Tag: learning

Foreword

The SPX just had its worst week since 2020. You know, the year where everything shut down. Because of tariffs that everyone was warned about, for almost a year now. What happened?

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

Boom! Tariff the World

After the market closed slightly up on Wednesday (4/2/2025), the president announced the actual tariffs that he and his team have been talking about for months (since before they were elected).

Despite having been forewarned about the tariffs for almost a year, the next day (4/3) markets dropped the most in percentage terms since the early days of 2020 around the start of the pandemic, and dropped even more the day after (4/4). Combined, this is the largest weekly percentage drop of the SPX since the chaos of early 2020, and the largest absolute 2 days points drop ever.

Tariffs He Wrote

Despite the tariffs being announced well ahead of time, it was still shocking because the administration had been touting a “reciprocal tariff”, but when the details were revealed, what actually happened was anything but.

Reciprocal tariffs on most nations would amount to at most 10-20% for most items with a large number of items excluded. Instead, the administration went as far as to tariff effectively every nation by at least 10% for all imports, with some going as high as 50%. To justify the tariffs, the administration came up with what looks effectively like bogus tariffs the nations supposedly charge US exporters, even claiming that an uninhabited island populated mainly by penguins is charging tariffs on US exporters. I guess they don’t really like US fish?

After many commentors cried foul, the administration finally came clean and noted that the supposed tariffs imposed by other nations on US exporters is really just the ratio of US trade deficits to US imports from the country, with a 10% minimum cap.

To be absolutely clear, as many journalists, economists, financial advisors, finance professors and commentors have noted, this equation is utter bovine feces — despite dressing up the explanation with fancy maths symbols (that mean nothing!), the equation is meaningless in both economics and finance, an entire fabrication out of thin air.

Trade Deficits

In this one, incredibly unsophisticated, move, the administration has shown that it is deeply concerned about US trade deficits. So let’s talk about that for a while.

To simplify somewhat, a trade deficit is when a country (USA in this case) exports less to another nation than it imports from that nation. The deficit is simply the dollar amount of the difference between exports and imports to/from that nation.

As a general rule, deficits between 2 nations is a non-issue. Since trade is global and bilateral between different nation pairs, it is inevitable that there is an imbalance in trade between any 2 nations pair.

For example, Madagascar exports mainly vanilla beans to the USA, something that does not grow very well on American soil and climate, and so the USA has no real vanilla bean industry. However, because Madagascar is so poor, with the average person making just over $500 USD a year, there simply isn’t a lot that the average Madagascan can afford, and thus they simply don’t import a whole lot from developed nations which generally produce higher value added, and higher priced, goods — when you make $500 a year, an iPhone really isn’t something you think much about.

In theory, this trade deficit “goes away” when we consider the entire world. Let’s say the US imports a lot of Chinese stools, but exports a relatively smaller amount of tables to China — the US has a trade deficit with China. In the idealized Econs 101 case, this is fine because, in theory, the US will have a trade surplus (exports more to this country than the US imports from this country) with a 3rd country, say, Germany. Germany in turn has a trade surplus with China. So while every nation in our 3 nations scenario has a trade deficit with one nation, they also have a trade surplus with another, and the balance of trade (the sum of all trade deficits and surpluses for a single nation) will be 0, or at least very close to 0 over time, for all 3 nations.

In practice, this doesn’t really work. Empirically, we know that most developed nations have been consistently running balance of trade deficits for years, if not decades. There are many reasons for this phenomenon, but a large part of which is what the president said he is trying to address — unfair competition from some countries, such as China, where a combination of state level subsidies to domestic producers and tariffs or other barriers to foreign producers result in extremely one sided trade dynamics.

Face Off

But are trade deficits really bad? Think about it — some country is putting their citizens to work, and putting in their natural resources, to make a product that they then send to us. That country has spent non-trivial amounts of resources to produce that product, and in return, all they want from us is a few pieces of green paper. Green paper that we, as a country, can create almost for free.

In fact, Milton Friedman, a celebrated economist, made this point exactly.

Now, if you look at it from that perspective, it would seem that America should strive for larger trade deficits, not smaller!

Of course, reality is not quite so simple. There are very good reasons why a country would want to have a smaller balance of trade deficit:

• It is painful for those workers who are displaced by foreign goods. Yes, perhaps if you reduce the balance of trade deficit, you’ll incur a larger loss of jobs via not creating jobs in new industries that are never borne as the necessary inputs are never imported (as part of reducing your deficit). But as Milton Friedman notes (in the video above), those displaced are real people, with real voices, while those jobs that you never gain? They don’t exist yet, and thus have no say in the matter.
• If a country allows its industries to atrophy due to cheaper foreign imports, then at some point, expertise for producing those goods will be lost to that country. This means that any future goods based on that product may not be invented in that country simply because it doesn’t have that industry anymore. For example, a country is unlikely to invent the next generation of chips if they don’t even a chips industry.
• There are some products that a country needs in order to be independently strong. For example, steel is needed to build weaponry, and if a country imports all of its steel, then it is at the mercy of whoever sells it that steel — if they cut off supply, and then invades, the country will be in a pretty serious pickle.
• A large and prolonged balance of trade deficit is not sustainable. It may not be an issue in the near term, and problems may not emerge for many decades, but eventually, a country’s trade partners may find that they don’t really care for anything it produces, thus they have no need of its green pieces of paper, so they just cut it off from their goods. What then? Without industries, and without the expertise to restart those industries, the country would be at a dead end.

In summary, while deficits in the short term are good — they improve the average standard of living of the country’s inhabitants, in the long term, they can cause very serious issues for the country as a whole.

Sliding Doors

To be clear — I agree in general that a country needs to protect certain critical industries in order to remain independent and prosperous, and that tariffs are one of the tools to achieve those ends.

However, this needs to be better thought out and implemented. From inauguration day till just before the tariff details announcement on 4/2, the president made around 20 tariff announcements (in around 2 months!), most of which were changed or rescinded completely within days, if not hours. And then, out of nowhere, he announces tariffs that are wildly out of proportion to their stated intent, with what many speculators are saying seems like the output of a particularly bad LLM hallucination.

At the same time, the flipflopping of tariff policies resulted in serious business paralysis. Businesses typically order their inputs months in advance. If they cannot be sure what price they’ll ultimately pay for the inputs (since payment and tariffs both apply after the goods arrive), they simply cannot make any major decisions with regards to their supply chains and operations.

Finally, it is important to recognize that it takes years to build factories and to plan out supply chains. You simply cannot impose a tariff and demand companies shift their productions onshore in order to avoid the tariffs the next day. In the short run, there is nothing a company can do about their current supply chain, so they are forced to pay the tariff, even if they want to onshore their productions eventually.

If the short term goal of the tariffs are indeed to rebuild America’s industries, I’m all for it. But we have to recognize that rebuilding America’s industries is to serve a longer term goal, which is to strengthen the nation and enrich its people. Trying to rebuild industries by creating chaos in the business and international trading landscapes, while simultaneously alienating and insulting our allies is going to isolate America while making it that much harder to do business either domestically or internationally — the exact opposite of the end goal of a strong and prosperous nation.

Inflation

As discussed in Politinomics, tariffs are inflationary. There are some who argue against this, but I believe those arguments are wrong.

Some argue that tariffs are not inflationary because if the imported good becomes more expensive because of the tariff, consumers can simply substitute with domestic goods. This is a flawed argument, because it conflates inflation with inflation measures.

A similar argument is that as foreign goods become more expensive, it’ll trigger a recession, because consumers simply cannot afford to consume as much goods. As recessions are deflationary, the argument then concludes that tariffs are deflationary. Again, I believe this is a flawed argument, for the same reason:

As mentioned in Inflations, inflation measures are very flawed, though they are pretty much the best that we have right now. One pet peeve of mine about most inflation measures is that they usually take a basket of goods at some point in time, then measure the change in prices of those goods over some period of time to compute inflation rates. Most measures use baskets based on what consumers actually buy, which seems reasonable, except that it has a “too expensive” problem.

Imagine that you are currently able to afford to eat out every meal. However, for whatever reasons, restaurants all around the world suddenly raise their prices by 1,000%, though all other goods and services remain at the same prices. After the price hikes, you no longer are able to afford to eat out at all, so instead, you cook at home, which turns out to be cheaper than eating out before the price hikes, though it is not your preference.

In our scenario above, would you say that inflation is up, down or flat? Most people would say that inflation was up, despite the fact that you are now spending less money cooking at home. However, most inflation measures that use the “basket of goods consumers buy” approach will initially register a spike in inflation (due to the 10x increase in eating out costs), until the basket of goods is updated to reflect that you no longer eat out, at which point it’ll register deflation, because now you are spending less money on your basket of goods.

Obviously, this is wrong — inflation clearly went up, the fact that you are no longer able to afford your previous lifestyle is testimony to that.

