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. 

Desperately Seeking Alpha

Great investing is generally about taking on the right risks and being compensated properly for risks taken. It is primarily NOT about out trading other investors.  

This is a sister post to Does Active Investing Work in Theory? exploring the two types of active management: alpha seeking and risk-adjusted return matching. The former is the sexy one; for almost all of us the latter is the realistic one. 

Let's make sure when we say "alpha" we all agree on what we are talking about. The term alpha generally means some version of outperformance. Imagine two runners in a 400m race where one finishes half a second ahead of the other. The faster finisher could be said to have .5 seconds of alpha over the opponent. But that is a bit too simplistic. In investing we usually want to know if any apparent outperformance is actually truly outperformance once we consider any inherent differences between competitors including adjusting for risk taken. 

In a fair race there shouldn't be inherent differences in the playing field so to speak. The runners are on the same track travelling at the same time. For investors we don't get such clean, simple comparisons. Even for our runners on an elliptical track the runner on the inside ring will have to start a bit behind the other runner so as to compensate for the less distance of the inner track lane and so the finish line can be a straight line across the track. 

What about risk taken? Pushing the analogy consider if one of the runners was using performance-enhancing drugs. This could be in one of two varieties. In one case they could be banned substances that if caught he would be disqualified. An outside gambler betting on him was taking a greater risk than perhaps he intended. In the other case they could be allowed substances but that have dangerous potential side effects. His risk now is that he runs the race (maybe winning and maybe not) and then suffers a bad health outcome. 

Back to investing, we ideally want to compare the performance of two investors isolating just the set of factors inherent in their investment "skill". I put skill in quotes because we never can be quite sure we are seeing skill or luck or that we have forgotten about an important difference we would have intended to adjust away. 

Most of the time in investing it is risk in its many forms that we want to adjust for. As an example, if I tell you I am a great investor because I have substantially outperformed my S&P 500 benchmark for the past 5 years, you might not be so impressed if I then reveal that it is because my only investment has been the single stock Apple, Inc. Sure, I outperformed in total return, but I took WAY more risk to do so. If that risk adjustment isn't made, we can't say much about this so-called outperformance.

There are other adjustments to consider like if an investor has been using inside information to facilitate his outperformance. The fact that this unethical practice might not be repeatable should make us doubt that this outperformance is replicable. At some point we would have to consider if the inside information advantage was just a different version of luck. 

Alpha seeking in active management is an attempt to outperform the competition, be it other investors or a benchmark index, adjusted for risk. How is this such a daunting task? Don't we hear about great investors all the time doing exactly this? Actually we do not. We hear about some investors' performances when they happen to be outperforming and often that is not true outperformance because they are not risk adjusted. But there is more to say about how difficult this is.

The capital markets (stocks, bonds, etc.) are very efficient markets primarily because they are very thick markets (i.e., there are lots of people participating in them). This is helped by the fact that they are very lucrative to those who perform well in them. The idea that some investors will outperform is a near certainty. The idea that that investor is you or someone you pick to follow is highly unlikely. 

Public capital markets are a ruthless machine viciously and constantly seeking to eliminate any advantage an investor may possess. The more brilliant your new method of discovering and unlocking outperformance, the more quickly and decisively the market will absorb it away from you. And in those cases where apparent persistence in outperformance exists, the more likely a hidden risk difference has yet to be understood.

For active management the sooner one gives up on alpha the happier and more financially successful one will likely be. Instead of trying to outperform adjusted for risk, try to just keep up by taking the right risks. 

A human investor's benchmark isn't a stock index or a bond index or some combination of the two. It is the realistic financial goals they are trying to achieve. These are some combination of consuming well today and being able to consume well tomorrow and for the rest of one's life. For most of us this includes more than ourselves--primarily our family and somewhat our friends and our charitable desires.

Our investment portfolios must be constructed initially and revised regularly to be appropriate for achieving these goals successfully. This is intentionally vague since it isn't something we easily know even for ourselves much less specifically for others. What we can say is that broadly diversified, low-fee investment into marketable securities should help our cause in most cases. 

Hence, the active management of financial assets that I believe desirable for most all investors is simply risk-adjusted return matching. Try to get the market's return adjusted for the risk you want and need to take. Notice two important nuances in that last sentence: the market is more than the stock market and I am framing risk not as something to avoid but rather as something to embrace appropriately. Risk negation isn't a thing. Risk tradeoff is. You are taking and will take risk. PERIOD. 

