Ten Morsels in Sixty Minutes

August 1, 2011

Some of my Loyal Readers (hi, Mom and Dad!) have expressed interest in hearing my take on all the many ways in which our government and economy are dysfunctional, but they have been too respectful of my hectic life to really insist on it (thanks).  Herewith, some observations and conjectures, most of which have probably been debated in greater factual detail elsewhere, and which reflect my views as of this point in time.  Unlike politicians, I reserve the right to change my mind if the facts, or my understanding of them, change!

  1. Public finance operates on totally counter-intuitive principles.  Responsible households and companies try to forecast what their revenues will look like and attempt to calibrate their expenses accordingly.  Sometimes expenses will outpace revenues for short-term reasons (e.g., the car breaks down) or long-term reasons (e.g., Junior goes to college increase his lifetime earnings potential).  In such cases, borrowing that is matched in tenor to the underlying reason, and for which there is a clear path to payback, may be advisable.  But, ultimately, the “top line” should drive the thinking.  Government, particularly in the last decade, evidently prefers to start with the level of expenditures it wants (i.e., generally, “more”) and then hope that the economy will grow enough to bring revenue into balance (and/or hope that it will be the other team that gets stuck with the task of raising revenues).  This strikes me as profoundly silly and probably intractable.
  2. There should be more outrage that the government’s fall-back option is always to cut discretionary spending.  I’d wager that some of the best rates of “return on investment” from government dollars come from spending under this rubric.  I’m pretty comfortable asserting that, compared to some schmancy new weapons program, it would be significantly more beneficial to America, for example, to triple the budget of the FDA and the US Patent Office to eliminate bureaucratic bottlenecks to innovation and improve the capacity to monitor, say, safety and effectiveness in the one case, and true novelty to weed out patent trolling (a cost to the economy) in the other.
  3. There is a corollary to #2 that I’m going to put in as stark and non-PC terms as possible just to make the point.  Instead of making investments that will increase America’s productive capacity (and future ability to generate revenue!) we are collectively committing the public purse to keeping old people alive as long as humanly possible.  This is a choice that we always want to make for our own family, but which in aggregate constitutes an extremely unproductive way to allocate resources.
  4. Here is another corollary to #2, also framed as starkly as possible: this is basically the Boomers’ own fault (albeit indirectly).  The tax revenues generated from their peak years of productivity should have given our government an amazing war chest with which to pay for their future care.  Instead, they (and their parents) elected politicians who chose to pour this money into the wealth-destroying enterprises of war and lots of healthcare for their parents.  Privately, many who could have saved during their peak earning years to fund healthcare in old age also failed to do so, because they generally, in aggregate, chose current consumption.  Unfortunately, the consequences of these decisions (i.e., what’s happening now) are likely to fall in a regressive manner, when they could have been funded progressively (via taxes already assessed and spent).
  5. An interesting dynamic related to #3 is that the current cohort of retirees and near-retirees is exceptionally rich in benefits-terms, whatever their wealth looks like otherwise.  Put another way, the government’s contingent liabilities to Medicaid Medicare [thanks Alison 😉 ] are, by accounting logic, assets to individuals that may or may not be monetized.  (When monetized, of course, the cash actually goes to healthcare providers – but the right to receive services is an asset of the individual.)  I wonder whether, if you offered the average 70 year-old a choice between (a) Medicaid Medicare status quo and (b) a much more limited entitlement and $100k for their grandkids, lots of them wouldn’t take (b).  Right now we give the elderly no incentive to consume less healthcare, even if they might derive significantly greater joy and happiness from other uses of the funds government was willing to spend on them anyway.
  6. I actually think my conclusion in #5 is the general case of what’s wrong with healthcare in America.  It’s impossible to rein in costs when a large cohort of consumers (i.e., the well-insured) are price insensitive.  In the abstract, everyone wants above-average healthcare at below-average cost.  Paging Dr. Wobegon!
  7. Politicians like bashing the wealthy who have done extraordinarily well but apparently have not incurred their fair share of society’s burdens.  This reasoning ignores the bug (or feature, depending on your persuasion) that we tax income, not wealth.  Once a person has made her fortune, we can perhaps squeeze out more at the margins, but the wealth horse has basically left the barn.  The estate tax should be the principal remedy for this.  Progressives should be mortally ashamed that they’ve lost this debate by allowing it to be anchored around how many small business owners will be “punished for dying” because their estate is worth some middling number of millions of dollars.  This is ludicrous.  Set the cap at $50 million, or some arbitrary number that doesn’t have a ‘B’ in it.  Confiscatory policies are un-American, yes.  But so is the entrenchment of wealth and privilege that is the destination this freight train is heading to, anyway.
  8. I’m more inclined than ever to think that political parties are The Problem in terms of why government can’t seem to act in the national interest instead of in political interests (and they clearly doth protest too much to the contrary).  I still don’t know how to fix this.  Attacking the gerrymandering of Congressional districts seems absolutely like one good way to start, although I am not holding my breath that this will be a Congressional priority…
  9. And, by the way, there is a lot that is profoundly screwed up and not at all in our national interest about how we as a society use prisons.  Besides the obvious dollar costs, I would love to see a thoughtful estimate of how much human capital we have essentially destroyed by imposing prison sentences for minor offenses, particularly those solely related to drug possession.  This may seem like a random point to make here, but the connection is that I think cornerstones of our prison system represent a massive nationwide misallocation of resources that we just can’t afford.
  10. That all said, I actually think a reasonable proprtion of politicians understand all of the above, but just don’t have the courage or influence to do anything about them.  I hope this dynamic will change, but I am not optimistic.

