Tag: musing

Foreword

It seems nowadays, just about everybody is complaining about the Federal Reserve’s “money printing” via Quantitative Easing (QE).

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.

Thought experiment 1

Let’s say you give me a $1 note. In return, I give you another $1 note.

Thought experiment 2

Let’s say you give me a $1 note. In return, I give you 4 quarters.

Thought experiment 3

Let’s say you give me a $1 note. In return, I write you an IOU saying that I owe you $1.

Additionally, I create a reasonably widely used infrastructure that accepts that IOU as payment for services and goods.

Finally, I subject myself to annual third party audits, which verify that as long as that IOU is outstanding, I indeed hold that $1, at all times.

Consider

I think in the first 2 cases, everyone would agree that whatever I gave you, is worth exactly $1, which is also exactly what you gave me.

In the 3rd case, it becomes a bit more iffy. Some people would say that the IOU I handed you is fiat, and in a sense they’d be correct.

But assuming that everybody is acting in good faith, i.e. the $1 backing that IOU exists, I think it’s fair to say that the IOU is indeed worth $1.

Banks

Banks generally work on the basis of Thought experiment 3 — a depositor gives the bank cash, which the bank keeps on its balance sheet. In exchange, the bank creates an account for the depositor indicating the bank owes the depositor $1, the IOU in question.

There are multiple money transfer networks (ACH, debit cards, FedWire, etc.) which allow the depositor to spend that $1 the bank owes them, and at least within the USA, these networks are widely accepted.

At the same time, the bank is subject to frequent third party audits, as well as various strict regulations to ensure that the $1 it claims it holds on its balance sheet actually exists in some form (1).

In short, most people would probably treat bank account balances as “money good” — as long as the bank remains solvent.

Money market funds

Money market funds generally work by taking money (cash) from investors, and then investing that cash in short term bonds, either corporate or government. In exchange for the cash, money market funds similarly create accounts for the investors, indicating that the funds owe the investors the amount invested.

Because bonds are fixed income assets with a predetermined maturity date and fixed coupon payments, the present value of the bond fluctuates over time — if interest rates go up, the current value of a bond will drop.

This presents a problem for money market funds — they are supposed to have $1 on their balance sheet for each $1 invested, so if the value of their holdings can fall arbitrarily, it seems like they are breaking the rules?

In general, this works out via 2 means:

1. Not every investor will want their money back at the same time. So the fund generally only needs a relatively small portion of its assets in actual cash to meet redemptions.
2. Since the bonds are short term, they’ll generally expire in the near future. While the present value of a bond can fluctuate based on interest rate, the terminal value of a bond (i.e. par payment + all coupons) is nominally fixed in value. That is, if the fund simply waits until all its bonds matures, it’ll have more than enough cash to meet the redemption of every investor (2).

Together, these allow for money market funds to be extremely stable in value, despite their underlying being subject to market pricing forces.

Like banks, money market funds are subject to frequent third party audits. Many brokerages and banks allow the use of money market funds in lieu of the customer keeping a cash balance to pay for their purchases, which effectively means that these money market funds are widely accepted for payments of goods and services.

In short, most people would probably treat money market fund balances as “money good”.

Stablecoins

There are 2 main types of stablecoins — algorithmic stablecoins which try to control the value of the coin via some sort of balancing algorithm and backed stablecoins, which keeps assets to offset the coins issued.

Algorithmic stablecoins have a terrible reputation, with multiple such coins “breaking the buck” and going to $0 (or close enough) within just the past few years. For our discussions, I am not talking about these.

Backed stablecoins, on the other hand, are supposed to hold assets that fully back their outstanding issued coins — for every $1 the stablecoin takes in, it issues $1 worth of stablecoin, while holding that original $1 taken in in some account.

Now, to be clear, there are a lot of problems with stablecoins:

• As far as I know, none of them are audited by well regarded, third party, large auditing firms.
• A lot of them are technically securities under the laws of the USA, which means that they either need to be registered with the SEC, or can only be sold to accredited investors. As far as I know, none of them are registered, yet all of them are sold to anyone who cares to buy them.
• A lot of them run on relatively immature infrastructure, which can have unforeseen problems (such as temporarily breaking the buck) during periods of high volume or stress.

But at least at a high level, stablecoins basically look like money market funds.

Generalization

In all the above, the process is similar:

• Entity takes Value from Customer.
• Entity holds Value on its balance sheet.
• Entity issues IOU to Customer.

Whether Entity is a bank, a money market fund or a stablecoin, whether Customer is a depositor, an investor or a speculator, whether Value is actual dollars or some other representation of value, and whether IOU is a bank statement, a money market fund statement or a stablecoin, the results are essentially the same — Value is transferred from Customer to Entity, and Entity issues an IOU, which Customer than can use to represent the Value given up.

Federal Reserve

And finally, we get to the big one. The one that everybody is arguing about.

Officially, the US dollar is a liability of the Federal Reserve, which is why the official name of the US dollar is “Federal Reserve Note” — “note” is a financial term meaning “short term debt”. Each US dollar is actually an IOU from the Fed, indicating it owes you $1 in value.

When the Fed conducts Quantitative Easing, what it is doing is buying Treasuries and other types of assets on the open market, in exchange for US dollars it essentially conjures up. The steps are:

• Fed takes Value from bank (the Fed only trades against banks).
• Fed holds Value on its balance sheet.
• Fed issues US dollar to bank.

Again, “US dollar” is, literally, an IOU issued by the Fed. Does the above process sound familiar?

In this case, Value generally takes the form of US Treasuries (3). In more recent cases, the Fed bought mortgage backed securities (MBS) and corporate bonds.

Most people would probably be fine with US Treasuries — if the US Treasuries default, we’ll have bigger problems to worry about, so most people treat US Treasuries as essentially “money good” (4). But MBS and corporate bonds are another matter — these can default, and they default quite often. What then?

Well, the Fed doesn’t actually just buy MBS nor corporate bonds. Instead, the Fed is actually buying the MBS/corporate bonds, as well as a put, an insurance, from the US Treasury. Effectively, if the MBS/corporate bonds default, the US Treasury has to reimburse the Fed any losses.

Effectively, balance sheet of the Fed is entirely backed by the US Treasury.

Just to clarify

So, just to clarify:

• In the case of banks, money market funds, stablecoins and the Fed’s QE, effectively some entity is taking value in exchange for an IOU indicating the same value.
• In all cases, the value is kept on the entity’s balance sheet, via an asset ultimately backed by the US Treasury.
• In all cases, the IOU issued is essentially conjured out of thin air.

