WEBVTT - 58: Ignore Investing's Mathematical Underpinnings at Your Peril 0:00:08.960 --> 0:00:11.920 High and welcome to another edition of the Odd Thoughts podcast. 0:00:11.960 --> 0:00:15.120 I'm Tracy Alloway and I'm Joe. Wasn't all Joe, I 0:00:15.160 --> 0:00:17.279 got to ask when you were at school, were you 0:00:17.400 --> 0:00:20.280 good at math? So it's really funny that you should 0:00:20.320 --> 0:00:23.960 ask that, um, Because so my dad is a physics professor, 0:00:24.520 --> 0:00:27.360 and he started me on math training when I was 0:00:27.520 --> 0:00:30.560 very young. And I was really good at math and 0:00:30.600 --> 0:00:33.360 really good at mental math and super good at multiplications 0:00:33.720 --> 0:00:37.080 up until like fourth grade. And then as soon as 0:00:37.080 --> 0:00:39.320 it like hit the level of like where I actually 0:00:39.360 --> 0:00:41.120 had to do work and couldn't just do stuff in 0:00:41.159 --> 0:00:45.080 my head, I just like I just totally became very average. 0:00:45.080 --> 0:00:47.240 So I went from being really good at math to 0:00:47.440 --> 0:00:51.000 really mediocre very fast. But I do really love math, 0:00:51.120 --> 0:00:53.080 and I do really like doing a sort of math 0:00:53.120 --> 0:00:54.960 in my head and think about math and stuff like that. 0:00:55.120 --> 0:00:57.640 So I think I have a love hate relationship with math, 0:00:57.720 --> 0:00:59.840 Like I find it very very difficult to do and 0:01:00.120 --> 0:01:04.600 is probably my most hated subject, but conceptually I think 0:01:04.640 --> 0:01:08.040 it's really interesting and statistics. I was actually quite good 0:01:08.080 --> 0:01:12.400 at UM, so I like thinking about math ideas I 0:01:12.440 --> 0:01:15.520 hate actually doing the math. I mean, I think I 0:01:15.800 --> 0:01:18.600 think we're probably in the same boat on this one. Okay, well, 0:01:18.840 --> 0:01:21.480 we're going to talk about maths, and yeah, we're not 0:01:21.520 --> 0:01:23.480 going to do do math because that would be the 0:01:23.520 --> 0:01:26.120 world's most boring podcast ever. But we are going to 0:01:26.160 --> 0:01:29.760 talk about mathematical ideas and specifically how they applied to 0:01:30.240 --> 0:01:34.000 investment and markets and finance. And we have a very 0:01:34.160 --> 0:01:38.160 cool guest who is probably better better able to talk 0:01:38.160 --> 0:01:40.800 about math and investments than just about anyone else. Yeah, 0:01:40.880 --> 0:01:43.760 that's right. So, anyone who's ever heard of long term 0:01:43.800 --> 0:01:46.560 capital Management, you know that there was a quant there 0:01:46.840 --> 0:01:52.320 co founder called Victor Hagani and basically was hugely instrumental 0:01:52.640 --> 0:01:55.960 in the founding of that firm and is a mathematical 0:01:56.040 --> 0:01:59.680 expert of the highest order, I suppose you would say, right. 0:01:59.720 --> 0:02:02.000 And so these days there's so much interest in like 0:02:02.040 --> 0:02:06.120 algorithms and computers and quantitative finance and stuff, and there 0:02:06.160 --> 0:02:08.000 of course really ahead of the curve on a lot 0:02:08.040 --> 0:02:11.560 of these ideas, and now there's much more interest. So 0:02:11.919 --> 0:02:15.320 we're going to talk about the connection between math and 0:02:15.360 --> 0:02:20.480 finance and particularly some important mathematical concepts that investors should understand. 0:02:20.639 --> 0:02:23.480 Maybe we'll get an LTCM questioned in there too. Who knows. 0:02:33.440 --> 0:02:36.800 Let's bring in Victor Hagani. Like I said, he was 0:02:36.840 --> 0:02:38.480 at l T c M, but he is now the 0:02:38.520 --> 0:02:42.240 CEO of ELM Partners, which is basically a portfolio of 0:02:42.360 --> 0:02:45.720 low cost index and exchange traded funds. Victor, thanks so 0:02:45.800 --> 0:02:48.120 much for joining us. Thank you very much for having 0:02:48.160 --> 0:02:51.560 me so. Victor. We actually brought you on after reading 0:02:51.680 --> 0:02:55.720 a paper that you did, UH basically about what coin 0:02:55.840 --> 0:03:00.200 tossing and the probabilities involved in coin tossing? Can each 0:03:00.240 --> 0:03:04.360 us about investment? Can you tell us about that paper? 