Review: Week of September 10

I’m trying to understand Friston’s free energy, and the predictive processing theory of neuroscience more generally. Very loosely, predictive processing states that instead of the usual model of “brain collects information from senses, analyzes it, and decides on actions” instead the brain constantly simulations, which it updates based on errors that arise when it predicts sensory data. Free energy serves as an objective function for this updating. Minimizing free energy punishes a) prediction inaccuracy and b) deviation from priors, providing an approximate solution to Bayesian learning. Although framed as learning, Friston also claims to explain allostatic behaviors as falling out of the predictions. I’m a little hazy on how that works but it seems to essentially include homeostasis in the prior. The theory explains important data from many domains of neuroscience, including why there are so many reverse connections in the brain. Reading materials:

  • Scott Alexander’s (2017) review of Surfing Uncertainty [goodreads]. The best short article on why this is interesting.
  • Scott Alexander (2018) “God help us let’s try to understand Friston on free energy” here.
  • Friston explaining it himself (2017). [youtube]
  • Shamil Chandaria, “The Bayesian Brain and Meditation.” (2022) [youtube]
  • Ruben E. Laukkonen and Heleen A. Slagter (2021). “From Many to (N)one: Meditation and the plasticity of the predictive mind.” [url]

Why both countercultures failed by Matt Arnold, part of David Chapman’s Meaningness project. I hadn’t realized how much the evangelical movement of the 1980s and 90s owed to the hippie movement and is arguably another offshoot. Arnold describes them here, basically claiming (along meaningness lines) that the hippies were monists and the evangelicals were dualists. In brief: “Identity is not community, although the countercultures often confused the two.” These countercultures gave way to the subcultural mode. John’s take, as of 2023 it sort of seems like there are again two major countercultures, “movement progressivism” (pejoratively called “wokeness”) and “MAGA.” Again they are mostly identitarian with community tacked on haphazardly. Movement progressivism seems a bit more coherent. My expectation is these won’t last forever but, like their predecessors, will be highly influential.

I’ve been doing Jenny Turbell’s Monday night series on the four immeasurables (also known as the brahmaviharas) at the Berkeley Alembic. Doing these practices makes me feel very warm and fuzzy inside, strongly recommended.

Currently Reading

  • Seeing that Frees by Rob Burbea [goodreads]. Michael Taft’s favorite meditation book, also recommended by Nick Cammaratta. “When you find yourself feeling somehow imprisoned in a situation, or grasping unhelpfully at something that is not present, see if you can look within and around you in a way that ‘deconstructs’ your world into its aggregate appearances of sights, sounds, smells, tastes, physical sensations, and mental and emotional experiences.”
  • Breathing Underwater by Richard Rohr [goodreads]. The 12 steps from a mystical Christian perspective. This is sort of a collection of musings, I think I needed more context about how 12 steps works in practice but much of it seemed like useful perspective. Also made me think about the vitality of Christianity. “We often given a bogus version of the Gospel, some fast-food religion, without any deep transformation of the self; and the result has been the spiritual disaster of “Christian” countries that tend to be as consumer-oriented, proud, warlike, racist, class conscious, and addictive as everybody else-and often more so, I’m afraid.”
  • Pieces of the Action by Vannevar Bush [goodreads]. How we set up our defense research to win WWII.
  • The Pathless Path: Imagining a New Story for Work and Life. Paul Millerd. I appreciate that Millerd was able to break out of one type of frame that was imprisoning him (careerism). But so far (I’m about halfway through) he still seems to be a victim of millenial narcissism. Our culture is failing badly in the meaning department.

Random links

  • Scott Alexander posted this book review contest entry for Zuozhuan. Society was in decline and people mostly knew it. This is a Chinese equivalent of post-Roman empire nostalgia.
  • Do progressives disparage one-parent families? MR post here. My hot take, children are much better off with two parents, much of the race gap is explained by single parenting rates. We can find compassionate ways to close this gap.
  • “The number of legal abortions has held steady, if not increased, nationwide since 2020, our colleagues Amy Schoenfeld Walker and Allison McCann reported today.” [MR post]
  • Shinzen Young’s equation for pain, suffering, and purification [twitter]


  • Gary’s stelfonta injections succeeded for the tumor on his leg but not for the one on his ear. We are going to try again tomorrow. The steroid he had to take during this treatment made him really miserable and caused him to pee on the floor many times which he’s almost never done before.
  • I finally decided to defeat Ganondorf in Legend of Zelda: TotK. It was fun but hopefully I can replace this compulsive activity with more accretive compulsive activities.