As far as I can tell, very few people are really concerned about banks and money market funds. Some people are concerned about stablecoins, yet others are not. And funnily enough, the people not concerned about stablecoins, tend to be the ones most concerned about the Fed’s QE.

Huh.

Money printing

Many people call QE “money printing”. Technically, it is accurate — money, in the form of US dollars, is indeed conjured out of thin air.

But the term “money printing” hails from another time, when monetary and fiscal policies were both controlled by the same government entity, and the conjured up money was not used to buy up assets kept on balance sheets (effectively backing the conjured money), but instead spent.

Yes, in its original form, “money printing” is highly inflationary, but the modern day QE form of “money printing” isn’t quite the same, and as explained above, and in the prior “Inflation Model“, isn’t really inflationary, at least not without a fiscal component.

Fiat/currency debasement

Another common complaint is that QE is fiat/currency debasement. It is not.

Debasement is defined as the lowering of the value of the currency. Originally, this hails from government entities literally reducing the percentage of precious metals used in minting coins. In the modern day, it refers to the printing of money without a corresponding increase in output.

However, an exchange of value, as I’ve explained above, doesn’t really debase the currency. Just like nobody will say that Thought experiments 1 and 2 debases the $1 or 4 quarters I give you, most people should intuitively understand that the IOU given in Thought experiment 3 or the bank account statement or the money market fund statement, or the US dollar, isn’t really debased in the transactions noted above.

Liquidity

The problem, it seems to me, that most people have trouble wrapping their heads around, is the issue of “money supply”. They will point at M1/M2 during periods of QE, and correctly note that money supply goes up. But that’s mostly an illusion — as noted above, Value can take many forms. The main difference between a US dollar, and IOU issued by a bank backed by a US dollar, is that the US dollar is more widely accepted and thus counted as part of M1/M2, while the IOU is not (it is part of M3).

The issue isn’t that “value is created out of thin air”, it’s just that value has shifted in liquidity — QE shifts assets, such as Treasuries, MBS, corporate bonds from less liquid forms of money supply to more liquid forms of money supply.

In other words, QE shifts assets in M3 and above, to MB, which is part of M1 and M2 (see https://en.wikipedia.org/wiki/Money_supply for definitions). That’s why QE is said to be “providing liquidity” to the system — it is, literally, converting less liquid assets into more liquid ones via the Fed’s balance sheet.

This isn’t to say that QE is “good” or even “neutral”. There are issues with increasing (or decreasing) liquidity in the system via shifting the liquidity of assets. There are issues with an entity with essentially unlimited money putting out price insensitive bids on assets. But that’s not quite the same as “fiat/currency debasement” or “money printing” (the original, bad kind).

Footnotes

1. Technically, banks don’t hold actual cash on their balance sheets against deposits. Instead, the money is invested, similar to money market funds. However, the regulations are different because banks can invest in more risky assets, which subject them to a lot more rules to prevent bank failures.
2. I’m intentionally skipping the potential for bonds to default. In practice, market market funds buy very high quality bonds (government bonds, etc.) or buy insurance for any risky bonds for the bulk of their holdings. So while the possibility of a fund “breaking the buck” is not 0, it is extremely small. In reality, since such funds were introduced in the 70s, only 2 have ever “broken the buck” (fell below $1 per $1 invested). In both cases, the losses were relatively small (under 10%) and regulations were introduced to prevent similar issues from happening.
3. The confusion many people have, is that Treasuries are issued by the Fed, which seems to make the whole thing circular. But that’s not true — Treasuries are issued by the US Treasury (hence the name “Treasuries”), which is part of the government. The Fed is technically a private bank owned by other private banks (US banks are its main shareholders). Also, even if Treasuries are issued by the Fed, we just go back to Thought experiment 1 and 2 — while silly, the argument still stands.
4. Large institutions actually frequently conduct trades by paying with US Treasuries instead of actual cash.

Foreword

You’ll be excused for thinking the stock market is schizophrenic the past few weeks — one moment it is down, the next it is up, and often on the same day!

In an environment like that, how should the rational investor price stocks?

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.

Magical pot of cash

Let’s say you have a magical pot of cash, where every 3 months, an additional $2.50 appears in that pot of cash, and you know this, because the pot is transparent and you can see the money actually in it, and count it.

However, the pot is completely sealed, and there is no way to get at the cash unless you break the pot. Unfortunately, breaking that pot will mean that it no longer generates that additional $2.50 every quarter.

If the pot currently contains $100. How much do you think you can sell this pot of cash for?

Well, if the buyer is rational, they’ll pay at least $99 for it — if nothing else, they can buy the pot for $99, break it and immediately make a $1 profit.

But what if the buyer only has $50? Clearly they won’t be able to pay more than $50 for the pot. And so that’ll be the maximum they’ll be able to bid. Remember, a transaction can only happen when the buyer is willing and able to afford the trade.

Secondly, let’s say the buyer has $150, but anticipates needing that $150 in 2 years. Well, the maximum they would be willing to pay for the pot is $120 — if they pay $120 for the pot, in 2 years, it’ll grow to $120, and they’ll be able to break it to take that $120 out, combined with the $30 in cash they’ll have remaining, they’ll be able to just meet their $150 obligation. Obviously if they want to make a profit, they’ll likely want to spend less than $120 for the pot, but $120 remains the upper bound.

Next, let’s say the buyer, for whatever reasons, feels that starting next quarter, the pot will grow by $5 a quarter instead of the current $2.50. Well, in this case, even if they still only have that $150 and still need that $150 in 2 years, they may be willing to pay up to $140 for the pot — they believe the pot will grow $40 in 2 years, and with the $10 in cash left, they’ll be able to meet their obligations. The buyer may be right, or they may be wrong — maybe they know how the pot actually works, maybe they consulted an Ouija board, or maybe they simply read some anonymous stranger make the claim on Reddit. Either way, that’s their belief, and they are willing to act on it.

Finally, let’s say the buyer has infinite money. In this case, they clearly aren’t worried about liquidity issues, and they may be willing to pay absurd amounts of money for the pot! Even if they pay, say, $1,000 for the pot, they’ll break even in 90 years and anything beyond is pure profit. And they’ll be willing to wait 90 years, because they have no immediate need for the money anyway.

Sentiments

To put it in more general terms, the amount that the buyer is willing to buy your pot for, is based on their personal situation and what they feel the future portends. In a single word, it depends on their sentiments — how and what they feel is going to happen in the future. The fact that the pot generates a stable flow of additional cash is relevant, but orthogonal to how much they are willing and able to pay for the pot.

