Stock Picking: The Game Within The Game

It is important to understand the game you’re actually playing in all endeavors. In stock picking among other areas of active investment many times the game that is being played is not the one that is at first perceived. It is also not always the one commonly believed or advertised to be being played. 

Goldman Sachs is on the other side of grandma's trade. Grandma and her investment club might have been putting in some pretty good research, but they’re very unlikely to outperform the models and information advantage a firm like Goldman Sachs will have. 

As general investors selecting exposure to the market when we evaluate Goldman Sachs, we evaluate them against the market. That is the correct benchmark for a potential or current investor as that is the central question: Am I better off investing with this particular active stock picker or is there another that can do a better job including using a passive index fund? Perhaps more appropriately and completely the question really is: Is the performance Goldman Sachs delivered appropriate for the risk taken, and could I have achieved as good or better results with as much or even less risk? 

That is the game we are playing when we choose investment in a fund manager, but that is not the game that Goldman Sachs, a fund manager, is playing. Goldman Sachs is not trying to beat the market per se. Goldman Sachs and more precisely specific fund managers within the large organization that is Goldman Sachs are trying to beat grandma and her investment club along with all the other relatively novice investors in the market. 

Personally as a wealth manager I am trying to help clients reach financial goals by investing so that their risk-adjusted return is appropriate for them. That is the game I am trying to play--rather than trying to beat the market, I am trying to match their risk/return exposure to their goals. That might mean using a Goldman Sachs fund if I think it is the best option in that specific area. 

Yet clients often don't want to play that game. In wealth management one of the more frustrating things to deal with is competing against mythical portfolios that clients think exist. An example of which might be when a client is told stories at the country club or down at the barbershop about how great someone else’s portfolio is performing. 

It is very difficult to compete against a phantom. Floyd in the barbershop is probably not doing as well as he claims. In fact it is very likely Floyd is under performing the competition because the competition for Floyd is Goldman Sachs among others. 

For Floyd to feel good with his investments, he only has to compare himself to those decisions he happens to remember along with hypothetical investments he did or did not choose to make. Floyd’s benchmark is cash and imagination. 

For Goldman Sachs to succeed they specifically have to beat most of the Floyds out there and only loosely do they need to keep up with the market. In the long run they probably don’t stand a chance against the market but in the long run that’s not who they really are competing against. 

For those of us who want to be investors with Goldman Sachs, the proper benchmark to compare them to is the market. But the bottom line for Goldman Sachs is a benchmark against Floyd, and Floyd never stood a chance. 

Economic Sanctions - Failure in Theory and Practice

Imagine you are trying to change someone's mind. How would you go about it? What techniques would be effective? 

Imagine now you are trying to change a group of people's minds. The difficulty multiplies. 

Now imagine you are trying to get a group of people to change their behavior or worse yet to get them to make active changes in their own status quo implementing changes that put them at high risk or involve great hardship. 

For instance, suppose you are strongly opposed to abortion. You believe it is morally wrong--it is the taking of a human life. Suppose you took political power and while you could not yet overturn the legalization of abortion, you could impose sanctions on those who engage or enable it. To bring about change you would like to cut off access to credit for those who have been a customer of or worked for an abortion clinic. This can't be done, though, because you cannot identify those individuals nor can you legally target them. But you do find a technicality in the law allowing you to target an area that has an abortion clinic. All those who live and work in that area suddenly cannot access credit or the banking system. This is crippling.* 

Do you think this would be constructive to your ultimate cause? Think of those marginal or median voters. While they don't have a strongly-held position on abortion, they are not just caught in this crossfire--they are the target. You are aiming to harm them so as to bring about change. At the very least you are willingly harming them because the shotgun approach you are limited to forces the collateral damage.

If that is too politically charged for you, consider this. You are the mayor of Shelbyville. One of the things that really irks you is how many of your citizens root for the nearby town of Springfield's baseball team, the Isotopes. This isn't just a minor annoyance. Your administration is trying to support the local team and economy by building a huge new stadium complex for the home team. The lack of hometown support, though, is making this quite difficult. So what to do? You institute a blackout zone through an indirect tax. All broadcasters are subject to the onerous tax, $10,000/minute of broadcasting, for any broadcast of a sporting event of a team located more than 20 miles from the Shelbyville town center. Viola, problem solved, right? 

The desire to have people change what sports team they root for is not going to be solved by force. Many people who never watched a single game before are likely to take up the cause against you. 

Want to increase vaccine acceptance and injection rates? Well, you could . . . oh, we've been doing that experiment. I don't think it moved many needles [pun intended].

We can extend this hypothetical to all kinds of causes: disuse of fossil fuels, antipornography, zipper merging, etc.

The result is consistently and predictably emboldened and extended resistance. It is not human nature to succumb to external pressure. Any parent knows reverse psychology and distraction are the keys to getting a young child to change course. Tell them they can't, and the deviant battle begins. 

This thought experiment alludes to why economic sanctions applied by governments so often fail to achieve their desired ends. 

Setting aside all of the very important concerns about moral authority and moral culpability given who is actually harmed by sanctions, consider just if they should work to begin with. Stated differently, why do they so often completely fail? The do so because that's not how people change or how they are made to change.

So why do we do it? Partially it is action bias, the fallacy of . . . something must be done . . . this is something . . . therefore, do it!

Perhaps more importantly it relies on social desirability bias. It seems like a strategy that is more humane than active warfare. However, it is arguably much less noble and less morally defensible as it targets noncombatants attempting to turn them into double agents. In an age of high-precision bombs, economic sanctions are carpet bombing combined with landmines. 

