Showing posts with label tradeoffs. Show all posts
Showing posts with label tradeoffs. Show all posts

Sunday, May 15, 2022

The (False) Law of Conservation of Effort and Reward

Most people seem to think within the framework of a supposed "law of conservation of effort and reward" (LCER) and its corollary "law of conservation of happiness". One might think of these as a spin on the forever-popular and equally incorrect labor theory of value. 

The thinking goes that somehow there should always be a linear and somewhat direct trade-off between work/life balance--that is, the effort one puts into something should be proportional to what one gets out, and there should be a trade-off between the chosen path and the "obvious" alternative path that together net out. Tightly zero sum. 

People resent the very idea that someone could have it all. The working mother should have delinquent kids who don't love her; the investment banker should long for relaxing weekends and be doomed to an unfulfilling life without meaning. 

The problem with these laws is that they conflict starkly with the magical human ability to tap the power of scale and compounding. The dynamics that these forces bring separate man from nature. Animals cannot coordinate nor plan for the future nor command exponential growth in any meaningful sense the way people can. 

Therefore, it should not be any surprise that some people and organizations can get more out of less and excel along multiple dimensions. In thinking about jobs, sometimes the grass is actually almost always greener

Consider how many people look to sports stars and other icons as “great follows” in social media making them big influencers succeeding in a realm outside of their primary area of success. Many adherents to LCER dismiss this as some obviously irrational behavior on the part of those less enlightened than themselves. The truth is these influencers probably are above average in ways that impact both the direct source of their fame (say basketball skills or acting ability) as well as many other areas. IQ becomes more and more important in sports the higher and higher the level. Dumb athletes don't last long at the pro level. 

Jeff Bezos would probably be an above average gardener. The reason he doesn't mow lawns and trim bushes isn't because he wouldn't be very good at it. He might in fact be better than the people who do the job for him at his own house(s). If you think he doesn't do those jobs himself because he is rich, you're right for the wrong reasons. The reason he doesn't is because of the very real law of comparative advantage

At the same time I think that some of what makes amazing people amazing often has a dark side. This might make them a bit eccentric or frustrating or detestable. It varies and is not always the case. This might sound like a contradiction, but I don’t think so. Rather it is part of the complexity and mystery of it all—what distinguishes elites. This is very much in agreement with point #6 here

Arnold Kling makes related points calling this the "convergence assumption":
What I call the convergence assumption is the assumption that everyone is fundamentally the same, so that it is more natural to expect people to develop the same skills and adopt the same values than for divergence to persist.
... 
We are not all the same. This makes moral issues very complicated. When we acknowledge genetic and cultural differences, what is the meaning of equality? When should we suppress differences and when should we accommodate them?
I think that the great appeal of the convergence assumption is that it allows us to avoid the challenge and complexity posed by these problems. But avoiding complexity is not a good approach if the complexity is an important characteristic of the environment.

Exceptional people are generally and not just specifically exceptional. How this maps onto agreement with you will vary along dimensions of morality as well as taste among others. Those differences are not tradeoffs they are making such that in some cosmic justice sense you and they are on equal footing when all is balanced out.  



Saturday, February 19, 2022

Rather Sorry Than Safe



When friends who are interested in "prepping" ask me about planning for doomsday scenarios, I love the looks on their faces when I reply, "I'm planning on being one of the attacking barbarians ravaging the countryside. Thanks for telling me about your hideout." 

Let's consider the perspective of a prepper in regards to prepping for financial disaster. There are always reasons to be fearful about the future, and it doesn't take too much imagination to spin these true risks into worry of cataclysm. As I write, worries about the COVID-19 pandemic are gradually fading only to be replaced by concern of war with Russia vis-à-vis Ukraine.* 

If you don't have a back-up plan, you are naively gallivanting about while the asteroid circles the planet. Yet if you always hunker down in the bomb shelter, you are letting your fears prevent you from enjoying life. Risk inconsistency can be worse than consistent, willful exposure to high risk. If you are prepared for and understand that actions you are taking are likely risking bankruptcy for the chance to strike it rich and possibly very rich, then the risk you are taking may very well be prudent and necessary. Extremely few entrepreneurial efforts with appropriate upside potential do not inherently contain that kind of downside risk. But if you are running a decent risk of bankruptcy just through your spending patterns and arbitrary investment decisions, you are likely not getting enough reward for the risk. In a more technical sense you are not matching potential return with the level of risk. 

Return is the expected compensation for risk taken. It is not guaranteed nor predetermined. A lot can get in the way and almost always it is a spectrum of potential returns (some of them low if not negative) that result in the expected return. Sometimes we qualify return compensation in terms of a required rate of return. Required can really be thought of as minimum acceptable expected return. In highly efficient markets this required return becomes equal to the expected return as any potential return above this required level gets competed away.

Successful decision making in life as with successful investing is not about avoiding risk or taking risk. It is about understanding and managing the many varied risks one is exposed to while getting the proper potential compensations. 

