Tribalism and Consistency in a Volatile Market

A somewhat lengthy piece discussing some of the psychological hindrances all of us face from time-to-time in investing and trading pursuits.

We share one chart right at the end of the piece with little comment, which is the basis of our expectation that the US equity market is to see new highs still.

The Science of Tribalism

 “Everybody wants to protect their own tribe, whether they are right or wrong.”Charles Barkley

While watching television, have you ever looked away or squealed in response to a gruesome scene, the kind that became a regular occurrence on HBO’s Game of Thrones?  Turns out, this is because the imagery activates our brain’s empathy network, which then stimulates brain areas involved in the sensation of our own pain.

Neuroimaging studies have revealed that watching another person in pain triggers brain areas that are active when we feel pain. The neural response to seeing others in pain, however, is not constant; rather it is modulated by context and by allegiances.

Neuroscientist David Eagleman used functional magnetic resonance imaging (fMRI) to measure the response in the brain’s empathy network. He examined the brains of people watching videos of other people’s hand getting pricked by a needle or touched by a Q-tip. When the hand being pricked by the needle was labelled with the participant’s own religion, the participant’s empathy network showed a larger spike of activity than when the hand was labelled with a different religion.

More surprisingly, when participants were assigned to an arbitrary group immediately before the subject entered the MRI machine, and the hand being pricked was labelled as belonging to the same arbitrary group as the participant, the participant’s brain still showed a larger spike ― even though the grouping did not exist just moments earlier!

Participants also exhibited a diminished response in their empathy networks if they believed the pain-recipient has acted unfairly in a simple economic exchange or were told that the victim is receiving a large monetary compensation for undergoing the pain.

Commitment and Consistency

“Consistency is the hallmark of the unimaginative.”Oscar Wilde

Last week we were forwarded a quarterly commentary and portfolio review for a fund managed by a self-proclaimed “old-school value investor”. The commentary was standard fare really, espousing the well-known values of Graham and Dodd and Buffet and Munger schools of investing as would be expected from a value-oriented manager. The fund manager was particularly insistent that they only buy “companies at a big discount to the present value of their future cash flows”.

As we turned to the section listing the fund’s top holdings, that too read like a standard portfolio that we had seen from countless other value managers. There was a lot of Google in the portfolio, a little Apple, a few big-name financial stocks and a not-so-insignificant allocation to General Motors. Except there was one holding which we did not expect, Netflix. And seeing it in the list of holdings, one of top-five in terms of allocation, irked us. Reading the commentary already felt like it was not the best use of our time but after seeing Netflix in the portfolio, the feeling changed to that of being cheated somehow.

Feeling cheated after reading the commentary and seeing the holdings for a fund we are not invested in, strange right?

The following passage is excerpted from Influence: The Psychology of Persuasion by Robert B. Caldini (emphasis added):

Psychologists have long understood the power of the consistency principle to direct human action. Prominent early theorists such as Leon Festinger (1957), Fritz Heider (1946), and Theodore Newcomb (1953) viewed the desire for consistency as a central motivator of behavior. Is this tendency to be consistent really strong enough to compel us to do what we ordinarily would not want to do? There is no question about it. The drive to be (and look) consistent constitutes a highly potent weapon of social influence, often causing us to act in ways that are clearly contrary to our own best interest.

Consider what happened when researchers staged thefts on a New York City beach to see if onlookers would risk personal harm to halt the crime. In the study, an accomplice of the researchers would put a beach blanket down five feet from the blanket of a randomly chosen individual—the experimental subject. After several minutes of relaxing on the blanket and listening to music from a portable radio, the accomplice would stand up and leave the blanket to stroll down the beach. Soon thereafter, a researcher, pretending to be a thief, would approach, grab the radio, and try to hurry away with it. As you might guess, under normal conditions, subjects were very reluctant to put themselves in harm’s way by challenging the thief—only four people did so in the 20 times that the theft was staged. But when the same procedure was tried another 20 times with a slight twist, the results were drastically different. In these incidents, before leaving the blanket, the accomplice would simply ask the subject to please “watch my things,” something everyone agreed to do. Now, propelled by the rule for consistency, 19 of the 20 subjects became virtual vigilantes, running after and stopping the thief, demanding an explanation, often restraining the thief physically or snatching the radio away (Moriarty, 1975).

