The Compound and Friends - An Economist Walks Into a Brothel (with Josh and Allison Schrager)

Episode Date: March 29, 2019

Enable the skill on Amazon - "Alexa, play The Compound Show" Josh here - I had so much fun hanging out with my friend Allison Schrager this week on the eve of her gigantic book launch for An Economist Walks Into a Brothel. Allison spent time with big wave surfers, Nevada prostitutes, Hollywood film producers, paparazzi cameramen, horse breeders, magicians and other real world practitioners to discover the way they handle risk. It's one of the most fascinating books I've ever read and Allison has the perfect combination of writing chops and mental horsepower to pull the whole thing off. Learning about the difference between insurance and hedging, for example, in a really fun format, will definitely pay off. There are lessons about ecosystems with a delicate trust factor, the dangers of overconfidence, the limitation of data analysis and so much more. Get Allison Schrager's new book, An Economist Walks Into a Brothel, right here: https://amzn.to/2HXaQob Follow her on Twitter and ask a question! https://twitter.com/AllisonSchrager Be sure to subscribe to our channel so you never miss an update: https://www.youtube.com/THECOMPOUNDRWM Follow us on Twitter: https://twitter.com/RitholtzWealth Follow us on Facebook: https://www.facebook.com/ritholtzwealth/ Talk to us about your portfolio or financial plan here: http://ritholtzwealth.com/ Hosted on Acast. See acast.com/privacy for more information. Learn more about your ad choices. Visit megaphone.fm/adchoices

Hey, it's Josh Brown. We are live from the compound for an all-new episode of Talk Your Book with my friend Allison Schrager. Allison, say hello. Hello. Okay. Allison's book is blowing up right now. We're only days away from the launch of An Economist Walks Into a Brothel. Did I say that right? Yep. Okay. We're not going to talk about brothels, but we are going to talk about some of the everyday economics lessons that everyone can learn from some of the strangest, I would say, anecdotes and stories that you've ever read in a book of this sort.

You're going to love it. Stick around. Okay. So, Allison, first things first. I love the cover. I love the art. Did you design any of this or you just kind of approved it? I take no credit.

You take no credit. Okay. No blame. I take no credit. I publish books. I didn't have that much to say either. But let's get into like the idea behind the book, which I'm going to tell it to you and you tell me if I'm right or wrong. I feel like you have this really incredible breadth of expertise about economics, but it's so boring to have an economics conversation. So instead of that, you go find all these people

that are exhibiting traits that are classic economic ideas and you tell their stories and why you can pull some investing lessons out of that. So I think like you're talking about Hollywood, you're talking about surfing, you're talking about horse breeding and what are the lessons? Like was that the original idea and did it come out exactly like you thought it would it did my idea was this um because i had a background in academia i worked in finance and i'd worked in journalism and it dawned on me that phd yes you're gonna drop that it's all right i didn't um you know it's cooler if you're just like i have a background i have one too it's's okay. Go ahead.

I was thinking specifically like I wanted to bring financial economics, which is a discipline within economics, more to the front because you hear a lot about macro. You hear about applied micro, which is like what Freakonomics is. But I feel like financial economics had implications beyond financial markets. Financial economics is investing, insurance, portfolio management. It's the study of risk in financial markets. Financial economics is investing, insurance, portfolio management? It's the study of risk in financial markets. Okay. And the other thought I had was that any economic model,

financial model or macro model, is really effectively a parable, right? Because what are parables? But they're just these little abstractions of how the world works to teach people a broader lesson. And that's what a model is. So, I mean, I think this book is a direct descendant of like Adam Smith. Like that's what he was doing.

He was talking about merchants and he was talking. But from those parables, he was explaining how money moves or how people make financial decisions. Exactly. Because parables are great storytelling. It's how people connect and relate to things. So I figured I could find characters who illustrate these concepts. All right, let's get into some of the characters because I'm reading the book for the second time

that I read it when it was a manuscript. And now I'm like halfway through my second go round. And like some of these chapters are just amazing. Like they're standalone. They're so great. I want to talk about the Hollywood chapter. Somebody came along and convinced people that put money behind Hollywood movies that they could come up with factors that would ensure a better portfolio of things to that. Like, I don't know what they were using, like the directors or the theme or whatever. Like, tell me about how you found that story and what it's about. So I spoke to a lot of people in the movie industry because I was looking for something, you know, risk measurement. What's immeasurable? Movie risk. Because a quote you recently said that, as William Golden said, no one knows anything. Nobody, like you have no way

of knowing. No matter how much money you spend or what star you sign, you just can't tell you're going to have a head. Yeah, because as you know in finance, some risks are easier to measure than others. Right. And I was looking for something that's hard to measure. And so I started talking to people in the movie industry and they told me about this guy Ryan others. Right. And I was looking for something that's hard to measure. And so I started talking to people in the movie industry, and they told me about this guy, Ryan Cavanaugh. And this was when his whole scheme was just blowing up. It was about 10 years ago? Yeah.