*Arguably the linked (trucker convoy and Canada's emergency response to it) is an example of sanctions that worked! But only in the narrow sense of getting the result of disbanding the convoy. I am not sure it won any hearts and minds on net. Rather I think it turned a lot of people against the government of Canada. It also was an arguably more harmful action than simple police action would have been. The greater harm is in the threat and concern of it being used going forward as a regular tool. In this way the actions of the Canadian government are not analogous to economic sanctions but rather analogous to escalating hot-war conflict.

Mr. Blandings Builds His Dream Portfolio

Imagine being an architect for a couple wanting to build a dream house. Their sentiment and emotions would influence what they asked for, but your job  includes a need to keep them within reason (not too big (or fancy) and not to small (or modest in terms of amenities)—basically Goldilocks).

Now image that they want to argue with you about how certain features should look, about how large certain rooms need to be, about what it takes to be within code and best practices, even about structural and engineering issues. Now complicate it by making yourself somewhat unsure about some of these answers and downright ignorant about the underlying truth of, say, why certain designs will likely work better for structural integrity than others. You must win the initial bid and keep their confidence throughout the project without misleading them or giving them what they think they want without regard to the tradeoffs, the downsides.

Financial management and financial planning is a lot about being the architect and general contractor for some principal (individuals, families, organizations, et al.) who probably wants more than they can reasonably afford and wants to achieve it with unreasonable certainty. Being a financial advisor means always having to say you're sorry.

This is not a rant. Clients are trusting you with their money--potentially all of their financial wealth. For many like individual retirees this will be all their potential wealth too because they are no longer able to work. For others their capacity not to mention willingness to go back into the workforce would leave them only with a fraction of the wages they are entrusting you to earn for them with, let me remind you, their money. They may not know what they do not know, but part and parcel with that is they do not know it. 

Oh, and one more thing: you as their advisor may not know what you think you know about them. It is a continual discovery process seeking to learn and refine and revise what goals they are trying to achieve and what constraints and risk tolerances they are subject to. 

Good car mechanics know a lot about fixing cars and keeping them running well. They know basically nothing about where you should drive. London cabbies know how to get you where you want to go (in London). They cannot know if you should want to go there.

Humility and honesty are essential attributes of a good advisor (financial and otherwise). They are among the necessary conditions for potential success along with actual skill in the area of advisement, good communication, and ability to establish and keep trust. Most clients are know they want the latter qualities in an advisor (skill, communication, trust), but in many cases they give little to no importance to the former (humility and honesty). In fact those often repel rather than attract clients. Add overcoming this bias to that which separates beneficial, successful advisors from charlatans and quacks. 

Losers Don't Pay Taxes

This is just a rambling thought experiment. Feel free to ignore as it probably has vast shortcomings I have not considered in the admittedly short amount of time I have spent on it.

What if we instituted a rule via Constitutional amendment that the voters for a losing Presidential candidate in the general election do not have to pay federal income taxes for the term of office for which their loser was running? Suppose further that this amendment was so firmly established that there would be no question of it being followed (unlike so much of the Constitution) and no question of it being permanent for the foreseeable future.

I can think of lots and lots of problems with this as I'm sure you can too. A chief one is that Congress and not the executive branch determines taxes. Not to sideline those, but let's jump straight into some game theory.

What might some implications be?

• Any rational potential voter would probably chose to vote given the prospect of tax avoidance.
• Those votes would likely gravitate at first to candidates who looked very unlikely to win.
• This seems to help third parties get on to ballots and garner significant vote share.
• Knowing that everyone else is pursuing this strategy, voters likely would be reluctant to throw their vote for scary candidates. Even if they realize their vote will not affect the outcome of the election (spoiler alert: your vote doesn't matter mathematically), if presented with two similar candidates where one was slightly less objectionable than the other but both rather unlikely to win, the better of the two would tend to get the vote.
• Candidates would know all this as well. That should push them to be slightly more objectionable at the margin. However, power still matters and is desired. So they would also have an incentive to try to win if they thought they could win. Now what would make them very desirable to getting votes so as to win? hmmm? Promises for very low taxes of course.
• Could they or would they promise no taxes? I think this is unlikely as everyone knows that there have to be some taxes if there is to be some government spending. What about funding spending exclusively through debt, which is promises of either future taxes or future inflation? While this could be a workaround, it would have problems. The threat of inflation harms current voters as once inflation is suspected and to the degree it is suspected, it arrives immediately, or at least eventually. Future taxes might come soon enough to affect current voters and will likely affect their offspring, a group for which voters care.
• This is starting to sound like a powerful tool to restrain government. Candidates are encouraged to campaign on small government so as to allow for low taxes. Voters are encouraged to support candidates who pursue small government. It also seems to promote experimentation as candidates are encouraged to be a bit wacky but not too wacky for fear (by voters) that they would actually get elected, and voters are incentivized to vote for marginally more wacky candidates (more than current but less than the wackiest). Here wacky means stuff like: drug legalization, troop withdrawal/de-escalation, privatization, deregulation, etc. Consider me wacky, btw.
• I would fear it would degenerate into some suboptimal game, though, like where we all pretend to pursue small government and then don't actually do it leading to a need for higher future taxes. This would create a ratchet effect making the next election a competition between greater liars offering lesser improvements. Another BIG problem relates to the issue raised and promptly ignored at the top: Congress. Would Congress be emboldened to spend more? An opposing-party Congress as compared to the President seems likely to. This could not be fixed by changing the amendment to instead be a voter for a losing party in the next Congress since we don't vote for one Congressional position. Would the rule need to be it applies only to straight-party voters? If we went down that road, perhaps we would need another amendment limiting all elections to just two parties--the default situation we have now anyway. Lock in the Democrats and Republicans granting them the oligopoly of two. This might work making them compete along the tax dimension axis almost exclusively with all other policy subservient to it. Now we might be back to strong incentives for small government. Yet another suboptimal result might be one party in each election is always aiming to be the losing party and the other party tacitly agrees to be the winning party. Would this still give a small-government outcome? Maybe. Voters can switch who they vote for, but if there is strong lock-in on policy, they may not be so quick to change their votes. Where does social desirability bias and virtue signaling come it?
• Who knows? I do like the integrity of only the voters who supported people in power have to pay for the actions of those people. 