I’d welcome any comments on the above – as I pointed out, these views are evolving.

On Being Wrong (whether or not for justifiable reasons)

July 5, 2011

I’ve been eager to revisit my earlier thoughts on l’affaire DSK as the case against him began to unravel during the past few days.  As it turns out, we’ll probably never know for sure what happened in that hotel room.  It’s hard to imagine how a case can proceed in the face of questions about the alleged victim’s credibility.  This outcome would be understandable even though it may fall short of the ideal of justice (in the sense of objectively determining what happened and either punishing or vindicating the accused).  A witness’ credibility matters, but in theory it doesn’t map directly to truth or falsehood.  On the one hand, people may lie if they sense there could be something in it for them, no matter what the consequences for themselves or those accused – the Duke lacrosse case is one particularly salient example.  On the other hand, it’s also possible for people with questionable judgment or even bad intentions to be the victims of crime.  But as Citizens and Jurors, often the best we can do is handicap the likelihood that a given account is true, false, or somewhere in between, and questions of consistency and motivation matter in that calculus.

Given that my initial intuition about the case now appears much more likely to have been wrong, What have I learned?  The four heuristics that formed the basis of my intuition all still seem reasonable to me.  However, I think there were two probable sources of error that I underestimated at the time.  The first, which I think is the dominant source of error, is that the DA’s office was compelled to act on an accelerated timeline because DSK was in imminent danger of leaving the country.  I took the facts of an arrest and indictment as indications of the probability of the truth of the allegations (given the risks to various parties of “getting it wrong”) when in reality they may not have been more than a necessity to give the alleged victim a fair hearing.  The second is that I did not give sufficient consideration to the possibility that the alleged victim would act irrationally.  I had assumed that she would view her downside risk as being very high (in fact, it is – she may be headed for deportation or jail!) and would only take action if she were very sure she would prevail.  In reality, she may have either not been aware of the downside risks, or may have had unwarranted confidence in her likelihood of success.

My sense is that the DA’s office has acted properly throughout and has had the unenviable task of trying to balance the protection of a seemingly vulnerable accuser with fairness to a powerful international figure.  If they end up dropping this case due to the inconsistencies that have come to light, I don’t think it would be to their discredit.

Perhaps the DA’s next balancing act will be between the need to do justice to DSK to the extent that he has been wrongfully accused, and the desire to avoid chilling the powerless from speaking out against the powerful when they have truly been victimized.

Jameson on the Rocks

May 16, 2011

The past few weeks have been rather Busy for your humble correspondent, which is not to say that they have been Unpleasant but rather that they have allowed precious little time for reflection and synthesis.  I can’t tell when I’ll be able to resume a more regular schedule, but rest assured that I will feel at least some pangs of guilt the next time an evening is spent with America’s Next Top Model on DVR instead of with my Dear Readers.