0:03:04.800 --> 0:03:08.240 So it came out of an experiment that that I 0:03:08.280 --> 0:03:11.480 did with the colleague of mine UM who I worked 0:03:11.480 --> 0:03:16.280 with at Ellen Partners, Rich Dewey, and we had heard 0:03:16.280 --> 0:03:19.640 about some research that was that had been done involving 0:03:19.800 --> 0:03:24.640 coin flipping and how people UH managed situations where they 0:03:24.680 --> 0:03:29.040 were given a favorable odds kind of investment opportunity. And 0:03:29.639 --> 0:03:32.320 I know we can't remember it with with these things, 0:03:32.360 --> 0:03:35.040 sometimes you can't quite remember where the ideas come from. 0:03:35.040 --> 0:03:37.400 But we decided to do this experiment where we would 0:03:38.080 --> 0:03:42.280 UM give gives depends some some real money and allow 0:03:42.360 --> 0:03:45.920 them to flip a coin that was biased to come 0:03:46.000 --> 0:03:50.920 up six likely to come up heads tails, and we 0:03:51.040 --> 0:03:53.000 told them that to begin with, and we gave them 0:03:53.040 --> 0:03:55.760 half an hour to flip to bed as much of 0:03:55.920 --> 0:04:00.000 their starting as they wanted. And at the end, however, 0:04:00.000 --> 0:04:02.800 were much money they had left in their bank, we 0:04:02.800 --> 0:04:05.880 would pay them up to a maximum amount of two 0:04:06.240 --> 0:04:09.360 and fifty dollars. And what we found was that UM 0:04:11.040 --> 0:04:16.600 our participants, who were pretty quantitatively quantitatively trained UM young 0:04:16.680 --> 0:04:19.120 men and women, didn't do very well and they didn't 0:04:19.200 --> 0:04:23.440 kind of get some of the basic concepts of UM 0:04:23.640 --> 0:04:27.600 decision making under uncertainty or the they didn't quite get 0:04:27.680 --> 0:04:30.480 the independent nature of the flips and the fact that 0:04:30.839 --> 0:04:33.800 it just made sense to keep betting on heads to 0:04:33.960 --> 0:04:38.600 debt you know, some modest constant proportion of how much 0:04:38.640 --> 0:04:41.480 they had in their bank at any point in time 0:04:41.560 --> 0:04:45.120 on heads and so UM. Yeah, it was, it was. 0:04:45.160 --> 0:04:48.200 It was really interesting to think about, you know, how 0:04:48.279 --> 0:04:52.159 people were we're having trouble with that, and you know, 0:04:52.279 --> 0:04:54.599 to give us some ideas for trying to help with 0:04:55.040 --> 0:04:58.560 UM with education as well. On on that, on that topic, 0:04:58.920 --> 0:05:02.040 explain real quickly the exact mechanics they were supposed to play. 0:05:02.080 --> 0:05:05.560 They had twenty five dollars and they were supposed to bet, 0:05:05.600 --> 0:05:08.160 what explained to us what the nature of the bet is, 0:05:08.400 --> 0:05:12.120 and then what did the lessons show about mistakes that 0:05:12.160 --> 0:05:15.320 people might or might not make when they invest. Sure, 0:05:15.600 --> 0:05:18.279 so the you know, the exact mechanics of it were that, 0:05:18.800 --> 0:05:20.920 you know, we told that the people to come for 0:05:20.960 --> 0:05:23.880 a lecture and uh, and then we asked them to 0:05:23.920 --> 0:05:26.680 get out their laptops and to play this game. So 0:05:26.720 --> 0:05:29.520 we gave them twenty five dollars that turned up on 0:05:29.560 --> 0:05:31.919 their screen and their banks and their bank accounts or 0:05:31.920 --> 0:05:35.480 their bank roll, and then they could bet up to 0:05:35.520 --> 0:05:38.240 the on the flip of a coin, and they could 0:05:38.279 --> 0:05:42.080 do it repeatedly. Some people flipped the coin three hundred 0:05:42.200 --> 0:05:45.160 times in the thirty minutes that they had and if 0:05:45.200 --> 0:05:47.640 they won the slip, then their bank roll would go 0:05:47.839 --> 0:05:50.440 up and and and vice versa. And however much they 0:05:50.480 --> 0:05:53.680 were left with