Review: Week of September 3

Late posting!

Robin Hanson claims “escalating signaling” cuts fertility, fairly pessimistic about restoring fertility.

Austin Vernon thinks brick thermal storage might actually already be competitive for industrial use cases, enabling 100% renewable energy in situations where you just need heat.

I did a retreat with Toby Sola’s Brightmind on Expansion and Contraction. It reminded me of a lot of the great insights Shinzen shared in his book The Science of Enlightenment. Basically the idea is that as you are able to see the nature of sensations arising, you can see closely that they are always moving (this is called flow). In fact, much of sensation can be thought of as expansion and contraction (waves of sensations that are arising and passing). This is key to maintaining equanimity even with very difficult sensations.

I looked at a bunch of literature on contemplative neuroscience. I was sort of just cruising through, there an example might be this one showing meditators perceived pain as less unpleasant.

Review: Week of August 27


Contemplative Neuroscience. I had a really cool IRL conversation with Kati Devaney at the Alembic about contemplative neuroscience and she sent me on a few reading rabbit holes. One was a Substack post she coauthered with Sasha Chapin about researching enlightenment. One big point they made was that the research is mostly either extremely light interventions on naïve target groups (mostly referring to Kabat-Zinn’s Mindfulness Based Stress Reduction, or MBSR), or research into deeply enlightened people. But what would be really cool is uncovering the journey from naïve to fully awakened! One banger:

Some interesting questions:

  • Which practices are most effective for which people?
  • What factors accelerate meditation learning?
  • Can we create useful reference states?
  • How can we prevent adverse effects of meditation?
  • Is there one kind of awakening or multiple kinds?
  • Are there predictable effects of awakening?

She also got me curious about the neuroscience of meditation, and what kind of biomarkers we can look at while trying to understand it. A few random links

  • Jhourney is a startup she’s involved in that I’ve tweeted about before, they are looking at EEG markers of the jhanas (among other things).
  • There is some evidence that mindfulness increases gray matter: paper
  • Kati has a paper showing that meditation induces lower default mode network relative to dorsal attention network

In general I find this area really interesting but a lot of brain signals have poor signal-noise ratio which can make it hard to study.

Claim: Social mobility is unchanged in England for 400 years. Gregory Clark wrote a paper about the inheritance of social status in England using a population of 422,374 English people through 422 years of history (1600–2022). He gets some really wild results. He finds that social mobility was unchanged during the entire period. Instead, social status seems to be strongly inherited. Even 4th cousins have correlated social status. This heritability is highly persistent, for example father-son correlation is not diminished when the father dies early in the son’s life. He has evidence to rule out direct wealth transmission as a mechanism; for instance having many children (meaning each child inherits less) does not affect heritability. Part of the reason the effect is so strong is that mating is highly assortative. Interestingly, there is no evidence of a “poverty trap” or “elite lock-in”: social mobility is symmetric and identical across the spectrum. See also podcast here.

Does China need more consumption? Paul Krugman seems to think so. As does the WSJ. When I heard this claim I was a bit puzzled: How would consuming scarce resources help an economy recover? I felt vindicated when Tyler Cowen posted similar skepticism with followup here. But the best explanation comes from Scott Sumner. In short, people are talking past each other. Obviously a better scenario is one in which Chinese consumers are able to consume more, but the more constructive conversation is to ask what sort of policy changes are under consideration and why China’s leadership is unable to easily chart a path through. Here’s how he frames it:

Here we can see what’s really going on: The CCP wants to allocate resources based on favoritism. Unfortunately, its favorite investments are not actually good investments, at least not in the sense of producing more than they cost. It is also unwilling to significantly devalue the RMB, which might be able to sweep at least some of the mispricing issues under the rug. As a result, it needs to allocate a lot of resources to its failing favorites and a lot of resources to propping up the RMB and there’s not much left either for good investments for consumption. You could say they need to allow more consumption or you could just say they need to stop misallocating massive amounts of capital. It’s all academic anyway because they are committed to digging in their heels. Something will have to give, but they may be able to stagnate and kick the can down the road for a long time.


