Dr RICHARD SMITH | From RiskSmith
Are capital markets more of a simulation than reality? How important is it to understand that we are being manipulated by the media, Wall Street and other players to have our attention distracted and be part of their business models not ours.
"We don't control the narrative of markets. And neither do the vast majority of people that are trying to find their way through the markets. The media of course, which has an interest in essentially what I call an addiction based economy. And so the things that get us addicted are sticky and get a lot of press and reinforcement. And that addiction happens largely because of the way that narratives can be manipulated and swung back and forth, up and down. And it's in those extremes where we experience the highest dopamine drip. And those are the things that keep us coming back. And that, you know, create eyeballs and revenues and subscriptions and media appearances, et cetera. Right? And anybody who's thinking that they can learn about the markets and start to participate in the markets, you really have to understand this about markets."
Dr. Richard Smith – Berkeley Mathematician and PhD in System Science – is the founder and CEO of RiskSmith, a risk analytics platform for independent investors who want to invest like the pros, and the author of The Risk Rituals newsletter. Dr. Smith has built a reputation as "The Doctor of Uncertainty" amongst his academic peers and has helped government agencies and Fortune 500 companies alike make sense of complex sets of data. In his upcoming book The Risk Manifesto, Dr. Smith will aim to further educate investors on how to circumvent self-destructive instincts and adopt a systematic way to manage their fear of risk.
"Markets exist because corporations have risks that they can't fully manage themselves. So we can earn a return in the markets by taking on some of that risk, right? We put our capital in the markets and get paid based on the risk that we're willing to assume and hopefully holding on long enough to get rewarded for that risk that we take. But people don't understand that this is the, the nature of investing, this is what you're doing as an investor. You're putting your capital in the markets, you're agreeing to kind of take on the risk that the corporations want to, you know, offload to somebody else"
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Stocks for beginners.
Most of the things that our attention get drawn to by the media are things that have fat tails. Okay? They're things that are more volatile because it creates a lot of churn, it creates a lot of transaction. It's exciting. It gives us the dopamine drip. And it's because again, we live in, in the attention economy and the main business model and the attention economy is addiction.
Hi, and welcome back to Stocks for Beginners. I'm Phil Muscatello. Our capital markets more of a simulation than reality. It feels a little bit like that these days. Are we caught in a matrix? Joining me today to discuss risk diversification and the matrix is Dr. Richard Smith. Hello Richard.
Hi Phil. Great to be here. Thanks for having me.
Thanks very much for coming on. Now, Dr. Richard Smith has built his work around understanding risk. He's a Berkeley mathematician and PhD in system science, and he's the founder and CEO of Risk Smith, a risk analytics platform for independent investors and the author of the Risk Rituals Newsletter on Sub Stack. So tell us why do you believe that markets are more of a simulation than reality?
Richard (1m 11s):
Well, I think that a lot of our economy today is more simulation than reality. But if we're talking specifically about markets, I think it's pretty easy to see that we're all interacting with our screens. We're not out there, you know, going and visiting the companies that we're investing in and trying to understand their economics. It's really all trading on price. And that's happening in a lot of areas of our economy because as a culture, we're ed with quantification for multiple reasons. One of the reasons is it kind of creates an illusion of certainty, right? That we have control, we've quantified things.
Richard (1m 54s):
And of course, if you look at what's going on in the markets, institutions, hedge funds, et cetera, it's all quantification, right? It's all essentially modern portfolio theory or post-modern portfolio theory. I don't wanna go too deep down the rabbit hole here, but everybody's calculating everybody's computing, everybody's quantifying, and that by definition is a simulation. You know, my PhD in system science, I studied, you know, decision making under uncertainty, and how do we use computers and mathematics to kind of calculate uncertainty and help use those computational tools to make better decisions, right?
