The Dao of Capital

  • “The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy.” Hazlet
  • “You have to love to lose money and hate to make money to be successful” Klopp
  • Far better to avoid direct, head-on competition and instead, pursue the roundabout path toward an intermediate step that leads to an eventual position of advantage
  • Natural systems – from forests to markets – continuously seek balance.
  • Mises on the evenly rotating economy:
    • “The same market transactions are repeated again and again. The goods of the higher orders pass in the same quantities through the same stages of processing until ultimately the produced consumers’ goods come into the hands of the consumers and are consumed. No changes in the market data occur. Today does not differ from yesterday and tomorrow will not differ from today…Therefore prices–commonly called static or equilibrium prices–remain constant too.”
    • Here there are no pure profits; rather, everyone earns the same rate of return from investing in marginal land that they could get if they bought a bond.
  • Austrian investing takes a roundabout path to market success by pursuing immediate loss during the investment process so you can gain more advantageously in the future.
  • If investors could use history to predict market movements, they’d never be surprised by them or lose huge amounts of money.
  • The market cannot be understood as predictable and law-abiding since it’s unpredictable and chaotic at its core.
  • The roundabout – the pain of positioning and paying now for the advantage and payoff later – only works when we remove our temporal blinders that keep us hyper focused in the moment. Then, and only then, can we pursue those proximal aims intended to give us an intermediate advantage from which the distal ends are more easily and effectively achieved. To say this is extremely challenging is an understatement.
  • “Faustmann’s ratio” LEV/LRV.
  • To succeed with the strategy of Austrian Investing, you must be able to tolerate initial setbacks.
  • A system should naturally achieve balance through internal guidance. Attempts to intervene in the system will usually cause more problems than they solve. The Austrian School of Economics believes this about markets: government intervention doesn’t help balance markets, it distorts them.
  • We can only succeed with Austrian investing if we can stop focusing on the short term. This is extremely difficult, but it’s also critical to our success in the long run. It’s hard because humans are designed to prefer things that benefit them now rather than later.
    • This is part of our evolution as humans; we had to focus on immediate threats in order to survive and thrive as a species. Our culture also teaches us that the moment is all that matters—we live in an instant gratification society where people want everything right now without having to work hard for it or wait long periods of time (such as saving money).
  • Patience is the most precious treasure
    • Most people are unable to take the roundabout route because our evolution and desire for the here and now (Like the children in the marshmallow study, 1 now or 2 later). Therein lies an edge to the Austrian investor who can take the roundabout approach
    • The reason for this difficulty can be found in our wiring, those genetic tracings of our evolutionary journey rooted in survival, when overlooking immediate needs was reckless and life-threatening.
  • Without a functioning feedback loop, the system goes haywire like a faulty thermostat
  • The Federal Reserves attempts at “Fire Suppression” leads inevitably to bigger and more deadly “Forest Fires”
  • Austrians believe in the “boom and bust cycle” where artificially low interest rates foster an unsustainable boom (characterized by overleveraged borrowers investing in operating capital that will be unproductive at natural interest rates) and the inevitable bust.
  • Markets tend to experience infrequent, large moves or “fat tails”
  • Wall Street’s problem is one of lost opportunity; you MUST go for it now or you won’t have a chance tomorrow. This causes Wall Street traders to focus on the now
  • You can’t time the market. IE – Pick tops and bottoms.
  • Short term doesn’t matter
  • When interest rates are low, bonds are not as negative correlated as you would like with equities and not as much of a safe haven. Do not chase yields
  • The federal reserve will have difficulty “normalizing rates”
  • Alpha (inefficiencies) is difficult to capture for investors
    • The question you have to ask yourself is “Can you be more efficient than the market?” NO
  • We don’t know how the next recession will play out ahead of time. Cover your contingencies. Don’t just plan for one.
  • Don’t fight the fed. IE – Shorting risk assets
  • In a crash, almost all asset correlation goes to 1
    • Diversification in that scenario won’t protect your portfolio If you are in the derivatives market (IE – ETNs), you are taking credit risk from the issuer
  • 2 types of safe havens. Nothing else is a safe haven.