Interview between Tara Isabella Burton and Bishop Barron. I didn’t realize she was a practicing Episcopalian! I found her book on the religiously unaffiliated (Strange Rites) a bit uneven but it’s one of the only books I’ve seen about how people in the new “unaffiliated” bloc actually have a lot of quasi-religious beliefs and practices. The book made it seem like she was unaffiliated herself. Maybe her conversion is recent. One interesting exchange: Barron asked her how she’d start a religious conversation with a “none.” She says social justice people would be easy to talk to, there’s a lot in common! It’s the people who believe in “doing whatever I want” as the highest value that are really hard to engage.

Random Links

  • A Reconstruction of ancient Tenochtitlan here
  • Vitalik on Community Notes (they’re pretty neat!) here

Review: Week of August 20


The Comfort Crisis (Money Mustache Blog). Michael Easter is a recovering addict who believes the lack of hardship and abundance of material comfort is generating a psychological crisis. When nothing is wrong your brain will still look for stuff to be wrong. This post doesn’t investigate deeply but it seems like an important truth about the modern world. Venkatesh Rao has covered similar topics. Reminds me of this paper claiming that people’s sense of safety and abundance is not correlated to actual experiences:

Austin Vernon (email to Tyler Cowen) on the extent of the Inflation Reduction Act’s subsidies. Some are completely uncapped. It would seem solar factories are not a long term investment: “Another wrinkle with solar factories is that they depreciate at an extreme rate. Usually they are obsolete after 2-3 years and need to shut down. So there is a real possibility at the end of the law that you see a massive drop in solar deployment because the inflated supply chain will have to rationalize to non-subsidy conditions and then our factories will not have the revenue to upgrade to the next generation. That will then kill the supplier ecosystem, etc”

Bluesky writes about their custom feeds. I think this is a really cool approach but I’m concerned that there’s just not much content on Bluesky. I would die to have this on Twitter.

Random Critical Analysis (2015) writes about homicide and race. Socioeconomics and demographics don’t explain group differences well, but single parenting does. This finding mirrors a fascinating thread by Alice Evans on the links between falling marriage and increasing inner city violence:

I owe @nickcammaratta for helping me understand the Buddhist idea of “attachment.” I always thought, “How is it at all wholesome to not be attached to, e.g., my daughter?” But the problem isn’t loving your loved ones, it’s a specific mental clenching motion that gets translated as attachment.

…incidentally attempts to popularize deeper meditative states are starting to get more attention, as in this Vox writeup by @OshanJarow. Apparently some are calling this “spirit tech.”

I enjoyed this critical review of Acemoglu and Robinson’s book Why Nations Fail. It excoriates the book for failing to produce quantitative evidence in favor of the thesis that differences in the wealth of nations result from differences in the extractiveness of institutions. Instead it focuses on anecdotes. Although this critique is valid, I nevertheless got a lot out of the book when I read it several years ago. For example, the section on the Kongo they explain how precolonial Kongo had such extractive elites that it wasn’t even worth farmers’ while to employ the plow in agriculture, since any surplus would be expropriated. Obviously this one case doesn’t prove generally why some nations succeed and fail. But before reading this book I had had a naïve view that central institutions generally favor and support progress. It’s clear that they can do that, but at many times and places they have likely worked against it.

Tyler on what Harvard can learn from the Olive Garden. “Wealthier institutions or establishments attract a mixed customer or user base only when they give up cultural control.”

Researchers are conducting a human challenge trial to fight malaria! I applaud the bravery of the participants.


  • I started using @malcolm_Ocean’s app It seems useful so far. Good framing. Not a todo app (no concept of a todo that lives more than a day)
  • Our dog Gary has mast cell tumors :-(. We have scheduled a chemo approach called stelfonta that seems to have a high success rate at treatment.
  • This week on BrightMind I did the lesson pack on the “Concentration Algorithm.” The idea is to check in halfway through a sit, decide if you have a reasonable level of concentration, and if not identify what’s distracting you and shift your focus to that part of sensation-space. I found this useful but I kept being really interested in my original concentration object so rarely changed.

Cultural Deep Dive: Scotland 🏴󠁧󠁢󠁳󠁣󠁴󠁿🏴󠁧󠁢󠁳󠁣󠁴󠁿🏴󠁧󠁢󠁳󠁣󠁴󠁿

Lost Portrait of Charles Edward Stuart
Allan Ramsey‘s “Lost portrait” of Charles Edward “Bonnie Prince Charlie” Stuart, currently on display in the Scottish Portrait Gallery.

