More insurance distortions

More insurance distortions

The Ideological Turing Test

A few days ago I added a single line to the “about me” section of this blog.

I am a big believer in the Ideological Turing Test

Well — what is that exactly?

First, let’s talk about the Turing Test. This test, proposed by Alan Turing, key inventor of computation, defines a key milestone in artificial intelligence. The idea is that if a human is systematically unable to tell machine from human in the course of conversation, then the machine could be said to be “thinking” — like a human. To pass the test, of course, the machine has to be very good at imitating a human being.

So that brings us to our variation. I am sure that versions of this idea have existed for a very long time, but the genesis of this idea in the form that it reached me can be traced to Bryan Caplan. The idea is that in a debate between two opponents, the competitor that can more ably imitate the other’s argument is the more credible of the two. Why?

Mill states it well: “He who knows only his own side of the case knows little of that.”  If someone can correctly explain a position but continue to disagree with it, that position is less likely to be correct.  And if ability to correctly explain a position leads almost automatically to agreement with it, that position is more likely to be correct.  …  It’s not a perfect criterion, of course, especially for highly idiosyncratic views.  But the ability to pass ideological Turing tests – to state opposing views as clearly and persuasively as their proponents – is a genuine symptom of objectivity and wisdom.

I think this is unbelievably spot-on. Caplan, and others, go further and suggest that in long-running debates (like those between different camps of economists, which is the sort of conflict that inspired Caplan to develop this idea) that actual competitions be organized to determine a winner. But in general the logic of this thinking speaks for itself. In so many mini-debates I see the opponents mis-stating each others’ positions to the point where the points of contention are undefined, or at least understood differently by each participant. In these cases, no progress is made through discourse, and that’s a shame.

So, to repeat a homely adage, “Seek first to understand, then to be understood.”

Is socially responsible investing worth it?

Following Betteridge’s Law of Headlines, you may infer that the correct answer to this question is “no”. 

I was inspired to write this post while perusing the latest scandal around Herbalife, a very large company which appears to be a giant pyramid scheme. This presentation, done by a prominent hedge fund that has taken a massive short position, is an impressive takedown of the company. (Here is an accompanying website.)

While the company produces cash for shareholders, the thesis is that the company will eventually deteriorate due to legal issues and business model unsustainability. The most interesting take, however, came from an investor with a slightly different take:

“I am utterly convinced by everything in Bill Ackman’s presentation except the final conclusion — that Herbalife’s stock will collapse,” said Hempton, who also is a noted short seller. ”I took a long position on Christmas Eve.

“I suspect that Herbalife is so profitable and so powerful they will see Mr. Ackman’s attack off — and the easiest way to do that is to buy back stock (and make the stock go up),” he adds. “Mr. Ackman has given them the incentive to return their huge (but tainted) profits to shareholders (and I plan to be a recipient shareholder).”

This illustrates a fundamental problem with socially responsible investing (SRI), or paying a premium for one type of asset over another, holding relative risk and return constant: there will always be people that only care about the money.

This means two things will happen: first, this group will bid back up the price of non-socially-responsible investments (because they only care about return characteristics), confounding any attempt to create a non-financial premium. Second, this opportunity to correct the price imbalance just gives this group an opportunity to make more money! So not only should SRI not have a lasting effect, but it should also reward non-SRI investors in the bargain!

To illustrate this, imagine that there are two groups of people (“do-gooders” and “cold-hearts”) and two types of investments (“SRI” and “non-SRI”). Let’s imagine that the SRI and non-SRI investments offer the same risk/return characteristics and are priced at par — 100.

Let’s say that to the do-gooders, the SRI assets have a non-financial premium of 20, and the non-SRI assets have a non-financial premium of -20, so the two types of assets are worth 120 and 80, respectively. To the cold-hearts, there is no non-financial premium; both are just worth 100. 

If we modeled this in two stages, first the do-gooders would sell their non-SRI assets to buy SRI assets until they hit their equilibrium prices of 120 and 80, respectively. Then, the cold-hearts would just undo all that, effectively arbitraging across the two (financially) equivalent classes of assets, until their prices were back at 100/100. 

Of course, this interplay would not happen in discrete stages — it happens continuously — but the effect is the same. SRI is a broken concept. To drive investment towards the things that we want, we need to make them more profitable, plain and simple.