    • Insurance (Left tail way OTM 30% puts)
      • Does very well in a crash
      • small loss during up market
      • has a high degree of confidence (not a lot of “noise”)
    • Store of Value (Gold)
      • does ok in a crash
      • up/down during an up market
      • has a high degree of confidence
      • No counter party risk
  • Safe Haven imposters - vulnerable in a crash, needs a lot of luck for that safe haven to pay off in a crash. Have a low degree of confidence it will pay off during a crash
    • Unsafe Haven
      • Hedge funds
      • long/short equity fund (can’t time correctly)
      • High dividend stocks
      • REITs
      • Commodity index
    • Hopeful Haven
      • Value stocks
      • 10 - year bonds
      • VIX (difficult to time and it will punish you severely during a up market)
      • Silver
  • The federal reserve low interest rates are causing investors to chase yield and creating distortions in the market
  • You want to have money for when the liquidation of this malinvestment occurs so you can buy cheap equities
  • Precious Metals/Gold are a great store of value
  • Focus on your “dry powder”
  • Investing in the stock market is a good idea, but you have to be careful. When interest rates are too low and there’s too much money being printed by central banks, it can lead to malinvestment. Malinvestment is when people invest in things that aren’t useful or valuable for society. That leads to crashes in the market.
    • Distorted markets are prone to crashes
    • So, stay out of them and wait for the distortions to pass before investing again.
  • Tobin’s Q (Misesian Stationary index) is a good measure of stock valuations. Market is fair valued at 1
  • It is the ratio of the market value of the companies/replacement cost of those business or total US corporate equity/total US corporate net worth. Lower number is better. High was 2.15 in 2000. 2021 is 2.75
  • Tobin’s Q has a direct inverse correlation with future stock returns. Higher number = lower returns. When financial markets are distorted, they carry the seeds of their own destruction. The inevitable bust that follows the boom is not an unexpected event.
  • Basic premise is to stay out of the market for long periods of time when distortions are running high and wait for the inevitable collapse to purchase cheap equities. The objective of roundabout investing is not to make money now, but to position ourselves for better investment opportunities later
  • The challenge to the Misesian strategy is that it requires contrarian thinking, to “zig” when the rest of the world is “zagging”. You have to step back when the MS Index is high so you can act like a corporate raider when it is low
  • Explosive Left Tail risk hedging (what Mark does) is very difficult for the average investor or even professional. Don’t try it
  • For the average retail investor, Cash is good when Tobins Q is high so you have “dry powder” for the inevitable collapse. You don’t want to be shorting the market or in risk assets. This is difficult because you will watch the market go up while you are setting on the sidelines
  • Benjamin Graham – “Many shall be restored that now are fallen and many shall fall that now are in honor.”

Safe Havens

  • Safe Haven – An asset that provides safety from risk
    • Risk is exposure to bad contingencies. Most of these will never happen, but they can and they can appear in any number of forms
      • Investment risk is the potential for loss, and the scope of that loss
  • A Safe haven asset is an investment that mitigates that risk to preserve and protect your capital. They are shelters from financial storms
  • Safe haven investing is both a defensive measure to avert future loss and an offensive one to exploit future opportunities with “dry powder”.
  • A risk mitigation strategy must be cost effective. Anyone can develop a strategy that does well in a down market, but we must not have a cure that is worse than the disease
  • Benjamin Graham – “The essence of investment management is the management of risks, not the management of returns.”
  • Do not attempt what Spitznagel does as a retail investor or even professional.
  • Everett Klipp - “A small loss is a good loss.” Risk mitigation and survival are everything in investing. Don’t try to predict
  • Investing needn’t be about making grandiose forecasts. No one has a crystal ball
  • A cost-effective safe haven doesn’t just slash risk, it actually lets you take more risk in other parts of the portfolio
  • Aristotle pointed out that, while it is easy to make a couple lucky rolls of a die, with 10,000 repeated rolls, the “luck” of the die evens out
  • When your sample size is small, and even worse, unique and unrepeatable, no matter your subjective probabilities, there is so much noise in sample you can hardly know anything. You are hoping for good luck. Your Number (N) is 1
  • But if your success or failure relying on many outcomes, over many rolls of the dice. Your Number (N) is large. You are acting as the “House” exploiting the house edge through repetition to quash randomness. The house doesn’t gamble. We are as Poker theorist David Sklansky said, “at war with luck.”