We simply cannot predict the future nor can we entirely remove our exposure to it as good and bad as it will be. Well, I guess there is one way, but if that is your solution, this post isn't for you at all. For those of us who want to go prudently into that good night, remember the old adage:

Don't try to hedge the end of the world. It's only gonna happen once, and regardless of what you do, it won't work out too well for you.



*Calvin: You're sure?

Adam: Positive. The Soviet Union collapsed without a shot being fired. The Cold War is over.

Calvin: That's what everybody believes?

Adam: Yes, sir. It's true.

Calvin: What? Did the Politburo just one day say, "We give up?"

Adam: Yes. That's kind of how it was.

Calvin: Uh-huh.

Calvin: My gosh, those Commies are brilliant! You've got to hand it to 'em! "No, we didn't drop any bombs! Oh yes, our evil empire has collapsed! Poor, poor us!" I bet they've even asked the West for aid! Right?

Adam: Uh, I think they have.

Calvin: Hah! Those cagey rascals! Those sly dissemblers! Those, uh... They've finally pulled the wool over everybody's eyes!

--"Blast From The Past" via IMDB

Monday, May 17, 2021

Two Methods of Improvement

Let's compare two general methods of improvement: 
  1. Truncating the left tail so as to eliminate the undesired portion of the distribution
  2. Increasing the distribution so as to grow (fatten) the right tail and therefore increase the desired portion of the distribution. 


Both methods have the effect of shifting the mean rightward. But the first is artificial.

Let's explore the first method. People paid primarily for their looks are an example of truncating the left tail. (One might be tempted to say “supermodels”, but that is a particular, specialized subclass of this universe. It is like saying basketball players when we are actually talking about athletes.) They exist within a distribution of attractiveness (subjectively considered as that is the only way) that simply has lopped off most or all of the left side. Some are gorgeous to you; others are gorgeous to me. Some are not so attractive to you while others, perhaps ones you really like, are not so attractive to me. Anyone in particular within this group might be just okay to any random observer. Taking everyone's opinions together as a whole, though, on average gives us an ordered distribution [similar to the theoretical and problematic Keynesian Beauty Contest]. 

When considered from the average observer’s viewpoint, the only thing missing in the distribution are all those who would be below some threshold. In other words the “lowest” (most left) person paid for looks is just an average looking person compared to all of humanity. Because we can’t manufacture attractive people yet, we are forced to use the truncate strategy. 



So the only way to bring about beauty improvement is by leaving out those who are less than some level of beauty (I used eliminated everyone below the average beauty score in the example). So we can get there, but it is artificial--we just left out the less than "beautiful", whatever that actually means in this hypothetical.

Now think about wealth. How do you increase average societal wealth? This is problem from a different realm because unlike beauty where we are currently limited to some degree of diet control, physical fitness training, and plastic surgery we can move wealth around. 

In the case of wealth what is the better path: Minimizing the impact of bad ideas (truncating the left tail via redistribution) or increasing the rewards for good ideas (fattening the right tail)? 

Bailing out bad ideas has moral hazard risks--we are subsidizing bad ideas. When you subsidize something, you get more of it. Taken to the extreme income redistribution is not sustainable. The system collapses in on itself through actual complete resignation (a dead-end Nash equilibrium) or deliberate exit (John Galt). Because of this, we are forced to use the grow the distribution strategy. 


Notice how this distribution is truncated and non normal (there is a minimum at 70 and the distribution has a right skew). No one is below some level of actual wealth (even debtors and prisoners get a meal and a place to sleep). So in some sense I am assuming some of the first strategy--a social safety net of some kind. I wanted to make it more realistically skewed, but time didn't permit. However, we should be careful how easily we succumb to the notion that there are people with true wealth at the far, far reaches of the distribution. Just how rich is Jeff Bezos compared to you or me really, seriously

Growing the distribution has a side benefit of minimizing the impact of bad ideas--a kind of resistance to bad ideas having meaningful, lasting impact. Subsequently the opportunities for good ideas are increased since this method is positive sum (it grows the pie) while the former strategy is zero sum and eventually negative sum if taken too far.

Am I assuming too much? I really don't think so. 

Unfortunately, advocacy for method two is unpopular because of social desirability bias. People don't want to admit that they want the rich to get richer. Or worse yet, they think letting the rich get richer somehow makes us all worse off. 

Sunday, May 16, 2021

Dynamic versus Static Investments

One way to categorize investments would be dynamic assets like stocks and bonds and static assets like commodities and art. 

Investment taxonomy is multidimensional. Along one dimension would be concentration/dispersion diversification. For example owning stock in one company alone as compared to several companies within the same industry as compared to several companies among different industries. Still a greater level of diversification can be achieved as an investment portfolio approaches a share in all companies (e.g., broad-market index funds).

Along another dimension would be type of return claim. A stock investor has a residual claim to the profits that remain after all other claims have been satisfied. That is after all creditors have been paid--all liabilities have been settled. A bond investor (lender/creditor) has a primary claim putting them somewhere higher up the priority list. Keep in mind there are various levels for various types of debt issued. 