Trust Is a Fragile Fabric

https://en.wikipedia.org/wiki/Bayeux_Tapestry

Of the many, many lessons to be learned from the COVID-19 Pandemic, one that stands out to me is how important honest communication is. Honesty is a bedrock of trust. Trust is an essential quality for a thriving society.

While fear can enable a society to survive, it takes trust to allow it to flourish. Largely we are only surviving the most recent pandemic. There are many reasons for this from poor understanding and application of science to isolationist responses regarding testing and vaccination driven by nationalist pride (distrust!) to blatant failure to test to failure to properly quarantine to failure to experiment and on and on. Granted that many of these failures came about because we were starting from a poor state of trust, we did not do much to improve the arrangement. In fact we set it back meaningfully along the way.

Suppose we get another pandemic (we will, just wait). Suppose further that it is similar to COVID in terms of virulence and contagion. Perhaps it is dissimilar enough that we have a caught-off-guard type of reaction thus making it even more similar to COVID. But we do remember COVID, so we actually do have some improvements in societal and government response. For example, some communities, large business firms, perhaps the federal government wants to conduct wipe-spread, rapid testing. What might stand in the way of that policy being well received and complied with?

The people that would need to be getting tested would need strong assurance that a positive test would be met with reasonable consequences. What about our response to COVID would give them that assurance? Although people would definitely want to know if they were infected all else equal, pushing back against this desire would be multiple, reasonable concerns. Namely, that they would be subject to harsh treatment if positive (social stigma, rough or indefinite or otherwise undesirable detention, etc.) and perhaps more reasonably that they would be subject to involuntary quarantine, lockdown, social stigma, etc. even if they tested negative. 

Compounding this would be a distrust that they were getting the full story. Vaccination acceptance still suffers from the horrible Tuskegee Study crime. To a lesser degree dismissive elite responses to those with concerns about vaccination, as unfounded as those may be, also deters people from trusting authorities on vaccines. Being told masks are worthless and then that masks were essential sent a clear message--don't trust the authorities. This was one of many noble lies, a short-sighted concept that completely fails to ask the essential question: And then what?

The Chinese government lied to the world at the early stages of the pandemic. They have characteristically been very deceptive as the pandemic has unfolded including apparently not cooperating with the investigation of a lab leak cause. We should expect and demand better from our authorities. In the long run people respect the concept of 'we don't know' especially when coupled with transparent, honest, and updating 'here is what we are thinking'. The 'And then what?' from this approach is productive responsibility and fruitful experimentation. 

You May Not Always Believe in Incentives, but Incentives ...

... believe in you.

Progressives are not hesitant to believe that McDonald's, for example, induces consumers to eat at McDonald's. They in fact will in many cases paint a picture whereby McDonald's is insidiously using some kind of mind-control secret sauce to force people to buy and eat lots more of its food than they would otherwise want to. 

What's more progressives tend to believe that many people can't or won't decide for themselves how best to choose something as important as education for their children--especially in a voucher/school choice system that funds students rather than systems. If left up to "them" (so the narrative goes), they would opt for a choice that benefited the parent even if it harmed the child. 

It seems that progressives believe many or most people are bad at making good choices for themselves and easily influenced by convenient temptations. Their worry often is that people will be hapless victims to manipulation in opposition to their own actual long-term interest. 

So why is it so hard for progressives to believe that government programs invite moral hazard and incite poor behavior and bad long-term choices? How is it that they can with a straight face claim unemployment benefits do not impede job search and acceptance? 

Megan McArdle illuminates the problem quite plainly. This is not a new problem with regard to unemployment benefits nor is it unique to it. There are many examples of this phenomenon. We saw the same obstinance the last time unemployment benefits were interfering with economic recovery. Progressives pushed back emotionally and strongly against arguments and evidence like that from Casey Mulligan.

It is as if progressives are not entirely consistent when it comes to believing in the power of incentives.

P.S. Veronique de Rugy was ahead of this problem over a year ago developing a straightforward and MUCH better method for unemployment insurance. From the linked piece:

Personal unemployment insurance savings accounts (PISAs) are designed to maintain a financial incentive to return to work as soon as possible. These accounts are individually owned by workers who, during spells of unemployment, can make orderly withdrawals to partially compensate for the loss to their income but can keep and build the balance during their regular times of employment. At the time of retirement, workers can use the balance in these accounts to bolster their retirement income or transfer to their heirs.

The incentive for workers to return to work is as strong as their desire to keep their own savings for retirement. It is thus a solution that solves the double bind of providing insurance and keeping strong incentives to return to work.

The Seductive Allure of Socialism

The more local something is the more essentially socialistic it becomes. I think the best way to describe this is that size/complexity has a positive relationship with the net benefits of the market (free market principles and market incentives, etc.) while size/complexity has a inverse relationship with the net benefits of socialism (yes, there are benefits). Simply put: the bigger or more complex something is, the more you want/need markets and not central planning to do the heavy lifting.

Intelligent people recognize that they know things and understand how to solve problems much better than most other people. They see this in action locally where it works or seems to at least. Thus, their belief is reinforced. This leads them down a bad path to an unreasonable conclusion that they can guide the world.

Keep in mind that what distinguishes a person as being "intelligent" can be local knowledge rather than pure IQ. Therefore, a local shop keeper may be orders of magnitude more intelligent about running her shop than would be a team of McKinsey consultants. 

