StreetEYE Blog

The Game Theory of Assholes

The reasonable man adapts himself to the world; the unreasonable one persists in trying to adapt the world to himself. Therefore, all progress depends on the unreasonable man. – George Bernard Shaw

I beseech you, in the bowels of Christ, think it possible you may be mistaken! – Oliver Cromwell

Nassim Nicholas Taleb has a pretty good piece on the tyranny of the stubborn minority.

A few of the many good points: A lot of social and economic problems are complex system problems with emergent behavior, not problems of stochastic equilibrium, as economics tends to model them, like mixing inert hot and cold fluids…complex social systems have tipping points where behaviors go viral and emergent behavior emerges…stubborn minorities will make impact beyond their numbers, like a smart border collie can herd a huge flock of sheep.

It’s not always horribly unjust or maladaptive, if a few feel strongly about doing something and the rest are indifferent, to do that something.

On the other hand, if entitled people always get their way then it’s a successful strategy to act that way a lot of the time.

It goes both ways. Leaders can move the needle. Early adopters decide what everyone else adopts. But also, bad actors mess it up for everybody.

In the extreme, look at terrorists. The terrorist says, publish Mohammed cartoons, I’m going to come over and gun you down. A reasonable person (like Dave Chappelle) might tell the publishers, well I respect your right to free speech, but if you’re going to get on the A train and start yelling the N-word at people I’m going to think you’re kind of an asshole and tell you to STFU. If crazies are going to kill you, sure, I hope cops step up to protect you, but I’m also going to say, a pox on both your houses, why are you bringing the rest of us into it and putting us at risk?

Which is reasonable from my point of view, but then people are going to say I’m not committed to free speech. I’m letting a threat of violence silence a guy’s right to speech on a train. To which I’m going to say, a people can only have freedom to the extent they’re decent and not assholes. And you’re both being assholes, you can both eff off and leave me out of it. And the violent assholes win, and the non-violent assholes lose.

And the non-violent, non-assholes always tend to lose, whatever happens.

If you’re playing a game of chicken, barreling down a highway to see who will swerve later, and you really want to win, just throw the wheel out the window first and you are pretty sure to win. Reasonable always loses out to crazy in the game of who can be a bigger asshole.

The Big Lebowski is a classic movie from the Coen brothers, it’s a lot of fun to watch and you can read a lot into it if you want to. What I see is, everybody in the movie has some extreme narrative they’re living about themselves and the world, and thinks the others are on some strange trip, and their narratives interact in ludicrous ways. Except for poor straight man Steve Buscemi, who just tries to get along with everybody and constantly has to suffers their crap. That’s how I feel when I look at the world…but of course every character on their own strange trip feels the same way.

When you’re in a social game, sometimes the best strategy is the least cooperative strategy that doesn’t get everyone to gang up on you. If you’re not going to get heavily penalized, kicked out of the game, the uncooperative person wins against the cooperative people.

But society just doesn’t work if everybody is that way, so you need penalties and rewards for cooperation.

In society, that takes the form of branding, signaling, the class system. They are forms of human attention that lead to trust, or at least in-group trust. You join a religion and paint yourself as subscribing to religious principles, i.e. not being an asshole. In theory, if you break with those principles, you have a lot to lose, like going to hell, being ostracized. This lets you interact with people who think that signal is credible in a more cooperative way. Of course that creates the dominating strategy of pretending to be religious, while cooperating as little as you can get away with, being a religious asshole. Signaling works best if it’s costly and relatively irreversible, like a tattoo.

If you play Prisoner’s Dilemma once for all the marbles, then defection, i.e. screwing over your partner in crime, is the dominating strategy. If you play repeatedly for an unknown or infinite number of times, tit-for-tat may be the proper strategy. If you play twice, or by induction a known finite number of times, cooperation falls apart again and you are back to defection. A religious person may argue that therefore, a belief in eternal life, or a belief in some kind of of divine retribution, is a prerequisite for ethical behavior.

I don’t really agree with that, I tend think humans are hard-wired by evolution to co-operate, and to seek meaning, and therefore build up religious narratives to justify ethical behavior and cooperation. That hard wiring, coupled with small social sticks and carrots, makes the overwhelming majority act decently. But you need those small social sticks and carrots to make sure everyone knows where the lines are. If the incentives and game theory were all that mattered, people would be a lot less ethical than they are.

Twitter and online comments have become a tragedy of the commons, with awful folks driving out reasonable discussion. When online discussion was pretty new, and primarily educated early adopters, everything was great. As more people joined, you got adverse selection. A few assholes poison the well, and all the reasonable people leave, because who wants to argue with assholes, or expose yourself to mob attacks for minor perceived transgressions.

What Twitter, comments teach us is that if you don’t have an effective system for signaling reputation you can’t have an effective social system. Originally the signal was just being part of the elite who used Twitter. But as it grows, if the system doesn’t afford mechanisms to signal good behavior, it only rewards attention-seeking. The strategy of being an asshole dominates the strategy of being a constructive, reasonable, decent human being. In Taleb’s parlance, reputation is your skin in the game. Without it, you’re just a poser and bullshitter. And all media will be 4chan, the equivalent of bathroom graffiti.

In social systems, a small amount of bad behavior drives out the good. It’s why we can’t have nice things. I would love to believe every woman who says she was raped. The problem is that creates a dominant strategy of being an asshole: every woman gets a ‘put a man in jail’ card and can indulge a grudge by crying rape. Assholes like the UVA woman are why, unfortunately, some reputational scrutiny needs to be in place. And yeah, it sucks if you’re a righteous woman who gets assaulted for no reason, to then be subject to that scrutiny. Never mind if you’re a low status person, someone with a little reputational scratch and dent who may not be believed, a sex worker for whom the scrutiny is hurtful and costly. But assholes are why we can’t have nice things.

Personally I don’t believe an anonymous tweet is sufficient evidence to tar and feather someone. If you think that, then don’t say all online rough mob justice must be stopped…or harassment should only be stopped for people you like.

(Please don’t break out the torches and pitchforks on me for saying that. All I know about this case is that at least one person is an asshole, and don’t know which one, I’m just trying to explain the logic of both sides. Fear of mob justice shouldn’t prevent us from ever talking about anything controversial in public. We’ll never evolve that way.)

