In the investing foxhole there are no atheists
You have to believe in something, and to survive when your beliefs are wrong
I’m also doing my first salon with my friend Sam on connecting the idea dots. Come join us as we chat about how to connect ideas from multiple fields together!
There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know.
– John Kenneth Galbraith
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I’ve been investing in one way or another for a little while. And as I’ve hopped between different strategies and themes, I keep going back to a theme. One that’s been echoed by far weirder minds than mine.
There’s that common question that gets asked about how one should invest, or how you’re not that comfortable with the markets, or that you might not know what you’re actually doing. While the truth of the matter is, investing is about beliefs in the future, and what to do when they’re wrong. Everything else is back-solving.
Only two things are true in the markets, like much of life:
You must have a belief about the future
You must survive that belief being wrong
Like sometimes I have conversations about what makes venture capital special, in how it funds ideas that turn out to be integral to humanity decades in the future. Sometimes I have conversations about what makes venture capital dumb, in how it throws money into seemingly crazy things with no due diligence. And whichever extreme I hear I feel we misunderstand what investing actually is.
So here’s one way I think about it.
You have $100. You want to invest it. That is, you want to do something with it so that later when you go back to this money pot, it will be bigger.
The challenge, as always, is that you don’t know exactly when you’ll want to go back to it, or how much bigger you’d need it to be, or how much of it you’re actually willing to lose.
So what are the options? Let’s have a look.
You could take the pot of money you set aside for investing and put it in a high interest account in the bank. You’re not going to lose money, thanks to the government backing it with the likes of FDIC, but you’re also not going to make much.
You could take a bit more risk, and invest in bonds and fixed income. Some might even be inflation linked. The yield is better than the bank account, but it won’t be much more.
The higher the yield, the higher the risk. Whether that’s Emerging Market Bonds from some countries with an iffy balance of trade, or scarily named Junk Bonds for companies who might have an iffy balance sheet.
But this isn’t gonna make you much richer. The benchmark here, because of history primarily and a lot of CNBC shows, is an equity index. Take S&P 500, the benchmark, which has had annualised returns of around 11-12% for a long while. What if you put it in the market?
Well, not a bad plan for most people, and precisely because of that it’s highly popular. Both amongst individuals and also amongst those who give financial advice.
There are, however, occasional periods of high drawdowns. 10k diver did a great thread on this, and how a large enough occasional drawdown would wipe out the gains of a large chunk of growth. In other words, it relies on you having a propitious series of bull markets.
You could try and beat this in two ways:
Find those great stocks that do better than the rest - Warren Buffett
Find those times when the stocks do better than the rest - market timing
Historically 2 has been very difficult to actually execute because timing is very difficult and 1 has been very difficult to actually execute because adhering to your investing principles is mentally taxing.
But once you skip beyond this, and want to beat S&P at its own game, or the best equity investors at their own game, you want to get north of 20% a year return. That’s where alternative investments come into the picture.
If you get 20% returns for 6 years, that’s 3x your invested capital. If you get it for 10 years, that’s 6x your invested capital. That’s it, that’s the PE model.
You could get this by taking over an existing company, leveraging it with debt, and running it leaner and tighter. This way if you can get a company to grow its EBITDA an extra 5-10%, you might with debt juice your returns to be similar. The risk, of course, is that you can’t do any of what you think you can do!
The Venture Capital model sidesteps this difficulty by giving primary capital and trying to grow companies.
In both these models, you have very high risk on an individual investment, so you’ll have to make several bets, so you have an overall portfolio that can do 20% a year return.
But if you’re making many investments, that means each one has to have much higher than 20% return, since some would undoubtedly die. Stripe is a $100B company, having grown from zero for just over a decade.
The higher the risk of losing all your money on an individual investment, the more risk you need to take per investment to get that crazy outlier outcome!
What’s absolutely fascinating about this macro view of how investing strategies evolve is that it’s incredibly clear how all these investment strategies are some combination of risk you’re willing to take, returns you want, & the time horizon.
Everyone plays on the risk-reward spectrum - looking for an IRR - usually on a very tight range. If your portfolio needs a steeper power law, because it takes more risks, it has to focus on investing only in outliers, leading to a positive feedback loop. Outliers are hard to find, so its easier to default to "known" patterns - schools founders went to, location etc. Known patterns however are exploitable, so competition emerges, and this reduces reward for the risk.
And thus goes the lifecycle of most of these strategies. Successful until the environment changes.
But there is another crucial point here. Every single strategy is also a function of your specific belief in the future.
How do I best invest my $100 is a function of what do I believe? It might very well be that you don’t have a fully formed belief in the particulars of companies, but do believe that we’ll continue to have a strong economy. And then you go buy S&P ETFs on that belief. Or you go buy mutual funds that reflect the Biotech sector because you believe that the world is gonna need more medicines and bio innovation. That’s your belief.