  • Cost-effective risk mitigation or raising our compound growth rates (CAGR) and thus wealth through lower risk is really our comprehensive goal as investors.
  • Golden Theorem – As you accumulate more and more data in a random sample, you should expect the sample’s average to converge to the true average.
    • The more you roll a fair 6-sided die, the more the percentage of all those rolls in which you see any particular number will converge toward 1/6 or 16.66%
  • It isn’t just the single wager that matters, it is the iterative, multiplicative impact of that result on the next wager, and on the next! A large loss disproportionately lowers our geometric average return, because it leaves us with a much lower stake, or capital base to reinvest and compound on the next wager.
  • We cannot only judge our decisions by their outcomes. As good decisions can have bad outcomes. But we only get 1 outcome.
  • We have just one life (N=1), but our fate is a range of outcomes.
  • The most intuitive way for us to think about the meaning of the expected geometric average return and, equivalently, the geometric average ending wealth outcome under multiplicative growth is simply as the expected median ending wealth outcome
  • The geometric average return, rather than the arithmetic average return is close to what you should expect from random samples from all possible ending outcomes
  • By giving all the weight to this path(N=1), we essentially need to have gotten pretty much every possible path right. We must be robust to the realized path or “covered all the bases.” We don’t know what “path” we are going to get
  • Not all losses and not all risks are created equal, so not all risk mitigation is created equal

  • We need a risk-mitigation strategy that makes our returns both more accurate and more precise to win the bloody “war with luck.” We want a tighter grouping of our expected return or a reduced variance.

  • You have 2 options for achieving this. The store of value method or the insurance method. These 2 strategies can be very different in their cost-effectiveness
  • What makes something a safe haven vs a non-safe haven?
    • How does it do during a Crash? +/-
    • How does it do during normal times? +/-
    • What is the expected payoff during a crash and how does it achieve it?
  • You have 3 different types of safe havens.
    • Store of Value – Fixed in time and space. Key is low to no correlation. It provides both a cushion and “dry powder” should a crash take place. It is basically a matter of diluting risk. Crash return is +/0, Non-Crash Return is +/-, and Payoff type is low correlation
    • Alpha – Is like store of value, but its correlation is now expected to be negative. That means during a crash, it is expected to generate a positive return. Think of the flight to quality we see during a crash. Crash return is +, non-Crash return is +/-, Payoff type is negative correlation
    • Insurance – What Mark Spitznagel does, don’t try. Extreme version of the Alpha payoff. Needs to make a very large profit during a crash, relative to its expected losses the rest of the time. Needs to be highly convex to crashes or have an explosive payoff to justify its costs. Crash return is ++++, non-Crash return is -, Payoff type is “Convexity”
  • Safe Havens can be exceedingly costly, so much so that, as a cure, they can be worse than the disease.
  • Some safe havens require a very large asset allocation within the portfolio. The problem is large AA comes at a very large cost (drag) when times are good (which is most of the time). Gold has this problem.
  • Strategic vs Tactical Safe Haven
    • Strategic – Mitigates systemic risks in a more fixed way and letting it play out
    • Tactical – Requires moving into and out of safe havens. This requires timing and short-term forecasting skill (which people don’t have)
  • The problem is no one possess a “crystal ball” to know when to do this.
    • If you risk-mitigation strategy requires a crystal ball to work, then you are doing it all wrong. Don’t try to predict the market. Cost effective safe haven investing needs to be agnostic investing
  • Cassandras typically and ironically lose more in their safety from looming crashes than those crashes would have even harmed them.
