Hurdle Rate

A disclaimer: I am not writing for you. I am writing for my future children. I also realize that I am writing this in my mid 30s where my perspective is inevitably incomplete.

The world is filled with noise, uninformed outrage, an affinity for drugs, problems that don’t matter. The people who let those things consume their lives tend to live lives of no consequence. On the other hand, a life filled with the things you choose to care about, I think, is a more meaningful life. That is, either you care about things that other people choose for you, or you choose the things you want to care about. 

In finance, an important concept is that of the hurdle rate. The idea is this: all investment ideas that you expect to return below a certain number, you reject. Above that number, you invest in. If all you have is very high returning investments, the idea is your portfolio will tend to be very high returning. One corollary: the higher your hurdle rate, the harder you have to work to find investments but the better the portfolio. I think the same applies to life. If you have a high hurdle rate for things in your life, your life will tend to be better. However, it requires more work to fill your life with those things.

In mathematical optimization, the objective function is a mathematical function where one scores how good a solution is. Finance is simple in that there tends to be one objective function: money or IRR (internal rate of return). Life, however, is multidimensional and the objective function is entirely subjective (ie. not objective at all). There is a lot of literature out there on how one should define an “objective function”. The Bible, Taoism, Confucianism, Epicureanism, national/cultural values, and so on. The definition is left as an exercise to the reader. That said, Warren Buffett has a novel distinction worth thinking about: the internal and external scorecard. An external scorecard is one where your objective function is defined by others. Your reputation, status, and so on. An internal scorecard is one where your objective function is defined by oneself. Life is simpler and sweeter when one lives by an internal scorecard.

As time goes on, one’s objective function changes. When you are a child, it is likely something along the lines of how many boogers one can pick and how giraffe-like one can be. In adolescence, it tends to go towards attracting the opposite sex. Then money tends to be the thing to optimize for. I am in that phase right now. As people get older, I notice that money becomes less of a thing that is valued and I am fully aware that at some point my endeavors will be seen by a future me as unimportant. One metaphor I view life through is that of a tasting menu. When you are at the beginning of a meal, the appetizers come. Appetizers whet the appetite. They tend to be some of the most creative parts of the meal. However, most of the time, they are not satiating. I see many people get stuck in this phase of life. Forever wandering, forever seeking dopamine. They’re the ones who do a ton of drugs (weed, LSD, ayahuasca, etc.). Do a ton of therapy and wonder why they feel something is missing. They protest and are outraged at things they have done next to no homework on. It is important to both explore and move on from this phase of life as eventually, it is a road to nowhere. The main courses are the things to sink your teeth into. The hard work of raising kids, contributing to society, etc. And dessert is for those in the golden years where the absolute best parts of life are savored and creativity tends to return. 

A high hurdle rate can be applied to people in your life, your vocation, your spouse, and so on. Likely, the topic that is most important is that of a spouse. When I was younger, I thought my objective function for my partner would be that she had to be smart, super hot, and very successful. Janet, my wife, completely changed my perspective on the topic. Notice that in my criteria, heart isn’t there but it’s probably the most important factor. I’ve iterated through all of the people I know who have married. I’m in my 30s and just under half of marriages I know of have ended up in divorce. It’s likely as time goes on and people have kids, the divorce statistics increase. I notice that among the marriages that end in ruin, the marriages tend to optimize for the criteria I used to have. That is, the bigger the wedding, the larger the diamonds on the wife’s hand, the hotter the couple, the more likely they are to end up going nowhere. In hindsight this makes sense to me. If you care a lot about dumb things, you are less likely to care about the things that lead to success. Marrying Janet has been the best decision of my life. Period. I am not sure how I got so lucky. It is worth having a high hurdle rate for a spouse, but it is also worth ensuring that the objective function for that hurdle rate is correct.

One other takeaway I have gotten from investing is how hard it is to be right. Most people think they are right about everything, myself included. In most endeavors, there is no scoreboard that will reward and punish views so honestly/cleanly like investing. One measure of how correct an investor is, is the hit rate. This is an oversimplification, but roughly, a hit rate of 50% means that an investor gets an investment right 50% of the time. Because of bet sizing, asymmetry of bets, etc. typically the wins more than overcompensate for the losses. A hit rate of 60% is considered "high". Investors must consider the opposite perspective and be able to articulate the opposing perspective. Most people who have strong views are unlikely to hit that standard. And yet investors still get it wrong at a spectacularly high rate. Personally, I am almost always working, likely putting in more than 100 hours a week. They are not intense hours, I’ll be listening to an earnings call while washing dishes or reading a financial statement lying in bed. But I can tell you even with hundreds of hours of homework, it is still very easy to get things wrong. In daily life, I see so many people get worked up over things that they’re very obviously wrong about. So one other application of a high hurdle rate I would recommend is the number of things to care about and/or be sure about. 

One area I see this as especially true is whether something is possible or not. When I was a teenager, I believed I wasn’t ever going to be good enough to have a woman love me. Today, I have the best wife one can ask for. It is tragic to see people robbing themselves through the “sure belief” that they cannot do something or that something is too hard. It is worth having a high bar for having confidence that something isn’t worth pursuing. The only way to be sure is to do the homework rather than rely on those gut feelings.

The areas upon which one can apply a high hurdle rate, a high bar, are numerous. Hurdle rate on time, attention, love, capital, hobbies, etc. It's my hope that you, the reader, are convinced have a high hurdle rate and that it helps you lead a better life. Best of luck!


Popular Posts