Well, it started then where he had a Monte Carlo simulation, which is what we use in finance all the time, to try to predict what movies were going to make money. And like anything, like a lot of models at first, it looked great. Did some backtesting. Backtests look good in Hollywood too. Yeah. Right. But after a while it fell apart because they all do because the problem with the movie industry is the data is always changing. Right. And the profit models are so skewed. It gets really just a complete crapshoot. They're so hard to predict that eventually his model failed. Right. So, and he was doing mostly smaller

films. So, which I would argue it sounds like it would be harder. I feel like if you spend a lot of money, you have a lot of risk, but also you can get a lot of marketing. If you're trying to do a slate of indie films, doesn't that seem like it would intuitively be harder? It is. It is harder. And what I did is I got all this movie data

and plotted the risk distribution. And we always think of horror movies now because we see things like you and they're they're coming out and everyone or us and you know they seem like oh this was a sure bet but actually if you look at the profit distribution for horror and indie films it's just complete crapshoot there's really no pattern you can discern from it as opposed to action movies which are bigger budget, they're fairly predictable in how they're going to do. So you were saying action movies have twice the potential of breaking even or earning money above?

I believe so. But a horror movie, if it is a hit, can be a much bigger outlier to the upside? Exactly. And the return on investment can be huge. Because horror movies are relatively cheap to make. But when they hit, they hit big. Okay. So Ryan's scheme didn't exactly work.

People put a lot of money in based on these factors, the simulation. And then when the actual movies came out, they were terrible movies. Nobody went. Yeah. Okay. So maybe that'll be the end of that or somebody 10 years later will come along. Probably less than that. I mean, when you look into the history of the movie industry and the financial industry

and their overlap, it's like every five years someone pushes a new model. Okay. Now you talk about the difference between hedging and insurance. And I thought that was really interesting from one chapter to another. Tell me about hedging and the idea that you use to represent that in the book. So hedging is, you know, is risk management. So what you're doing is you're just taking less upside. And in exchange, you get rid of downside, you're accepting less upside. And as a result, you can lose less. Exactly. So that's a good that's like a good. That's an okay trade off for most people. Yeah, in most cases, it's just taking less risk, right. And the example I had two examples for that one is Arnold Donald, the CEO of Carnival.

The cruise line. Yeah. Okay. But I thought it was an interesting story because he's incredibly cautious, and we always talk about the CEOs who charged ahead and took risk blindly. But really the CEOs who have longevity are the ones who hedge. How long has he been in the CEO of Carnival? I think like five, six years before that, he was at Monsanto. But he has a fascinating

story. He grew up in poverty in New Orleans and just had this very slow, steady meteoric climb. The other example I talked about was David Bowie, who turned out, it turns out, I don't think a lot of people know this about him, was a really brilliant wrist tactician. So when he was young, like 18 years old, and the music industry came to him, they said, well, you know, you can, you know, we'll give you a big advance and we own all your royalties. And he's like, no, I'll take a smaller advance. But I want more later. Exactly. Which is taking a risk on yourself because most people don't make it in the music industry. The royalties is all you got. So he took it like a negative hedge. He took more risk.

Okay. He leveraged what he thought he would earn in the future. I mean, leverage is not the right term, but... Yeah, exactly. He took more risk then instead of letting the... You know, it's funny, like when I was hiring financial advisor brokers in another life, we would talk about, like we would have salary negotiations. And I was always more excited about the people that said give me less guaranteed and more potential upside a year from now yeah like that like those were the people that worked they i mean those yeah those are type a and exactly that's what he did but what's interesting is when he was in his uh 40s or 50s he took the opposite bet and he securitized his royalties and he could do that because he owned them from when he took the risk when he was younger i almost feel like that was like

a part financial decision but it was part almost uh performance art like and now i shall turn myself into money like he turned his catalog into a bond he said okay it's very unlikely that i'm gonna write all these new songs that are going to be as big as the old songs. So let me put the whole thing into a bond and there'll be an interest payment. But I'll get all the cash today. Also, streaming was starting. He was worried about that. Was he?