Finally, the last argument I’ve heard is that tariffs are paid for by the exporters, and that somehow, tariffs are a tax on the exporters and so consumers will not see price hikes. Empirically, this is wrong — multiple goods are forecasted to go up in prices, and multiple companies have stated that they plan to hike prices in response to the tariffs.

The key to remember is this — businesses are commercial ventures, they need to make a profit to survive. There is no business in the world that can survive losing money perpetually (companies that do that are called charities, not businesses, and they are funded by donations).

Now, some may claim that businesses are making so much money, they can afford to make a little less. That argument may sound correct, right up till you look at the details. Most businesses (outside of tech and finance) make profit margins of around 5-15%. Retail businesses, in particular, are famous for having razor thin margins, some as low as 1-3%. What do you think happens if you are making 10% margins, and then a minimum 10% tariff is imposed on the inputs into your businesses? 10 – 10 = 0.

Immediately after the tariffs are imposed, some businesses may be able to raise prices, while others may not raise prices for a while. For example, companies which sell mostly online tend to be able to adjust prices faster, while brick and mortar stores tend to lag because their prices are on physical price tags and it takes a while to manually adjust all the price tags. Similarly, businesses locked into long term purchase orders may not be able to raise prices due to contractual obligations.

However, in the long run, where short run considerations like price tags and time limited contracts are no longer factors, the business can, and literally must (in order to stay alive), raise their prices. These raises may be gradual or fast, depending on the industry, and they may be explicit (prices actually going up) or implicit (reduction in costs due to better productivity not being passed on to customers as price decreases). But one way or another, the business must raise its prices due to the tariffs, or they simply go bankrupt.

Possibilities

So what are the possible outcomes of these tariffs? First, I must say that I am extremely unqualified to discuss this — I have no inside knowledge of how the administration thinks, and obviously I cannot see the future. Also, all of these are extremes — I don’t think any of them will become reality in their entirety, but instead, the final outcome may incorporate aspects of each of these.

Tariff gotcha

Possibly the best possible outcome for America. The president uses the tariffs for bargaining leverage to negotiate better trading terms with the rest of the world, and the tariffs are never actually implemented, or they are only live for a very short (days) period of time.

Soon after the announcements of the tariffs, Vietnam is already in talks with the president to reduce their duties on US goods.

Oh, never mind

The president, willingly or forced, retracts the tariffs without getting a deal with the rest of the world, before tariffs actually go live, or go live for only a very short (days) period of time.

Tariffs are, legally, a tax, and the Constitution endows only Congress with the power to impose new taxes or update existing ones. However, Congress has passed laws in the past which allowed the president to unilaterally impose or adjust tariffs in certain circumstances. It is possible that Congress changes its mind and removes the president’s authority to impose/update tariffs.

Fight club

The tariffed countries retaliate by imposing their own tariffs or other trade barriers, effectively engaging the trade war head on. The fight may spiral with each side escalating back and forth until one side surrenders, or some compromise is reached.

This would be seriously detrimental to the economies of both the US and the countries involved (assuming both sides are a large percentage of trade of the other). There is no winner in this situation, only a loser and a slightly less battled loser.

In particular, the tariffs currently slated to be implemented are already so high for some countries that they are effectively already cut off from the US market. This means that for them, higher US tariffs would make very little meaningful difference, so they may be more inclined to fight.

Given that many goods imported into the US have no other source of readily available producers, this would mean that US consumers will simply be deprived of those goods until new production can be started up somewhere else (or in the US itself), which can take years/decades, depending on the goods.

China has already announced actually reciprocal tariffs on the USA.

New BFFs

The worst possible outcome for the USA, would be if some of America’s largest trading partners decide to cooperate and defend against the new tariffs as a bloc. The new bloc could be used to gain leverage over the US to extract better trading terms, possibly even worse (for the US) terms than existing ones, or, much worse yet, the bloc could effectively trade amongst themselves, cutting out the US entirely.

Canada sent trade envoys to the EU soon after their recent elections (before tariff details were revealed), and rumors are that they are thinking of forming a bloc to better negotiate with the US, or perhaps even to cut out the US entirely.

Fin

Nobody really knows how this will all end. While some countries have stated that they will not contest the tariffs but will instead work towards a compromise, they may change their minds if other countries start getting preferential treatment. At the same time, countries that opted to fight may find the president to be unyielding, and quickly lose their appetite to continue the war.

In the end, this entire mess creates chaos in international trading, a lifeblood of effectively all large businesses and many/most small/medium ones as well. It is no wonder that the markets are treating this as a very serious event, on par with the pandemic.

For now, all we can do is watch helplessly as the leaders of the world try and secure what’s best for their nations, praying that whatever happens won’t be too detrimental for us, personally.

Are you not liberated?

Foreword

SPY is the first S&P500 ETF ever listed, and because of that first mover advantage, it has amassed a large number of shareholders. However, VOO, a competitor from Vanguard now beats SPY by net asset value, even though it launched much later. Should you switch?

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

Background

SPY is an ETF that tracks the S&P500 index, and so is VOO. In practice, the ETF providers have some leeway on how they actually implement the fund, but for the most part, they have a very high correlation and most people can treat them as effectively the same thing.

However, SPY has a 9bps (0.09%) expense ratio, while VOO has a 3bps (0.03%) expense ratio, making VOO slightly cheaper in terms of fees that users pay to own the shares ¹.

Because VOO has a lower expense ratio, and I believe it is one of the cheapest, if not the cheapest, S&P500 funds, it has drawn significant interest from many investors.

Expense ratio

You can think of the expense ratio as roughly “how much I pay per year to own this fund”. So for SPY, if you’ve bought $10,000 worth of SPY shares, then every year you will pay about $9 — this is done by the fund provider selling $9 worth of assets in the fund to cover your share of the fees. One way to think about it is, absent all other factors, the value of your holdings in the fund goes down by $9 per year.

Similarly, for VOO, you will pay about $3 per year if you had bought $10,000 worth of VOO shares.

So, if you bought VOO instead of SPY, you would save about $6 a year.

$6 isn’t a whole lot, but it’s not nothing. And given that there’s nothing you need to do, it seems like a no-brainer, right?

Liquidity

If it is a no-brainer, then why does SPY even have shareholders? Why don’t all investors just sell out of SPY and buy VOO instead? And why hasn’t the provider of SPY just lowered their fees to compete?

Well, the answer is that it is not that simple. It never is.

This is a screenshot from Interactive Brokers sometime this afternoon (Feb 21st, 2025) showing the prices of SPY vs VOO (edited to show the relevant bits):

As you can see, VOO has bid/ask prices of 557.68 vs 557.71, while SPY has bid/ask prices of 606.47 vs 606.48. As a simple model, let’s say the “correct” prices of a security is the midpoint price, i.e. the average of the bid and ask price. So for VOO, the “correct” price is 557.695, while for SPY it would be 606.475.

From the quotes, VOO trades with a spread (ask price – bid price) of 3 cents, while SPY trades with a spread of 1 cent. As a rough approximation, you can think of the spread as how much you pay (excluding broker and exchange fees) every time you buy and sell (i.e. one roundtrip) a share. So if you buy and immediately sold VOO, you’d pay 557.71 to buy, but only get back 557.68 when you sold, giving you a loss of 3 cents.

So, as a percentage of the “correct” price, the spread for VOO is about 0.5bps (0.00005%), while the spread for SPY is about 0.2bps. In other words, if you trade in and out of both SPY and VOO, you’d pay about 3x more for the trades due to the spread for VOO, than for SPY.

In concrete terms, if you buy $10,000 of SPY, you’ll pay in spread about 8 cents (0.01 * (10000 / 606.475) / 2), while for VOO, you’ll pay about 27 cents (0.03 * (10000 / 557.695) / 2). Note that divide by 2, because we are only buying and not selling, so we “pay” half the spread². Or, if you trade in and out of either position, you’ll pay 16 cents for SPY and 54 cents for VOO.

Given these numbers, if you trade in and out of your position 16 or more times a year, then it would make more sense to trade SPY than VOO — even if you hold the position everyday at the end of day, and thus pay the full $6 additional fee for holding SPY, you’ll more than make up for that by paying less in spreads when you trade — (54c – 16c) * 16 = $6.08.

If you don’t even hold the position at the end of every day, then trading SPY will come out further ahead, since you will pay a smaller fee to the provider (as a ratio of how many days you actually own the position out of the year).

16!

“But I’m a buy and hold investor”, you say, “I’m not going to trade in and out 16 times a year!”

And that is very true. Most people do not turn over their entire portfolio 16 times a year.

But that’s just one part of the liquidity story.

Here are some screenshots (again, edited for focus) of options expiring on March 21st, 2025 for SPY:

and VOO:

As you can see, an at the money call option for SPY trades at 9.17/9.20 bid/ask, while a similar at the money call option for VOO trades at 7.40/7.80 bid/ask.

As a percentage of the “correct” price per share, the SPY option has a spread cost of about 0.5bps, while the VOO option has a spread cost of about 7bps, an order of magnitude higher.

