Ben Hunt: Epsilon Theory, Wall Street's Game of Leverage, Forecasting Uncertainty and Narratives
Ben Hunt is the creator of Epsilon Theory and inspiration behind Second Foundation Partners, which he co-founded with Rusty Guinn in June 2018.
The following is from Tiger’s Substack email "You're not smarter than the crowd you try to play..." about the interview:
It would be an understatement to say that I was tremendously excited to interview Ben Hunt, who is one of the most thoughtful thinkers in the financial world that I got to follow.
Ben always boils things down to their core and reveals the underlying structures of the issues. You may not agree with his analysis, but you feel that everything from his renowned blog “Epsilon Theory” is about advancing our fundamental understanding of the bigger picture, rather than scratching the surface and inundating us in noises.
Here are some of Ben’s many fascinating arguments in our interview:
It’s dangerous to consider ourselves as the only ones who know how to “game the system,” while in fact there are much smarter players watching the crowd playing the crowd and ending up devouring us all;
The core function of Wall Street narratives and financial innovations is to involve retail investors more deeply into the financialization of this economy by giving them easier access to credit and leverage;
We need to reduce Wall Street’s influence on democracy, rather than trying to “democratize Wall Street.”
In the interview, there are much more detailed explanations on the GameStop saga and other recent market accidents; the business model of Wall Street; the power of narratives, common knowledge, and crowd playing the crowd… We discussed a lot about finance, but it’s really a far-reaching conversation with Ben’s insights on politics, social structures, human nature, and beyond.
Why the “epsilon” term matters
The name “Epsilon Theory” comes from the most classic normal linear regression model in econometrics and social science analyses at large: Y = β0 + β1 x + 𝜺. You want to find the best linear model for observed data that shows the relationship between two variables Y and X, but since it’s very rare to get a perfect fit, you group everything else into this error term that we call “epsilon.” However, as Ben explains, so much that determines one’s performance in the financial markets is neither one’s “alpha” (excess returns over the broader market, so one’s edge) nor “beta” (the broader market benchmark), but rather how one deals with the epsilon – the error term that we often ignore.
For example, we often say “you don’t just play the cards; you play the players.” The cards you’re dealt with are the fundamentals of the markets and companies, but everything to do with playing the player is in fact in the epsilon term. These shouldn’t just be treated as an error term. There is so much more to learn from this epsilon term as it can create an edge when used properly, or become a disadvantage to investors when misunderstood and ignored.
This is the power and significance of narratives. Every social influencer and public company CEO understands this game: to create a story and widely distribute that narrative so that it becomes public knowledge. This is how central bankers use “forward guidance” to influence the markets; this is how Wall Street bankers determine the valuation multiples… It all comes down to the narrative and the common knowledge.
Yes, it’s about the fundamentals and the cards, but they’re amplified and distorted by narratives and the crowd. Just look at the GameStop saga! Ben explains how the whole “David vs. Goliath” narrative enthusiastically portrayed by the media is not what truly happened, and the retail traders were used and abused. But what truly happened also does not matter. The story of the retail trader revolt is “what everyone knows everyone knows,” and the narrative of the story has become the reality and ended up influencing market dynamics more than the reality itself.
Average investors think they’re good at playing the players when they really aren’t
It’s not a new idea to say that narratives matter – we’ve all heard of John Maynard Keynes’s analogy of the stock market to beauty contest – but the danger is to consider ourselves as the only ones who know how to play the narrative game, while in fact there are much smarter investors watching the crowd playing the crowd and end up devouring us all. This is not just the second-order consequences of market behaviors, but third-order and probably extending to Nth-order!
Funny enough, I interviewed Ben on 4/21 right after “420” – the “Weed Day” where the dominant narrative was everyone should buy Dogecoin so that we can rebrand 4/20 as the “DogeDay.” On 4/19 the price was hovering around $0.39, and people wanted to push it to $0.69 by 4/20. One of my friends bought Dogecoin around 4/19 – not because he believed in Dogecoin’s vision, but because he thought there would be enough people buying Doge around that time so that he can play the crowd and make a quick profit.