  • Markets scare us more than they harm us
  • Markets are very, very good at making us feel safe when we shouldn’t and scared when we needn’t
  • Risk mitigation therefore needs to be a sustained way of life or habit, not a transient one
  • Imposter Safe Havens
    • Hopeful – Payoff is very unreliable. Requires a lot of luck to pay off in a crash. Sometimes requires good timing. It is like jumping out of an airplane with a parachute that only sometimes deploys, you are better off not wearing one in the first place and making a more informed decision. Crash return is (don’t know??), non-Crash return is +/- and the Payoff type is “Fingers Crossed”
    • Unsafe – This asset or strategy has so far always gone up, so it likely has a good story for why that should always be the case. This logic is then extended to their performance in a crash. They are often vulnerable in a crash, perhaps they have even shown some evidence of that vulnerability, but this doesn’t change the optimism around their safe haven status. It is like jumping out of an airplane and thinking you can fly. Crash return is -, non-Crash return is +, and payoff type is “Always goes up so it must be safe”
    • Diworsifier – Most common form you see in modern finance. It is pervasive throughout almost all investment portfolios. Diversification is fundamentally a dilution of risk, not a solution to risk. It is about evading risk. Diversification never tends to be as great (lower correlations) as it appears. When the investing herd heads for the exits in a crisis, most strategies and assets tend to get swept away. Strategies that were once uncorrelated, stable and liquid become the opposite of all those things as investors are forced to sell what they are able to, all at the same time. Diversification is “NOT A FREE LUNCH” as mentioned in modern finance theory. Crash return is -, non-Crash return is +, Payoff type is “Loses less, so it is worth it”
  • Diversification lowers returns in the name of higher Sharpe ratios, some investors who use this strategy but aren’t content with the lower returns are then forced to apply leverage in hopes of raising them back up. True risk mitigation should not require financial engineering and leverage in order to both lower risk and raise CAGR. Doing so adds a different kind of risk by magnifying the portfolio’s sensitivity to errors in those correlation estimates.
  • Aristotle – “The whole is not the same as the sum of its parts.”
    • This is true in finance. You can move a portion of your portfolio to an asset with zero expected return and away from an asset with a high expected return and raise the whole of your wealth, even though it lowered your average. All of this is due to compounding. Key Point of Book!!!
  • The properties emerge from the interactions of those component assets as they are rebalanced and compounded. Safe Havens adding so much ending wealth to the portfolio (geometric return) is due to the iterative nature of the game. They provide capital for the next “dice roll” by resetting or rebalancing the size of the wager at the end of each “dice roll”. Safe havens can thus top up or feed the wagers in the main game (large part of portfolio), particularly if the previous roll resulted in a big loss, without costing the frequent positive wagers enough to matter. The assets now interact, rather than act independently. Thus, an entirely new whole is formed, one that is very different from the sum of its parts.
  • If we only look at the way that things happened and obsess over it as the only likely outcome, then we are engaged in naĂŻve empiricism. IE - we over-extrapolate the past
  • To avoid that we need to look at the past in the context of the many other paths that COULD HAVE happened, but never did, as well as our sensitivities to those outcomes
  • Most investors add a risk-mitigation strategy for its effect, but don’t properly account for the cost paid to gain that effect and thus don’t account for the net portfolio effect
  • There is always this risk-mitigation tension or tradeoff between the two contrary forces of cost and effectiveness (IE – arithmetic costs and geometric return). That tradeoff is between lower arithmetic returns (costs) as payment for the geometric pickup (effect). There is NO FREE LUNCH!!! But if can tilt that tradeoff in your favor, with an effect that outpaces the costs resulting in a positive net portfolio effect, then risk mitigation on net raises compounding and consequently, wealth. This is cost effective risk mitigation.
  • Remember, anyone can develop an asset or strategy that does well in a crash, the trick though is to do it while also raising the median return. Most risk mitigation strategies fail this portion
  • We cannot judge the cost effectiveness of a given risk mitigation strategy on its own, in a vacuum, based solely on its attributes.
  • The bigger the crash bang for the buck, the less that is needed and the less its potential drag or cost when it isn’t needed.
