Practice Second Gear Thinking

Moontower #178

Friends,

Economist, author, and host of the Econtalker podcast (running since 2006!), Russ Roberts is one of my favorite public personalities. He is wise in the holistic sense of the word. He brings a wide perspective to every topic and guest, including those he disagrees with.

As he promotes his new book Wild Problems: A Guide to the Decisions That Define Us which addresses the important decisions in our lives for which data is not a helpful guide (like marriage, where to live, etc), the microphone is being turned back on him — he was recently on Tim Ferriss’ show. The episode is great but I want to talk about a topic that comes right at the beginning — parenting.

Tim quotes from Russ’ eulogy to his father:

“I sometimes think that my dad really could have been a minor American poet or a more renowned storywriter if he had spent less time with his children and grandchildren. The tradeoff was easy for him…He chose us.

“He had many talents. Being a father was the talent he chose to cultivate.”

“All of us who survive him, his good wife, his children and his grandchildren, are so lucky that we had him for so long.

“So If you want to honor my father’s memory, spend more time with your children. Or your parents. Or those you love. For Dad, quality time demanded quantity time. It’s harder than it seems. So many things, more tangible, more alluring, with more immediate returns, call for our attention and distract us.”

He expands during the conversation with Tim (emphasis mine):

I think parenting, but more than parenting, life requires paying attention. And I would say my dad was one of the least meditative people who was born in 1930. There weren’t that many of them, to be honest. It’s a more recent phenomenon, but my dad had zero — I went on three silent meditation retreats while he was alive. And he found that utterly bewildering. So he was not a meditator, but he understood somehow that principle about paying attention to what’s important. And what was important to him was us, his children and his wife and his family. As I said, he used to complain. He said, “It’s terrible. God gave me such a big soul and so little talent. I have so much to say, and I can’t say it.”

He wanted to be a poet. He wrote lots of poems, many of them pretty good. He liked a few of them. And his joke really was — you read the line, but the joke was, he’d like to be a minor American poet. Didn’t want to be Robert Frost or Edna St. Vincent Millay. He would have been happy to be a quieter person with a couple good poems. And he might have achieved that if he had devoted himself to that craft, but he instead devoted himself to us. One of my favorite things about my dad, when we had our kids and I’d say, “Dad, you want to read a story? You want to read a book to one of my kids?” He was so disdainful of that. The idea of reading a book that someone else had written was so cheating to him. All of his stories were made up. He told us hundreds of stories, my children hundreds of stories that he crafted, that he made up. And he could have been a great children’s writer. He could have been maybe a minor American poet, but he spent most of his time with us, his free time.

These excerpts grabbed my attention because, while beautiful, they are not the only way. The larger question for any parental approach is — Are you doing this for kids? Or for you?

A dad I was speaking to recently had his first child. He had been reading me for a while and presumed that my decision to stay home was calculated as the best thing for my kids.

I stopped him right there to share a bit of wisdom that has stayed with me from another friend and his wife. I’ll share it here as well. A little background first. Both members of this couple are elite talents (mentally and physically — genetic mutants kinda). They ultimately split duties explicitly. Where one pursued career, the other managed the family life. But to get to that point there was tremendous introspection about priorities. There was even an off-the-grid type arrangement on the table. They were thinking intentionally, skeptical of the comfort of canned life scripts. And this is despite the fact that one of them is world-class at their profession. Like Russ’ father, they were willing to table personal ambition if that’s what their hearts decided was necessary. In fact, they were torn because the pull to be present with their children was powerful. These pulls, in a spreadsheet sense, were especially expensive given their opportunity costs.

(On an episode of Founders, I learned that David Ogilvy was blown away by an employee who’d consistently leave the office at 5pm. He wondered how this individual could have such discipline! Ogilvy reveals something people often don’t admit — your martyrdom about work can be the opposite — it’s often selfish. High performers are ambitious. They would rather work than go home. Your family’s holistic needs extend well beyond money. Are the boundaries you draw for them…or you? And what stories do you tell yourself about where you draw them?)