at the end, we actually told them 0:05:53.800 --> 0:05:56.640 and we did pay them as a check or cash, 0:05:57.160 --> 0:06:00.080 which was you know, especially for a bunch of college students, 0:06:00.120 --> 0:06:02.960 which were the majority of our subject. You know, it 0:06:03.040 --> 0:06:05.960 was very welcome. And the two d and fifty dollar 0:06:06.120 --> 0:06:08.880 maximum that we were going to pay them, uh, we 0:06:08.960 --> 0:06:11.440 only told them that if they got close to it, 0:06:11.520 --> 0:06:13.560 so we told them that there was a maximum payout 0:06:13.640 --> 0:06:16.520 to begin with, but it was only when they got 0:06:16.560 --> 0:06:19.039 to a point where they could reach the two hundred 0:06:19.080 --> 0:06:20.800 and fifties. So if they had two d and twenty 0:06:20.839 --> 0:06:23.760 five dollars in their bank account and they were betting 0:06:23.800 --> 0:06:26.320 thirty dollars on heads, we would say, by the way, 0:06:26.480 --> 0:06:29.040 the most will pay you is two fifties. So you 0:06:29.120 --> 0:06:31.520 might want to do see your best from thirty dollars 0:06:31.520 --> 0:06:34.919 to twenty five dollars, because there's no point in winning 0:06:34.920 --> 0:06:37.160 two hundred and fifty five dollars. We won't pay you that. 0:06:37.720 --> 0:06:40.680 The most surprising thing, uh, in a way, was the 0:06:40.720 --> 0:06:45.640 fact that people would relatively frequently bet on tails, um, 0:06:45.640 --> 0:06:47.880 you know, even though we told him it was likely 0:06:47.960 --> 0:06:50.479 to be heads. You know, even though in general, you know, 0:06:50.640 --> 0:06:53.680 heads was coming up more frequently for most people, you know, 0:06:53.720 --> 0:06:56.440 after they have flipped a number of times, they still 0:06:56.480 --> 0:07:00.480 felled them, particularly after a string of head So like 0:07:00.520 --> 0:07:03.440 if they got four heads in a row, they were 0:07:03.480 --> 0:07:06.840 then more likely to bet on tails. Not everybody. That 0:07:06.920 --> 0:07:11.120 seems like a deep failure of numerousy to ever bet 0:07:11.240 --> 0:07:15.600 on tails, even and to think that something like the 0:07:15.640 --> 0:07:20.640 past streak of flips. Is any bearing on the next flip, Yeah, 0:07:19.920 --> 0:07:22.679 it is, But it's just that it's like the deep 0:07:22.800 --> 0:07:25.680 seated need that we have, you know, to sort of 0:07:25.800 --> 0:07:29.440 see a story and random thing. It's very you know 0:07:29.480 --> 0:07:32.360 that given that like half of the people did you know, 0:07:32.520 --> 0:07:37.360 half of these subjects at some point bet on tails, 0:07:37.400 --> 0:07:40.480 and like thirty percent of them bet on tails fair 0:07:40.520 --> 0:07:43.280 amount of the time. So there's something kind of deep 0:07:43.320 --> 0:07:45.680 seated and there my mom. I had my mom through 0:07:45.720 --> 0:07:48.880 the experiment and we talked about it afterwards, and she 0:07:48.920 --> 0:07:50.760 said to me, I know that I should never bet 0:07:50.800 --> 0:07:53.120 on tails, but I just couldn't resist. So she knew it, 0:07:53.720 --> 0:07:56.480 she knew it didn't make any sense, but she just 0:07:56.600 --> 0:07:59.960 couldn't resist. And it was interesting. We did another experiment 0:08:00.040 --> 0:08:03.160 and following up on this, this the same as interview 0:08:03.240 --> 0:08:06.920 question about the family planning that if you uh, you 0:08:06.920 --> 0:08:09.120 know that if if in a if you're going to 0:08:09.360 --> 0:08:12.040 in a society, if if everybody wants to have a 0:08:12.040 --> 0:08:15.560 girl and so they keep having children, each family has 0:08:15.640 --> 0:08:18.800 children until they have a girl, does that change the 0:08:18.840 --> 0:08:22.239 expected number of boys and girls? And most people feel 0:08:22.320 --> 0:08:25.520 that it does, even though when father as a coin flip, 0:08:25.600 --> 0:08:28.120 you can kind of see that they're independent, and you 0:08:28.160 --> 0:08:30.520 know that there's nothing there's really nothing much you can 0:08:30.520 --> 0:08:33.280 do to change the expect number of boys being equal 0:08:33.320 --> 0:08:36.280 to the expect number of girls to any finite horizon. 