Art Carden gives a model, salient version of this. For example, consider the family, the firm, and especially small and midsize towns. The local banking relationship in these places illustrates this nicely. 

The key skill of a banker today is not financial acumen. It was once upon a time at least to the degree of assessing credit risk. But large firms, algorithmic models, and risk spreading have largely supplanted that need. It is still important--vitally important for the bank itself--but it is not primarily dependent on the skill of individual banker. I believe financial risk assessment is a quality of secondary importance.

Rather the key skill of a banker today is relationship building. That is what makes a great banker. Hence, bankers are deeply involved in their communities. Again, this is not new, but it is now the primary attribute rather than a secondary one as it was in decades past.

It is strange then that a bank and its bankers, the stereotypical image of a capitalist (think of the board game Monopoly) are in fact the leading proponents of a road to local socialism. 

Here is how it unintentionally works. First, bankers are deeply interested in current customers' wellbeing and credit soundness. They have made loans, and they want them paid back. Second, they want to make future loans. These same customers would be the easy way to accomplish that goal. This gives them an all-too human impulse to favor the known and familiar as opposed to the new and (perceived) extra risky. 

Certainly bankers are interested in growth and new development. It is just that the unseen has a built-in bias against it. 

How is this a slippery road to socialism? I am not proposing that it formally leads to socialism, but it is central planning friendly. Most directly it runs the same risks of all central planning whether at the household, firm, or governmental level: decisions are made that suffer from the knowledge problem and are subject to the local maximum problem. 

Bankers are deeply imbedded within their communities for good reason: they want the business relationships and they want to stay close to the credit--all the better to monitor the risk. Yet this presents a sort of capture risk similar to formal regulatory capture. The bankers can easily be persuaded to support their customers' desires at the expense of their customers' competition. 

P.S. When I was in college I had a righteous disdain for kids wearing Che Guevara t-shirts, etc. They were "old enough" to know better. As the great P.J. O'Rourke explains, that is no longer true of kids these days, who are now the same ages as those who I rebuked back in the day.

P.P.S. Iain Murray's The Socialist Temptation explores this topic in depth. For a good discussion on it I recommend this recent episode of Jonah Goldberg's The Remnant. 

See this for more on the source for the above image and related story.

Annuities - A Troubled Solution in Search of a Problem

Years ago I'm sitting in a San Francisco coffee shop with my wife enjoying breakfast. Without trying to or really wanting to we can easily hear the conversation from a close-by table. It was two young couples. Both were well dressed, but one was decidedly more outgoing and charismatic. One might even describe them as smooth.

They were clearly on travelling together. Somehow their conversation turned to topics that drew my attention. It began innocently enough.

"Well, what are your plans?" or so went the inquiry. "Nobody wants to think about this stuff, but it is important." They were clearly talking about someone who wasn't there. 

"It is hard to know what to do."

"Look, we obviously can't know the future. But with this approach at least you have something to show for it..." Turning to her partner a little too on cue, "Remember Grandma’s experience..."

I don't remember too vividly the exact conversation--I honestly wasn't trying to listen.* It was not a simple case of a couple-friend giving friendly advice. This was a sales pitch. And they were selling the other couple on the idea of long-term care insurance, a type of annuity that has very strict terms regarding when it will be paid along with sharp limits on how much and long payment will occur. 

LTC insurance plans are not bad per se. They can work in practice; though they more frequently work in theory. While I didn't know all the relevant facts in this situation, and it was none of my business regardless, the conversation frustrated me. In fact I was offended. Why?

I was offended because they were using emotion to solve a math problem. Well, more precisely they were disguising an emotional pitch as if it were a math problem, pretending it was a math problem, and not doing or even hinting at any math! 

Presumably there would be some assumption-laden work-up presented at some point before signing on the dotted line. Let's charitably assume there was--that all we were witness to was the initial hook. Regardless, I resented both the approach and the fact that it appeared to be working.

It was a learning moment for me. As analytical as I want things to be, the truth is humans are emotion-driven beings. Many of our decisions are based on feelings. We seek social desirability and find comfort in confirmation. 

This is why confident people are charming. Especially it is so when they are selling us something. 

How you say it versus what you say--delivery versus content. They will remember how confident they were in you long after they have forgotten what you actually said. 

I remembered this story as I read this recent piece from Vanguard, Guaranteed Income: A Tricky Trade-Off. From the summary bullet points:

The math is clear. A certain income can leave retirees better prepared for an uncertain lifetime. But retirees’ reluctance to annuitize suggests that the irrevocable decision to exchange liquid wealth for guaranteed income is about more than math.**

It is not too much of an exaggeration to say that there are two types of people in the financial products industry: those who sell annuities and those who detest them. A derogatory but perhaps not unfair way of describing annuities is to say that they are never bought always sold. Another is that the primary beneficiary on a variable annuity is the sales person.

Annuities work extremely well in theory. They are straightforward instruments that spread risk and smooth income. 

In practice they are extremely complicated, notoriously misleading, and very expensive. There are exceptions. The regulations around them have improved the situation some, but I would argue strongly that this is a second-best solution behind simply allowing more competition in the industry in the first place. World-class fine dining in Napa Valley isn't because of world-class restaurant regulation. 

If you're paying attention, you'll have noticed a paradox. I started by showing that people often use emotion to sell a financial solution but then argued that emotion is keeping people from adopting those same financial solutions. But that really isn't a mystery. If people are reluctant to listen to the clear math supporting annuitizing future income, it stands to reason that emotion will be perhaps necessary to get them over the hump. 

*In fact they were so bad at attempting to be discrete that I can only assume we too were part of the sales audience.