Guns. If you don’t want to have a strong reputational system where this guy who killed a neighbor can’t legally carry a gun, I think you’re an asshole. The founding fathers were smart. They knew a people could only remain free to the extent they weren’t assholes. That’s why they put ‘well-regulated’ in the second amendment.

The larger a population grows, the more assholes there are. And the more harm an individual asshole can do, the more you need a system of reputation that restricts what you can do based on past behavior.

The irony of Taleb’s excellent essay, of course, is that if you know anything about Nassim Nicholas Taleb, it’s that he is himself a stubborn minority, someone who takes pleasure at trolling the establishment, even as he claims they smear him. Criticize him, you’re an imbecile. He’s the guy who criticizes everybody, while having incredible thin skin if anybody criticizes him.

It’s OK to be a stubborn minority against a misguided tyranny, less so against reasonable people trying to figure out the truth and get along. If you run into an asshole in the morning, you ran into an asshole. If you run into assholes all day, you’re the asshole.

Just because you’re brilliant and you’ve figured some stuff out, there’s no need to treat other people like imbeciles when they are honestly trying to figure it out for themselves. If you’re going to be unreasonable, you had better be really really right. Otherwise you’re just another unreasonable asshole. Even if you’re a would-be genius, a little humility goes a long way. It will make you a better thinker and make people more willing to listen. (See also Eric Falkenstein, Steven Pinker, John Horgan).

Anyway, I’m in 100% agreement with Taleb that if you want to call yourself an economist, you should think about complex system dynamics, market designs. I feel like Steve Buscemi when I hear people have strong opinions about Uber without apparently having given a moment’s thought to the dynamics of creating a 2-way market between riders and drivers, what ‘surge pricing’ should look like. A lot of times, the people who disrupt and move things forward are opinionated, entitled minorities and jerks.

Be brilliant and opinionated. Try not to be an asshole. Be excellent to each other.

Here’s to the crazy ones. The misfits. The rebels. The trouble-makers. The round pegs in the square holes. The ones who see things differently. They’re not fond of rules, and they have no respect for the status-quo. You can quote them, disagree with them, glorify, or vilify them. But the only thing you can’t do is ignore them. Because they change things. They push the human race forward. And while some may see them as the crazy ones, we see genius. Because the people who are crazy enough to think they can change the world, are the ones who do. – Iconic Apple ad narrated by Richard Dreyfuss

Pokémon economics, secular stagnation, and cognitive dissonance

There are these two young fish swimming along, and they come across an older fish swimming the other way, who nods at them and says, “Morning, boys, how’s the water?”

And the two young fish swim on for a bit, and then eventually one of them looks over at the other and goes, “What the hell is water?” – David Foster Wallace

A physicist, an engineer, and an economist are stranded on an island with nothing to eat. A can of beans washes ashore. The physicist says, “Let’s build a fire and heat the can, the pressure will make it pop open, and we can eat the beans.” The engineer says, “The can will explode and beans will go everywhere. Let’s smash the can open with a rock.” The economist says, “Lets assume that we have a can-opener…” – Original author unknown

Do economists really understand the essence of what’s going on in the economy, or are they like fish who don’t know what water is, assuming can openers to solve what ails it?

Vox had an article on what Pokémon Go says about capitalism.

The gist: all the money from the digital economy goes to a few people in large companies like Apple and Nintendo, and the rest of the world is in a brutal race to the bottom.

Now, that’s not 100% true…Pokémon Go creator Niantic is a startup, if an unusually well-heeled and well-financed startup.

But it feels essentially true.

The reason I started writing this long and digressive rant, is that I posted the Vox story about Pokémon Go in an economics forum, and it got banned for not contributing to the economic discussion. The notion that there could be secular stagnation, and it could have to do with income distribution, and there might be policy implications, was, to some folks, not even a proper subject for analysis and debate.

We’re in a world where something like Pokémon Go can achieve global scale, and the results accrue to relatively few. Lower income folks who receive an additional dollar of income immediately spend two or three times as much wealthy folks. So, if growth in personal income goes mostly (or entirely) to the wealthy, it doesn’t boost demand as much.

In a digital winner-take-all land grab economy, with the returns accruing to fewer people…the spending multiplier doesn’t ripple through the economy, except in $10,000/sf NYC apartments in the sky…The literal land grab for people lucky enough to have acquired NYC/SF real estate before it took off.

These days, you don’t need to build big factories and infrastructure to create a tremendous amount of value. Messaging company WhatsApp had 55 employees when they were bought by Facebook for $19b!

Meanwhile old-world messaging company Verizon is for all intents and purposes exiting land lines, not rolling out FiOS to compete in competitive markets like e.g. NYC, laying off employees who picket stores, while spending big on mobile, digital, content like Yahoo. (Verizon snookered an NYC franchise out of Mike Bloomberg with a promise to roll out FiOS — don’t get me started on their non-competition/collusion with cable companies, and FCC net neutrality shenanigans.)

Invest in FiOS, or a restaurant, or a hotel, or a transportation fleet, be lucky to earn any risk-adjusted real return…meanwhile Seamless, Airbnb, Uber take 15%+ off the top line and earn huge returns on equity and make billionaires of a lucky few big winners.

The phone is the new car, the totemic identity-defining product that drives the economy. If you want your teenager to stay in line, threaten to take his or her phone away. Or is that now considered child abuse?

In the old days the threat would have been to take way TV privileges, or car privileges. The phone is now the teenager’s passport into an independent social life away from parents’ watchful eyes.

But when kids drove cars, they would drive to the mall, spend money, or at least get exposed to the mindset of expressing themselves through consumption within their own generational subculture. They would buy records and CDs and go to movies…now they download and share on social media all day, watch YouTube and Netflix and listen to Spotify for much less money.

Mass media, car culture, consumer goods, they all came of age in the postwar era. Is it possible that, without a new social contract, they will all decline in tandem, as Ben Thompson has suggested?

Capital utilization becomes more and more efficient. In our lifetimes, trains of driverless trucks will be dispatched by central software, making whomever develops it rich, drafting to avoid air resistance, taking up less road, needing less fuel, fewer gas stations and truck stops, and of course drivers.

