Investing Is Biology Not Physics
Markets evolve and adapt. Be careful extrapolating from the past.
Since the 1980s, there has been a tradition of Wall Street luring physicists from academia. Option math has more in common with the laws of thermodynamics than it does with accounting. But if the nature of markets themselves resembled any science it would be biology. Markets are governed by predator-prey dynamics. Models are adaptive. The actors learn. Doublethink and tradecraft.
In physics, the rules are fixed. No matter how many of us use the laws of gravity to keep firmly planted on planet Earth, gravity doesn’t get crowded. It keeps me just as bound to its surface as it did the Neanderthals. In markets, if I raise a bunch of money by showing people that selling volatility “harvests” a risk premium and the strategy continues to work then people will give me money to do it even more. So the strategy’s assets will grow both via inflows and via returns. The only problem is that to continue delivering the same performance on the larger asset base the strategy needs to sell ever more options. Assumptions of market liquidity when a strategy manages X will not hold when the strategy manages 10x or 100x. That’s about as close as we get to a physical law in finance.
The nature of liquidity is biological. It is subject to the whims of masses. It is the physical point where the backtest meets reality. Reality is a recursive, perma-learning system, with constraints and desires whose steers are pulled by investors, politicians, and corporations.
One of the best discussions I’ve ever listened to about what this looks like in practice is investor Andy Redleaf on Ted Seides’ Capital Allocators podcast. Redleaf has been in the game for over 40 years and was an early options market maker when they were listed in the 1970s. Since then he has followed opportunities that present themselves as markets change. A true agnostic on the hunt for profitable niches. Especially niches with structural reasons for being extra profitable. The advantage of this approach is that when the reasons go away, you know it is safe to cut and run. The disadvantage is that you cannot be a one-trick pony. You need to keep finding easy games.
For the full discussion of market history, where sources of edge often lurk, investing challenges today, and why he bought a bank check out the episode including my notes. (Link)