During one of these recent Busy weeks, I had the pleasure of taking a brief business trip to Dublin, a place I last visited as a student just under a decade ago.  It was a treat to be back, not least of all because I now had the novel combination of comfortable lodging and disposable personal income.  I realized that this was the first time I had revisited an international travel destination after any meaningful gap, so it was impossible to resist the temptation to compare notes with my memories and seek out familiar streets and sights.  I was pleased to have retained enough of a sense of the geography to project that typical city-kid confidence and purpose even in aimless wandering; within an hour of my first adventure outside the hotel, I was asked for directions by American tourists.  (My guess would have been correct, but I punted.)

I don’t at all mean to downplay the distinctiveness of Dublin, but my overarching conclusion was that it felt vaguely more “American” than I had remembered.  Some of the parallels were superficial and amusing (e.g., gourmet burger franchises, white people with dreadlocks) but others more ominous (e.g., foreclosed houses, moth-balled construction projects).  I remember how shocked I and my fellow American students were at the lack of conspicuous obesity that is such a hallmark of travel within the States.  Based on my extremely non-scientific observation from a few hours of walking and pubbing, however, I’d posit that the gap has narrowed as the Irish, perhaps, have widened.

And of course there was the economy.  During my summer as a student, the Celtic Tiger was somewhat wobbly on the back of the post-Dot Com global contraction (particularly in IT, which had become one of the country’s strengths) but it was still fundamentally sound.  Now… well, even the cab drivers wanted to chat about negative home equity.  My reception at the border could only have been more palpably chilly if instead of describing my profession as “Finance” I had opted for “Smothering Cute Animals.”  Young Americans are often wise to pretend to be Canadian if they happen to be abroad during moments of geopolitical instability.  I think from now on I may offer something squishy and believable in lieu of my actual business purpose; aren’t I, after all, part of the new media by virtue of this site?

I haven’t studied Ireland’s public finances (it’s hard enough to analyze enterprises that aren’t run by politicians) but the contours of their situation will be familiar to most observers of the developed world: gross misallocation (in hindsight!) of capital to housing and construction, whose asset values kept rising until they didn’t; insufficient capital to absorb losses at highly-leveraged financial institutions; sudden structural dislocations in labor markets; prohibitively expensive entitlements but no dry powder for countercyclical fiscal policy; etc etc.  Some sort of rationalization is inevitable, but I don’t have a view on when or what will trigger it, or how it will play out in practice.

I would, however, caution against counting Ireland out.  In my occasional conversations with businesspeople and with Joe Soap (again, an extremely non-scientific set of data) I was struck by how not-angry it seemed that people were about the situation.  Their tones were generally sober and pragmatic – certainly not optimistic – but inflected with a sense of collective responsibility.  The narrative was not that the country was screwed by, take your pick: greedy bankers, incompetent government, reckless consumers, or some other Other.  It was more like that the country had had a grand old bender and now everyone needed to clean themselves up.  Assuming that my reading is fair, this wouldn’t change the vast scale of the problems that Ireland (and many of the world’s governments, i.e., people) have ahead, but it would give me more hope that a solution might be reached there before it’s reached in a country where folks take to the barricades to protect the social entitlements that they refuse to pay for.

Slogans and economic dogma aren’t going to fix the massive structural problems with the world’s economies.  Patience, pragmatism, and a sense of collective responsibility, however, seem like constructive places to start.

Numbers Game

March 27, 2011

The question is sometimes asked, among trusted colleagues, as they suffer together through a particularly grueling stretch of work: what’s your Number?  If you left the office tonight, checked your bank statements one last time before bed (as one does…), and discovered that some magnificent windfall had increased your net worth to the point that you no longer felt you needed to come back to the office tomorrow: what would that Number be?  At what point would you decide you had ‘enough’ and could choose from then on to do only that which you actually wanted to do, rather than continue to make compromises to get to that point?

In polite company, one rarely discusses matters financial in such concrete terms – one prefers to hint instead at one’s level of compensation through one’s branded possessions, vacation destinations, taste or consciously-affected lack thereof.  Discussions of the Number, however, seem to fall outside this prohibition.  I think this may be because the people with whom I’ve had such discussions over the years all generally believe, with good reason, that everyone in the discussion is likely to be able to hit their Numbers eventually, assuming they choose to maintain their professional status quo.  It’s not a question of one’s pole position (i.e., how much do I have?) as much as one of where the checkered flag is.