**The Vanguard piece points to fear of regret and a strong bequest motive as the major obstacles to annuity adoption. I liked their analysis, but I don't think they sufficiently considered just how few good, honest annuity options there are. Hard to buy what isn't being sold--especially with fair options that do leave bequests. And it is harder and harder to sell them. Whether deserved or not (it is definitely deserved!), annuities have been given a bad name by all the many investment advisors who rail against them. 

The Local Maximum Problem

Ever since being introduced to this concept, I’ve been intrigued by it and see examples of it more and more throughout life, business, and public policy. This is the problem that occurs when people get stuck in a situation that is the best near-term or near-possible outcome but is not the best possible yet reasonable long-term outcome. 

The analogy is to imagine four people playing a game that has them blindfolded and linked arm-in-arm in a square configuration. Each member of this team is responsible for one of the cardinal directions (north, south, east, and west). Their goal is to locate the highest point possible. They experiment by taking steps to see if a step in that direction is up or down. If the step is down, they don’t take it. If the step is up, they take it. They keep walking until none of the four can make a step that is in the upward direction. This point is the conclusion of their game by reaching the local maximum. However it is most likely not the highest point on the surface where they’re walking. They just can’t reach (or detect) a higher point by virtue of their own rules. 

I believe governments are particularly susceptible to this problem. The rewards for experimentation that drive one out of a local maximum are very dispersed or completely irrelevant to those bearing the costs of experimentation. This is more than just people not wanting their cheese moved or having their apple cart disrupted. This is the very legitimate concern that an ambitious idea is going to have significant negative outcomes or the potential rewards will not accrue to those bearing the risk. It is an acute combination of asymmetric risk-reward and principal-agent problems.

The many, many public and private failures in the COVID pandemic are vivid examples. Perhaps the most costly in the United States were the CDC and FDA's insistence on using their own developed testing (staying with the controllable and familiar) and as important if not more so the refusal to allow challenge trials to speed the vaccine development process. Sadly this list goes on and on from "pausing" the Johnson & Johnson vaccine to not approving AstraZeneca's. 

The position those in power have taken are understandable but completely inexcusable. And we have ourselves to blame as these mistakes are just the latest examples of how the FDA works against medical advancement and is a deep net cost to society. 

To be sure individuals, firms, and other organizations are also susceptible to the LMP. Notice, though, the degree to which these entities are somewhat or greatly better structured and incentivized to resist and correct it.  

As a general rule, the more insulated and protected an entity is from competition, the more vulnerable they are to a local maximum. Hence, traditional banks are more vulnerable than are start-up fintech firms. 

To whom a firm or organization is held responsive has strong implications for its fragility to local maximums. As a firm is more responsive to those who reap rewards proportional to risk taken, it will better prevent the LMP. Hence, non-profits (highly responsive to donors rather than customers) are more at risk than are profit-seeking firms (highly responsive to owners and customers). 

Within a firm the dominant force becomes existing and entrenched stakeholders who are in comfortable, conventional positions. Hence, no one in marketing will ever suggest the firm experiment by not running ads. 

The degree to which a person faces public scrutiny or cannot capitalize on public adoration, the more they will rest once finding the local maximum. Hence, a public figure with a lot to lose/little to gain will tend to play it safe. 

Risk bearing requires compensation in the form of return, and this risk-return should be commensurate, symmetrical, and willfully accepted. Those are tough hurdles to achieve. All the more so when we are relying on force rather than persuasion. 

P.S. I believe Arnold Kling deserves credit for introducing me to this concept.

Does Active Investing Work in Theory?

We know active investing almost always doesn't work in practice. The vast majority of professional money managers underperform their respective index over meaningful periods of time. Let that sink in. Compared to what we could easily do on our own through indexing, most of the people we pay very large sums to invest our money give us back less after they do their job and take their fee. For those few that do, we say they earn alpha--return in excess of the market for the same level of risk taken. 

As a side note realize something. Your Uncle Fred with all the great stock picks or your friend who just quit his job to start day trading and who has actually has been making money trading stocks, bonds, options, or whatever HAS NOT been taking the same level of risk as any index. Those two happen to be winners in a likely random pool of many people taking on tremendously more risk than they realize. If 10,000 people all flip coins ten times in a row, some of them almost certainly will get ten heads in a row (singularly by itself a 1 in 1,024 chance). 

However, I am focused on professionals here. Guys and gals who dress sharp, use all the right jargon, are actually highly intelligent and reasonable, and who most of the time lose money for their clients. Perhaps their clients are buying something else than returns [paging Robin Hanson--investing professionally isn't about making money]. Highly likely in many cases. It feels good to deal with these pros. Plus they can in fact help investors stay disciplined--better to make 5% versus the benchmark's 6% over 10 years than to bail out when the market declines and earn only 1% over that same 10 years. Fortunately for EMH and unfortunately for this theory, this affect has been shrinking to recently be nearly nothing.

So, while active management doesn't work in practice, does it work in theory? Start with the assumption of a manager that can consistently and reliably earn 1% alpha. When her benchmark is up 6%, she is up 7% on average. Why does she need your money? 

I can think of two likely reasons:

1. She could want to use it to reduce her own risk. 
2. She could have more opportunity than she can herself realize.

Notice that these are not altruistic motivations. The first is fairly unfavorable for the client--you are giving her money not for your benefit but for hers. She uses the additional funds to smooth out the volatility in her own income. When you pay a management fee to her, you are directly subsidizing her income. And just the use of the funds themselves is an indirect subsidy allowing her to invest more broadly. All of this might be justified if the second reason holds.

