The difficulty with shorting and inverse positions

Shorting is hard

Shorting assets is intrinsically difficult because
  1. while your position goes against you it gets bigger
  2. and when you win your position is getting smaller
Consider the impact of a $1mm fund that is designed to mimic a $1mm short in stock X.
  • X down 50% scenario

    • The fund earns 50% return. So now the fund has $1.5mm aum and the short is only $500k. For the fund to match the return of X going forward the fund must now triple its position.
      • Note this requires selling into a declining market (negative gamma)
      • The fund must keep its initial Position/AUM ratio constant. So initially this was 1:1 but then became 1/3 which is why it needs to triple the position
  • X up 50% scenario

    • If the stock increased 50% the fund loses 50%. Its AUM is $500k and the short is $1.5mm. The fund must cover much of the short.
      • The fund must buy in a rallying market (negative gamma).
      • The new position/AUM ratio is 3:1 so the fund must buy back $1mm or 2/3 of its position so that its AUM is $500k and its position is $500k. In this case the fund is insolvent.

Inverse ETFs and ETNs

The above dynamic is also how an inverse ETF or ETN work. The ETN must match the inverse return of a reference asset. So if all the AUM is exposed to the asset then we calculate the fund PositionSize/AUM.
  • NAV = AUM / Shares Outstanding
  • The down case

    • As the reference asset moves lower the fund must sell more of it to maintain the PositionNotional/AUM ratio. In this case, as the reference asset moved lower, the fund AUM increased due to profits while its position size decreased as the price of the reference asset declined. The fund must sell enough of the asset to rebalance the initial PositionNotional/AUM ratio. Selling into a declining market. This ensures the ensuing percentage move in the reference asset corresponds to the percentage change in NAV.
    • Redemptions are stabilizing as they require the position rebalance to be smaller as the AUM declines and the reference asset is purchased
  • The up case

    • As the reference asset rallies the fund must cover its notionally increasing short. PositionSize is increasing while AUM declines, so the reference asset must be purchased to reduce the position size and again normalize the notional/AUM ratio.
    • In this case, redemptions are de-stabilizing as they reduce AUM which further moves away from its initial value and the redemption also prompts an in-kind purchase of the already appreciated reference asset.

In sum:

  • For inverse etfs to maintain a constant exposure in return space to their reference asset they must rebalance such that the dollar size of the underlying position is a fixed ratio to the AUM.
  • The inverse nature means that the AUM and position size are always moving in opposite directions requiring constant rebalance (negative gamma). This creates a downward drift to the product NAVs.
  • As the reference asset rallies, position size gets bigger and AUM drops due to losses. As reference asset falls, position size shrinks while AUM increase due to profits.
  • Redemptions can stabilize rebalance requirements in declines and exacerbate rebalance quantities in rallies as redemptions reduce shares outstanding and in turn AUM while in both cases triggering the fund’s need to buy the reference asset which again is stabilizing after declines but not after rallies. In other words, profit-taking is stabilizing while puking is de-stabilizing.
  • I extend this explanation to levered funds here.

The Zeroth Commandment

The culture war stuff is complicated. You’d need to be willfully ignorant to be wholly unconflicted. As I wrestle with it, I try to salvage something small that is purely positive even if it is not comprehensive. Sort of a let’s not make coherent an enemy of the good idea. Just a takeaway that can be used as a north star in day to day life.

As a broad rule, many macro things break down when you get to the micro. Crowds don’t act like individuals. If we all eat fish than nobody will have fish. So in the aggregate, we may accept that talent is evenly distributed while the opportunity is not. But trying to democratize that opportunity in the macro, is not an excuse to tell an individual child to “check his privilege” in the micro.

To highlight this difference consider this example from HotelConcierge:

Intentionally misgendering someone is an aggressive act. This is true even if transgenderism is attention whoring or special snowflakism or whatever—misgendering violates the Zeroth Commandment of “Thou shalt call others by their chosen name.” You can argue that misgendering is justified, that it’s impractical to cater to every pronoun, that you shouldn’t encourage a society-wide “mental illness”—we can duke that out elsewhere—but don’t pretend it isn’t an act of aggression.

Contrast with [outrage over] posting offensive memes in a private group chat. [That] is not an act of aggression. It may suggest poor character, it certainly suggests weak judgment…, but don’t pretend the dichotomy is between victim and victimizer when there was no victim.

Discussions of political correctness go nowhere because one team is hurt by the first example and retaliates with the second, the other is hurt by the second and retaliates with the first.

When you tell that child to “check your privilege” you are calling that child by their parent’s name, not their own. You are violating the Zeroth Commandment. What about telling the parent to check their privilege? If you trace that logic up it starts to feel like you are peeling a hundred nested bananas. There might be some flesh somewhere in there but I’m not sure the fruit justifies what it took to get there.

I don’t know how to reconcile many of the tradeoffs we face, but I try to do at least one thing faithfully — adhere to the Zeroth Commandment. Every individual gets a little barrier of their own making. They can’t extend it to others. They can’t force everyone to honor it. But they can ask. And I can try. And in the order of operations, it’s called Zeroth for a reason.

