Captain’s log. Stardate 17943; 18:50 UST.
The bridge is quiet today. The crew, hushed with anxiety. For days we have been drifting closer to the jump coordinates, all the while a sense of dread lurking just beyond the reach of our scanners. The vectors are clear and the calculations have been triple-checked; this is the path. But nobody at Command informed us that it would be like this, so ambiguous and fraught with doubt.
Command, ha! What do they know in their ivory space stations? They’ve never travelled beyond The Galactic Veil! How could they possibly understand the fear and uncertainty that eats away at us daily. They claim with their elegant mathematics that the wormhole will jump us immediately to Sector Whiskey/Zulu 6.6, but where would their faith be out here? Would they charge forth with such confidence? Would their chalkboard theories see them through to the other side?
So many questions. The hour of action is drawing near. I – we, shall boldly go…
Sigh. “What is it, Ensign?”
“Are we buying the stock market here or not?”
As you can tell, I read a lot of science fiction. You can probably also tell that I have zero future as a science fiction writer.
In the world of sci-fi, wormholes are a pretty big deal. Outer space is vast. So vast, in fact, that even when travelling at the speed of light, the cosmological speed limit, it can take millions and millions of years to journey from one alien galaxy to another. Enter the concept of wormholes. Or as they’re known in less-geeky circles “Einstein-Rosen Bridges”. Maybe that’s more geeky. I don’t know. I’m probably too big a geek in both circles to judge.
When Einstein put the finishing touches on his theory of general relativity in 1915, he had literally written the book on gravity. Isaac Newton’s centuries-old work on gravity was doing a good job describing most of the physical phenomena that we witness here on earth, but the Newtonian framework didn’t translate so well to the world of astrophysics.
Einstein came along at the right time, just as we were becoming more and more curious about the world beyond the stars. General relativity is an immensely important part of modern physics, and helps us explain all sorts of things from black holes to the Big Bang to other crazy stuff like the relation of space with time. Combining space and time into one continuum (3 dimensions + 1 time dimension) solved all sorts of problems in physics, and physicists were so excited by this they gave it an awesome and exciting name: space-time!
The neat thing about space-time in the framework of Einstein’s general relativity is that it’s curved by the presence of matter. Curved space-time has all sorts of interesting and technical applications, but for our purposes today, this curvature can imply shortcuts from one point on the space-time fabric to the other should certain conditions be met. If you thought economists used some bizarre, complicated math, you have no idea how bizarre and complicated some of the math in the world of physics can be. Physicist math is way beyond me, so let me explain it visually.
Think of space-time as a big sheet of graph paper or maybe a blanket that you can pull tight or wrap around other objects. If you fold it in half all the points on one half are now touching or very close to corresponding points on the other half.
Here’s a picture:
As captain of the USS Concord, I could fly my starship from point A all the way around the space-time fabric to point B which will probably take a long time. Many lifetimes or more, even if I could travel at the speed of light. Alternatively, I could fly straight through the wormhole and immediately pop out on the other side of the universe. Pretty cool.
Nobody knows whether or not wormholes actually exist. They’re certainly not a joke, as major physicists from Einstein to Wheeler to Hawking have put forth serious work about how they might work and even how they might be traversed.
Wormholes were the greatest thing to hit science fiction since Swift opened up a world of possibility and imagination with Gulliver’s Travels and Mary Shelley’s Frankenstein definitively carved out the fledgling genre. There is no name more important in science fiction than Isaac Asimov, and he incorporated the idea of wormholes into his Foundation series over 60 years ago. Many of Asimov’s stories feature characters that traverse great distances of space and time. Today the TV show Battlestar Galactica relies on the same act of “jumping” instantly from one point in the universe to another. The science fiction of tomorrow will continue to lean on this concept of instant, interstellar travel. Wormholes are a tidy fix to a tricky problem.