Stocks

Now, to bring the discussion home — a share is basically just a representation of fractional ownership of a company. If we assume that the company is run by competent managers who are honest (i.e. no fraud), then the company’s business will generate profits over time. The company may or may not pay dividends, and for the sake of simplicity, we’ll assume it does not, in which case, the profits simply accrue on the books of the company forever, either as cash, product inventory, equipment or other assets.

Given that the company does not issue dividends, the average investor has no way to readily access those profits. Like our magic pot, the investor can only watch the profits accrue on the books of the company. However, our investor does have the option of selling their shares.

At the same time, a wealthy enough entity can also buy out the entire company, at which point that entity can then sell the company for its parts and get at the accrued profits, essentially “breaking the pot”.

Profit accrual

The fact that profits accrue on the books of our company is crucial — the company is a productive asset, and so buying and selling shares of that company is not a zero sum game; This is a positive sum game, because the accrued profits are an external injection of “value” into our system.

However, as we’ve discussed before, just because a company is profitable and well run, does not mean that buyers are willing and able to pay up for it. In different periods of time, people may value the same dollar of profit differently.

This may be due to demographics — an economy of retirees may have a shorter time horizon and thus less willing to pay for future profits, while an economy of twenty-year-olds may be more willing to pay more for future profits.

It may be due to political factors — in times of war, physical assets may get destroyed, which may cause losses to the company.

It may be due to irrational reasons — a group of investors who are collectively financially significant may decide to buy up shares of a company for no real reasons other than because “they like the stock”, etc.

In short, the price for each dollar of profit that a buyer is willing to pay (e.g. P/E ratio) changes based on sentiments, mostly orthogonally with the actual performance of the company.

Investing for profit

To profit as an investor, it is thus important to understand that the price paid for each dollar of profit is not a constant, and the market can and do over or under value that dollar of profit at different times. The intelligent investor should understand this, and treat the market as the proverbial irrational neighbor, who comes every day with a different price they are willing to buy or sell the shares our investor is interested in.

As long as the company remains profitable and well run, then the most profits can be made by buying when the market is irrationally valuing its shares at a low price. Similarly, our investor condemns themself to poor future investment returns if they buy the company’s shares at irrationally high prices — the accrual of profits by the company is generally independent on how high the shares for that company trade for.

That’s not to say that you should never buy shares of a company that are clearly overvalued. Just because you cannot make a decent investment return, does not mean that you cannot make a great speculative return! After all, just because you are a fool, does not mean that someone else won’t be a Greater Fool.

Foreword

Stocks are on sale, with almost all stocks down at least 5-8% from all time highs, with some tech stocks down as much as 80-90%. Is now a good time to buy?

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.

Stock for sale

Let’s say you are looking at a stock to buy. A month and change ago, it was selling for $100 per share, and today, it’s selling for right around $50 a share — a 50% discount in just over a month. Would you buy it? Is it a great deal?

If the stock just gets back to where it was, you’ll double your money!

Bread for sale

Let’s say a bakery opens for business, and starts selling loaves of bread at $1.50 per loaf (1). One day, out of the blue, it starts offering to sell the exact same loaves of bread for $0.75 per loaf. Would you buy it? Is it a great deal?

Competition

Now, let’s say the first bakery returns its pricing to $1.50 per loaf. And another bakery opens offering to sell the exact same loaves of bread for $100 a loaf. It gets little business, and so decides to pull the same trick, offering the same loaves of bread for $50 a loaf. Would you buy it? Is it a great deal?

Monopoly

And finally, in our last scenario, let’s say the first bakery moves out of town, and the only bakery left is the one selling loaves of bread for $50 a loaf. Would you buy it? Is it a great deal?

Price vs Value

Price is what you pay for something. Value is what you get out of buying that something. These 2 measures are related, but separate. You can easily pay way too much (price) for way too little (value)!

So, considering our bakery scenarios –

Buying a loaf of bread at $0.75 per loaf? Yes, I believe that’s a great deal.

Buying a loaf of bread at $50 per loaf when the next door bakery is selling it for $1.50? No, that’s a terrible deal, even if it was discounted 50% from the original $100.

Finally, buying a loaf of bread at $50 when its the only bakery in town? Maybe! If there is no other food around, and I desperately need to eat, I’d certainly pay $50 (if I had it!) for a loaf of bread. But if there were other food in town, I’d probably eat something else.

In all 3 scenarios, the prices I pay for the same loaf of bread changes, but the value I get — a full tummy, remains the same. Whether the value justifies the price depends entirely on my circumstance. For example, even in the first scenario, where loaves were selling for $0.75, while I would probably buy the first and maybe second loaves of bread, I probably wouldn’t buy more than that — bread is a perishable product, and once my tummy is full, there’s not much value in more bread, to me.

Stock? For sale?

So what about the stock going for 50% less per share? Is it a great deal? Well, it depends!

If you believe in the efficient market hypothesis, then one way of thinking about it is: the stock was fairly priced at $100 a share. So, $50 a share should be a great bargain. Right?

If that’s the gist of your reasoning, then consider this — if the market was indeed efficient a month ago, what makes you think the market isn’t efficient now? Why couldn’t stocks be fairly priced at $100 a share a month ago, yet still be fairly priced at $50 a share today? Maybe something has changed to justify the stock being 50% lower!

If you don’t believe in the efficient market hypothesis, then why do you think a 50% discount, from some arbitrary value to another arbitrary value, means that stocks are a bargain now? Maybe like the $50 loaves of bread, stocks are still overpriced?

Value of a stock

There are two main ways to make a profit from stocks — investing vs speculating. When you invest, you are looking to make a return based on the productive capacity of the stock. So whether the stock is cheap or expensive depends on 3 things only:

• How much return you expect to get from the stock for each dollar invested.
• How much this return increases with time.
• How much return you would like to make, for each dollar invested.

The first is generally measured by metrics like the P/E ratio, P/S ratio, etc. The second depends on your projections and expectations for the business represented by the stock. The third, and arguably the most important, is entirely a personal preference — some people expect to earn at least 8% per annum from their investments, while others may demand as high as 20%, or higher!

For example, if you’d like to make at least a 20% annual profit per dollar invested, and you don’t expect the business to improve, then investing at any P/E more than 5 simply does not make sense.