To understand why consistency is so powerful a motive, we should recognize that, in most circumstances, consistency is valued and adaptive. Inconsistency is commonly thought to be an undesirable personality trait (Allgeier, Byrne, Brooks, & Revnes, 1979; Asch, 1946). The person whose beliefs, words, and deeds don’t match is seen as confused, two-faced, even mentally ill. On the other side, a high degree of consistency is normally associated with personal and intellectual strength. It is the heart of logic, rationality, stability, and honesty.

The fund manager was inconsistent. He championed investing in “companies at a big discount to the present value of their future cash flows” and then went ahead and owned Netflix. The gall of it!

The Incompatibility of Tribalism and Consistency in a Volatile Market

Our vocation is such that we are often engaged in debate. On the merits of buying one security over another. On the signals from one asset class for the prospects of another asset class. On the reaction function of the Federal Reserve to the latest release of economic data. And on many other topics much like these.

Over the last eighteen or so months, markets have been extraordinarily challenging.

US stocks have rallied, sold off, rallied sharply, sold off sharply, rallied sharply and now started to chop. G-7 governments have sold-off with the US ten-year reaching yields of 3 per cent and then rallied to record low yields. The trade-dispute between the US and China has escalated, de-escalated and escalated again on more occasions than we care to recall. Bitcoin lost more than two-thirds of its value, then tripled and then halved. Repo rates spiked for reasons no-one can fully comprehend. Oil witnessed the re-emergence of a geopolitical premium only for it to subside almost instantly.

In our discussions and debates, we have found that a fair share of traders, active managers and asset allocators are, more than ever, struggling to keep up, let alone outperform, broader market indices. Markets are never easy, in these challenging climes even less so. Nonetheless, two of the recurring hindrances to better performance we have increasingly noticed are tribalism and consistency.

Tribalism in Social Media and Investment Decision Making

Tribalism can be easy to spot. Just go on to Twitter and you will find bond bulls re-tweeting bond bulls, goldbugs sharing articles of Paul Tudor Jones stating that gold is his best idea for the next two years, equity market bears praising the analysis of other bearish analysts, Tesla bulls and bears slinging mud at each other, the examples are countless. Worse still, try debating with someone you do not know but disagree with and present factual data that invalidates their view and you are likely to be blocked more often than you would expect.

Tribalism in a social media context leads to filter bubbles and to the consumption of news, views and research that confirms that which we already know or believe. The utility of a social media platform, such as Twitter, to a user is significantly reduced by tribal behaviour. It has never been easier, faster and cheaper to seek out and obtain a variant perception. Investment professionals and traders would be better served and probably see improving performance if they used social media platforms more to seek out non-conforming views rather than searching for the false sense of security that belonging to arbitrary Twitter tribe would bring.

In professional settings tribalism is less of a problem but at the same time harder to spot. At investment firms, it usually manifests in team members with non-consensus views or opinions being cast aside in the investment decision making process.

Tribalism can lead to poor investment decision making when good ideas are rejected because they are put forth by those long belonging to the ‘other tribe’ and bad ideas presented by those belong to ‘our tribe’ are accepted.

Worse still, is the case of tribal behaviour on social media that creeps into professional settings. If you are wondering if it really happens, we recently attended a meeting with a prospective client where one of the analysts quoted recent tweets by three, to remain unnamed, permabears to make a case against an allocation to US equities.

Consistency is the Real Enemy

“Laziness isn’t merely a physical phenomenon,about being a couch potato,stuffing your face with fries and watching cricket all day. It’s a mental thing, too, and that’s the part I have never aspired for.”Shah Rukh Khan, Indian actor, film producer, and television personality

While tribalism can be toxic, it is consistency that can be the real enemy in the investment decision making process.

Since a “high degree of consistency is normally associated with personal and intellectual strength” it usually serves one’s interests to remain consistent. The downside, however, is that this fosters almost blind consistency which is detrimental, and at times outright disastrous, in the process of investment decision making.

Blind consistency, outside of investment decision making, has its attractions. For starters, it frees up our mental resources by giving us a relatively effortless means for dealing with the complexities of daily life that make severe demands on our mental energies and capacities. Having made up our mind about an issue, blind consistency allows us to stop thinking about the issue and when confronted with the issue we only react in a manner consistent with our earlier decision.

Another attraction of mechanically reacting to an issue is that it protects us from the uncomfortable truth that we may be wrong. If we never expend the energy to understand the counter-argument, and reject it off the bat, we never have to confront the possibility that we may wrong.

Consider the following (real life) examples and if any resonate with you.

