Last week’s article was about how the world is now increasingly driven by extreme outcomes. While this obviously generally increases the need to diversify, it will also produce a wealth of asymmetrical opportunities.
“Being A Pig”
[8 minute read]
“Fatter Tails Mean Fatter Pitches”
Stan Druckenmiller’s “Lost Tree Club” speech is a wealth of contrarian insights on how to bet big when the time is right.
“The first thing I heard when I got in the business, not from my mentor, was bulls make money, bears make money, and pigs get slaughtered…. I’m here to tell you I was a pig. And strongly believe the only way to make long-term returns in our business that are superior is by being a pig. I think diversification and all the stuff they’re teaching at business school today is probably the most misguided concept everywhere.”
His speech also contains one of my all-time-favorite anecdotes in finance. Druckenmiller describes walking into George Soros’ office and suggesting that they put 100% of their entire fund into a single trade shorting the British Pound.
“And as I’m talking, he starts wincing like what is wrong with this kid and I think he’s about to blow away my thesis and he says, “That is the most ridiculous use of money management I ever heard, what you described is an incredible one-way bet. We should have 200 percent of our net worth in this trade, not 100 percent. Do you know how often something like this comes around?”’
This kind of risk concentration is obviously questionable investment advice. We’ve all just been ringside for one of the biggest blow-ups of a highly concentrated, leveraged portfolio in financial history! But it still illustrates an interesting point. Soros’ philosophy was generally a mix of capital preservation and home runs.
Anyone who gets fabulously wealthy from home-run swinging alone might just represent the right-tail of survivorship bias. There are a great many ruined geniuses who took risky, concentrated bets and lost. We just don’t hear about them as much. There are even more one-hit-wonders who had a single huge public win then never replicated their success.
But this doesn’t invalidate the thesis that you should bet bigger when you’ve achieved something closer to certainty. And be appropriately diversified the rest of the time. It’s the crucial difference between getting your predictions right and calculating your payoffs correctly.
This has never been more relevant. The world is now increasingly driven by the tails. The COVID-19 crisis has again laid bare the now unfathomable degree of global complexity and interdependence. The larger the network gets, the more returns will be clustered in the extremes. Digitization plus globalization has made the world increasingly winner-takes-all. I’m really not sure everyone has already worked this out and fully priced it in. I’m not sure it can ever be priced in. Bill Ackman famously hit a generational home run early in the pandemic when he paid $27 million per month in credit default swap insurance and cashed out at a gain of $2.6 billion after the very first month.
The true ‘fat pitch’ opportunity often results from when this tail-driven world is priced like a normal distribution. Nassim Taleb calls this Mediocristan vs Extremistan. The most dangerous person is an inhabitant of volatile, real-world Extremistan who thinks he lives in stable, abstract-model Mediocristan. As a reminder from last week, this is what it looks like graphically (in the case of European companies pre-and-post globalization):
Source: Assessing Competitiveness: How Firm-Level Data Can Help, Carlo Altomonte, Giorgio Barba Navaretti, Filippo di Mauro, and Gianmarco Ottaviano
In 2009, Felix Salmon wrote a seminal article on the failure of this approach titled “The Formula That Killed Wall Street.” He describes how a single mathematical formula, the Gaussian Copula, was misapplied to the pricing of housing derivatives. It effectively allowed gargantuan packages of securities to be determined as essentially riskless. Salmon argued that the quants may have been able to spot the shortcomings of the model, but the asset allocation decisions were largely being made by their more innumerate managers.
Determining the difference between Mediocristan and Extremistan requires getting accurate “ground truth.” As portrayed in The Big Short, Steve Eisman personally travelled to Florida, California, Nevada, and Arizona to get a startlingly different picture to what was being presented to investors.
As the new global network flows and pulses, things that are too rigid will get broken by its turbulence. Just as a volatile British Pound was trapped in a rigid European exchange rate mechanism. Until it wasn’t. Meanwhile leverageable digital business models often benefit from the disruption. That’s how you get a video conferencing company being worth more than the combined value of the world’s seven largest airlines in May of last year. We are learning the same hard lessons with supply chains right now. Rigid physical vs flexible digital. I regularly ask myself whether traditional “value” companies can ever successfully span the global network.
Taleb has popularized the term antifragile to describe things that gain from chaos. To be honest, it’s a clever concept, but I’ve never been sure how to actually translate it into actionable investment vehicles. Too many tail-risk strategies just bleed premiums over time.
It’s a bit abstract and philosophical (me?!), but fascinating civilizational design expert (yes, that’s a thing) Daniel Schmachtenberger makes a rather profound point about antifragility.
“If I burn a forest it will regenerate itself, if I cut my body it will heal itself. If I damage my laptop it won’t heal itself. Humans take the antifragility of the natural world and turn it into fragile stuff. We turn it into simple and complicated stuff. So we turn a tree, that’s antifragile and complex, into a two-by-four that is simple; or a house that is complicated; but both are fragile. We have complicated systems subsume the complex systems, so we’re creating an increasingly higher fragility-to-antifragility ratio. We’re trying to run exponentially more energy through an exponentially more fragile system.”
His metaphor is even more appropriate in the context of the current demand surge in the physical lumber market. Prices are skyrocketing- and yet it still takes 80 years for a usable tree to grow.
Complex things are adaptable, complicated things are not. A jet engine is complicated, a thunderstorm is complex. Centrally-planned, top-down communist economies couldn’t adapt fast enough to changing circumstances. There are no straight lines in nature. It’s helpful to understand that so much policy now is effectively a volatility dampener. Fiscal and monetary stimulus is trying to smooth out these sudden energy surges through an increasingly fragile system. But risk can never be removed, it can only be transferred somewhere else.
Having gone down the blockchain rabbit hole for a while (see my recent primer), the promise of that technology is that it’s a natural evolution of this trend. Web 2.0 became dominated by huge platforms that centralized power by spanning the new global network. The most optimistic view is that blockchain can disrupt that centralization by providing an even more “antifragile” distributed network that disintermediates middlemen. [Packy McCormick’s latest Not Boring Substack this week and Chris Dixon’s recent Invest Like The Best podcast are good current resources to dig deeper into the topic].
But stepping back, in this increasingly tail-driven world, there are more fat pitches for both gamblers and traders. But while gamblers can become addicted to risk, good traders try to minimize it. For investors, it actually reinforces the need for a better understanding and application of position-sizing.
- Read: The Formula That Killed Wall Street by Felix Salmon in Wired (32 minute read).
- Why read: An absolute classic from 2009. Contains all the hubris and nuance you’d expect from an explainer on the subprime debacle. But it’s more useful than that: it helps illustrate the opportunity between map and territory in finance. It’s also a cautionary tale relevant across businesses as to what can happen when managers don’t understand the maths and data being produced by the people they’ve hired….
- Read: The Man Who Broke Atlantic City in The Atlantic (30 minute read).
- Why Read: Another fun story of a whale gambler who played the casinos off of each other to even the odds.
Have an amazing weekend!
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