I asked them how they eventually decided to have one parent go all-in on their professional career and they harkened back to their own parents. One of them had a father who was like the dad of the neighborhood. He was an active local sports coach too (he himself an Olympic-level athlete) but he was just that guy that the whole town knew. A super-involved community member, all the kids called him coach. His posture is reminiscent of Russ’ description of his own father.

The other member of the couple had a father who was always working. But here’s the thing — both members of the couple felt the same. A deep sense that their fathers loved them. The fathers were as different as their approaches. The introvert and neighborhood “dad”. But their children all felt open lines of communication to their fathers.

And then it dawned on me. Your approach is not about your kids. It’s about you. You can rationalize any specific life plan as “for your kids” but as long as they feel loved, you've done your job. My mother was the work-all-the-time archetype. She had to be. She didn’t finish college, got married too early, and often worked 2 jobs. My sis and I were classic 80s latchkey kids. But my mom has always been a best friend. I could talk to her about anything. I was a very insecure kid, always trying to fit in, and increasingly difficult as I got older. But she is a great listener. She never judged me. And while she always challenged me, it was clear — her love was unconditional. All of this was an open invitation to confide in her¹. Even if she was at work all the time, there was always an open ear for me.

Russ’ sentiments are profound personal expressions of love and gratitude. But they are not prescriptive. They are simply “my dad lived like X, and we are thankful”. They are opinions reflecting Russ’ own values. Optimizing for kids to reflect back on you the way Russ reflects on his own dad might not work. You are not Russ’ dad. And your kids might not have Russ’ needs.

My own view is staying home with your kids is about what you want. My mom has openly regret that she wasn’t around more, not for us, but for her. She wished she “enjoyed” us more when we were children. But as kids we relished the freedom. Playing with mom wasn’t important to us. She’s not fun like that. And that’s ok.

Your parenting approach is a personal mold to fit within the contours of your strengths and weaknesses. You can find inspiration in others but not a recipe. Don’t let the pressures to be [insert type of parent] come from anyone else. The internet will gladly serve you as much FOMO as you’ll take.

Every time I see this ad I want to swing copywriters right into the sun. GFY.

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Money Angle

A theme I harp on is that investing is biology not physics. It’s a competitive game. You figure something out, the game adjusts. When people say “X happens in Y-year cycles” they are thinking like an astronomer who notes the fixed periodicity by which the Earth orbits the sun. This is physics thinking.

But markets price in common information.

Housing has been an inflation hedge. But if everyone knows that, will they bid it up until it’s not? If someone pays 2x the Zestimate for your house, then is this “investment” still an inflation hedge?

Absolute statements in the world of investing without any consideration of price are a red flag that the speaker doesn’t understand the difference. We know the Celtics are good. But what matters to a bettor is their record against the point spread. The point spread is why investing will never be QED’d.

You can learn more about investing from games and betting than books that have “investing” in the title. The investing books are fine for glossaries and knowing the mechanics of a bond just as the rulebook is imperative to play Scrabble. But the rulebook, like the textbooks, teaches you nothing of how to be good at the game at hand.

In an adaptive game, you need to see the next level. Let's look at 2 types of second-level.

“Theory of Mind”

Wikipedia defines “theory of mind” as the “capacity to understand other people by ascribing mental states to them.”

In poker, when you bet, you know your cards and some sense of how they might rank at the table. But the key piece of information, is “when I make a bet, what hand do my opponents think I have?” Without considering such second-order knowledge how do you weigh the information you receive when they call your bet? You must inhabit your opponent’s mind. It’s the same skill you need to interpret market prices (see Staring Out The Window). What expectations and beliefs are in the price? This is second-order thinking.

Second order sensitivities

Besides second-order thinking, we must identify second-order effects. In the options world, the “greeks” are sensitivities. Delta is the option’s sensitivity to the underlying. Gamma is a second-order sensitivity that describes how an option’s delta changes with respect to the underlying.