Separately, when you are speculating, you are looking to buy an asset at a price that is lower than what you’d expect someone else is willing to pay for the same asset, perhaps at a later time. In this case, the only 2 things that matter are:

• Your projection of what that someone else would be willing to pay in the future.
• How much return you would like to make for each dollar invested from now until then.

For example, if you expect someone is willing to pay $100 a share in a month, and you’d like to make a 100% return in one month, then yes, buying at $50 today may make sense.

You can always sit on your hands

The basic fundamental truth is that it doesn’t make sense to buy any asset at a price which you do not like. If you think an asset is too richly priced, even after a 50% or even 90% drop, and you don’t feel that you can make a sufficient return to justify your time and resources, then you can simply sit on your hands and do nothing.

Of course, this assumes that you have other uses for your resources, such as other investment/speculation avenues, or perhaps you think prices will get even better in the near future.

If you have no other avenues to deploy your resources, and you do not feel that prices will get better in the near future, then perhaps your expectations for returns are simply too high.

Footnotes

1. $1.50 is roughly the average cost of a loaf of bread in 2021, in the USA.

Foreword

This is a discussion of how I think about my personal portfolio, and what I do with it.

I want to be absolutely clear here — this post is about me, myself and I, and nobody else. What I do for my portfolio may or may not be suitable for anyone else, especially you. I am not a trained financial analyst, financial planner nor financial anything — please consult a professional if you need help with your own financial planning and/or portfolio management.

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

Conservative overall portfolio

Firstly, let’s get this out of the way — I am a scaredy cat. I am not trying to become a billionaire — my financial plan resolves entirely around early retirement, paying for my children’s college degrees and leaving them enough assets to bootstrap their adult lives. So, my investment choices generally tend towards more conservative assets, which as we’ve discussed before, are expected to provide more stable cash flows and allow for a higher safe withdrawal rate.

Ballast portfolio

I’m not sure where I first heard the term “ballast”, but it refers to the part of the portfolio that forms the “foundation” or “fallback” — if everything else goes to smelly, this is the part that will likely remain, relatively unscathed. A long time ago (does anyone still remember pre-QE days?), this part of my portfolio was just US Treasury bonds and municipal bonds. They provide a very safe, but lower, yield, which I can generally depend upon.

However, with the advent of QE, these bonds yield too little to be meaningful, yet are priced so richly that even a relatively small increase in interest rates(1) will cause their current mark-to-market values to plummet. As such, they went from “safe, but lower yield” to “risky, and essentially no yield”. Not really what I would call ballast-material!

In place of government bonds, I have been trying various other assets to form the ballast of my portfolio. For now(2), I have settled on these:

1. Private real estate equity funds
2. Various short term bonds (of both government and corporate varieties)
3. Short term private notes

The main goal of the ballast portfolio is to provide a source of stable cash flow, from which to fund all other endeavors.

Stocks portfolio

Other than the ballast side of my portfolio, everything else is invested in stocks. In my stocks portfolio, I further divide into 3 accounts:

1. Ballast-lite
2. Main
3. Gamble

Ballast-lite account

The ballast-lite account of my stocks portfolio is, as its name implies, allocated in safer, more conservative stocks and strategies. For example,

1. Stable, conservative dividend stocks
2. Index funds with the wheel strategy(3)

Like the ballast portfolio, the goal is for stable growth, with relatively controlled downside.

Main account

The main account of my stocks portfolio is where I do what most people do (or should do) in the bulk of their portfolios — buy index funds and mostly forget about it. In this account, I also buy some blue chip stocks that I’ve done research on, and are willing to hold for the long term.

Generally, I buy the stocks outright, though for the single name stocks, I may use the wheel strategy to tamp down on volatility and/or squeeze out some additional yield.

Gamble account

The gamble account of my stocks portfolio is where I do crazy things. This is a relatively small account, where I try out experimental strategies, or just bet on silly things (I’ve bought and sold puts and calls on GME during the Jan-Mar 2021 madness).

This is also the account I generally use when I’m uncomfortable about the market, and just want to hedge some of the exposure in the other accounts — in that case, I’ll buy some puts or even outright short in this account to counterbalance the stock exposures in the other accounts.

Target proportions

Ultimately, the goal is for the ballast portfolio to yield enough cash flow to support my lifestyle (with inflation adjusted), while remaining under 50% of my investable assets. When that happens, I’ll know that I can comfortably and safely retire.

The ballast-lite account is meant to provide additional spending money as a buffer, as well as for splurges — maybe I fancy a new flashy car, or to go on an exotic vacation, etc. The main and the gamble accounts are meant to provide for growth in the overall portfolio, as well as assets to leave to my children.

In my stocks portfolio, I generally keep around 30-45% in the ballast-lite account, 30-45% in the main account, and everything else in the gamble account. The exact ratio depends on their recent performances and how I feel about the market — sometimes I forget to rebalance for months on end.

Final word

As noted before, this is a rather conservative portfolio — most people in their prime working years should probably have less than ~60-70% of their portfolio in “ballast”-like investments(4).

However, I’ve found that this suits me fine — I have a day job that pays reasonably well, and so, for my investments, I prefer surety to higher expected, but much more volatile, returns. If nothing else, it helps me sleep at night.

This, again, may or may not be suitable for you. Please consult a professional advisor if you need help with financial planning.

Footnotes

1. Recall that the Federal Reserve can, almost unilaterally, increase short term interest rates at will.
2. As the market environment changes, I may tweak or even completely revamp the assets I hold as ballast. And I almost certainly will not be giving anyone a heads up before I do. Therefore, recall the disclaimer — please consult a professional advisor if you need help with financial planning.
3. The wheel strategy is where you start by having cash, and writing cash secured puts on the asset. If you don’t get assigned, then you just roll the puts over to the next period. If you get assigned, then you switch to writing stock secured calls. Essentially, this caps your upside, but provides a buffer on the downside before you suffer losses.
4. In my defense, I’ve found that I’ve consistently managed to squeeze out fairly reasonable returns from the “ballast”-like assets, generally to the tune of around 10%, which as we’ve discussed before, is what stocks generally yield over long periods of time anyway.

Foreword

QE, money printing, fiscal stimulus… inflation?! What is inflation? What determines how high inflation gets?

This is a discussion of my personal model of inflation and how it occurs.

I want to be absolutely clear here — this is based entirely on personal study and understanding — I am not a trained economist. All I have, is a high school diploma(1) in Economics, from over 2 decades ago — no doubt there are gaps and/or flaws in my understanding.

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

What is inflation?