What risks to take more of and what risks to take less of is the essence of good investing. Being well diversified into low-fee index funds takes care of some of the typical risk factors like concentration risk, market risk, and credit risk, but others persist beyond that first step. In most cases one needs to also consider liquidity risk (being able to use one's financial assets when one needs to), inflation risk (maintaining purchasing power), wipe-out risk (losing so much one is permanently set back to a lower standard of living or truly financially wiped out), bad-discipline risk (letting emotion drive decisions that thwart the long-term plan; this could be the more obvious bailing out at the worst possible moment but also the less obvious overexposure due to complacency or exuberance), and mismatch risk (having an investment portfolio poorly constructed to fit with an investor's specific investment horizon and objectives). These risks push in different directions at different times and with different magnitudes. Active management is a fluid process of balancing and rebalancing risk tradeoffs.

Successful active management is difficult enough before attempting to then add alpha to the objective set. Notice also that attempts at alpha generation might certainly interfere both intentionally and unintentionally with risk management since taking on different risk profiles is both a means and an effect of reaching for alpha.

Leave it up to the professionals to try to generate alpha. You are too smart to lose money they way they do. 

P.S. Related: How Active is Your Passive? - The Big Picture (ritholtz.com)

The Party's Over

The Republican Party is facing an existential crisis. It is at a point where it must decide as an organization if it is going to continue to be a personality cult devoid of ideas and completely unable and unwilling to provide potential solutions to problems. 

The Democratic Party is facing an existential crisis of its own. It must decide as an organization if it is going to continue to be an elitist cabal that refuses to engage in anything but gesture politics. Interestingly the Democratic Party just emerged from or narrowly avoided becoming its own personality cult during the years of Obama. But the next iteration of the party was a substantial backward step rather than a major mistake averted. 

The Republicans basically do not have ideas. The Democrats basically have only bad ideas. I’m not sure which is worse, and I am equally unsure about which one can right its listing ship both of which are at risk of completely capsizing.

If there is any salience to my Five Tribes of Politics theory, then perhaps that can shine some light on where things go next. 

To recall, I think there are five key factions that in order to be electorally successful the major parties must appeal to. They are:

• Crony Capitalists
• Labor
• Patriots
• Evangelicals
• Woke Champions

Balance is important as too much appeal to any one group can alienate the others making a strong coalition of resistance. 

The Republicans are about to get what they supposedly were asking for with abortion pleasing evangelicals. While this enrages woke champions, that is not a group the Republicans have any interest in appealing to. However, like the dog that caught the car, evangelicals might be done with the strategy of "using Trump to get the courts". At the same time the extent of strictness of some state's abortion laws might turn away others who find the developments a bridge too far.

More problematic for the personality cult would be the shifting ground on geopolitical tensions. Praise for Putin doesn't look so hot to patriots these days, and both labor and crony capitalists have reasons to see a strong, engaged American military as a benefit. 

But for Democrats the footing isn't any better. So many parts of the woke agenda eventually conflict with the real-world aims of labor and crony capitalists. Patriots too tend to lean toward an America-first policy world. At some point you cannot keep convincing these factions that what you "really, really mean to say is [thing that benefits them most truly]". 

A very big part of what the parties are grappling with is the same phenomenon that is reshaping so much of society and institutions--namely, disintermediation in all its gory and wonderful forms. America's two-party system has been remarkably enduring. Perhaps this was a function of America spending over 100 years fighting obvious enemies with the parties arguing about whose ideas were best suited to bring a better world. 

These enemies included economic collapse just as the industrial revolution hit its stride (i.e., the Great Depression), tyrannical kingdoms hell bent on world domination (i.e., the axis powers of WWII followed by the USSR; the hottest of wars and the Cold War), domestic unrest as people no longer tolerated various inequalities (i.e., the civil rights and women's liberation movements; note these virtuous developments were "enemies" in that they threatened the order of things--they were enemies of the regime), and threats to American hegemony (i.e., economic globalization and terrorism). 