In the second she only would invest your money once she has invested all of her own money including all the money she can borrow at less than the total return of the investment, which is the market return plus alpha (6% plus the 1% in this case). Theoretically and in practice she will charge you a small fee to cover transaction cost plus a little profit to her to let you participate in her investing endeavors. Yet as we saw in the first reason she should probably be paying you as you are giving her a benefit of lower risk in the form of a smoother income stream.

Essentially this is an arbitrage which we know is going to have a limited capacity. Even if she is in that elite company of professionals who can outperform the market, her last idea (say the last stock her analysis says to buy) will be her worst idea and only be at best just as good as the market itself. It seems very likely by the time she gets to your money, we are firmly in reason-one (personal risk reduction) territory. 

This is quite damning for professional money management--in theory. What might save it and asset managers like myself who do in fact invest client money with money managers? 

First, we must admit just how challenging it is to find professionals who can outperform the market. Second, we must consider that the first reason above, income-smoothing risk reduction, might actually have a win-win aspect to it. Yes, she does enjoy less risk by using your money, but she doesn't get this for free. In fact she is probably risk averse enough that the second reason doesn't hold firmly.

Rather than fully lever all of her available resources--put her risk at ludicrous speed--she would likely prefer giving you most all of the risk of her performance and collect a steady fee for doing so. She is giving up the potential for return upside so that she has only very little downside risk. This flips the concern from being a pure doesn't-work-in-theory problem to being a pure principal-agent problem. sigh We can't catch a break. Now we have to worry that she isn't incentivized properly to continue to do what we hope she can do--outperform the market at the same level of risk. But at least we partially rescued active management in theory.

As bad as this is (in theory), this is in public market active management. The same forces are at play plaguing private markets like private equity and private debt. At least public markets are not opaque, very hard to benchmark, illiquid, et al.

The Future of Education Post COVID-19

Tyler Cowen pointed to this “debate”, which I was a bit disappointed in for being too much an untethered discussion. Tyler’s portion I found more meaningful, but still it didn’t do much to advance my thinking.

Since they didn’t really have an objective topic, I guess I shouldn’t be too critical. But I find that a lot of the recent thinking on how things will change in the age of COVID-19 to be like this—not very deep, a combination of wish list and fear. My own view is an attempt at nuance between "most things will change very little" (we will snap back to prior norms) and "this epoch event has accelerated by multiple years that which was already underway" (e.g., teleworking just leapt forward at least 5 years along the prior trendline). To be clear I think holding both views is the best prediction--that is the nuance. Not a lot will change, but that which was already changing has been accelerated. 

Here are some of my thoughts regarding changes in education (both what was already happening and how they have accelerated) as well as the obstacles faced (incumbents and traditionalists don’t go down without a fight).

Elementary and High School

• The major role of babysitting that school plays for many families has been shown to be replaceable. Schools aren’t as essential as previously imagined.
• While the pandemic-induced schooling-from-home experience was miserable for most of us forced into it, schooling from home was already widely assumed to be awful. Now many are probably seeing arrangements other than traditional school as decent substitutes.
• Much of what kids do in elementary school has little to no benefit for them. This is likely much more widely realized or at least considered as parents got a more up-close look at their kids “learning”.
• For the kids trapped in poor schools, online and other arrangements now look like realistic improvements.
• Teachers and schools that cannot provide good online options and flexibility have been considerably exposed.
• For students old enough to not need babysitting and for those capable of learning outside of the regimented classroom (perhaps a large majority of students are in this latter category), questioning the necessity of a 7 to 8-hour daily routine is rising.
• Unions and bureaucracies will be as formidable obstacles to change. However, they have a conundrum: teachers, administrators, and parents are afraid of the risk of infection. All of this pushes for alternative options to be explored, which drive experimentation toward alternatives that threaten the existing power structure.
• Status quo bias/inertia are also obstacles. People tend to be very traditional when it comes to choices for their children. It is hard for them to wrap their heads around questioning the conventional wisdom narrative of school as we know it--especially government school.

Higher Education

For higher education I think we should solve for the equilibrium and use a typical university, the University of Oklahoma, as an example.

• Although non-profits are insulated from market forces, they are still subject to the strength of the underlying economy on which they draw resources as well as the philosophical support of those in power. For universities those in power includes donors, alumni, legislators, employers of graduates, purchasers of research, and the public zeitgeist. So where are these headed? Saying that expectations will be to do more with less is a considerable understatement. Donor money and state funding will be much lower for a long time. However, desires/demands of universities will continue with smaller changes in overall goals. We will continue to virtue-signal about college-education being great hope for the future. So….
• How does OU do more with less? By outsourcing what is not in their core competency. Why would we have students show up in a gigantic auditorium to watch a professor repeat a lecture he has given every semester for a decade plus? What is the value in having everyone in that room squinting at the board from the back rows and trying to avoid the inherent, multiple distractions? Can’t that be done online without the risk of infection? And once you realize that it can, it is just one more step to realize not each and every university need duplicate the tasks. Rather have grad students available to perform office hours and optional workshops. What is the point in offering the ~100th best programs in this, that, and the other? Partner with other universities for those services especially the undergrad basics. Specialize in only that where there is comparative advantage. For OU that might be areas like petroleum engineering, social networking, and football.
• Social networking? Yes, with one of the biggest/best Greek life systems in all of higher ed, OU is among those that offer this feature. Even if the benefit is only perceived rather than real, perception matters to consumers. Drinking Gatorade doesn’t make you a better athlete.
• And football? Yes, the football team is a source of revenue and marketing for the university. OU is great at it. And OU is in a much better position than most now that paying football players for their value contribution is rightfully (finally) trending to be the reality.
• Thinking more of the general case, these trends lead to barbell effects: niche schools (elite quality where average is very much over) and enormous diploma-producing machines (economies of scale). While this is probably a trend within the realms of both undergraduate and advanced degree programs, it is more so a trend between these levels because . . .
• The line between high school and undergraduate college will blur greatly while the line between undergraduate and graduate work will likely sharpen. This latter division will resemble the distinction that once existed between high school and major university such that grad school becomes the new, true higher education. 
• Universities need to maintain their status (true in either the human capital model or the signaling model). To do so will require some exclusivity, which I think comes mostly at the entrance process to grad school--getting accepted to graduate programs becomes much more difficult. 
• What happens to research? More rent-a-lab, rent-a-brain with corporate interests outsourcing to universities more than ever and universities renting away these resources. 
• Obstacles? The same forces as above are at work against change here, and they are probably more powerful. But the stakes are higher and the willingness to experiment is probably higher too.
• The major universities aren't going away, but they may be transforming so much that what emerges over the next ten years is vastly different from what we've known for so long. Imagine "going to" a major university, but not directly taking but a few classes there until upper-division-level work.

