#7 - Vineer Bhansali: Tail Risk, Investment Lessons

27:05For instance, I'm sure you've experienced this like I have, that everybody says if the market goes down 20 % or 30 % or 40%, I'm going to buy X percent more stocks. But we've seen in many episodes that when the market goes down that much, either people get frozen, they don't do anything, or worse still, they say, well, this is different. Let's sell. So they actually sell, they liquidate. And inevitably, the market turns around and starts rallying. And that mistake then gets locked in. So there's ways, there's tools, and that's just a very human response function. There's nothing wrong with it because it's a survival mechanism.

27:41But there are tools that allow you to effectively cancel out the more egregious parts of that heat of the battle, pepper decision making. So, you know, one thing that I have learned is actually building enough guardrails and enough constraints in your process so that you'd never get to the point where you are actually making large, consequential, irrational decisions just in the heat of the moment. Yeah, protect yourself from yourself. Exactly. That's exactly right. Protect yourself from yourself. And again, yourself doesn't mean just you as an individual. I've been on a number of investment committees, and it's entirely possible for investment committees and a group of very smart people all to do this, even though they're independent people.

28:25But, you know, the group think in moments of fear actually ends up dominating a lot of the rationality. Yeah, there was a famous quote by Mike Tyson. I'm sure you've heard it. You know, everybody has a plan until they get punched in the face. Exactly. And then the plan changes. How do you define tail risk? I know it's a subject that you've spent a lot of time on and worked in and written about. And why build a firm around this notion of tail risk? Again, it's one of these things which is very hard to precisely define. Of course, when we build portfolios, tail risk-hatching portfolios, we're defining parameters like horizon over which a big loss can happen, likelihood of losses, and attachment points, i.e.

29:09the magnitude of the losses, and so on. But it's not, again, like risk in general. It's not one definition for everybody. So tail risk obviously changes. Somebody who's got a lot of equities might have tail risk related to equity markets falling. somebody who's got a lot of bonds might have tail risk related to inflation rising, for instance, the last couple of years. So again, it's very hard to define it as one type of risk for everybody. But at a very high level, the way I think about it is a low probability event that has a large enough severity that it can impair your decision-making process, right?

29:44So that's a very high level abstract notion is that you have a plan. Every institutional investor has a plan to do something, but an event happens, which is not in your statistics, or you're not looking for it, that is such large magnitude, that again, like we were just speaking about before, it throws your plans temporarily, or maybe semi permanently out the window. So how do you manage against that? But to me, tail risk is, once you come from this framework, it allows you to create strategies, hedging portfolios. Like you said, I spent pretty much my whole financial life doing this to mitigate the impact of this very severe low probability event.

30:28And I'm curious, why do you think these tail events happen in the first place? And is it something that's predictable at all? So that's, again, a great thing to think about. Again, I spend a lot of time thinking about it, Not just, you know, in the context of finance, but also in the context of things like earthquakes and hurricanes and physical phenomena and so on. So why do they happen? I think typically they happen because of some sort of instability that is brewing inside the system that gets magnified, right? So what does that mean? In the financial markets, what that means is there's something that's distorted.

31:02So let's take an example today, for instance, inverted yield curves. Inverted yield curves is what I call sand in the machine. And I've written a number of pieces about this on Forbes and other places. But the financial system works because there is a cost to lending money for longer. You borrow money and like a bank, you borrow money short, you lend it long and you make a carry. So our financial system is basically based on this idea of having carry, the fact that there's compensation for putting your money out. investors who invest in large capital projects do that because over time, they expect that long-term projects will return you more than short-term risk-free rates.

31:46Now, today, the curve is inverted, which means that there is negative carry in many different areas. There's negative carry in the bond markets. There's negative carry in the equity markets. One way of looking at it is saying interest rates are higher than dividend yields, which means that equity markets today are basically pricing in forward equity rate or prices that are much higher than spot. And you can go look at currencies and other markets. So what ends up happening is when the system gets into a situation for good reasons here, the good reason is rates were very low, they were negative.

