Thinking about investment strategies in terms of levels

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jacob
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Thinking about investment strategies in terms of levels

Post by jacob » Mon Jul 01, 2019 12:55 pm

https://medium.com/personal-growth/thin ... 09afbe4fed

I think this is a useful model for thinking about various investment strategies. It builds on the Keynesian beauty contest but puts some meat on the idea. Inverting it, the question should be what the level a given strategy is? Knowing this is useful because it determines the level of confidence + the time horizon. This is a question that can be answered in advance with enough analysis/reflection of one's idea. This is highly useful because the level of the idea is connected with how quickly the payoff/outperformance appears. Thus it gives a sense of how patient one needs to be to cash in.

Level 0: Random outcome and in fairness likely negative, but it's the rare person who manages not to think at all.
Level 1: 10-30 years.
Level 2: 10 years (the next crash or the next major trend)
Level 3: 1-3 years
Level 4: 1 year or less.
Level 5: A few weeks to a couple of months.

This presumes that the idea/hypothesis is correct. I think the reason is that it takes a while for ideas to trickle down through the levels and become known to enough people to actually move the price. The higher the levels, the smarter the money tends to be and the faster it tends to be. It's important to understand that knowledge does not disseminate instantly. The market is only efficient with information. Not with opinions.

Note this relates to investing, that is, adding information to the market. Not to be confused with trading which is adding liquidity to the market. I don't think trading has similar characteristic timescales.

7Wannabe5
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Re: Thinking about investment strategies in terms of levels

Post by 7Wannabe5 » Mon Jul 01, 2019 2:30 pm

It seems to me that there could be a good many one-hit-wonder investment strategies (if this isn't an oxymoron) that would result in shorter time frame for pay-off for adding information to the market, depending on how narrow and/or shallow the domain of new knowledge brought. I mean, to reference the article, calligraphy could be scoffed at as a useless art to study these-a-days, but it is deep because ancient. OTOH, an individual could have an insight into the market that was based on wide knowledge in one field, deep knowledge in another, but also critically based on highly trivial knowledge in a third field, resulting in quick pay off unlikely ever again to be repeated.

jacob
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Re: Thinking about investment strategies in terms of levels

Post by jacob » Mon Jul 01, 2019 2:44 pm

The level refers to the particular investment thesis+strategy, not the investor.

An individual who is otherwise develop all their other ideas to level 0-1 could have a rare level 5 idea based on idiosyncratic happenstance and concentrated expertise. Going through the levels is a good gauge of how well thought out a particular strategy is. E.g. if it's a "I have {X} because I think this strategy will do well"-argument depth (level 1), then will likely take decades before any outperformance materializes (presuming the investor is correct). Whereas a "I have {X} because the market has {Y}" (level 2) will resolve within the business cycle. A "I have {X} because the market has {Y} because they wrongly think that {X} is dispreferred but will eventually realize that they are wrong" (level 3) will only take a few years to resolve. And so on ...

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Re: Thinking about investment strategies in terms of levels

Post by jacob » Mon Jul 01, 2019 3:12 pm

I think this was better explained by my younger self: http://earlyretirementextreme.com/theory-of-mind.html

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Re: Thinking about investment strategies in terms of levels

Post by 7Wannabe5 » Tue Jul 02, 2019 8:29 am

I may be way off in left field here, but perhaps the time until payoff relates to number of players? I am imagining something like a million people in a field all working together to keep a ball up in the air vs. 5 people playing poker.

Since I am currently reading 4 books on the topic of data science, including one meant for business people who just want to have enough knowledge to work intelligently with data scientists, my above suggestion was based on imagining somebody who was maybe Level 3 in both Finance and Data Science, but also in possession of some arcane piece of information related to Mechanical Engineering.

If/when number of players is related to time until payoff, it may prove to be more efficient to go sideways in knowledge acquisition, because the area composing the intersections of knowledge bases will shrink faster (with less effort applied ) than the decline from base to peak in any specific realm of knowledge.

Simple example from unrelated market would be focusing all one's effort on weight training in order to better get a date vs. spending some time at the gym and some time at charm school and some time at improving income enough to afford moving out of Grandma's basement. Or maybe this is a weak analogy since the sole purpose of playing in the financial market is to make money (would equal muscles in analogy)? However, your note on investment=adding information seems to suggest some needful underlying reliance on basis of reality in general economy.

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Re: Thinking about investment strategies in terms of levels

Post by jacob » Tue Jul 02, 2019 9:24 am

A game like poker differs from a game like investing because the former is finite and the latter is infinite. In poker, the trickle-down resolution doesn't happen before the game is long over. In poker, players level up by playing many games and slowly developing new ways of playing. In the markets, the trickle-down is continuous and the very reason for the existence of the game itself---there is only one game and no do-overs or restarts.

As for what it takes to construct level N ideas or what kind of person does that that is a whole other question. For example, to construct a level 1 investment strategy, you can read a few standard books to learn about portfolio construction [in a vacuum]. Whereas level 2 would require understanding where the market currently is at and including these considerations in one's strategy. Level 3 will include those concerns plus an understanding of where the market is going based on its reaction when it changes its mind. Speaking very loosely---because there's a lot more to it---then level 1 can be handled with math. Level 2 requires yet more math + history and news. Level 3 requires yet more history and news + psychology.

