Safe Haven. Mark Spitznagel
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center developer), get it right away. On the other hand the neither‐this‐nor‐that MBA in finance with year‐end evaluation filed by the personnel department needs a helping hand—they can neither connect to the intuitions nor to the mathematics. At the time when I met Mark, we both were at the intersection of pit trading and novel branches of probability theory (such as Extreme Value Theory), an intersection that at the time (and still, presently) included no more than two persons.
MUTUA MULI
Now what was the dominant idea to emerge?
There are activities with remove payoff and no feedback that are ignored by the common crowd.
With the associated corollary:
Never underestimate the effect of absence of feedback on the unconscious behavior and choices of people.
Mark kept using the example of someone playing piano for a long time with no improvement (that is, hardly capable of performing Chopsticks) yet persevering; then, suddenly, one day, impeccably playing Chopin or Rachmaninoff.
No, it is not related to modern psychology. Psychologists discuss the notion of deferred payoff and the inability to delay one's gratification as a hindrance. They hold that people who prefer a dollar now versus two in the future will eventually fare poorly in the course of life. But this is not at all what Spitz's idea is about, since you do not know whether there might be a payoff at the end of the line, and, furthermore, psychologists are shoddy scientists, wrong almost all the time about almost all the things they discuss. The idea that delayed gratification confers some socioeconomic advantage to those who defer was eventually debunked. The real world is a bit different. Under uncertainty, you must consider taking what you can now, since the person offering you two dollars in one year versus one today might be bankrupt then (or serving a jail sentence).
So what this idea is about isn't delayed gratification, but the ability to operate without external gratification—or rather, with random gratification. Have the fortitude to live without promises.
Hence the second corollary:
Things that are good but don't look good must have some edge.
The latter point allows she or he who is perseverant and mentally equipped to do the right thing with an endless reservoir of suckers.
Never underestimate people's need to look good in the eyes of others. Scientists and artists, in order to cope with the absence of gratification, had to create such a thing as prizes and prestige journals. These are designed to satisfy the needs of the nonheroics to look good on the occasion. It does not matter if your idea is eventually proved right; there are intermediary steps in between that can be won. So “research” will be eventually gamed into some brand of nonresearch that looks cosmetically like research. You publish in a “prestige” journal and you are done, even if the full idea never materializes in the future. The game creates citation rings and clubs in fields like academic finance and economics (with no tangible feedback) where one can BS endlessly and collect accolades by peers.
For instance, the theory of portfolio construction (or the associated “risk parity”) à la Markowitz requires correlations between assets to be both known and nonrandom. You remove these assumptions and you have no case for portfolio construction (not counting other, vastly more severe flaws, such as ergodicity, discussed in this book). Yet one must have no knowledge of the existence of computer screens and no access to data to avoid noticing that correlations are, if anything, not fixed, changing randomly. People's only excuse for using these models is that other people are using these models.
And you end up with individuals who know practically nothing, but with huge résumés (a few have Nobel Prizes). These citation rings or circular support groups were called mutua muli by the ancients: the association of mutually respecting mules.
COST‐EFFECTIVE RISK MITIGATION
Most financial and business returns come from rare events—what happens in ordinary times is hardly relevant for the total. Financial models have done just the opposite. A fund miscalled Long Term Capital Management that blew up in 1998 was representative of such decorated mutua muli misunderstanding. The Nobel‐decorated academics proved in a single month the fakeness of their models. Practically everyone in the 1980s, particularly after the crash of 1987, must have known it was quackery. However, most if not all financial analysts exhibit the clarity of mind of a New York sewer after a long weekend, which explains how the mutua muli can take hold of an entire industry.
Indeed the investment world is populated by analysts who, while using patently wrong mathematics, managed to look good and cosmetically sophisticated but eventually harm their clients in the long run. Why? Because, simply, it is OPM (other people's money) they are risking while the returns are theirs—again, absence of skin in the game.
Steady returns (continuous ratification) comes along with hiding tail risks. Banks lost more money in two episodes, 1982 and 2008, than they made in the history of banking—but managers are still rich. They claimed that the standard models were showing low risk when they were sitting on barrels of dynamite—so we needed to destroy these models as tools of deception.
This risk transfer is visible in all business activities: corporations end up obeying the financial analyst dictum to avoid tail insurance: in their eyes, a company that can withstand storms can be inferior to one that is fragile to the next slight downturn or rise in interest rates, if the latter's earning per share exceed the former's by a fraction of a penny!
So the tools of modern finance helped create a “rent‐seeking” class of people whose interest diverged from those of their clients—and ones who get eventually bailed out by taxpayers.
While the financial rent seekers were clearly the enemies of society, we found actually worse enemies: the imitators.
For, at Universa, Spitz built a structure that tail‐hedged portfolios, hence insulated him from the need for delayed random gratification. As introduced (and formulated) in Safe Haven, risk mitigation needs to be “cost‐effective” (i.e., it should raise your wealth), and to do that it needs to mitigate the risks that matter, not the risks that don't.
It was the birth of tail risk hedging as an investable asset class. Tail risk hedging removed the effect of the nasty Black Swan on portfolios; cost‐effective tail risk hedging obliterated all the other forms of risk mitigation. Accordingly, the idea grew on people and a new category was born. This led to a legion of imitators—those very same mutua muli persons who had previously been fooled by modern finance tools, finding a new thing to sell.
Universa proved the following: not only is there no substitute to tail risk hedging, but, when it comes to tail risk hedging, simply—as per the boast in the Porsche advertisement—there is no substitute.
For when you go from a principle to execution, things are much more complicated: the output is simple to the outsider, the process is hard seen from the inside. Indeed, it takes years of study and practice, not counting natural edges and understanding of the payoffs and probabilistic mechanisms.
I said earlier that Mark's edge came from pit trading and a natural (noncontrived) understanding of the mathematics of tails. Not quite. His edge has been largely behavioral, and my description of hardheaded was an understatement. Perhaps the most undervalued attribute for humans is dogged, obsessive, boring discipline: in more than two decades, I never saw him once deviate a micro‐inch from a given protocol.
This is his monumental f*** you to the investment industry.
Part One What Comes First