32:19Central banks ease policy, they created inflation, then they have to step on the brakes, jack up short-term rates, but long-term rates haven't gone up very much. So you are in this artificial, somewhat unsustainable situation, and you take this situation and combine it with the inherent human tendency to take risk, i.e. leverage, when leverage doesn't work very well in a negatively yielding environment and in an environment where there's too much leverage and when volatility is very low. So tail risks happen because of a number of things, right? The first is distortions that come from macro events, which is, I described one case here.

32:56Another reason is complacency. So you look at volatility levels today, even though the market is at its highs, implied volatility, if you measure by VIX, is basically pre-2008 crisis levels, almost extremely low. And then the third is leverage and this thinking that nothing can go wrong. When you combine this, the original two drivers of investment movements or market movements come in, which is fear and greed. People end up going in the direction of buying too much at the wrong time. When the market's turned, they end up selling it, liquidating it, fear and greed. So tail risk happened because of the confluence of market distortions, pricing, too much leverage, too much complacency, and then people's dynamic tendency to not take too much pain, whether it's on the side of liquidating assets or buying assets if their neighbors are doing very well, being long to equity market or something like that.

33:57So it's going to keep happening. In my view, is it predictable? It's not predictable in the sense of point estimates, just like you can't predict earthquakes precisely. But the way I look at it is the hazard rate, the likelihood of something bad happening, you can forecast with a relatively high degree of accuracy. Just like a good analogy would be if I'm out today in California driving, you know, it's a nice dry day. It's no rain. It's not very slippery. Driving, you know, it's probably fairly safe today in terms of these weather conditions. But you take that same car, same driver, put them in an icy road, you know, in Minnesota in the middle of a storm and low visibility.

34:41Now, you know that the same conditions, the same actions could result in a pretty nasty accident. So in that sense, my behavior doesn't predict tail risks in California, but it certainly predicts the higher likelihood of tail risks in Minnesota on a cold, wintry, stormy day. So I think, yes, environmental conditions, market behavior, if you put them all together, investors who've been doing this for a long time, like myself, sensing cycles turning, start sensing damage potentially. This morning, we saw news from New York with the implosion of a bank that got effectively bailed out last year. Today, the stock price dropped by 50 percent.

35:23So those kind of signals come out of nowhere. And for somebody who's been paying attention, those battle events are somewhat inevitable. The thing that I think is really interesting and I guess in some ways unique about the markets relative to the rest of the world is market pricing is impacted by investor sentiment. sentiment, right? So it's like that example that you just explained about driving in, you know, sunny California versus driving in freezing Minnesota. It's almost like if you had the drivers in Minnesota feel like they were driving in sunny Southern California, and they were driving like it's sunny, but because they don't see the ice and the snow, in some ways, the risk is elevated even beyond what the conditions would suggest.

36:09And then as an outside observer, if you have that perspective to see that these people are viewing it that way, you may have even better insight into the risks of some catastrophic event. Correct. That's right. Yeah, I completely agree with that. And there's many various cases, right? So we saw back in 07-08 before the financial crisis, and I was at PIMCO at that time, and my colleagues, famously Bill Gross and others, saw what was happening in our Southern California housing market. And they saw it is not the rates doing what they're doing and amount of credit and what people are doing. These are not normal situation, not normal conditions.

36:45And at some point, this is a very slippery, dangerous road to be in. So we tightened our seatbelts, we got off the road, so to speak. And of course, you know, we missed a good fraction of euphoria for a few months. But then when the fact-tale event happened, it was so large that anything that you had left on the side of the table, on the side of the road, didn't really matter because the losses were so significant. And you made a very important point, which is the timing is not, you can't get the timing right. And if you did, you maybe just got lucky because so much of it depends on factors that you can't predict.