Which is to say, if you, like me, like to occasionally sell calls against, or buy puts to protect your S&P500 position, just buying 2 rounds of puts (or selling 2 rounds of calls) per year will result in SPY being a better vehicle for your portfolio — You’d pay roughly 6.5bps higher in spread costs to buy 2 rounds of puts (or sell 2 rounds of calls), if you let the options expire (i.e. you only pay the half the spread cost per trade), if you had used VOO instead of SPY (edit: for clarity).

While I don’t really trade that much, I almost definitely sell more than 2 rounds of calls per year on my holdings to juice my returns when I feel that the markets are especially richly valued, so for me, personally, trading SPY is usually a better idea.

Summary

While it is true that holding VOO is cheaper in terms of fees paid to the fund provider, be careful of all the other costs of investing. The 6bps you save per year by holding VOO instead of SPY is easily eroded if you trade options or the underlying even semi-frequently.

Of course, if you are a pure buy and hold investor who holds for the long term, then as of right now, VOO does indeed seem to be a no-brainer.

Footnotes

1. Users don’t actually get a bill or send money — the ETF provider just sells some of the assets of the fund to pay itself. ↩︎
2. Experienced traders will know that you can actually buy and sell closer to the midpoint than the spread, but that’s a story for another time. ↩︎

Foreword

Nowadays, many tech companies compensate their employees with restricted stock units (RSUs), effectively stock grants that vest over time. In most discussions with recruiters I’ve had, wonky maths was used to describe the actual compensation that is actually being offered, making comparisons between RSU-based and non-RSU based compensation packages difficult.

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

Restricted Stock Units

The typical RSU award works like this:

Let’s say your employer wants to pay you $100k over 4 years in RSUs. They will figure out a reference price of the stock at the time of the grant (i.e. when they decided to give you the award). Usually this is the price of the stock at market close on some particular day, or the average of the market closing price of some number of days.

Let’s say for our example the reference price is $100. In this case, you would be awarded with 1000 RSUs. The grant itself typically does not actually result in you getting shares. Instead, the grant is the promise of future shares. You only get the shares at set dates in the future, called vesting dates. For example, let’s say the shares vest once per quarter for the next 4 years. So each quarter, for the next 16 quarters, you’ll get 1000/16 = 62.5 shares each.

Vesting dates typically come with the stipulation that you remain employed with the employer — that is, if you quit (or are fired) before the full 16 quarters are up, you’ll forfeit any unvested shares of the grant.

To further complicate things, it’s common that a (large) part of your total compensation will come in the form of refresh grants, which are annual grants of new RSU awards, each of which are tied to a different reference price as well as award value (i.e. how much money your employer wants to actually give you). The employer may or may not disclose the reference price and/or award value, and may instead just choose to give you the total number of shares for each grant.

So, what you end up with, is a vesting schedule that looks something like this (assuming 1000 shares per grant, and consolidating all grants in the same year to shorten the table):

Year	Grant 1	Grant 2	Grant 3	Grant 4	Total
1	250				250
2	250	250			500
3	250	250	250		750
4	250	250	250	250	1000

After the 16th quarter, the first grant will be fully vested and you’ll stop getting shares from it. But the 5th grant will kick in, so you’ll continue getting 250 shares per quarter.

Note that typically the first grant is much larger than the refresher grants — this is because it is actually 2 grants in 1 — the first is the typical annual grant like a refresher grant, and the second is actually you sign on bonus. For simplicity, I’m ignoring the sign on bonus component for now, so all grants are more similar in size.

Presentation

When the RSUs award schedule is presented, recruiter will usually present the actual dollar amount of the shares you’ll get. Assuming that the shares start at $100 and increase by 10% per year, then the dollar amount of the vesting schedule looks like:

Year	Total shares vested	Dollar amount
1	250	$25,000
2	500	$55,000
3	750	$90,750
4	1000	$133,100

And from then on, the total value will increase by 10% a year (same number of shares, but share price increases 10% per year).

Now, if you want to estimate the value of your total RSU compensation in year 3, it is natural to think that it is $90,750. Did you notice the sleight of hand?

Sleight of Hand

There are 2 main issues with computing your actual RSU compensation:

• The increase in the share price confuses the matter
• You forfeit whatever shares are not vested in all grants if you leave the company

Now, given that, what do you think is the RSU based compensation for the 3rd year? Is it

• $90,750 — the actual value of RSUs received in year 3

OR

• $121,000 — the actual value of RSUs granted in year 3

?

The answer is… neither. It is actually $82,750, which is $25,000 (the value from the first grant) + $27,500 (the value from the second grant) + $30,250 (the value from the third grant).

Think of it this way — because you forfeit any shares not vested if you leave the company, at the time of the grant, you haven’t actually earned the award yet, so $121,000 is wrong.

At the same time, the first grant is worth only $25,000, despite you getting $30,250 from the 250 shares because that’s what the company intended to pay you when it made the grant — 250 shares at $100 each. The fact that the shares have gone up in value over the next 2 years is irrelevant — the additional 30,250 – 25,000 = $5,250 is the compensation you get for taking the risk of the stock exposure! Remember that instead of going up 10% a year, the stock price could just as easily have gone down instead.

Another way of thinking of it is this — if instead of giving you a 4 year deferred grant 1, the company had just given you the $100,000 flat out. In this case, you would have the choice of whether to buy the company’s stock or not. If you did, then you’d have bought 1000 shares (at a price of $100 per share). After the 4th year, your shares would then be worth $133,100. Would you now say that the first grant was $133,100 instead of $100,000? Obviously not!

If you had valued grant 1’s shares at the vesting price instead of the reference price, then you would value grant 1’s RSUs at a total of $25,000 + $27,500 + $30,250 + $33,275 = $116,025 over the 4 years, and that just doesn’t make sense — receiving the $100,000 upfront in year 1 is clearly better, since you get the money earlier, and you have the optionality of what to do with the money, so how can it be worth less than being forced to effectively buy your employer’s stock and to hold the stock for 4 years, while risk forfeiting part of the grant if you leave the employer early?

Taxes

One argument that some make for the RSUs instead of cash upfront, is that by deferring the payment, you are also deferring taxes, and since you are getting stock, you are benefiting from the deferred payment being invested, effectively compounding the part of the upfront payment that would have been paid in taxes.

Let’s model this out. Let’s say you pay long term capital gains taxes of 20% (highest) and marginal income taxes of 25% (somewhere in the middle).

In the RSU case, you would then receive:

Year	Vesting shares	Received shares	Total shares	Shares value (pretax)	Shares value (post tax)
1	250	187.5	187.5	$18,750	$18,750
2	500	375	562.5	$61,875	$61,500
3	750	562.5	1125	$136,125	$134,512.50
4	1000	750	1875	$249,562.5	$245,227.50

If instead you had been paid cash upfront, paid your taxes, and then bought the shares:

Year	Post tax grant	Total shares	Shares value (pretax)	Shares value (post tax)
1	$75,000	750	$75,000	$75,000
2	$82,500	1500	$165,000	$150,000
3	$90,750	2250	$272,250	$267,450
4	$99,825	3000	$399,300	$389,055

I think it should be clear in terms of cash flow, getting the cash upfront is better. However, if we just look at the first grant mathematically, in year 4, it will be worth:

• If received in RSUs, with 187.5 vested at 100, 187.5 vested at 110, 187.5 vested at 121, 187.5 vested at 133.10, for a total of 750 shares worth $99,825 pretax, or $97,263.75 post tax.
• If received in upfront cash, you’ll still end up with 750 shares, but worth $94,860 post tax, due to the lower cost basis of 100 for all shares.

So the main benefit of the deferral is that you have a higher cost basis for the shares received later, which does translate to a higher after tax dollar value if sold.

Whether this benefit is enough compensation for losing control/optionality of the grant for 4 years, and having to forfeit the unvested shares if you leave the employer early, is up to you.

Comparison shopping

When comparing compensation packages between an employer that pays with RSUs, vs another one that pays with cash, it is important to remember the RSU sleight of hand, and properly value what your compensation package will actually be.

The 3 key points to watch out for are:

• If you leave the employer, will the deferred part of the compensation still be paid?¹
• Properly value the dollar value of each grant by adjusting for the risk you are taking by being forced to effectively buy your employer’s stock.²
• The tax benefits of a higher cost basis for those shares that vest at a higher stock price than the reference price.

Footnotes

1. Some employers may have wording in the contract to the effect of “if you do something we do not like, and you get terminated for it, then the deferred part is forfeit”. In these cases, you’ll have to estimate for yourself how likely it is that you fall afoul of those rules. In many cases, the rules are actually pretty generous and you only forfeit the deferred payments if you break a law or otherwise get involved in some serious shenanigans.
   
   If you are confident the deferred payments will actually be made, then you should consider the payments to be made at time of grant (because that’s also when they vest). ↩︎
2. If the deferred portion is paid in cash, then you may need to discount the value of that cash to the time of vesting. ↩︎

Foreword

Everyone in finance seems to be chasing alpha, but very few people seem to really understand what it is. What is alpha, and why does it matter?