First off, let’s define inflation. The official economics definition of inflation has undergone some changes throughout history. In this post, I’ll be using the more common, modern day textbook definition which is roughly: Inflation is the general increase in prices of goods and services, and thus a general decrease in the purchasing value of money.

In the quantity theory of money, the equation of exchange gives us(2):

MV = PT

(Simplified) Equation of exchange, https://en.wikipedia.org/wiki/Equation_of_exchange

where

• M – The total nominal money supply
• V – The velocity of money
• P – Price level
• T – The number of financial transactions

So, assuming the number of financial transactions is the same, then an increase in P (inflation) is simply an increase in MV.

i.e.: Inflation is a product of increasing total money supply times the velocity of money.

Of particular note, and this is something that a lot of people get wrong — inflation is the increase in general price levels:

• Inflation is not the increase in price(s) of one or even a handful of products.
  • It needs to be an increase in prices of all or almost all products.
• Inflation is not high prices.
  • Inflation is the increase in prices.
  • Even if prices are still low after the increase, it is still inflation.
  • Conversely, if prices are high, but didn’t increase, then it is not inflation.
• If after a round of high inflation (large increases in prices), prices remain stable at very high levels, then inflation did not persist.
  • Just because the effects of inflation are permanent, need not mean that inflation itself is permanent.
  • For prices to go back to “normal” levels, would require negative inflation (decrease in prices), also known as deflation.

Hyperinflation

In today’s financial environment, whenever inflation is brought up, people immediately jump to hyperinflation, conjuring up images in their minds of stacks of useless cash pushed around in wheelbarrows.

To be clear, the official definition of hyperinflation is 50% month over month increases in prices, which translates to around 129x (12974.63%) annually. Compared to that, the current 5-6% annual inflation rate is pretty tame.

That said, what causes hyperinflation? Well, happily(3), history provides a lot of examples of where hyperinflation struck. In the popular retellings of these events, the story generally goes along the lines of, “the government/central bank printed more and more bank notes, resulting in an excessive supply of these notes, which then resulted in their devaluation and thus inflation”.

In my opinion, that is a very misleading description of what transpired. As a thought experiment, imagine if the governments of the hyperinflationary events were to print the bank notes, and then burn them up in a giant bonfire. Do you think there would have been hyperinflation, or even high inflation then? It seems to me, that the excessive printing of money was a necessary, but not sufficient step towards hyperinflation. It was the left out bit, the part where “the government then spent the newly printed money with abandon”, which resulted in hyperinflation. In effect — simply printing the bank notes did nothing. But distributing them via government spending (i.e.: fiscal policy), resulted in the increase of money supply(4) (increase in M), and the excessive spending by the government resulted in more money being spent and circulated (increases in V). And that excessive spending is the actual trigger of hyperinflation.

In simple terms, it is not “printing money” that is the problem, but the attempt at creating “value” out of thin air — by printing bank notes not backed or offset by anything, and then spending them as if they were valuable.

Monetary vs fiscal policy

Just a quick note here, because we are going to talk about monetary and fiscal policies a lot.

Monetary policies are generally policies with regards to the money supply .

Fiscal policies are generally policies with regards to taxation and government spending.

In modern society/finance, you can think of monetary polices loosely as “what central banks decide to do”, and you can think of fiscal policies loosely as “what governments decide to tax and spend on”.

Quantitative easing

Since 2009 when quantitative easing (QE) started in the USA (and most of the world), there have been many analysts going on about how QE is printing money, and that it would result in hyperinflation. These doomsayers make very compelling arguments by equating QE to money printing, conjuring up images of massive industrial printers working overtime. However, it has been over 12 years, and only fairly recently did inflation even get comfortably past the 2% that central banks generally target. What happened?

Facts

Before we discuss what happened with QE, let’s talk about some facts:

• In the USA, QE started in 2009, and was increase multiple times since then, with the latest increase in around March 2020 due to the Covid-19 pandemic.
• In the USA, inflation from 2009 to March 2020 has generally been low to very low, generally in the 0-2% range.
• Most other developed nations saw similar trajectories with regards to QE and inflation as the USA, though numbers and dates may be slightly different.
• Japan started aggressive monetary policies in the early 90’s, culminating in QE around 2001 — 8 years before most of the other developed nations.
• Japan’s annual inflation rate up to March 2020 has generally been extremely low, with bouts of deflation (negative inflation).
• In March 2020, in addition to aggressive monetary policies by central banks around the world, fiscal policies around the world also stepped up, culminating in a series of transfer payments(5) around late 2020 into early 2021.
• In March 2021, we finally saw inflation pick up in the USA.
• Again, most of the world mirrored the USA’s experience since 2020.

Printing money

The first thing to note when discussing QE, is that it isn’t really “printing money”. In the popular nomenclature, “printing money” generally implies a(n) (attempted) creation of additional “value” out of thin air. However, that is simply not what QE does.

Imagine if you are a bank and I am a client. I choose to deposit $1000 cash with you. In exchange for my cash, you give me a little deposit slip saying I now have $1000 with you. Now, I can write a check against my $1000 with you, and most places would accept my check as payment for services. In effect, that check is “money”(6), and I have, almost literally, “printed money” (with a pen!). I’m sure we can all agree, that lil’ ol’ me isn’t going to cause inflation, much less hyperinflation.

In technical terms, when I deposit $1000 with you, you created 2 entries in your ledger — one under “assets”, which is the actual $1000 cash I deposited with you. The other entry is under “liabilities”, which is the $1000 you now owe me. The total amount of “value” in the system is the same — the $1000 under your assets cancels out the -$1000 under your liabilities.

In a similar fashion, central banks are the banks of normal banks — normal banks can deposit their money with central banks. Generally, (normal) banks need to put up a certain amount of money with their central banks known as reserves. There are complicated rules around the minimum level of reserves a bank needs, and we won’t go into that here, but basically, for a bank to operate, it needs a certain amount of money in the central bank. Any money the bank has in excess of that reserve requirement, is called “excess reserves”(7).

During the Great Financial Crisis of 2008, a lot of assets held on banks’ balance sheets were deemed “risky”. To avoid bank failures, regulators demand that banks increase their amount of reserves. However, there was a general liquidity crunch at the time, so banks couldn’t really do that. At the time, central banks stepped in, and essentially bought up a lot of these assets on the banks’ balance sheets (generally government debt, and government guaranteed mortgage debts). In some sense, this is the same as me depositing my $1000 with you — the banks give the Federal Reserve assets worth $X(8), and the Federal Reserve give the banks a little deposit slip saying “I now owe you $X” (9). On the Federal Reserve’s books, under “assets”, we have these newly bought assets, and under “liabilities”, we have $X owed to the banks.