Map the most common job in every state, drivers is at the top of the list…what is it going to be in 30 years? I’m not too sure ‘app developer’ is a good candidate.

The more the economy develops, the more abstract it gets. Instead of being constrained by labor, capital, energy, everything becomes a land grab for screen real estate, network effects, or mind-share (branding being a franchise in brain real estate).

When you’re buying a stock, a McDonald’s franchise, a piece of real estate, what are you buying, exactly? You’re buying the cash flows from ownership. But what are the cash flows from ownership? The course of the economy, the competitive landscape determine that. But so do regulation, taxes. Either way, what you’re buying is a story.

You may not like it, but when you buy a stock, you’re buying a story about why it’s going to grow and be a strong brand, and the value will change depending on how the HQ grows the brand, changes the rules about how revenues and profits get allocated.

When you buy a bond, you buy a defined cash flow, modulo credit risk, but you’re buying a narrative about whether the Fed and the economy will keep the value of that cash reasonably stable.

The more we evolve, the more we climb the abstraction layer from sweat to clever invention, to stories and viral media land grabs. The new world smells like buzzword globaloney. But that’s what it is…the job of the powers that be is to keep the story machinery humming because the business of the world is manufacturing self-perpetuating stories, i.e. bubbles. We are all Lloyd Dobler now.

If you don’t buy into one of those narratives you end up holding cash and gold, but in the long arc of history the stock and bond narratives have more or less worked out most of the time, so you end up losing out.

We’re all in a Thorstein Veblen world now. Except there’s no leisure class. There’s a work-like-crazy-for-status class, a work-like-crazy-to-survive class, and an underclass.

Economics has things to say about this game of stories and bits, where every bit strives to be the high-order bit. But it’s not the economics of competitive markets and supply and demand.

Consider Apple iOS. No Apple phone is the most leading-edge hardware, the teardown cost of the iPhone is always lagging e.g. the latest Samsung Galaxy. But the software and ecosystem are why the ASP of iPhone is in the $600s, while Android is in the $200s.

The iPhone platform is more of a mini-state of law than a product. The US has to go begging for access (or hire people Apple would consider outlaws to hack it).

I cry a little inside over Twitter’s harassment issues, which represent a loss of innocence. There was a time when I thought anonymous/pseudonymous public speech was OK, but it just hasn’t worked out. People suck and that’s why we can’t have nice things. You can only have freedom to the extent there’s virtue a/k/a social capital. Neither Milo nor ‘Help! Help! I’m being repressed’ activists should be able to hound people and shut anyone down. But no one asks the government for rules (well, at least, not most reasonable people). They ask Twitter to put something in place…presumably in the not too-distant future users will be able to only see approved or verified folks in their stream and not have trolls calling them out all day (and maybe live in their own left- or right-wing bubble of stories).

The economic holy grail is carving out a platform with increasing returns to scale and a massive moat–not being the low-cost producer, market leader, etc. It’s seizing the commanding heights, making the rules, not making the product. It’s not the game you learn in Micro 101.

I don’t think you can treat these companies as monopolies like Elizabeth Warren suggests. Well, you should probably rein in some of the most egregious behavior. But Microsoft would have argued that splitting their OS from the apps business would have done more harm than good by making it harder for apps and OS to co-evolve, and they were probably right.

This is where I think some economists and some libertarian types miss the boat.

Here’s a thought experiment…how much of your brain do you think is devoted to social processes, and how much to utility-maximizing processes?

I don’t have a link, but I’m quite sure the answer is the former. If you’re a business person or policy person, you may spend a lot of time thinking about markets and incentives. But only a small percentage of our interactions work that way. Economics is the tip of the iceberg, the point of the spear. Marginal thinking and incentives may be decisive in important interactions. But they only allow you to act within a framework of social conventions and laws which is more determinative.

Coase’s theory of the firm is that markets are inefficient coordinators… they excel at high level allocation of resources, but for the last mile of complex processes you need a hierarchical, organization with command and control…and culture.

In a physics sense, the market economy is incredibly inefficient. People massively duplicate effort. You have multiple competing gas stations at every big intersection. Huge amounts are spent on marketing, products with questionable social value.

In a computer science sense, however, it is highly distributed, highly parallel at exploring the search space for best practices, technological evolution.

The market economy is like sexual reproduction. It makes animals waste a huge amount of energy searching for mates and creating courtship displays. But it powers a constant search to mix and match the features that allow survival and drive improvement. In the words of Darwin, “It’s not the strongest of the species that survive, nor the most intelligent, but those that are the most responsive to change.” The meta-feature of adaptability is more crucial than efficiency narrowly defined.

Marx viewed economics and relations of productions as the base, and politics and political relations as the superstructure. I think it is much more correct to view social/political and market structure as highly co-evolved, and they together define the ‘water.’

I think if you want to understand human behavior, study social psychology, anthropology, zoology, not economics. Most of human behavior is social psychology, seeking the hierarchy of needs, which mostly boil down to social status…if you have that all your other needs are taken care of. And economics is a game or a collections of games or market designs humans have created to coordinate activity, and by winning them you gain one component of social status. But social behavior comes first, and economics is the game within the game. You optimize your economic choices, but only within the choices society makes available, and the point of economic choices is, once you get past survival, to win a social game, that in turn gives you mating choices, propagates your genes, etc.

You go to a store, you pick something out, you hand over cash, you get a receipt. How long would it take to explain that to an alien? In fact economists can’t even agree on why things like money and gold have value, and why they fluctuate (for instance whether monetary easing right now lowers or increases inflation).

When you get to something like iOS, it’s not so much a product as its own nation of people and laws, its own ecosystem, its own market structure. The product is not the phone, it is the platform, the standards, the ecosystem. The market structure and ecosystem is the product. Same with Pokémon Go…there is no product, all there is is a set of rules that create its own social and economic ecosystem.

Thinking about massively multiplayer game play is essentially the same as thinking about economics. Not for nothing do game companies hire real economists… they are our most empirical economists, market planners, ecosystem engineers.

