Blessed by the Potato

Coincidentally, I had this post on grad school and mental health come up across my stream today. (It’s a coincidence because I got out 10 years ago today though the server time on that old post indicates I didn’t post until after midnight)

Grad school is about as harmful to a person’s mental health as the death of a spouse was one tweet summary. Collectively, it causes as much disability adjusted life years lost as HIV/AIDS and other STDs per the post, which yeah, tracks about right.

I had a lot of good times in grad school, faced some interesting challenges, made some friends, and learned a lot. It was far from all bad. But I also wasted years of my life, with a huge opportunity cost.

My mental health has been terrible for the last year and a half or so. But this last decade I think overall it’s been fair to good (highs and lows, of course). Part of that is that fatherhood suits me. Yet even having to face the pressures of the real world and all the monkey feces it has thrown at me, I’ve been less anxious and less depressed than in grad school. To say it plainly: I, too, suffered with bouts of anxiety and depression on that journey. Of course, I can’t place the full blame on grad school: part of that was pre-existing. It may be generalizable/self-selecting, as I suppose you don’t go get a PhD unless you’re already a little cracked in the head in the first place.

It’s also a little sad to see that 10 years on and Science-with-a-capital-S still hasn’t figured this shit out. The profession is structurally hostile to people looking to reproduce, is more than a little exploitative and pyramid-schemy, and yet absolutely vital to human progress. We’ve been talking for years about how PhD students are often poorly prepared for “alternative” careers (though academia and research are the minority outcomes, by a lot). We under-value research talent (severely in many cases), and even then can’t manage to pull out sustainable and secure funding programs. On the bright side, I am seeing more positions for people as working scientists (e.g. Research Associates) that aren’t some under-paid holding-pattern position on the mythical ladder to tenure.

I wasn’t planning on posting anything to mark the day, but when I saw that tweet I had to put something up, so this rambling mess is all the retrospective you get today.

— Doctor Potato

It’s been a hard slog for mental health this last year. Tough on physical health, too.

Err… year and a half. Damn.

Anyway, it just never seems to end.

There are some things we can do to help cope better, of course. They’re not panaceas, but they can help at least a little. The thing is, I have never managed to internalize those lessons.

Some pretty basic things can help with mood and energy levels: if I do some exercise, if I eat some fresh fruit, and I do it consistently, I’ll start to feel a little better in about 2 weeks. I’ve done enough tests with getting into a depressive funk where I don’t do those things and then forcing myself to do them again and it helps (not a full cure, but helpful).

So I try, every day, to at least go for a walk and it’s such an easy sounding thing to do and yet so hard. The eating is even harder — pandemic baking and potato chips have done a real number on my diet, but I consciously work in at least one piece of fresh fruit.

Then someone posted this meme of a determined/upset-looking bald eagle and that has become my new slogan. “I’m going on a stupid walk for my stupid mental and physical health. See you in an hour.” and I repeat it each night.

It’s still not a habit, and it’s still not an internalized lesson — I very much consciously get up and go for that walk (and repeat my refrain about my stupid mental and physical health). Maybe one day I’ll be one of those people who jumps out of bed and then exercises before staring the day, though that has always sounded just terrible to me. I also have to try to remember the gremlin rule: no snacking after midnight (I mean, no snacking ever would be even more effective but it’s not as cute and super-hard).

Am I feeling better now that it’s been a few months of semi-consistent bare minimum self-care? I don’t know, I guess, a little.

I think there was also something about sleep? Crap, forgot about that one.

Anyway, I think because the effects are so delayed I never learn that lesson. I don’t often feel energized after exercising, I feel tired and sweaty — but after a few weeks of doing it every day, I do feel more energized. But such a long stimulus-response delay keeps me from internalizing that message, and without that constant conscious effort, I quickly slip back into slothful inaction.

I can of course relate that back to investing: there are lots of lessons that aren’t easily internalized and we have to keep reminding ourselves of. Market timing and adding complexity are two that immediately spring to mind, especially in the current age of meme stonks and bubble warnings.

I have so much to say about the last crazy, lunatic, unprecedented year, and not sure how to say any of it — my own thoughts are still all muddled. Covid was just a part of that for me — we’re also coming up on a year since my dad died. I haven’t properly eulogized him, or told his story Speaker for the Dead style, and don’t know if I will ever be able to.