Equality vs Meritocracy

What do windmills and highrises have in common? I’ll wait.

True, they are both tall. What else?

What are things I don’t want in my backyard, Alex.

Ding, ding. That’s the money answer.

Nimby. The proof that you were called on a bluff.

You want clean energy and you want lower rents. But the moment you become a homeowner you change teams. You are now balls long a housing crisis. Your outward embrace of high-density housing is like a private unicorn stock. It sounds great but nobody really knows what your untested sentiment is worth. The moment Avalon buys a plot of land in your town, your virtuous stance has to go public and it gets immediately “marked-to-market”. If you don’t want that building in your lovely, bucolic town, then you can write that stance down to zero. Abstract ideals, that was a cute ride you took us on but its time to step aside. Concrete self-interest is gonna drive, we’ve got places to be.

That was a morality warmup.

Going from renter to homeowner is one thing. Now try urban DINKs to parents. The Atlantic’s George Packer is an esteemed journalist, part of the white privileged class. His children were guinea pigs in a prisoner’s dilemma where democracy and meritocracy are on trial. But he at least had a choice. For those less fortunate, there is no shelter from the prevailing winds of current school politics. His story will make you wonder what you will do when the culture war comes to your kids. When your egalitarian values go on trial.

The article is controversial if not poignant. You should read the whole thing because the dilemmas live in the details. At his family’s supper table. At the school board meetings. In the “N-word” passes, and the bathroom crisis. The details are what our kids have to deal with day-to-day while their parents battle over idealogy.

The article is here.

I said you should read the whole thing. Some of you won’t. So I refactored it’s 10,000 words into 1,000 words. You can find that version here.

Refactored “When the Culture War Comes for the Kids”

This is a 10:1 compression and refactoring of George Packer’s When the Culture War Comes for the Kids

There is a deep sense of inequality prevailing in America. 

The parents on the fortunate ledge 0f this chasm gaze down, vertigo stuns them. Far below they see a dim world of processed food, obesity, divorce, addiction, online-education scams, stagnant wages, outsourcing, rising morbidity rates—and they pledge to do whatever they can to keep their children from falling…By kindergarten, the children of elite professionals are already a full two years ahead of middle-class children, and the achievement gap is almost unbridgeable.

The need for equality and the role of merit.

The claim of democracy doesn’t negate meritocracy, but they’re in tension. One values equality and openness, the other achievement and security. Neither can answer every need. To lose sight of either makes life poorer. The essential task is to bring meritocracy and democracy into a relation where they can coexist and even flourish.

In 2014 the front line of social advocacy hardened

This new mood was progressive but not hopeful…At the heart of the new progressivism was indignation, sometimes rage, about ongoing injustice against groups of Americans who had always been relegated to the outskirts of power and dignity…Over time the new mood took on the substance and hard edges of a radically egalitarian ideology…its biggest influence came in realms more inchoate than policy: the private spaces where we think and imagine and talk and write, and the public spaces where institutions shape the contours of our culture and guard its perimeter…You could almost believe they spoke for a majority—but you would be wrong…The new progressivism was a limited, mainly elite phenomenon.

“For better or worse, it’s all identity now.”

The battleground of the new progressivism is identity…progressive politics meant thinking in groups. In politics, identity is an appeal to authority—the moral authority of the oppressed: I am what I am, which explains my view and makes it the truth. The politics of identity starts out with the universal principles of equality, dignity, and freedom, but in practice it becomes an end in itself—often a dead end, a trap from which there’s no easy escape and maybe no desire for escape. Instead of equality, it sets up a new hierarchy that inverts the old, discredited one—a new moral caste system that ranks people by the oppression of their group identity. It makes race, which is a dubious and sinister social construct, an essence that defines individuals regardless of agency or circumstance—as when Representative Ayanna Pressley said, “We don’t need any more brown faces that don’t want to be a brown voice; we don’t need black faces that don’t want to be a black voice.”

De Blasio’s schools chancellor, Richard Carranza, has answered critics of the diversity initiative by calling them out for racism…Carranza has mandated anti-bias training…One training slide was titled “White Supremacy Culture.” It included “Perfectionism,” “Individualism,” “Objectivity,” and “Worship of the Written Word” among the white-supremacist values that need to be disrupted.


At times the new progressivism, for all its up-to-the-minuteness, carries a whiff of the 17th century, with heresy hunts and denunciations of sin and displays of self-mortification. The atmosphere of mental constriction in progressive milieus, the self-censorship and fear of public shaming, the intolerance of dissent—these are qualities of an illiberal politics.

[In Jared Dillian’s Daily Dirtnap, he recounts “I’m not sure if you heard about the spectacle at the Des Moines Register, but here goes. Guy goes to a football game and holds up a sign asking for beer money over Venmo. He gets some money. He gets more money. Then more money. He has $1 million! He donates it to a children’s hospital. Reporter at the Des Moines Register digs up old racist tweets from him when he was 16. The guy who saved the children. Outrage mob forms, digs up old racist and homophobic tweets on the reporter. Pandemonium ensues. Thousands of people canceling subscriptions from the newspaper. Newspaper editors stonewalling. Now death threats. This is where we are. Every day is worse than the last. Tomorrow will be worse than today. Yesterday was worse than the day before. This will continue for the next 20-30 years.”]