Along another dimension would be whether the investment generates cash flows or is dependent upon perpetual new buyers at higher prices for its rate of return. Consider my prior partial list and the explanation behind the distinction

Still another dimension would be how dynamic are the assets one is investing in. Can the asset maintain or gain value in a changing world? This is where I would like to focus today.

In my thinking dynamic assets are essentially investments in ideas with potential cash flows. Static assets are essentially investments in inputs (costs) where the market is continually working against you and high-risk speculations on future tastes and technologies (future desirability & greater fool theory rolled into one speculative bet). 

With static assets you can be right and still be wrong. The opposite is true of dynamic assets to some degree as businesses can change direction

Since static assets have a locked-in nature, they should command a risk premium. Indeed they do but it isn't necessarily sufficient compensation for the added risk of loss they offer. 

The general case is that the more dynamic an asset is the lower its experienced volatility and thus the lower its expected return. But there is more to this story. Volatility is a cruel mistress. It can rob an investor by impairing capital because of the pattern of returns--negative or even just low returns at the beginning of an investment horizon while cash is being pulled out can leave the principle so low that eventual recovery is not possible. Therefore, a static asset with high volatility and high expected return might experience high (negative) volatility, prices going down rapidly, at just the wrong time, early in the investment horizon. Dynamic assets can be the slow and steady that wins the race. 

Volatility's cruelty doesn't end there. It can collapse and vanish as well, but this leaves investors with low expected returns. A static investor needs volatility to justify future returns. 

One should not assume I am saying that one is preferred necessarily to the other. Rather this is one exploration into how assets can be categorized and how to think about investments. Assets along this spectrum fulfill differing objectives with differing opportunity/risk characters. Investing is about tradeoffs.

Consider this stylized linear example: 



Forever people have been trying to eliminate oil: first they were doing so because it was nothing but a nuisance, next they we're doing so because it was getting more and more expensive as more and more of the world's machines ran on it where the solution was to find more and more of it and produce it cheaper and cheaper, and now substitutes are becoming a better and better option. 

To bet on a technology one needs to be compensated for risk with commensurate returns, and because the chance of a given technology profitably working is incredibly small, those need to be exceptionally high potential returns. In that case don’t own oil; own mineral rights. Don’t own proven reserves; own unproven reserves. Don’t own production; own potential production. 

Oil was to the 1920s what cryptocurrency assets might be to the 2020s. Bitcoin, Ethereum, and all other crypto assets are bets on a particular strategy within a particular technology.  So invest with care. These are highly speculative and certainly very static within my classification. Do not mistake the dynamic ability of people and firms with ideas and fluidity to be attributes of the underlying crypto technologies these people and firms may be employing. 

One last example: Diversified real estate is a dynamic asset while concentrated real estate is static. Similarly investment in the rights to a franchise within a geographical area is more dynamic than is the franchise location itself and even more so than the specific land the franchise sits upon. To this end see the picture below and keep looking until you see it:



Wednesday, May 5, 2021

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. 

Sunday, May 2, 2021

Zoning Laws Suffer From The Fixed Window Fallacy

The Fixed Window Fallacy is an error in reasoning whereby people believe they know or can know what is nice/preferred/optimal. This line of thought is based on unimaginative, linear-thinking and further held back by the Local Maximum Problem

It can be summarized as a thought process that goes: "We know what is best. We/they can afford what is desired (after all, it is usually for our/their own good). Therefore, we should make ourselves/them provide it." 

Both premises are false, and the conclusion is fallacious (non sequitur) as it ignores the critical questions: do we have a right to do this, and can we successfully do this? 
The only constant is change, and it comes in two types. 
  1. Depreciation, which is the natural condition, difficult to counter, and mostly objective.
  2. Appreciation, which is the abnormal condition, difficult to achieve, and highly subjective. 
Attempts to stop depreciation such as zoning laws are never done in a vacuum. They are not single events where good replaces bad, and we move on to the next decision. They are part of economic evolution where decisions made affect trend trajectories with uncertain net outcomes and unpredictable magnitudes. 

Similarly collective action attempts to realize appreciation such as subsidizes for development and master plans are fraught with captured interest risk bringing asymmetric outcomes adverse to the presumed collective goal. In other words the rent-seeking developers and their friends in power do what is good for them and costly for society. For those cases where everyone has the best of intentions, we still have the knowledge problem. When artificial outcomes are engineered by those who do not bear the full risk, bad ideas do not get properly punished and good ideas do not get properly rewarded. 

Back to zoning, trying to stop people from doing things they want to do is prohibition. People and markets work to thwart prohibitions in proportion to how much they desire that which is prohibited. The less morally sound the prohibition, the less compliant are those working against it and those third parties who have no dog in the fight. Fortunately the long-term trend is for less and less prohibition. Unfortunately working against a prohibition is costly as is the administration of a prohibition. 

Whether it is in icky markets (e.g., sex work, recreational drugs deemed illicit, kidney transplants, etc.) or in we-know-better markets (e.g., zoning), an underlying force supporting the prohibition is not in my backyard thinking. In fact I believe NIMBY is the last vestige of prohibition rationalization.