But this topic is everywhere. If a company sells more widgets it makes more profit. But second-order effects mean attracting more competition or saturating a market. Every satisfied customer is one less customer that needs satisfying. So if I build a model of profitability based on units sold, when does the function inflect? When does opportunity fade into unsold inventory?

[A fun way to think about second-order sensitivities is playing “engine builder” boardgames like Dominion or Wingspan where synergies between your cards lower the marginal costs of later actions². In essence, the cards have gamma based on how you stack them. Every time I use a card it might increase my odds of winning by X. That’s the delta or "benefit per use". But the delta itself increases with synergy, so as the game progresses, you get more delta or benefit/use ratio, from the same card]

An exercise in thinking about second-order sensitivities

Commercial real estate investor Bill Lenehan on Invest Like The Best:

Here in Marin County, where values have gone up substantially and having a small house in Montana, where that market has similarly boomed post-COVID is that it is unquestionable that these property values are not sustainable…As someone who's trying to build a business, which includes recruiting people, training them, compensating them, et cetera, doing that in this housing market is substantially more challenging. Well, I guess it feels good that the house is worth more than you paid for it. Net-net, I would welcome a decline in housing to a more normalized level.

Bill is looking at second-order effects. What would it look like if we translated bits of this quote to “greeks”?

Bill’s personal net worth sounds like it had an uptick because he owns a home in Marin. But he knows it would go up even more if it didn’t go up by residential home appreciation. That’s because he knows he has a larger delta to his business than his home.

Define delta as a change in Bill’s net worth with respect to real estate prices

What does this depend on?

For our narrow example, we will limit this to 2 sources of his net worth.

• The weight of his home as % of net worth

• The (delta of his business to RE prices) x (his ownership of the business)

But delta of his business to RE prices decomposes further:

1. There’s the value of his company’s real estate

2. The expected growth of the business which depends on operating margins amortized into a current valuation.

Bill recognizes that the growth of the business is the largest driver of his net worth and the rise in value of his Marin home represents a slowdown on this larger (albeit nebulous) factor.

First-order thinking is delta. “What happens to my income if I work more hours?” That’s a simple line with a slope of “pay per hour”. Suppose the extra work means you need to employ a babysitter. The slope is just “net pay per hour after paying the sitter”. But if the sitter is a student who can only work an additional 5 hours per week, then the delta or net pay per hour changes because you need to find a higher-priced sitter at some threshold of hours. That’s gamma - the change in your delta. What if there are no other sitters? Then you hit a wall. Your payoff function is abruptly halted. Or what if it inflects because now you need more massages because work makes your body hurt? These are all second-order effects on your delta (slope = net pay per hour) with respect to an increase in hours.

Mathematically, deltas are the slopes of lines. The cause-effect relationship of anything important is rarely so simple. It is convenience that compels us to describe how things work by pointing to lines. The deltas themselves change reminding you that linear thinking is just a snapshot in time. In fact, that’s all a calculus derivative is — zooming in so close to a function that its slope at that point describes a line.

When you listen to explanations, try to fill in the gaps of logic that the speaker understands but are unsaid. You are making the “greeks” or sensitivities explicit. Then you are only one step away from asking “what other greeks are at play?” and what is the “shape of their functions?”

To ponder:

What does a “too much of a good thing” function look like?

How about a hormesis (ie “a little of bad” thing) function?

What does a discontinuous phase transition(ie “gas > liquid> solid”) look like?

What does a logistics or S-curve function signify?

What phenomena follow a convex function? A concave function?

What’s a “winner-take-all” function look like?

Money Angle For Masochists

My bias is traders should study gambling, not investors and definitely not macroeconomics. I feel trading requires self-awareness and unique mix of humility and confidence. Humility demands questioning how you know what you think you know. But this is also a description of a cat chasing its epistemological tail. This needs to be balanced with the confidence to make a decision before you are comfortable, otherwise, you will be too late.