Richard (2m 37s):
And they're very powerful and they do have an application. But the conclusion that I've reached, Phil, is that they're not the real world. They're models, But our models have become so complex and so fascinating that we spend more time in our models than we do in the real world. You know, in the metaverse, if you will, is a model of the world, okay? The financial markets are a model of actual things that you can invest in. So we've moved into a world of models and we spend more time in our models today than we do in the real world. So that's what markets have become.
Richard (3m 20s):
And I think it's important that people really understand that because the tools that you use for decision making in a model based world are different than the tools you would use in the real world. And so, as somebody who cares about helping the average investor do a better job in the markets, right? I think that part of the way we get tripped up as individual investors who don't have, you know, all the resources that institutional investors have, right? And that things can happen in model-based realities. That can't happen in the real world. So right now, here we are, it's October, 2022 when we're making this recording, right?
Richard (4m 5s):
Markets have fallen and they're still falling. And it's crazy, right? It's like you can't understand it. How can this keep happening? I think I saw some where, I think it was maybe Jeremy Grantham saying like, the volatility in markets is something like 13 times what it should be. All that extra movement in the markets is because it's a model based world, right? A great recent example is Bed Bath and Beyond. Okay? So this was about a month ago. Now, you know, the guy who started Chewy, he was kind of accumulating Bed Bath and Beyond, right? Cumulated like a 10% stake or more. And the stock just soars, you know, in, in like two weeks.
Richard (4m 47s):
It goes from $8 to $40. And then he files something that says, Well, I could sell everything. And then there's all kinds of chatter around that. Oh, he's just setting them up. He's not really gonna sell everything. And the next day he does sell all of his holdings in Bed Bath and Beyond, and the stock goes back down to $8, right? Or maybe it's even lower now. So that whole move from $8 to $40 back below $8 was all part of a model. It was all part of a simulation. Nothing happened in the actual business of Bed Bath and Beyond for it to go up 500% and back down, right? All of that was a simulation. And that kind of simulation is pretty much what we're all doing in the markets almost all the time.
Richard (5m 30s):
And we really need to understand that. Yep.
Phil (5m 32s):
Now it's interesting that you give that as a point because that that's, that's a really good reflection that nothing has changed in the business. And exactly. When investors are putting a thesis together, you've gotta have confidence in your thesis based on what the business and the numbers are telling you.
Richard (5m 48s):
I mean, think back to November of 21, when all after the races, and it was a, it was a new era, right? And we're making new eyes and, and there was a certain model that was driving that, right? And now here we are, it in the doldrums, you know, and, and well these aren't doldrums, they're actually quite
Phil (6m 11s):
Richard (6m 12s):
We're in stormy waters. Yeah. And now there's a new model that's driving valuations, you know, and the model is very fear based instead of greed based. So these are models, The US economy hasn't actually changed that much from November 21st to October 22, right? The changes in the markets don't, I mean, in the underlying economy, haven't justified the changes that we've seen in the markets. And that's because markets are models. And by the way, when you're dealing with models, there are certain parties who have more control over what those narratives are than others.
Richard (6m 52s):
And you know, that's not you and me, Phil, We don't control the narrative of markets. And neither do the vast majority of people that are trying to find their way through the markets.
Phil (7m 4s):
So they wouldn't be the people with the, the yachts in New York Harbor by any chance, would they?
Richard (7m 9s):
They might be some of them, you know, or the Robin Hoods and Citadel Securities doing the payment for order flow stuff. The media of course, which has an interest in essentially a, what I call an addiction based economy. So we live in the attention economy and the main business model in the attention economy is an addiction based business model. And so the things that get us addicted are sticky and the things that get high valuations and get a lot of press and reinforcement.
Richard (7m 48s):
And that addiction happens largely because of the way that narratives can be manipulated and swung back and forth, up and down. And it's in those extremes where we experience the highest dopamine drip. And those are the things that keep us coming back. And that, you know, create eyeballs and revenues and subscriptions and media appearances, et cetera. Right? And anybody who's thinking that they can learn about the markets and start to participate in the markets, you really have to understand this about markets. Cuz if you don't, you know, you're the patsy at the table.