0:08:36.800 --> 0:08:39.880 So the point of those types of experiments is essentially 0:08:39.920 --> 0:08:46.120 that the optimum investment strategy is dictated by maths, right, 0:08:46.160 --> 0:08:49.679 and yet we choose to ignore it for whatever reason 0:08:49.720 --> 0:08:54.439 because we instinctively don't understand probabilities, or there's some emotional 0:08:54.559 --> 0:08:58.360 thing going on. Yeah, I mean I think people, you know, 0:08:58.679 --> 0:09:03.240 understand it. I mean like our subjects were really quantitatively trained. 0:09:03.240 --> 0:09:05.280 I mean they understood all of this, you know, there 0:09:05.320 --> 0:09:08.679 they were some of them were even mathematicians that at 0:09:08.720 --> 0:09:11.439 one of the universities where we did it, and and 0:09:11.000 --> 0:09:13.800 U some of and some of the subjects were also 0:09:13.960 --> 0:09:18.280 professional investment investment professionals that had both know a lot 0:09:18.360 --> 0:09:21.439 of maths and econ and finance training. So they understand it. 0:09:21.480 --> 0:09:23.199 But I think there is this sort of there's something 0:09:23.280 --> 0:09:28.000 deep seated that that sort of comes up and steers 0:09:28.080 --> 0:09:31.559 us off the path. And so you know, it's kind 0:09:31.559 --> 0:09:34.440 of like quite a lot of specific training is probably 0:09:34.440 --> 0:09:37.840 what's needed to get people to be disciplined, and you know, 0:09:37.920 --> 0:09:40.640 to be disciplined, it's not a lot of fun. I 0:09:40.640 --> 0:09:42.800 mean thinking about you're sitting there flipping a coin for 0:09:42.880 --> 0:09:46.600 half an hour and you're just trying to get of 0:09:46.640 --> 0:09:48.960 your bank roll on it and keep betting on head. 0:09:49.320 --> 0:09:53.000 It reminds me of reading about professional poker players who 0:09:53.120 --> 0:09:56.160 know that they can make a steady profit playing limit poker, 0:09:56.679 --> 0:10:00.360 which is a very mathematical, no, very little bluffing version 0:10:00.360 --> 0:10:03.360 of the game of poker, but they're just bored out 0:10:03.360 --> 0:10:05.720 of their minds when they play it. So they no 0:10:05.880 --> 0:10:09.080 limit is more fun and more exciting. There's it's a 0:10:09.120 --> 0:10:13.720 little less mathematical and more sort of based on emotion. Uh, 0:10:13.840 --> 0:10:16.560 they are more inclined to lose, Like you know, these games, 0:10:16.800 --> 0:10:21.360 these sort of sure things are not very enjoyable practices. Yeah. Yeah, Well, 0:10:21.559 --> 0:10:24.320 and think about index investing, right, I mean kind of 0:10:24.360 --> 0:10:26.480 the most you know, the most boring thing you could 0:10:26.520 --> 0:10:28.560 do is to take all of your savings and to 0:10:28.600 --> 0:10:32.200 put it into two index funds. You know, very few 0:10:32.240 --> 0:10:34.839 people really do that, and very you know, very few 0:10:34.880 --> 0:10:36.640 people do that and stick to it. I mean, people 0:10:36.640 --> 0:10:38.679 will do it and then they sort of will come 0:10:38.679 --> 0:10:40.800 back and feel that they need to change it because 0:10:40.920 --> 0:10:42.760 you know, there was an election, or there was a 0:10:42.920 --> 0:10:46.240 change in interest rates or something. So it's sort of 0:10:46.440 --> 0:10:50.440 fighting that that urged to us. That fighting the urge 0:10:50.480 --> 0:10:53.840 to be active is difficult in a lot of different contexts. 