Hedging
Dear Readers,
I decided what might be a good [or useful] topic for this fortnight’s article would be hedging. I’ve had a few followers recently enquiring about hedging, and have noticed a general lack of it, on the one hand, or some muddled thinking about what hedging actually means on the other. Though thinking doesn’t make it so, the way we think does to a large extent determine the way in which we act [and invest, trade etc]. Accordingly, I thought I’d tackle this somewhat complex topic at the grass levels first; with the way in which we think. For as anyone familiar with Thomas Kuhn realizes, our observations [and interpretations] are all ‘theory-laden’. Even if we are not aware of those theories, they lurk there sub-consciously, absorbed by some previous process of mental osmosis, given the social animals we are. And if this is so, then all the more reason to try to hold those implicit theories at arm’s length, in a more critical manner, in order to better recognize them, and thus become the agent of our own actions as opposed to just reacting in volatile markets, to be blown this way and that like flotsam on the sea. And so first a mapping out of the dominant ‘paradigms’ [to use Kuhnian language]. It’s my hope that in describing these paradigms, one might also develop a healthy sense of skepticism toward them, and so too develop an outlook that hedges.
Subscribed
Today, I think it’s fair to say we live in the shadow of Rationalism, with Rationalism being that over-reaching mode of thought that sought to map reason onto reality through the notion of Representation. The implicit belief was that the cogitations of theoretical/ pure Reason could make clear and distinct to us the otherwise murky nature of the real world… the one that lurked behind the phenomena of appearances. What started out so optimistically has slowly devolved over the course of centuries and could be said to have morphed into its very opposite today, that of Irrationalism [the ‘inner contradictions’ working themselves out]. For the irrationalist, there was never any objective god’s eye view to begin with, but all was seen to have been shaped by natural [or subconscious] forces. Overly optimistic Reason has certainly come crashing back to earth. It’s my opinion that with a history of thought we can better understand the way in which we [the dominant paradigm/ culture] tend to currently interpret the world . The truth is that many of us have absorbed a habit of thought without ever having stopped to critically assess it. And critically assess it one must, especially if one wants to gain a competitive advantage in speculative markets as the contrarian is like to do.
A speculative market is primarily a mass phenomenon driven by the collective behavior of market participants. However, the [somewhat old-fashioned] Rationalist may argue that the market is actually efficient, and that a kind of ‘wisdom of crowd’ logic is in operation [a derivative of the Adam Smith’s invisible hand]. This is thought to bring about a price discovery that is perfectly rational. It’s nice in theory, and that’s the problem. We all know that actual markets can be under or over valued, and that bubbles can form, and then burst, or slowly deflate. It’s in these kinds of episodes that the ‘madness of crowds’ hypothesis comes to the fore. It would seem that besides being wise at times, the crowd can be perfectly foolish at times [and does it have to be one of the other, and not both at various times?]. And so it should be as a market consist of a mass of human beings, a collective human nature, a Leviathan of sorts, with all its reason, and all its capriciousness. To think of it abstractly as some incredibly intricate and determined ‘mechanical’ operation is very nineteenth century. Despite all the theoretical fabrication, and despite however much we would like it to be that [remember Quant theory that nearly blew the financial world up in 2008], markets will elude our analysis, for that kind of analysis cannot account for the at times [or essentially] idiosyncratic quality of human nature around which markets revolve. No matter how much we want to rationalize markets, or the prices of certain assets within a market, their value will always be to a certain extent arbitrary as this value is created by the speculative fervor [or the opposite] of market participants.
