It's beliefs all the way down

A look at reinforcing or weakening dynamics when our belief about the belief of others has significant economic impacts.

Greetings from Northern Germany,

The past two weeks have flown by like nothing. I have been busy building my digital home. It took some time, but I am thrilled that I can now focus on creating and building as often as possible.
In this vein, I started sharing ideas on Youtube. I aim for the content there to be more practical: how to make decisions, gain some perspective/knowledge or learn a skill that would be useful for an Indie Life. But we’ll see how it goes. I’d love to have you onboard!

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I love coincidences. Just as Silicon Valley Bank was collapsing, I was reading the paragraph below. And there was a little gem about money and related beliefs.

Christian and Muslims who could not agree on religious beliefs could nevertheless agree on monetary belief, because whereas religion asks us to believe in something, money asks us to believe that other people believe in something.

Yuval Noah Harari, Sapiens: A Brief History of Humankind

Why is this interesting? Well, if you have a penchant for independence, you will also need to manage your money. Defaulting to employer plans is not an option anymore. You are the manager of your savings, insurance, investments (and pension, if you choose to have one).

So let’s build a reflex: we should think more about beliefs than numbers when dealing with money.

Money 101 to bring everyone up to speed

Money is not the coins, notes, or credit cards we use, nor is it gold in central bank vaults. Money is a credit promise. This promise is transferrable.

It is not “backed” by the US federal reserves. You cannot go to the Fed and ask it to change your money to another store of value like gold. Interesting fact: this stopped being the case for individual citizens in 1934. The more famous gold unpegging in 1971 was related to stopping conversion for foreign central banks. Confusingly the US Fed holds large amounts of gold as an asset. But gold is an insurance policy in case of disruptions to currency markets not “backing” the US Dollars’ value.

The US government enforces the value of the USD. It guarantees the promise is worth something in the future. It can enforce it with taxation and force (including laws). A percentage of the value US citizens produce or gain through capital appreciation goes to Uncle Sam to fund this enforcement ability.

When you pay for the latest iPhone, you transfer a credit promise from your account at Chase bank to Apple’s account at Bank of America.

In the modern world, money is made up of numbers in electronic ledgers. I wish I had learned to code in my teens, not in my 30s (and also learned how to hack safely - hack evil criminals only, of course :P)!

Money is created in an economy by lending. The central bank controls how much lending is created with the interest rate, the price at which banks can borrow from it. An excellent and very readable book on the history of money is The Ascent of Money by Niall Ferguson.

The intro quote about believing that other people believe in something is pretty important in finance.

The loss of belief in SVB

Silicon Valley Bank customers withdrew $42 billion in a day at the end of last week. This led to the collapse of the bank. Customers did not believe that investors believed in the solvency of SVB. Without investors, SVB could not plug a big hole in its balance sheet.

SVB made mistakes in allocating the capital it received from customers. It put a big chunk in low-yielding long-term debt securities (mortgage-backed bonds - MBBs). These lost significant value because interest rates increased rapidly over the past 12 months.

When it tried to plug the hole by asking professional investors for fresh capital, it received a big fat “We’ll pass, Thanks!”.

SVB’s main customers are startup tech companies. Their deposits are expected to continue declining in the current climate. These startups are not generating cash (in aggregate) and rely on venture capital investors to keep funding them. This dynamic would have created further funding complications for the bank and its investors over the next 12-24 months.

The bank collapse may not have happened if SVB had not received a big inflow of deposits in the heyday of the tech funding boom in 2020/21. The bank would not have lost so much value so abruptly if the inflow had happened over 5 years.

The mismatch between long-term and short-term commitments was not the problem. Banks take short-term deposits and loan them out to businesses or persons for longer periods at higher rates. A timing mismatch is a basis for bank profits. They pocket the difference between the loan rates and the rates they owe customers.

But loans are not revalued as frequently as tradable securities like MBBs. Banks record losses on loans when the borrower is not making payments. MBBs are investment assets, and their losses crystalize quickly in banks' books.

Trading value is always about what others believe

Believing that others believe in something is the basis of tradable value, not just money. It is fundamental to understanding how markets work.

The recent NFT trend is a great example of this "mutual alignment of belief” regarding value.