There’s a brand of economist that thinks everything fixes itself. It exists, therefore it is optimal (unless government is involved). There can’t be any problem with existing market economic structures that could fail to adapt. It’s like the guys who said when Saddam Hussein is deposed in Iraq, it will evolve into a social democracy.

It’s assuming this whole can opener of soft infrastructure, social capital, a legal system, a state that can enforce its will and a political infrastructure that can evolve over time.

Market structure is everything, and social capital that enables market structure is everything. They are the water. You can’t say, just let everyone be free, and a working capitalist system will spontaneously emerge. You want market structures that maximize freedom to trade and innovate. But markets don’t exist without complex social contracts, virtuous people who abide by them a/k/a social capital, explicit laws, and a strong government that enforces them.

Returning to the implications of Pokémon economics, possibly this is the new world we live in, with lower GDP growth, lower population growth, more efficient capital utilization via e.g. Uber which direct capital utilization and control the commanding heights and mean we don’t need a car in every driveway. And everything will be OK.

Maybe machine intelligence is just a latter-day John Henry man vs. machine story, and it will free people from rote work. But, a thought experiment: suppose capital took the form of perfect human robots … what would the economy look like? Would it fix itself, or fall into a Piketty singularity leading to an economy of a lumpenproletariat, robots plus overclass? At what point does the social contract break?

Maybe negative interest rates are post-capitalism, or post-capital, the end of capitalism.

The financial system is totally broken if negative interest rates are a long-term state of affairs, a lot of banking business models are borked, government may have to step up to invest in a lot of infrastructure that doesn’t pay huge returns.

This would make sense. If we’re paying Switzerland to take our money for 30 years, they might as well take it and tunnel the Alps til they’re Swiss cheese. But most countries aren’t doing it.

But if all the income goes to firms that don’t need massive investment, and you use the infrastructure far more efficiently, and government doesn’t step up to invest…you get zero interest rates which lead to financial crisis, and you get Milanović’s elephant chart, which leads to political crisis, Trump, Brexit, etc.

Rethinking investment and the financial system to work in this environment won’t happen without another massive financial crisis, and restructuring of the financial system and even social contract. Hopefully not along the lines of Trump/Brexit/de-globalization and conflict.

People can only absorb so much change. Globalization has been pretty intense for a lot of people, and intelligent machines will throw more over the edge.

The economy is like the human body. We know broadly what will kill it (cough) and broadly what it needs to stay healthy, but we can’t predict everything it does, and sometimes it gets sick for inexplicable reasons.

Something is pretty broken right now. Maybe it will fix itself. But assuming everything is self-healing is a bit like a fish, who doesn’t know what water is, assuming a hammer. The big errors, like the financial crisis, happen when you keep applying old models, when the assumptions they were built on have changed. How can you be so sure they haven’t?

The transition from agrarian to manufacturing economy didn’t happen without massive crisis, depressions, wars, a long culture war between capitalism and communism. Seems like a bad idea to be complacent that models that worked in the past won’t need updating, that problems will solve themselves. Have a little humility. How could we possibly know? What would change your view? If nothing in reality will change your view, then your view isn’t based on reality.

There aren’t a lot of people who understand systems well enough to fix them from first principles, let alone build them, be they economic systems, ecosystems, human bodies, climate. Fortunately, systems that have been around a long time have evolved complex, highly redundant ways of adapting, maintaining equilibrium, and surviving. But they all have their breaking point. There’s an arrogance to thinking humans can understand and control everything, and an arrogance to thinking everything that exists is for the best and will always fix itself.

If you keep making bigger changes to a model, quantitative change becomes qualitative change to the dynamics of a model. When you perturb a system, maybe nothing changes, maybe it starts to oscillate and return to equilibrium, or it breaks/explodes.

Economics is not the study of models, it’s the study of the real world. The map is not the territory. You don’t get to say, what you’re talking about falls outside my model, so ipso facto it is not economics.

We may be bad at forecasting the future, but you still have to act and your actions determine the future, so you have a moral obligation to think about reality, and not just a closed model.

How is the water?

A fun 3D visualization of the financial Twittersphere

Here’s a fun little update of that visualization of the financial Twittersphere I posted in May. This one is in 3D, you can zoom (with scroll wheel) and drag it around (with mouse, also see controls in top right).

It might take a minute to load up, not work too well on older computers/browsers. Just wait out/ignore any popups, warnings about script on page running slowly. If the iframe below is wonky, try this full-page version.
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Negative interest rates are an unnatural abomination

Mayor: What do you mean, “biblical”?
Dr Ray Stantz: What he means is Old Testament, Mr. Mayor, real wrath of God type stuff.
Dr. Peter Venkman: Exactly.
Dr Ray Stantz: Fire and brimstone coming down from the skies! Rivers and seas boiling!
Dr. Egon Spengler: Forty years of darkness! Earthquakes, volcanoes…
Winston Zeddemore: The dead rising from the grave!
Dr. Peter Venkman: Human sacrifice, dogs and cats living together… mass hysteria!
Mayor: All right, all right! I get the point!
Ghostbusters (1984)

Happy 4th of July weekend! Some macro ‘blinding glimpse of the obvious’ blogging.
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A weekend Brexit reading list

This business will get out of control. It will get out of control and we’ll be lucky to live through it. – Admiral Josh Painter, The Hunt for Red October
Cly4cy0WYAAJHYq
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Hillary’s damn emails

The soldier who loses his rifle faces harsher punishment than the general who loses the war. — Anonymous soldier

So, I was reading this, by Kristy Culpepper. She’s smart, you should follow her. I agree with some of it but ultimately I think it’s off base from a tech / security / policy standpoint, like most of the furor on this issue.
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The Top 100 People To Follow To Discover Financial News On Twitter, May 2016


It’s been a year since we posted our last list of people to follow on Twitter for financial news. Time for an update!
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A possibly ill-conceived rant

There is no racial bigotry here. I do not look down on niggers, kikes, wops or greasers. Here, you are all equally worthless. – Gunnery Sergeant Francis Hartman

Against my better judgment, here’s a quick rant about race.

They say, on the Internet, no one knows you’re a dog…but here’s a controlled experiment: list a bunch of things on Ebay, some with a black hand showing them off, and some with a white hand. The one with the white hand will get higher prices.