As you can see, there isn’t really any attempt to create “value” out of thin air. Yes, in a very literal sense, “money is printed” (via increase in reserves on the banks’ books). But that “money” is really just a matched asset/liability pair on the Federal Reserve’s books, and the net “value” in the system is the same — just as me depositing $1000 with you, and then spending that $1000 via a check doesn’t really create “value”.

Liquidity

After the Great Financial Crisis, central banks continued QE, essentially buying up assets from banks, and increasing banks’ excess reserves account (after the immediate crisis, banks already meet your reserve requirements, so any excess sales of assets to central banks really only increase excess reserves).

A further charge of the doomsayers, is that these excess reserves is money, and thus this “money printing” causes inflation.

As we’ve discussed above, while this is “money printing” in the literal sense, there is no attempt at creating “value” out of thin air unlike hyperinflationary episodes from history, because while the central banks issue (excess) reserves, they also take away “value” by taking away equivalent value in assets.

However, there are some effects of this QE! By buying up assets in a price insensitive manner, the central banks effectively put a floor on the value of some assets (generally safe assets like government bonds and government backed debts). This has 2 effects:

1. These assets that the central banks target effectively have a higher clearing price (i.e.: become more expensive than they would be without QE).
2. The money that was previously invested in these assets now need to be invested elsewhere.

Together, this resulted in what is colloquially known as “yield tourism” — investors forced out of safe Treasuries and government backed debts, now have to “reach for yield” by buying more risky assets, such as corporate debt, municipal bonds, equities, etc.

In effect, this increased the liquidity in the system, by both reducing the amount of assets that money can buy, and increasing the amount of money in the system. However, this effect is generally confined to financial markets — the Federal Reserve really isn’t in the market to buy baby diapers or new cars. The money displaced by the Federal Reserve’s buying will generally go into buying other financial assets instead of being spent on consumer goods.

In simple terms, if you’ve $1000 to invest, just because the Federal Reserve prevents you from buying some financial assets, doesn’t mean that you’ll just spend that $1000 on chocolate bars! You will likely just invest in something else — that $1000 doesn’t really make it into the consumer goods market.

Putting it all together

In summary, I believe that QE does not result in inflation. Instead, it results in “financial assets inflation”, which is colloquially used to mean increase in financial asset prices only. This is also why, I believe, the prices of stocks, bonds and various other liquid financial assets have been going up non-stop since 2009.

How then, do we explain the high inflation that started around March 2021? Well, recall under “Facts” above, that QE wasn’t the only thing that happened in 2020. Something else happened. Something new. Something changed in mid/late 2020 — governments started massive fiscal policy programs.

Recall from our short note in “Hyperinflation”(10) how inflation doesn’t really begin until that newly created money is spent. Well, that newly created money started being distributed for spending around mid/late 2020 into early 2021. And then we saw inflation take off in early 2021.

In technical terms, before 2020, while M (the money supply) was rapidly increasing, V (the velocity of money) was rapidly decreasing. As a result, the product MV was actually increasing at a rather slow rate, thus low inflation. After late 2020, the rate at which V decreased slowed down dramatically (it is now almost flat), but M increased dramatically. As a result, MV started increasing at a higher rate, i.e.: higher inflation.

Crimping inflation

Recall that in my August inflation update I noted that I believe the Federal Reserve has all the tools it needs to combat inflation. How would that work if I’m now saying fiscal policy is the cause of inflation?

Well, one way of analogizing about this is that loose monetary policy is fuel, and loose fiscal policy is heat. You cannot start a fire with only fuel, and you cannot start a fire with only heat. You need to combine both(11) to start a fire.

Which is to say, I believe that the Federal Reserve can clamp down on inflation by simply tightening monetary policies — inflation can be reduced by simply reducing money supply faster than the velocity of money. And since the velocity of money isn’t really going up — it’s just “mostly flat” (compared to rapidly decreasing in the past ~2 decades) — the Federal Reserve can simply cool down inflation by stopping QE and increasing interest rates back to “normal”. If need be, they can even increase interest rates to high levels, like what Volcker did in the 70’s (12).

Footnotes

1. Technically, A-levels Economics, which is roughly the equivalent of a high school diploma / AP examinations.
2. Note that this is a simplification. The complete equation is much more complicated. If interested, please refer to the Wikipedia page.
3. From a purely academic perspective. Obviously, if hyperinflation strikes a country, the country’s people wouldn’t be happy about it.
4. To be clear, “total money supply” is short for “total circulating money supply”. Simply printing bank notes and storing them in a vault does not increase the “total money supply” — you have to circulate the newly printed notes first.
5. Transfer payments in the form of deferred rent, loan payments, government subsidies, etc.
6. This is actually a pretty accurate description of how the central banks work. For example, each $1 US dollar bill is actually just a “standardized check” — it is a debt instrument issued by the Federal Reserve indicating that someone had previously deposit $1 with the Federal Reserve, and that $1 US dollar bill is the “check” which represents that $1 now on the Federal Reserve’s books.
7. Yes, bankers are not very original with their naming.
8. There are some quibbles with regards to pricing. The gist is that these assets are under duress and should not be valued at such high levels. The reality is more complicated, since the Federal Reserve, unlike regular banks, don’t have reserve requirements and can hold on till maturity — in some sense, the same assets are “safer” on the Federal Reserve’s books. In practice, I believe the Federal Reserve actually made money on these assets, which suggests some truth to that idea.
9. No, they don’t literally give out deposit slips. C’mon, we live in the digital age.
10. To be absolutely clear, I’m using the hyperinflationary episodes as a way to illustrate the relationships between monetary and fiscal policies. I am not saying that there will be hyperinflation in the USA, or any other developed nation in the near/medium term.
11. And technically oxygen as well. But this is not a physics lesson.
12. I say it rather dispassionately here, but there is a very good chance that a rapid tightening cycle as described will be extremely painful financially for a lot of people.

Foreword

When you enter a financial position, either by buying or shorting an asset, you are, very literally, underwriting the risks associated with that position, whether you care to or not, and whether you know/understand the risks or not.

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.