I’ve tended to arrive at my Number through pretty simple analysis.  What amount of after-tax cash flow do I think I’d need each year to maintain my desired lifestyle (which does not necessarily involve Per Se for dinner every night, but probably does still involve seeing my trainer twice a week)?  What pre-tax income is required to produce that amount of after-tax cash flow?  Assuming this pre-tax income can be generated from an endowment that produces a fairly conservative 4-5% annual return (net of inflation), I multiply this pre-tax income by 20-25 and have my range of Numbers.  Clearly the definition of “lifestyle” is the driver.  My Number would be much lower if I planned to live in a less expensive city that New York (i.e., basically anywhere) and lower still if my game plan were to retire to a beach in, say, Belize.  It will probably have to be significantly higher if I decide I want to have children.  In any event, I can see a path to getting there while I still have a few decades left to enjoy it, God willing.

By happy coincidence, I read Graeme Wood’s piece from April’s Atlantic shortly after having refreshed my mental calculations and having steeled myself for another 15 or so years of the status quo before I’d expect my Number to be within reach.  I’m still in such (pleasant) shock from this essay that I’m struggling to hone in on what, exactly, was so shocking to me.  Wood paints a balanced, nuanced portrait of the “Secret Fears of the Super-Rich” as they emerge in a Boston College study of people whose net worths exceed $25 million.  Among other gems, I keep coming back to the chilling finding that, “most of [the families in this study] still do not consider themselves financially secure; for that, they say, they would require on average one-quarter more wealth than they currently possess.”  These are people with tens of millions of dollars! People who have done a swan-dive past my Number, straight into Scrooge McDuck’s money bin!  Could these stories really mean that there’s always a white flag after every lap?

There’s nothing particularly novel about the observation that money can’t buy happiness (or, one of hip-hop’s great lessons in causality: Mo Money, Mo Problems) but I had never really considered that it can’t even necessarily buy a sense of financial security.  Or that the price of even hard-earned wealth could be disenfranchisement from the shared human experience.  On feeling unable to discuss one’s everyday problems with those who haven’t hit their Numbers: “The poor-little-rich-kid retort is so obvious—and seemingly so sensible—that the rich themselves often internalize it, and as a result become uncomfortable in their interactions with the non-wealthy. Once people cross a certain financial threshold, they have a tendency to hang out with one another, to enjoy the company of other people who know that money relieves some burdens but not others.”  It must be excruciating to feel as though one has permanently surrendered one’s right to complain or commiserate.

I recommend Wood’s article highly and I expect to use it as a prompt to try to stop counting laps and, instead, start to learn to enjoy driving.

You’re Not Gonna Reach My Telephone

March 26, 2011

The Gray Lady, bless her heart, has such a way with real-time anthropology.  Much as the academic literature in psychology is, out of necessity, a generalization from studies of the hearts and minds of undergraduates, the NYT has a gift for spotting the evolution of American norms and tastes through its authors’ careful observation of a few of their well-educated, cosmpolitan friends – sprinkled of course with references to a few boldface names and experts in implausibly narrow fields.  Were you aware, for example, that the unscheduled phone call, except in cases of emergency, is actively inconsiderate?

Now, I happen to sympathize with this sentiment.  I have some professional contacts who seem hard-wired to interact only by long phone calls throughout which I can actually feel my time being wasted; a bit like the queasy light-headedness that immediately follows a blood donation.  (I think this is partly generational and partly regional.  Where a New Yorker might pay me a call to “quickly catch up,” I’ve found that among contacts in Texas they’re more likely to call to “visit with [me]” – which is kind of a quaint and adorable way to put it.)  And my friends know that I’m unlikely to answer a phone call, even though I’m happy to turn around 80% of my e-mails and text messages just about as soon as I receive them.

I dislike the phone.  Sometimes the pace of conversations is awkward.  Sometimes I can’t hear what is being said, even after several repetitions.  Sometimes calls drop in the middle of an emotionally-rich line of discussion.  I’d prefer to have most meaningful interactions face-to-face, where I can give my undivided attention; or via chat where I can at least edit myself as I’m “speaking.”  For simple coordination, by contrast, I think e-mail and text messaging are usually more efficient.  I tend to agree with the Times that conversations with family are the main exception, but even then any variance from our usual patterns (a call in the middle of the day, for example) usually require the preface that it’s not an emergency.