This may set off cognitive dissonance that it was a poorly executed experiment, or that it’s meaningless. But I feel confident this result holds up to some degree in any careful attempt to replicate it. When was the last time you saw an ad with hands showing off a product in a mainstream media publication, and they weren’t white, usually female? (Edit: see also Airbnb while black.)

No one is immune to acting differently towards people based on their skin color/sex/religion, or any perceived difference. It’s just a matter of degree. Some people perceive stronger distinctions and reflect stronger distinctions in the way they speak and act.

First degree: I inflict, support, desire harm on someone based on the color of their skin. Lynching someone, or calling them the n word (or wearing “Kill all whites slogans” or killing someone because they’re white).

Second degree: I claim I don’t have anything against white/black people, but I am uncomfortable with my daughter marrying one. ‘Sorority racist’ as Chris Rock calls it.

Third degree: I am open toward people of many races in different roles, but I identify as a race, and have subtly different feelings, expectations, reactions, and actions toward people based on race.

No one is immune to this third degree. We’re a tribal, social, territorial, hierarchical, violent species. (See Desmond Morris.) And even if we were purely logical and rational, growing up in say New York, where people of different races talk differently, eat differently, listen to different music, watch different TV and movies, are somewhat segregated, and have different representation in different socio-economic roles, one develops a different set of expectations about the likelihood of attitudes and behavior from different races.

Lest you say this third degree doesn’t matter much, I refer you to the Ebay experiment and urge you to think about what the same means in the job market or housing market. Simple models show that modest preferences to be around some folks of your own race lead to a high degree of racial segregation, even if the starting point is well integrated. Over time, small differences add up to a lot 1.

I have seen this Ebay experiment arouse a strong reaction of cognitive dissonance. Libertarians say markets cannot discriminate, the use of group averages as a proxy in the absence of other information is not discrimination, liberals respond indignantly, everyone starts pointing fingers and resorting to ad-hominems. Read the comments on the Ebay article just a taste.

What do you do about it? I don’t know. But in terms of policy, I lean toward:

  • Laws that are 100% race blind and treat everyone as equal in front of the law.
  • Processes that try to take race out of the equation. When there are disparate outcomes based on race, take a stronger look at the process, but try to make it relatively race-blind, while avoiding completely unrepresentative and undesirable outcomes.
  • A safety net that ensures regardless of race, people aren’t denied opportunity for a decent education, health care, basic needs. We do a pretty good job of making sure old people don’t starve or get denied access to health care, we do a pretty poor job for children.

If you had college admissions based purely on an admissions test, which happens in many countries, you’d have a lot more Asians. Maybe a lot of top colleges would be like Caltech’s 45% Asian student body. Much was made about blacks at the Oscars, but here’s the entirety of Asian nominees (not winners) for Best Actor/Actress: Ben Kingsley, Yul Brynner, Merle Oberon. Something seem off? Maybe Asian performers have more to complain about with regard to access to opportunity than black folks. Ask Aziz Ansari. If you go 100% race blind, you perpetuate whatever existing advantage some group has. So be careful what you wish for.

Is it wrong to put a modest finger on the scale to get outcomes that are more representative? I think it is a proxy for fairness because we haven’t all had the same chances. It is also practical because society is better off if its elite and political leadership is representative.

But if you put too much of a finger on the scale, there are unintended consequences. Everyone starts to feel disadvantaged. People who feel disadvantaged get angry. Everyone starts fighting over who is getting more of the pie.

Disadvantaged and unpopular minorities should expect fairness from democratic government – that’s what the Bill of Rights means. But the kind of strong government that acts for fairness can be oppressive in the hands of the wrong person <cough>Trump<cough>. The Ebay market outcome is unfair, but there seems no way to remedy it without making the market as a whole even more imperfect. So, again, be careful what you wish for.

People throw around accusations of racism as if people who are racist are evil others who must be punished. But everyone’s a little bit racist. We’re neurotic, because something that is part of all of us is treated as a disease or a crime against decency.

We should all strive mightily to treat people as individuals, recognize that we are flawed and will never do so perfectly, and be reasonably tolerant of the shortcomings of others. And at the same time draw some clear lines about what type of racist action and language is not acceptable in a civilized society, and not allow the more angry and disturbed souls among us to poison the well. And see what we can do, within reason and without trampling the rights of others, to create a fairer society.


1 And if you read social media and comment sections, there sure are a lot of people who go well into degrees one and two.

What if everyone was a passive investor except Warren Buffett?

This is a slightly extended “director’s cut” of a post written for CFA Institute Enterprising Investor.

Warren Buffett sometimes says things that seem . . . contradictory.

For example, in the “You don’t have to be a genius to be a great investor” category:

Success in investing doesn’t correlate with IQ once you’re above the level of 25.”

If you are in the investment business and have an IQ of 150, sell 30 points to someone else.

He loves tweaking academic proponents of the efficient market hypothesis (EMH):

I’d be a bum on the street with a tin cup if the markets were always efficient.

Naturally the disservice done students and gullible investment professionals who have swallowed EMH has been an extraordinary service to us . . . In any sort of a contest — financial, mental, or physical — it’s an enormous advantage to have opponents who have been taught that it’s useless to even try.

And yet Buffett also says most people should steer clear of active investing: Like those same gullible investment professionals and misguided EMH proponents, he recommends low-cost index funds.

A low-cost index fund is the most sensible equity investment for the great majority of investors.

[To his own self-selected trustee] My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors — whether pension funds, institutions or individuals — who employ high-fee managers.”

How can Buffett say passive investing is best for most people and also an “enormous advantage” for active investors like him? If it helps everyone else, how can it also help him?

The opposite view is sometimes described as the “suckers at the poker table” hypothesis — the theory that an increase in passive investing is bad for active investors like Buffett because the fewer suckers there are to fleece, the less profit there is for smart active investors.

So which view is right? The “suckers at the poker table” theory, or Warren Buffett, who says passive investors make his job easier? And how can Buffett be right while at the same time saying most people should invest passively?

Let’s do a simple thought experiment: What would happen if everyone was a passive investor except Warren Buffett?

As is often the case, we find that Buffett is way ahead of everyone else. He is both correct and self-serving. Anyone can use an index to match the market on a holding period–return basis, and yet Buffett can still crush everyone else on a money-weighted basis.