All of these were ironically existential threats to the United States. All of them called for solutions ranging from combat to embracement. Big parties were an efficient means of fighting these battles. That era may have ended. Economies of scale have limits and one of the virtues of specialization is that bespoke eventually outcompetes commodification. 

What I'm Worried About as a Crypto Investor

Much like throwing a pass in football, there are three general outcomes from crypto investing, and two of them are bad. Namely, aside from maintaining or increasing in value, crypto assets like Bitcoin and Ethereum could become nearly valueless to an investor in two distinct ways. They could go bust or they could fail to reward investors even though they prove valuable to society in general. 

I consider these two bad outcomes distinct since they are so different in every manner except for the ultimate experience for investors. In the one case we have the conjecture that cryptocurrencies are vaporware that are just riding a greater-fool wave that will ultimately come crashing down. Label this one the "worthless" scenario.

In the other case we have the concern that even though crypto and its inseparable blockchain technology are godsends, there is no way to actually profit from their benefits directly. Label this one the "unable-to-capture-worth" scenario. 

Which one you subscribe to or concern yourself with says a lot about your crypto demeanor. For me the second concern is what keeps me up at night. I am a modest investor and a big, enthusiastic supporter. I want it to win and for me to win with it. 

Others are rooting for it to lose because they don't believe or don't want to believe in it or maybe some of both. For these doubters there is often a FOMO element that partially drives the want for crypto's demise. But in many cases these are thoughtful people making intelligent arguments against.

While the case against crypto isn't completely empty, I believe the clock is running out on that perspective. As crypto assets continue to establish themselves now more than a decade into their existence, this view looks more and more like a trivial dismissal similar to thinking the Internet would not amount to much beyond a step up from a fax machine.

Much more likely is that if crypto investors are left holding the bag the value has melted away from investors flowing to the benefit of all of society in general. Tyler Cowen made this case recently in his Bloomberg column:

So you can be bullish on crypto’s future without being bullish on current crypto prices. For a simple analogy, Spotify and YouTube have greatly expanded music’s reach, but overall the price of recorded music has fallen, and many performers earn much less than did their peers in the LP era. Or consider the agriculture sector, defined broadly: It has done very well over the last few centuries, but food prices have fallen rather than risen, due to higher output and greater competition.

I consider the unable-to-capture-worth scenario the serious, thoughtful worry. There are many ways this almost certainly will be true if crypto pans out for the long haul. You can make a great living as a bathroom remodeler or a plumber, but you aren't coming anywhere close to capturing all the value to consumers of indoor plumbing. 

If crypto investing fails, I think it will fail despite succeeding as a technology rather than because of it failing to ever deliver.

 

P.S. I take it as a very positive sign for crypto assets that the serious ones (Bitcoin, Ethereum, etc.) are becoming more and more correlated with the performance of "real" financial assets like stocks and bonds. It is an unfortunate economic fact that assets tend to become more highly correlated together as they mature making investing more difficult as some of the benefits of diversification erode.

Partial List of Best Last Meals

Perhaps which one you choose says a lot about you. Perhaps what I list and the order I choose says a lot about me. 

• Holy Eucharist 
• bread and water
• Nic’s burger and fries
• The French Laundry
• one hour at the Las Vegas buffet of your choice
• Nathan's Hot Dog Eating Contest
• liver with some fava beans and a nice Chianti

I leave it up to the reader to consider why it is your last meal; be it choice (yours or someone else's) or unexpected circumstance.

Advice to a Recent Graduate (and everyone else too)

As it is currently graduation season, I was recently asked on-the-spot to provide some advice to a recent graduate. Below is what I came up with. I think it is decent advice for all of us at all stages of life's graduations.

1. Take in lots of diverse information.
2. Be willing to change your mind.
3. Gracefully stand up for what you believe in.

WWCF: War of the Future

Which will come first?

Intentional detonation of a nuclear weapon as an act of war

or

A battle with robots fighting robots as the dominant form of combat

Terms:

The basic terms are fairly straightforward in the first case--a nuke blows up on purpose designed to hurt targeted victims. But I guess there could be some ambiguity like if a bomb detonation is attempted but somehow fails or is thwarted or if it melts down rather than properly explodes. In the interest of specificity I will stipulate that the device must be truly an intentional nuclear explosion. 