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

Simply alpha

Alpha, in finance, specifically quantitative finance, is defined as the excess returns of a strategy above and beyond market returns. In other words, alpha measures the outperformance of a strategy — the higher the alpha, the better the strategy¹.

And because everything in finance is about *ahem* number measuring exercises, everyone in finance seems to be striving for higher alpha.

Unfortunately, many people, including those working in finance, don’t really understand what alpha is, and often conflate increased risk (which you do not want) with increased alpha (which you do want).

Maths

According to https://corporatefinanceinstitute.com/resources/career-map/sell-side/capital-markets/alpha/, the mathematical formula for alpha is:

If you look at the equation more carefully, you’ll realize that:

• Alpha is net of the risk free rate.
• Alpha is independent of market return.

Which is to say, if all the return of a strategy can be expressed as a function of market return, then that strategy, by definition, has zero alpha.

To “simplify” things a bit, to compute the alpha of a strategy, run a correlation test of that strategy’s returns against SPX minus the risk-free rate (assuming you are using SPX as a benchmark), and the correlation, with magnitude, is your beta. (edit: clarified that beta is correlation + magnitude)

The part of the strategy’s return beyond that which can be explained by market returns (i.e. beta(R_m – R_f)) would be alpha + R_f, so you can compute alpha by just taking away from that remainder the risk-free rate.

Some examples

Now, let’s consider some examples:

• A fund that simply buys SPY, returning 33% in 2021, -14% in 2022 and 19% in 2023, with a cumulative total return over the 3 years of 34%.
• A fund that simply buys UPRO (3x SPY), returning 106% in 2021, -49% in 2022 and 43% in 2023, with a cumulative total return over the 3 years of 50%.
• A fund that returned 6% in 2021, 8% in 2022 and 9% in 2023, with a cumulative total return over the 3 years of 25%.

Clearly, the second fund has the highest cumulative total return, but which strategy has higher alpha?

Well, SPY is basically just the ETF expression of SPX, and UPRO is just 3x SPY, so the correlation of both funds would be very close to 1 (with SPY having a beta of around 1, and UPRO having a beta of around 3, edit: clarified that beta is correlation + magnitude), which implies both funds have zero alpha. However, the 3rd fund clearly does not move with the market — it goes up every year even when the SPX went down in 2022, and if you do the maths, it is returning about 5% above the risk-free rate every year. So the alpha of the 3rd fund is actually 5%.

Cue surprise

The above result often surprises many who don’t really understand what alpha means — how can a fund that returns less than SPY be considered to have alpha, while a fund that returned almost double of SPY has 0 alpha?

Recall that alpha is the part of the return that is above and beyond what can be explained by market returns. Both SPY and UPRO explicitly try to mimic market returns, with the exception that UPRO does it with 3x leverage. So neither have an excess return above that which can be explained by market returns, and the additional return UPRO provides over SPY is really just the result of UPRO taking more risk, in the form of using leverage.

Recall when we said people often confuse more risk (bad!) with more alpha (good!)? There you go.

The 3rd fund, on the other hand, has 0 beta², so all its returns are just alpha + R_f, and if you subtract the risk-free rate (generally assumed to be 10Y US Treasury yield), you get about 5% alpha per year.

But the returns suck!

Yes. Compared to both the first 2 funds, the return of the 3rd fund is indeed subpar. This is a common theme of true alpha funds — their returns tend to be around the 5-10% mark annually (edit: This is net of risk-free rate, i.e. alpha). Yes, there are some funds that have much higher alpha (e.g. the Medallion fund from Renaissance), but those tend to be closed off to outside investors.

The reason alpha funds tend to have lower returns, is because they are hard, and more often than not, they are rare. Alpha is hard because it is genuinely hard to find a strategy which will do well regardless of what the market does — most strategies have some non-trivial amount of beta associated with it just because they need to operate in the market. They are also rare, because most alpha strategies tend to have low capacity, meaning you can only put so much money into the strategy, before your positions affect the markets, and you distort the market enough that the returns dissipate.

Constructing an alpha only fund

To get some insights into a true alpha fund, consider a fund which returns 5% of alpha, and 80% of beta, i.e. the fund returns 80% of whatever SPX returns in any single year, and on top of that, returns 5% additionally (+ risk-free rate).

Well, we can convert such a fund into a true alpha fund by simply bundling this fund with a short up to 80% of your portfolio value of SPY. The total return of this bundle will now be: 5% + 80%SPY – 80%SPY = 5%, the alpha.

Not so fast though — shorting is not free. You typically pay a fee (short borrow fee, maybe margin costs, etc.) to short. To keep the maths simple, let’s say that the total fee for this shorting is 1% of total returns.

Which means, your true alpha fund, the bundle, will only return 4% alpha.

In general, a true alpha fund tends to involve a lot of trades to hedge out market exposure, which in turn will reduce the actual return (and thus alpha) of the fund.

Why bother?

So to recap, a true alpha fund first needs to find a good strategy, then pay fees to trade that strategy, and pay more fees to hedge out market exposure, just to get a net return of around 5-10% of alpha. While market return, at least in the past few years, has dramatically outperformed that with much less hassle.

So… why bother? Are Wall Streeters just stupid? Or maybe they just like Rube Goldberg-esque exercises in futility?

Let’s consider our 3rd fund again, which returned 5% alpha, i.e. 5% return net of risk-free rate.

Large institutional traders (and even savvy individual traders), can often get financing (i.e. loans) at, or close to, the risk-free rate.

If you are in such a position, then you can borrow, say $1m, at risk-free rate (R_f), then put that $1m into the fund to deliver a total return of alpha + R_f, which means effectively you get a return of alpha “for free”. Since this is a positive value arbitrage, you can simply re-lever your positions to get another loan at risk-free rate, put that new money into the fund to increase your returns. This process can be repeated forever — an infinite money glitch.

The ability to re-lever into positive alpha strategies, is also why these strategies tend to be rare — any existing alpha found will likely be pushed to its limits, until little, if any, alpha is left.

You can also lever into beta funds (i.e. buy UPRO), but that has limits — because market return can be negative, you cannot re-lever into the fund infinitely; There is a chance that a large enough negative year will wipe you out, so your lenders will likely place very strict and very conservative limits to how much leverage you can apply. After all, even if your strategy blows up, they still want to be paid!

Quickly identifying alpha

To conclude, if you are looking at a strategy, and you’re trying to figure out if the strategy has alpha, a simple way to quickly estimate this is just to look at the strategy’s total return over a period which includes a number of high return years and negative return years.

If any of these are true, then there’s a good chance that the strategy has positive alpha:

• The strategy manages to return more than the market in all of those years.
• The strategy has a fairly stable, positive return in all of those years.

But if the strategy simply returns more in good years, but also loses more in bad years, then even if the strategy’s total return over all the years is greater than the market, the fund may not have alpha, or may even have negative alpha.

Footnotes

1. A better and more complete definition can be found at https://corporatefinanceinstitute.com/resources/career-map/sell-side/capital-markets/alpha/. ↩︎
2. You can’t compute this based on the data provided, but let’s go with it. ↩︎

Foreword

For as long as I can remember, inflation measures have been criticized as being inaccurate, biased towards the current political ruling elite. The complaints generally assert that inflation was under reported to serve some nefarious political means, usually related to re-elections or other political goals. At the same time, numerous alternative inflation measures were introduced, almost all with much higher numbers than the official inflation figure, some even consistently in the double digits.

What gives?

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

Looking outside the window

As I type this, I look outside the window at what looks to be a dreary day — overcast skies and just generally gloomy. At the same time, Google is reporting that the temperature is 82 degrees Fahrenheit (28 degrees Celsius), a warm, bright sunny day.

As I shake my head at the obvious lies the government is feeding us, trying to convince us of global warming to justify the nonsense Green Transition, I changed the Google query from “weather tokyo” to “weather toronto”. Now it says 58 degrees Fahrenheit (14 degrees Celsius), with a heavy downpour. Well, which is it?! Is it hot and sunny or chilly and raining?!

Looking outside the window that is cloudy but clearly not raining, much less a downpour, I can only sigh. What is the world coming to, when even Google’s weather reports are so influenced by the government that you cannot trust it to tell you the weather, here, in New Jersey?

Headline inflation

As we all know, the preferred inflation measure of the US government is CPI inflation, sometimes called headline inflation. More accurately, this is the Consumer Price Index for All Urban Consumers (CPI-U) inflation. This inflation measure is the rate of change of the CPI-U index, itself a composite measure of what the average urban consumer pays for their goods and services in the measurement period.

To simplify it a lot, the CPI-U index is the “composite price” of a basket of goods over time, and CPI inflation is just the rate of change of that composite price. You can find the basket of goods, their relative weights, and the prices of those goods in data from the Bureau of Labor Statistics (BLS), for example, here.

To recap – CPI inflation is based on a known methodology (rate of change) of the CPI-U index. The CPI-U index is a composite index with publicly released methodology on how it decides what is or is not included, with details on the underlying components, their weights and prices, all freely available.

