## Friday, December 23, 2016

### The New Year's Game

US tax code creates some… interesting incentives. One of these is the New Year’s Game: a once-a-year opportunity for individuals to make an expected annualized return of 10% to 20% on a \$3000 investment.

Background
In the US, money made from selling any sort of investment instrument (usually financial assets or real estate) held for at least one year, is classified as long-term capital gains. So if I buy a stock or option contract on December 28 this year, and sell it on December 29 next year, then any profit made on trade is classified as long-term capital gains. Long-term capital gains are taxed at a much lower rate than ordinary income: 0% for individual income up to \$37650, 15% up to \$415050, and 20% from there. (Note that this is federal tax only.)

Aside from long-term capital gains tax, the other interesting thing about investment income is what happens when investments generate a loss. Individual investors are allowed to deduct up to \$3000 of capital losses from their taxable income each year.

Opportunity
Together, long-term capital gains tax and capital loss deduction create an asymmetry: gains on investments are taxed at the lower capital gains rate, while losses are deducted from higher-taxed ordinary income. Let’s look at an example to see how it plays out.

Let’s say I pay 15% tax on long-term capital gains, and 25% tax on ordinary income (I wish it were that low...). If I hold a stock for one year, and make \$100 profit off of it, then I pay \$15 in taxes and keep \$85 after taxes. On the other hand, if I lose \$100 on that stock, then I deduct that \$100 loss from my ordinary income and get \$25 back with my tax return, so my effective after-tax loss was only \$75. Thus the asymmetry: even if this investment is a coin flip, I still gain more in the good case than I lose in the bad case.

For simplicity, let’s assume that we’re investing in an efficient market with zero discount rate. That means the price of any asset is its average expected payout: if an asset has 50% chance of paying off \$1.00 and 50% chance of paying off \$0, then it costs 0.5*1.00 + 0.5*0.00 = \$0.50.

In this simplified efficient market, an asset with a 50% chance of gaining \$100 and a 50% chance of losing \$100 costs 0.5*100 + 0.5*(-100) = 0, i.e. the asset is free to buy (we’ll talk later about how to implement this). But after accounting for taxes, this asset would return 0.5*85 + 0.5*(-75) = \$5 on average. So we have an asset which is free to acquire, but has an expected after-tax return of \$5!

Optimization
The idea of the New Year’s Game is to push this idea to the maximum.

Abstractly, the trick outlined above works by turning ordinary income into long-term capital gains. In our simplified efficient market, everything has an expected return of zero, so all expected gains are offset by expected losses. But the expected losses are deducted from ordinary income, while expected gains are long-term capital gains. So for every expected dollar taken away from ordinary income, we add an expected dollar to capital gains. In other words, expected dollars are taken out of ordinary income, and put into long-term capital gains.

The expected gain is just the difference in tax rates times the amount of money moved from ordinary income to long-term capital gains. In the example above, the difference in tax rates was 25% - 15% = 10%, while the number of expected dollars moved was 0.5*100 = 50, for an expected gain of 0.1*50 = \$5.

Since the profit comes from turning ordinary income into long-term capital gains, we maximize profit by turning as much income as possible into capital gains. Counterintuitively, the trick here is to maximize expected losses: because the market is efficient, expected (pre-tax) loss equals expected (pre-tax) gain equals the amount of money transformed from ordinary income to capital gains. The losses are capped at \$3000: that’s the maximum amount we’re allowed to deduct from ordinary income, so that’s the maximum amount we can transform into expected capital gains.

So we want an investment which, in most years, loses exactly \$3000.

Let’s choose an investment which has some small probability p of making a huge windfall return, and probability (1-p) of losing \$3000. The expected loss will be (1-p)*3000, so on average, the investment returns (1-p)*3000 times the difference in tax rates. (The difference in federal tax rates is always 10% - 20%, depending on income.)

Implementation
In practice, this can roughly be done with some number of long call options and the same number of short calls at adjacent strike prices, so the investment pays off some amount if the underlying stock ends up above \$K, and loses \$3000 if the underlying stock ends up below \$(K-1). By adjusting the strike price, we can adjust the probability p that the investment pays off in any given year.

The main tradeoff is the probability p. For example, if p is ½, then the investment pays off every other year on average, but the long-run average return is only (1-p)*3000 = \$1500 times the difference in tax rates. If p is ¼, then the long-run average return improves to (1-p)*3000 = \$2250 times the difference in tax rates, but the investment only pays off once every 4 years on average. As p decreases, the long-run average return approaches its maximum limit of \$3000 times the difference in tax rates, but the investment pays off less and less often (though the windfall when it does pay off gets larger and larger).