Matt Levine

One of my favorite financial journalist, Matt Levine, wrote today about Evergrande. That’s kinda related, but it’s really the after effects, when it is way too late. What’s really important, I feel, is captured by this paragraph from Levine:

But another lesson, one that I think about a lot around here, is that the way to reduce systemic risk and potential bailouts is for everyone to know how much risk they are taking, for risks to come with clear warnings and accurate labels, and for the risks to be taken by people who can handle them. If you must have big interconnected companies, it is good to know in advance whose claims are senior and safe and who is taking a big gamble in the hope of a high return. It is fine for a company to fund itself by selling speculative investments to retail gamblers, and it is fine for a company to fund itself by selling safe-as-houses investments to retail retirement savers, but either way it is important for people to know which one they’re buying. Much post-Lehman financial regulation is about this sort of labeling: The way to prevent after-the-fact government bailouts is by making sure that risk is borne by people who bear it knowingly and can afford to. When companies fail, people will lose money, and you want to be able to say to whoever loses money, “well, you knew what you were getting into.”

Matt Levine, Bloomberg. https://www.bloomberg.com/opinion/articles/2021-09-21/evergrande-borrowed-from-everyone

In short: Know what you are getting into.

Subtext: And no, your BFF probably isn’t the best person to listen to about this. (1)

Risks

Very literally, every financial position has some sort of risk. Some of these risks are big and obvious — like buying far out the money calls expiring today at 4pm Eastern. Yes, you may 10x your money in 1 day! Or, you know, you may not.

Some of the risks are hidden. Like buying financial assets that are unsecured, and only backed by the balance sheet of some entity that is based in another jurisdiction. Yes, maybe they pay 4% or 6% or even 12% interest rates, but how confident are you that they’ll continue to pay long enough for you to even get back your capital? And if they decide to stop paying, then what? It’s really hard to sue a company in another jurisdiction — maybe what they are doing is totally legal where they are based! Maybe starting a new Ponzi scheme is just what everyone in that jurisdiction does after breakfast — it’s a ritual, a national sport, a traditional passed down from parent to child since time immemorial! You probably don’t know, and in many cases, you probably don’t want to be in a situation where you need to know.

Some of the risks are due to fraud. Like you bought a bond backed by commodities in a warehouse… that doesn’t exist. Oops! Easy mistake to make, Schrödinger and all that — how do you prove that the commodities don’t exist, if you can’t find the warehouse to observe it?

Some of the risks are due to technical issues. Like you invest in a company that is going to disrupt finance by introducing a new type of checking/savings account combo! But they don’t have a banking license. They can try to tweak things a bit so it’s not technically a banking product, but what if the SEC then comes and tell them the product is a security, and, you know, has the bad manners not to give them the secret cheat code to make it not a security. I mean, why wouldn’t a regulator teach just anyone the secret ways of avoiding regulations. The world will never know.

Some of the risks are due to just bad execution. Like the CEO decides to publicly blog about their misadventures when potentially (almost) breaking the law. Oops! Too late to claim plausible deniability now.

No matter the exact nature of the risk, know that there will always be risk. And if you think the only risk is “the price moves against me”, then you are probably underthinking it.

Investing as underwriting risk

When you enter into a long term financial position, e.g.: investing, you should take some time to understand the risks involved in that position. Just looking at their financial statements and fancy projections is not enough — if nothing else, there are the risks that the projections are too rosy, the financial statements are inflated (either legally or not), or an asteroid drops out of the sky and obliterates the company’s headquarters. Crazier things have happened.

Only when you have a good understanding of the major risks involved with a position, can you honestly say that you are making an informed decision to invest in something; It is almost a truism in finance, that there is never return without risk. So just because there are risks, doesn’t mean you should turn away. Instead, seek to know the risks, understand the risks, and be able to honestly say to yourself that you are willingly taking on the risks, in exchange for the potential returns (2).

A non-obvious corollary of this, is that if someone comes to you with a potential risk in your investment, and your first reaction is “FUD!” or “he’s a hater!”, then maybe you are getting too emotionally tied to that asset, and maybe that is clouding your judgement.

Footnotes

1. Unless you happen to be BFF with someone really financially savvy. No, that Rolex does not prove that they are; Some may make the case that that Rolex proves they are not.
2. Because returns are never guaranteed. The return may be highly probable, but if anyone tells you that something has a “guaranteed return”, they are probably scamming you and/or doing something illegal.

Foreword

Nowadays, it seems everybody is chasing net worth — trying to be the next millionaire, billionaire, trillionaire, etc. I’ve talked to multiple people, all of whom look only at the balance of their portfolios, completely disregarding things like risk, liquidity, etc.

Thinking like that really only works when you have an infinite capacity to take on risk (which generally means you intend to live forever, amongst other things). Otherwise, it is important to remember that not all net worth are created equal.

Are you really rich, if you have $100m on paper, but are not allowed to spend a single cent of 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.

Fatal flaw

I was talking to a financial products sales person today, trying to sell me on a variable universal life insurance. Essentially, money put in is invested in some stocks of my choice, and grows completely tax free. Withdrawals are tax free, and on top of everything, there is a life insurance component.

They made a really good case — on paper, the product outperforms a traditional brokerage account, assuming you hold the same stocks in both, due to the tax advantage, which generally out shadows the insurance premiums. However, it has a (literally) fatal flaw — in order to completely withdraw everything from the account tax free, I’ll need to die.

Wait… what?!

My understanding is that the insurance component of the product is what keeps the withdrawals tax free. If I take out all the money before I die (i.e.: cancel the life insurance), then all the gains are immediately taxable. So, while on paper, after 8 years of contributing $100k per year, I can withdraw up to $4m from the policy after 30 years, with a $7.1m death benefit, in practice, I can really only take out $3.2m — taking out any more will risk leaving too little to fund the insurance premiums, which then triggers taxes on the withdrawn amount.

Now, if I had just dumped that same amount of cash into SPY, and held for the same 30 years, I’d have $4.9m before taxes. Selling everything and paying taxes, will leave me with about $3.5m. Cash.

So, while on paper, my net worth is $4m/7.1m (depending on whether I live), in practice, I can really only access $3.2m, which is quite a bit less than just buying SPY.

You cannot eat net worth

The thing most people get confused by, is the number on their “balance sheet” indicating their net worth. But net worth isn’t the whole story. To put it bluntly, you cannot eat net worth. Having a net worth of $100m is completely useless unless you can liquidate that net worth to get actual cash, with which to actually buy stuff.

And that’s where it gets complicated — not all net worth are created equal. As we discussed in Zero sum game, it is very easy to manipulate numbers to make your net worth essentially say whatever you want. Heck, if you want, I will give you $10m — I have a piece of paper here, on which I’ll write “So-and-so has $10m… as long as they agree never to ever withdraw that money”. Congrats on being a multi-millionaire.