Conspiracy 1

One of the most common conspiracies about the inflation measure is that it is opaque, and legislators/regulators change it at a whim to sugar coat bad economic numbers or to somehow achieve some political gains.

As we can see from above, that is.. quite a far from the truth. The methodologies and details are all public information, and freely available. Yes, they are provided more than a month after the fact, and the data is often revised. But if you think about the scope of the project, the amount of data that needs to be collected, the number of people that need to be sampled and interviewed to determine the basket, it should be obvious that it’s hard to get everything in place in real time, and often initial estimates will be slightly wrong as more data comes in.

Conspiracy 2

The CPI-U methodology (not the data) is changed intentionally over time to make things look better.

Yes, the CPI-U methodology has changed over time. As research into consumer behaviors increase, and as we understand more about economics and finance, it often becomes clear that previous models are less accurate, and new models are made.

This is a common practice in the hard sciences, for example, we used to believe in Newtonian physics, but Einstein introduced Relativity and Einsteinian physics which are believed to be more accurate on a galactic scale. Despite this, Newtonian physics is still taught in schools, because it is pretty accurate when dealing with terrestrial matters and it is much easier to grasp. I don’t hear anyone screaming that the government is up to some nefarious purpose with regards to these 2 physics, do you?

The fact is that economics is not a hard science — there is generally no real way to conduct experiments to verify hypotheses. As a result, there are a lot of assumptions and unknowns in economics which, over time, get refined. Inflation is an area of economics that is most in debate, because of its significance and because so little is understood about it.

And to make it clear that there doesn’t seem to be some higher conspiracy at work, the BLS typically publish the CPI-U for historical dates using the new methodology when it does change, for example here.

So yes, maybe inflation is slightly better now with the new methodology, but it is also probably better for previous periods, which gives us a frame of reference.

Conspiracy 3

My favorite (not) conspiracy is that the government is intentionally lying to us by publishing only one inflation measure and claiming it is the unblemished truth.

If you pay attention to the news, you’ll see that the news outlets typically equivocate “inflation” to “CPI inflation” as we’ve discussed above. The claim by the conspiracy theorists is that this is intentional! That this one number, that clearly does not reflect anybody’s, certainly not their own, experiences is forced upon us for some ulterior motive.

First of all, this is utter bovine feces. There are many measures of inflation, and anybody bothering to spend 5s on Google can find that the government even explains why there are so many, why it’s so hard, and why certain measures are used, for example, here.

For government purposes, there are 2 main variants of inflation measures — the CPI series and the PCE series. There are various differences between how CPI and PCE collects data which I will not go into, and more importantly, each of these 2 series also have different methodologies applied to them to arrive at different inflation numbers.

For example, if you have paid attention in the past ~4 years, you’ll probably have heard of “trimmed mean” inflation, “sticky” inflation, “median” inflation, etc. These are different methodologies applied on the same underlying data (either CPI or PCE) to arrive at different numbers.

Of these, the trimmed mean inflation has a bad rep because it was accused of being conjured out of thin air to present a better picture during the Covid inflation scare of 2021/2022. The truth is that this measure was first proposed in the early 90’s, and has been published for a long time, with historical data points backfilled using the same methodology.

Trimmed mean inflation is just inflation calculated excluding the outliers. There are various ways to determine which outliers are, and different measures may use slightly different methodologies here, but the basic idea is one rooted in statistics. In statistics, an outlier is a data point more than 2 standard deviation away from the mean. The idea is that by removing these outliers, which are likely due to measurement errors or noise, we can arrive at a cleaner signal. Similarly, the trimmed mean inflation measure is intended to provide a cleaner read of inflation trends, by removing what may be erroneous data points.

So, to recap, there are many, many inflation numbers, for example, the regular CPI inflation, PCE inflation, trimmed mean CPI inflation, trimmed mean PCE inflation, median CPI inflation, median PCE inflation, etc., etc. And the government also publishes other measures of inflation outside of the CPI/PCE series.

And if you don’t like any of these, the good news is that the underlying data is all freely available, so you are free to pick your own basket of goods, their weights, and the methodology to determine your own inflation rate.

Conspiracy 4

There are many inflation measures and the government chooses the one that it likes the most for propaganda purposes!

Believe it or not, this argument was made to me by the same person who made conspiracy theory 3. Yes, go figure.

As mentioned above, to make policy decisions, the government (or its various agencies) needs to pick one inflation measure to use. They may look at all of the inflation measures, but there will always be one that is preferred, due to their particular purposes.

For example, for cost of living adjustments to social security payouts, it makes sense to look at the CPI series of data, because that series reflects prices that consumers pay. Of the CPI series of data, CPI-W (Consumer Price Index for Urban Wage Earners and Clerical Workers) was determined to be most representative of Americans on average, so that’s the one used.

Notice the bolded terms, on average. A single number must be used to adjust for whatever policy is at hand, and clearly the one representing the average American is the one most representatives of all Americans in this case. That doesn’t mean that all Americans will see the same inflation! For obvious reasons, everyone spends their money differently, and so will experience different levels of inflation. But for policy purposes, across all Americans, we can’t just pick the inflation that ConspiracyTheoristA faces and apply that to everyone else, can we?

So yes, the inflation measures that each government agency chooses may not represent you, but that’s more of a feasibility limitation than a conspiratorial one.

Other government agencies prefer other inflation measures because it makes more sense for them. For example, the Federal Reserve prefers “core” inflation measures using the PCE series for policy decisions. Core inflation measures strip out items that are generally not affected by interest rates, which generally means core inflation measures do not include food and energy items.

Yes, it is ironic that the Federal Reserve ignores food and energy, 2 of the largest components of inflation experienced by most everyday Americans, but there is a good reason. The Federal Reserve mainly has control over short term interest rates. However, food prices are mainly tied to weather (and thus how crops perform) and energy prices are heavily tied to geopolitical developments (e.g. instability in the Middle East). As such, it doesn’t make sense for the Federal Reserve to make short term interest rates policies based on food/energy prices, because those things are not very affected by short term interest rates in the first place!

Imperfect

The above argues that inflation measures are probably not nefarious in design, but that doesn’t mean they are perfect. And if your argument is that inflation measures are generally flawed, then I will agree completely with you!

Inflation is a subject that is emotional and very poorly understood. So any model of inflation, and any measure of it, is almost by definition wrong. That said, it should be noted that, all models are wrong, but some models are selectively useful.

The topic of what’s wrong with inflation measures is long, and best left for another day. The point I want to make in this post is that in most cases, it seems like the government is making the best of a bad situation, and adjusting their methods as more is learned through research. Maybe on the margins there are some shenanigans going on, but it doesn’t appear, to me, that there is institutional bad faith in policy decisions.

Average, imperfect world

You probably think I’m an idiot, complaining that the weather report for Tokyo and Toronto does not reflect what I’m personally experiencing here in New Jersey. And you’d be right.

Similarly, it doesn’t make sense to complain that any particular inflation measure doesn’t reflect your personal experience — they aren’t meant to. There are many different measures of inflation, for different purposes. Some are tailored to particular segments of the economy, or to particular regions of the country. Depending on how you spend your money, one or more, or none, of these inflation measures may apply to you.

It is, ultimately, up to you to figure out which inflation measure best reflects your personal situation, just like it is up to me, to figure out which weather measure best reflects my experiences.

Just understand that for policy purposes, one single measure needs to be chosen as representative for inflation. It doesn’t mean that some shady government officials shrouded in shadows are decreeing that measure is what everyone must be experiencing! It’s just that for whatever reasons, that measure is deemed to be most appropriate for the situation.

Personal finance

Quick note: It should be obvious from the above, that using CPI inflation for your personal financial planning is probably not the best idea.

Yes, it may represent the average American pretty well for certain purposes, but it probably doesn’t reflect you.

If you are so inclined, you can use the raw data published by the BLS, and your actual spending, to determine a better inflation measure for yourself.

But this is tedious and hard and easy to get wrong — there are legitimate one time expenses (e.g. roof repairs) that will skew the numbers and make things seem better or worse than they really are. Trying to properly adjust/account for these is a science unto itself, which I will not go into.

Personally, being the lazy slob that I am, I typically just take CPI inflation and add 1% to it. Which is to say, for most intents and purposes, for long term planning, I assume a personal inflation rate of 3% (2% Federal Reserve target +1% headroom).

Foreword

The Green Transition is the new name given to the idea that human activities are affecting the natural environment negatively, and that effort should be made to transition the economy to a more sustainable and Earth-friendly path.

Over time, it has garnered much discussion both for and against the idea, and right now, is a politically charged topic, when it really shouldn’t be.

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

Background

It is hard to deny that global temperatures have been rising steadily, on the average, across time. Most of the debate in recent times have centered around whether this is a temporary cyclic phenomenon which will revert by itself, and whether this phenomenon is due to human activities, and thus whether human efforts can pause, halt or even reverse the change.