  • Mechanical vs Statistical payoff
    • Mechanical – is one that happens as a direct, intrinsic consequence. IE – an option going into the money from out of the money. It must go up in value.
    • Statistical – is one that only tends to be so, based on observed history, but it needn’t be so. It is more extrinsic and thus noisier. This would be like a flight to quality or safety that we see during a crash.
  • You also have other possibilities for payoff warping, like counterparty risk (or the risk of not getting paid). Gold bullion has no counter park risk.
  • The question to ask yourself is do you need a lot of things to go right for a safe-haven to be effective? Is their history a good guide to their future, or is everything always different?
  • An ideal safe-haven is more mechanical but real-world payoffs tend to be much less so. They tend to fall somewhere on a spectrum between mechanical and statical.
  • Not Safe Havens VIX futures – Volatility index but they are always in contango which causes them to have a very steep “roll” making them a really bad trade
    • High-Dividend Stocks
    • Hedge Funds
    • Fine Art
    • US Farmland
  • Only 2 safe havens are worthy of that name – Gold and Equity Tail Hedge
  • Store of Value
    • Cash (3-Month Treasury Bill) – Less interest rate risks than longer dated maturities. Not a safe haven
    • 10-20 Year Bonds (Typical of “Balanced” portfolio) – More interest rate risks vs shorter maturities (as of 2021 those rates are extremely low which hurts their current safe haven status), classic flight to safety asset when things turn bad for the stock market and the economy. They are a hopeful haven or a Diworsification
  • Alpha
    • CTA (Commodity Trading Advisors) – Active managed strategies (usually hedge funds) and trend following strategies. Attempt to capture Alpha by using momentum. Other derivatives-based strategies use similar strategies like long volatility and generic tail hedging. Not a safe haven
  • Insurance
    • Gold – Hedge against the banking system. No counter party risk. Historically thought of as a hedge against inflation. But, is a very noisy hedge against inflation. It is mostly tied to movements in real interest rates (When inflation goes up faster than nominal interest rates, real rates go down, pushing up gold prices). Mildly explosive crash (market down 15%) payoff on average (30% in the 1970’s and 7% since) but, it has had a very wide range of returns since the 1970’s. Gold is all about investors’ expectations of value, it has no yield and has no intrinsic value. It is for that reason impossible to fundamentally value. Its payoff profile is largely statistical as expected. During the 1970’s, golds payoff profile made it very cost effective as a safe haven, outside of that, gold has been much less cost effective. Gold has required a tactical call regarding inflation or real interest rates in order to be a cost-effective safe haven. This means we need certain things to go right for gold to be an effective safe haven in mitigating systemic risk (of a crash), much less cost-effective. The amount of gold needed to fully hedge our portfolio is very high adding to its carry costs.
    • Generic Tail Risk Hedge Strategy – A Barrons Article Mark wrote describes an extremely simplified version of his strategy. He does not describe his strategy is this book in any way. He says the academics are right when they say generic tail risk hedging fails to increase portfolio returns. He does not recommend using this strategy. Each month spend a fixed amount of capital on way OTM four month puts on S+P 500 futures (with a straightforward constraint to avoid the priciest options) and mechanically delta hedge those; the puts are kept until expiration or sold if the explode to a high level.
  • Cryptocurrencies – Some people are saying that Cryptocurrencies are “Digital Gold” and destined to take golds role, but their payoff profiles are currently too sparse and too noisy evaluate intelligently (though the early indication is that they look more like unsafe havens or a hopeful haven at best.) Cryptocurrencies are thought of as insurance policies against the failure of central bankers. This, by extension, has also given them the presumed role of being an insurance policy against economic crises. Cryptos are a significant technology platform (the blockchain). They are like secure, virtual safety deposit boxes that only you can access. It will change the world. But the stuff inside those boxes, just by virtue of the secure, convenient, cool boxes, is now presumed to have value – by decree or fiat (The Austrian economist Robert Murphy argues that in Mises framework, we have no choice but to call all crypto fiat currencies.) Worst of all, as a highly speculative vehicle, it is symptom of the liquidity-fueled environment that crated it.

References