Thread by @TaylorPearsonMe

1/ I think Goodhart’s Law is one of the most underappreciated ideas I know

The law itself is simple: when a measure becomes a target, it ceases to be a good measure.

2/ For example, when most people buying/renting a house or a condo, the internet search order goes something like:

1) Pick the location
2) Pick the price range
3) Pick the square footage/nr of bedrooms
4) Finally, bring in other parameters, such as a garden, backyard, etc.

3/ However, this obscures important factors: My current apartment has far more natural light and higher ceilings than my previous place but it’s cheaper because it has fewer square feet.

4/ Because things like location, price, and square footage are easily measurable, they have become not just measures, but targets.

Things like natural light or architectural style are hard to illegible (taylorpearson.me/illegible/), and so they tend to get ignored.

5/ A measure is always a proxy. It is a form of compression that loses some of its original fidelity. Revenue is an important measure of a business’s health, but it is not the only one.

6/ There’s nothing wrong with using measures as proxies as long as you recognize that’s what’s going on.

However, when we forget that they are simplifications of a much more complex underlying reality and make them into targets, they can cease to become good measures.

7/ Consider another, more pernicious, example of Goodhart’s Law: the use of simplified measures in investing and investment management. Take, as a single example, the Sharpe Ratio.

8/ The Sharpe ratio is the asset management industry’s go-to statistic for summarizing achieved (or back-tested) performance. According to Institutional Investor magazine, it is the most-cited reason to hire or fire individual money managers or invest in an asset.

9/ An asset with a high historical return that hasn’t been very volatile has a high Sharpe ratio while something with a comparatively lower return and more volatility has a lower Sharpe.

10/ This has a reasonable logic underlying it, investments usually don’t go to zero at a slow and steady rate, it tends to be accompanied by volatility and so using volatility as one proxy for risk is not unreasonable.

However, using it as a target becomes deeply problematic.

11/ It is Goodhart’s Law in all its glory and ugly consequences: responsible for many billions (trillions?) in unexpected losses.

First, Sharpe isn’t a measure of risk in the way any rational person would define risk.

12/ The Sharpe ratio was originally called “reward-to-variability” because volatility is not the same thing as risk.

What matters is not the volatility of an investment over the past few years (or even a few decades), but the risk of ruin – can it go to zero?

13/ Second, a long period of good risk-adjusted returns (whether risk is defined by Sharpe or something else) doesn’t mean anything about the future.

14/ The third problem with the Sharpe ratio is that investors tend to look at the return per unit of risk of an individual investment as opposed to their overall portfolio.

15/ They never look at a strategy’s holistic effect on their portfolio, however, that’s really all that matters in the long run.

Most investors fail to understand that combining two seemingly “risky” but negatively correlated assets, actually creates a less risky portfolio.

16/ Though there are no such guarantees of two assets being perfectly negatively correlated in the real world, of course, it is a good toy model for the power of constructing a portfolio of truly diversified, negatively correlated assets.

17/ This means it is impossible to know if something is a good investment for an individual without understanding what the rest of their portfolio looks like.

18/ The whole is greater than the sum of its parts: a portfolio of seemingly risky assets that are not correlated to each other actually creates a safe portfolio.

19/ A combination of individual assets with good historical returns or high Sharpe ratios doesn’t necessarily result in a portfolio with a good Sharpe ratio. Strategies and asset classes that have performed well over a period often share exposure to something in common.

20/ Most people just look at historical returns and hold their thumb up in the air and do some mental calculation of risk that is typically like “do my friends and neighbors do this and if so, then I’m sure one of them did due diligence and it’s not too risky”

21/ Focusing purely on returns is an even more dramatic example of Goodhart’s Law. When returns become the only measure that matters, people tend to end up with highly correlated portfolios where everything goes down at once, often in a spectacular and tragic fashion.

22/ Recognizing where Goodhart’s law is at play can be a big advantage, an illegibility arbitrage.taylorpearson.me/illegible/

In the case of your portfolio, it could mean the difference between a sustainable long-term approach and holding a ticking time bomb.

23/ Because reality has a surprising amount of detail (taylorpearson.me/overconfidence…) we can never fully understand the nuances of every last thing. This is why Goodhart’s law exists. In an incredibly complex world, we must rely on simplified measures.

24/ However, we can never forget that they are simplified measures, not targets.