I try to train my friends, and particularly my professional contacts, to call me sparingly.  The pattern goes something like: I ignore a phone call from X, a relatively unimportant professional contact with whom I interact on issues that are rarely a priority for me (these aren’t personal judgments; the people in question are lovely).  X calls me back several hours later, and I ignore it again.  X calls me back the next day, and I ignore it a third time.  X finally cracks and asks me the factual question that prompted his phone call via e-mail.  I respond instantaneously.  X calls me again immediately, thinking that he has outsmarted me and found a time when I am at my desk.  I ignore it and e-mail back that I am on the other line.  X replies that it’s ok, his call wasn’t important.  I resist the temptation to scream, if it wasn’t important, why in God’s name are you calling me??? I eventually call back, at my convenience, to shoot the breeze, and confirm that there was indeed nothing important to talk about.  It’s amazing, though, that no matter how many times I smack the dog on the nose with a newspaper, the pattern doesn’t change.

Perhaps the Times is overstating the extent to which people really believe in the case against the phone, but it’s a worthwhile prompt to be thoughtful about the channels we use for communication.  Good written communication provides a wonderful efficiency gain to the reader.  I can summarize two days of progress at work in a memo that may take me two hours to write, which can be digested by my manager in two minutes.  It’s scalable, too.  The Times is at its best when it is bringing its legions of readers up to date on developments as distilled by their journalists and editors.  By contrast, there is no time-efficiency gained in spoken communication.  What takes me five minutes to say takes you exactly five minutes to hear, and it’s likely that my spontaneous commentary will lack precision relative to whatever I could have written for your consumption in those same five minutes.  There are certainly benefits to real-time communication: it’s usually the easiest way to resolve misunderstandings, for example.  But for simple transmission of information, it is hard to outweigh the gains from ‘time compression’ afforded by the written word.

I find it infuriating when content that could have been delivered in a time-compressed format is not; and vice versa.  My orienation at my new employer, for example, required me to spend two hours listening to our earnest HR professional talk to me about content that could have taken me ten minutes to read.  Had I been sent the information in advance, I might have needed another five minutes in person to ask questions, and both she and I could have walked away a combined three and a half hours richer.   The mindless drive to generate “multimedia” content on the websites of organizations like the Times has spawned an even greater time-evil: the video interview.  Even if the content were interesting, there is no good reason not to provide the time-compressed format of a transcript as an alternative (here I must give a shout out to the McKinsey Quarterly for following this practice).  But, more damningly, one has little sense in advance for whether an interview is going to elicit interesting content or, more likely, produce a few banalities and talking points.

The ‘vice versa’ case is most obvious where attempts are made to reach decisions or forge consensus over e-mail, which induces all participants to spend hours reading and responding to issues that could have been resolved in a quick phone call or meeting.  But it also manifests in shoddy PowerPoint presentations that so butcher the subject matter in order to reduce it to bullet points that one is left feeling more confused than when one began.  When a time-compressed format produces insight-compressed content, that is generally not a good thing.

I’ve been thinking about better integrating my cell phone with Google Voice, which has the life-changing feature of transcribing voicemail and sparing the wasted minutes of dialing through voicemail menus just to find out if someone has left me an interesting message (that they should have e-mailed me instead!!).  I believe there’s a “Visual Voice Mail” feature on my phone that does this, too, but I object on principle to paying the small monthly fee for it.

I appreciate the irony that as my cell phone has become more of a fixture in my life, I’ve become less inclined to use it for, well, actually being a telephone.  But I think it’s exactly this ubiquity that makes it so important to be selective in who, when, and why we call.

Staying Sharpe

March 12, 2011

It’s hard to make decisions in the face of uncertainty, but often we must – whether in the case of our investments or our broader lives.  I find it useful to apply concepts from finance as I reflect on my decisions and prepare to make decisions in the future.  In part, this is because I’m lazy: I get paid to think this way already.  But, unromantic though this may sound, aren’t we all investment managers for ourselves?  We invest our resources (our time, attention, energy, skills) in the hope of achieving some sort of returns (perhaps happiness, comfort, companionship, pleasure) that are in all cases subject to fundamental uncertainties and disruptions.  If we accept this metaphor, perhaps it’s reasonable to think that we could learn something by reflecting on how an investment manager makes her decisions, and how her skill would be measured by others.

Roughly two-thirds of this post will be basic finance, in which I’ll take some shortcuts with your permission.  If you’d like to fast-forward to the punchline (punchparagraphs?), search for ‘dolphins’.