A brief theoretical digression: The Grossman-Stiglitz paradox holds that you can’t have a perfectly efficient market because that requires someone to be willing to arbitrage away any inefficient price. But arbitrageurs have to get paid. So they will only step in if they’re compensated for their time, data services, research, compliance, office rent, overhead, and an adequate after-tax, risk-adjusted return.

So markets tend toward an equilibrium where prices are boundedly efficient, where there is no more mispricing than at the level that would make arbitrage profitable.

The set of all investors is the market itself and, in the aggregate in any given period, earns the market return. The subset of index investors, by virtue of owning the market portfolio, also earns the market return. To make the indexers and non-indexers add up to the market, the non-index investors in the aggregate must also earn the market return.1

In the aggregate, those “arbitrageur” active investors aren’t making any excess profits! Before expenses, they are matching the market, and after expenses they are underperforming.

In order to have any profitable active investors, it seems you need overconfident, “dumb” active money that loses money trading against the “smart” arbitrageurs. And that doesn’t make much sense. It implies the persistence of a class of irrational investors. If there’s a tug of war between smart money and dumb money, and a priori the dumb money is as strong as the smart money, and it’s to the smart money’s advantage to trick the dumb money whenever possible, why should that make prices efficient?

It sounds like a theory of irrational traders and not very efficient markets.

Let’s see if a thought experiment can shed some light:

What happens if passive investors take over the market so there is only one active investor left: our hypothetical Warren Buffett?

Let’s disregard, for now, changes in the composition of the index. We only have Buffett trading with passive investors. The passive investors just want to enter and exit the whole market. They don’t want to trade individual stocks or a non-market-weighted portfolio. And there are no other active investors to trade with other than Buffett, who makes a bid-ask market for the index, selling when it’s above his estimate of fair value and buying when it’s below fair value.

A somewhat trivial example, which should be familiar to those who have done the CFA curriculum on holding period vs. money-weighted returns:

Cash Flows
Index
Fair Value
(%Chg)
Index
Price
(Premium/
Discount)
Passive
Investor 1
Passive
Investor 2
Dumb
Investor 3
Dumb
Investor 4
Warren
Buffett
Corporate
Issuance
Year 0 $ 100.00 100.00 (0%) (1,000) (1,000) (1,000) (1,000) 4,000
Year 1 $ 105.00 (5%) 94.50 (-10%) (1,000) 945 (1,000) 1,055
Year 2 $ 110.25 (5%) 121.28 (28.3%) (1,000) (1,000) (1,000) 1,283 1,717
Final value $ 115.76 (5%) 115.76 (0%) 1,158 3,337 2,112 955
Holding period return 5.0% 5.0% 5.0% 5.0% 5.0%
Money weighted return (IRR) 5.0% 5.4% 2.7% -5.0% 28.3%

 

  • The index fair value grows at 5% per year.
  • It starts priced at fair value in Year 0, in Year 1 it trades at a 10% discount, in Year 2 at a 10% premium, and then finally returns to fair value in Year 3.
  • The holding period return, which ignores flows, is 5%, matching the index.
  • Passive Investor 1 buys $1,000 worth of stock in year 0, never trades thereafter, and has holding period and money-weighted return of 5%, the market return.
  • Passive Investor 2 buys $1,000 worth of stock each year and has a money-weighted return of 5.4% as a result of automatically buying more shares when they are cheap and fewer when they are expensive.
  • Dumb Investor 3 panics when the market goes to a 10% discount and doesn’t buy that year and ends up with a 2.7% money-weighted return.
  • Dumb Investor 4 panics even worse, sells when the market goes to a 10% discount, and ends up with a -5.0% money-weighted return.
  • Warren Buffett stays out of the market until it trades at a 10% discount, sells at a 10% premium, and ends up with a 28.3% money-weighted return.
  • Corporate issuance is included as a reminder that there are two sides to the market and overall cash flows in and out have to net to zero.2

If you examine any individual year, everyone here is a passive investor in the sense of always holding the index.

Everyone gets the same 5% holding period return, which ignores flows.

But on a money-weighted, risk-adjusted basis, of course, the returns are very different, and our Warren Buffett crushes the market.

One way of looking at it is Buffett times the market, increasing the size of the overall pie when the odds are in his favor, shrinks it when they aren’t, and outperforms without necessarily taking anything from the other investors, who earn the market return in each holding period.

Another way of looking at it is to consider the whole scenario as one holding period during which Buffett took advantage of people who were selling low and buying high. Effectively, our Warren Buffett sets a floor under the market when events or cash flows make the passive investor inclined to sell excessively cheap and sets a ceiling when the market gets expensive.

Even though everyone here is passive in a given year, if you think of the entire scenario as one holding period, only someone who owns the index and never trades is really a passive investor. Everyone else is buying high or selling low within the period.

The key point here is, the only person who is a passive investor is the one who never trades. That person is guaranteed the market return. Even if you are just re-investing dividends, there’s no guarantee of how well you will execute. As soon as you trade, you are at risk of being exploited.

On a sufficiently long timeline, the probability of being a completely passive investor goes to zero. If you’re planning to invest for an objective other than buying and holding forever, you have to make decisions about when and how much to invest and when and how much to withdraw.

Eventually you have to make an active investment decision, and at that point the shrewd investors are lying in wait. Everyone eventually has to pay Charon to cross the river Styx.

It gets even better for Buffett when you incorporate index changes.

An IPO comes out. The IPO is initially not in the index. Our hypothetical Warren Buffett sets the IPO price. He doesn’t have anyone to bid against or anyone to trade with besides the issuers since the stock is not yet in the index. Being an accommodating fellow, he sets the price at fair value minus his margin of safety, illiquidity discount, etc.

The IPO eventually gets added to the index. Indexers have to buy the stock. Buffett solely determines the price at which it gets added to the index. In his obliging manner, he sets it at fair value for a liquid index stock plus a reasonable convenience premium.

What a sweet deal! Pay a steep discount for any security not in the index and demand a big premium when it goes into the index. Similar profits are available when securities exit the index.

