The Interesting Times: Illegible Inefficiencies

Happy Friday,

No big news updates from me this week. Still chugging along on a couple of beefier research/writing projects including a primer on long volatility that I hope to have out in the next few weeks.

We’re also potentially looking for a part-time research assistant at Mutiny Fund. The right candidate is an excel wizard (and maybe knows some R). They have experience finding historical return data and running hypothetical backtests. It’s part-time and entry-level so I suspect a student may be the best fit, but open to other options. If you or someone you know fits this profile, hit reply and let me know.

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Illegible Inefficiencies

I’ve been (rental) house hunting for the last couple of months. I don’t really know anything about real estate investing, but I’ve been trying to read up (John T. Reed’s Best Practices for the Intelligent Real Estate Investor is my favorite so far).

It’s been interesting seeing what aspects of a home (rental or for sale) that I care about are priced in and which aren't

Factors which I care about that the market seems to price really efficiently include:

Square footage
Neighborhood

Some factors I don't really care about but get priced into the market efficiently:

Amenities/"Finishes"
Nice view

There are also some factors that (in my experience) have very high quality of life implications and basically don’t seem priced in at all.

The big ones I’ve noticed here are:

Natural light - Fairly clear research that natural light affects mood, but a dark house doesn’t get any discount nor a bright house any premium.

Intra-neighborhood location - Broadly, neighborhoods seem to have a standard price but location within that neighborhood doesn’t matter much. So, a place that is a 3 minute walk from the pedestrian street with a grocery store and coffee shop is priced the same as a place that is a 15 minute walk.

However, there is an exponential decay function of how often you will use it based on walk time - something that is 3 minutes away will get used 10x something 15 minutes away - and this doesn’t seem priced in at all.

Design - a house beautifully designed by an architect will be priced the same as a cookie-cutter house thrown up by a developer that is stamping out properties without much thought or consideration.
Commute Time - It's not really fair to say this is priced inefficiently because everyone's commute time is different, but generally people seem to be too willing to take on a longer daily commute for other variables that matter less to overall mood/wellbeing.

If you assume 200 working days per year then the difference between a 10 minute daily commute and 30 minute daily commute is ~140 hours per year. That's a lot of time to give up.

The process has made me think more about the idea of efficient markets. The strict version of the efficient market hypothesis is obviously wrong and no one outside the halls of academia really considers it (and probably not many within it?)

However, it’s usually a good starting point. If you stumble on what looks like a great opportunity that the market is ignoring, 99 times out of 100, the market as a whole knows something you don’t. So it’s good to start with the assumption that markets are efficient and then work to disprove that on a case-by-case basis.

Even though you're usually wrong and the market is right, the 1 out of 100 times that you really did identify an inefficiency are worth a lot. They are what Peter Thiel refers to as secrets - things you believe to be true that few others do - and are often the basis for the most profitable “trades” whether that’s an actual trade, starting a business, or positioning yourself in your career.

One interesting place where I think markets are often inefficient is what I call The Illegible Margin. Things that are easy to measure and put into an Excel spreadsheet tend to get priced pretty efficiently. Things that are hard to measure often get ignored.

In the case of residential housing: natural light and design are both very hard to quantify. I think that leads to them largely being ignored. (The lack of pricing good intra-neighborhood seems driven by most people in the U.S. driving instead of walking places so people don’t really care about walking distance. The commute time "mispricing" seems driven by people wanting to live in a "good neighborhood" often driving by school districts).

In the context of careers, new industries tend to be mispriced because the path isn’t very legible. I started learning about Search Engine Optimization (SEO) in 2011 and that was how I got my first job.

At the time, I couldn’t even explain to my parents what SEO was. There certainly weren’t any degrees or formal credentials. Everyone in the field was self-taught.

It wasn’t a particularly bold or savvy bet on my part. By 2011, it was pretty clear that search engines weren’t going anywhere and that more and more businesses would rely on them to acquire customers. It was just illegible and so the competition relative to the demand made it easier to break in and grow quickly.

What opportunities do you see that might be mispriced because of The Illegible Margin? That’s usually where the best investments are.

If you find this idea interesting, see the very related notion of Goodhart’s Law. H/t to Rory Sutherland's post about inefficient pricing in architecture which got me thinking about this a few years ago.

Making Market Music with Roy Niederhoffer with Roy Niederhoffer
The Derivative

Great conversation with Roy Neiderhoffer who has been trading the commodities and futures markets for over four decades.

They look at:

-Why US stocks looked so unattractive just before their largest bull run.

“In 1983 when I had some money from my computer software business, I look back at Track Records and the stock market was completely unchanged in real terms for a dozen years.

And I just like why would anybody invest in the stock market? I want to be in the bond market.”

-The dangers of relying on the negative stock/bond correlation or diversification:

“My whole career, until recently, has been spent in a falling rate environment. And it's only now that we're starting to see the potential for bonds and stocks and moving the same direction.

And that throws off this whole 60/40 idea that you should have stocks and bonds and, of course, risk parity.

When you have leveraged multiple times to things that are positively correlated that's a tremendously risky trade, especially if that trade needs to be reduced when volatility increases.”

-The Sharpe ratio of your fire insurance:

“A lot of people are very comfortable with protective strategies in other parts of their lives such as fire insurance, let's say. So if you ask me, what's the Sharpe ratio of your fire insurance?

You know, you know, scratching like, oh, it looks like it's minus infinity.
...

That's literally the worst investment you'll ever make in your life. For 96% of people or something like that, it will never pay out. But everybody has it [because it prevents risk of ruin].”

The labor market, like any other market, is dynamic.

Just because something worked for a prior generation, doesn't mean it will work for the next.

If anything, it is less likely.

In financial markets, the best performing strategy over the past 20 years is usually one of the poorest performing strategies over the next 20 because it gets crowded and returns deteriorate.

The same is true of the labor market. (I have heard the theory that you could build a trading strategy around doing the opposite of whatever Harvard graduates did in a given year. E.g. I suspect the peak of Harvard grads going into finance was mid-2000s, just before the GFC. h/t Byrne Hobart).

In general, while much parental advice to kids about careers is very well-intentioned, it is often out of tune with reality.

“Do not seek to follow in the footsteps of the wise. Seek what they sought.” Matsuo Basho

Hyperion

Dan Simmons

If you are into sci-fi, this book is a banger. It’s interesting from a technological perspective because it came out in the 1990s and suggested some pretty interesting ways of thinking about artificial intelligence.

More than that though, it is just a superbly written story. Multiple times throughout the book, I got chills at how good the plot twists were and how seamlessly the whole world-building was weaved together.

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