Phil (8m 30s):
So what is your definition of risk then? I mean, you work in the risk space. Yeah. Where's your starting point from for defining what risk is?
Richard (8m 39s):
Well, risk for the most part in financial decision making, I use volatility as a proxy for risk.
Phil (8m 46s):
Is that like the VIX index that we see sometimes in the, the list of indicators?
Richard (8m 51s):
Sure it is, but you can just measure, you know, for any price history, you can measure kind of the way that it varies over time. So something like, say Exxon Mobil or Johnson and Johnson, big blue chip companies, these are relatively low volatility. Something like Bed Bath and Beyond that goes from $8 to $440 and back to $8 in a month. That's very high volatility. So, and that volatility really matters, and it's telling you something about the predictability of the returns that that business might eventually give to its shareholders. So we kind of know what Exxon Mobil and Johnson and Johnson are doing in the world.
Richard (9m 35s):
You know, they're pretty established. Their returns are fairly predictable, not so with Bed Bath and Beyond, right? The part of the volatility is, well, you had this kind of sinking failing company, but now this hero, Ryan Cohen, I think is gonna sweep in and save it and do what he did with Chewy to Bed Bath and beyond. And it's gonna make a ton of money. So you have a very wide spectrum of one, it's going bankrupt to two, it's, you know, gonna be saved by a, you know, a, a caped hero. That's why you get a lot more swings in the prices that people are willing to pay for those future return streams.
Richard (10m 15s):
Volatility is the proxy for risk. It's not true risk, right? There are things that can happen that the volatility will never tell you about, right? Exxon Mobile is not a very volatile stock, but you know, let's say that something happens where new regulations happen, or you know, they have a a disas natural disaster, right? Those aren't things that volatility can predict, but knowing the volatility or using the volatility of different investment streams in your decision making is a really powerful tool for essentially risk management.
Phil (10m 60s):
I was interested to see, I was just looking this morning at the your page talking about histograms. Now, can you describe what a histogram is? And you say that line charts don't really tell you as much as what a histogram is, and it's gonna be difficult in an audio format. But what's the difference with a histogram and what is it that's showing you about a stocks prospects?
Richard (11m 22s):
Yeah. So you're talking about risk smith.com? Yes. Right? Where we focus on helping people to use the lens of risk, aka volatility to better understand their portfolios and to better build portfolios. So most of the time are looking at price data on stocks. Don't tell my mom, but you know, one time she said to me, Hey, your sister's investing in Dogecoin because it's cheap, right? And Dogecoin at the time was like 75 cents. And I said, Mom, if you add up all the Dogecoin in the world, it comes out to like 75 billion.
Richard (12m 7s):
So Doge coin isn't cheap and Dogecoin doesn't do anything right now, and there aren't really many prospects for it to do something in the future. So we can't call something cheap just because it's price of 75 cents is cheaper than say, you know, what's the price of Berkshire Hathaway a share? Berkshire Hathaway is like some hundred to thousands. Yep. $250,000 or something, you know, But which one's cheaper? Right? One's actually giving you a return stream and the other one isn't. So I think that price data can be very misleading and it's also really gets us kind of caught up emotionally in a lot of different ways.
Richard (12m 48s):
So histograms aren't looking at kind of the, the price over time. It's looking at kind of how prices change day to day and giving you a picture of the volatility of the stock. Okay? So you've probably heard of the bell curve. Something that is normally distributed or has kind of a bell curve distribution is something that, you know, you have kind of the most frequent occurrences are in, right in the middle, right? The average man is five foot 10, you know, you have a few less that are five foot 11 and a few less that are six foot or five foot nine on either side of the piece.