As with most charged debates where both sides are firmly entrenched, politics have gotten involved, and that has dragged in more polarization based upon one’s political affiliations.

Not helping is the apocalyptic language used by some proponents, especially earlier in the discussion (around the 80’s), in some cases suggesting the Earth may be inhabitable by around this time. Ooops. To make matters worse, it has come to light recently that some of the climate studies supporting the narrative have been doctored, fueling conspiracy theorists on the other side. Of course, that big moneyed interests are involved on both sides (building new green infrastructures vs existing fossil fuel based infrastructures) just makes this into an all out dog-fight.

My personal opinion

Before we go on, just as a disclaimer of sorts, here’s my personal take. I have not personally gone over the climate change data in detail — I am not a researcher in the area so the data will just go over my head anyway. I have, however, read quite a bit on the summaries of studies, as well as various layman oriented articles published by both news and scientific outlets.

While I am not 100% convinced, I lean heavily towards the belief that human activities are affecting global climate, and that the current means by which humans extract energy is unsustainable. I have no idea if changes in human behavior will pause/halt/reverse the effects, but I figure it can’t hurt, and more importantly, we need to find more sustainable sources of energy anyway — at some point we’ll run out of dead dinosaurs.

To the tree huggers

A message to the those who are for the climate change narrative — calm down. Yes, I think the scientific evidence leans heavily towards supporting your views, and some hypotheses floating around suggest that not doing anything, or even doing too little, could be disastrous. But crying your eyes out, screaming at the Earth murderers is not conducive to rational debate, and certainly does nothing more than alienate your audience.

Instead, think of it rationally — there is no point crying over spilled milk. The world and reality is what they are now, and we must make do with what is available to us, instead of crying over what it should have been.

First of all, it is impossible that all fossil fuel programs will stop right now, no matter how much you wish it. For all the advancement in sustainable energy sources, there are severe downsides:

• Solar energy is terrible for base load power supply — there is too much of it during the summer, and way too little during the winter. While batteries can bridge the gap between day and night, even across multiple days to account for rain vs shine, there currently exists no battery technology that can store power across months at a large scale. Do not fret though, this is a well recognized problem, and there is a lot of scientific research into this area (more later!).
• Wind energy works across the seasons and times of day, but is unpredictable because the wind itself is unpredictable. Also, during periods of strong gusts, wind turbines actually have to be shutdown to prevent damage to the turbines, an irony not lost to the other side. Wind turbines are also loud which means they need to be situated further from their use, and the nature of them requires much larger land acreage to deploy. Finally, like solar, wind energy isn’t very reliable in winter as extreme cold can sometimes require the turbines to be shutdown. So while less dependent on battery technology, wind energy still requires battery backup.
• Tidal and hydropower sources tend to involve installing largish installations over rivers/beaches. Tidal energy is not deployed right now due to various issues, mostly to do with concerns about their effects on marine life, the sediment process (i.e. how beaches are formed), and that the turbines tend to need a lot more maintenance/replacement than other forms of green energy. Hydropower similarly affects the natural landscape and thus the wildlife and population centers that depend on it, and while much more durable, breaks in the dams built for hydropower can have devastating consequences for the people that live downstream.

At the same time, the transition is going to cost vast sums of capital, capital which the vast majority of the world simply does not have. Yes, over long periods of time, sustainable energy sources generally pencil out to be more cost effective, but that’s not the problem — the problem is the start up costs. Most countries simply do not have the resources to embark on such large scale transition, especially when there are attendant problems with the technologies (which, again, hopefully will be resolved with time). While it is easy for us in our air conditioned offices to type out articles about how the world should behave, it is important to understand that reality is very much different in other parts of the world. Current fossil fuel energy sources remain the most abundant and easily accessible energy sources for the less affluent countries. Yes, over time, investments in sustainable energy sources are very likely to pay off, but that does not address the very real need these countries need, to survive, now — it is hard to think of a better future when current reality simply demands all your focus.

Finally, and most importantly, it simply doesn’t work to shut off all fossil fuels immediately, not in a “we can’t afford it” way, but in a “it hurts the green transition” way. For the green transition to proceed, there things that we simply cannot do without — steel, fiber glass, copper wiring, etc.

As an extreme example, currently, steel cannot be made without coal — each ton of steel requires about 750kg of metallurgical coal, so if we shut down all coal mines, we’ll also be shutting down all steel production. No steel, no wind turbines, no solar panels (admittedly not a lot of steel is needed in solar panels), etc.

And more importantly, until the transition is over, we actually do need fossil energy to, well, power the transition! How else are we going to transport those gigantic wind turbines to remote parts of the country? How are we going to power the factories that manufacturer the solar panels?

A pet peeve of mine, and to illustrate the counter-productiveness of indiscriminate green protests, is the demand for shutting down of coal mines in some industrial countries. Shutting down a coal mine does not eliminate the fact that some industries (steelmaking!) and power plants need coal still to operate — they can’t simply shutdown overnight and leave entire towns without power. So what happens is that the same amount of coal is mined elsewhere, and then shipped to the original country. Think about it, instead of mining the coal nearby and then using it, we now:

• Mine the coal elsewhere, often in a less regulated part of the world, thereby increasing the amount of environmental disruption (though admittedly out of sight),
• Expend more energy, often in the form of burning fossil fuels, to ship the coal to where it is still needed.

How dumb is that?

To the climate deniers

Hey, I understand — those holier-than-thou, green woke hippies can be annoying. Like, really annoying. But let’s ignore their juvenile tactics for now and think rationally for a bit.

What if, just what if, they are right? Even if it’s a 1% of 1% chance, you have to admit, if they are right, the amount of gloating you’ll have to suffer through will be intolerable. But more than that, the Earth itself may be uninhabitable. Kinda makes the whole point of that Hummer pointless, no?

Now, I get it — you love your gas engines — they’re reliable, refuel in a minute and sound awesome. But the price of gas has been on a tear lately, and that is a bummer right? What if I told you, that there is a way for you to secure more gas for yourself, a way that’ll outright prevent some other folks from buying gas? Less demand, lower prices, I mean, you gotta love that right?

Which is why, I think you should support EVs. Yes, they are terrible — they take forever to charge, they don’t work right when it’s cold, and they simply have no soul. But you don’t have to drive one! Just encourage everyone else around you to buy one. Once they buy an EV, they will stop going to the gas station, and there’ll be less competition for gas, which should, all else equal, reduce the price of gas that you have to pay. Imagine paying for a tank of gas with a $50, and getting change!

Similarly for electricity. The more those climate idiots spend of their money developing new energy sources, the more supply of electricity there will be. And Economics 101 tells us that with increased supply, prices should go down. In parts of Europe, power generation during the daytime is so high due to solar power that energy prices went negative. Negative! Imagine being paid by the power company to blast the A/C at max?

So, don’t do it for them. They are wrong. But do it for your wallet. Smile politely and nod as they make their nonsensical case, and tell them to go about their plans, because it is good for you. It’ll lower the price of a tank of gas, it’ll reduce your monthly electricity bills, and more importantly, you get to gloat about how those idiots are paying you to live your life. What’s not to like?

Supporting the green transition

Now, whether you believe in climate change or not, I hope I have made the point that investment (by others, not necessarily you!) into new green technologies is beneficial.

And here comes the controversial part — buying the shares of “green” companies does almost nothing. Yes, maybe it makes you feel better to own shares of “Green Company XYZ”, but you have to understand that when you buy shares on the stock market, you are buying them off someone else, someone who is not “Green Company XYZ”. The company itself sees none of the money that transacted. While there is a case of be made that a higher stock price makes it easier to hold secondary funding rounds, the reality is that most public companies never, ever hold secondary funding rounds — it is generally seen as a sign of weakness, and the stock price tends to get demolished because of it. Also, a high share price does not make it easier for the company to hire better people. Stock/option grants are based on the current price of the share, so for those employees to benefit, the share price doesn’t have to be high, it has to be rising, and it is generally easier for shares with lower prices to rise than for shares with higher prices.

Instead, if you are willing and able to invest to support the green transition, I would recommend that you invest in the debt of green companies, or even better, to invest in green startups. Unlike stock, companies issue debt all the time, and tend to do so on a recurring basis. So the price of their debt is actually important to them, and affects their ability to continue operating. By buying their debt, you are providing another source of demand for that debt, and with higher demand comes higher prices, which directly helps the company during their next debt funding round.

Finally, startups are almost always in need of equity funding. Unlike buying shares from the stock market, investing directly in a startup means the money goes directly into that startup’s treasury, meaning the money is directly available to them to pursue their business needs.

