Gross Expectations

Vol #208 - January 2nd, 2025

During the 2021 crypto bonanza, there was a protocol called Anchor that offered a 20% yield on stablecoin deposits.

The clickbait TikToks showed envelope math on how you could afford a house in Malibu with some simple recursive borrowing and leverage. The multi-M lifestyle floated by only a few hundred K. A nearly self-evident fraud. Yet plenty of “sophisticated” firms got caught in a second order trap related to this structure, so don’t mock the retail buyers too loudly.

Parabolic compounding was a found secret because nothing like it existed anywhere else. If you got a mortgage in the early ‘80s you know the power of double digit interest, but boomers weren’t exactly bridging over to Terra. Nearly two decades with a zero cost of capital rotted the collective spidey sense on what interest and credit risk could be.

If you’re sending funds through wormholes and dodging anarchist memes in support chat rooms, know you’re shopping at the Caveat Emporium. Something that was earning the blistering rate of 20% per annum was several decentralized orders of risk greater than t-bills. But even those rates weren’t enough to account for the ultimate risk. They were barely coins, and certainly not stable.

It takes a few minutes with a compounding calculator to realize just how much more powerful 20% is than your 4.5% T-Bills or 10% SPX “average”. You can’t graduate high school without learning this math. Yet twice in the past month I’ve been asked by individuals with higher level degrees and who are licensed to perform surgery if I could target that in a month.

Sorry to disappoint my loyal readership, but I don’t have the golden goose. And if you believe that anything in this world will passively pay you 743% in a year, I’ve got a pile of scrap metal in Paris to sell you to fund that. You’re asking to build castles in the sky with absolutely no foundation.

Focus on the lower left hand side, that’s where reality lies. 20% per annum feels like it’s within the grasp of 4.5% and 10% strategies, but within a few years it has more than doubled the return. It’s such an impressive wealth generation track record that we know the names of the few people to have done that.

But *clearly* 20% a month (generously treated as the non compounded 240%/annum) from your futures trading friend is possible. Seems like a mistake to go to med school if one year's tuition could have made you a billionaire twice over before the residency was done.

It’s absolutely wrong for financial advisors or content creators to suggest, let alone indulge this reality. The regulation says so, but you also have to be noxiously high on your own supply to believe this is going to work out. However even if you don’t traffic in nonsense, the fantasy sells itself, and corrupts “sophisticated” investor expectations. There’s no sales here, the dreamers are cold calling up asking for it.

Because financial advisors are the experts, and they’re being compensated for sage advice, it’s natural to regulate the supply side from pandering grossly inflated returns. But anyone who has the privilege and responsibility to be putting money away for tomorrow must do an ounce of homework here. There’s both a U and I in suitability.

If you’re a high earner, you’re likely to believe you’re a good investor too. Maybe you are. But the reality of the investment landscape is that the products that are accessible and suitable for the $1,000 account are in most cases the best for your $10M or $50M account too. A pretty efficient market means mostly the same opportunities and expectations for investors.

The secret to successful investing isn’t using your highly pedigreed cerebellum to “find” the right thing, it’s forcing your limbic system to get in line with the simple and boring. Just as successful financiers develop Dunning Kruger symptoms with post career ventures, the stock market has an uncanny ability to entice non professionals to think they’re smart enough to beat the odds.

An Achilles heel for big brains is believing complex is better. Matt Levine has certainly proven that arcane is interesting, but it’s not guaranteed to be the right investment answer. Whether it was crypto or crowdfunding, all of the worst investments I’ve made have been extremely interesting. If only that club had ever opened…

Allocating to private funds can be lucrative. They tout a 10.5% compounded return since the year 2000, with less volatility. The S&P500 CAGR for total return was about 7.8% over that time period. Distinctly better, but with a number of caveats. Yes, just 2.7% of alpha is significant!

Importantly, beware of liquidity and volatility laundering here. You can sell the S&P500 ETF any day you want to. (Though to get that 7.8% I’d strongly encourage you not to try for market timing purposes). A couple days of account setup and wire transfer patience is all you need. Forget about the next quarter, vintage, or whatever the gating rules say about redemptions.

Venture capital has similar restrictions on liquidity, but shows significant disparities in their results. Something like 2% of VCs earn 95% of the profits. A true irony as the herd of Patagonia vests goes unicorn hunting en masse.

The top quartile of funds earn 15-27% a year, roughly 2-3x the S&P. That means at least 75% of funds split the remaining 5% of the earnings, with many of them going negative. Unless you’re picking the top player there, odds look a lot worse than public markets.

But, but, you say, you’ve got a friend who has a secret momentum trading signal that he only works an hour a day and makes $10k on average? I’m not even going to get into that.

Looking at these three buckets of “equity” investments, by pushing out the risk spectrum we can have the most extreme upside expectations tempered just below 30% a year. And with any reasonable diversification, grounding yourself in the teens is still significant outperformance.

If you want to make more than that, it might be tough for your ego to hear, but your capital isn’t wanted. There are pockets of opportunities that will earn a risk managed 50% or even 100% a year. Just not for you.

The biggest limiter is capacity constraints. One of the super stars we can name with a >20% compounding record is Jim Simons, founder of Renaissance Technologies. Yet they only allow employees to invest in the fund and they return capital every year because they have no place to put it. But boy is that equity curve smooth.

Otherwise, or in addition, you find a money making operation is more like a business than a fund. Jane Stree made $14B in trading revenue for 9 months on a net cash balance of $8.6B. They also have 2600 people that show up every trading day with a chip on their shoulder to prove they're smarter than you. Prop shops can spit off more cash than operating a massive infrastructure requires and don’t care how big your check is.

Capital means very little to a highly efficient operation. Nothing that is exceptionally successful is in need of silent check funding.

Everything in trading and investment management is about results. Tell me the returns, the volatility, and perhaps the maximum drawdown, and you can frame a pretty accurate expectation. The dollars and cents don’t lie, so the other half of the match making exercise is knowing what you want.

Everyone has a different risk tolerance. Being willing to roll the dice is a symbol of pride for many. As is maintaining the discipline to meticulously compound your dividends.

Risk comes in many forms. It’s the price volatility, the liquidity, and everything else you don’t think about. As you take more risk, your return expectations can also increase. But as you dream of sponsoring a lavish wedding or sunsetting in a gorgeous beachfront condo, make sure you keep your feet on the ground.

The greatest disappointments come from mis-aligned expectations. It sounds like a pittance, but a few consistent percentage points add up. It’s time to start asking questions about volatility once those numbers get into the double digits. Those returns are possible, but it means taking more risk than the S&P500, which regularly drops more than 20%.

If nothing else, just do a little napkin math. If you can fantasize about all the things you can do with that money, so can everyone else. Take a half step further and realize that because the global mass of investors is chasing free money, there is no such thing. That should make it easier to stay simple and steady.