This has been fun, but this is an investment newsletter after all. What relevance could this possibly have? Well, I’ll tell you:
Investing doesn’t work like a wormhole
When you look at a market and study data both past and present, you might develop a thesis about where that market is ultimately heading. If you’re a trader or an investor, you might even actually establish a position or two around that thesis, perhaps buying stocks if you think they are cheap and will get more expensive or selling real estate because you think it’s too expensive and will get cheaper.
Investors, stationed in their starships at Point A, make the buy or sell focusing solely on where they’ll be at Point B. Since investing doesn’t work like a wormhole, they can’t just make the trade and pop out on the other side. Investors have to travel the long way around. And the problem with taking the long way around is that they fail to consider the things that can happen while they’re on that path.
It’s one of the biggest mistakes that novice traders make. Why do they do it?
Thinking of trading as a wormhole makes life vastly easier for investors, a broad galaxy with a diverse citizenship, all of whom are firmly fixated on the future and most of whom lack sufficient sophistication to understand where the black holes lie. It’s not their fault. Their brains just aren’t wired properly. Humans can easily understand where they are at present as well as where they expect to be in the future. But they have a much harder time mapping out what the paths between those two points actually look like.
There can be a lot of volatility lurking between the time one puts on a trade and the time one plans to take it off. Changes in environment, too. There are literally an infinite number of paths that an investment can take. Many of these paths are fraught with dangerous black holes. Trying to anticipate all these factors is tricky work. The potential frontiers a trade can take divide and multiply, complexity spiraling out of control.
Buy & Hold is a wormhole
This is why buy and hold is a bad strategy. Does it work? Yeah, it does. There’s too much evidence to the contrary. About the only thing we can say conclusively about the stock market is that over the long, long run, it has a tendency to go up. So buying it and holding it sounds like a strategy that makes sense.
But you can’t just buy stocks, hop through a wormhole, and immediately emerge 50 years later with all of them being more valuable. All sorts of things can happen over that 50 years of space-time.
What happens if you come across a deadly asteroid field or a black hole? What if you have to abandon ship? What if the market crashes and you are forced to pull the plug, or what if you get a margin call on some of your real estate holdings and need to raise some cash? What sort of other factors aren’t you considering along the path between Points A and B?
For an actual wormhole example, imagine you bought stocks in 2001 thinking you were getting a great deal by buying on a big dip. Did you capitulate by 2003 after losing another 30%? Did you buy again during the enthusiasm of 2005 and 2006? Or did you really load up in 2007, afraid you’d missed the party only to be blindsided by the crash of 2008? How committed were you, really, to the “hold” portion of buy-and-hold? You made that buy back in 2001 with the expectation that you could pop through the wormhole and have it be 2025 with nice profits in your account. But a lot happened along the way.
Many trades and investments seem like no-brainers when you look at them as though they were wormholes. It sounds so easy to compare the facts of now with what you expect them to be in the future. But don’t forget John Maynard Keynes’ famous quip, “the market can stay irrational longer than you can stay solvent”. Make sure your investment starship is built to withstand the dangers of the long way around, a path fraught with irrationality.
The Black Hole of AIG
Wormhole thinking was what got AIG into trouble. They basically sold insurance (structured as derivatives, the infamous CDS’s) on all sorts of different types of debt obligations. AIG focused solely on the other side of the wormhole and ignored everything in between. They assumed that all this insurance they were writing would never be called on, and so they wrote as much of it as they could – way, way more insurance than they could ever possibly pay.
All of this seemed like a great idea at the time. The more contracts they wrote the more revenue they collected. Their rationale was that over the long run they would never have to pay out on too many of these insurance policies and if they did have to, it would probably mean the end of their business anyway and would probably also mean that the financial apocalypse would be here. No big deal. Everybody else would be screwed too.
In 2008 you saw firsthand the danger of large firms employing this kind of logic.
The credit markets did fall apart. AIG did have to start marking the value of some of these derivatives to market, realizing mountains of losses in the process. It did put them out of business.
But instead of allowing them to die a violent, supernova death, we, the taxpayer, then bailed them out to the tune of over $180 billion. The rationale at the time was that we were doing it to prevent a chain reaction from spreading and sucking neighbor firms on Wall Street into the AIG black hole.
