Monthly Archives: May 2014

The Problem With Smart People

The problem with smart people is that they think of ideas before I do. I keep getting a sinking feeling that Nassim Taleb has anticipated the entire contents of this blog: the more I read Antrifragile, the more I want to transcribe passages of his book here and follow it with a simple, “Ditto.” However, his project revolves around decision making in a world that we don’t understand. This isn’t quite the same as mine: living the good life, which is described by so many, yet unheeded by many more. So, I’ll soldier on, pointing out Taleb’s sharp wit and good ideas frequently, and applying his work to my goals as I can. There are, of course, others who have anticipated much of the content on this blog, and I’ll cite them as I pluck their good ideas from the tree of knowledge too.

The problem with smart people is that they make you realize you’re not alone. Now, most of the time, folks like good company. But when your a writer, it’s easy and desirable to fool yourself into believing that your breaking new trail. When it’s just the case that you’re reading too little, and your writing is too superficial. If my writing covers ideas that others have already described, it’s time to read those writers more closely, and cover the topic more deeply.

So, all of this is a long preamble to a brief update. The completion of the “How to Press Olives” series is on the way, as is a new article about science and religion — one of my favorite false dilemmas to explore!

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Navigation & Hurricanes

Rita, Katrina, Andrew, the list goes on. Every year, the weather forecasters go to work plotting the courses of hurricanes. Every so often, a hurricane doesn’t listen to the prognostications of forecasters, and things get messy. In risk management, these “every so often” events are also known as “tail events”: they are events with a statistically low probability of occurring, but when they do, big problems can occur.

Nassim Taleb’s book, Antifragile, explores these tail events. He hopes to describe how to survive, and maybe even prosper, in a world where they happen. The conventional solution to surviving tail events is better and more frequent forecasting. Taleb criticizes this solution because more and better forecasting doesn’t improve the odds of navigating through a hurricane when it changes its course. The problem ought to be “building a better boat”. In other words, the way to survive and prosper in a world with hurricanes is to build lifestyles that successfully coexist with them, rather than building a fragile lifestyle that relies on the accurate forecast in order to evacuate and get out of the way.

Detractors might claim that building systems robust enough to survive tail events is expensive, and they are correct. However, it is also expensive to insure the millions of lives that live in the paths of these events, and supporting the forecasting systems that inaccurately predict tail events. If we spend money designing systems that can survive despite tail events, we will have front-load our expenses, paying less in the future once the initial design work is finished. The current system of insuring a fragile system against tail events has a high recurring cost that we cannot escape unless we focus on designing systems that survive in the face of tail events.

Taleb describes a spectrum from “fragile” to “robust” to “anti-fragile” in order to make sense of different responses one might take towards tail events. Fragile systems rely on forecasting to prevent them from toppling over: think of a house of cards — any small disturbance would upset the house of cards. Robust systems can survive tail events, but repeated exposure to tail events might cause them to fail; think of over-engineering a bridge, such that it can survive powerful earthquakes and heavy trucks; eventually such a bridge would fall down, but it would be robust enough to avoid this catastrophe for a very long time. Anti-fragile systems actually thrive on tail events: to use one of Taleb’s examples, the airline industry improves after each plane crash by gathering information about the details surrounding the incident, and then improving guidelines for airline operation and design. Taleb uses the mythical tropes of The Sword of Damocles, The Phoenix, and The Hydra to illustrate fragile, robust, and anti-fragile systems respectively: The Sword will fall if the thread holding it snaps, The Phoenix rebuilds itself after each destruction, and The Hydra grows two new heads in the place of each one that is destroyed.

It is important to note that antifragility is relative to the system it is describing. For example, individuals in a Darwinian population are fragile because they die, but the population is (hopefully) antifragile because natural selection removes the weaker individuals from the gene pool, thereby improving the genetic material available for reproducing the population. Populations may be fragile in an ecosystem, as various populations compete for common resources, but the ecosystem is (hopefully) antifragile because of the redundant, or overlapping, roles played by various populations competing for resources. It is important to note how the concept of antifragility applies to the individual or population that it is describing, since the concept depends on the behavior of the object in the system in order to determine whether it is antifragile.