0:10:54.080 --> 0:10:56.960 We're all suckers for a sense of control. Let's talk 0:10:57.000 --> 0:11:01.880 about a different mathematical concept that's incredibly important to investing 0:11:01.960 --> 0:11:05.400 and that is compounding. This sort of I forget who 0:11:05.400 --> 0:11:07.920 said it. Maybe it's like Einstein, someone famous said something 0:11:07.960 --> 0:11:11.280 about compounding or being one of the most powerful forces 0:11:11.320 --> 0:11:14.120 on earth. Yeah, I think that they say Einstein may 0:11:14.200 --> 0:11:16.760 said something like that. As strange as it me. Yeah, 0:11:17.120 --> 0:11:18.720 I don't know why he would have been talking about it, 0:11:18.760 --> 0:11:20.360 but I think he did say something about it for 0:11:20.360 --> 0:11:24.959 whatever reason. Um, what don't people understand? What is it? 0:11:25.040 --> 0:11:28.320 Why is compounding such an important concept to understand? And 0:11:28.360 --> 0:11:32.600 what do people what do people get wrong about this? Well? 0:11:33.200 --> 0:11:35.559 You know, I think that you know that in these 0:11:35.600 --> 0:11:38.560 sort of investing things or mass things in general. You know, 0:11:38.559 --> 0:11:41.520 one of the things that really gets us is nonlinearities, 0:11:41.520 --> 0:11:44.719 you know, as things that are not proportional, and compounding 0:11:44.760 --> 0:11:48.800 is one of those things. So, um that the growth 0:11:48.800 --> 0:11:50.520 of your money doesn't kind of go up in a 0:11:50.600 --> 0:11:53.240 straight line. It goes up in this exponential line. It 0:11:53.600 --> 0:11:56.160 starts off growing slowly, and then as it gets bigger, 0:11:56.160 --> 0:11:59.120 it's growing faster in terms of the amount of money 0:11:59.240 --> 0:12:01.240 by which it's growing, I mean, the rate of growth, 0:12:01.360 --> 0:12:04.599 let's say, stays the same. And and so you know, 0:12:04.640 --> 0:12:07.920 when you start to look at relatively long periods of time, 0:12:07.920 --> 0:12:11.160 which are the kinds of periods of time that are 0:12:11.200 --> 0:12:15.400 relevant to us in terms of building savings for retirement 0:12:15.720 --> 0:12:18.000 or or uh, you know, our our our sort of 0:12:18.000 --> 0:12:22.600 personal security longer term, or for our family or our kids. Um, 0:12:22.640 --> 0:12:25.120 you know, those long term horizons are important, and and 0:12:25.320 --> 0:12:29.600 compounding and small effects really magnify out there. So you know, 0:12:29.720 --> 0:12:31.760 the one that we always that we can hear a 0:12:31.760 --> 0:12:34.560 lot about, right, is sort of the effect of fees. 0:12:34.640 --> 0:12:37.640 You know that, Um, you know that if you're compounding 0:12:37.840 --> 0:12:42.000 at a five percent return because you're paying two percent fees, 0:12:42.360 --> 0:12:45.079 or if your account compounding at a seven percent return, 0:12:45.720 --> 0:12:48.600 that what you wind up with at the end is 0:12:48.640 --> 0:12:53.079 not proportional to seven over five, right, that that seven 0:12:53.120 --> 0:12:56.120 winds up giving you a lot more um at the 0:12:56.280 --> 0:12:59.040 end because it's it's you know, it's it's one point 0:12:59.040 --> 0:13:02.200 oh seven being raised to a power divided by one 0:13:02.240 --> 0:13:05.000 point oh five being raised to a power. So you know, 0:13:05.080 --> 0:13:10.320 everything kind of gets magnified by by compounding, and so yeah, 0:13:10.320 --> 0:13:12.199 you get a lot of you know, like another thing 0:13:12.240 --> 0:13:15.000 that you know, sort of similar to sees as taxes. 0:13:15.080 --> 0:13:17.760 So if we can invest in a way where we 0:13:17.920 --> 0:13:22.400 don't pay tax until the end of our investment horizon, um, 0:13:22.480 --> 0:13:24.160 you know, we wind up with a lot more money 0:13:24.200 --> 0:13:26.840 than if we're paying the same rate of tax on 0:13:26.840 --> 0:13:31.200 our growth every year that we go along. So um, 0:13:31.240 --> 0:13:33.080 like you know, an example of that would be let's 0:13:33.080 --> 0:13:35.880 say that you have a uh an investment that has 0:13:35.920 --> 0:13:38.160 an eight percent rate of return and let's say a 0:13:38.200 --> 0:13:42.400 tax rates or fifty percent. Just to make the mass simple, Um, Well, 0:13:42.480 --> 0:13:45.040 after thirty years, if you were well, if you're paying 0:13:45.120 --> 0:13:48.160 tax every year, then your eight percent return duringly like 