This may be a personal blog, but a big focus is on finances so let’s stick to that aspect. It’s easier to talk about, at any rate.

Doing taxes was painful this year, for lots of reasons. I had to prepare the final return for him, as well as a T3 return for the estate, which had quite the learning curve and lots of weird CRA idiosyncrasies. Some examples to delay us before getting to the meat of the post? Sure, why not. Let’s start with where to simply mail the form. It wasn’t a simple Ontario and East send it here, Manitoba and West, send it there — Ontario was spit up with some cities sending it to one tax centre, others to another. Why does that matter? It’s not on its own a complex thing to figure out, but it’s one more step of complexity in what was already a hard process, and one that most people only face under hard circumstances. And it seems like the sort of thing that makes no damned difference so why is the CRA making it needlessly harder? Oh, and there was also one page that got sent on its own to another tax centre in Quebec. Why? Who knows.

It was painful because it was the “final” return and well, that’s a reminder that he’s dead, that’s it. Things are final now, and there are feelings there.

But the other reason tax season was painful was that I had to go over all the financial losses from 2020 to report capital losses. For most people, 2020 wasn’t such a big deal, investing-wise — scary for a brief while, insanely bubbly in a few pockets of the market, but a buy-and-hold index investor ended the year in the positive. Not so for us.

I’ve said many times before that my dad was a good investor. He got me into investing at a young age, etc. etc. That was an understatement: he was a great investor. He didn’t want to be famous, but would give his head a little shake whenever someone else tried to proclaim themselves “Canada’s Warren Buffett”. He was Canada’s Warren Buffett, or at least it seemed that way for a long time.

But as Buffett said, a long string of impressive numbers multiplied by a single zero is still a zero. In the end my dad wasn’t Canada’s Warren Buffett: he was Canada’s Bill Miller or Hwang.

The problem was that he was so good for so long that he got over-confident. He was not afraid of leverage — indeed, he used a lot of it.

On an episode of Because Money (I can’t remember which one to link it now), I shared the tale of how he was in the hospital, sick from his cancer, and needed to check in on the market — because a drop of 5% would be enough to trigger a margin call.

We argued a lot about leverage after that.

I tried to tell him that he was taking too much risk — risk he didn’t even need to take. He tried to convince me that if I ever wanted to be rich, to do more than just get by on my public sector salary (which he also argued I could do much better if I just switched careers), I needed to use leverage.

So he gave me a two-part gift: the first was an amount of money, which here we’ll just call X, a large amount that was roughly a year’s salary for me. The second half of the gift was that he would manage it for me, including by using margin. When I was young he had taught me to invest, but he never really taught me how to invest, at least not like he did. Dad was not the teaching type — he had no patience for it. So this was a chance to finally pass along that knowledge, as I could see what he did in an account in my name almost in real time.

X went into a brokerage account, and he borrowed another 2.48X against it. All it would take would be a 28% market correction to completely wipe me out, which was terrifying. “Relax,” he said, “you need to get used to this. If I do lose you your money, I’ll just write you another cheque. But it won’t happen, and this is something you have to learn.”

Well, Covid-19 hit. I bought some puts on the S&P500 in the early days as a hedge — I briefly felt like a market genius when the virus escaped Wuhan and the market started to wake up to the risk. I sold those for a small profit as things got volatile and it reduced the margin a tad. But the market kept going down, violently. The overall markets were down about 30% by the end, but the highly concentrated active portfolio he was in was down even more, despite appearing more conservative. But all those staid dividend-payers suddenly looked like broken businesses in the wake of shutdowns, and the overall indexes were buoyed by tech stocks that we didn’t own. I threw more money from my savings at the account to try to stave off a margin call, but finally got margin called on March 22, and became a forced seller just a day before the bottom was in.

In the end, X became 0.1X — my inheritance was essentially gone. The market recovered over the rest of 2020, but I did not leverage back up, and even if I wanted to there are limits to how much I could have added.

That’s the real danger of leverage: even if you have the psychological risk tolerance to ride out a volatile period in the market, a big enough dip can cause a permanent loss of capital as you’re forced to sell at the bottom to cover the loan. I should perhaps interject that while that non-registered account was actively managed, I do have registered accounts that are invested in passive index funds, which fared much better though the market crash and recovery, and which is my general recommendation for people — obviously active investing entails various risks, doing so with leverage even moreso.