* * *

We can apply this idea of antifragility to the goal of living a good life. We should seek to live our lives in such a way that tail events don’t harm us, and in the best case, help us. Financially, this means diversifying streams of income to avoid relying on one source too heavily, because if a single stream of income fails, or several streams of income that depend on a single source fail, we would be up the creek without a paddle. It also means reducing debt, to be less dependent on all sources of income, increasing our the redundancy of our financial resources: with fewer payments to make, we can save more of our income and have it available to support us. If you’re an investor, it means diversifying your investments across asset classes and individual assets. (There are problems with the current economic system, according to Taleb, since it is inherently fragile, but it is possible to build a more robust investment portfolio versus a more fragile one, despite this systemic fragility.) Personally, it means developing a network of friends and neighbors who can help you; this is probably different from your LinkedIn and Facebook contacts. We are talking about people you meet for movies and meals, who may be your friend on Facebook, but who would also help shovel your car out of a snowbank in a blizzard. It means having hobbies that fit your income: collecting Gibson guitars, or Versace dresses, on a quickie mart salary probably lies closer to the Sword of Damocles than it does to the Hydra.

Risk Management

I’ve found an interesting writer, named Nassim Taleb. Many folks have probably already heard of this guy. In an intellectual climate that seems to have long given up on polymaths and generalists, he’s somehow emerged as exactly that — a polymath and a generalist.

His views on risk management are particularly interesting because they’re unusual and antithetical to the current standards in this field. Taleb believes that risk cannot be accurately predicted, and the models by which people try to predict risk are faulty. To distill his analysis, there’s a reason that finance companies say, “Past performance does not guarantee future results”. And yet, risk managers continue to analyze past performance for a way to mitigate future risks, thereby attempting to guarantee future results. According to Taleb, we cannot predict when risks will strike our carefully constructed systems, and we also cannot predict the size of the risk that will next wash over us.

The response to this wrong-headed attempt at risk management is to control the details we can. We should give up our standard deviations, and focus on building systems that can withstand, and even prosper from, all the risks we’re likely to encounter. Taleb calls these systems “antifragile” systems: they are the opposite of fragile systems that are prone to destruction when a particular degree of risk strikes. By contrast, antifragile systems are not destroyed: like living organisms, they can survive many types of use and abuse. Some types of use and abuse are even beneficial to antifragile systems, e.g. exercise, or exposure to low levels of a disease or poison.

This idea can be successfully applied to many parts of life: finance, health, urban planning, etc. Of course, this contrarian view of risk management still requires risk analysis, in order to determine the types of risk that a system ought to be antifragile to, versus simply resistant to, since it is not possible or efficient to be antifragile to every risk: this would take too much time and too many resources to achieve. However, his point that we can apply the results of our risk analysis to building a better boat, rather than trying to predict and avoid the hurricane bearing down on our currently unsuitable boat is a useful observation: one that I look forward to reading more about, and trying to apply to my life.

Have you read any of Taleb’s other books? Share your thoughts about Taleb’s idea in the comments.

How to Press Olives, Part Two

In part one of this series, I discussed some methods by which a poor Thales could accumulate the capital with which to rent all the olive presses in the area, cornering the market on olive oil production. However, monopolies are illegal and difficult to create in the current day, which raises the question, once a contemporary Thales raises his capital, what on earth is the guy supposed to do with it?

Like Thales’ character in Aristotle’s anecdote, we invest the capital. But since the olive oil market has expanded into a global monstrosity since the fourth century B.C. we need to find a different financial vehicle. No, we won’t be rolling in a drop-top ’64: classic cars are a bad investment vehicle. I’m a fan of boring vehicles, when it comes to finances.