Bond bulls who will exit their bonds positions to lock in profits but will never go long stocks because a recession is always just around the corner.

– Gold bears that short at the lows because it’s a ‘barbarous relic’ and fail to cover or go long even as real rates are collapsing.

– Federal Reserve critics that see every market jitter as further confirmation of central banker incompetence but have not taken the time to understand the intricacies of the financial system.

– US dollar bulls that never go long another currency against the greenback even as it becomes painfully obvious that a rally has become over stretched.

– Permabears that told you that Apple was done after the ‘failed’ iPhone 5 and now poo-poo over the company’s services narrative.

– The bearish fund manager that identifies the flaw in his framework that led them to catastrophically underperform over the last decade somehow finds that the updated framework indicates that is time to short US stocks.

– The technical analyst that shows you analogs of today’s US market performance versus sometime leading up to the crash in 1929, 1987, 2008 or any other market crash that can be found or compressed to fit the narrative but never one that shows the market going higher.

All of the above examples are of blindly consistent people. In any other context you would respect them. In an investment context, they would have at times cost you money, a lot of it. In many instances it is acceptable to underperform. It is, however, unacceptable to underperform because you were unwilling to do the work or to appear inconsistent.

Improving Liquidity Indicators Suggest New Highs Still to Come

Combine the below with the three charts we shared last week and the prospect of the S&P 500 reaching levels 10 to 15 per cent higher from here is not altogether unreasonable.

Thanks for reading and please share!

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed

Volatility Selling and Volatility Arbitrage Ideas Using Equities

“Here’s something to think about: How come you never see a headline like ‘Psychic Wins Lottery’?” – Jay Leno

 “Nothing in life is as important as you think it is when you are thinking about it.” – Thinking, Fast and Slow, Daniel Kahneman

 “I hate to lose more than I love to win.” – Jimmy Connors


Prospect Theory, developed by Daniel Kahneman and Amos Tversky in 1979, is a descriptive model that characterises how people choose between different options and how they estimate the perceived likelihood of each of these options. The main findings of Prospect Theory are:

  1. People care about gains or losses more than about overall wealth;
  2. People exhibit loss aversion and can be risk seeking when facing the possibility of loss; and
  3. People overweight low-probability events.

The Chicago Board Options Exchange Volatility Index, better known as the VIX, is the primary gauge used by equity and options traders to monitor the anxiety level of market participants. The VIX measures the market’s expectation of 30-day volatility of the S&P 500 index. The higher VIX is, the higher the anxiety levels amongst market participants.

Market participants can express their view on short-term market volatility through a number of instruments. Two of the most common ways used are selling options on an equity index or by shorting the VIX. As equities tend to decline as volatility rises, the preference amongst market participants is to sell puts over selling calls. Added to that, puts are usually more expensive than calls; selling puts generates a higher premium.

Selling volatility, using either equity index options or by shorting the VIX, is the capital markets equivalent to selling lottery tickets. Large losses in a strategy involving selling volatility tend to coincide with market crashes. Large but rare losses, i.e. negative skewness, justify a positive risk premium for the strategy.

Selling volatility on equity indices has provided attractive payoffs over long periods of time. The strategy had a high long-run Sharpe ratio over the two decades between the 1987 crash and the 2008 Global Financial Crisis. Even higher levels of performance have been achieved by the strategy since the equity market lows in 2009. The reason the strategy has been profitable is largely due to implied volatilityon equity indices consistently trading at a premium over realised volatility. Based on monthly data from 2005 till date, as shown in the chart below, the average differential between the implied and realised volatility on the S&P 500 index is 1.2%.

S&P 500 Index Implied Volatility less Realised Volatility

Implied vs RealisedSource: Bloomberg

Selling volatility has become a very popular trade, to say the least. The proliferation of exchange traded funds (ETFs) and exchanged traded notes (ETNs) that track either the performance or the inverse of the performance of the VIX has made selling or buying volatility, otherwise complicated trades to structure, accessible for the average investor. Investors can go long the inverse VIX instruments or short the long VIX products if they want to sell volatility.

Based on the tenets of Prospect Theory, the popularity of short volatility strategies is somewhat confounding. By investing in such strategies, investors are under weighting as opposed to over weighting a low probability event (a market crash). At the same time, they are giving preference to negative skewness, favouring small gains at the risk of incurring large losses.

