Practicing Wisdom — Issue #20

A distillation of the most interesting things I explored, learned, and thought about.

1. What I Learned This Time

When Not Playing Is Not an Option

There is a comforting story we tell ourselves about bubbles: stupid people get carried away, smart people recognize what is happening, and eventually reality wins. What if this was backwards?

Some of the most important participants in a bubble may understand perfectly well that prices are stretched, leverage is rising, and the music will eventually stop. They participate anyway because being early can be more professionally dangerous than being wrong. Warren Buffett gave this phenomenon a name decades ago: the institutional imperative. Organizations resist changing direction, find reasons to spend available capital, justify whatever leadership already wants to do and, perhaps most importantly, imitate their peers. Rationality tends to wilt under institutional pressure.

Eric Cinnamond gives a wonderfully concrete example. He runs an absolute-return value strategy and describes the strange business problem created by a roaring bull market. If he refuses to buy expensive stocks, clients leave. A friend’s proposed solution is almost comically simple: why not just get invested? Elsewhere in the piece, professional investors are described buying options not to protect against losses, but to insure themselves against the possibility that stocks keep going up without them.

Imagine two portfolio managers. One owns the fashionable AI stocks and loses 30% alongside everyone else. The other stays out, watches them rise another 50%, underperforms the benchmark, loses clients and possibly loses his job. Which mistake is easier to explain? The first manager can say, “Nobody saw it coming.” The second has to say, “I thought everyone else was wrong.” Institutions have a remarkable preference for conventional failure over unconventional embarrassment.

The same mechanism appears in credit markets. GMO argues that monetary policy is currently restrictive for consumers and weaker borrowers while remaining considerably less restrictive for large corporations and borrowers with access to private credit. The interesting reason isn't simply that private lenders are more optimistic: their economics are different. A bank has to worry about deposits, capital requirements, reserves and its balance sheet. A private credit fund may already have committed capital and earn fees for putting that capital to work.

One institution is asking, Should we make this loan? The other is also asking, What happens if we don't deploy the money? That second question changes behavior.

This may help explain why high rates have not produced the kind of uniform tightening policymakers might have expected. Capital that has been raised to be deployed has an institutional imperative of its own. If everyone is paid to put money to work, simply making money more expensive may not be enough. GMO's provocative conclusion is that volatility and price discovery may actually be necessary to break the cycle: somebody eventually has to experience losses, forced selling or a genuine scarcity of capital before the system resets.

The mechanisms of monetary policy presuppose that the levers in place can reach market participants effectively. It would be an interesting outcome if the capital requirements put in place to make banking safer actually made the system more fragile towards market forces.

Dror Poleg offers an interesting mental model. Borrowing from physics, he calls it the “Totalitarian Alignment Principle”: everything not impossible is compulsory. His argument concerns AI agents: if an action remains possible and there is some incentive to take it, eventually some agent will.

• It feels applicable to markets:

• If leverage is available, somebody will use it.

• If zero-day options exist, somebody will trade them.

• If a fund has committed capital, somebody will deploy it.

• If executives can justify an AI investment because every competitor is making one, somebody will build the data center.

• If a portfolio manager can protect himself from career risk by buying the same thing everyone else owns, eventually he will.

Markets don't require everyone to believe the story, they only require enough people to be incentivized to behave as though they believe it. This is an important distinction.

Marc Rubinstein's piece on European markets contains a great profile of European retail investors. American households participate in equities far more heavily than European households. The answer as to why is of course, incentives. Part of the difference is tax policy and pension structure, but Rubinstein suggests another explanation: Europe has historically had much easier access to sports betting. Some of the speculative urge that Americans expressed through trading may simply have found another outlet in Europe.

This is a gap that America may now be closing. Robinhood is illustrative: in Q2, event contracts generated $156 million of transaction revenue, already exceeding the $129 million generated by equities. In July, customers traded 6.1 billion event contracts, roughly twenty times the volume from a year earlier. The boundary between brokerage and casino is getting harder to see. There is nothing mysterious about why: a brokerage benefits when customers transact. An investor benefits when wealth compounds. Those objectives overlap sometimes, but not always.

That leads to what I think is the most useful lesson for an ordinary investor.

Retail investors have one enormous structural advantage over professionals: nobody requires us to play. We don't have a benchmark, quarterly redemptions, an investment committee asking why we missed Nvidia. We don't have committed capital that must be deployed before the investment period expires and we don't lose our jobs because cash underperformed the S&P 500 for eighteen months.

The irony is that modern investing platforms are extraordinarily good at persuading us to voluntarily surrender this advantage. Notifications, prediction markets, 0DTE options, leverage and twenty-four-hour markets transform an activity in which patience should be rewarded into one in which inactivity feels like failure.

Cinnamond cites research suggesting that many younger investors speculate precisely because they feel financially behind. That may be the most dangerous feedback loop of all: the person with the least margin for error is encouraged to take the most risk because watching everyone else get richer makes waiting psychologically intolerable. Professional investors have career risk; retail investors increasingly manufacture career risk for themselves.

The great advantage of managing your own capital is the ability to look stupid for a long time. You can hold cash. You can own boring businesses. You can refuse leverage. You can watch something double without owning it. You can wait for a fat pitch.

Maybe the scarce investing skill isn't knowing when to play, it's retaining the freedom not to.

Sources Referenced

We’re Crazy — Palm Valley Capital (link)

What Does AI Want? — Dror Poleg (link)

Hot European Summer — Net Interest (link)

Triple Mandate - GMO (link)

2. Key Distillations

• Markets can be irrational without their participants being irrational. The incentives can be crazy even when the people aren't.

• The institutional imperative turns FOMO from an emotion into a mandate.

• If capital must be deployed, price eventually becomes a secondary consideration.

• Retail's greatest edge is not information or speed: it's the right to do nothing.

• Liquidity is a call option on other people's constraints.

3. One Contrarian Viewpoint

The bubble may be driven by rational professionals, not irrational amateurs.

We tend to blame speculative excess on gullible retail investors, but professionals often face the stronger compulsion. A retail investor can sell everything and go fishing. A benchmarked manager who does that while the market rises 30% may no longer have a fund to return to.

That means the marginal buyer near the end of a cycle doesn't necessarily have to believe an asset is cheap. They may merely believe that not owning it is more dangerous to their career than owning it is to their capital. This helps explain how bubbles can persist long after sophisticated participants recognize them. Being wrong with everyone else is survivable but being right alone can take longer than your institution allows.

4. One Investable Idea

Liquidity may be unusually valuable when everyone else is required to deploy.

GMO's positioning struck me as more interesting than any particular security: low risk budgets, low spread duration and substantial dry powder. Their thesis is essentially that if pro-cyclical leverage eventually has to clear, the winner isn't necessarily the investor who predicts the exact date, it's the investor who still has capital when somebody else is forced to sell.

This suggests a useful inversion. Most investors think of cash as an asset that is not earning enough. When institutions are benchmarked, levered or contractually compelled to deploy capital, cash also represents freedom from their constraints. The optionality becomes most valuable precisely when everyone wishes they had kept some.

The trade isn't “predict the crash,” it's to preserve enough liquidity to become the buyer when someone else's mandate turns them into the seller.

5. From the Archives: A Recall Highlight

“Wait until the odds are tilted, then bet huge.”

From The Outsiders. The best capital allocators didn’t feel compelled to constantly act. They walked away often, ignored Wall Street, and deployed aggressively only when the opportunity was asymmetric.