The story sadly doesn’t have a silver lining, as I also didn’t learn much about his style of active investing — the cancer made him tired, and a little extra motivation to teach didn’t magically imbue him with the patience for it. “So tell me son, why did I do that trade?”
“I don’t know.”
“Well if you’re too fucking stupid to see it then I guess this family is doomed.”
“Thanks, Dad.”

He wanted to spend what little energy he had left on trading, not teaching.

In addition to learning a lot about leverage — or rather, strongly reinforcing my previous view — I also got an object lesson in risk correlation. Because part of this whole experiment was a compromise that stemmed from those arguments on leverage: I would have an account with more leverage to get used to it and see first-hand its power, and he would in turn take down the level of leverage on his own portfolio. Because even setting aside how nuts it was to run so close to the red-line that a 5% correction would make you start blocking the margin clerk’s number in good times, it was not good times. He had by that point had several run-ins with the hospital system for his cancer, and many more days where he didn’t want to get out of bed to trade. So he agreed that he was going to reduce his own leverage, begrudgingly. But “reduce” didn’t mean “eliminate,” and he too was margin called, almost every damned day through March, 2020.

The ability of an insurer to pay out insurance that was also tied to that very risk — risk correlation is not a good scene. So very understandably, Dad had to renege on his promise to insulate me from losses related to the leverage. In hindsight that was a completely obvious outcome, but it somehow never occurred to me when I let him go nuts with margin loans in my account.

That whole year was crazy in so many ways, and I want to try to be clear (I know I’m not, but I’ll try) that the human losses were the real tragedy… but those are hard to talk about, and this is in many ways a personal finance blog, and there are financial aspects to talk about.

Another aspect of the whole affair was a huge whipsaw in my own financial planning.

Back before we found out my Dad had cancer, before we found out it had returned and spread, before we knew that it was terminal, we did a Because Money episode on expecting vs *expecting* an inheritance. Basically, I never factored in receiving an inheritance into my own financial plans, at least not in a major way. My parents were definitely better-off than I was, so my standard-of-living in part is facilitated by gifts from them. While they don’t pay my rent or anything quite that co-dependent, a lot of my luxuries have come from gifts: plane tickets for vacations, curling equipment, or new video game systems. A good portion of my clothes I didn’t buy myself. So of course I was leaning on them in some ways (hashtag privilege?) but I also wasn’t factoring an inheritance into my long-term plans.

Suddenly that was changing. I was getting a rather large gift up front, and dad was dying — the prospect of an inheritance was becoming very real and updating my planning to take it into account seemed like the next step. In-between arguments over leverage and trading strategies, we also argued about frugality. I’m a pretty frugal person by nature, and over 8 years of grad school only reinforced that. I save a decent portion of my earnings, and have nearly zero affinity for conspicuous consumption. Dad tried to convince me to spend more, and live more in the moment. He didn’t want me to save that gift for the future — he wanted to grow it briefly, then have me plan to spend the dividends on the extra gas and insurance for a new showy gas guzzler to replace my Prius. He wanted me to spend 100% of my income — I already had enough saved up for the first few years of retirement, and I could count on an inheritance after that.

I wasn’t willing to go that far (I mean, I love my Prius), but hey, I can get greedy too. I was off work to take care of him, but was already imagining what it would be like to spend a few extra thousand per year once I had a paycheque again. I had started *expecting* an inheritance.

Then Covid hit and we got to be on a first-name basis with the margin clerk and it all went to hell. Whipsaw: back to planning to save the normal way.

With passive index investing, there’s a bit of a concern from some corners that if too many people become indexers, then there won’t be anyone to do security analysis. The market will stop being efficient, and the free ride that passive investors enjoy will be over. While it’s a “paradox” in that passive investing only works if there are active investors to make the market efficient, in practice, most of us aren’t too worried about it — there will always be some active investors to help determine prices.

I’ve seen the argument (not that I can find it now to link to it) that the weakest active managers will be forced out first (the ones who were basically closet indexers but charging 2.4% for the privilege). The remaining good managers may make some pre-fee alpha, and help keep prices rational for the passive investors. So as active managers continue to broadly under-perform index funds net of fees, and more investors move to passive funds, the ones who were least able to generate alpha will be the ones forced out of the industry.

