#10: Think Different; Big Pair Trade; Work on Important Problems; Models > Beliefs
July 24 - Aug 7, 2021
10 Rules of Alchemy, by Rory Sutherland
The opposite of a good idea can also be a good idea.
Don't design for Average (Corollary: Disruptive Innovation).
It doesn't pay to be logical (since everyone else is also being logical).
The nature of our attention impacts the nature of our experience (context and expectations play a major role).
A flower is a weed with an advertising budget.
The problem with logic is it kills off magic.
A good guess which stands up to empirical observation is still science ... but so is a lucky accident.
Test counter-intuitive things because no one else will.
Solving problems using only rationality is like playing golf with only one club.
Dare to be trivial.
If there were already a logical answer, we would have already found it (If a problem is persistent, it’s likely that its solution is not derivable by sequential logic).
Dare to look stupid (same as #10?)
(Source)
Most of these can be reduced to “Think different”, though they are different ways of looking at that statement :)
The talk had another very interesting idea/strategy:
Humans are very good at post-rationalizing their experiences to be a product of their choices. So if we are offering a product with different experiences at the same price point, then we shouldn’t make one experience clearly better than the other. That will lead to resentment, even if the distribution is fair (eg: first come first serve). Instead, think of the various features as a multi-variate problem, and make each experience better in some features (and hence, worse in others). That will allow people to segment themselves according to their preferences (Adaptive Preference Theory), which they can further post-rationalize to be their own choice, and thus make a larger number of people happier with their experience. Rory uses the example of a train compartment where he suggests that the seats should be placed in the middle, while the standing people will have the window view and should be given better hand-holds.
The Big Pair Trade: How to short a credit bubble
Byrne Hobart describes a trade that happened alongside The Big Short:
Take a subprime mortgage-backed CDO and buy protection against the AAA-rated slice.
But also buy the unrated (highest yield, highest risk) slice.
The Big Pair Trade was based on the observation that correlations within CDOs were higher than the models said, because demand from CDOs was what led to incremental mortgages, and consumer spending fueled by the real estate wealth effect was one of the reasons subprime borrowers could pay their bills.
When the credit bubble crashed, the unrated slice would get wiped out, but the insurance on the AAA would jump (similar to a deep out of money put). And until then, the yield on the unrated slice would pay for the insurance premiums.
Unlike the Big Short, this trade could be structured to generate positive or neutral returns in the event that the bubble kept going, but would also produce good numbers if it popped—the strategy was a bet that timing the bubble was hard, but that its internal mechanisms created an implicit contradiction, and that the crash will be rapid and widespread.
Can we structure this trade today (if we believe that we are in a bubble)?
One possible way: Growth stocks in hot sectors (EVs, fintech?) might be akin to the [risk characteristics of the] unrated CDO slice, whereas puts on indices with low implied vol (IV) are the AAA protection equivalent.
Unfortunately, stocks don’t lend well to the mechanics of the Big Pair Trade since there is no reliable “high yield” with the risky segment; further EV stocks have already fallen from their highs, and might stay flat or fall modestly even without a broader market crash for our puts to pay off. Junk bond yields might be a better direct equivalent, but even junk bond yields are very low1. And IV has been high across the board since 2020 with the explosion in options trading, so the protection is also expensive.
Working on important problems
Richard Hamming’s essay “You and Your Research” has been doing the rounds across my newsletter subscriptions, and this anecdote is worth remembering:
Over on the other side of the dining hall was a chemistry table. I had worked with one of the fellows, Dave McCall; furthermore he was courting our secretary at the time. I went over and said, “Do you mind if I join you?” They couldn't say no, so I started eating with them for a while. And I started asking, “What are the important problems of your field?” And after a week or so, “What important problems are you working on?” And after some more time I came in one day and said, “If what you are doing is not important, and if you don't think it is going to lead to something important, why are you working on it?” I wasn't welcomed after that; I had to find somebody else to eat with! That was in the spring.
In the fall, Dave McCall stopped me in the hall and said, “Hamming, that remark of yours got underneath my skin. I thought about it all summer, i.e. what were the important problems in my field. I haven't changed my research, but I think it was well worthwhile.” And I said, “Thank you Dave”, and went on. I noticed a couple of months later he was made the head of the department. I noticed the other day he was a Member of the National Academy of Engineering. I noticed he has succeeded. I have never heard the names of any of the other fellows at that table mentioned in science and scientific circles. They were unable to ask themselves, “What are the important problems in my field?”
If you do not work on an important problem, it's unlikely you'll do important work.
PS. Hamming did clarify later that when he says “important problems”, he means the kind that will change the world, or at least, win you a Nobel prize.
Models > Beliefs
Jim o'Shaughnessy often suggests in his podcast to rephrase and change our thought process from “I believe X” to “I have a model that suggests X”.
That reduces our ego, and makes it easier to challenge the model, to accept criticism about its flaws, and thus to update it and make it more useful.
HYLD has a dividend yield of 6% (net expenses), and ANGL/FALN are in the low 4%. CDO high yield tranches used to offer coupons in the high teens.