Right now, the areas which I believe are most in need of research are:

• Battery technologies, specifically long term energy storage with minimal leakage. Battery energy density research are good too, as they can help make EVs more palatable by having longer ranges.
• Solar energy efficiencies. Solar power panels typically have an efficiency of under 20%, which is pretty abysmal — 80% of the energy that falls on the solar panel are simply not captured. Increasing that to just a barely passing 60% will decrease the surface area of panels needed to supply the same amount of energy by 67%! Imagine if a solar panels of roughly the size of a dinner table being able to supply all the power needs of a home!
• More efficient/synergistic technologies. Right now, a lot of electricity is wasted simply because existing technologies are terrible at reusing heat. Think about it — we use electricity to remove heat from our fridges, which then dumps that heat in our homes. We then use electricity to turn on the A/C to move that heat outdoors, while at the same time using more electricity to heat up the pool/hot tub (for those who are lucky enough to have one). What if we could just remove the heat from inside the fridge, bypass the rest of the house and dump that heat directly into the pool/hot tub? While we’ll still need A/C to cool down the house during a hot day, the need will be reduced, and even better, that heat can also be pumped into the pool/hot tub! This basic idea of reusing heat can be applied to other areas too — heat generated from cooling of EV batteries can be used to warm up the interior of the car during winter, heat removed from giant datacenters can be used to heat homes, etc.
• Cleaner fossil fuels. Refinement techniques to reduce emissions when burning fuels, while not a long term solution, can buy humanity more time for the green transition. At source carbon capture and sequestration techniques can be developed to reduce and safely store emissions from polluting industries, etc.

Closing

Whether you believe in climate change or not, the fact remains that all of us are stuck on this little rock floating around in space. So maybe let’s stop arguing and let’s start finding commonalities, and where particular efforts can be win-win.

Foreword

Everyone is out to find the next long term compounder — a company with such a strong business model that its earnings compounds steadily over the years. The thinking is that for such a company, if you have a long time horizon, then the price mostly doesn’t matter — simply buy and hold, and eventually, the compounding will make it all worthwhile.

Or will it?

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

Consistent, long term compounder

Consider the revenue graph of company X, which compounds from $20.22B in 2000 to $58.03B in 2022, a CAGR of about 4.9%:

And its earnings graph, which compounds from -$1.39B in 2000, to $3.74B in 2001, to $16.72B in 2022, a CAGR of about 7% (from 2001 to 2022):

It should be clear, visually, that this company is doing pretty well — even in the depths of the Great Financial Crisis, it was holding up pretty well, and since it first became profitable in 2001, company X has never even flirted with the 0 earnings line at any point in time.

So, if I told you that company X has an all time market cap high of $Y, where do you think its market cap is today?

1. $Y
2. Within 5% of $Y
3. Within 10% of $Y

This is the market cap chart of company X, also known as Cisco (CSCO) from the same source of the graphs above (Companies MarketCap):

23 years after annualized growth of ~5% revenue and ~7% earnings, the company’s market cap is DOWN about 30%. (edit: I was informed that this is misleading — CSCO pays a dividend and has had for years, so if you include the dividends, the performance is much better. That said, the return will still be subpar due to the high entry price.)

How’s that for a consistent, long term compounder?

Relevance

As we come out of what appears to be (at least, temporarily) a downturn in the markets (in 2022), a point to remember, is that by most historical metrics (1), the markets are pretty expensive today. They were, of course, much more insanely expensive in 2021, when the markets had truly gone wild, but Q4 2021 and 2022 brought us back down to Earth just a little bit.

However, even as most of the market, minus the Magnificent 7, appears to be close to fairly priced (again, by historical metrics (1)), it is important to remember that there are still pockets of excessive exuberance, of stocks priced to such ridiculous extremes that the probability of them returning a generous rate of investment returns (2) over the long term seems rather unlikely.

To be clear, while it is possible to make a handsome profit if you are speculating (2) in these stocks in the short term, investment returns (2) requires holding that position for the long term and profiting only off its productive output, i.e. not selling to a greater fool.

And remember — the higher the price you are paying for a share of a company’s future productivity, the more speculative that position generally becomes.

So, short everything!?

And this is where some folks will start pointing fingers and start screaming “perma bear”. The truth is, if you follow me on StockClubs (3), you’ll realize that my portfolio is actually pretty long the market (levered long right now actually), and other than a brief period from early August to early November, it has generally been long.

There is, always, some assets that are overvalued, and some assets that are undervalued. Yes, sometimes, the only undervalued asset is “cash”, but that’s relatively rare.

Rational, long term portfolio management isn’t about putting money on things you like, or things that others like, or even things that are doing well now — it is to weigh the pros and cons of every position, figure out what is likely undervalued, and then overweight your portfolio towards those assets.

Certainly, overvalued assets can become more overvalued — that is how we get bubbles, after all. And certainly, undervalued assets can become more undervalued, which is how we get depressions.

But it is my opinion that if you consistently weigh your portfolio towards (4) what is undervalued, and underweight what is overvalued, then over the long term, reversion to the mean of ridiculously high (or low) valuations will generally work out in your favor.

Footnotes

1. A constant consternation by some is my reference to “historical metrics”. By this, I mean things like trailing P/E, P/S ratios, etc. For an example of what the the S&P500 looks like today relative to its past in terms of P/E ratio, please see https://www.multpl.com/s-p-500-pe-ratio.
2. For a description of investing vs speculating, please see https://jankythoughts.com/2021/04/12/investing-vs-speculating/.
3. Disclaimer: I am an investor in StockClubs, and I’m only sharing one (out of 10+) of my brokerage accounts on the app.
4. To be clear, “weigh your portfolio towards” does NOT mean sell everything else and only buy something or other. It simply means giving something more weight in the portfolio.

Foreword

How should we evaluate a $100 company that pays $10 in dividends a year, every year, vs another $100 company that pays $5 in dividends this year, $5.25 next year, $5.51 the year after, and so on, increasing its dividends by 5% a year?

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

Perfect world

Let’s say we have a business that scales infinitely at 10% returns — for every $100 you invest in it, it will return $10 every year in perpetuity. Further, let’s say we live in a perfect world, where there are no taxes to worry about and other transactional costs.

This business is, then, the first example from above — the $100 company that pays $10 in dividends every year.

Transmogrify

Now, imagine if at the end of year 1, instead of pocketing the $10 in dividends, you pocket $5, and invest $5 into the company. Now you have $105 invested in the company, so your next dividend will be $10.5. Again, you do the same thing, pocket half, and put the rest back into the company — in year 2, you’ll then pocket $5.25, and reinvest $5.25 for a total of $110.25 invested. In year 3, you’ll get $11.02 in dividends, of which you’ll pocket $5.51, and reinvest $5.51, and so on.

If you look at the numbers closely, you’ll realize that we’ve transformed our 10% dividend paying company, into a 5% dividend paying company, but with a 5% increase in dividends every year.

In general, absent frictional costs (like taxes, transaction costs, etc.), an asset that yields X% a year every year, is equivalent to an asset that yields Y% a year, but which grows the dividends at (X-Y)% a year — The difference (X-Y)% in yearly yield can be considered as being re-invested to grow the next year’s yield at an additional (X-Y)%.

Welcome to Earth

Of course, in real life, there are taxes and there are transactional costs — in the prior example, your $10 per year in dividends will be taxed, leaving you less than the desired amount to reinvest so that you cannot achieve the 5% increase in dividends for the next year — one way of thinking of it, is if the money was directly reinvested instead of first being passed to you as dividends, the taxes on that reinvested part will not be due yet, and so will compound for you instead of the government.

But even though so, in many cases, it is useful as a rule of thumb to think of the two companies as essentially equivalent. There are many ways around the frictional costs conundrum:

• You could invest using a tax-advantaged account such as an IRA or a 401(k), in which case, there are no tax consequences right now either way.
• If you didn’t intend to reinvest anyway, the tax drag is irrelevant.
• When you pay taxes, and then reinvest in a smaller piece of the company with after tax money, your cost basis for that smaller piece of the company is higher, which reduces future taxes.
• Reinvesting involves increasing your stake, which involves additional risks. The taxes paid now can be considered a counterbalancing force for not taking on those additional risks.

In practice, since tax rates can differ dramatically between different investors, many financial decisions are evaluated without taking taxes into consideration, with tax considerations being worked in later at the edges. So while a single person investing their own money may prefer one company or the other (depending on their personal tax situation), a fund manager (who services multiple clients with different tax situations) may actually treat the two companies as essentially the same.

Risks

One thing we only briefly touched on, is the idea of risk. If you take the $10 in dividends now, that’s a $10 profit there and then. But if you reinvest $5, then you are betting that the increased 5% of investment will result in 5% (or higher!) increase in yield going forward.

That may not be true!

Unlike our toy example, most businesses in practice do not scale forever. Whether you are selling cars, TVs, or services, at some point, you simply run out of customers to sell to. Also, as companies get bigger and bigger, bureaucratic overheads tend to grow and at some point, the marginal rate of return simply diminishes to 0 or even negative.

Which is to say, cash now is certain, while future growth is uncertain, and most investors will generally demand that an increase in investment of X% results in more than X% increase in yield going forward. Otherwise, it may not make sense from a risk/reward perspective.