I suppose, at this point, I ought to make the disclaimer: I am not a financial adviser. I am not offering professional advice, and I do not offer any information on this website as a suggestion on which people should act. Check out the Good Reads page, if you want actionable advice.

Stocks, bonds, real estate, and the riskier cousins of these asset classes, are the closest thing we’ll get to olive presses in this century. I suppose you could invest in olive orchards, if you want to get closer, but if you care to read a bit about diversification, you’ll hopefully see why that’s impractical for most individual investors. So, we’ve waded further into the dry desert of personal finance, to talk about stocks, bonds, and real estate. For anyone who hated their philosophy and their economics classes in college, stop reading right now — I may have alienated at least eighty percent of the English speakers on the planet by marrying these two subjects in one blog post.

If you really want to learn How to Press Olives, Part Two, read A Random Walk Down Wall Street. That will give you an in-depth primer in what to do with the pile of money you’re scraping together after you’ve read How to Press Olives, Part One. But since we don’t all have the drive or time to wade through nearly 600 pages of financial analysis, and since we don’t all think of charts and graphs as the same as “pictures” in a book, I’ll try to digest 600 pages into one blog post, starting now.

So, Thales lands in 2014 with his small pile of money that he accumulated in Aristotle’s story. He finds the olive oil market overwhelming. Where does he go? What does he do? If you’re like Thales, and you’re new to investing, start simple. Index funds are diversified investment vehicles, and they’re usually lower risk than related actively managed funds because they’re diversified across an entire asset class that they represent. I’ll leave it to Dr. Malkiel in A Random Walk… to explain the details of why index funds outperform other mutual funds, but for our Cliff’s Notes reduction, suffice it to say that index funds are the place to put your money in today’s investment landscape — at least until you plow through The Intelligent Investor, Security Analysis, and Margin of Safety. After reading those three books, you might try picking individual stocks, but don’t expect to beat your index fund portfolio.

We’ve established that Thales, and you, ought to invest in index funds, but which funds do you buy with your money? There are dozens of options. Fortunately, picking an index fund is easy: 1) Choose your asset class, e.g. what kind of asset do you want to buy? 2) Find the index fund with the lowest expenses for that asset class. 3) Buy that index fund. William Bernstein has a “No Brainer” portfolio that has performed surprisingly well for as naive as its asset allocations appear to be. The No Brainer portfolio is only .09% behind the S&P500 index over a 10 year period. What is this portfolio? 25% of your money in the following four index funds: the S&P 500, U.S. small cap stocks such as the Dow Jones Total Stock Market Completion Index (DWCPF), the MSCI EAFE International Large Cap Stock Index, and a 5-year bond index. Bernstein recommends this portfolio in the opening pages of his book, The Intelligent Asset Allocator. It’s on my good reads page for a good reason. Check it out when you get A Random Walk from the library. They’re a nice pair.

A note about mutual fund expenses, you’ll find many folks touting the virtues of Vanguard’s index funds, and they’re generally very good. The company’s business model is admirable. However, Fidelity also has many low-cost, no load index funds. Either company will serve you well, and there may be other low-cost index funds or ETF’s out there that I’m not aware of, so do your own research as well. Leave a comment if you’ve found funds that are lower than those of Vanguard or Fidelity.

In the third part of this series we’ll cover managing investments and spending them. With these three parts, you’ll have the rudimentary tools you need to accumulate, invest, and use your capital to live the Good Life. Although, I highly recommend further research. These posts are far from exhaustive on the topic.

How to Press Olives, Part One

This series of posts seeks to analyze Thales’ actions, as described in Aristotle’s fragment about business monopolies. I’ll connect Thales’ actions with contemporary practices one can use to gain financial independence.

Olive Pressing is a three-part practice. Like so many useful things in life, it has a beginning, middle, and end. The first part is what we’ll consider in this post: the beginning. In other words, how do we raise “a small sum of money”, as Thales did?