Once we pick a value for p, we need to pick a strike price for the long/short option pair. If the gain when it pays off is G, and the loss when it doesn’t is L, then with zero expected return, p*G = (1-p)*L, or L/G = p/(1-p). Pick a p-value, and this formula will tell you what L/G ratio you need. I won’t spell out all the details, but it should be straightforward to compute the payoff for both the gain and loss scenarios with each strike price K, and then pick an option pair close to your target L/G. After that, just divide \$3000 by the loss amount to figure out how many to buy.

The final implementation detail is the one-year constraint: in order to qualify for long-term capital gains treatment, the investment must be held for at least one year. The final trading day of 2017 will be Friday, December 29, so the last chance to enter the New Year’s game for 2017 will be this coming week on Wednesday, December 28.

## Saturday, December 10, 2016

### A Conservative Approach to Climate Change

I think a big reason why conservatives ignore climate change is that the solutions usually proposed are very stereotypically liberal. Most are some variety of "Hey, let's all do our part to cut our energy usage!" The conservative's knee-jerk reaction to that is "Great! You guys have fun with that, and don't forget to join hands and sing kum-bay-ah when you're done."

Very important rule: if a proposed solution requires getting everyone together to pitch in, then conservatives probably aren't going to like it. Too much signalling, too small likelihood of success. Conservative solutions are all about making the solution happen, on time and on budget, whether anyone likes it or not.

Let's try to get into the mindset of a hypothetical conservative serious about climate change. Imagine that climate change were a very clear, immediate life-or-death threat, not just to cute coral species but to humans. Let's say that for some weird reason, once atmospheric CO2 crosses 500 ppm, major cities start blowing up at random intervals. What would be the conservative reaction?

Probably something like this:
1. Immediate shutdown of the power grid. A few areas with carbon-free power sources would be left online, mostly around the large damns in Washington and the southwest, and around nuclear plants. Areas with large solar and wind supply would be brought back online only when sufficient power was available, and alert systems would quickly be put in place to let people know when that was.
2. Fuel rationing. Mostly farming and shipping would receive priority. Need to keep people fed.
3. Demands for fuel rationing and grid shutdown in other countries, backed by threat of war.
4. A Manhattan project around geoengineering. If dumping iron in the ocean to produce an algae bloom can cut CO2, then we do that. Red tide? Worry about it after the CO2 drops.
5. Massive ramp-up in nuclear power construction. This would actually be very fast if the president declared a national emergency and completely overrode the usual zoning laws and approval processes. Mobile nuclear plants modeled after those used by the navy would likely come online first.

That's what a climate change strategy looks like when you stop fucking around.

Today, the threat is not nearly that immediate. 1-3 don't make sense without a very immediate threat. 4 does make sense, but it may or may not produce results. But 5? Nuclear power is what happens when you stop fucking around on climate change.

"But what about all that radioactive waste?" whine the liberals. "And those poor natives by the Cheyenne mountains? And those giant strip mines where the uranium comes from?"

Let's go back to the exploding cities scenario. That's a world where CO2 is a real threat to human survival. Let's even say that it requires 700 ppm CO2, to dampen the immediacy. So it's a few years out, but New York City is going to go boom. In that world, you shut up about the damn strip mines, and you build the damn reactors. Because when something is a real threat to human survival, nothing else is relevant. Nothing. Conservatives get this on a deep instinctive level. Liberals do not.

"But it's a few years out! As long as we've got the time, why not cut our energy use and build clean solar rather than dirty nuclear?" Does that sound like the strategy of someone who's worried about survival on a gut level? It's a lot like saying "Ok, the locusts are wiping out the crop. How about we cut back our food consumption by all going vegetarian? Then we can go organic, rather than using pesticides!" Conservative reaction: have fun with that. When the locusts swarm, we're calling Monsanto. If carbon's a real threat, we're going nuclear. Don't like nuclear waste? Fine. Worry about shifting to other power sources after the carbon threat is dealt with.

Look, solar panels and windmills and saving the rainforest are great for making people feel warm and fuzzy. But if you want to cut carbon, quickly and efficiently and economically and practically, then nuclear power and maybe geoengineering are the way to go. The root of the disagreement on climate change isn't whether or not it's happening. The root of the disagreement is that conservatives are big fans of efficiency and economy, and are definitely not happy with solutions which trade off efficiency and economy for warm fuzzies.

