The Interesting Times: Reality Has a Surprising Amount of Detail

Howdy,

I've spent the better part of the last month talking with startups and small business owners about how they are responding to the current situation.

I put together my best attempt at a list of "best practices" in an essay this week: A COVID-19 Crisis Management Plan for Startups and Small Businesses.

Other than that, I have been working on the Mutiny Investment Project that I mentioned in February. I hope to be able to make a public announcement about our progress soon.

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On a scale of 1 to 10, how well do you understand how a can opener works? Got a number? Good.

Now, take out a piece of paper and try to draw a diagram of a can opener. If you can’t draw well, write out an explanation, piece by piece.

Seriously, take out a piece of paper and do it. (Doing it in your head doesn't count, as we will see...)

A can opener is not that complicated and you’ve probably used one hundreds, if not thousands, of times in your life.

And if you are thinking "of course I know how a can opener works" then, seriously, try to draw the diagram or write out an explanation.

After you’ve done it, re-rate your understanding on a scale of 1-10.

I have tried this and seen other people try it and so far I have never seen anyone that accurately evaluated their own understanding of how a can opener works. Everyone is overconfident.

Leonid Rozenblit and Frank Keil, in a 2002 paper showed that people believe they understand familiar manufactured objects (such as can openers) and natural phenomena (such as tides) much better than they actually do.

The researchers had subjects rate their understanding of various objects and phenomena, and then asked them to give an explanation. After that, the subjects rated their own understanding again. Their second ratings were much lower.

"Most people feel they understand the world with far greater detail, coherence, and depth than they really do. … [They] wrongly attribute far too much fidelity and detail to their mental representations because the sparse renderings do have some efficacy and do provide a rush of insight."

This phenomenon is beautifully captured in a phrase I find myself using repeatedly: "Reality has a surprising amount of detail."

It is not merely that reality has a lot of detail, but that the amount of detail is continually surprising.

Almost everyone thinks they know how a can opener works but no one actually does.

This phenomenon doesn’t apply to kitchen appliances, but basically everything everywhere.

At the population level, saying "reality has a surprising amount of detail" implies that no one understands how anything works but everyone thinks they understand how everything works.

This is a critical insight for social media’s business model as you may have noticed. (Astoundingly, everyone in my feed that was so confident they knew who would win the 2016 U.S. presidential election has since become a "successful" macroeconomic forecaster.)

Another paper, "Political Extremism Is Supported by an Illusion of Understanding" (Fernbach et al., 2013), applies the Rozenblit method to political explanations. After subjects tried to explain how proposed political programs they supported would actually work, their confidence in them dropped.

Subjects realized that their explanations were not very good and that they didn’t really understand the programs. This decreased their certainty that they would work. The subjects then expressed more moderate opinions and became less willing to make political donations in support of the programs.

In the past few weeks, it is truly astonishing to me the number of people who believe they are capable of predicting different policy decisions and their macroeconomic reactions but can not draw a can opener.

The economy is 100x, 1000x, or 10000x more complicated than a can opener and yet this same illusion of understanding persists.

We saw this, to some extent, in the bond market in March. Lots of Bond ETF funds were trading at large discounts to Net Asset Value (NAV). The way bonds are traded is different than stocks for a bunch of complicated historical reasons that I don’t fully understand (history has a surprising amount of detail too!), and the end result is that bonds are less liquid in periods of high volatility.

That made it impossible to keep the underlying assets in the portfolio in line with the ETF. As a result, many passive bond investors lost a lot of money.

How many passive bond investors understood the liquidity risk they were taking on a month ago? Basically none, because everyone that understood it didn’t buy those ETFs.

REALITY HAS A REALLY, HUGELY SURPRISING AMOUNT OF DETAIL!!!

There are, I think, three reasonable and non-mutually exclusively approaches to deal with this.

The first is what economist Tyler Cowen calls "meta-rationality."

True "rationality" means recognizing the limits of our own understanding and knowing when to defer to experts, which experts to defer to or when to simply admit to that something is impossible for anyone to know.

I think most people who agree with this notion, but still vastly overestimate the limits of their own understanding. Whatever you actually understand is probably some fairly small fraction of what you think you understand

The second is captured in Steven Covey’s idea of a circle of competence.

As long as you know that you don’t know that much and stick to your knitting, that works out fine.

This is why I firmly believe that the best investment for most people is to reinvest in themselves. The biggest asset on your personal balance sheet is your future earnings. It’s also the one you have most control over.

You shouldn’t start buying an index fund every month when you are 25, you should take courses and go to conferences and start a side business that lets you expand the infinitesimally tiny sliver of reality that you do understand in a way that will be much more lucrative.

I own two small businesses and while I’m sure that my perceived understanding is great than my real understanding, my real understanding of them is still pretty decent.

I can explain, in detail, the types of customers they serve, their positioning in the marketplace and what’s going on in the personal lives of people working for them.

The third approach is that you want to have convex exposure to risk (also called positive skewness). In plain English, this means you want to take bets with fixed downside exposure but unlimited (or near unlimited) upside exposure.

Starting a business fits this profile. The most you can lose is everything you put in.

And, crucially, people starting businesses tend to assume that losing everything is a real possibility. People investing in the stock market generally do not.

However, you could make many multiples of that. I know many entrepreneurs that have 100,000x returns on starting a business. You will not get that with any other investment strategy.

This is basically the whole premise of my book, The End of Jobs. The internet made it cheap to start a business (low downside) but easier to scale and reach a global market (high upside). It’s not guaranteed to work and it's not for everyone, but it’s a pretty good bet and I think many people would be better off betting on themselves than betting on financial markets.

At a certain point, you can’t reinvest any more in yourself and it does make sense to invest that money in other companies or strategies. At which point, you want to invest part of that into strategies that have a convex return structure: losses are capped, but gains are unlimited.

If you have a "diversified portfolio" of investments, all of which have capped upside and uncapped downside, what you have is a ticking time bomb.

No amount of pointing to historical charts about how the bomb hasn’t gone off yet changes that. At that point, we are merely debating how long the fuse is.

Which is fine. Maybe the fuse on your portfolio is really, really long? I’m not smart enough to know.

A truly diversified investment portfolio requires combining both concave (AKA short volatility assets such as stocks, bonds and real estate) and convex (AKA long volatility assets such as Gold, Tail Risk/Long Volatility, and trend following) strategies.

Or, as my dad told me just about every day of my childhood: It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.

Thanks Dad.

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