Richard (13m 30s):
And then you have
4 (13m 30s):
Richard (13m 31s):
Then you have Shaquille O'Neil out in the tail, right out at the very end. You can do the same thing with how prices change. So on any given day, you know, a price can change like zero to 1%, or 1% to 2%, or 2% to 3%, right? Or zero to minus 1%, minus 1% to minus 2%. And those are buckets. So you put all of your percentage changes on a given day into one of those buckets, right? And you end up with a distribution of how the prices change. So something like ExxonMobil, Johnson and Johnson, most of their changes are gonna be between like zero and 1%, or zero and minus 1%.
Richard (14m 14s):
So you'll get a peak right in the middle. But if you're dealing with something like Dogecoin every day, it's usually changing 5%, 10%, sometimes 20% in a day, Okay? So you're not gonna have, you know, a nice peak in the middle with nice sloping lines down to the tails. You have what are called fat tails. All the changes are in the tails. You got, you know, big tails with like 10% changes up or 10% changes down. So a histogram lets you visualize this very easily. And so you can see right away, you know, am I dealing with something that is normal, that is kind of fit in with kind of my expectations of how things change, right?
Richard (14m 57s):
Because the normal distribution is called the normal distribution because it's what we experience as normal, right? You don't expect to have a huge number of tall people and a huge number of short people, right? You expect to have an average height and then, you know, kind of sloping down on both sides from there to in the tails you have, you know, very few really short people and very few really tall people. This is the way the world works, right? So when we get into these distributions that aren't normal, they're actually called bimodal that have fat tails. Okay? I don't know if Nasim tole coined the term Fat Tails or not. I don't think he did, but he talked about Black Swans
Phil (15m 37s):
And which is a fantastic book that I'd recommend to.
Richard (15m 40s):
It is a fantastic book,
Phil (15m 42s):
Listeners that change my view of the world. Yep.
Richard (15m 44s):
Most of the things that are attention get drawn to by the media are things that have fat tails. Okay? They're things that are more volatile because it creates a lot of churn, it creates a lot of transaction, it's exciting, it gives us the dopamine drip and a histogram. Lets you see at a glance, am I dealing with something normal or am I dealing with something abnormal? Unfortunately, abnormal has become the new normal. And it's because again, we live in, in the attention economy, and the main business model and the attention economy is addiction.
Phil (16m 18s):
And the main business model of Wall Street is turnover,
Richard (16m 22s):
Churn and transactions. And yeah, so Robin Hood, supposedly they are here to democratize investing from day one. They've been making money by selling your orders to wholesale market makers like Citadel Securities and getting paid for that. That's how they make money, okay? And not only do they get paid, but they get paid a percent of the spread between the bid and the ask. So what does that mean, right? If you're gonna buy a security, there's a price that somebody's willing to sell it for, and there's a price somebody's willing to buy it for, Okay? The price that somebody's willing to buy it for is the bid and the price that somebody's willing to sell it for is the ask.
Richard (17m 4s):
The difference between the bid and the ask is the spread. So a spread in Apple is gonna be very, very small, a fraction of a penny. But a spread in Game stop is gonna be a lot wider, especially when Game Stop was hitting 400 bucks. So maybe it was 3 95 to 4 0 5, you know, I don't know what it was. But then you have options. So a spread in an options on Game stop, a call option or a put option on Game Stop is huge. So Robin Hood is highly incentivized to teach you how to trade options and to put options in front of you because they make a percent of the spread, right?
Richard (17m 46s):
So the more illiquid and the more volatile the instruments that Robin Hood gets you to transact in, the more money Robin Hood makes. This is not democratizing investing, this is monetizing addiction because those things get you into a psychological loop of, you know, fear and greed and, and dopamine drips that ultimately get you stuck and get you coming back for more. Run down your account, by the way, and then you go refund it with new money. And that's the business model. And it's really a disastrous business model for the end user, right?
