meritocratic outcomes, and engaged owners. If we all abdicate our responsibilities, we risk perversion of the system that’s created more positive effects for humanity than arguably any other single phenomenon. Hope is not lost as history tends to move in cycles. We’re in need of the pendulum to change direction.

Hard Truth: This too shall pass.

Climb Higher