[Dave Chappelle, in his Netflix special Sticks and Stones, calls out the prevailing ‘cancel culture’: “If you do anything wrong in your life and I find out about it, I’m gonna try to take everything away from you!”]

It struck me that this would punish kids whom the movement was supposed to protect…

In the name of equality, disadvantaged kids were likelier to falter and disappear behind a mist of togetherness and self-deception. Banishing tests seemed like a way to let everyone off the hook. This was the price of dismissing meritocracy.

The middle-school scramble subjected 10- and 11-year-olds to the dictates of meritocracy and democracy at the same time: a furiously competitive contest and a heavy-handed ideology. The two systems don’t coexist so much as drive children simultaneously toward opposite extremes, realms that are equally inhospitable to the delicate, complex organism of a child’s mind.. Wokeness prettifies the success race, making contestants feel better about the heartless world into which they’re pushing their children. Constantly checking your privilege is one way of not having to give it up.

Our goal shouldn’t be to tell children what to think. The point is to teach them how to think so they can grow up to find their own answers.

There is no answer to this

I can imagine the retort—the rebuke to everything I’ve written here: Your privilege has spared them. There’s no answer to that—which is why it’s a potent weapon—except to say that identity alone should neither uphold nor invalidate an idea

“The legacy of racism, together with a false meritocracy in America today that keeps children trapped where they are, is the root cause of the inequalities in the city’s schools. But calling out racism and getting rid of objective standards won’t create real equality or close the achievement gap, and might have the perverse effect of making it worse by driving out families of all races who cling to an idea of education based on real merit. If integration is a necessary condition for equality, it isn’t sufficient. Equality is too important to be left to an ideology that rejects universal values.



Recap of my trip to Kyoto

Kyoto, being the former capital of Japan (capital is defined by where the emperor lived, although we learned the emperor was just a figurehead. Before the modern era, the shogun ruled) as you can probably tell is a magical mix of history and youth. It’s a city of education and many universities and the home of the majority of Japan’s Nobel winners. Here’s my annotated Google map to help.
  • Attractions we did
    • Fushimi Inari Shrine. It’s a pretty amazing shrine. We hiked up to the lookout about halfway up the mountain. If you want to go further up the mountain it’s a circular route and the gates thin out quite a bit so we thought the main lookout halfway up was adequate. Fyi this was the inspiration for the orange Gates exhibit that came to the states about 10 years ago
    • Sanjusangendo Temple. Home to 1001 human sized statues. This is in central Kyoto and quite a sight in person. You aren’t allowed to take photos so it’s disappointing that you can see it if you Google image it.
    • The bamboo forest in western Kyoto. It’s a bit of a trek (over 30 min cab ride from the center of the city) but it’s a beautiful, lush area and I’ve never seen a bamboo forest. There’s also a monkey park in that area but we didn’t make it. We did see some monkeys at Fushimi though.
    • I recommend tackling a number of historic sites with the guide we used. He speaks great English and lived in Kyoto his whole life. Well educated, incredibly kind. He brought handouts and even some thoughtful gifts. Just outstanding tour. Nijo Castle, and the last remaining tea house from Edo period, and several significant temples. A wealth of info, super-high yielding. Reach out to me if you want his contact info. 
    • Many friends highly recommended Kinkakuji. It’s the Golden Pavilion temple. We didn’t make it there ourselves. 

  • Nightlife
    • Walk through Gion (geisha district) at night. There are a few special historic streets and the area by the river is quiet and beautiful. For a dark, sexy bar check out Bar Aoi. Just the quiet, old streets are worth the trip at night.
    • For a more energetic scene, definitely see Pontocho Alley. We became well versed in the Japanese practice of hashigo (bar hopping). From restaurants to sake and dart bars this place is teeming with action and life. No particular place stood out, but def check out the areas by the river. The alley is along an awesome creek as well. The water really defined this city for me.
  • Dining
    •  You have to try the souffled pancakes at The Happy Pancake in the equally awesome Shinkygoku shopping area. Get the original pancake and also the matcha one. I’m not a huge matcha fan and found it better than the original. We also had this style pancake in Tokyo at Flipper. So good, nothing like it stateside.
    • Amazing pasta:  Trattoria Macedonia Yuki It’s small, you’ll need a reservation
    • Great ramen and even better karaage chicken at Ramen No Bonbo.
    • Dinner at Hafuu where we had well-priced, terrific wagyu and memorably special beef sandwiches.
  • Personal recommendations
    •   The Kamogawa river that runs through the center of the city feels like the main artery. We picked up a bunch of sushi, sake and baked goods from a supermarket and had a picnic on its bank. At the very least, walk across the river on its magnificent stones, many of which are shaped like animals. While walking on the bank we got a beautiful glimpse into locals living and leisure. Runners, bikers, picnickers, people just playing in the water and even a Pop Warner level American-style football practice!
    • And here the top recommendation esp if you like sake in any way. Book a tour at Matsui Sake Brewery. Ask for Jorge Navarette. I wrote about this briefly in my weekly email. You can learn his story in person. It’s worth it. It was one of my favorite things about the trip to Japan.