In the second case there would seem to be a lot of room for interpretation. Let us stipulate that it would need to be a significant engagement with at least a potentially meaningful affect on a larger conflict if not be the entire war by itself. This must be a major conflict in terms of world events. It must involve at least one nation state with the opponent being at least a major aggressor (significant terrorist group, etc. if not a state-level actor itself). To be robot-on-robot it must mean that humans cannot be directly targeted in the robot versus robot fighting--collateral damage notwithstanding as well as other human involvement/risk as a secondary part of the combat. I will allow that the devices doing the fighting can be "dumb" devices like drones fully controlled by humans remotely, but extra credit to the degree these are autonomous entities.

Discussion:

Tyler Cowen has been thinking a lot about nuclear war and nuclear device detonation recently including before the Russian invasion of Ukraine. His latest Bloomberg piece discusses just how thinkable the "unthinkable" has become. This is a bigger part of a much needed rethinking of MAD. 

Tyler's partner at Marginal Revolution, Alex Tabarrok, is in the game contributing this overview of the related probabilities. 

Thankfully, Max Roser has done the math for us. Relatedly, he argues that "reducing the risk of nuclear war should be a key concern of our generation". Before we get too excited about a white-flash end to civilization, consider as gentle pushback this piece arguing that nuclear weapons are likely not as destructive as we commonly believe--make no mistake, they are still really bad.*

If Roser is roughly correct, then within a decade we are at a 10% chance of nuclear war. I am not sure if his "nuclear war" would be a equal to or a different level of what would qualify in this WWCF. Suppose it is a higher threshold. Let's make the probability of nuclear weapon use as defined here slightly higher each year such that there is a 20% chance within 10 years (basically equal to his 2% annual risk curve). This gives us a baseline for comparison.

Turning to Rock 'Em Sock 'Em Robots it is not as farfetched as I think most people believe. In fact we may be quite close to it as defensive weapons like Israel's Iron Dome prepare to confront adversaries like drones and Saudi Arabia battles against drone counter attacks from Yemen. As Noah Smith writes, "the future of war is bizarre and terrifying".

It does sound terrifying in one reading, but in another there is a glimmer of hope. A proxy war using robots to settle disputes could be vastly better than any conflict humanity as known before. Imagine a world where the idea that a human would be actually physically harmed from combat was unthinkable. This is not too many steps away from professional armies, rules of engagement, and norms, laws, and treaties against harming civilians, et al.**

Back to the issue at hand, once we consider that dumb, remotely driven/released weapons might soon be battling smart, sophisticated devices with either of these being on defense from the other, we quickly relax how hard it is to foresee it all happening. The hardest hurdle might only be if the conflict big enough to qualify.

My Prediction:

I think nuclear risk is a lumpy, non-normal risk that follows a random walk (i.e., it can all of a sudden get a lot more likely but that likelihood can get absorbed away if conditions improve). It is not as linear and cumulative as Roser suggests. At the same time play the game long enough and anything will happen.

Robot battles seem more like a cumulative progression, an inevitability. We almost cannot escape it eventually happening and probably soon. So, this comes down to how likely a nuclear pop is in the very near term as it tries to out race the tortoise of robot warfare. Just like in the fable, the turtle is going to win.***

I'll put it at 75% confidence that we see this one resolved robot fights robot.

*Of course other future potential weapons that are not nuclear can be extremely scary too--"Rods from God" doesn't just sound very ominous; it truly is. 

**Then again, maybe not:

As a result, conflicts involving AI complements are likely to unfold very differently than visions of AI substitution would suggest. Rather than rapid robotic wars and decisive shifts in military power, AI-enabled conflict will likely involve significant uncertainty, organizational friction, and chronic controversy. Greater military reliance on AI will therefore make the human element in war even more important, not less.

***I know they aren't the same thing! 

P.S. When I first conceived of this WWCF, I thought I'd be comparing robot wars to lasers as prolific, dominant weapons. I changed it as laser weaponry seemed to be consistently failing to launch. However, great strides have been made recently in this realm. Perhaps I was too hasty. However, thinking about it more I would guess that robot war will go hand in hand with laser weaponry. The development of one spurs the development of the other such that there isn't much room for a WWCF.

P.P.S. The ultimate tie would be an AI launches a preemptive nuclear strike on a rival nation's AI or other robot weaponry. Let's hope if they do this the battle is on Mars.