37:23So you could be two years early and look like an idiot for a long period of time until you're proven right. So that's one of the other challenges in markets. 100%, yeah. Yeah, that's why, I mean, just to echo that, yeah, we say forecasting the probability is not as important as making sure that you control the severity, control the damage from the severity, right? Because if there's a knockout punch, like we started this conversation with, that can take you out of the game, it doesn't really matter if you've got the probability right or not. If it knocks you out, it knocks you out, you're out.

37:53So never, or try never to let that happen. In terms of hedging that tail risk, why don't we begin with just a conceptual discussion question about how investors can at least think about hedging that tail risk. Yeah. So, you know, we are our approach and this is a framework that obviously has developed now for me over the last 30 something odd years I've been doing it, is that it's, you know, I'd like to distinguish the approach from the tools, right? So there are tools like we'll talk about options and futures and derivatives and all that kind of stuff from the approach. Those are of these implementations that some people like certain reliability or some people don't.

38:36But let's go to the framework. What's the framework? The framework is that if you look at your full probability distribution and you're not willing to take a loss of a certain magnitude, then you need to do something about it. And in the marketplace, there's various things you can do. You can look at very simply. First thing you can do is use diversification. So you've written books on this topic. Risk parity is a great example of balancing stocks versus bonds based on correlations and so on. And it's worked beautifully as long as that correlation is negative and there's not the risk of deleveraging in the fixed income side.

39:10Then there's other tools like trend following, CTAs. I mean, those are other techniques that are conceptually techniques that allow you to systematically, without being subject to behavioral biases go away from the mean reversion, mental bias to just try to catch a falling knife, so to speak. So trend following or CTA strategies also help in terms of diversification. Then you have things like using explicit options that I talked about or having cash or a few other things, alternative risk-breeness strategy and so on. So these are all part of the framework. And the framework really relies on taking a look at your existing portfolio plus what you could do such that the total distribution of the portfolio is basically within the realm of what you are actually trying to do.

40:01You go from that approach. Once you've done that, you say, okay, what are the most efficient liquid tools and in what combination? So some of the things I mentioned, for instance, risk parity, how much should risk parity, risk rebalancing should you do? How much trend following should you put in there if that's something that you're interested in, how much explicit optionality, how much cash. And that balance you can now evaluate because each one of these approaches or tools that I just described is in a form of taking exposure to an unforeseen event that is accompanied with volatility rising.

40:36So our framework relies on saying, what is everything out there in the toolkit that an investor can put in their portfolio? How do you combine them together such that the net portfolio, including what the investor already has, plus this new stuff ends up in a better place. So that's our framework. There are occasions when an investor might have a lot of equity risk and for whatever reason, they don't want to suffer a drawdown and they want the hedge to be extremely reliable and extremely cost efficient. We would recommend options, even though we know, generally speaking, options will cost time decay and bleed and so on.

41:12But that's like buying insurance, because that will actually protect them. There are times when investors say, look, I'm not worried about the reliability. I just don't want to spend too much money. In which case, we'll direct them towards more internal diversification or de-risking their portfolio or putting more money into cash. Right now, that's a great strategy because cash is yielding 5.5%. So if you're willing to give up a little bit of your risky portfolio, you can get pretty solid protection against risk while getting 5%, 5.5 % yield on a simple treasury bill. And I'm curious, what are some of the mistakes you've seen investors make when trying to protect their portfolio against some of these tail risks?

41:55Yeah, probably the biggest one I have seen is not thinking of this as a part of, quote-unquote, doing business. Meaning if you're an investor, just like if you're sitting on the coast of or living on the coast of Florida in a hurricane or you live in California, we all have earthquake insurance here, thinking of having some sort of protection, whether it's through explicit options or trend following or risk parity or other diversification strategy, as a luxury rather than a necessity. And if you don't think of this as a necessity to long-term performance, and there's a lot of literature, including some of our own research that shows that if you create a robust portfolio and you make really not great decisions, but reasonably good decisions, the compounding will create a lot better profile of wealth growth.

