Necessary generalists: Financial planning (gambling)

In a relatively free-market financial system, the way you grow your wealth is by risking it. This is inherently dangerous, but that danger can be mitigated with knowledge and experience.

Some people learn a great deal about markets just for fun, and others want absolutely nothing to do with them. So this post could seem distressingly strange or just boring, depending on who you are. The contents of this post are not financial advice, and I hope I make that clear enough by speaking broadly and not getting into specifics (on which I’m unqualified to give advice).

This post is a component of the Necessary generalists theme, which says that there are some fields of study where pretty much everybody should have competence (such as personal finance). We are actually forced to be generalists when it comes to these things.

The global casino

The global financial markets are a casino. Prices of assets go up and down seemingly at random, and you can place all kinds of bets on these outcomes.

The January 2021 GameStop saga demonstrated this as well as anything else. A bunch of Redditors rallied each other into buying GameStop stock in order to raise its price and squeeze out existing short positions (which would further raise the price). It appeared to work. The price move was so drastic that many brokerages temporarily halted trading. In those chaotic days and weeks, a handful of Redditors made life-changing amounts of money. Did they outsmart the hedge funds like they’d planned, or did those hedge funds only lose to other hedge funds that took the long position? I have no idea. But I remember the talking heads on the news pretending to be scandalized by the fact that these Internet kids were making trades based on memes and tribalism instead of the fundamentals of GameStop as a company. Someone called it “nihilism” at some point. All that is to say: the stock market was clearly being used as a “money go up” machine with no regard for what a stock represents.

Was stock investing ever actually about the value of a company? Sure, but it hasn’t been purely about valuation for a long time. There’s a whole industry in using automated trading bots to buy and sell on <1min timescales: this has nothing to do with valuation and everything to do with getting into a small price move before the next trader, and taking their money.

Similarly, most (all?) cryptocurrency values are based on nothing more than memes and hype. You can theoretically make retirement-level money in a single day if you just get in and out of a lucky coin before everyone else does. Then the value goes to zero, and nobody talks about it again.

It does seem like the kind of thing that mid-20s men on Reddit would enjoy. But almost everybody wants more money in the future than they have today, or they want some amount of money in the future without always having to work for a paycheck. So we find ourselves in this weird state of affairs where everybody needs to win at the wild global casino experience just to be able to support themselves in old age or preserve wealth for their children.

But this investment is safe!

Maybe you’re thinking that broad-market index funds, or a 60-40 stock-bond portfolio, or one of the “target date retirement” funds, are clearly the right investment for you, and you don’t need to know anything else. I’m not so sure. Part of why I’m not sure is that this is the standard advice that everybody follows. And everybody knows that everybody’s following it. And in financial markets, if you know what everybody else is going to do, that’s an opportunity for you to win at their expense. But let’s get more specific:

• For one thing, your investments need to grow faster than inflation. Inflation in the US is high at the time of this writing and might get higher in the future. In 2020, we saw the Federal Reserve print 40% of all the money that it has ever printed. Printing money gives the government “free” money to solve its problems in the present, but it devalues the currency (inflation), which is kind of equivalent to taking a little bit of money from everybody. In that sense, printing money is like a tax, but a special kind of tax that people don’t notice as easily. And since it basically worked in 2020 (the 2020 recession was very short; the stock market was effectively “propped up” during this period of diminished economic activity), it’s hard to imagine the US government won’t continue doing this in situations where “free money” seems like it would help. Or, the Federal Reserve might keep raising interest rates, as it’s doing at the time of this writing, which will lower inflation but also kill the value of your investments (according to the Discounted Cash Flow model, which is pretty straightforward). So your portfolio would still need to “win” by losing less than others.

• Second, broad-market index funds have a hidden risk. A major reason that indexes like the S&P 500 are such good investments is that they’re a large set of (ideally) uncorrelated stocks. When some stocks are up, others are down, and this makes the whole fund less volatile. And lower volatility is crucial for long-term gains. Plus, the S&P 500 rebalances its components quarterly: companies that are performing poorly are given a lower weight, or removed from the index. That means you never really have to ride a stock “all the way down,” even though individual companies take major hits and outright fail all the time. All of that is supposed to give you great investment performance. Here’s the catch: when you buy into a broad market index fund, that fund just buys a bit of every stock in the index. And when you sell, the fund sells a bit of every stock. (It doesn’t really happen on an individual level like this, but ultimately the effect is the same). The activity of that index fund affects the prices of those individual stocks, so their prices rise and fall together. They’re no longer a basket of companies being evaluated independently; their prices are correlated, which is bad! The internal correlation of S&P 500 stocks has nearly doubled since the 90s (this is covered in much more detail in this Acheron Insights essay).

• Third, just look at what actually happens. In 2007-09 the whole US stock market lost 58% of its value, and it didn’t reclaim its previous (2007) high for over five years. That was a move of life-changing magnitude, and it happened to the entire US stock market. “But we know what caused that recession, and the banks don’t invest in shady mortgage-backed securities anymore!” But the previous recession before 2008 had nothing to do with shady mortgage-backed securities, it was about unwarranted hype around internet companies. And the previous recession before that had nothing to do with internet companies, and so on. In each recession, investors and/or regulators learned how to not make that mistake again, but had no idea what the next one would be. Every recession comes at us from a brand new direction. Are we constantly ready for another 2008-level crash that’ll affect the entire market and not just a few unlucky stocks or industries?

Looking for alpha

“Alpha” is the part of an investment’s performance that’s uncorrelated to the performance of the total market. You want positive alpha, because that means you’re getting a better return per risk than the market average.

Investing in a broad-market index fund like $SPY would give zero alpha. Investing with 2X leverage in $SPY would also give zero alpha, because even though you’d be doubling the growth, you’d also be doubling the risk. The reward / risk ratio remains the same.

There are many ways to get a better reward / risk ratio than the total stock market; there are a lot of places to look. Diversifying into bonds might do it; you might get impressive growth by holding the right crypto assets; you might perform better in a market drawdown by holding a put option as a hedge; you might invest in a specific industry, or a specific company, that outperforms expectations; you might have a particular trading strategy that you only execute when certain triggers are met. Ultimately you want to have a strategy that utilizes your own special knowledge or skill.

This isn’t as hard as it sounds. You don’t need to outperform everybody in the market, you only need to outperform some. Most regular investors just dump their money into an index fund, and the sophisticated trading firms have so many regulations they have to adhere to (that you don’t), that there are opportunities for you to outperform the market, with appropriate risk.

Remind me, why can’t I outsource this?

This kind of work is engaging for me personally, but it isn’t for everyone. Of course you can get someone to manage your investments on your behalf, but that’ll need to be someone you trust a lot, like family. A professional financial advisor could work well, but you’d need to really trust them—picking a random service from LinkedIn or Google is far too risky, in my opinion. There’s fundamentally a moral hazard in this situation that needs to be mitigated.

In any case, you should be literate enough in these things yourself, if for no other reason than you’ll avoid panicking in a drawdown and moving your funds against the plans of your trusted advisor. Unless you have perfect confidence in both their trustworthiness and competence, you’ll want to know some stuff yourself, so you can “trust but verify.”

How do I start?

If you’re anywhere near a beginner at this, I’d recommend starting with the best economics video on the Internet. Then, reach out to your more economically savvy peers—see what they can teach you. And then see what you can teach yourself. What kinds of tasks are you good at? What kind of thinking are you good at? Whatever your answer, there is most likely a style of investment that was invented to help you gain some alpha.