Yeah. So brilliant. So he was like, I mean, it was like Napster time. Like, I mean, this is early. Like, so Napster. Oh, so stolen streaming. Yeah. So he was like, my royalties aren't going to be worth much at all.

I may as well securitize. So that, so that's hedging. Um, and then insurance is different from hedging. How just generally speaking. Well, with insurance, what you do is you keep the upside, but you pay someone to get rid of your downside. So it's not the same thing. No. Insurance is different from hedging in that what you're really trying to do is offlay risk, but not give up upside. Exactly. I mean, you have to pay, have to pay a premium if you buy an option or an insurance contract. But after that, the upside is all yours. Okay. So what's the example that you use to illustrate that idea?

Well, this is going to sound a little strange, but I talked to a magician. Okay. And I talked to her about all the ways she insures against a risk failing. Like sawing somebody in half and they actually die? Or what are we talking about? Or just the way she manipulates the audience so they trust her. What's her risk

that somebody sees through the charade? Or she just does a trick like she can't find the card. Oh, she blows a trick live. It happens all the time. And the reason why I talked to a magician is Robert Merton, who solved Black Scholes,

you know, this famous insurance pricing model. Ben, she's still name dropping. I don't know if we want to edit that out. All right, go ahead. 10% of the audience will know Robert Merton, but in this office, we revere Merton. Well, he's the one who gave us the price that we all use for insurance prices. His father was also a famous sociologist. He became a sociologist because a career as a professional magician did not work out.

Okay. Really? Yeah. So pivot to option pricing? No, pivot to sociology. Sociology. Come up with a self-fulfilling. He came up with a self-fulfilling prophecy with unintended consequence.

Okay. And like, cause magic didn't work out how does the magician are we giving away too much of the book how does the magician figure out how to ensure against the risk of a bad trick she builds up trust in the audience so they'll laugh it off if it happens or notice because they're so attuned to what she how she can distract them oh it's so killer yeah are any other chapters that we should just mention that people should get excited to read?

Surfing. I love them all. Thank you. You love the surfing chapter. I love the surfing chapter. Do you think that's going to be the big one for everyone? I don't know. I like to think, I mean, what I love is when I talk to people

and they all connect with a different chapter. Okay. Maybe I love the surfing because I got to go to Hawaii. Okay. That might just be. So you have memories, you have the experience of riding it that kind of colors your. I got to hang out with these surfers in Hawaii. It was just.

Now these are, okay. Now these are not regular surfers. These are the people that are paddling out to a hundred foot waves. Yeah. Like waves that look like they're fake. Okay. So what's the, what's the concept that you were illustrating there? A systemic risk.

Wow. Okay. I would say that's a pretty big one. Yeah, so they have an annual risk conference to talk about risk because when they take big risks, they pose risks to others. And certain technology allows them to lever up

and they are talking about how to be more responsible. The surfers? Yeah. Like what risks? How do they risk each other's life? Like hitting someone with your board? Yeah, Or if you wipe out that takes resources, you have to be rescued. People put themselves in a line when

they were, so then the next person that's out there doing this foolish thing can't exactly, can't get saved. And so if you, you know, you can get a jet ski to push you on a wave. You have no business surfing, you wipe out and someone else isn't, it doesn't have some jet ski. Isn't there to pull them to safety? Well, that's what's interesting about jet skis. Both hedging and insurance, what's fascinating about them is they can help reduce your risk, but you can also flip them both upside down and take more risk. I mean, that's what leverage is.

Leverage is a negative hedge. Okay, so here's what I want to tell you. This should be a Netflix show. Each chapter is an episode. There should be a season. You agree with me? We're talking to production company about it

okay good all right let's not blow that but listen this is the book this is the book like this is the one that everyone's going to be

talking about this summer this is like the like pop science like finance economics book you're going to be famous when this is over are you going to come back

of course you promise of course okay all right listen Alison Schrager buy this book you're going to love it when this is over. Thank you. Are you going to come back? Of course. You promise? Of course. Okay.

All right. Listen, Alison Schrager, buy this book. You're going to love it. It's so much fun to read. You will learn so much no matter what level of investing you're at. Thank you. Thank you. All right.

Bye. Bye. Bye. Bye. Bye. Bye. Bye. Bye.

Bye. Bye. Bye. Bye. Bye.