Obviously one important question to us as investors is: what rate of return do we expect to get on the investment?  Mechanically this analysis is pretty simple – it’s a question of cash flows in versus cash flows out, and their respective timing, which a computer can calculate in tiny fractions of a second.  Bear in mind that by treating the future cash flows, the probability of realizing those cash flows, and the time horizon associated with their realization, as discrete and knowable in the examples that follow, I’m glossing over 95% of the art and science of investing.  Let’s just assume for now that we can.  Do not try this at home.

Suppose we buy a piece of paper for $10 today.  We believe there’s an equal probability that the paper will be worth $30, $15, $10, and $5 in one year’s time, and that no other outcome is possible.  We could take a weighted average of those outcomes (i.e., 25% * $30 + 25% * $15 … ) and conclude that the expected (i.e., probability-weighted) value of the paper in one year is $15.  Our expected return would be $5, since we bought it for $10, and so we could think of our return as 50%.  If we wanted extra credit, we’d also look at what return we could have earned on a risk-free investment over the same time horizon.  The yield on a one-year Treasury bill is about 0.23% as of this writing, so we could have earned about a whopping two pennies with our cash if we had not chosen to buy the paper instead.  So we’d really think of our expected ‘excess’ return as being the $4.98 difference between the expected return on our investment and return on a risk-free asset (i.e., $5.00 – $0.02).

A second important question is: how risky is the investment?  Suppose we have two pieces of paper, Paper X and Paper Y.  Paper X will be worth $11 or $9 in one year, with equal probability (i.e., the expected value is $10).  Paper Y will be worth $20 or $0 in one year, also with equal probability, so the expected value is also $10.  Even though each piece of paper has the same expected value, the difference between them is clear.  Paper X has a very tight range of outcomes, but Paper Y is either going to be a home run or an easy fly ball for the outfielder.  Intuivitely, Paper Y seems much riskier, even if we don’t have a well-defined notion of risk.  Fortunately for our intuition, one measure of the risk of an investment is the standard deviation of its expected values (or returns), which essentially computes how wide is the dispersion or range of possible outcomes with respect to the expected outcome; the wider the dispersion, the higher the standard deviation.  The standard deviation of the possible values of Paper Y will clearly be higher than that of Paper X, which accords with our intuition that it has more risk.

The marriage of these concepts – expected return and the risk associated with that expected return – is the core of investment management.  One powerful intuition is that if we have two pieces of paper with the same expected return, we generally prefer the one that gets us there with less risk.  (If you want more extra credit, though, think about situations where that might not be the case.)  Similarly, if we have two pieces of paper with different levels of risk, we would generally demand a higher expected return on the riskier piece of paper in order to prefer it over the less-risky one.  If you would like to see me twitch uncontrollably, say something like, “higher risk means higher return” – a tragically common colloquial bastardization of the preceding concept.  The kernel of truth is that you should demand to be compensated for the risk you take, so a higher-risk investment should have a commensurately higher expected return.  But to see the distinction between the kernel and the bastardization, compare picking up a dollar from the sidewalk with picking one up in front of an oncoming train.

We can use these concepts to characterize the historical performance of investments, and investment managers by extension.  We could look at the manager’s performance over time, e.g., the annual return of her portfolio of investments.  For extra credit, we’d subtract the return she could have earned if the portfolio had been entirely in risk-free investments, which would produce the annual ‘excess’ return of her portfolio.  We could derive a notion of the expected return of her strategy just by taking the average of her annual excess returns.  We could derive a notion of the risk of her strategy by taking the standard deviation of her annual excess returns.  We could even calibrate the returns of her strategy relative to the risk of her strategy by dividing the first quantity (return) by the second (risk), since we’re expressing both quantities as annual percentages.

The result is known as the Sharpe Ratio, which essentially captures how much excess return an asset, strategy, or portfolio generated (or is expected to generate) per unit of risk.  It gives a way of normalizing investments that may have very different return expectations.  An investment with an expected return of 2% and standard deviation 1% would have the same Sharpe Ratio as one with an expected return of 10% and a standard deviation of 5%.  A higher Sharpe Ratio suggests that you are getting more “bang for your buck” when you take risk.  Going back a few paragraphs, assuming Paper X and Paper Y sold for the same price, an investment in Paper X would have a much higher Sharpe Ratio than one in Paper Y.  The Sharpe Ratio doesn’t tell you which of a set of investments is better, but it helps you assess how well compensated you are for the risk you have taken or expect to take.