But watching the chaos of the markets over the last little while, I also remembered the Dunning-Kruger effect: those who are least skilled are also not generally able to accurately assess their skill. So as passive continues to prove to be a good strategy, the ones who don’t switch are not just the most skilled (still generating alpha) but also the least (who may not know the risks they take or that they’re not generating alpha). And professional managers are not the only ones in the market — there are a lot of retail traders out there. On the whole they’re dwarfed by institutional money, but they can certainly move a few sectors and specific names. And so they have.

And social media in some ways fuels it — most people would never trade on a tip made in a video, tweet, or forum post. But the world’s a big place, and there are lots of people who do. And the algorithms are good at serving up more and more of that if you engage with it.

The last little while has seen some market moves that are just plain hard to call “efficient”. The weak-form efficient market hypothesis still applies — no matter how crazy it is, it’s still unpredictable enough that you can’t reliably profit from it, so just stick with index funds. Looking at the Gamestonk run-up and crash, calling the top never looked like a sure enough bet that I wanted to do it. Tesla, a niche, money-losing maker of electric vehicles (with a money-losing solar panel division that’s shrunk significantly since its related-party bailout, I should add, before the comments section fills with wails that it is also “an energy company”) somehow became the world’s most valuable automaker. And if you tried to short it at the point that it passed Toyota, you got destroyed as it continued to go straight up and become the most valuable automaker by such a margin that it’s worth more than all the global brands you recognize combined.

But even then, you just have to look around and shake your head at the stuff people are buying. An electric — no, hydrogen! — truck company with no working trucks, no plan to make any, and an executive chairman who left in disgrace is worth $9B, with $500M in shares traded on a given day. Weed companies went up and up and up ahead of legalization in Canada, even as the sector became way bigger than the most optimistic projections of post-legalization market size, and you could not escape the hype. Space is a cool idea, but is Virgin Galactic really worth $13B (and 3X what it was a year ago?).

I’ve read a lot of stuff on active investing, and many articles make points about second-order, third-order thinking — how will the market react, what’s already priced in, etc. Lately it seems like that stuff will get you killed. There seems to be a lot of people in the meme trades, but there’s no way to go and become an active investor and profit from it: all I can do is rant on my blog about how crazy some of this stuff seems.

[Editor’s note: I’ve been sitting on this draft for a few months. Other than compiling some ideas from others and ranting a bit, the post as it is isn’t all that original. I thought the really clever bit would be to add some actual research and back-testing on fads and frauds to semi-seriously answer the question, but that turned out to be too much work and I now realize I’m never going to do that much research and stats even if there’s a chance that it’s more than just a lark. Anyway, I figured you may as well get to read it instead of killing it off. This one certainly isn’t investment advice, and I’m not alleging any companies or people are frauds here — I’m linking to the allegations and cases where I can, innocent until proven guilty, etc. etc.]

Elon Musk tweeted out in the middle of the trading day: “Am considering taking Tesla private at $420. Funding secured.”

Funding was not secured, not remotely. It was one of the most egregious and blatant cases in living memory and the SEC filed fraud charges. It revealed significant problems with corporate controls given that his Twitter account was identified as a channel for official company communications, and looked like a slam-dunk open-and shut case for the SEC.

Yet he settled for a slap on the wrist: no D&O ban, no forced divestiture of his holdings, just a requirement to add two new independent directors, and a $20M penalty (the company also paid $20M). Less than two years later, he got an incredible pay package tied to the stock price, orders of magnitude larger than the fine, despite the company still not producing an annual profit [at the time — it has eeked one out between drafting and posting this] and even clawing back bonuses for its workers. Oh, and despite coming very close to driving the company into the ground along the way (though there was no going concern language in its reporting at the time).

Securities regulators are broken. They are not working to protect investors or provide for rational, functioning markets. It was only at the last minute that the SEC stopped a bankrupt company from issuing more stock that it knew to be worthless. It’s the golden age of fraud.

And it’s not just a SEC problem. Germany’s BaFin failed spectacularly in regulating Wirecard, even prosecuting people working to expose issues at the company, instead of taking their leads and investigating the company (i.e., their jobs). And here in Canada, we have a patchwork mess of regulators. Not just the provincial securities regulators, where even when they get someone, the penalties can be the cost of doing business, but even within a province we can have different regulatory bodies letting problems slide. Bad actors can use the courts as a weapon, and even if you win a SLAPP suit, it can be costly and disruptive to your life, while bad actors buy themselves months or years more time to keep fleecing investors as critics and defenders of everyday investors are forced into silence.