Tradeoffs in tax policy

Excerpts from Howard Mark’s memo: It’s All Very Taxing

The concept of “paying a fair share” is nebulous at best. It’s very contentious because everyone has a horse in the race. Mark’s memo is my favorite reference for the complexities and competing goals when designing tax policy.

Mark’s published the memo in November 2011 so the specifics are outdated but this doesn’t negate the reasoning. In fact, the changes actually highlight how our tax code evolves to punish or incentivize certain behavior.


We have a progressive system of taxation, meaning that higher earners don’t merely pay more in terms of dollars; they generally pay a higher percentage of their incomes in taxes. Most people agree that this is fair. But is it? Why should success be penalized through greater taxation? And if the tax rate for those who earn more should be higher, how much higher?

Under the U.S. system, people in higher income brackets pay tax at higher rates. In large part, the question of fairness primarily surrounds whether the higher rates are high enough. Talk about “the eye of the beholder.” There’s evidence on both sides of this debate: The top 1% of U.S. taxpayers pay 38% of all individual federal taxes.

A breakdown of the numbers

The top 10% pay 70% of all taxes, the top 25% pay 86%, and the top 50% pay 97%. The bottom 50% of all taxpayers paying only 3% of the total.

About half of Americans pay no federal income tax, and almost 25% pay no federal taxes at all. The average federal income tax rate for the top 1% of Americans is 23% (and for the top half it’s 14%), while the average rate for the bottom half is 3%.

They pay at lower rates than they used to and it seems progressivity has declined. . . . the effective federal tax rate, including payroll taxes, for the wealthiest 0.01 percent of earners fell to 31.5 percent in 2005, from 42.9 percent in 1979 [for a decline of 26.6%], according to data from the Congressional Budget Office. Over the same time, effective rates for taxpayers in the center of the range fell to 14.2 percent, a decrease of just 4 percentage points [or 22.0%]. (The New York Times, September 21, 2011). Total revenues from income taxes have declined in the U.S. – they “are at a historic low. of 15.3 percent of the gross domestic product, compared with a postwar average of 18.5. percent” (Financial Times, September 25) – and they’ve declined more for top earners. than for the rest. This is because of both specific rate cuts that have been enacted and the fact that the rates applied to dividends and capital gains – which clearly flow more to people in the upper-income brackets – have declined relative to the rates on salaries and wages.

  • On average, higher earners absolutely do pay a higher percentage than those who earn less.
  • But the decision as to whether the differential is just right, too little or too great is highly subjective and certainly a valid topic for debate.

A non-exhaustive list of trade-offs to consider

  • Are some forms of income more desirable to society and thus deserving of taxation at lower rates?

A discussion about investment vs wage income

    • Long-term capital gains are taxed at reduced rates because of a judgment that long-term investment in things like securities, companies and real estate is beneficial for the economy and should be encouraged. Right now, the top tax rate on long-term investment profit is less than half that on short-term gains and ordinary income.
    • What about interest? Why are dividends taxed at preferential rates and interest at ordinary rates? The explanation may lie in the fact that interest is deductible for corporations, while dividends aren’t. Interest is paid out of pretax income, while in theory dividends are paid out of after-tax income – although the existence of corporate deductions and credits means dividends may, in fact, be paid out of income that hasn’t been taxed by the U.S. Alternatively, the difference in tax treatment may be the result of a desire to encourage investment in “risky” equities rather than “safe” debt. But some companies’ dividends are no doubt safer than some other companies’ interest payments, so this distinction is questionable. If the goal is to encourage risk-bearing, is dividend versus interest the right criterion?
    • While on the subject of gains from investments, it’s interesting to note that, not long ago, dividends were included with interest under the rubric “unearned income.” And it was taxed more heavily than wages.
    • But now things have turned 180 degrees, and returns on capital are taxed at lower rates than wages. It’s worth noting that the Democrats – commonly considered the party of labor – controlled the government for much of the period 1928 to 1980, when earned income was favored. On the other hand, the Republicans – the party of those with capital to invest – have been in control more of the time since 1980, and the taxation of returns on capital has declined in relative terms. The definition of virtuous income that should be encouraged through lower taxes clearly is subjective, impermanent and subject to change with the winds of politics.
  • Should we encourage certain expenditures by making them deductible from taxable income?

The drafters called them deductions: provisions that reduce the net income on which taxes are levied. Critics call them loopholes, suggesting there’s something underhanded
about those provisions. And politicians use the laudatory-sounding term tax incentives to describe tax code provisions that reduce tax revenues in order to encourage certain
behavior. It all depends on your point of view.