Going back to the Grossman-Stiglitz paradox, the arbitrageur active traders can do pretty well, even without the existence of a large pool of permanently underperforming “dumb money,” which is unnecessary and illogical.

They pull a bit of Star Trek’s Kobayashi Maru scenario by going outside the bounds of picking stocks from within the index, by timing the market, by charging a toll for the more passive investors to enter and exit the index.

The “suckers at the poker table” paradigm goes astray because there isn’t some exogenous fixed size of the investment pie investors are fighting over. The returns are endogenous: They are in part determined by how smart the investors are, how well the capital in the economy is allocated, and by everything else that impacts economic and market outcomes.

The performance pie is not fixed. When someone invests in an early Apple or Google, are they stealing performance from someone else? Was Ron Baron stealing performance from someone else when he funded Wynn as a startup? He’s creating something that eventually goes into the index…pulling a bit of a Kobayashi Maru by redefining the index.

When Buffett invested in Goldman Sachs during the crisis is he stealing performance from someone else? You could argue Goldman Sachs made excess returns on his investment, it gave them opportunities no one else had, and benefited all shareholders. Buffett pulls a bit of a Kobayashi Maru by expanding the investable market when it’s cheap, instead of taking it as a given fixed pie. 3

Smart money going into appropriately priced investment opportunities grows the whole pie. Dumb money going to bad businesses shrinks the pie. Once it’s not a strictly zero-sum game, you don’t need “suckers at the poker table” to outperform. Sufficiently smart money creates its own suckers.

The more extreme advocates of passive investing go astray, I think, in concluding that passive investors can always match active investors.

See for instance, Sharpe. His mathematical proof that indexers always match the market is, of course, correct insofar as the passive investor who does nothing, gets the market return. But as soon as you trade, you’re an active investor in that period (Sharpe’s footnote 4). And the spread you have to pay to transact is the gain of the active player on the other side. So passive performance = active performance, but only because the passive investor has to briefly become an active investor in order to get fleeced.

Sharpe’s proof is correct on an accounting basis, but tautological and not fully descriptive of market reality. In order for the passive investor to match the market in practice, he must be able to trade in size at the market price and not allow himself be exploited. Which is not a bad assumption at small scale but gets harder as the passive investor gets bigger. (Sharpe hand-waves past this in footnote 3, saying trading makes the math more complicated but doesn’t change the basic principles. But if passive trading is big enough to move the market, if effective trading spreads are sufficiently large, that can no longer be true.)

Passive investors cannot always have a free option to match the market, unless the other side gives it to them. The outcome is an equilibrium. When few people are passive, indexers get to match the market and free ride with the people who do the research and set the prices. On the other hand, when many are passive and few are active, there are mispricings, and when indexers have to trade, for instance around big dividends, corporate actions, index changes, rebalancing, seasonal cash flows, economic developments that necessitate cash flows, they can be exploited because they herd.

It’s a little absurd to take a fanatical view about indexing. Active vs. passive is a continuum, from matching the market portfolio and never trading, at one extreme, to finding big bets where you have an edge and trading often, at the other extreme. Anyone who trades inside your time frame is active and giving you an option to potentially eat their lunch if they’re willing to trade at a favorable price, and on a long enough time frame no one can be completely passive forever. What one should be fanatical about is expenses, after-tax risk-adjusted returns, keeping it simple, and avoiding mistakes – all of which are good arguments for indexing.

There are many useful parallels between investing and poker. You have to zig when everyone else zags. Simple strategies can be exploited. You have to use a meta strategy, like a mixed Nash equilibrium.

Unlike poker, investing is not a zero-sum game. Dumb money is not the primary driver of returns for most strategies, and “suckers at the poker table” is not a useful analogy for most long-term investors. There is always a game beyond the game, where the best players astutely redefine the game to find an edge.

Efficient market proponents make the point that there ain’t no such thing as a free lunch, in the form of persistent pricing inefficiencies that provide excess risk-adjusted returns. But in a sense, indexing is yet another attempt to find a free lunch … the indexer gets a free ride on efficient prices determined by everyone who does their homework. Like all free lunches, this one also goes away if enough people take advantage of it.

Takeaways:

  • If sufficiently few people index, indexing is a free lunch: same performance with lower costs.
  • If you can index and never trade, you are guaranteed the index return (without reinvesting dividends).
  • Nobody can be totally passive forever. Everyone has to trade sometime. Even re-investing dividends, rebalancing has a cost.
  • Everybody can’t be passive, someone has to take the other side of each trade.
  • If enough people index, and have to trade, they can be exploited.
  • As indexing increases, herding increases, correlation increases, overall volatility increases. 4
  • The math that proves indexers can always closely or perfectly match the index performance, doesn’t add up when the indexer has to trade, and trades are big enough to move markets.
  • Instead, there’s a Nash-like mixed strategy equilibrium: too little passive, passive can exploit active, too much active, active can exploit passive.
  • Dumb money doesn’t become smart money because it indexes. It just finds another way to lose. There is always a game beyond the game.
  • And finally, everybody likes a good Buffett angle, even if it’s a MacGuffin for a boring discussion of limits of active v. passive.

This benefited from discussion with Will Ortel of CFA Institute and Wes Gray of Alpha Architect.


1. This accounting excludes issuers of stock, who are kind of important. Companies are net distributors of cash to their stockholders. They pay dividends and they on net buy back stock, these days. So everyone cannot be a passive investor in the S&P and reinvest dividends. If they tried, something would have to give. Investors would bid up stocks until someone capitulated and started selling, or companies started issuing stock, or something. When it’s not a zero-sum game, reasoning from accounting identities tends to be misleading.

2. Here’s a thought exercise: do you think the issuers are on balance generally timing their corporate actions efficiently, issuing high and buying back low? Does it matter? Answer (I think): On any finite time period, of course it matters! If companies are acting efficiently over time, generally selling stock when it’s expensive and buying it back when it’s cheap, that is bad for whoever took the other side of that trade. The shareholders on the other side have a lower return than the market average. The company has a lower effective cost of capital than long-term market averages would suggest. And the shareholder who holds indefinitely and never trades gets a benefit.

Going back to footnote 1, this is another reason active=passive only with simplifying assumptions of ignoring issuance and distributions and trading, which are rather significant to returns and properly functioning capital markets.

