Discover more from Capital Flows
The Preponderence of Evidence
Testing An Adaptive Thesis
A lot of fun things to discuss in this edition so let’s get right into it!
My last article was short and sweet, saying I was opening a short ES position. For those of you who are a little newer to financial markets and this Substack, "ES" is simply the futures contract for the S&P 500 index. It is a way to bet on the movement of the overall index.
This short was opened at ES 4150. Today ES hit an intraday low of 4091. After cash equity close, MSFT and GOOGL earnings were released, coming in higher than expectations:
This caused both MSFT and GOOGL to rally post-market, which pushed up ES futures to 4109. Remember, these stocks have a higher weighting in the index, so they can move the index around a lot more.
We will see how things get priced through the London open and US open tomorrow. The ES short remains intact. I will let you know if anything changes.
A lot of people have asked me how exactly I determine the signals for a specific thesis. Here's the thing, there are a lot of ways to do this, but the underlying logic is the same for any domain of life. This isn't about trading and markets; it's about how to construct ideas in any domain.
As a baseline, I would point people to the book The Beginning of Infinity. This is a great starter for people understanding what a thesis is and how to create testability around it.
Fundamentally, though, you want to create a thesis that has BOTH falsifiability and confirmation built into it. This allows you to have clear actions based on the outcome, not purely your bias. If I want to short ES, I want a clear testable thesis that says, IF ES is doing X, then I do Y. And IF ES is doing A, I will do B.
There must be clear testability so that you know when you are right and when you are wrong. This applies to any domain of life. If you are running a business, managing a relationship, interacting with clients, etc., you need to have some type of process for testability.
What becomes more complicated is when you inject additional variables into hierarchies for testability. For example, IF ES is going down AND credit spreads are expanding AND the dollar is rising AND VIX is spiking AND specific sectors are leading = hold SHORT.
This could be true of a specific business decision: IF X client is doing Y AND TAM remains Z, perform a specific action UNTIL a specific event catalyst happens. Then from here, you can have redundancy planning or scenario analysis.
These principles exist in life for how to manage uncertainty. It's not just about US financial markets.
What do I do? I have a combination of systematic models and discretionary processes where I weigh insights and look for a "preponderance of evidence" for actions. I then create scenarios for clear action based on this. However, something I do is have processes/models in place to consistently update the thesis and inputs for signals. My goal is to have an adaptive thesis, with adaptive signals and adaptive risk management. This is easier said than done, and I am still working to perfect it. But I found it incredibly valuable. There are some great papers on SSRN going over adaptive risk management that are helpful, but to have a really good system, I think the input of experience is key.
Can't really talk more about the technical side of it, but what I would say is I want to match my adaptability to the changing environment. Quantifying this is powerful, regardless of the domain you are in.
What I still find absolutely astonishing is how little people read from other domains. You will be surprised how much alpha you find in your domain by reading books and having experiences in other domains. I actually came up with some strategies last year while reading a book on ancient architecture. Kind of wild!
The one thing I have gotten better at and continue to improve on is losing money. This might sound a little strange to some of you, but in reality, the way you manage your losses determines your success with anything in life.
In life, you are going to make mistakes. If you can minimize the impact of them, decrease their frequency, or bounce back from them faster, the speed at which you succeed increases.
Defining your risk is so much more important than dreaming about your reward. Optimally, I want to continually put myself in situations where my reward is infinite and my risk of loss is minimal.
The interesting thing is that depending on the domain you operate in and how your return profile functions, managing losses can be very different. For example, let's say you are running some type of strategy or in some type of business where the number of times you make money in a situation is around 10%. This means out of every 100 deals or trades you run, only 10% pay you. However, these 10% payout A LOT. This means you might have to go really long periods of time without making any money. The mental fortitude required for making money only 10% of the time is much higher than a domain where 60% of your trades/deals work out.
When you begin to think about these different types of "hit ratios" (the % of trades/deals where you make money), you can begin to see how different mentalities are required in different domains/strategies.
One of the things I spend time thinking about is how discretionary and systematic strategies function across this "hit ratio" spectrum. What I have realized is if you can be a discretionary manager with a low hit ratio but a crazy high payout, there is a lot of edges because the mental fortitude required for this is incredibly high, and most people prefer a systematic strategy to manage a lower hit ratio.
These messages mean a lot!
I received this message today, and it really meant a lot. I truly appreciate them! As I have said, you can always reach out to me via email or DM on Twitter. It might take me a little time to reply because I have a lot of stuff on my plate, but I will get back to you.
Also, these books are a must-read! Here is the link to the Twitter thread of the books I mentioned:
Whatever domain you are in, analyze the hit ratio of your work, how you are building a testable thesis, and your process for managing risk. Are these operating at maximum efficiency or simply in cruise mode?
Part of this process starts by taking extreme accountability for your results. Start there.
Be well, thanks for reading!