42:44What investors tend to do is not protect, not take that important decision of saying, manage risk when managing risk is cheap like it is today. But then when the bad event happens, surge towards buying hurricane insurance after the storm or earthquake insurance after the earthquake. So this pro-cyclical behavior in terms of balancing the portfolio results in generally suboptimal portfolio construction. And as we both know, if you just bought the stock market, just hung on to it and done nothing, you would end up pretty much beating pretty much any investment that's out there. But if you bought the stock market levered, you would have such significant drawdowns that you would probably not be able to take the pain.

43:31So what's the counterbalance? The counterbalance is just take enough risks so you don't get liquidated. If you have too much risk, you think, that you can't handle, then think about it in times like today and saying, what am I going to do? Not what I want to do, but what am I actually going to do in a bad event? And then is there something I can do to save myself from myself in that bad event? And I think that's the biggest psychological mistake that I've seen happen repeatedly. I mean, some other mistakes are legendary where people buy hedges, they don't cost too much money cumulatively over time.

44:07But then right before a big bad event, they decide that they don't need it anymore. And then they shut it off. And then, of course, the big bad event comes knocking on the door. So having a plan, not sticking to the plan, abandoning the plan at the wrong time is probably the biggest mistake. And all of this relates back to our earlier conversation about risk being a concept that is just so widely misunderstood. It's hard to grasp because it's not always apparent. And what's interesting about markets, and this also relates to our discussion about pricing, when risk protection and tail protection is cheaper, it's probably because backward looking, there hasn't been a need for protection.

44:54Investors generally don't think they need protection. So the price falls. And at the same time, the risk is probably greater and vice versa, right? After the big event, the cost of protection goes up a lot and you probably needed less than than you did when everybody was complacent and not worried about the risk. Absolutely. And yeah, and again, like you said earlier, the wonderful difference between markets and science like physics is that we create in markets, we create our own stories and our rhetoric and our actions create the markets that we then have to live with tomorrow. The very dynamic, the feedback loop is extremely important here, right?

45:30And so when volatility is low, that typically means that asset prices are high. Asset prices are high means yields are generally low, which typically means there's strategies like volatility selling, which we talked about a lot in 2018. I wrote a paper right before the XIV debacle. This is even prior to COVID when every academic and every practitioner was talking about how amazing the Sharpe ratio of all selling is. And you have ETFs invested. So everybody got on that bandwagon just at the wrong time. And, of course, when in whatever February or March of 2018, when the market blew up, people found that there was lurking risks because of the behavior of people.

46:16that just amplified, you know, the potential factales. And I think that's very important. It's always step back, you know, try to think for yourself, I guess, and say, you know, what could it be that everybody is missing here that maybe, you know, I might have a slightly better handle on. And, you know, for me, fortunately, I've always been a little bit, maybe because of my physics training or whatever, I've always tried to do some of the thinking for myself from scratch. and it's very tedious, but all that's being equal, it's generally kept me out of trouble, I hope. I hope to do so, yeah. It sounds like it has thus far.

46:55Let's talk a little bit about tail risk hedging and the cost. So if you're buying fire insurance for your house, it has a negative return, right? It has a cost of insurance. Would you talk from a high level, just conceptually, how can an investor hedge the tail, the risk? but do it in a way that actually doesn't have a cost over time? How does that conceptual framework work? Yeah, so I mean, there's various ways of looking at it. The first one I'll start with is just this accounting identity, which is right to the cost that you spend on hedging. Let's say you have some option premium. You have to control it.

47:30You can't go crazy. You know, if you're earning 6 % on your portfolio, you can't spend 3 % on tail risk hedging. You want to spend a small amount, call it 50 basis points, whatever the number is. Now, if you don't have any equities, if you're sitting in T-bills, then you don't need to hedge. You should not hedge because you don't really have much market risk. You might have inflation risk, which is a different kind of tail hedge you might need. But generally speaking, most investors have 60%, 70 % in equities, and many of them have a lot of embedded capital gains, obviously, that they don't want to realize.