Interest on mortgages

    • For as long as I can remember, interest on home mortgages has been treated as a desirable expenditure that should be encouraged. Because homeownership is considered part of the American dream, the tax code subsidizes it by reducing the after-tax cost for those who borrow to buy homes (and are able to itemize rather than take the standard deduction). While everything else may be arguable, certainly this seems fair. But is it? Are homeowners more virtuous than renters? If mortgage interest is deductible but rent isn’t, we’re requiring renters to subsidize owners. Is that appropriate?
    • On average, homeowners are from the middle and upper-income brackets. Is it fair that poorer renters provide a benefit for richer owners?
    • And is it desirable that those able to buy more expensive homes should get more of a subsidy than those consigned to cheaper ones?
    • As with the taxation of dividends, judgments on these matters change over time. Until 1987, there was no limit on the amount of mortgage interest that could be deducted. If you could afford to own ten homes with multiple million-dollar mortgages on each one, taxpayers would collectively share the cost by reducing your income taxes due. Today interest is deductible on only a maximum of $1.1 million of debt, and only on first and second mortgages, and only on a primary residence and a second home. So the tax treatment of owners of many homes and more expensive homes has become less generous. But it’s still better than that of renters. Is that proper?

Charitable deductions

    • As I travel the world visiting with clients, I see that two things about the U.S. are quite uncommon: (a) Americans give a lot of money to charity and (b) donations to charity are deductible in calculating taxable income. Everyone tells me the latter is the main reason for the former. In particular, these things are part of the explanation for the existence of the
      many private, non-state-supported colleges and universities in the U.S.
    • Part of this is true because legislators decided at some point to subsidize non-profits by encouraging contributions through the tax code. That’s certainly understandable. And yet, changes were made in recent years to limit upper-bracket taxpayers’ use of deductions in order to ensure that they pay some minimum tax rate. What about the unevenness of the subsidy?
      • The cost of giving $1 to charity is reduced by the amount of taxes it saves the donor, which is equal to $1 times the person’s tax rate. So today, speaking simplistically, it costs a top-bracket taxpayer 65 cents to give a dollar to charity, while it costs a bottom-bracket taxpayer 85 cents. Is that fair? Should the bigger earner receive a greater reward for a dollar of philanthropy than someone who can afford it less easily?
      • And should those who aren’t inclined to give to charity be required to subsidize those who are?

State and local deductions (SALT)

    • Deductibility on the federal tax return somewhat evens out the burden and ensures that (a) the states get first crack at taxing income and (b) the federal government can only tax
      what’s left, in line with federalist principles.
    • This raises a number of questions. Is the deductibility of state and local taxes fair? As with other deductions, the key question is “fair to whom?” Some people pay more state
      and local taxes than others, meaning they get greater deductions than others. As a result, while a person with a given income who lives in a high-tax state pays higher total taxes,
      he or she pays less federal tax than someone in a low-tax state. Is that fair?
    • Should the federal government subsidize spending on the part of high-tax states? That is, should residents in low-tax states bear part of the expenses of high-tax states?
    • While the source of an exemption rather than a deduction, what about interest on “municipal bonds” issued by states, counties, cities and local agencies. This is exempt from federal taxation, under the legal doctrine that the federal government mustn’t tax the operations of the states. But here again, we’re talking about a federal benefit (in the form of a lower cost of capital) for the biggest-spending local governments and their citizens, and a tax break for people who lend to them.

Property and sales taxes

    • Property taxes deductible without limitation. Thus the owner of a mansion – or ten mansions – receives more of a tax benefit than a low-income earner. And it’s another subsidy for homeowners versus renters. Is this right, or should it be changed?
    • Sales tax used to be deductible, too (meaning the buyer of a Rolls Royce got assistance from the federal government). Now it’s not. More fair?

The biggest exclusions of all: employer-provided health care and the deferral of taxation of contributions to pension plans

    • In both cases, those receiving these employer-paid benefits enjoy a substantial benefit not shared by those not fortunate enough to participate. For instance, is it fair that many better-paid workers get thousands of dollars a year in untaxed health-care benefits, while other workers enjoy no such subsidy?
  • Just think of how complicated the argument is on “fair” ways to raise taxesThere’s an argument that for the deficit solution to be equitable, all citizens should contribute to it. Though some government spending benefits all citizens alike, such as national defense, national parks and the administration of justice, much spending disproportionately benefits lower earners, in the form of public education and transportation (which are supported by the federal government), unemployment insurance, food stamps, Medicare and Medicaid, etc. Thus the effect of the coming spending cuts will fall more heavily on the poor. Some argue that since they receive less in benefits and are therefore less likely to experience their loss, the wealthy should share the burden of reducing the deficit through increased tax payments.
  • Keeping taxes low in general
    • Reduce wastefulness
    • Laffer curve
    • Encourage growth

Notes from The Rebel Allocator

The Rebel Allocator
by Jacob L. Taylor


Using a Socratic device, the author creates a Buffet/Munger composite doppelganger named Mr X to help guide Nick, a young left-leaning journalist turned investor. Nick is disillusioned by the business world from his seat at Big Rock, a cartoon of a private equity firm whose short-term, scorched earth practices give capitalism a bad name. Through his regular lessons, Nick learns the principles of sound capital allocation and sees them applied within billionaire Mr X’s nationwide burger chain. The book covers a broad array of ideas that underpin business and strategy, while its narrative structure makes the lessons more enjoyable and practical than the dry texts that typically teach these topics.