P.S., John Cochrane had two great posts recently on this topic (here and here).

What Do Weddings and College Football Have in Common?

Besides not going together as in: do not schedule your wedding in conflict with an OU football game and expect me to attend (the wedding).

Weddings, sporting events, and so much more are all subject to alternatives for the audience. And that competition is demanding that average is over.

Consider weddings first. They have to be getting more and more expensive and outlandish just to keep up--not just with each other but with the opportunity costs for the guests. The explicit cost of attending a wedding is time, travel, and gift. Since there is no admission fee to reduce, the only way a wedding can become more attractive is along the quality dimension (differentiation). In the extreme think about trying to get people to attend a Manhattan wedding. Of course it would have to be fabulous! The opportunity cost for guests would simply be too high to allow otherwise.

Now consider sporting events. They face opportunity costs from far substitutes (other leisure and non-leisure activities) and near substitutes (watching the game at home or a friend's house on a giant high-definition TV with no traffic, weather, cheaper food and drink, etc.). Sporting events do have admission fees which means these competitive forces are at work making college football et al. choose a strategy of differentiation (high quality, value-added experiences for select audiences) or low price (mass market to fill enormous venues). Over the long-term the latter strategy probably is suboptimal if not outright unfeasible given competitive pressures and expense demands. It might all become various first-class seating only at the highest levels of various sports.

Thinking back to weddings, people don't need the superficial opportunity to stay in touch that weddings once offered. Social media now provides this. With sports feeling like you are there and a part of it can be closely simulated through viewing on TV, interacting with others via social media or texting, and all the other media/internet follow up.

This goes a long way to explaining the wedding-industrial complex I pondered previously.

We're on a Highway to Hell

And we're paving our way there with good intentions of course.

Incentives matter. A key hallmark of higher-level thinking is understanding this and understanding the true implications behind certain actions looking beyond the good intentions.

Partial list of cases in point:

• Anti vaping = pro cigarette smoking
• Minimum wage = worse labor conditions for low-wage workers 
• Taxing income = less work
• Taxing capital = less investment 
• Rent control = housing shortages 
• Zoning = higher real estate cost & more inequality
• Drug prohibition = large profit to smugglers and gangsters 
• Anti prostitution = pro pimp
• Industry regulation = protection for incumbent firms 
• Prohibition on organ donation compensation = more death and suffering
• Forced recycling = environmental harm

The Rational Fan: Managing Hopes and Constantly Adjusting Expectations

(I love the mirror image below the bars hinting at the symmetrical negative to any observable outcome.)

Consider the analogy of graphic equalizer meters on a old 70s-80s-era stereo--the ones that would show the recent high-point marks. I think this is a good symbol of the high-water-mark thinking that commonly clouds the judgment of sports fans. Specifically, an irrational (typical?) fan mistakes the best performance for the expected performance. The rational fan thinks in realistic terms where future expectations are influenced by past achievements but not set by them and mean reversion is always expected (eventually).

This would include updating for new information (e.g., a recent trend of wins or losses) when projecting the long-term expectation of winning. (i.e., Is recent performance simply an aberration and regression to the historic mean should be expected? Alternatively, has a new plateau been reached and future expectations must be appropriately adjusted?)

Consider also the emotional impact of a team's performance on a fan. The rational fan must contend with and accept the great irony that the more one's team wins, the more the wins tend to run together and the losses stand out, and vice versa. This is simply the law of diminishing marginal utility (not to be confused with the law of diminishing returns).

Irrational fan foresight is almost always myopic as they only see one side of what could be and probably do so in a vacuum. When an irrational fan imagines a play executed, he imagines an outcome determined by his conviction of the play’s potential success or failure. His judgment is probably additionally clouded by the play's potential excitement. If he would like to see a particular play call, he envisions a successful, if not the perfectly successful, outcome. If he disagrees with a play, he conceives of only its failure. A coach doesn’t get that luxury. Coaches should rationally weight the probability of success and the degree of success with the probability of failure and the degree of failure—what could be and how likely it is. Fans are allowed to dream, coaches are required to calculate. For coaches, magnitude matters.

So on any given play fans are liable to be deeply unsatisfied while coaches see the outcome as satisfactory toward a larger goal. But as should be expected, this is subject to error and unintended consequences. The error can be that coaches have bad incentives leading them to take less risk than they should (another example). The error can also be that fans expect too much. Back to the equalizer analogy, setting expectations on the abnormal high point causes fans to demand an unreasonable level of success. Fans can also be subject to what I would term conventional-wisdom bias--the primary source driving coaches to be overly conservative.

Also, when is a fan a true fan? Consider a convert. As opposed to religion, there is no long process filled with sacrifice and commitment culminating in a grand ceremony to becoming a team's fan. But perhaps there is such a process for becoming a "true" fan. Hence, the concept of bandwagon fans as illegitimate. It is only those who have been there through the tough times who can claim righteousness. For my teams I certainly feel this way.