48:01And so if you spend a certain amount of premium, called 50 basis points or so today, over time, it allows you to stay in your portfolio. So you're spending money, yes, but if you put it together with the fact that you are invested in the market and the markets generally tend to go up, then the cumulative return over time, risk-adjusted cumulative return actually goes up. And we've done a lot of studies and tests of it. So the first thing you can do is when you look at the cost, don't look at the hedging costs myopically, meaning just year by year, and the return on your underlying equity portfolio as a multiple year long portfolio.

48:37take it, combine it, put it on the same horizon, the long-term horizon. That's number one. Number two is there are occasionally events. And today is a great example. I'm very curious how you came up with this question because today is a very interesting time where you can actually do something. And I've written a couple of pieces on this recently. If you have an equity portfolio, you can actually tilt the risk reward for it for essentially no cost, right? So what am I talking about here? So just options market for a second. So today, the S &P 500 is, you know, call it around 4 ,900. And if you look at the dividend yield on S &P 500, is about 1.5%.

49:19Interest rates are about 5%, 4.5%, 5%. So what that means is that interest rates are higher than dividend yields. Now, what that reflects into in the pricing of options today is that if you look at a one-year option, a call option, let's say, on equities, it's the forward rate, the implied rate for the S &P 500 is basically higher by that difference between the dividend yield and the interest rate or interest rate and the dividend yield. So the forward break-even S &P price is much higher than it is today, which says today you're in a situation where you can, for instance, just an example, sell a 10 % out of the money call on the S &P 500 and buy a 10 % out of the money put for net premium in, meaning you can insure your hedging portfolio, insure your equities, if that's what you're interested in hedging, down 10 % for one year without any cash out of your pocket by just selling covered calls, so to speak, on the S &P 500, 10%.

50:21So you keep 10 % of the upside and you lose no more than 10 % ad expiration. So that's a very interesting situation where you can create these tilts using option markets where you can actually create a better, safer, at least safer outcome for very little premium out. And the last part I'll just say, one thing about the cost is if you have tail risk protection, let's say like an option, what tends to happen is when the markets fall sharply like they did during COVID and you have a disciplined rule for monetization, i.e. you sell those options in the marketplace. Unlike traditional insurance, obviously you can sell options in the marketplace.

51:01You can take that capital, which is now much larger because of the crash, the value of the options has gone up. You can redeploy that capital into the stock market. Now, if you think about what we're doing here is just rebalancing, rebalancing back into stocks when stocks are down, which then allows you to capture the rebound. And if you believe in capitalism like I do over the long run, then yes, that rebalancing when things are cheap ends up resulting in net cumulative gains over time. So that's also been demonstrated to be a net value add. But the common theme, the common denominator between all three of these things that I mentioned, holding your portfolio, being able to sell something to finance, but or the rebalancing part of it requires individuals to have a longer horizon that you can't just look at month to month, day to day, week to week.

51:53You have to think about your portfolio over a long-term holding horizon, right? Which comes back full circle to where we started. It is like a race. It's a marathon. It's an ultra marathon, not a sprint. Investing is very much like a long-term race, which is why you have to plan things out and then deploy your capital carefully. And then recognize what your biases and blind spots are. Absolutely. And oftentimes people make decisions based on emotions. And in my experience, the clients and the investors who are less sophisticated in this space, they'll make emotional decisions because they just see losses and they have to respond.

52:30They have to do something about it. The more sophisticated investors, they actually end up making the same decisions, but they justify it with analysis, but they end up in the same place oftentimes. You can always rationalize your moves. So it's really interesting how these cycles just repeat over and over and over again. Absolutely, yeah. Do you feel that, you alluded to this a little bit earlier, do you feel that every investor needs tail risk hedging? And as an investor, how do you know whether you need to hedge against those tails? Yeah, that comes back to this question. If there's any risk in your portfolio, whether through your own analysis or through, you know, more quantitative analysis or something like that, where you feel that there is an event that can happen that could significantly impair your ability to make good decisions or to fund whatever, or, you know, pay your distribution, whatever it might be, then you need to have risk heading, right?