The AIG bailout shouldn’t be thought of as a strict bailout of AIG, but rather a bailout of its counterparties that were made whole at the taxpayer’s expense: Goldman Sachs, Societe Generale, Deutsche Bank, Bank of America, Barclay’s, Merrill Lynch, UBS, and sordid others including even a few states that will remain nameless *ahemCaliforniaAHEM*. AIG owed these firms billions and billions of dollars, and not getting paid back represented a serious threat to the already-shaky solvency of those firms.
Only time will tell if a bailout was the right call. In the meantime, AIG will go down in history as one of the greatest Wormhole disasters of all time.
The Wormhole Solution
How does one avoid the pitfalls of wormhole trading?
It’s a lot harder to do than it sounds, but try to live in the present with your investing. Continually reassess the validity of each investment every day, and do it rationally rather than emotionally. It’s a lot of work, but unless you use a perpetual continuum as your investment horizon, you won’t realize that the bad decisions you made were bad ones until it’s too late.
You’ll notice this has been a theme present in many of our newsletters. Investing is hard work. It’s no different than any other endeavor. The lazy are punished for his sloth and the diligent are rewarded for their preparation. Sorry folks. Go watch Jim Cramer if you want cheap investing faith, but don’t come crying back here if you’re disappointed by the results. Investing is a harsh world. We are here to help you develop sane, prudent perspectives, however unpopular that may seem in certain environments. We think it will make you a stronger investor.
Here are some other tips for avoiding wormholes:
- Map out some possible paths the investment can take before putting it on. Map it out over different time horizons, not just to where you think the investment is ultimately going. In a three-year trade, think of where things could be one year from now and how you might respond to that. Attempt to forecast ways in which the trade could go wrong and ensure you have appropriate counterstrategies queued up if necessary.
- Recall the old chess adage and ask yourself two questions: “With this move, what is the opportunity? And what is threatened?“ The strategic goal might always be to move your pieces towards a checkmate, but make sure you don’t allow yourself to be mated along the way.
- Use diversification. If the risk of one investment is contained in a relatively small portion of your overall portfolio, you’ll be more likely to see that trade through to where it’s ultimately heading. When you keep black holes from swallowing your entire ship, it’s easier to get where you’re going in one piece. Low correlation should always be your guide when diversifying your portfolio.
Most investors fixate only on the opportunity and don’t realistically analyze the potential risk. They look at the stock market in a year like 2009 and are blinded by an 80% bounce – nevermind the fact that there is plenty of historical precedent for bounces like that in the middle of nasty bear markets, many of which are followed by subsequent crashes. Investors rationalize a buy with the Wormhole Fallacy, reminding themselves that even if they lose money after making the investment, over the long run, it will probably go up. They ignore the risk of losing half their money like they did the year before and they fail again to consider how long it might take to recover those losses. Then they see something like 2010 outside their spaceship window and they panic. A flood of emotion and memory comes back to them at once. They sell out.
Few investors give credit to their shifting needs and the emotions that accompany periods of severe loss and volatility. Trying to anticipate the risks along the way and making sure you have contingency plans in place will help you navigate safely from point A to B.
Your final destination may be a great place to be, but you can’t travel there instantly. Ask yourself: is it worth what lurks along the way? Is your investment spaceship equipped to handle it?
Beyond the Galactic Veil
Captain’s log. Stardate 17945; 01:02 UST.
This marks the 25th consecutive hour in our attempts to reestablish contact with Command. There has been no reply. Even still, would blame prove worthwhile at this point? Rightness and wrongness are now mere trivialities. Irrelevant concepts.
Our laser turrets have malfunctioned. The scanners crackle and hiss, worthless. Our fuel leaks slowly into the cold. We are blind and without defense, drifting towards…what? There is nothing but black silence. A yawning, indifferent void.
The crew looks to me, unblinking. I see it reflected in their eyes. Hope has abandoned us.
Out here, where we were going matters not.