The Profit Constraint

Apply this: revenue – profit = expenses aka pay yourself first.

  • Yarak: “hungry but not weakened”
    • A bird in this state is the purest expression of its genetic capabilities.

3 Key qualities in employees

Integrity, intelligent, energy

  • 2 out of 3 will do so long as you have integrity!

A compass for what to focus on

4 hours a day spent on something that will make other things easier or unnecessary

Zero-based budgeting

Every year budget items are subject to a ‘delight’ test. If the expense doesn’t delight the customer it’s non-strategic and subject to trimming. Don’t paint the (unseen) fourth wall.

Effect of compounding improvement

365 days of 1% improvement is 37x return

Iron Law of Economic Survival

Cost, price, value triangle (straws model introduced in ch 19)

  1. Cost is true economic cost not accounting cost.
  2. Price can be based on lifetime revenue.
  3. Value is subjective,context dependent, and variable.
  • Trade-off between profit (price minus cost) and brand (value minus price).
  • By flying under the radar with lower profits you may be able to store brand in your customer’s mind.
    • Profit would alert competitors and regulators! Brand is poorly measured.
    • Me: Interesting to think of underpriced companies as those storing economic value in their brand which exists in the customer mind.
    • Net promoter score surveys compare the percent of people who are superfans vs those who are ambivalent or detractors

Customers don’t want a quarter-inch drill bit they want a quarter-inch hole

A business should consider its competition broadly with the criteria of who else fills the need. (ie Southwest airlines early on was competing with Greyhound for short trips).

Understand your edge

​Franchise model allows parent company to do what it does best: source ingredients, craft customer experience, marketing. The franchisee is really in the real estate business. (in the 4 seasons model this is same). Real estate unlevered returns are close to inflation while the fictional McDonald’s is closer to 12%

Effective capital allocation requires evaluating all options

Mr X looking at an empty plot poses the question, how many ways could we build a restaurant?

Student answers buy a plot, hire a construction crew and build one. But there are more strategies:

  1. Buy land and erect building later
  2. Buy land and wait
  3. Buy competitors store and convert
  4. Buy public stock
  5. Buyback your own stock
  6. Just waiting
  • Your next best option is your opportunity cost. Important to not define menu too narrowly
  • If you were trying to improve the experience of traveling across the country one option is to fly faster. This will cost substantial additional fuel and maintenance. Installing TVs on the planes may provide a better ratio of benefit to cost to the consumer.

2 kidneys for a reason

Tradeoff between efficiency and survival: virtue of cash and less leverage

Trees don’t grow to the sky

There are feedback loops which lead to mean reversion

The virtues of efficient capital allocation

“Good capital allocation means doing more with less to create happier customers. The pressure to continually deliver value is one of the wonders of the free market. Roll up all of those customers into society at large. When you are able to provide value for the least required cost, you free up resources that can go toward adding value somewhere else.

Imagine that inside you are all of these different locks. Each lock represents one of your wants or desires. You have a lock for food, a lock for shelter, a lock for water, a lock for the opposite sex. Now imagine that each capital allocation project creates one key. Ideally, the entrepreneur knows the lock their key will fit beforehand. A restaurant provides you food, a hotel gives you shelter, shoes protect your feet. The role of business is to use the least amount Of resources to create the key that fits a certain lock. Doing a proper job spares resources to create more keys for other locks. In this sense, profit should be celebrated as a signal that an entrepreneur provided value while consuming the least amount of resources to do so. When all of society’s businesses are properly allocating capital, more locks get keys, and we’re all better off.

That’s all technology really is: the means for us to turn more locks using fewer and cheaper keys.”

When simple models outperform experts

Simple models thrive when:

  • Problem is ill-structured and complex.
  • The information is incomplete, ambiguous, and changing.
  • The goals are ill-defined, shifting, or competing.
  • The stress is high, due to time constraints and/or high stakes.

Notes on Invisible Heart

Invisible Heart
by Russ Roberts

Thinking like an economist: Second Order

Price modulates supply/demand

Suppose the world has 531 billions of barrels of oil in reserve and on balance consumes 16.5 billion barrels a year. How long before we run out of oil?I’ll give you a hint. You don’t need any more information. If you know the answer it is because you reasoned like an economist. I never said it required more horsepower to think like an economist. It’s just a different lens. 

If you are stumped then consider Robert’s thought exercise.

I gave you a room full of pistachio nuts in the shell. It’s a big room, say the size of a classroom. The room is filled with pistachio nuts up to a height of five feet. There are millions of them. Welcome to the Nut Room. The nuts in this room are yours for the taking. Any time you want to come in here and help yourself, there is no charge. Bring your friends if you’d like. Just wade in and have a pistachio party.