Which brings me to dolphins.  They actually have nothing to do with what follows, but I needed to pick a word that wouldn’t show up anywhere else in this post.  When I reflect on how I’m managing my portfolio of investments in myself, I find the Sharpe Ratio to be a useful framework.  I think I’ve managed my life to an extraordinarily high Sharpe Ratio.  I’m generally very happy and comfortable, and I’ve been growing my personal capital (i.e., not just money; my rich memories, experiences, network of relationships, professional skills, opportunities, etc.) at a solid rate.  At the same time, I’ve taken very few significant risks, and I think I’m very well insured against downside – again, not just literal insurance; I think my strong relationships with family and friends are like ‘insurance’ against negative experiences like loneliness and fear.  Of course I have rough periods, like everyone, but my choices have been remarkable for how little volatility they’ve introduced for me.

I’m mindful, though, that a higher Sharpe Ratio is not necessarily better.  Some people are perfectly happy to live their lives pursuing incredibly low Sharpe Ratio ambitions – the aspiring actress, the serial entrepreneur.  The likelihood of failure is so much higher than the likelihood of success, and there’s a wide dispersion of outcomes under each of those headings.  These are lifestyles that will have a high standard deviatio in their actual past and likely future returns, but perhaps for them the pursuit of the highest possible ‘highs’ is subjectively worth the risk in a way that something as reductive as the Sharpe Ratio can’t capture.  (Actually, to reinforce my metaphor, it’s well known that the Sharpe Ratio is less useful when applied to non-Gaussian returns…)

The conventional wisdom is that one’s life migrates to a higher Sharpe Ratio as one becomes more of an adult.  A family, a mortgage, a professional reputation – as one acquires them, they (sensibly) constrain the amount of risk that one is willing to take.  If I look at how my own decision-making has changed, particularly in the last year, the remarkable thing to me is that I’ve gone in the opposite direction.  I’ve accepted a lot more volatility than I’m accustomed to (although, objectively, still not a lot!) in pursuit of uncertain higher-highs: relationships that might grow deeper, career trajectories that might be more rewarding, investments in people and causes that might make a big difference – or, in all cases, might not.  The outcomes all remain to be seen, but now that I’ve proven to myself that my return on risk has historically been pretty good, I’m ready to fly a little closer to the sun.

On Bankruptcy as Metaphor (or, Chapter 11 and Verse)

March 3, 2011

As a so-called investment professional who hunts for opportunity in the securities of highly leveraged or financially distressed companies, I spend a fair amount of time contemplating corporate bankruptcy.

I developed an instinctive aversion to bankruptcy at an early age, thanks to “Wheel of Fortune” and that dreadful slide whistle sound effect.  It was heart-wrenching!  All that money lost, those dreams dashed; all too often as the morality-play outcome of the promise to take “just one more spin…”  Few perils ranked higher than bankruptcy in my young, impressionable, game-show-watching mind; but of course the Whammy was the undisputed king of the peril kindgom, since it was ‘Bankrupt’ anthropomorphized into a terrifying little gremlin.  A small amount of strategic (if not moral) ambiguity was introduced by the board game of Life, where the last refuge of the hopelessly behind was to bet the game on one number out of ten and spin the wheel.  Nine times out of ten, you’d be consigned to the ignominious “Bankrupt” space, permanently neutered for the duration.  But, if you got lucky, you’d automatically win, no matter how diligently your competitors accumulated their wealth.  In any event, these games gave me the intuition that bankruptcy was a bad outcome of risk-taking that rarely happened to prudent and conservative people.  So it is a rather remarkable reversal for me to consider its virtues, and even moreso for me to become an investor in distressed credit.  But I digress.

The objective of bankruptcy, in a nutshell, is to attempt to make the best of a bad situation — i.e., an individual or business who has an unsustainable amount of debt that it cannot realistically hope to repay.  In America, the bankruptcy process consists of general rules that lend predictability to an endeavor that could easily devolve into a chaos of competing claims; but it also affords some amount of discretion to the stakeholders, and ultimately the judge overseeing the proceedings, to adapt to the facts and circumstances of each case.  It is, in my view, a pretty elegant solution (or, more precisely, a pretty elegant process for arriving at a solution).  This is not to say that bankruptcy cannot be exceedingly painful for many stakeholders, including a company’s employees, business partners, and communities.  But by the time a person or company chooses or is forced to declare bankruptcy, it is well past the point of avoiding pain and arguably does the most justice to its stakeholders by focusing on how to minimize it.  As medical practice has it, sometimes it is necessary to amputate a limb to save the patient.