53:26So the question comes back, there's no general one solution, but if there is an unforeseen event that can happen in your portfolio that you believe could be so damaging that you wouldn't be able to make good decisions or you wouldn't be able to recover from it, then yes, you need tail hedging. I can't say everybody needs equity tail hedging because clearly not everybody needs it. Somebody who's put a portfolio of 20 % equities and just a lot of T-bills, and they're never going to look at it, they don't need tail hedging on equities because there's no event under which they're probably going to be, you know, forced sellers.

54:01So when I talk with friends and colleagues and, you know, other investors, you know, in some of our strategies, I always tell them, you know, the whole goal here is never get forced, never get forced because of things outside your control to make bad decisions. And if you think you're going to get forced, that means you probably needed something. You needed some hedge of some sort. Are there any specific market or economic tale events that you're contemplating today, given the world in which we live? One thing that has been on my radar screen for quite a while, and this alludes, comes back to this idea of negative carry across bond markets and equities and so on, is this idea that our financial system, especially the banking sector, doesn't work very well when there's negative carry.

54:50Now, what does that mean? It just means that if the cost of deposits for most of those banks is high, which it is today because rates are quite high, and the cost of deposits is higher than their assets. And many of these assets become non-performing, like it could be commercial loans, like we just saw this morning from the announcement from one of the banks. Then you are running in a place where on your portfolio, you're not getting any income. But at the same time, if some of those assets get impaired, then you end up in a situation where, A, you have negative carry, and secondly, your valuation of your enterprise goes down.

55:28So to me, one of the big things that could emanate or come from this negative carry in the markets is the second round of banking sector problems. Now, the setup is almost perfect in a way. I'm not saying that we're going to get a banking system crash because after what the Fed did last year in March, where they effectively gave that long-term loan to the banks, banks were sort of bailed out. And today, there is no real sign of banking sector troubles or crisis, at least until this morning. The economy seems to be doing fine. The Fed doesn't seem to be worried, but the underlying frictions are still there and the volatility is very low.

56:09So this is almost a perfect setup for something bad to happen. So it's very much on my radar screen because again, having done this for 35 years, these are the kind of situations where, you know, put up the alarm bells for us because this is typically when big moves can happen without very much warning. I know you've spoken and written about one of the biggest investment lessons that you've learned is to not automatically follow the herd. Would you talk about that a little bit? Yeah. So, you know, it comes back to in my training as a physicist, maybe, or, you know, going back to maybe even my childhood years is actually try to analyze and just try to do everything, you know, step by step yourself and figure out what the assumptions are.

56:53And in investing, it's so easy to take the latest piece of literature or take a formula that somebody has written up and use that to make a decision or look at a money-making strategy that cannot go wrong. And there's lots of them that are advertised to everybody, which obviously go wrong. So, you know, from my perspective, all that means is that there's no substitute for thinking for yourself. And typically when the herd is doing something, you know, you have to be careful. You can't fight the herd because, you know, trend following and momentum is basically herd. But you also need to know, you know, what are the assumptions that the herd is making that can change?

57:37Now, obviously, we don't always know that. And I've made my mistakes for sure, you know, in my 30 something odd years. But the idea is to always say, what are the underlying assumptions? How do these assumptions, you know, come under challenge? And then how do you make sure that you're not one of the ones who gets run over when the herd decides to change your mind? So I think, you know, generically speaking, the more analysis and modeling and thinking, whether it's conceptual or quantitative, one can do for themselves, the better, the more likely that the decisions are going to be more robust.