During October, 2017, the VIX recorded its lowest monthly average since the launch of the index dating back to January, 1993. What makes this statistic even more remarkable is that autumn months are generally more volatile with October being, on average, the most volatile month during the year.  The average level of the VIX for October, starting 1993, is 21.8 – more than double the 10.1 averaged last month.

Proshares Short VIX Short Term Futures ETF Price Performance Proshares Sort VIXSource: Bloomberg

With volatility recording all-times lows and equity markets at all-time highs, some have called selling volatility the “most dangerous trade in the world” while others expect an inevitable rise in volatility to cause a significant correction in US equity markets. While these views may prove to be correct, our view is slightly more nuanced.

The increased availability of volatility instruments has made trading volatility more liquid than it used to be. Just as other securities benefit from a re-rating as their liquidity improves, volatility has structurally re-priced due to the proliferation of vehicles facilitating short and long volatility trades. We do not know the degree to which this increased liquidity should improve valuation but accept that volatility should be lower than it used to be prior to this structural shift.

Another reason why we think volatility should be structurally lower today than it used to be is the rise of passive investing. Passive investment vehicles are gathering an increasing share of assets and deploying them in systematic manner. A systematic allocation strategy is by construct more predictable, less volatile than a discretionary allocation strategy.

Taleb, in his paper “Bleed or Blowup? Why Do We Prefer Asymmetric Payoffs?” featured in the Journal of Behavioral Finance in 2004, argues that the growth of institutional fund management also contributes to the rise in the negative skewness bias. We consider the case for money managers preferring investment strategies exhibiting negative skewness to be credible as such strategies superficially boost Sharpe ratio over extended periods of time, supporting asset gathering efforts.   

With all that being said, we do consider the short volatility trade to be richly valued. That does not mean we expect the equity market to crash, instead the differential between implied and realised volatility has tightened to such a degree that this gap can easily close and invert. The trade can become loss making without a meaningful correction in equity markets.


Investment Perspective

The S&P 500 index’s implied volatility is almost two standard deviations below its average over the last 7 years. Not being psychics and being cognisant of the incremental improvements in the economy, we are not calling for a significant correction in the overall market. However, such low levels of volatility, in our opinion, are bound to lead to investor complacency in areas of the market that do not warrant it. And it is these areas of the market we search for to avoid or short. While at the same time we also search for areas where anxiety levels are extended and have the potential to revert back towards the mean.

S&P 500 Index Historical Implied VolatilitySPX imp volSource: Bloomberg

In our search we have found two sectors where we find unwarranted levels of complacency: airlines and cable & satellite and broadcasting businesses.

Capacities are rising in the airline sector at a time where costs are also rising. Airlines have enjoyed a significant tailwind due to the crash in oil prices; however, oil prices are rising and we expect further upside to oil prices from here. This will be a major headwind for airlines at a time when there are already cost pressures from rising  salaries for pilots due to a shortage of qualified pilots. Despite the headwinds, implied volatility for airlines stocks are at one to two standard deviations below their averages.

Southwest Airlines Historical Implied VolatilityLUV imp vol

Source: Bloomberg

American Airlines Historical Implied VolatilityAAL Imp Source: Bloomberg

Delta Airlines Historical Implied Volatility DAL imp volSource: Bloomberg

Cable & satellite and broadcasting businesses face structural issues that bring into question the viability of their business models. These issues are similar to the challenges faced by advertising agencies that we have articulated in Unbranded: The Risk in Household Consumer Names. Despite the challenging outlook, we find investor complacency to be high in a number of names within the sector.

CBS Historical Implied Volatility CBS imp volSource: Bloomberg

We consider the shorting of stocks in the sectors with challenging prospects combined with high levels of investor complacency, as a means to selectively reduce short volatility exposure or to go long volatility without the time decay or negative carry of direct long volatility trades.

To complement our short ideas, we have also identified one area of the market where we find high levels of anxiety after significant draw downs have already taken place: the general merchandising sector. While there is still potential for further pain in the overall retail sector, we find there is an opportunity to pick up the pieces in a segment where we find some value.

Target Historical Implied Volatility TGT imp volSource: Bloomberg

 Dollar General Historical Implied Volatility DG imp volSource: Bloomberg


Dollar Tree Historical Implied Volatility DLTR imp volSource: Bloomberg

We are long target ($TGT), Dollar General ($DG) and Dollar Tree ($DLTR) and are short Southwest Airlines ($LUV), American Airlines ($AAL), Delta Airlines ($DAL) and CBS ($CBS).



This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.