File under: Context is that which is scarce.

I recently spent two weeks in Scotland. Inspired by Tyler Cowen’s “favorite things” posts (especially this one on Scotland), here are notes on what resonated with me:

  • Historical context: Scotland was prominently defined by efforts to remain independent. Wars of Scottish independence  [wiki], establishment of Presbyterianism [wiki]. James VI and I [wiki]; he did not miss his homeland! Jacobite uprisings [wiki]. I did not study the recent independence referenda in detail.
  • Art: Henry Raeburn, Allan Ramsay, design and architecture by Charles Rennie MacIntosh,  tartansThis book was helpful.
  • Authors: Classics (Robert Louis Stevenson, Walter Scott), Moderns (Alistair Gray). Scott has an enormous memorial in Edinburgh. Lots of crazy folktales too, like this one about the formation of the Hebrides and Iceland.
  • Music: Traditional (Loch Lomond, this album of folk songs about Bonnie Charlie with excellent oral commentary), Contemporary (Boards of Canada, Belle & Sebastian).
  • Philosophy: Scottish enlightenment especially David Hume, Adam Smith. Both have significant monuments in Edinburgh. Smith has an anti-slavery quotation on his tombstone.
  • Archaeology: Kilmartin Glen is a great day trip. Standing stones, cairns, and Dunadd.
  • Culinary: I ate and greatly enjoyed many pies and scones. I found the haggis unmemorable. Excellent Indian takeout is readily available, I’d recommend Slumdog Delivered and Tuk Tuk. For an upscale experience, my wife went to Kitchin with her family and raved about it.
  • Whisky: I barely drank any scotch, but am partial to Islays such as Lagavulin (peaty) or Bruichladdich “clasic laddy” (not peaty).

Fun fact: Kilts are not ancient attire in Scotland. Contra Braveheart, William Wallace’s men would have worn similar garb to their English adversaries. The “small kilt” widely known today was invented in the 1720s by a Quaker Englishman, Thomas Rawlinson.

On Cultural Immersion

The returns to researching culture compound. For example in the novel Lanark the protagonist attends the Glasgow art school where Macintosh designed the library, which is mentioned, and some sections are incomprehensible without awareness of the Scottish reformation. A whole section of the Scottish portrait gallery is dedicated to Jacobitism. The famous refrain “you take the high road and I’ll take the low road and I’ll be in Scotland before you” is about the soul of an executed Jacobite zipping home.

Is the university system doomed?

David Perell’s essay “What the Hell is Going On” provides a thought provoking review of how technology and the information age continues to disrupt the most time honored information markets: advertising, education, and politics. Much of his discussion is inspired by the hypothesis of Martin Gurri that the information age has permanently diminished the authority of existing elites. Perell is willing to go out on a limb a bit in its quest to “solve for the equilibrium” (as Tyler Cowen would put it).

This includes the bold claim that the university system is doomed to be replaced by online courses and new types of signaling. According to Perell, the proliferation of low-cost and high-quality online education spells the end of universities, or at least the middling ones.

In his recent book The Case Against Education, Bryan Caplan lays out the opposite case, and it’s worth examining the differences. Caplan begins with the point that the correlation between college graduation and later income appear substantial, clocking in at 30% (correcting for ability bias) even for “impractical” majors like Philosophy and Art History, and much higher for hard sciences and engineering.

He notes that this link between education and income can be ascribed to a mix of three sources:

  1. Social capital added. The “improvement” of the individual via training and coursework.
  2. Pre-existing skill. The tendency of the competent to enroll in college.
  3. Signaling. The tendency of employers to prefer candidates with better credentials.

Caplan argues that signaling accounts for ~80% of the premium for college graduates. He provides research to back that number up, but he also asks a question that’s hard to ignore: “Would you rather have 4 years of world-class education at Princeton and no degree, or a Princeton degree without the coursework?” I for one am fairly convinced by the argument that the latter would make you better off financially than the former, even if you believe that the college experience itself is a priceless spiritual journey.