Conservatives see liberals suggesting warm fuzzy solutions to climate change, and assume that this whole climate change thing is just a made-up excuse for the warm fuzzies. After all, if it we actually feared for our lives from CO2, we'd be advocating nuclear power and geoengineering.

So I'll wrap it up with this: liberals, if you want to convince conservatives to support climate change action, then tell them that you want to fast-track nuclear power plant construction. See how they feel about that.

## Wednesday, December 7, 2016

### What Signalling Feels Like

Guest-written by Sisi Cheng.

Background: Eric Anderson suggested a post on what signalling feels like from the inside. Awesome idea! I've never explicitly practiced noticing myself signalling, but Sisi has. Most of this post is her work, and it opens in her voice.

At one point, I asked John if I could change my facebook profile photo to a couple-y shot of the two of us. I came up with all sorts of reasons: my old profile photo has been there for ages and it’s getting boring to look at; it’d be a good opportunity for us to go out and take a nice photo of us two...etc. In retrospect, all of these reasons were just excuses. The real reason was I wanted to signal that I was in a happy relationship.

It’s not wrong a priori to use a couple-y photo as your facebook profile picture. However, you may make very different choices in profile photos if you intend to signal a happy relationship vs. post a generic good shot of you. Understanding your motivations fully and realizing your intention to signal is important to optimizing your choices. This post focuses on what signaling is, what unintentional signaling feels like from the inside, and tips on how to spot it in yourself. This will help you realize when you’re unintentionally signaling, allowing you to make decisions like: a). Do I actually want to be signaling this? And b). Either stop signaling or signal more effectively.

## What is Signaling?

Before we can spot signaling behavior, we need a better idea of what signaling is, psychologically. There are two main underlying factors in signaling: status and identity. Any signaling may include one or both of these factors, in varying amounts.

### Status:

Using a couple-y facebook profile photo is a good example of signaling one’s status. Having a good, healthy relationship is a classic status symbol. I look around facebook and see that many of my friends have posted couple-y photos or updates from their happy relationships. I feel the need to one-up them (or at least match them) by showcasing my own happy relationship. A public visible photo feels a bit like having the last word in an argument, or a socially acceptable way to show off. Much of signaling is related to aspects of status, be it wealth, career success, marital happiness, or knowledge. Signaling is a way we establish our places on the social ladder and our positions in our friend circles.

### Identity:

Continuing with the theme of facebook profile photos, another time, I considered changing it to a group shot of me and my friends from work having fun at a party. I was unintentionally signaling a part of my identity: me as a member of my work group. Every time someone likes that photo, or every time I see it as I wander around on Facebook, it asserts that I’m part of a team. I get a warm fuzzy feeling inside every time I log in and am reminded of how well I fit-in with my colleagues. It feels good to have a well-defined in-group identity. It gives a sense of belonging and purpose. Often, signaling achieves such an effect by echoing a part of your identity, whether it be a relationship, a personality type, or a social group.

Like the above examples have shown, signaling is not inherently right or wrong. We just want to be aware of our underlying motivations so we have the opportunity to either stop it or do it with more efficiency. In my examples above, after much introspection and consideration, I decided against the couple-y profile photo because I felt it reinforced my relationship as part of my identity, and my desire to not have that effect outweighed the benefits of signaling my status of happily in a relationship. However, I decided to go for the coworker group shot, because I believed the sense of belonging with my colleagues can promote my happiness at work and boost my productivity. One can easily imagine that having made this decision to signal, I might optimize it by rallying several of the coworkers in the photo to all change their facebook profile photo to the same picture, amplifying the in-group identity.

## How to spot unintentional signaling in yourself

Now that we understand the underlying factors to signaling, we’re ready for some self-reflection. A key to realizing you’re signaling is to understand your motivations. If you take a moment to examine your motivations, unintentional signaling should feel confusing: you want something but your explanations for why you want it doesn’t quite feel right. As soon as you suspect you might be unintentionally signaling, you should ask yourself “why do I want to do this thing I feel like I want to do?” and be very critical of your own answers. Does the answer make sense? Does doing this thing accomplish what I say I want, and could other things accomplish my nominal goal much more efficiently? Or do I have an underlying real reason I haven’t admitted yet?