Richard (18m 26s):
But Robin's users are not their customers. Their customers are the market makers, citadel, virtue, et cetera, who pay them, just like with Google, right? We're not Google's customers, we're their users. Google's customers are the big advertisers that Google uses the data on its users to help change their user behavior to give a better result to the advertiser. So Google's in the behavior modification business with data, right? To ultimately serve the needs of its customers, which are its advertisers.
Phil (19m 1s):
Armed with this kind of information that you're describing, how would you suggest beginners in the stock market change their mental model to start thinking about how to become better investors?
Richard (19m 12s):
So you really have to think about risk, which is why I'm building risk. This is what
Phil (19m 19s):
We're here to talk about
Richard (19m 19s):
Today, trying to teach people about this, right? And so, I mean, just so you know, it's not just me. There's a famous author, Jack Swagger, who wrote a set of famous books called The Market Wizards. So for, I don't know, 30 years now, Jack's been interviewing really successful market participants and kind of writing up stories about them. And I interviewed Jack Swagger a couple years ago, and I asked him, What are the market wizards all have in common? And he said, Oh, nothing. I mean, they're all completely different. Their systems are totally different. Their, you know, their time horizons are totally different.
Richard (19m 60s):
I mean, no two of them are the same, but they are all pretty religious about risk management, okay? So even Jack who inter has interviewed all these market wizards thinks that risk management is something secondary to the primary driver of success, which is your unique system or your unique approach.
Phil (20m 24s):
You're saying he didn't even recognize it, that that was the common thing. I
Richard (20m 28s):
Think he recognized it. He thought that was kind of an accident almost. So I believe that risk management is the primary concern, the primary tool that individuals need in order to be successful. And I'm not talking about just kind of buy and hold an index fund for 40 years in your ira, right? That's a, that's something different. If you're gonna be active in the markets at all, you need risk management, you need it. Because the main thing that happens to us as novice investors in the attention addiction economy is that we keep getting pulled into positions that we can't sustain.
Richard (21m 14s):
And by the way, those positions can be both on the over leveraged side as well as the, I'm completely out of the markets and I'm not participating in this side, right? So they, it gets us into these, this polarized state, this bimodal state, meaning you have two peaks, okay? That's where you get in trouble because that's where you get forced into radical decisions that are reactive instead of proactive. So in order to be strong hands, in order to be in a proactive position in the markets, you have to understand your own risk tolerance, How long you have to leave your, put your money at risk, how much risk you're likely to experience, and that you are gonna get a reward for the risks that you're taking.
Richard (22m 6s):
So the markets pay for risk taking, the markets exist because corporations have risks that they can't fully manage themselves. So we can earn a return in the markets by taking on some of that risk, right? We put our capital in the markets and get paid based on the risk that we're willing to assume and hopefully holding on long enough to get rewarded for that risk that we take. But people don't understand that this is the, the nature of investing, this is what you're doing as an investor. You're putting your capital in the markets, you're agreeing to kind of take on the risk that the corporations want to, you know, offload to somebody else, right?
Richard (22m 55s):
And then you need to get paid for taking on that risk. So starting to view the markets, which are really models now much more than reality, right? What's dry? All these models behind the scenes that institutions and hedge funds are using, they're creating volatility and risk based markets. Yes, the real world does intervene at times like an invasion of Ukraine, for example, Inflation. Inflation. But you have to be able to survive in the markets long enough to thrive. And that comes from risk management.
Richard (23m 35s):
You know, early on when I was first learning about investing a mentor, Jake Bernstein, I asked him what separates the winners and the losers? And he said, the winners don't need the money. And I thought about that for a long time, you know, and I thought, Hmm, okay, the rich keep getting richer and the rest of us keep getting the shaft right? But over time, I came to see that we can all put ourselves in a position that we don't need the money, right? It's when you get put under pressure because you're not positioned in the markets in a way that you don't need the money, right? So people ask me right now, Oh, you know, the market's fallen so much, is it too late to sell?