Bryan goes on to argue that the signal provided by a degree is valuable to employers, because it connotes a package of three traits: intelligence, conscientiousness, and conformity. A technology company hiring a philosophy major as a project manager isn’t counting on them to produce well-argued treatises on Locke, or make use of any information about philosophy whatsoever. Rather, the company is counting on them to be able to reason well about novel situations (intelligence), ensure that their work is produced on time and to a high standard (conscientiousness), and that they will “get with the program” and act in accordance with company values and incentives (conformity).

If college degrees are truly 80% signalling, then even the best online courses or MOOCs could not replace them. Under this hypothesis, universities do not owe their success in the modern world to their status as gatekeepers of information. Rather, owe it to their reputation for educational programs whose completion signals intelligence, conscientiousness, and conformity. As Bryan points out in later chapters, the conformity signal in particular provides a catch-22 to would-be disruptors: Doing anything other than going to a four year college would be non-conformist.

So what’s the prognosis right now? There are predictions circulating that the demand for 4-year colleges will diminish starting around 2026, but these have to do with a drop in the number of high school graduates rather than a reduction in the proportion of graduates attending. Perell claims that mid-sized liberal arts schools are already beginning to decline, but it’s not clear that the institution more broadly is suffering.

I don’t doubt that there is opportunity in the education space: college provides little in the way of useful job skills, and as a signaling device, it is both costly and inequitable. Delivering content and university-like interactions should be feasible in an online format. But delivering on the strong signal currently sent by attending a selective four-year institution, and especially signaling conformity, is an uphill battle for any disruptor. We’ve already seen some experiments that have produced quality content but failed to make a dent against 4-year degrees (e.g., Khan academy, edX) and a generation of boot-camps that have been hugely useful to a niche set of students, but may not be able to scale to the level of universities (e.g., Lambda School, App Academy). There’s still an opening for new entrants, and for an ensemble of these disruptors to coalesce into a better route to success for new high school graduates. But the university system is a hardy weed with deep pockets and a centuries-long track record. It won’t be uprooted overnight.

Correction 2019-02-10: I originally had listed Philosophy’s premium as ~20%, in fact Caplan lists it as closer to 30% after correcting for ability bias. I also added the graph of adjusted premia.


Caplan, Bryan (2018). The Case Against Education: Why the Education System Is a Waste of Time and Money. [amazon]

Fox, Justin (2019). “The Coming College Enrollment Bust.” Bloomberg Opinion. [link]

Gurri, Martin (2018). The Revolt of The Public and the Crisis of Authority in the New Millennium. [amazon]

Perell, David. “What the hell is going on?” [link]

Perell, David & Forte, Tiago. “Tiago Forte: The Future of Education.” [link]

David Perell on the Paradox of Abundance

David Perell recently published a long read article on the new age of democratized digital media we are entering. Although he gives a history of the last century of media, his ultimate message centers around how we should be consuming information in the digital era. The most important concept he shares is the Paradox of Abundance. Briefly, we have access to more information than ever before. Because there is so much information out there, information purveyors are in a desperate zero-sum competition for eyeballs. They respond by creating urgency and emotional hooks around articles and information that aren’t actually very important. This confronts consumers with a tsunami of clickbait and emotional appeals, which either sends us running from false crisis to false crisis, or makes us check out from media altogether. This means that people who can focus on truly useful and enlightening content are richer than ever before, while the median user is worse off, tugged in all directions by emotionally captivating but ultimately non-enriching content.

This feels most real to me whenever I log onto Twitter. The transcendent moments on Twitter are truly transcendent. Rarely do I spend 20 minutes on Twitter without encountering some new perspective or piece of information that I hadn’t considered before. But the tsunami can be overpowering: I often spend far longer than I had planned following trails of seemingly alarming scandals or political trends. Twitter’s algorithm accelerates this, bubbling the most alarming, shocking, or polarizing content to the top of the feed. My Feedly experience could not be more different: Since I mostly follow only academic blogs or writers I deeply respect, my feed is a bit more boring but also has a much higher signal-to-noise ratio. It’s also less addictive.

Perell draws an analogy to eating right that feels particularly apt. Ultimately this may be the sort of thing our culture needs to adapt to. Just as abundance in food resulted in the evolution of cultural norms around eating right, we may need to develop cultural norms around “informing” right. My feedly is more like a quinoa bowl, whereas a twitter binge can leave me feeling like I just ate a bagful of tootsie rolls. He even mentions writing as analogous to cooking at home, another regularizing function that can improve diet.