The most expensive NFT sold, outside artsy ones, was Cryptopunk 5822. It was sold for $23 million on February 12, 2022

NFTs were valuable because collectors believed others saw value in them. They believed this group belief would be sustainable.

Technology infrastructure (blockchain) supported a notion of uniqueness. Electronic markets provided a way to trade them easily. People created cultural stories about the dawn of a new era. Owning these unique tradeable assets brought advantages not transferrable with the pixels. This was the narrative.

It might be easy to dunk on NFTs now that crypto has crashed. But the value in tradeable art is based on the same principles. The difference is that we have developed intricate ways to justify the worth of art. We are also more used to it. It evokes emotions. Few people question paying millions for old paint on a canvas. But another skilled artist or a high-end photocopy machine could easily reproduce it. People buy narratives and a belief that others will see value in the art.

Spotting what others believe as an investment tool

The belief about others’ beliefs underpins the notion of money and value. And it goes even further. A fundamental belief about this sequence of beliefs (getting confusing yet?) determines how market participants act.

Efficient market supporters think that all available information is reflected in prices. They think it’s pointless to try to beat the market. If you follow this line of reasoning, you will not think about how beliefs about the beliefs of others in aggregate impact the market. You will not think much about how this feeds reflexively (influencing itself), as the famous investor George Soros called it, back into market dynamics.

But if you understand the illusionary mechanism of value, you cannot assume that everyone’s belief about other people’s beliefs is synchronized and aligned. There would be little selling and buying except to execute life necessities or reallocate risks to those willing to bear them.

Belief updates are usually quick and deviate little from facts. Everyone agrees about facts and other peoples’ beliefs in them. When information flows easily to most market participants and is easy to digest, prices are efficient because beliefs converge toward the “correct” answer. Participants who do not converge to the market view will be selected out of the market by going bankrupt.

But belief updates in markets happen as a continuous process, and they are sometimes slow and incorrect. In times of volatility, beliefs about facts and other people’s beliefs become much more uncertain and fuzzy. This is when most participants can be wrong and when the psychological and circular effects, in my opinion, take over.

The school of investing which I like is value investing. It takes advantage of this inefficiency. I am currently writing a book about its key principles to help non-finance people invest. It is slow work because it is less fun to figure out what is obvious or not for others and what needs to be explained. But it will DEFINITELY come out sometime in 2023 :).

Let me perhaps cannibalize my future income and recognition. The book could be summarized in this simple perspective by famous investor Howard Marks. A value investor is a contrarian. You need to think you have a different view than others, or you will not find mispricings. A contrarian investor needs to think, at least, about second-order effects:

• what the herd is doing;

• why it’s doing it;

• what’s wrong, if anything, with what it’s doing; and

• what you should do about it.

Sometimes when dynamics have reinforcing effects on market participants, you need to think in 3rd or 4th order effects.

Executing these four principles so that you lose little when you are wrong and gain a lot when you are right made Warren Buffett who he is.

The complexity lies in knowing where to fish for herd views likely impacted by fuzzy beliefs. You must also avoid fooling yourself into believing you are right too often. It is akin to first principle thinking in science and engineering: based on a starting solid assumption, what else can I assume that is highly likely true? And do I come to a different view compared to the herd?

n-order effects elsewhere

Here I would have loved to open the introductory notion onto other more interesting fields. But I haven’t yet formed concrete views on this.

Where else are our beliefs about other people’s beliefs in something creating a different dynamic than if we just believed this “something” directly?

Does choosing a leader falls into this category? Do we believe in a leader because of the strength of other people’s beliefs about this person?

The leaders, in turn, may act in such a way as to keep enough positive beliefs about them alive among a group of people. Importantly, they hope others believe this group’s view will hold and likely increase and create momentum. It’s a dynamic often seen in US primaries where people vote based on their belief about what others believe. They often don’t vote for the person they prefer independently but integrate game-theoretic perspectives on others’ beliefs.

By now, you may have noticed that I am moving this newsletter to be a playground of ideas that I am starting to explore but which may not be fully formed. The longer, more formed essays will live on my personal site and will sometimes be referenced here (for the curious!).

My wife rightly reminds me that my belief about the beliefs of others is often wrong outside Finance. Please let me know your thoughts or feedback on these ideas. You can comment or reply privately to the email.

Take care!