The last post talked a bit about diversification. We are used to thinking about diversification within a portfolio context, both at the position level and the asset class level.

The diversification math is straightforward conceptually. Ideally, you’d like a bunch of positive expected value bets that are independent and uncorrelated. This is wonderful in theory. It gets tricky in practice. For one thing, correlations tend to go up as you add assets and strategies to a portfolio. For another, cross-asset correlations tend to rise sharply in severe crisis periods, as aggressive selling pressures suck up liquidity.

Sometimes a certain genus of permabear will say something like, “what if the entire financial system collapses? Where will your diversification get you then?”

In one sense, these are silly questions. You can’t address this kind of existential risk through portfolio construction. You can’t even address it with portfolio hedging. If the world ends, good luck collecting on your SPX puts. This is CAPM’s non-diversifiable, systemic risk.

In another sense, these questions aren’t silly at all. I suspect people have come to think of CAPM’s equity risk premium not as compensation for bearing non-diversifiable, systemic risk, but as a free lunch. Something close to a free lunch, anyway. Exhibit good behavior over a long enough time period and these returns will be yours. This interpretation downplays the seriousness of systemic risk. People joke of permabear types that even broken clocks are right twice a day. But catastrophes are catastrophes, regardless of predictability or frequency. This kind of risk is worth taking seriously.

So where does this leave us? We have systemic risk that represents a potential existential threat. This risk is difficult, if not impossible, to hedge in-system. It is meta to the system. It is the risk of the system itself breaking down.

We laugh at people who stockpile guns, medicine and canned goods. But they’re thinking about this the right way. Diversifying against systemic risks requires us to think beyond in-system instruments and methods. This isn’t to argue for stockpiling guns, medicine and canned goods in a bunker (though don’t let me stop you if you are so inclined). For now, it probably suffices to think about ways one can create “value” in the real world, outside the abstracted games of financial markets.

We can think about this in terms of real-world, cash generating assets, like owning and operating a business.

We can think about this in terms of careers and career earnings power.

We can think about this in terms of political participation.

We can think about this in terms of basic skills like cultivating, cooking and building.

What would you do if your portfolio was forced to zero? No more trading. No more investing. This is an extreme scenario to consider, but it’s hardly unprecedented in human history.

In my Values post I quoted the famous line from Fight Club: “the things you own, end up owning you.” I suspect people tend to interpret this line in a narrow, materialist sense. We look down our noses at people spending vast sums on conspicuous consumption. The line is more interesting as a comment on attachment more generally. Attachment to things, sure. But also attachment to particular mythologies, cosmologies, models.

Most things die. All things change.

The ultimate failure mode for diversification is to consider it in too narrow a context, and mistake our attachment to particular mythologies, cosmologies and models for the immutability of those things. There are many triggering ways of illustrating this, but I’ll leave it at this: society can remain communist longer than you can remain alive.

There is a particular zen koan, the buffalo koan, that is relevant here.

Goso said, “To give an example, it is like a buffalo passing through a window. Its head, horns, and four legs have all passed through. Why is it that its tail cannot?”

The Christian version of this talks about being IN the world without being OF the world.

I originally titled this post Diversification. That’s what I intended for it to be about. But I came to like Attachment better. Attachment is a core failure mode that extends into many domains.