I will probably gloss over some relevant concepts in the rest of this post, for which I apologize in advance.  It may be helpful to peruse Megan McArdle’s piece from about two years ago, in which she gives a layperson’s overview of various regimes for resolving insolvency.  I don’t think the ‘opinion’  portion of the piece represents her strongest work (and, for the sake of (my) convenience, I’ll punt for now on substantiating this view) but I also think it will resonate with many of my readers, which will perhaps make the medicine of bankruptcy education go down in a more delightful way.

I find bankruptcy a useful metaphor because there are often situations where one can only realistically play for the least-bad outcome.  And I mean this for very mundane matters in one’s personal life, not the sort of mammoth political problems that can actually push societies to the brink of insolvency.  I’m amused to read of e-mail bankruptcy and laundry bankruptcy as strategies for coping with an overabundance of communication and clothing, respectively.  The metaphor isn’t quite right in the instances I’ve chosen, but it seems to capture closely enough the simplicity, starkness, and (one hopes) finality of the remedy.

What I add to this metaphor – and I think this is an important element of its generality – is the notion that there are different classes of ‘stakeholders’ in many complex problems.  In a corporate bankruptcy, for instance, different lenders may have different elements of priority to their claims.  Some creditors, for instance, have specific assets that serve as collateral for their loan, whereas others may just have a general claim on the assets of the estate after higher-priority creditors have been fully satisfied.  The groups of stakeholders will certainly fight for as much value as they can, but the notions of priority and collateral make it relatively straightforward to determine broadly which groups will be more or less heavily impaired (if at all) as a result of the process.

To apply this framework to the case of “e-mail bankruptcy,” it would seem like family and close friends (your senior secured creditors, if you will) should at least receive some sort of personalized apology or acknowledgement for any dropped correspondence.  Perhaps there is a class of your unsecured creditors — your acquaintances; facebook-friends; and figures from your past with whom you sincerely intend to get coffee, but it never quite works out — where a general apology and declaration of bankruptcy is sufficient, at least to give them the courtesy of lodging a protest, or to give them instructions for how to resume dialogue with your post-reorganization self.  And it may be the most efficient path to wipe out your equity-holders without any further consideration — friends-of-facebook-friends, people who only write to ask for favors, random business contacts with whom you at one point felt it advisable to ‘network’ — because they must recognize that their claim on your attention is pretty heavily subordinated.

Could there be a way to declare emotional bankruptcy about specific personal demons, unresolved conflicts, feelings of guilt, anxiety over injustices inflicted or received?  To assert that one’s baggage (either in general, or in particular) is unsustainable and to commit to giving oneself the freedom to start fresh once it has been emptied and divvied up among one’s stakeholders, however one defines them?  The canonical twelve-step program reads somewhat like a playbook for emotional bankruptcy, with a Higher Power as the judge, and a sincere effort required of the indebted party to make whole all his or her senior secured creditors.  The self-help literature has its own way (N.B. I’m extrapolating from a few examples) of defining and encouraging various paths to closure and a clean slate.  There may be different recommendations for how to identify and appropriately compensate one’s stakeholders, but the objective is to give one license to disclaim any further liability for unwanted baggage and to reinvest one’s emotional capital in more rewarding and fulfilling pursuits.

There is another concept that shows up in the world of bankruptcy and adds a wrinkle to the analysis: moral hazard.  The more painless is bankruptcy, the more tempting it is to simply walk away from debts, which has dire consequences for the financial system if replicated on a large scale.  This is why I don’t like the idea that one can simply wash away one’s sense of obligation simply because one wants to.  A plan for emotional bankruptcy should be somewhat incrementally painful up front, while also being healthy and sustainable for the long-term.

I’ve not exactly applied this concept to my own life, and thankfully I don’t have any specific concerns or personal dramas that I expect might compel me to do so.  But as I prepare to celebrate my birthday today, I plan to take an inventory of my emotional liabilities and make sure that I’m at least conscious of the cost of defeasing them.