0:13:48.200 --> 0:13:51.520 a four percent after tax return. So if you have 0:13:51.600 --> 0:13:53.959 a if you have a hundred thousand dollars and you're 0:13:54.000 --> 0:13:57.840 investing it, then after tax, that hundred thousand dollars has 0:13:57.960 --> 0:14:03.160 grown to three four thousand dollars after thirty years at 0:14:03.200 --> 0:14:06.480 this four percent rate of growth. Half of the five 0:14:07.760 --> 0:14:11.040 but it's instead you're deferring your tax to the end. 0:14:11.640 --> 0:14:15.160 Then you're growing at eight percent right, um, because you're 0:14:15.160 --> 0:14:17.000 not paying any tax on it. But at the end 0:14:17.040 --> 0:14:20.720 you have to pay tax on all your games. And 0:14:20.760 --> 0:14:23.520 when you do that, you wind up with clothes to 0:14:23.560 --> 0:14:25.800 double the money. After thirty years, you wind up with 0:14:26.040 --> 0:14:30.440 like five fifty thou dollars and almost a six percent 0:14:30.600 --> 0:14:33.240 instead of a four percent rate of return. So that 0:14:33.360 --> 0:14:37.560 stuff really kicks in over these long horizons and is important. 0:14:37.600 --> 0:14:40.960 You know, small differences wind up being big differences because 0:14:41.000 --> 0:14:47.480 it's compounding. What's your favorite um financial formula for investing? Like, 0:14:47.520 --> 0:14:53.800 if you had to choose one, UM, well, I don't know. 0:14:53.840 --> 0:14:56.200 I guess, uh, you know, one of the simplest ones 0:14:56.640 --> 0:14:58.800 one that there's been on my mind lately. I don't 0:14:58.800 --> 0:15:01.000 know if it's and I think if I had more 0:15:01.000 --> 0:15:03.520 time to think of it, I find a better one, 0:15:03.560 --> 0:15:06.880 but it's been on my mind. Of that is is 0:15:06.880 --> 0:15:11.200 what's known as Sharp equality, from a paper that William Sharp, 0:15:11.320 --> 0:15:16.280 the Nobel Prize winner, wrote, um in the early it 0:15:16.320 --> 0:15:18.600 was I think the paper was called like the Aristhetic 0:15:18.920 --> 0:15:22.360 of Active Investing, And in that he just made the 0:15:22.560 --> 0:15:27.840 very simple, uh statement, that the return on the average 0:15:27.880 --> 0:15:32.560 actively managed dollar has to equal the return of market 0:15:32.960 --> 0:15:36.520 minus minus fees on the active stuff, and that comes 0:15:36.560 --> 0:15:42.200 about the market return is UM must equal a weighted 0:15:42.280 --> 0:15:45.080 average of the reach end of the passive and active 0:15:45.160 --> 0:15:49.720 segments of the market. So if the uh, if the 0:15:49.760 --> 0:15:52.240 total market return is the same as the index thing 0:15:52.320 --> 0:15:55.960 return of the passive part, then you know, it's sort 0:15:56.000 --> 0:15:59.720 of like, you know, if if two equals one plus one, 0:16:00.440 --> 0:16:03.880 then two minus one equals one is kind of um. 0:16:03.920 --> 0:16:05.920 You know, I guess I suppose the way of seeing it. 0:16:05.920 --> 0:16:09.160 So it's a very simple. It's kind of like in physics, 0:16:09.280 --> 0:16:14.120 the the idea of the conservation of energy UM and 0:16:14.400 --> 0:16:17.480 you know, so what are the practical ramifications of that? 0:16:17.560 --> 0:16:20.240 From an investor standpoint? This sort of I get it 0:16:20.720 --> 0:16:24.400 sounds like an identity essentially, what do the how does 0:16:24.480 --> 0:16:28.680 that manifest itself practically in terms of making investing decisions? Well, 0:16:28.680 --> 0:16:31.000 it just helps us a lot in terms of thinking 0:16:31.040 --> 0:16:34.360 about what we're doing when we choose active strategies. That 0:16:35.040 --> 0:16:39.240 for an active strategy to be working for us UM 0:16:39.560 --> 0:16:42.200 that we have to believe that there's some other active 0:16:42.280 --> 0:16:44.880 strategy that's losing money and we have to be able 0:16:44.920 --> 0:16:49.480 to identify, um, you know why and who that's likely 0:16:49.600 --> 0:16:52.240 to be. You know that if we're that that, if 0:16:52.280 --> 0:16:54.120 we're if we