The Invisible Hands

Foreword to the 2010 Edition

Question: What is the difference between a Peruvian peasant farmer and a Harvard or Yale endowment manager?

Answer: The peasant is the one who understands risk-sensitive investing and sound investment goals.

That question and answer illustrate why I, as a mere impractical academic historian, find the practical world of investment fascinating.

I got my first peek into the mystery-wrapped world of hedge funds several years ago, when Steven Drobny invited me to give the opening address at his annual conference for hedge fund managers. That initial peek aroused my curiosity. It led me to return to his conference in the following year as an observer, to meet some of Steven's colleagues and invited managers, to read Steven's previous book, Inside the House of Money, and to enjoy brunches with Steven from time to time, where we talk about anything from hedge funds and raising children to fixing the world.

One reason why I became fascinated in the world of investing was the parallels that I saw between investing and history. The issue of risk is acute in both of those spheres. Endowment and hedge fund managers evaluate upside and downside risk to the money they manage for other people, and they make or lose money as a result of those evaluations. The historical and modern peoples whom I study assess upside and downside risk to their own resources that they manage, and they and their families survive or die as a result of those evaluations.

For example, in the Middle Ages, the Norse on the island of Greenland, descended from Viking settlers who colonized Greenland in the year AD 984, made decisions each year about how many of their cows to cull in the fall. They knew the amount of hay that they had harvested during the previous summer, and knew the length of each individual winter (hence the demand for hay to feed the cows over the winter) over many past decades, but did not know the length of the particular winter lying ahead. If they still had hay left in the spring, that meant that they had culled a certain unnecessary quantity of cows, and they could have brought more cows through the winter, then produced more milk, cheese, and meat as a result and been less hungry the following year. If they instead found themselves running out of hay during the winter, that meant they had culled too few cows in the fall, meaning they would have to start sacrificing cows in the winter, ending up with fewer cows in the spring than if they had culled more cows already in the fall.

For about 376 years, the Greenland Norse made those annual decisions about risk-sensitive investment in cow herds sufficiently well that they flourished. But around year AD 1360 there was a particularly cold series of winters for which their hay gamble proved to be a bad miscalculation, with the result that all their cows died during one winter, and all of the thousand or so Norse of Greenland's Western Settlement starved to death in the late winter. Hedge fund managers will undoubtedly empathize with the dilemma that the Norse faced, and with their temptation to be greedy and to invest in many cows in their winter herd. But managers will be grateful, when their own risk calculations prove to be in error, that they themselves lose only their investors' money and don't lose their own lives.

Another reason why I was fascinated with what I learned about the world of investments was the parallels between investment managers and modern farming peoples. For instance, studies of modern Peruvian peasants resolved a mystery that long puzzled medieval historians, and that should have puzzled college investment managers. Each medieval peasant family didn't cultivate one large plot of ground; instead, they cultivated up to several dozen little strips of land scattered in several different directions from their hut, despite the obvious inefficiency of wasting time on traveling and carrying supplies between strips, as well as the waste of land inevitably left uncultivated at boundaries between adjacent strips belonging to different peasants. A possible explanation for the peasants' apparently irrationally stupid behavior was that they were practicing the virtue of diversification praised by modern financial managers: don't put all your eggs in one basket but instead diversify your portfolio. In any given year, all the strips in a single field may fail because of pest infestation, local climate, or thieves. You (the peasant family) are less likely to starve if you plant different scattered strips.

That idea of diversification is plausible, but only recently did economic historians and agronomists discover how sophisticated are the underlying calculations performed unconsciously by peasants. Modern Peruvian peasants scatter their strips of land as did medieval English peasants. Any individual Peruvian peasant owns between 9 and 26 different strips, whose yields of potatoes and other crops vary from year to year independently of each other and partly unpredictably. The peasants can't store significant quantities of potatoes from one year to the next; their food needs have to be satisfied by the current year's harvest. In analogy to the medieval Norse farmers' need for hay, the modern Peruvian peasants must succeed in obtaining a certain minimum potato harvest amounting to about 680,000 calories in every single year, otherwise they and their families end up starving. For 20 different peasants owning a total of 488 strips, the anthropologist Carol Goland measured the potato yields in successive years, then used those measured years to calculate the yield that each peasant would have harvested each year by cultivating only 1, or 2, or 3… etc. strips, with total area held constant but with yield per acre equal to the value for each possible combination of the 1, 2, 3 etc. actual strips. She also measured the calories invested in travel between 1, 2, 3… strips, in order to obtain the net calories remaining to the peasant for each combination.

Four interesting conclusions emerged from Goland's study. First, the long-term time-averaged potato harvest decreased with subdivision of the peasant's land, in agreement with the expectations of horrified western agronomists who urged the peasants to consolidate their strips, and for several reasons including wasted travel time. Second, the year-to-year variance in potato harvest decreased with increasing subdivision of the peasant's land, as expected from the principle ``don't put all your eggs in one basket.'' But, because of that variance, the third conclusion was that the frequency of the years with a harvest so low as to cause starvation was highest for a single strip and decreased with subdivision to reach zero at a certain number of strips varying between 4 and 13, depending on the particular peasant's land. Finally, each individual peasant planted 2 or 3 strips more than the number required to reduce the risk of starvation to zero.

In short, the peasants do not aim at maximizing long-term time-averaged yield, even though that is an appropriate goal for investors not spending their earnings and just investing to pay for luxuries on a rainy day in the distant future. Instead, the peasants only maximize long-term yield insofar as that is consistent with their overriding goal of eliminating their risk of starving in any given year, and throwing in a small safety margin for that calculation. It seems to me that the Harvard and Yale endowment managers are in a position analogous to that of the peasants, and would have done better to set a goal of maximizing yield only above a certain minimal level. As a Harvard graduate myself, I receive my college's periodic mailings, the tone of which has recently changed from pride in Harvard's wisdom to tales of woe. Harvard, like Peruvian peasants, uses endowment income for current needs; in fact, as it turns out, a considerable fraction of college expenses is paid from the endowment each year. As a result, Harvard has had to impose a hiring freeze, and recently it had to cancel its plan for a new science campus.

Naturally, Peruvian peasants did not perform the sophisticated statistical analysis that Carol Goland performed retrospectively. Instead, they arrived at their solution of optimizing strip numbers to avoid starvation on the basis of long experience. They had observed some greedy but lazy peasants with overconsolidated holdings who glutted themselves for many years, only to starve to death in a bad year. Likewise, they observed other peasants with overspread holdings who never starved but also never glutted, while still others discovered a happy medium of strip numbers that permitted frequent modest gluts and never any starvation. Should you suspect that the peasants really did use a pocket calculator and a friendly visiting mathematical modeler, birds such as sparrows, which certainly don't have pocket calculators, also make similar risk-sensitive decisions such that they are never starving.

Steven Drobny's latest book is about the Peruvian peasants of the hedge-fund world: that minority of managers who made money or at least preserved capital during the Annus horribilis of 2008, while greedier managers who had accumulated major gluts and perhaps even achieved higher long-term time-averaged returns in previous happy years lost disastrously or went bankrupt. Hence, anyone interested in the world of finance and making money will pour over this book to extract some powerful lessons: What can I do to emulate those successful guys and gals in order to make money or preserve capital, even under the worst conditions, and become rich and famous?

But this book will also fascinate anyone interested in people. My other interest in the hedge fund world...