(If any good research summary on how well capital transactions are timed, I would love to read about it. À priori I would guess IPOs and LBOs tend to be not advantageously timed for public shareholders; dividend adjustments tend to lag market developments; buybacks tend to be distorted by management incentives around return on equity and stock options; cash mergers, not sure. )

3. When someone invests in an early Microsoft, they are partly creating wealth, partly taking it from e.g. IBM shareholders. Similarly when Buffett invests in GE on the cheap, he is partly increasing the pie for everyone, partly giving himself a better deal at the expense of everyone else. The beauty of a properly designed free market is that everyone has to harness creativity for the benefit of all to gain something for themselves.

4. These seem the most plausible first-order approximations. The reasoning is that as active investors turn passive, flows are more correlated, the inside bid-ask from the remaining active investors can only get wider, and a given flow has a bigger impact on price. But if the one Warren Buffett who is left changes his mind daily on intra-index relative prices more than the exiting investors did, you could conceivably see an increase in intra-index volatility.

Stories Are Powerful, But Check the Math

The first principle [of scientific inquiry] is that you must not fool yourself – and you are the easiest person to fool – Richard Feynman

In God we trust; all others must bring data. – attributed to W. Edwards Deming (ironically without any primary source backing up the attribution)

This Amy Cuddy TED talk was electrifying.

Video spoiler: If you adopt a “power pose” for 2 minutes, Amy Cuddy says it will not only change your posture, image, and attitude, but even your body chemistry, with more production of testosterone and anti-stress hormones.

It’s a great story, which is probably why it’s currently the second most-viewed TED talk.

Unfortunately, the published study study had only 42 participants. And other studies haven’t replicated the results on hormone production. Andrew Gelman even uses the opprobrious term p-hacking: data-mining to find a spectacular result.

The curse of dimensionality: the more things you measure, the more things will significantly deviate from the median.

The math can be counterintuitive.

Take a sample of apples. Grade each apple with a single number, like weight. For a contrived example, let’s say weight is uniformly distributed between 0 and 1.

What percentage of objects lie between 0.25 and 0.75 (the middle 50%?).

50% number line

Obviously, the blue line is 50% of the orange line.

Let’s grade apples along 2 dimensions, e.g. weight and redness.

What percentage of objects lie in the middle along both dimensions? Assuming weight and redness are uncorrelated, the answer is 50% squared, i.e. 25%.

How big a circle do we have to select to get to 50% of objects? We have to solve

    \[ \Pi r^2 = 0.5 \]

which gives r = 0.3989.

We see that we need a circle with almost 80% diameter to capture 50% of the square.

Number square

Let’s grade apples along 3 dimensions, e.g. weight, redness, and sweetness.

What range do we have to select to get to 50% of objects? We have to solve

    \[ \dfrac{4}{3} \Pi r^3 = 0.5 \]

which gives r = 0.492373.

We need a sphere with almost 100% diameter to capture 50% of the cube.

Sphere in cube

The point is, as you add more variables, the central 50% (or any x%) contains more and more extreme values. As you add dimensions, the outlying regions get bigger faster.

We can extend to higher dimensions which we can’t visualize, and chart the width of the 50% hypercube as we increase the dimension:

Capture

If you have 14 dimensions, the 50% hypercube is 95% of the length of the unit hypercube.

With enough features, anything or anybody is an outlier on some dimension.

Suppose you do an experiment measuring the variation of testosterone after assuming a power pose.

Suppose the power pose in fact has no effect on the level of testosterone (the ‘null hypothesis’).

If you observe a change due to chance variation, 95% of the time it will be statistically insignificant at the p > 0.05 level, and significant (p < 0.05) 5% of the time.

If testosterone and corticosteroids both exhibit no effect, the measured change in both will be statistically insignificant 0.95 * 0.95 = 90% of the time (assuming no correlation between them). As you measure more variables, the chance of one of them being significant goes up rapidly.

If you measure 14 insignificant variables, there’s a 50% chance one will be significant at the p < 0.05 level.

If you measure 50 insignificant variables, there’s a 92% chance one will be significant. 92% of that 50-dimensional ‘hypercube’ is in its outermost 5% region.

That’s how you get a prank paper to go viral showing chocolate helps people lose weight.

This sort of thing could be avoided if it was standard practice to hold back some test data, and do an out-of-sample test on any scientific finding. The methodology as practiced, to assume errors are unsystematic, and report p-values and significance on that basis, even on small samples tested for multiple relationships, seems weak and unscientific.

Returning to Amy Cuddy, you can interpret this a couple of different ways.

One interpretation: Statistics do not back up her story, that power poses raise hormone levels.

Another interpretation: Statistical methods are weak at finding complex stories, and you have to come up with a story to understand the world, and look for statistical confirmation where you can find it.

Acting with confidence and joy is contagious, to your own psyche and how others view you. That’s a story. Stories let humans understand and remember very complex phenomena.

For instance, attach a story related to their personal experience, and people solve tricky logic problems easily. Show them the same version as an abstract math problem, they fail miserably.

Feynman, quoted above about not fooling yourself, also said you must develop your intuition, thinking through examples and understanding the story of how things work as more than mathematical abstractions.

Stories are powerful. The more interesting things in the universe are complex interactions, like stories: evolution, the Big Bang, the French Revolution.

The curse of dimensionality means that as you absorb more features of the world, the possible states and explanations and oddities rise according to factorials and exponents. Things get curiouser and curiouser. There are complex interactions that can’t easily be explained. Stories are how humans make sense of a complex world.

Stories can mislead. A great story can be spurious, T. H. Huxley’s “great tragedy of science – the slaying of a beautiful hypothesis by an ugly fact.”

Stories are a powerful shortcut (Kahneman’s ‘thinking fast.’). But they are a shortcut that can lead you astray, so you also need to stop from time to time and make sure you know where you are going (Kahneman’s ‘thinking slow’).

So use your evolution-given power to understand complexity through narrative — but check the math.

Even if poses don’t elevate hormone levels, Superman and Wonder Woman were depicted that way for a reason. Don’t slouch through life due to lack of statistical evidence you shouldn’t!

(Mathematica notebook.)


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