“You’re happy because you love pistachio nuts. Outside the Nut Room, they’re expensive. Inside, they’re free. There’s only one rule in the Nut Room. As you eat the nuts, you’ve got to leave the shells in the room. You can’t take them out with you. At first, that’s no problem. For the first few days and maybe weeks and months, the pistachios are plentiful. But as the years go by, it takes longer and longer to find a pistachio. The shells start getting in the way. You come in with your friends and you spend hours wading through the shells of pistachios you’ve already eaten in order to find one containing a nut. Your friends say, we’ve got to stop meeting like this. ‘Why?’ you ask. ‘Don’t you like free pistachio nuts?’ And what do your friends say in response?”

The nuts aren’t free anymore” In other words, the price of finding the nuts has exceeded the price of just getting them at a store. The price rationed demand. 

So what about the oil?

“Remember the pistachios!”

You will never run out of oil. The price of finding the marginal barrel will become high enough that people will find cheaper sources of energy before they ever extract the final barrel. By thinking like a microeconomist you were able to see that the relative price of substitutes meant the supply of oil was not headed to zero with a slope of negative one. It’s a curved line that never approaches zero.

Being a nanny state

“Children don’t anticipate the future very well, so we treat children differently from adults. But when we start treating adults like children, we start taking away the essential human challenge of coping with uncertainty and making decisions”

  • A life without consequences and costs has no meaningful choices. A life without meaningful choices is the life of a “child, animal, or robot”
  • The connection between choices and rewards is the essence of responsibility

Chapter 13: The Rules of the Game

  • Thought experiment about designing the perfect law highlights the reality that every choice is a trade-off. If you had access to a “Dream Machine” a construct referenced from Nozick’s Anarchy, State, and Utopia then you would fast forward to the goals and prizes but the seeking, trials, failures and risks of the world would never be endured but remember without valleys, there are no peaks.
  • When people are laid off it sharpens our focus on them. What’s blurred is the competition which rose to combat the cost-cutting company. The employees of those competitors get to have jobs.
  • Maimonides thoughts on charity. The giver and receiver must be considered.

On an ascending level, they are as follows:

8. When donations are given grudgingly.

7. When one gives less than he should, but does so cheerfully.

6. When one gives directly to the poor upon being asked.

5. When one gives directly to the poor without being asked.

4. Donations when the recipient is aware of the donor’s identity, but the donor still doesn’t know the specific identity of the recipient.

3. Donations when the donor is aware to whom the charity is being given, but the recipient is unaware of the source.

2. Giving assistance in such a way that the giver and recipient are unknown to each other. Communal funds, administered by responsible people are also in this category.

1. The highest form of charity is to help sustain a person before they become impoverished by offering a substantial gift in a dignified manner, or by extending a suitable loan, or by helping them find employment or establish themselves in business so as to make it unnecessary for them to become dependent on others.

  • A key to the self-regulating property of economies is private property. Regulation can make far more sense when dealing with a common resource that nobody owns. How did Zimbabwe turn such a resource into a form of ownership, thwart poachers and increase elephant populations? Making the villages able to charge to hunt them. This gave villages an incentive to care for the elephant population since elephants were now a source of revenue. While some conservationists found it reprehensible others found it practical. If you care more about elephant populations it turned out to be an effective strategy.
  • “The human heart has its reasons that reason cannot know”. A divorce is complex and its cause is never as simple as one reason (ie infidelity). A divorce is the “product of a thousand misused moments”. The legal system is smart enough to recognize this and not try to determine whose fault it is. This is a good lesson when thinking about using courts to adjudicate discrimination. While some cases may be cut and dry most will not be and the ability of courts to intervene leads to changing incentives and potential for unintended consequences.

Notes on The Accounting Game

The Accounting Game: Basic Accounting Fresh from the Lemonade Stand
by Darrell Mullis and Judith Orloff

Balance sheet

Assets = Liabilities + Equity

Income statement

The movie that connects a period’s beginning and ending balance sheets which are snapshots.




Gross Profit



Net profit

Examples of expenses

bad debt, interest, insurance

An expense like insurance can be prepaid (ie a 10 year policy). So while you may pay cash for it upfront reducing your cash assets, you will expense only 1 year worth of its benefit while booking the remaining value as a “prepaid asset” on the balance sheet

For service businesses:


-Cost of services


Gross profits



Net profit

Cost of services are direct cost of providing service hours. Expenses include items like admin, sales & marketing including commission for leads, and R&D to develop materials, salaries including to owners.

  • Income taxes are deducted on the income statement to compute a net income after taxes.
  • If you sell an asset at a value higher/lower than book value you will register a gain/loss on the income statement


  • The inventory from a beginning balance sheet will be part of the COGS in an income statement.
  • Inventory on balance sheet can be divided into raw materials and finished good. It takes cash (for example to pay labor) to turn a raw material to a finished good so there can be cash “locked” up in the balance sheet in the finished goods that can only be realized by making sales.