This brings me to Aaron Brown’s article in Bloomberg (paywalled):

Want to Succeed on Wall Street? Learn Poker, Not Economics

These excerpts will save you a click.

What

The Federal Reserve Bank of New York in conjunction with researchers at the University of Southern California and University College London for a paper titled Strategic Sophistication and Trading Profits: An Experiment with Professional Traders. The authors recruited 56 professional traders, plus an equal-size sample of students for controls, and evaluated their performance in a computer-simulated trading game. They then tested their subjects on a wide range of specific skills to see which skills were correlated to trading success.

Main findings

• Among students, the only useful predictor of trading success was general intelligence.

• Among professional traders, though, neither intelligence nor other personality traits and cognitive skills mattered much. Success did not depend on any fundamental insight about value. What mattered was strategic sophistication in the sense of taking an analysis of other people’s behavior to high levels. This calls to mind the folk wisdom found in poker, which is that “beginners think about their cards. With a little experience, they start thinking of the other guy’s cards. Poker begins when you think about what the other guy thinks about your cards.” The Fed paper suggests that professional traders are playing poker, while the students are playing games like chess, backgammon, or blackjack that depend on intelligence rather than guessing what other people are thinking.

• The paper’s finding goes well beyond the claim that strategy is valuable for trading. It suggests that other things such as intelligence, risk strategies, personality traits or knowledge of fundamental value do not matter — or at least are evenly distributed among traders that they can’t be used to predict success.

Murky interpretations

• The Fed paper did not find any advantage to years of education or experience or other indicators of trading. Who should you believe? The Turtle experiment and Wall Street folk wisdom have one great advantage, in that they are based on real people trading large amounts of money in real financial markets. Unfortunately, that makes controlled experimentation prohibitively expensive. Formal studies and other academic work conducted under laboratory conditions make the results much more scientific but at the cost of being one layer removed from reality.
  

• If you are not a trader but want to be one, either for your own account or for an institution, the study suggests you should play poker rather than attending class and take game theory courses over economics
  
  …but
  

• Conventional wisdom says you should develop your comparative advantages, whatever they are, and study successful traders. If your interest is to understand the economic function of trading, the study suggests it is a game that rewards aggregating information from others’ bids and offers and using that information to provide liquidity. Conventional wisdom suggests trading is a broader skill that combines fundamental and technical information to produce an equilibrium, with many different types of traders performing different functions.
  

Practical upshot (emphasis mine)

If you like poker more than class and game theory more than economics, it’s good news. You may lose in trading competitions with fellow students, but you have a bright future on Wall Street. On the other hand, if you’re counting on traders to assess fundamental economic value, the study is bad news. It suggests they’re focused on outsmarting each other, not on investigating reality.

Whatever you think about the study and possible implications, it’s always good to see a careful, controlled, rigorous analysis in an area where opinions tend to be much stronger than the foundations for those opinions.

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For an outro enjoy:

Spread’em Tight by

The Till

This is a nice post about option market-maker thinking. My own description of the job:

Pay me $10k up front and I'll flip a $1mm coin with you

Stay groovy!

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1. A bit of a personal thought — my parents split when I was in middle school. In a traditional Egyptian culture, my mom was an iconoclast. She got a college degree in her 40s, she’s fiercely independent, and travels the world by herself. The biggest lesson I learned from her was to not care what others thought. There are always haters. I learned that courage is not bravado. It’s persistently being honest with yourself. You might not find widespread acceptance but the acceptance you find will be worth more. And the acceptance starts with yourself.

2. The real currency in these games is felt but not explicit — it’s “actions”. The more things you can do on your turn the more “victory points” you can acquire — which are the explicit goal. Implicitly, you are striving for efficiency. The gameflow nudges you to start pricing victory points according to how many actions it requires to get them. Those prices change as your engine gets more efficient