I told Ben about this story, and he described it as the “common knowledge game” – which is what everyone knows everyone knows. When Elon Musk tweets about Dogecoin, rational people who see the tweet would understand that everyone else also saw the tweet. It’s not so much that everyone else is so stupid that they’ll all buy Dogecoin because Elon Musk says so, but rather that everyone thinks there are also a lot of other people like themselves who are looking at other people’s behaviors and contemplating about buying Dogecoin.
It’s the power of the crowd watching the crowd, which is one of the most powerful forces in history for social influence and social control. This is why executions used to be done all the time: it’s not about punishing one specific person per se, but rather making sure that the crowd can see the crowd watching the execution.
“Everyone else is as smart as you are,” said Ben. Nobody is stupid out there. “Everyone is thinking like you’re thinking” – everyone believes they’re artfully playing the crowd, but not everyone ends up making money, so someone has to be left holding the bag.
My personal takeaway is that there is definitely someone out there smarter than me who is better at playing the narrative game, and it’s more likely that I fall prey to these smarter investors than being the smarter one myself. It’s not that retail investors should never play the narrative game, but a bit more caution and humility would go a long way.
Trying to game the system sounds like a waste of human potential
We can extend this idea of “playing the crowd” into life beyond financial markets. It’s mind-boggling to me why so many young people try so hard chasing meaningless titles like “Forbes 30 Under 30,” “social entrepreneurs,” “young thought leaders” rather than spending time mastering their craft. Many of my friends spend so much energy constructing a public image that they admit to me in private is bullsh*t. Why?
They say they’re being smart and gaming the system. “Oh I know the tech discussions on Clubhouse are circle jerks filled with noises and a waste of my time, but I still do them because there are other more superficial people caring about it, and I’m just taking advantage of it all.”
Well, perhaps, but more likely it’s just a waste of human potential. Just like there are very few investors who can truly time the market, I believe there are very few who are truly great at gaming the social systems they’re respectively part of. Most just think they’re being smart but are in fact wasting their lives away.
Often, the smartest thing an average investor should do is to simply do nothing – don’t day trade; don’t play around with leverage and credit; just design a long-term plan, stick to it, and let compounding do its work. Likewise, the smartest thing all of us should do might simply be to find something we truly love and master our craft in it, instead of constantly trying to outsmart the system.
The nudging state wants everyone in on the game of Wall Street
Right now making money in financial markets feels very easy, and the biggest risk almost seems to be to not getting in the game. It’s hard to have a sense of humility when making money is easy for retail investors, and our overconfidence in our ability to “play the crowd” and “time the market” may nudge us into making poor choices. This is how people buy cryptocurrencies and stocks at the top and end up losing their life savings…
Ben would call this “the nudging state,” where Wall Street and the government use various financial innovations and narratives to nudge the public into playing their game – a game where ultimately the establishment institutions with bigger stacks and “too-big-to-fail” insurance policies will prevail.
Robinhood is about “democratizing finance;” SPACs are about “breaking free from your traditional passive investing portfolio and finally being exposed to tech innovations;” and GameStop is a “David vs. Goliath” moment where “the little guys took down the corrupt establishment”...
But ultimately all these narratives serve one core function – to involve retail investors more deeply into the financialization of this economy by giving them easier access to credit and leverage. And as Ben and I have both written many times, we’re pretty sure that’s not a good thing.
As Ben put it – it’s not helpful to democratize Wall Street. It is a game that he loves playing, but he doesn’t confuse it with democracy and what it means to be a good human. He believes this country needs to reduce Wall Street’s influence on democracy, rather than trying to “democratize Wall Street.” To do that, we would need to take leverage out of the system and get fewer people involved in the game.
It’s truly not enough to go over all of Ben’s fascinating arguments here, so I’ll stop for now. I highly encourage you to listen to the interview and follow Ben’s writing and podcast, so that we may all reach the goal of “clear eyes, full hearts, can't lose” – as Ben advocates.
Ben Hunt