Perhaps another way to look at it is that to be a true fan you have to feel physical pain when your team loses. Alternatively, you're not a team's true fan until the opponent's pain is your pleasure.

One more nostalgic image:

To UBI, or not to UBI

Alternatively titled, "I Wish I Were BIG".

An idea that has been percolating for a couple years now is a replacement of the current welfare/income transfer system with a Universal Basic Income (UBI) or Basic Income Guarantee (BIG). This idea has origins back to Milton Friedman's Negative Income Tax idea first introduced in Capitalism and Freedom back in 1962.

Watch this space. I predict this idea grows to dominate the debate especially as the unarguably unsustainable social welfare systems reach critical breaking points.

I find the idea fascinating for a number of reasons. My biases creep in all along this debate starting with its origins with Friedman. Some central considerations:

1. Is the proposal(s) simplification a feature or a bug? My bias is to always simplify all else equal.
2. Does it replace the entire welfare system (including Medicare and Social Security)? My bias is to replace it all.
3. Can we reliably replace rather than have this be a politically-captured add on to the current mess? My bias is to avoid opportunities for add on--i.e., I worry about this risk.
4. Can we trust people to make their own decisions (i.e., cash versus in-kind support)? My bias is to allow adults to be adults and not dictate their choices at least not through the government. On-the-ground private charity will undoubtedly find their mileage varies along this dimension. 
5. Should it be a very basic subsistence level of aid or a substantial amount (i.e., allow you to pursue that well-fed artist career you've always dreamed of)? My bias is to the low end.

The tension between directional versus destination libertarians is thick here. The interesting and constructive debate is fully within the directional camp (i.e., is this a long-term improvement towards the ideal?). By no means is this a first-best solution (i.e., not a destination).

Bryan Caplan is against the idea. My bias is to first assume Caplan is correct in all things he has a strong opinion on. David Henderson agrees with Caplan. The discussion between Caplan and Ed Dolan is a very thorough treatment of the topic (DEFINITELY read the whole thing). Now cue Mike Munger to start making the strong case for it. Arnold Kling was not impressed. And he makes a strong point about means-tested aid versus behavior-tested aid including where (government or private charity) the competitive advantage in each resides. 

The devil is in the details SO MUCH in this quagmire. Perhaps the most critical (and damning) question is who would be politically capable of achieving this type of a change. While I am very sympathetic to the idea, I cannot conceive of any name attached to the Congressional act that would give me any trust I could support the measure.

P.S., Sorry for all the "i.e." use.

Can't Stop The Gods From Engineering

Well, we can all breathe a sigh of relief. The momentum won't end. At least that is the story now that Oklahoma City Mayor Mick Cornett has won re-election. His main opponent, City Councilman Ed Shadid, was apparently threatening to thwart that progress. And he continues to I guess by leading an initiative drive to bring back up for a vote both the >$250,000,000 new OKC convention center and the nearly permanent 1% sales tax associated with the city's long-term MAPS projects.

I'm not here to tout Shadid. The point I wish to make is a larger one. The winner of the mayor's race, Cornett, is seen and self proclaimed as the torchbearer for what I call the Coalition to Spend Other People's Money on Bright and Shiny Things. Shadid is one of the more high-profile challengers to this the received wisdom. But let's put the politicians aside and discuss the issue at hand. That issue is simply one of two questions:

1. Should we force people through taxes to pay for things they don't seem to want?
2. Why do we have to use taxes and government spending to express the people's desire?

I believe the first question is the correct framework of the issue. The supporters of MAPS have to believe the second is. I am presuming the people don't want these things because if they did, their wanting them would be sufficient to cause someone in the market to provide them without government involvement. Conversely, the supporters presume that the people* do want these things, but are unable to express that desire through the market. Let's assume the issue is framed properly by the second question, which means the challenge to the supporters is "show me the market failure!" Which really amounts to "show me the externality!"

Here is why. We've got lots and lots and lots of evidence that the market generally works at delivering the goods (the goods people want). That puts the burden of proof firmly on those who wish to make the case for the second question. Why is the market not able to connect demand and supply in this case? Ultimately that gets to what economists call externalities--positive externalities in this case. For some reason it must be that the benefits that would come from these projects cannot be sufficiently realized by those who would be the suppliers of these projects in the free market. But is a convention center really like clean air? There are lots of private suppliers of convention centers. What makes the OKC market so unique that convention centers become a public good?

Looking back to the funding into what is today Chesapeake Arena where the OKC Thunder play, why would private investors not be rewarded enough to build and improve such a facility? A self-serving, non-peer reviewed economic impact analysis is not relevant to this question. I understand how bright and shiny bright and shiny things are. This is a question of a cost/benefit analysis--both parts of which are critical to making a good investment decision. If only someone impartial studied these things . . .

Good public policy is shaped by setting aside what emotionally feels good for what critically is in the best interest of the public. Figuring that out is hard, but it is especially hard if you never look. See beyond the seen. Until the coalition can answer the second question effectively, I have to presume that the first question is the one to ask--the answer to which seems obvious.


*There is a BIG underlying assumption here that what is in the general (majority) interest of the public is expressed through the voting process and that that interest is a desirable end to impose on all of the people. It is not hard to poke holes in this assumption. If thirty people are trying to decide on what movie to go see where they all have to see the same movie, having fifteen of them vote on the movie will leave some of the voters dissatisfied and likely will leave some of the non voters dissatisfied too.

PS. Note that I am only discussing the economic efficiency facet of this debate wholly ignoring the important ethical argument about if it is right to tax some people (largely lower income/lower wealth people who have a harder time escaping the sales tax) for the benefit of some people.