There is one question Perell leaves unanswered: What is it all about? Is there an individual duty around online engagement as a sort of civic service? Or would we all just be better off unplugging and reading books? Either way, it is clear that information abundance is here to stay, and passive consumption of whatever passes across our screens is no longer an acceptable strategy.

Is malinvestment in advertising killing D2C ecommerce?

Alex Taussig of Lightspeed writes that there is a typical playbook for vertical ecommerce brands: “(1) Launch a “hero” product that provides branded product innovation, (2) at high gross margins, (3) enabled by an owned & operated e-commerce experience, (4) with high marketing efficiency, usually driven by viral or word-of-mouth campaigns.” (Taussig 2019). The filings from Blue Apron and now CSPR Casper that item (4) on that list, marketing efficiency, can prove elusive as these brands attempt to scale to the level of the expectations they’ve set with investors.

When Blue Apron released their S-1, I was working on Stitch Fix’s own S-1, and so I immediately found their filing interesting. I looked into the numbers that I knew to be important for a subscription service: customer net present value and acquisition cost. From what I could glean, NPV on a customer basis actually looked fairly high; my guess was around $200 assuming a reasonable discount rate. But marketing costs were astounding: ~$144M in 2016, and with Q1 2017 marketing annualized to over $242M. We can’t say for sure how many new customers they paid for with that. If we use the difference in number of customers at the beginning of the period and the end (this is conservative due to the effect of churn), the implied blended CPAs are $320 in 2016 and $385 in Q1 2017. That already implies a money losing proposition, but it obscures how bad things really were. The marginal acquisition cost is typically much higher than the blended cost, because advertising does not scale up efficiently. It’s impossible to know exactly what the ratio is between blended and marginal. In my experience, 2x is a fairly conservative estimate. This means it is quite possible that at the margin, APRN was largely paying $700 or more to acquire a customer worth only around $200. When I saw that, I knew they were toast right away.

Now we have a new filing from Casper with a similar trend. Although Casper claims to establish deep customer relationships, they have a repeat rate of only ~14%, suggesting that we can safely treat marketing acquisitions as one-off. AOVs were $710 in the first nine months of 2019. Revenue plus discounts (which are included in AOV) were $392M, with COGS + refunds of ~$237M, for a profit margin of 39%, or $277 per order. Like APRN, this value per acquired customer is quite impressive, and may be slightly understated if customers are coming back unprompted to buy more big ticket items. Using the above numbers, we can assume 552k acquisitions on a sales cost of $114M, implying a blended CPA of $202. This may seem like a reasonable figure until, again, one considers that the marginal cost is likely to double the blended figure or more. In this case, again, this means that Casper may well be paying a $400 marginal CPA to acquire $277 of gross margin. This is not quite as dire as the Blue Apron situation, but far from comfortable. We can’t tell from this report how much value there is in those repeat orders, but they are absolutely relying on them to make their strategy work.

Direct to consumer brands succeed by providing good margin on product via vertical integration and efficiencies in customer acquisition via strong branding. Often marketing is easy in the early days, when word of mouth provides costless customer acquisition. But $APRN and $CSPR show that acquisition efficiency does not come for free for these brands, especially once they attempt to scale past the growth level supported by referrals. Once organic and word of mouth peter out, the temptation is strong to dump money into paid acquisition well past the point of efficiency. Casper has already had to reduce its offer price below its recent round; this week we’ll see the public market’s judgment.


Form S-1, Blue Apron, filing date 6/1/2017 [link].

Form S-1, Casper, filing date 1/10/2020 [link].

Taussig, Alex. “Drinking from the Firehose #154.” 1/13/2019.

How a dart-throwing monkey can beat the S&P 500.

Main points:

  • A monkey throwing darts can beat the S&P 500 on a risk adjusted basis.
  • This is because cap weighting has historically been a poor portfolio construction strategy.
  • Passive portfolios aren’t fragile. Random perturbations are generally benign as long as they tilt toward the so-called “smart beta” factors such as value and small cap.

I recently read a paper that changed the way I think about passive indexing.