In contemporary economics, we’re talking about capital accumulation, and there are at least three ways to accumulate capital, as the popular aphorism states: beg, borrow or steal. However, I intend to maintain at least a semblance of ethics and dignity here, so we’ll discard the first and third options right out of the gate. That leaves borrowing, which is a less desirable option than saving, so let’s add saving to the list for two good options of capital accumulation: saving and borrowing.

Now that we have our methods of capital accumulation, let’s explore the details of their use. Aristotle says that Thales lived in poverty, so let’s assume he had no capital to start with. Let’s also assume that Thales had enough dignity and ethical stature to discard stealing and begging too. I think these are reasonable assumptions of most good philosophers, but a defense of this is a topic for another blog post. So, we have conveniently positioned our hypothetical character of Thales such that he has to save or borrow his “small sum of money” that he’ll later use to rent the olive presses. How does he do it?

Option 1 — Saving: Americans, the cohabitants of my country, are notoriously poor savers generally speaking. This needs to change, for more reasons than I care to list here, but the primary reason for this change is to “rent olive presses”. In other words, we need to make enough money to fund the good life, like Thales did. If you looked at the graph on the linked Economist article, and if you’ve read Early Retirement Extreme, then you know where I’m going: the easiest way to accumulate capital is by increasing one’s saving’s rate. This works for all individuals, corporate and biological.

How do you increase your savings rate? There are two time-tested methods to increase your savings rate: increase income and decrease expenses. For the first option, think of squirrels hoarding food for the winter — you work harder, you earn more. For the second option, think about the stereotypical  swami living in a cave in the Himalaya — you consume less, you have more resources left at the end of the day. Now, these examples aren’t to suggest that you should be a squirrel or an advanced yogi, although thinking about advanced yogi squirrels makes me smile. These are two ways you can positively affect your fiscal position, without anyone else’s help.

If you don’t believe me, check this out. This blog post shows the effect of one’s savings rate on how quickly one will be financially independent, it also analyzes different results of decreasing spending versus increasing income. Although, it is perfectly acceptable to use both strategies, decreasing your spending is the simpler and more powerful option: see the MMM article for details.

The second way to accumulate capital involves the help of someone who already has capital: we plebs call this borrowing. Unlike saving, Americans are very familiar with borrowing capital. However, we are bad at borrowing in a fiscally responsible way. Generally, we borrow to buy assets that depreciate before we throw them away: successful businesses don’t borrow in this way, and neither should you. The only time one ought to borrow is to buy an asset that will appreciate faster than the interest rate of the loan, which is known as leveraged investing: it’s risky and complicated. I can’t recommend it for most situations.*

Well now, where did we leave Thales? He’s waiting for us to accumulate capital: how does he do it? First, he reduces his spending, by buying no unnecessary items, such as the Pre-Socratic equivalent of iPads, new cars, and expensive designer food. He’s a rice-and-beans-and-6-year-old-laptop kind of guy until he gets enough money to lease the olive presses. If he can find good terms on a loan, and he can mathematically show that his return on investment (ROI) will be greater than his cost of loaning money, then he may borrow some capital to lease more olive presses too. However, the brunt of his capital should be accumulated by saving, since this is the least risky and most profitable capital available to him. The next article will cover part 2 of olive pressing, how Thales invests his capital when he leases the olive presses. Stay tuned.