The [more contemporary and savvier] reader might be nodding their head with me in sage agreement and thinking that of course markets are irrational, and that of course a bias, a narrative, a belief, and even a worldview lies at the heart of a speculative passion. They may go on to argue that irrational and passionate memes, advertising, and propaganda, are the way to influence the mass of market participants [and new entrants], not the cold, boring, efficient logic of the specialists. Markets, so they’ll say, are all about irrationalism. With this in mind, the rationalizations of yester-year start to appear a little quaint. But of course, what’s going on here is a second order rationalization that comes under the rubric of ‘fundamentals’ - the fundamentals, a set of self-evident truths that one must buy into, are the reason for the inexorable and exponential rise of values in the marketplace. The rational fundamentals become also a fully fledged ideology, and in doing so could be said to become a fundamentalism insofar as they become an object of indisputable faith. This Irrationalism shows itself in the end as a hybrid, tied to the hip of Rationalism, or the flip side of Rationalism, rooted as it is in the feeling and emotion of reactionary Romanticism.
But Dave, you might ask, what has the above digression to do with hedging. To which I’d say, everything and nothing - nothing insofar as subscribers to both Rationalism and Irrationalism do not feel the need to hedge, and so then also everything insofar as this starts to make the idea of hedging comprehensible [as something outside or alien to the dominant paradigms]. For hedging is based on the uncertainty principle, and that is something that both Rationalism and Irrationalism, as [often unconscious] ideologies, or theaters of the mind, inoculates people against. We can now say that hedging first involves a recognition of the uncertainty principle, and that this principle is a natural attribute of someone not having subscribed [or capitulated] to some self-contained and apparently self-evident ideology. The ‘hedger’ is in fact an enlightened sceptic, wary of all certainties and ultimate explanations. Explanations might be true [and certainly useful at times], but they also might not be true. The hedge here involves a ‘negative capability’. For the hedger, an explanatory idea [ideology] is only ever a provisional and pragmatic ‘truth’. As no particular idea is entertained at the exclusion of all else -opposite ideas might happily co-exist, and find themselves jostling side by side [this and that is the motto of the hedger, either/ or, the excluded middle, is the motto of the Rationalist, and this the motto of the Irrationalist]. They are in this sense also ‘hedged’ in that the various ideas also provide lines of demarcation or limits to each-other, just as properties with hedge-lines have.
And so goes the theory, or rather the meta-theory, or rather yet again the practical reason, or psychology, as opposed to the pure theoretical reason. This is the basis on which one will hedge. Given no certainties in the world of experience [beyond the a priori truths of math, geometry and logic], the investor in speculative markets will remain sober and always hedge, even as the markets might enter their ‘irrational exuberance’ stage. They’ve seen it all before, they’ve read it all before, and then are even unsure about all that [no-one since Leibniz knew everything]. Where those influenced by an ideology become uncomfortable with [and hence intolerant of] any cognitive dissonance whatsoever, those that hedge have this dissonance at their very core - it is that self-contained and completed cognition [ideology] that they are uncomfortable with and hence reject. Not looking for closure, they’re actually on guard against that theater of the mind also known as self-delusion.
And in more practical terms, when it comes to market positions, they’ll participate. They’ll look for long term investments that may make sense, without over-investing while diversifying. They’ll look out for signs of irrational exuberance, and look to utilize it in a contrarian manner. They’ll stake major and minor positions, and look to do well enough [moderation] as opposed to maximizing potential/ imaginative profits. They’ll take real profits at opportune times while holding longer positions as a hedge, or as their main position. And they’ll hedge against their main position altogether with the acquisition of real assets and real wealth [over and above financial assets], for as Ruskin said, there’s no wealth but Life.
I’ve hoped here to outline the rationale behind hedging. Ok, it did get a little intellectual. A more common-sense case could be made out for it, and in a single line - as there are no certainties, hedge. Unfortunately, I doubt that cuts it today, as people can lack common sense, and this erosion of common sense is largely due to a flood of popular ideology. Accordingly, this puts us back in the field of ideas. A quote from the first flowering of Rationalism comes to mind, ‘a little knowledge is a dangerous thing’. the suggestion was we we needed more. My take? If a little ‘knowledge’ is dangerous, then maybe a lot of it is positively fatal. : )
Until next time, stay safe out there.