think that we're making you're kind to 0:16:54.160 --> 0:16:56.240 make money, we really be sure of who we're making 0:16:56.240 --> 0:17:00.960 the money from. And it's not really it's some game essentially, yes, 0:17:01.960 --> 0:17:03.560 you know, within that space. I mean, at least too, 0:17:03.840 --> 0:17:06.159 you know, I think that at least to a first approximation, 0:17:06.240 --> 0:17:08.840 it's the it's a valid identity. I mean, there's some 0:17:09.600 --> 0:17:12.040 caveats and so on that people would bring into it, 0:17:12.160 --> 0:17:15.399 but I kind of like that. It's simple. Um. It 0:17:15.440 --> 0:17:18.840 reminds us of Bill Sharp, who is a really cool guy. 0:17:19.480 --> 0:17:21.320 I think it's I think it's a really useful It's 0:17:21.359 --> 0:17:25.280 really it's a really useful one. Um to to remember. 0:17:25.640 --> 0:17:31.280 Oh um, I promised a potential l t c M question. Um, so, 0:17:31.320 --> 0:17:33.400 I guess like one of the other things we've observed 0:17:33.400 --> 0:17:36.679 in markets recently is the rise of smart beta, but 0:17:36.760 --> 0:17:40.600 also risk parity strategies, and some people have likened risk 0:17:40.720 --> 0:17:47.880 parity to the old black shoal portfolio insurance of THEES, 0:17:48.240 --> 0:17:50.880 and some people have connected l t c MS collapse 0:17:51.280 --> 0:17:55.360 with black shoals. So I guess I'm just curious how 0:17:55.440 --> 0:17:58.159 you feel about risk parity and how you feel about 0:17:58.160 --> 0:18:02.080 the downsides of math addicts in finance. For me, the 0:18:02.119 --> 0:18:06.159 really short answer is that the the the leverage, you know, 0:18:06.240 --> 0:18:09.960 my ltc M experience has just made me not want 0:18:10.040 --> 0:18:15.920 to use leverage, um explicitly in any sort of investment strategy. Uh, 0:18:15.960 --> 0:18:18.000 you know, for myself, for anybody that I would be 0:18:18.040 --> 0:18:21.680 trying to help. Um, you know it. Leverage has its 0:18:21.680 --> 0:18:26.119 place in our financial system. It has its place perhaps 0:18:26.200 --> 0:18:30.159 within the investment community, but personally, um, you know, it 0:18:30.200 --> 0:18:34.280 was that that was you know, that's that was the 0:18:34.320 --> 0:18:39.480 primary cause of the problems at ltc M. And so 0:18:40.320 --> 0:18:42.919 for me anyway, I mean, I know the arguments for 0:18:43.000 --> 0:18:45.520 risk parity, UM, you know, it may well be that 0:18:45.680 --> 0:18:50.000 the aversion to leverage by people like me is what 0:18:50.200 --> 0:18:53.240 makes using a moderate amount of leverage a good idea. 0:18:53.400 --> 0:18:55.399 You know, That's what some people that are proponents of 0:18:55.480 --> 0:18:58.720 risk parity would argue that it's an inefficiency that a 0:18:58.760 --> 0:19:02.560 bunch of people like me now are averse using leverage. 0:19:02.600 --> 0:19:06.600 But I'm averse using it. I don't. So I'm not 0:19:06.680 --> 0:19:10.320 a fan of risk parity because I'm sort of you know, 0:19:10.359 --> 0:19:12.520 I just don't want to. I don't feel that I 0:19:12.560 --> 0:19:17.320 need to use leverage to get better quality returns. I 0:19:17.320 --> 0:19:21.360 think that the returns afforded by the marketplace without using leverage, 0:19:21.400 --> 0:19:25.520 and the risk attached there too, is all sufficient for me. 0:19:25.600 --> 0:19:27.439 And then I can go to sleep and not worry 0:19:27.440 --> 0:19:34.080 about having to reduce exposures because my leverage is causing 0:19:34.119 --> 0:19:37.280 me to do that. What about financial formulas in general 0:19:37.320 --> 0:19:43.080 and maths in investing, what are the downsides? Well, you know, 0:19:43.200 --> 0:19:47.680 models used in investing are are very useful. That they're 0:19:47.920 --> 0:19:51.159 they're a way of us um you know, thinking that 0:19:51.320 --> 0:19:53.640 that if we in one one of my colleagues one 0:19:53.720 --> 0:19:57.159 said that, uh, think about just the yield, yield to 0:19:57.240 --> 0:20:00.119 maturity of a bond. Think