58:14I guess, in other words, you can observe what the herd is doing as one data point, and then you can independently think about it and analyze it and see if it makes sense. and oftentimes it does make sense and many times it does not. So you're not just automatically following, but you're doing your own analysis. Absolutely, yeah. Yeah, I think that makes sense. Given your science background, I'm curious what you think about AI and machine learning and the potential impacts on investing. Is this going to change everything we do or is it just a small change in the grand scheme of things? I'm still observing it like most investors are.

58:52and I haven't made my own decision. Now, what we have done is self-selected a field, as you probably could say, this field of tales and rare events where there's not much data. So AI and machine learning, as we know it today, at least, relies on having a lot of statistical data from which you can make good, robust quantitative conclusions. Now, my view is that it's a technology that's here to stay. And it's been around for a long time in different forms, right? A lot of the technology that we have looks better now, does more things because the computational power and the algorithmic development that we've seen recently are way beyond what people saw back in the 60s or 70s when, you know, AI and machine learning and other things kind of made its first appearance.

59:39So I think it exists. And I think like other experiences in the past, some of the more simpler stuff will get commoditized, right? So things where if you have a stock portfolio and a bond portfolio, what should be the optimal allocation? I mean, that's now commoditized business. You just need to run mean variance. So I bet you I could just go to one of the GPTs and say, create for me an optimal portfolio using Markovic mean variance. And it'll probably come back with the right answer is my guess. But that's just commodity, right? That's just elevating common human knowledge to a new level. So does that mean it's permanently life-changing?

1:00:19Does that mean that investors or investment managers or decision-making will be relegated to the machines? I don't think so. I think as long as there's humans with fear and greed, we're just going to find a different level playing field where everybody's got AI, but we're going to be making different kinds of maybe higher level errors and mistakes. And there'll still be a lot of opportunity for people who are able to take the new technology and other tools and thinking for themselves and succeed at it. So I'm not there yet. Until we reach the plateau where everybody's a Terminator lookalike and everybody's a machine, I don't think investing is going to go away, right?

1:01:06I could sort of imagine myself sitting 5 ,000 years ago, you know, when perhaps the first trading between, you know, the ancient humans was invented and somebody saying, you know, look, when we invent fire, does it change everything? And will investing go, you know, will we have a job? It didn't. I think, you know, technology improves and people just elevate themselves to a new level. So I'm of the belief that we'll still have a job. Well, the market is competitive. So if you go to an extreme and you go from a world where there are no computers trading, you know, so 30, 40 years ago to a world where it's only computers trading and they're trading against each other, it's a competition.

1:01:50And I don't know if the returns increase, maybe the tail risks increase. You know, so it's not clear that you just generate more alpha. It's not clear that it's necessarily better because it's a competitive field. Absolutely. And like you just said, when machines are making markets, we've already seen that since I started trading 30-something odd years ago to even the last few years is when there's a large move in the markets, including during COVID, the depth in just even the E-mini futures contracts just evaporated because a lot of the market making was being done by algorithms, by bots. Think of them as precursors of a lot of the algorithms we have today.

1:02:29So, yes, it could be volatility enhancing if most of the actual high frequency market making is actually being, you know, being done by bots. And, you know, one other thing that kind of resonated with me when you said this thing about if everybody's using computers. So, you know, as an aviation person, you know, I've studied a lot on how, you know, the defense industry or, you know, the U.S. and the Soviet at that time raced to outdo each other. So back in the 50s and 60s, when we first broke the supersonic and then the hypersonic barrier and planes were flying at Mach 5, five times the speed of sound, there was this absolute crazy scramble to making faster and faster and faster machines.

1:03:16Everybody said, if you have the faster aircraft, you're going to win the war. And the people were making these extremely fast machines. And it was a beautiful book written by, and I recommend it to you and to your readers, about Colonel John Boyd, who was a tactician for the Air Force and then for the Marines. And he basically came up with this, maybe he and others obviously came up with this idea that speed was not the only thing, agility was just as important. So at that time, I think the F-16, which is one of the fighter jets that's still in the Air Force, was invented. And what was discovered is that, you know, if you have a very fast aircraft and a very agile aircraft, the fast aircraft is just going to go by the agile aircraft.

