Tuesday, June 12, 2018

Review of Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets by Nassim Nicholas Taleb

Taleb's Fooled by Randomness from 2004 was his first popular book and is least self-indulgent of the four. (The first book was Dynamic Hedging.) Of course, it is still pretty self-indulgent as that is his big weakness. See the Falkenstein critique of Taleb's work, but also Taleb's amusing reply.

As Taleb says, risk takers are often the victims of delusions leading to overoptimism and overconfidence thanks to systematic underestimation of possible adverse outcomes. (Previously on overconfidence: 1, 2.) Right now venture capital, banks, and growth stock investing are all absolutely flush with "lucky idiot" risk takers. You can read an excellent example of this is in Bad Blood, the new book about Theranos (review forthcoming). These lucky idiots probably think that their current success validates their personal models of the world, but the world will change at some point to an environment for which they are no longer adapted.

Taleb writes, "trading forces people to think hard; those who merely work hard generally lose their focus and intellectual energy. In addition, they end up drowning in randomness; work ethics draw people to focus on noise rather than the signal." 

Thus, few people can tolerate option buying (being long volatility). Options selling is steady like "work," the kind that Type A people who go from Ivy League athlete to investment bank are used to and comfortable with. Not being able to sit still is the key weakness of those types of people.

You can't really "blow up" being long volatility, but you can gradually bleed profits and assets under management. The Type A people feel huge pressure to show steady progress so they gravitate towards being short volatility. We have a friend who markets hedge funds and who was selling a "volatility trading" fund last year. It had been making steady returns in this falling volatility environment, so we knew it had to be either a fraud or else just short volatility. In February 2018 when volatility spiked, it blew up and shut down.

By the way, something that is dangerous about being long volatility is that successes and failures have an effect on neurochemistry, and to some extent these changes can result in self-reinforcing positive feedback loops. The positive reinforcement that the volatility sellers get on a daily basis more than compensates for the pain of periodically losing massive sums of the other people's money that they are managing. (Also, these people have an implicit cartel agreement to do the same trades so they can be held blameless and rehired when they blow up.) But the answer to this is not to change your investment strategy. Nor should it be to own overpriced real estate assets that are psychologically easier because they do not get marked to market. Instead, I think the answer in bubbles is to be "lazier" and look at the market less. In one of the Tim Ferriss books he writes about the importance of not being a Dow Joneser and to engage in an activity like weightlifting where one can experience steady progress.

Another thought after reading Fooled by Randomness is that if you are rich the most important thing is to stay that way. The portfolios of rich people (like Mr UWS who is crammed with overpriced tech right now) make no sense given the diminishing marginal utility of wealth and also prospect theory which would indicate that losing half their of their wealth will hurt them much, much more than doubling it would help them.

My conclusion from rereading Fooled By Randomness and also James Grant's compilation of essays from the first two bubbles is still that we are in our third bubble in twenty years. The central bank has been engineering these bubbles so that the government does not lose its mandate of heaven.

The alternative to my bubble hypothesis is to believe that profit margins are permanently elevated and interest rates are going to remain permanently low, yet also somehow believe that this will not result in the elevated profit margins being bid away by entrepreneurs armed with cheap capital. (Actually, we know from repeated experience that investors assign high P/Es to high earnings and low P/Es to low earnings, and that this is the great driver of market volatility. This is also documented in Shiller's research that market prices are much more volatile than the fundamentals they are supposed to reflect.)

There are two possible scenarios that I can see:

(A) Earnings multiples have become permanently elevated due to an increase in the supply of capital. (This implies that capital has been accumulating; not being dissipated through consumption and in malinvestments. But we should also notice some clues that society has been living off of capital. Under-investing in infrastructure, doing things to hide costs like pensions where assumed return on investment is implausible.) And also, profit margins have become permanently elevated and will no longer experience sizable periodic fluctuations. (Coincidentally at the same time as the cheap capital has become available, even though one might have expected the cheap capital to result in more competitive entrants bidding away the high profit margins.)

(B) This is just another mania, bull market, or bubble and the arguments regarding the above are special pleading and/or motivated reasoning by people who are forced participants in Investing Musical Chairs. This includes the lazy/lucky rich and the type A people who are not comfortable doing nothing or who would not be allowed to do nothing by their clients.

Then there is the payoff table for actions based on your decision of A vs B and the true outcome:

1. Decide A, actually A: You begin collecting 3% earnings yield on S&P 500 immediately. This is only a handful of basis points above the yield on 30 year treasuries which actually have a shorter duration. As a bull, you would be expecting that the earnings yield would grow at some rate for a higher actual total return.

2. Decide A, actually B: Massive capital impairment, possibly permanent, at the end of this cycle.

3. Decide B, actually A: You make the treasury bill yield (i.e. half of the S&P earnings yield now, but rising), and the opportunity cost is about 1.5% annually in foregone earnings until you realize you were wrong.

4. Decide B, actually B: You have a chance to make money off of the bear market and then buy investments from totally shell-shocked bulls who will really doubt themselves after being fooled three times in 20-25 years.

Because combination #3 is not that bad and combination #1 is not that great (and combination #2 is a disaster) I think it makes sense to decide B and wait for more data to come in. Again, because the two elements of A are logically inconsistent, and because the delusion that the combination is occurring has happened at the top of every market cycle, I think it is rational to give A a low probability of being true.

One other thing to consider is that if A is correct, we are in totally uncharted investment territory. All of our understanding that comes from personal experience and study of economic history would be obsolete.
     
But in fact we can already see two things that are reducing profit margins: rising labor costs and rising interest rates. For example, U.S. nonfinancial corporations have $6 trillion of debt outstanding. An extra 2% in the five year yield is a $120 billion annual hit to profits for a set of companies would have about $1 trillion of combined profit. The labor cost would probably be a bigger factor, back of the envelope. Total wages are something like $8 trillion and year over year they were growing at a 2.9% rate.

Some thoughts about how to play this. People think it is almost impossible that interest rates could rise a lot or that "quality" companies could fall in value a lot. Put options on indexes seem mispriced. Think NASDAQ or consumer staples which are priced like bonds and have two ways to lose. There could be a big air pocket if index funds collectively become sellers (which is automatic if they have net outflows) and the marginal bid is value investors. Also put options on the 3x leveraged vehicles and on short volatility vehicles. Puts on unprofitable companies with debt.

P.S. Remember from 2010: Nassim Taleb is Hilarious But I Disagree With Him About Treasuries.

1 comment:

eahilf said...

I certainly often feel I have a lot of bad luck.