Another case where not all net worth are equal is taxes. Let’s say Alex bought 1,000 shares of a company that pays no dividend 20 years ago at $1 per share. That stock is now worth $1,000, so on paper, Alex has $1m. Compared to Blair who, literally, just has $1m sitting in the bank. Some may think that both Alex and Blair are equally rich. But are they really?

If Alex wants to buy anything, they will have to liquidate some of the shares, which then triggers capital gains taxes. Taking out the capital gains taxes will leave Alex with quite a bit less than $1m. Blair, on the other hand, has $1m completely free and clear.

Net worth is useless?

Not quite. Net worth is still useful, as long as you can liquidate it easily. What you are doing when you liquidate your assets (i.e.: net worth) is literally to create cash flow. Cash flow which can then be used to buy stuff you actually do need, like, you know, food.

So while net worth is weird and funky in all sorts of unintuitive ways, cash flow, particularly after tax cash flow, is fairly simple to understand — if you have $1,000 in after tax cash flow, spending more than $1,000 means you’ll become poorer, and spending less than $1,000 means you’ll become richer, over time. Simple as.

Like the story in Zero sum game, we need to always keep in mind the distinction between stock and flow. Net worth, being a stock metric, is always subject to the whims of the market. If the market decides that your assets are worth $500 instead of $1,000 today, well, you just lost half your net worth. But flow is stable — a dollar is a dollar is a dollar (1).

So, given a choice, I’d rather have a guaranteed $500k of cash flow every year (indexed to inflation), than $10m of assets that I cannot sell (also indexed to inflation) — If you have $500k of cash flow every year, you pretty much can ignore your net worth and still live a very comfortable life. But having a, say, unsellable diamond worth $10m is really only useful if you eat diamonds for breakfast. Or something.

Net worth vs cash flow

In reality, net worth and cash flow are tied. (Hopefully) nobody is dumb enough to put all their money into illiquid assets with no cash flow. Instead, most people invest in either liquid assets (stocks, bonds, etc.) or illiquid assets with cash flow (real estate, private businesses, etc.). So in most cases, having a higher net worth means a higher cash flow, and vice versa.

The thing to keep in mind is, again, “you cannot eat net worth”. It’s all fine and well to have a high net worth, but if you like eating, or having a roof over your head (2), you need to figure out the cash flow picture.

And then what?

All these tie back to 3 words I ask a lot when someone shows me their latest highly levered bets on various speculative assets — and then what?

In all of these cases, the person has money in some levered asset that, for whatever reasons, has done well recently. On paper, they are doing pretty well.

That’s great! But unless you think that asset will continue to do well (or at least maintain its value) up until the point you need cash in the future (20, 30, 40 years from now when you retire?), the thing you need to ask yourself is… and then what?

Are you going to sell and buy something with a stable cash flow?

Are you going to keep the money in that asset and pray that it’s not just a temporary spike and everything will just disappear tomorrow?

Are you going to sell and keep everything in cash?

Recall that speculation is a zero sum game. At some point, somebody will have to eat a loss if somebody else made a gain. Which of the 2 somebodies are you gonna be in the future?

Footnotes

1. OK, not quite. Dollars (and all fiat currencies) tend to depreciate over time due to inflation. But that’s more of a long term thing compared to the short term issues we are discussing here.
2. Admittedly this is anecdotal — I like to eat on a regular basis and have a roof over my head. You are, of course, free to pursue your own preferences.

Foreword

I’ve been receiving a bunch of correspondences from various folks boasting about their (or their acquaintances’) trading prowess. In almost every case, these are folks who haven’t really been trading that long, or at least, their success hasn’t really materialized until the last few trades.

That concerns me, because the first thing you learn in quantitative finance (i.e.: quant trading), is that you need to be able to separate skill from luck. Lying to yourself rarely ends well.

FWIW, I believe that it is possible for individuals to do well (risk adjusted) in the market, and consistently.  But it’s hard enough that for the most part, most people shouldn’t try.

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.

It’s good to be great, it’s better to be lucky

Most people don’t seem to realize that it is extremely easy to be lucky.

Quite a few of my friends know this(1) — my best trade was a ~40x return in about 3 days.  It was my first ever options trade, I had no clue what I was doing, but I turned ~$200 into ~$8,000 before the end of the week.

That doesn’t mean I’m smart, successful or even had any clue what I was doing.  It just meant I was lucky.

But nobody (other than my wife) knows this next part: My next few trades were also winners.  None got close to the 40x in 3 days metric, but most of them did pretty well (30-50% gains in a few hours/days). In all the trades, I correctly called for gold/silver to go up, and I was just trading in and out of short term calls on GLD and SLV — the 40x was a 7DTE call on SLV.

All these mean nothing.  This entire episode happened during April of 2011 — I thought gold/silver would go up, because I read an article that said gold/silver would go up.  And like an idiot, I believed it without question.  That’s all.

I didn’t know it at the time, but the author of the article had been writing about gold/silver going up for years.  They would go on to continue writing about gold/silver going up pretty much all the way up to today. Other than for that ~2 weeks when I started reading their work, they were basically always wrong.

Yet I made a ton of money (percentage-wise) in a very short period of time.  Ergo, not genius, just pure, dumb luck.

Winning consistently vs winning big

Another thing that people don’t think very much about is consistency vs absolute magnitude.

The absolute return you make from a few trades means almost nothing in terms of how good you are. For reference, see the 40x gains I had above.

Instead, it is the ability to consistently do well that is a hallmark of those who really and truly know what they are doing.

Given that market/business cycles take around 8-12 years, at a minimum, if you want to prove that you are “good”, you’ll need to at least be outperforming the market by around a decade or more. This shows that you can outperform in any stage of a cycle, and not just be good at buying levered products (SSO, UPRO, etc.) during a bull market.

Finally, mathematically, ~10 years is also a decent measure — assuming any active trader has a 50/50 chance of outperforming the market, then being able to outperform over a 10 years period means they are 1 in a thousand (2), which gives some confidence and credibility towards their claim of greatness.

Diamond in the rough

So, if you come to me showing the latest 30% gain you make in a single trade, know that:

1. I am happy for you. Really. The curt tone is probably just because I’m jealous.
2. I can’t tell if you are good or just lucky, and given that most people fall in the latter bucket, I’m just gonna stick with the default option.

This doesn’t necessarily mean you’re not good. It just means you haven’t earned it yet.

Footnotes

1. I typically use the story above as a way to warn others when they seem to be overly sure of their prowess.
2. More accurately, 1 in 1,024.