Valuing inventory

  • In an inflationary business where the cost of materials rises over time, LIFO accounting will value the inventory and COGS higher, in turn, reducing paper profits and taxes.
  • Most businesses start using FIFO which is operationally easier but switch to LIFO for tax reasons. In fact, LIFO records are expensive to maintain and usually only done by companies with large inventories.
  • The IRS must grant permission for your business to switch methods a second time and require any back taxes be paid.
  • Where it was possible to report cash balance sheets to the IRS and accrual ones for investors it is required to be consistent with method used to value inventory (LIFO or FIFO). So accounting statements will usually footnote whether the assets are being under or overstated based on the method used.
  • If it is easy to value the inventory individually (ie each item has a serial number) then some businesses will average the value of the inventory.

Accrual vs Cash Accounting

  • Accrual accounting is more accurate but leads to higher profits than cash accounting so it leads to higher taxes. Companies prefer cash method for IRS but accrual method for investors.
  • Service companies have the advantage of being able to use cash accounting but companies who have inventories as a significant portion of business are required to use the accrual method. Otherwise, they could easily shield profits by spending cash on hand to buy inventory and reduce reported earnings.

By allocating items, we can allocate items in a way that lends economic insight into the business and price services correctly.

Capitalizing an asset vs expensing it

Plants and buildings are fixed assets although costs to maintain them would be recorded on the income statement as expenses.

  • Equipment is also a fixed asset but usually separated from plants and buildings which are stationary.
  • Whether a purchase is treated as an asset or expense really depends on:
  1. duration of its use. If it is many years then capitalize it as an asset. If it’s treated as an expense it will reduce earnings in the current period.
  2. Its cost. You can set a dollar limit, and any item which exceeds it will be capitalized.

Cash Statement

Keeps track of cash flow which is necessary when doing accrual accounting. For example, if you made a sale on credit in a previous accounting period and the cash for that sale comes in we do not adjust the income statement since we already accounted for the sale. However we will update the cash statement.


Shows up as an expense on the income statement reducing earnings. The balance sheet will be kept in balance by reducing the value of the fixed assets by the same amount as the expense.

  • It is a rare Non-Cash Expense allowing us to reduce earnings without losing cash!
  • Buildings must use “straight line” depreciation while equipment can use “straight line” or “accelerated”. There are a few types of “accelerated” schedules and the IRS intermittently changes them. “Accelerated” depreciation uses the updated “base” (ie the asset’s value after the last depreciation period) to calculate the new depreciation amount. The resulting curve will allow you to save taxes near term by taking steeper depreciation expense.

Categorization of Assets

“Current Assets”: assets such as cash, receivables, inventory and prepaid expenses which are probably convertible to cash within 1 year.

“Net Fixed Assets” or “net book value of assets”: gross fixed assets (using purchase price) + accumulated depreciation

  • By breaking net fixed assets into gross + depreciation we can estimate how old the assets are.
  • Assets are typically listed on a balance sheet in descending order of liquidity (ie cash is first).

Understanding the difference between earnings and cash

When you are investing in a business you may find that it has little cash and even if the business is very profitable it is very possible to have high retained earnings but no cash. Retained earnings are not cash! It is not a sum just sitting in a bank. It reflects that the business has been profitable, and also your ownership but it is not spendable like cash. It can be tied up in assets.

  • On a daily basis, cash runs the business!

Artisanal Social Media

Mass market trends always give birth to their own backlashes. Farm-to-table and localvore movements glorify bottoms-up artisans over top-down algorithms. Well, if Facebook is the McDonald’s of social media, be aware there is a back-to-the-land movement towards what Cal Newport calls the “long tail of social media”:

The mass audience strategy is starting to fray. As users become more familiar with both the joys and depredations of the attention economy, they’re increasingly shifting toward a long tail model for the social internet.

In this new model, users don’t want to connect with everyone they already know, but instead, want to connect with small groups they find really interesting. Similarly, they don’t need access to massive libraries of low-quality content, but instead, want access to curated collections covering topics they really care about.

Part of the quality control mechanism is permissions. Unlike Twitter and Instagram, you can’t just share anywhere you want. There are gatekeepers and moderators which act as a form of government within these new and not-so-new platforms. Examples of these platforms include:

  • Your iMessage and WhatsApp groups
  • Slack memberships
  • Nextdoor (requires address verification)
  • Email chats

The interactions in these smaller groups are, on average, more rewarding and useful than the mass-market platforms. Even Twitter which is mass market can be narrowed into a much tighter conversation if you curate and segment your groups as I’ve explained here and here.

If you are interested in meeting an awesome Slack community to see what I mean, my favorite one is Khe’s Rad Reads. A number of Moontower readers are actually in it. The interactions are much richer than what you will find in any permissionless forum. And it’s worth noting that the caliber of people across many dimensions is very impressive. It’s like when you wish Yelp reviewers were “more like you”. This is that place. You can subscribe here.

*I met Khe after being a long-time subscriber to his newsletter. It’s still my favorite one (out of about 20 letters I read — I don’t read the news if you wonder what gets displaced). Sign up to RadReads here.