* One example where leveraged investing may be useful involves the current housing market in the USA. It’s been touted for years that home loans are at record lows, and there’s no time like the present to buy a house. Enter leveraged investing: being a savvy investor, you reduce your expenses enough to save a 20% down payment and buy your house with a 15-year fixed-rate mortgage at 3.33% APR, which is the current national average mortgage rate as of this writing (bankrate.com). A survey of the various mortgage types are outside the scope of this post, so let’s assume this is the safest, lowest APR you can get. You now have a pathway to owning real estate at a low interest rate: since you’re already an expert saver, you have extra money piling up at the end of each month — even after you pay your mortgage. You can pay off the mortgage more quickly than this, or you can invest the leftover capital in asset classes that historically return a higher rate of interest over the long term. In this case, you’re leveraging your mortgage to invest in something like the stock market: rather than pay off your mortgage more quickly, you’ve effectively borrowed the cost of your house at 3.33% so you can invest money at 7% over the next 15 years. Note that there is risk in leveraging your mortgage to invest in stocks: if you lose your stream(s) of income, then you cannot pay your mortgage; and if the stock market also declines when you lose your income stream(s), you’ll be unable to sell stocks to pay the mortgage — when this happens, like it did for many in 2008 and 2009, you’re at risk of defaulting on your leveraged mortgage. What’s more, most loans available to individual investors don’t have such agreeable interest rates as current home loans, which makes leveraged investing even more risky because you need to invest in ever higher-returning assets to make the leverage work.

Book Review: The Intelligent Asset Allocator

1 May 2014

I just finished reading The Intelligent Asset Allocator, by William Bernstein. The man knows his stuff. He has the statistics, data, and analysis to wow any investor who is interested in paying the man to invest on their behalf. This is probably why he’s quit his day job as a neurologist, and now advises a handful of wealthy clients on their investment portfolios.

What I find most interesting about the book is the disconnect between his historical analysis of asset market prices and his statistical analysis of portfolio asset allocations. After demonstrating how to perform a mean-variance analysis on a particular portfolio, or after demonstrating how to analyze the return-risk correlation in a binary relationship between two asset classes, the eponymous clause gets dropped: “past returns may not be indicative of future results.” I take this to support Bernstein’s distinction between three types of optimized portfolio asset allocations: historical, hypothetical, and future. The historical optimized asset allocation for a portfolio is possibly useless to us, since we do not invest in the past, and the future optimized asset allocation cannot be known without a working crystal ball. Mine’s been broken for years, the piece of junk. This leaves us with the hypothetical optimized asset allocation, which is not an actual number; rather, it is a best guess derived from, what is hopefully, a large pool of historical returns. This is only slightly better than the historical optimization described earlier. In other words, you can do all the calculations that you want with the best databases that you can find, but at the end of the day, you’re going to have to invest your money somehow, and the market will likely misbehave for you one way or another. Bernstein describes this problem well, “The investor’s objective, then, is not to find the efficient frontier (i.e. the most optimal asset allocation); that is impossible. Rather, the goal of the intelligent asset allocator is to find a portfolio mix that will come reasonably close to the mark under a broad range of circumstances.” The solution to this problem is only as complicated as one wishes to make it.

To be clear, I am not discounting Bernstein’s statistical methods. Rather, I am discounting the degree to which one might apply these methods. At the outset of the book, Bernstein recommends putting your money equally into four different index funds if you don’t have the patience to read this book carefully — 25% each for S&P500, US Small Cap, EAFE, and 5-year treasuries. He offers more meticulous portfolio allocations later in the book, with the caveat that they are not appropriate for all types of investment accounts, such as taxable ones. Some taxable accounts are only suitable for three of the four index funds recommended at the beginning of the book! This is because minimizing one’s tax risk is often tantamount, or even paramount, to maximizing one’s investment returns. Ultimately, how one allocates their assets is as much determined by circumstance, as it is by statistical analysis.

I fully intend to re-read parts of this book before it goes back to the library, so I can better retain the mathematical analyses described in The Intelligent Asset Allocator. However, I don’t intend to let statistical analysis over-complicate a manageable and low-maintenance investment plan: pareto optimization is essential in this area of life!

P.S.
I’m struggling with a way to write the Olive Presser articles. How do I describe the method of reducing expenses and investing income without simply parroting what ERE, MMM, and BNL have already written? The subject is not that complicated, and they have covered it so well! Never fear — I have traction on the issue, and the article is underway.