I think I've described this kind of leveling up elsewhere. Search for "Hegelian constructor".

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Re: Thinking about investment strategies in terms of levels

Post by thai_tong » Tue Jul 02, 2019 4:23 pm

The time to see a payoff can be quantified easily by taking the log of the average log growth divided by the standard deviation of the log growth.

If the growth of an investment is treated as a Gaussian process then the above ratio of the average to the standard deviation is a precise measure of how long it takes to see results of an investment strategy

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Re: Thinking about investment strategies in terms of levels

Post by Campitor » Tue Jul 02, 2019 8:25 pm

@jacob

I think your model holds. To operate within level 5 requires a wide breadth of knowledge, vast amounts of reading, the ability to see the interconnectedness of all the component parts of any investment being analyzed. etc. Few people operate at this level and the ones that do probably are part of a group - the lone wolf operating at level 5 is probably so rare that his/her probability of existence rounds to zero.

Here's a hollywood depiction of a level 5 investor - he's trying to find a way to raise money by analyzing burgers and buns while everyone else thinks he's just wasting time: https://youtu.be/KUxMY77i0q4

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Re: Thinking about investment strategies in terms of levels

Post by fiby41 » Fri Jul 05, 2019 12:02 am

jacob wrote:
Mon Jul 01, 2019 12:55 pm

Level 0: Random outcome and in fairness likely negative, but it's the rare person who manages not to think at all.
Level 1: 10-30 years.
Level 2: 10 years (the next crash or the next major trend)
Level 3: 1-3 years
Level 4: 1 year or less.
Level 5: A few weeks to a couple of months.
I'm at level 3 :shock:

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Re: Thinking about investment strategies in terms of levels

Post by The Old Man » Fri Jul 05, 2019 6:55 am

"...level of the idea is connected with how quickly the payoff/outperformance appears."

Where do index funds fit in? The idea of index funds is not to seek "outperformance".

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Re: Thinking about investment strategies in terms of levels

Post by jacob » Fri Jul 05, 2019 7:26 am

@TOM - All price insensitive/formulaic strategies are level 1. At this level one buys chooses e.g. an allocation strategy that is conformed to by simply trading rules without regard for where the market is. It is this disregard that defines level 1. Level 1 only considers one side of the trade, e.g. the buyer, w/o any concern for why the other side, e.g. the seller, is selling. But unlike level 0, level 1 has thought about how their own strategy should work out. IOW, there's some mental discipline and coherent strategy. Level 0 would be characterized by someone who buys some random Tesla because they believe EVs are the future; then they have a few thousand in Lending Club; then they sell Tesla and buy gold; ... and so on. It is incoherent. Level 1 would outperform level 0 over the time period of a few decades.

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Re: Thinking about investment strategies in terms of levels

Post by Nomad » Fri Jul 05, 2019 7:38 am

@Jacob
I'm now cashing out / cashing in OR more simply put as switching on a monthly basis based upon preceding momentum.
Is this level 0, level 5 or I've misread it completely?

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Re: Thinking about investment strategies in terms of levels

Post by jacob » Fri Jul 05, 2019 8:05 am

@Nomad - Level 1 insofar you're sticking with it. Level 2 would require you to change your strategy (or the strategy to change itself) based on an understanding of how the rest of the market is performing. For example, if you picked your momentum strategy based on having identified the market as being in a growth phase, and then switching to a mean-reversion strategy when you identify a trading range, it would be level 2. Insofar this trading strategy replaces the previous strategy which replaced the previous one based on great ideas or blog posts ... it's level 0.

Level 0: I think I'm right.
Level 1: I know why I'm right.
Level 2: I know you [the market] are wrong.
Level 3: I know what [insight] you [the market] are missing and how you'll react when you learn it.

Recall that a level 1 poker player only knows the rules of poker and the odds of his own hand when placing his bets. His playing strategy does not depend on any information/concerns about what the other players are holding. Same with investors. Chess might offer an easier analogy in terms of how many moves a player thinks ahead. If you ever played someone who thinks two or more moves further ahead than you do, e.g. you see three and they see five or six, and then having them go over your bad moves later explaining not only how you were wrong but also why you were wrong, that is a good example of level 2 vs level 3. They will distinctly be able to discern how many moves you think ahead based on how you're playing.

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Re: Thinking about investment strategies in terms of levels

Post by jacob » Fri Jul 05, 2019 8:23 am

Also note that the situation with the market is asymmetric (unlike the one in poker or chess). Making money in the market ALWAYS requires the market to eventually come around and behave according to your strategy. As a small player (no market moving amounts of liquidity) you can not force price movement. For example, you might think {X} will go up for all sorts of sophisticated reasons, but until the market actually abides, you're not making any money.

This is reflected by the old observation that the market can be irrational longer than you can remain solvent. Thus, if you have a level 2 strategy, you can't really do much about the markets irrationality beyond staying out of the path of the juggernaut. If you have a level 3 strategy, you can start putting on the position that the market will prefer once it comes to its senses. The difference between 2 and 3 is that 2 knows that something will happen, while 3 knows what will happen. Whereas 1 either doesn't know or doesn't care.

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