1:03:58The agile aircraft is just going to do a loop and come back behind the fast aircraft and shoot it down. So I think at some point, this need for speed, this need for faster, better, more, just got supplanted. but is this actually smarter? And I think you could be at this inflection point where once this whole craziness about better, faster AI chips and so on settles down, people say, well, wait a minute, is this faster better? Or is this technology actually better in the realms that we're interested in? Or is certain types of agility and thinking algorithmic dominance even better. Yeah. And from my perspective, the big question is, is there real insight?

1:04:45You know, all this information is publicly available. Is there an ability to extract real insight that others don't see that is the truth that the market hasn't recognized? That's the hard part. Absolutely. And it's an open question, right? One other thing that came up in, you know, one semi-academic conference I was at is, is once everybody knows that a lot of the AI algorithms are just scraping the web and getting information from what's out there, what stops somebody from manufacturing misinformation that then educates a feedback loop where things just get out of control, where misinformation begets misinformation?

1:05:20Because obviously, if people are relying on decisions based on this scraped data, then if you can lead them to making bad decisions by creating bad data, obviously, right? So you're now at the level, the hall of mirrors, right? The game just gets elevated to a different level now. So that's why I don't believe that this is the end of financial markets or the end of, you know, people's mental ability to think and do things by thinking and by logic. I think, if anything, the need for logic and common sense is probably even higher now than it was before. Is there one unique insight that you've learned in your 30 plus years in the industry that you think many may not think about or have heard of that you'd like to share?

1:06:06I think pretty much everything I know people have learned and experimented and found for themselves. But one thing for me personally that I go back to, which has been very helpful, obviously, in surviving, doing well, and see just actually enjoying every day when I come in and do my work is this idea that every morning when I come in, I am learning something new. And, you know, it's just this freshness that comes from this putting that hat on every single day and saying, what am I going to learn new today? You know, whether it's new scientific stuff that might have applications of finance or, you know, maybe running a little bit better or maybe just doing a trade a little bit better or having a little bit more self-control or, you know, discovering something else.

1:06:50But this whole idea that every day when you come in, you know, we have this luxury, this vantage point in the financial markets to be able to make a living doing something that we like to do is that every day is a new learning experience. And that is absolutely precious. So for me, that's really the anchor, you know, is that there's more to learn every single day. And that's sort of what keeps me in the business. Yeah. And it's what keeps it interesting and keeps at least me personally driven to get better and better. And it's a lifelong journey. And you'll never get to the finish line unlike a race because there is no finish line.

1:07:27You're just constantly improving. Absolutely. Every day, the finish line, tomorrow's finish line. Exactly. That's right. Well, Vinir, you've been very kind with your time. We spent over an hour. You could have probably run a half marathon during that time. So I appreciate you spending some time with me and sharing your insights. Well, thanks for having me. It's a pleasure and looking forward to more of your writings. and podcasts as well. And I am as well. Thank you. Thank you. Take care. Thanks for listening. We hope you enjoyed this episode. Please visit our website at insightfulinvestor.org to access past shows and learn more about our podcast.

1:08:06If you have questions, feel free to email us at info at insightfulinvestor.org. And if you enjoyed the discussion, please subscribe to this podcast to ensure you don't miss future episodes. And don't forget to forward today's conversation to others you think would enjoy listening. This podcast is provided for informational purposes only and should not be relied upon as legal, business, investment, or tax advice. All opinions expressed by podcast participants are solely their own opinions and do not necessarily reflect the opinions of Evoke Advisors, their affiliates, or companies featured. Due to industry regulations, participants on this podcast are instructed not to make specific trade recommendations, no reference past or potential profits.

1:08:50And listeners are reminded that securities trading, commodity trading, and alternative investments are complex and carry a risk of substantial losses. As such, they are not suitable for all investors.