Cap weighting (short for market capitalization weighting) has long been upheld as the gold standard of passive investing, from Bogle’s Common Sense on Mutual Funds to Warren Buffet’s famous bet that hedge funds could not beat the S&P 500. Market capitalization is the implied value of all of a given company’s shares if you added them up at the market price. Indexes like the S&P 500 weight the importance of stocks based on market capitalization. So at ~1.3T, Apple, would receive over twice as much weight as Facebook, whose capitalization is ~600M. In theory, if markets are efficient, a cap weighted portfolio is perfectly efficient because it reflects the allocation of market capital as a whole. If some other weighting of assets could produce higher returns, one would imagine that the market as a whole would shift into those assets, restoring equilibrium.

As it turns out, however, it is easy to outperform the index. It is so easy that a monkey can do it. Arnott et al (2014) investigate several alternative portfolio allocation strategies that have been proposed in the literature and appear to outperform cap weighting. Shockingly, they find that these strategies work just as well, or often even better, when they are inverted. This is strange enough that it’s worth spelling out clearly. In the investment literature, researchers commonly identify some set of characteristics that might indicate that a stock will produce outsized returns. It is common practice to test these hypotheses by looking at the simulated performance of portfolios constructed using those characteristics at different points in the past. For example, one might imagine that stocks with high 5 year average earnings would be strong performers. In fact, these stocks do have higher returns: Arnott et al. estimate 11.18%, as opposed to 9.66% for a U.S. cap weighted index.

The authors make an astonishing revelation by flipping the strategies on their head. For example, they invert 5 year average earnings strategy, simulating portfolios filled with the stocks that earned the least. Common sense implies that the inverse of a winning strategy should be a losing strategy. Instead, the inverse index actually performs better, with returns of 14.38% and an improved Sharpe ratio (the ratio of expected return to variance in return). The authors show similar results for about a dozen other strategies, using two different techniques for inversion. This is almost spooky: If a strategy is good, how can its opposite also be good?

Superficially, the answer is clear. What do the 5 year high earner portfolio and 5 year low earner portfolio have in common? They are both not cap weighted. Cap weighting is such a bad way of selecting stocks that it is beaten by almost any alternative strategy! To drive this point home, the authors simulate a dart-throwing monkey, picking portfolios of 30 stocks completely at random, and show that these portfolios also beat the cap-weighted index: The monkey portfolios produced returns of 1.6 percent in excess of the index, with a better Sharpe ratio (0.33 vs. 0.29). Looking more deeply at why this is the case, the authors show that most of the excess returns they observed across all these strategies are explainable by an enriched Fama-French model. This is a widely discussed model in the finance world that assumes that investors are compensated for certain types of exposure, which are known as factors. In this case, the portfolios were typically weighted toward value and small-cap stocks. These anomalies are often referred to as Smart Beta, because the Fama-French equation uses the symbol beta to denote the coefficients for the factors.

I’ve been concerned in the past that smart beta indexing is inimical to the philosophy of passive investing. Trying to outsmart the index exposes your portfolio to the precise stock-picking scheme used by a bespoke ETF. Because of this, I had always been suspicious of Betterment’s decision to tilt the portfolio toward value, and the recent underperformance of value seemed to bear out my bias. But if even a monkey can pick a good portfolio, it implies that the effects are quite robust to the precise method of stock picking so long as you’re not actively trying to weight against the smart beta factors.

The literature is not clear on exactly how or why smart beta outperforms the cap weighted index. This outperformance is enigmatic since it seems contrary to EMH. Some argue that they result from investor irrationality or the perverse incentives of fund managers (e.g., Baker et al. 2011), while Fama and French themselves seem to believe that this reflects efficient pricing of hidden risk factors (Fama & French 1993). There is good reason to doubt that the past performance of these factors might not be consistent in the long run, since the explanation is not clear. Nevertheless, this paper made me stop worrying and love the tilt.

Resources & Bibliography

Arnott et al (2014) “The Surprising Alpha from Malkiel’s Monkey and Upside-Down Strategies.” The Journal of Portfolio Management.

Arnott et al. (2016) “How Can ‘Smart Beta’ Go Horribly Wrong?”

Baker, Bradley, and Wurgler (2011) “Benchmarks as Limits to Arbitrage: Understanding the Low-Volatility Anomaly” Financial Analysts Journal.

Bogle, John (1999). Common Sense on Mutual Funds.

Fama and French (1993), “Common risk factors in the returns on stocks and bonds.” Journal of Financial Economics.

Fama and Thaler discuss efficient markets, including the Fama-French 3-factor model.