Bad actors have free reign in the capital markets. None has put it quite so boldly as Musk’s “I do not respect the SEC,” (or the 2020 remix) but the days of fearing the wrath of the regulators appear to be a quaint figment of history. And regulatory capture is such a joke they don’t even try to hide it any more.

Indeed, I have heard it said¹ that frauds are some of the best investments out there. After all, they don’t have earnings misses when the numbers are fake anyway.

Or as some have so eloquently put it: Fraud creates alpha².

As an investor, you almost have³ to assign some portion of your portfolio to frauds and fads to keep up. And given that there is no downside any longer, as a CEO or Director of a company, you have a fiduciary duty to commit fraud².

That’s a fine angry rant against the state of the markets as they sit today. If we had elections for OSC or SEC head, I might be just ticked off enough to throw my hat in the ring (or go campaigning for someone with a more protectionist bent). But that’s not how it works. There’s nothing to do but rant and carry on. Yet I keep coming back to that lovely, infuriating phrase:

Fraud creates alpha.

It’s a thing that we say — shaking our heads and laugh-crying — to encapsulate the absurdity of our times. But… is it true? Does fraud create alpha? Like in a systematic way? Should we be checking if it might be a 6th factor in the Fama-French schema to round out size, value, profitability, and investment?

Let’s make it F&F — fads and frauds, because that’s another area where there has been some outsized stock performance lately. Indeed, it’s almost like that litmus test of the Nigerian scams, where the emails are purposefully full of spelling mistakes to try to weed out those who may not be sufficiently gullible. The business models in some cases have no hope of working, or at least will never reasonably justify the stock price⁴. But that’s likely the point — as long as no fundamental analysts are buying it anyway, then the sky’s the limit. 3X revenue may be crazy-sauce in a low-margin business, but once you’re already there, 7X is really no crazier! And with a touch of what some may interpret to be stock manipulation, why not see if we can shoot for 20X while we’re at it?

Many modern “success stories” are incinerators of capital, serially selling stock to fill the hole created by losses and growth for growth’s sake, though as a side effect they have created a world where our lifestyles are subsidized by dumb capital. Oh, and skirting (or at the very least, bending) the law is a key element of disruption for many of these start-ups — from how they pay and treat their workforce as independent contractors, to flaunting municipal taxi, zoning, or other laws, if not securities laws themselves.

We who can recite the Litany of Saint Graham (“In the short run the market is a voting machine, but in the long run it is a weighing machine”) believe that fads and frauds will one day crash. Some people even make their living shorting them. But far too often, they go up first. They go up a lot.

And therein is the question: do fads & frauds create alpha? Now if you hold until they crash — assuming they do eventually crash and burn — then you’d think not, it would be trivial. To cite the Disciple of Graham, a string of impressive numbers multiplied by a single zero is still a zero. But if you take an approach where you rebalance away as they go parabolic, there might be something there. In an equal-weight portfolio of shit, you may not care much when your German payment processor is finally de-listed if your California vapourware company has sextupled in value. It’s skewness of returns in over-drive.

So let’s build an index and backtest. For example, if you buy in as soon as a report or article or forum post first suggests something fishy, and then rebalance away after each doubling (to other F&Fs or a core market portfolio if you run out of ideas), would that generate alpha?

This is the point where I thought actually doing a bunch of research and math would make the post more fun (and maybe even prove or disprove the point instead of just ranting), but it’s also a lot of work and it’s been many months since I first drafted this and I don’t think I’m ever going to get the research/math part done. So I will leave the idea there — maybe someone else with some time on their hands can go back a few decades and see if you can construct an index of fads & frauds and some rules (equal weighting? trend-something?), and see if it provides improved risk-adjusted returns.

1. Likely Carson Block on a podcast — apologies to whoever said it as I didn’t keep the source, but I think it was a podcast and not an article if that helps.
2. I think this can be attributed to TC. There’s probably more in here that can be attributed to the Chartcast.
3. No you don’t especially if you’re a smart passive investor, this is a whiny post and not actual investment advice.
4. I have heard it said (Chanos?) that one of the worst things for a fad company to do is to make a profit because it’s stock will crash when it suddenly goes from being valued based on some dream about TAM to being valued on a price/cash flow or price/earnings basis.