If you’re Tiger Global, you might believe that late stage private companies are highly attractive and that a basket of them will outperform the markets, and you will act on that belief. If you’re Softbank, you might believe that you can use capital as an advantage, and you will act on that belief.
You could even decide to be market neutral, in crafting strategies such that you only act on beliefs inside microseconds like HFTs because you think you can predict how a security moves inside a few seconds window, or you have beliefs in your models that the shape of the stock’s returns over the next month is likely to be a particular probability distribution. And so on.
If you don’t have a point of view about specific stocks or bonds or companies or sectors or countries, then you might as well go passive and believe in something, like the US economy will undoubtedly rebound.
In the investing foxhole there are no atheists.
Even things like how much should you invest into property vs the equity markets is your belief of how those things will evolve. For instance, if you had $100 to invest as above, you should ideally divvy it into pots so that you can be slightly more sure that you won’t lose everything on one bad day1. This article by Kris has a game that talks about the incredible difficulty of bet sizing. It is hard.
You could end up creating some version of the permanent portfolio, as my friend at Market Sentiment writes. But this too is a function of our ignorance about the specifics of the future, and rather a function of our belief in a particular probability distribution regarding the future. It believes the future will broadly resemble the past, and that the US economic regime is likely to continue.
Ok. Now it might very well be that you don’t necessarily have a detailed map of what the future looks like that you particularly strongly believe. In fact, nobody does. Then what?
You could just index your money to the market and hope for a smooth ride, choosing an all-weather portfolio like the permanent portfolio above. If you do want to invest yourself, however, the key questions are:
What do you believe?
Can you act on those beliefs?
For instance you might well believe that waiting for the perfect pitch and investing in one stock a year like Buffet is the right strategy. But if you don’t have the analytical temperament or patience, then you can’t do this. This isn’t a personality flaw, it’s an input into your decision.
Or you might believe that doing advanced stats or AI to predict stock movements in a few second intervals is the best possible future we can predict, and we’re ignorant on all the rest, but you won’t be able to action this unless you have a few million burning a hole in your pocket to compete against Rentech.
The broader point is that visions of the future can intersect and occasionally coincide, but they don’t negate each other. This also means that the various investment strategies are only as good as they’re successful.
So it goes.
I don’t pay any attention to what economists say, frankly, Well, think about it. You have all these economists with 160 IQs that spend their life studying it, can you name me one super-wealthy economist that’s ever made money out of securities? No.
If you look at the whole history of [economists], they don’t make a lot of money buying and selling stocks, but people who buy and sell stocks listen to them. I have a little trouble with that.
Why is there such a chasm between the theorists who often have fantastic models of the world and the practitioners who often ignore all theorists and actually make money.
Even SFI, when I read the papers written or Michael Garfield's excellent podcast, showcase how clearly they saw the way the Covid pandemic could evolve, but were pretty powerless to actually do anything.
And its not just economics, its also physics, weirdly enough.
Or in the fun episode of CWT where Tyler asks Ray Dalio about why some publicly available information is not reflected in prices.
COWEN: If I look at the macroeconomic literature, it seems to me, even GDP — when we run statistical tests, it’s hard to distinguish that from a random walk with trend. There’s not a lot of obvious mean reversion in the system.
DALIO: I think we’re referring to different things. You’re referring to what you’re reading in the literature, and I’m referring to my 50 years of experience and what I’m doing, so we have a different perspective about those things.
Looking at the entirety of the investment landscape as a continuum helps me at least predict some common discourse dynamics. For instance.
It gets really interesting once your beliefs about the future start being about other people’s beliefs, where your actions become a sort of two-act-play where the call-and-response is what’s being optimised for
Those who over optimise for accuracy in a small segment of the landscape won’t necessarily be able to do all that well, because accuracy has to be measured against efficacy (eg, why aren’t economists filthy rich)
Every niche in the investment landscape will either expand to its natural size, get filled by bigger predators, or get outcompeted (alpha decays away)
If you’re playing in a high-risk space, the only way out is to have a larger number of bets (portfolio approach) or to have tighter ways to know when you’re losing (stop losses)
The more easily explainable the strategy is, the less it will be valued by others - eg the buy what you know in your circle of competence strategy from Omaha, or invest in what could be big in the future strategy for the VCs
What you think you know, what you think is important, and what actually contributes to empirical success can be wildly different. Or rather investing in a bull market can many anyone feel like a genius regardless of your process (see Buffett pretender 1, Buffett pretender 2)
And for me, this descriptive view of the world helps me figure out where I fit into the narrative, and the base rates of failure I should expect. It tells me what strengths of mine are even useful, and to learn to ignore the rest.
After all when thrown into this jungle, how would you survive and thrive? The answer isn’t to see what advantages others have and try copy them. That almost never works. But rather to see what advantages you have and to use them.
I had a fun interview with Market Sentiment here, think some of you will definitely enjoy it!
The same advice goes for being highly leveraged, by the way. But that’s not our immediate concern.