about that as a model. So, 0:20:00.560 --> 0:20:02.080 you know, for a while, you know, at some point 0:20:02.119 --> 0:20:04.879 in time, yield to maturities didn't wasn't really used. So 0:20:04.920 --> 0:20:07.399 people used to talk about the price of a bond. 0:20:07.440 --> 0:20:10.040 They talked about the current yield the coupon divided by 0:20:10.040 --> 0:20:12.359 the price, and then somebody and then people started to 0:20:12.400 --> 0:20:16.040 use yield to maturity or yield to worse more, Well, 0:20:16.680 --> 0:20:19.880 yield is just a much more useful thing to use 0:20:20.000 --> 0:20:23.240 and thinking about comparing different bonds with each other, implies 0:20:23.359 --> 0:20:26.440 volatility is a more useful way of thinking about comparing 0:20:26.480 --> 0:20:29.960 stock options to each other. There's nothing kind of magical, 0:20:30.000 --> 0:20:31.960 It doesn't tell you what to do, but it's just 0:20:32.000 --> 0:20:36.040 a more useful that that these models are a useful 0:20:36.080 --> 0:20:40.639 way of decomposing things into more intuitive quantities that we 0:20:40.720 --> 0:20:43.480 can that we can use in our decision makings. So 0:20:43.520 --> 0:20:47.520 I think that um, you know, math in finance is 0:20:47.520 --> 0:20:51.760 is useful, for sure, there's no doubt about that. But 0:20:52.200 --> 0:20:55.440 you know, but when we start to try to optimize 0:20:55.440 --> 0:20:59.000 things too much using math, when we when we try 0:20:59.080 --> 0:21:02.880 to get um, you know, trying trying to become too 0:21:02.920 --> 0:21:08.800 optimal and following you know, sort of narrow mathematical rigor 0:21:09.000 --> 0:21:12.840 too far, is extremely dangerous. Right. So it's it's sort 0:21:12.840 --> 0:21:14.800 of the you know, you you come up with a 0:21:14.800 --> 0:21:18.000 whole portfolio of different investments and you look at an 0:21:18.000 --> 0:21:21.560 optimization of that, and it tells you to do things 0:21:21.640 --> 0:21:24.920 that that common sense would tell you probably don't make 0:21:25.560 --> 0:21:29.000 sense to do. So taken to an extreme, I think 0:21:29.080 --> 0:21:33.320 that that math, that sort of mathematical outcome can lead 0:21:33.400 --> 0:21:37.480 us to uh, the dangerous places sometimes. But that's that's 0:21:37.480 --> 0:21:39.280 a great question. I wish I had more time to 0:21:39.320 --> 0:21:41.919 think about it and give you a better answer to it. 0:21:42.640 --> 0:21:46.080 That's a great answer, And Victor Hagani of ELM Funds 0:21:46.440 --> 0:21:51.159 really appreciate you coming on. Fascinating conversation, looking forward to 0:21:51.600 --> 0:21:54.080 reading and learning more about some of these concepts, and 0:21:54.119 --> 0:21:58.080 I think uh listeners will have learned a lot from this. Well, 0:21:58.080 --> 0:22:13.320 thank you very much as a pleasure, Joe, was that 0:22:13.359 --> 0:22:15.840 mathematical enough for you? I think that was just like 0:22:15.880 --> 0:22:20.800 the sort of a perfect level of mathematical sophistication while 0:22:21.480 --> 0:22:24.159 being able to understand the concepts without actually having to 0:22:24.520 --> 0:22:27.480 attempt to do math over the over audio, which I 0:22:27.480 --> 0:22:29.720 think would be tough. I mean, I sympathize with the 0:22:29.760 --> 0:22:32.440 coin tossers because if you think that like a coin 0:22:32.480 --> 0:22:35.240 toss has a fifty chance of coming up heads or tails, 0:22:35.320 --> 0:22:39.119 then if you got five in a row, well I 0:22:39.160 --> 0:22:42.399 suck at probabilities. I mean I get like, like you 0:22:42.520 --> 0:22:45.360 know there is something in your gut, like like you're 0:22:45.400 --> 0:22:48.679 something like that's exactly right, Like you really have to 0:22:49.080 --> 0:22:53.600 sort of sublimate your intuition and your feelings about how 0:22:53.640 --> 0:22:55.560 things work. Although then the question is like if you 0:22:55.640 --> 0:22:58.480 had a coin and say it came up twenty times 0:22:58.480 --> 0:23:00.359