Richard (24m 17s):
You know? And I say, Well, it depends. If you need the money in the next six to 12 months, then you better sell because it could easily fall more, right? If you don't need this money for five or 10 years, then no way this is a terrible time to sell. Hmm. Right? So we have to know what our risk tolerance is, what our time horizon is. We have to view the data in the markets through the lens of risk instead of through these crazy prices that you know are being thrown at us all day long that don't make any sense. They actually are nonsense. We need to be in a position that we don't need the money. That's how you win. You win if you don't need the money.
Richard (24m 59s):
And you can take smart risks and you can leave your money in there long enough to have a good shot of earning a reward for the risks that you take. So that's a totally different lens through which to assess investing and to build a portfolio. And there's lot, there's a few other pieces that we haven't talked about that we can maybe get into some other time, but it's a much better lens through which to understand and participate in the markets in a way that you will ultimately come out ahead.
Phil (25m 30s):
And what role does diversification play in that? And what is actually true diversification? Because it's quite a wooly concept that is not often well understood.
Richard (25m 40s):
Yeah. Well, diversification reduces your risk and it reduces your risk. And when we're talking about risk as volatility, okay? So if you are diversified, well, the thesis is that sometimes some of your investments will be going up while others are going down, right? And then sometimes that'll flip and another set will be going up while the other set's going down. So overall, you want things to all be going up, but to be going up and down at different times, right? So Ray Dalio famously said, The holy grail of investing is 15 to 20, good meaning going up, uncorrelated, meaning they don't all go up and down at the same time, return streams, Okay?
Richard (26m 29s):
Diversification means that all your eggs aren't in one basket. If you're all in tech stocks like many people are, right? Then those tech stocks go up and down together. But if you're in some tech stocks and you're in some utilities and you're in some muni bonds or treasuries, and maybe you're in a little bit of Bitcoin or some other cryptocurrency, that's a diversified portfolio. Now, the environment we're in right now, diversification isn't really helping because there are times in the markets when as they say, all correlations go to one.
Richard (27m 9s):
And so right now, both stocks and bonds are falling, even though stocks and bonds are traditionally uncorrelated. So lots of people who you know, thought they were diversified in say, a 60 40 or a 70 30 allocation to stocks and bonds, all correlations go to one. And stocks and bonds are both going the same direction. Your diversification doesn't work. But in general, diversification does help most of the time. It's just when markets get into these kinds of cardiac arrest kinds of states that you just have to hold on and make sure that you don't need the money.
Phil (27m 48s):
So how can listeners find out more about Risk Smith and your sub stack discord and many other channels?
Richard (27m 56s):
Well, risk smith.com, R I S K S M I T h.com is where you can learn about Risk Smith. And then you can follow some of my writings, which can be a little more philosophical at email@example.com. So Dr. Richard smith.com.
Phil (28m 14s):
Richard, thank you very much for joining me today.
Richard (28m 17s):
Thank you, Phil. It's great to speak with you.
Phil (28m 19s):
If you found this podcast helpful, please tell a friend, especially if it's someone who needs to start thinking about investing for their future, you'll be helping them and helping me to keep their show on the road.
Chloe (28m 29s):
Stocks for beginners is for information and educational purposes only. It isn't financial advice, and you shouldn't buy or sell any investments based on what you've heard here, any opinion or commentaries, The view of the Speaker Only not Stocks for beginners. This podcast doesn't replace professional advice regarding your personal financial needs, circumstances, or current situation.
Phil (28m 48s):
And thank you for listening to my podcast.
Stocks for Beginners is for information and educational purposes only. It isn’t financial advice, and you shouldn’t buy or sell any investments based on what you’ve heard here. Any opinion or commentary is the view of the speaker only not Stocks for Beginners. This podcast doesn’t replace professional advice regarding your personal financial needs, circumstances or current situation.