Foreword

We’ve discuss the capital stack of a company before — basically how the company funds its initial creation and ongoing concerns. But why are there so many classes of funding? Why not just fund the entire company with equity? Or with debt?

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

Perfect business

Let’s say we have found a magical business — it scales perfectly from $0 to infinity amount of money we invest in the business, and for every $1 invested, it will return 10c every single year. So, if we invest $100 into the business today, it’ll return $10 at the end of 1 year, another $10 at the end of the 2nd year, and so on.

A naïve view would say that this business returns 10%. But can we do better?

Terminologies

Before we go further, let’s get some terminologies out of the way:

Term	Definition
Returns on invested capital (ROIC)	A measure of the efficiency of a business, it is defined by NOPAT divided by invested capital: NOPAT / Invested capital
Cash returns on invested capital (CROIC)	A measure of the efficiency of a business, it is defined by free cash flow divided by invested capital: Free cash flow / Invested capital
Cash returns on capital invested (CROCI)	Not to be confused with CROIC, CROCI is another measure of the efficiency of a business and is more commonly used for enterprise purposes (i.e. when a company is trying to buy another company). It is defined by EBITDA divided by total equity: EBITDA / Equity
Invested capital	The total amount of capital invested into a business, generally defined as total equity + total debt: Equity + Debt
Net operating profit after tax (NOPAT)	A measure of how profitable a business is, it is defined by net operating profit – taxes: Net operating profits – taxes
Net operating profit	A measure of how profitable a business is, it is defined by free cash flow – depreciation – amortization: Free cash flow – depreciation – amortization (1)
Free cash flow	Another measure of how profitable a business is, it is defined by: Total sales – COGS – Operating expenses – Capex
Costs of goods sold (COGS)	The cost of making each unit of product sold by the business
Operating expenses	All costs related to a company’s primary business, other than COGS, such as sales and general administrative costs, etc.

For the purposes of this discussion, we’ll focus on ROIC.

ROIC

In our little toy example, the ROIC of the business is simply 10% — for every $1 invested, we get 10c back per year.

Does this mean that the owner of the company, i.e. the shareholders must settle for a 10% return on their money? Is there anything they can do to improve those returns?

Financial alchemy

Let’s say we want to invest $10,000 in the company, giving us a return of $1,000 per year.

We could put up that $10,000 ourselves and settle for a return of 10% a year, or we could borrow $5,000 at 5% interest rates, and only put up $5,000 of our own money:

Debt funding	Equity funding	Invested capital	Total return	Return to debt holders	Return to equity holders	% Return on equity
$0	$10,000	$10,000	$1,000	$0	$1,000	$1,000 / $10,000 = 10%
$5,000	$5,000	$10,000	$1,000	$5,000 x 5%= $250	$750	$750 / $5,000 = 15%

By funding half the business with debt at 5% interest rate, we’ve created an additional 5% of return for our equity holder!

In fact, if you think about it, as long as the interest rate paid for debt is below the ROIC, it always makes sense, in this example, to fund the business with debt — Since the debt holders demand a return less than the ROIC, the difference (ROIC – interest rate) effectively accrues to the equity holder.

ROIC vs CROIC

In our little toy example of a perfect business, ROIC = CROIC, as there are no taxes and the business is perfectly scalable with no drag (i.e. no depreciation nor amortization). In the real world, this is generally not true, and the difference between ROIC and CROIC is important!

ROIC measures how profitable a company is overall, while CROIC measures how good a company is at generating cash. Because debt interest payments are tax deductible, and because depreciation and amortization are tax deductible too, a company has some leeway to manipulate its funding sources (invested capital) to try and reduce its total taxes paid. For example, the more a company funds itself with debt, the higher ROIC it will generally be able to report, all else equal, as we’ve seen from above.

Furthermore, some businesses do not pay corporate taxes — REITs are a famous example, and instead, their shareholders pay taxes for profits directly on their own tax returns.

Finally, some businesses have depreciation and amortization costs that are far higher than what it actually costs the businesses — REITs again are a famous example, with proper maintenance, buildings tend to depreciate less than the accounting depreciation suggests.

For these reasons, generally speaking, most businesses should be valued on their ROIC, while real estate heavy businesses are generally better evaluated on their CROIC.

ROIC vs risk

In our perfect business example, because there is no risk, it is always preferable for the equity shareholders to fund the company with debt as long as the interest rate is below the ROIC. That is not always true in the real world — often, businesses tend to get less efficient after they reach a certain size, so infinite growth is impossible (edit: prior version had a typo saying infinite growth was possible — it’s not). Also, companies tend to get more risky as they take on more debt, as debt payments are mandatory, while equity dividends can generally be skipped without much financial repercussions — if a company falls on hard times, it can conserve cash by reducing or even skipping dividends, but it generally cannot reduce nor skip debt payments without an event of default.

Debt buyers understand that the more debt a business takes on, the more risky the debt becomes as there is less of an equity cushion if something goes wrong. As such, they’ll demand higher interest rates as the debt to equity ratio goes up.

Which is to say, the more debt a company takes on, the more levered it is, the more risky it tends to be. Though if everything works out, the more profitable for the equity shareholders it will be as well.

Footnotes

1. This isn’t exactly correct — certain non-cash expenditures such as stock based compensation, changes in inventory levels, etc. are taking out as well. For the purposes of this discussion, this is close enough.

Foreword

While hedging is mentioned in finance a lot, it is, surprisingly, not very well defined. Despite its frequent use in finance literature, it seems that most people have a rather hazy mental model of what hedging is, or how it works.

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

What is hedging

To try and make the discussion more concrete, I’m going to provide my own mental model of what hedging is. To put it simply, a hedge is simply an auxiliary position that reduces the risk of your main position, where “risk” is defined as the variability (i.e. variance) of the combined positions performance.

Types of hedging

In my framework, there are 2 main types of hedging:

Mechanical hedges

Mechanical hedges are positions which “mechanically” go down (or up) in value as your main position goes up (or down) in value. For example, buying a put to hedge your stock exposure is a mechanical hedge — the value of the put mechanically goes up or down as the value of the stock goes down or up.

Similarly, TIPS are a form of mechanical inflation hedge — as inflation (as measured by the CPI) goes up or down, the value of the bond mechanically goes up or down.

The key thing to note, is that the value of the hedge moves inversely to the main position, regardless of market conditions. This generally happens because there is arbitrage between the main position and the hedge, such that any spreads will be swiftly closed by market makers, and/or there is an authority (such as a regulator, a government, an exchange, etc.) that enforces that the hedge moves inversely with the main position.

Statistical hedges

Statistical hedges are positions which are known to generally go down (or up) in value as the main position goes up (or down) in value, though there is no guarantee for them to always do so.

For example, in the classic 60/40 portfolio, the 40% of the portfolio in bonds can be thought of as a hedge for the 60% of the portfolio in stocks. Over the short/medium term, the value of bonds tend to move inversely with the value of stocks.

Other types of statistical hedges generally involve what is colloquially known as “pair trades”. For example, the value of the Australian dollar tends to move with high correlation to the value of the Canadian dollar, as both countries are commodities exporters with fairly similar exports, so changes in commodity prices tend to affect both. Thus, AUDUSD (Australian dollar valued in US dollars) and USDCAD (US dollar valued in Canadian dollars) tend to move inversely with each other — it used to be profitable to trade these 2 in a pair trade that bets that any gaps in performance will eventually close.

Observations

• Assuming you do not rebalance, your total position (main position + hedge position) cannot perform better or worse than your main position. The performance of your total position, absent rebalancing, is always of a smaller amplitude of your main position.
  • If you find that your total position actually went up in value despite your main position going down in value (i.e. your hedge position went up in value more than your main position went down), then you’ve made a mistake — your main position is actually the hedge and vice versa.

• If you rebalance smartly, then it is possible for your total position to perform better than your main position, and with lesser risk (i.e. smaller variance).
  • This is a result of the Modern Portfolio Theory. In simple terms, when your main position goes down in value (and your hedge goes up in value), you’ll sell some of the hedge position to buy the main position, and vice versa. Assuming the main position generally increases in value over time (i.e. your main thesis is correct), then this essentially forces you to buy low and sell high, and over time, should outperform the main position, but with smaller variance.
• If the value of the hedge consistently or generally goes down when the value of the main position goes down, then you’ve made a mistake — the “hedge” is simply not a hedge for the main position.
• If the value of the hedge moves essentially randomly with regards to the value of the main position, then it can still be used as a hedge, but only if you rebalance diligently and size the positions properly.
  • This is a result of the Modern Portfolio Theory.

My personal hedging

If you follow my positions on StockClubs (Disclaimer: I am an investor in the app, and only show 1 [of 10+] brokerage accounts in that app), then you’ll see that I very often sell calls against my stock positions. In a hand-wavy kind of way, these can be considered as hedges as well — the short call goes up in value (less negative) if the stock goes down in value.

One way of thinking about this, is that I’m giving up some upside for the stock position, to reduce some downside (if the stock goes down in value, the premium from selling the calls “absorbs” some of that loss).