“Just as scissors cannot cut paper without two blades, a theory of thinking and problem solving cannot predict behavior unless it encompasses both an analysis of the structure of task environments and an analysis of the limits of rational adaptation to task requirements” Herbert Simon, 1972.
Everybody knows that we love a good analogy. There are few better than Herbert Simon’s analogy of scissors to describe the interaction of the two blades of one’s environment and one’s cognitive limitations. Simon, the predecessor to the works of the likes of Gerd Gigernenzer and Vernon Smith in the realm of bounded/ecological rationality, won the Nobel Memorial Prize in Economic Sciences in 1978. His work on decision-making, much of it in collaboration with Allen Newell, was the early precursor to artificial intelligence and led to the awarding of the ACM Turing Award in 1975.
Any that are unfamiliar with Simon, particularly those that have been trapped in the matrix of Sharpe World and inundated with theories around “homo economicus” (aka Rational Economic Man), will find Simon’s works liberating. There is something comforting about a model of behaviour that is based on how people actually behave.
The premise of the scissor’s analogy is very straightforward. Both blades of the scissors need to operate together. Decision makers need to factor in the environment in which they are acting, the initial conditions, the rules, the incentives. That is one blade. Then one must factor in their own cognitive limitations as to what information, knowledge, computational capacity, can be utilized. In the end, boundedly rational agents will rely on heuristics and intuition to proceed through the inevitable uncertainty of paths through time.
A very common version of this is the various forms of the catchy phrase, popularized by the legendary Charlie Munger:
“Show me the incentive and I’ll show you the behavior.”
We coined our own descriptor “Rational Accounting Man” to differentiate, for example, the risk decision making of employees of regulated financial institutions, who put none of their own capital at risk and are rewarded on a calendar year basis, versus boundedly rational agents who have actual skin-in-the-game and are making decisions to manage their own wealth through multi-year cycles. Two very different environments that lead to two very different cognitive decision processes.
Friend of Convex, Mike Green, in this wonderful discussion references another closely related quote from British organisational system theorist, Stafford Beer, and his famous acronym of “POSIWID”:
“The purpose of a system is what it does.” Mike Green, January 2026, quoting Stafford Beer.
Mike Green Explores the Inelastic Nature of Numerous Cross-Asset Markets
Such a great way to understand the persistent, supposedly unintended, outcomes of all that is driven by the flawed assumptions underlying the models of Sharpe World. How did we end up with unprecedented Debt/GDP across governments all around the world? How did we get to such extremes of wealth segregation? How did we get unsustainable global trade imbalances? How did fiat currencies lose so much of their value against precious metals? Maybe all of that was the purpose of the system.
Here is another great discussion on the directly related topic of unaccountability. Dan Davies, the author of the book, based on the work of the above-mentioned Stafford Beer, “The Unaccountability Machine: Why Big Systems Make Terrible Decisions – and How the World Lost its Mind”, absolutely nails it with this simple quote:
“History is the study of decisions, not of events, and many decisions are best understood as the outcomes of larger systems rather than individual acts of will.” Dan Davies, August 2025.
As we so often discuss, central bankers are eternally claiming that they are in control of the future, yet current circumstances have nothing to do with their past efforts to manipulate outcomes but are, rather, the results of unforeseen events.
Case in point: we discussed in some detail the efforts by esteemed Sharpe World luminary, Ben Bernanke, to formally review the shortcomings of the Bank of England’s (BOE) efforts to live up to their mandate of maintaining price stability, all without criticising Sharpe World itself, in our April 2024 Update – “Wittgenstein’s Ruler” Convex Strategies | Risk Update: April 2024 – “Wittgenstein’s Ruler”. We made this comment back then:
“The cynical amongst us might argue, much like the quarterly exchange of letters between the BOE Governor and the Chancellor of the Exchequer for not meeting the price stability mandate (now exchanged for 14 out of the 15 quarters that Andrew Bailey has been the Governor), that the review is just a charade to sidestep any sort of accountability.” Convex Strategies, April 2024.
On the back of the recommendations from Mr. Bernanke’s review, the BOE has come out with the below follow-up “Forecast Evaluation Report”. We wouldn’t recommend anybody getting their hopes up that there has been learning in the absence of accountability.
Forecast Evaluation Report – January 2026 | Bank of England
The Foreword for the report was drafted by none other than BOE Chief Economist, Huw Pill. Mr. Pill reiterates the objective that we previously referenced from his June 2023 speech at the annual ECB Sintra Conference in our own June 2023 Update – “One Thing” Convex Strategies | Risk Update: June 2023 – One Thing. We quoted Mr. Pill from that conference thusly:
“The role of CBs and CB forecasts is not necessarily to produce the best forecasts; the role is to support the best monetary policy decision which brings inflation back to target. I think that does lead you to a whole set of issues about how you organize your discussion internally and you allow that role for judgement, that role to have many different models, many different analytical frameworks, to help you have a robust and resilient view. Then ultimately how you convert that into a way of communicating with the public and financial markets. Monetary policy, and indeed economic policy making more generally, can have an effect on behaviour which supports what you are trying to achieve and internalizing that benefit is one that is pretty key to having a framework that just doesn’t put accurate forecasts, in some abstract sense, on a pinnacle above the thing that is the real importance of what the underlying process is.” Huw Pill, BOE Chief Economist. June 28, 2023.
After 2 ½ years to consider it and take to heart the extensive review done by Mr. Bernanke and team, Mr. Pill has hardly bothered to edit that which his speech writers handed to him in Sintra. His barely revised comments for their new Report read all but identically.
“From a policymaking perspective, the over-riding question is not solely, or even mainly, whether a forecast performs well on the statistical criteria of accuracy, unbiasedness or efficiency. Rather, a forecast that supports the monetary policy process needs to help the MPC form a view of the economic outlook, to prompt a rich discussion among MPC members that leads to appropriate monetary policy decisions, and to help communicate its decisions consistently with those views both internally within the Bank and to external stakeholders. The MPC’s job is to set good policy to meet the inflation target, and that is how it should be judged. Forecasts – along with other analytical inputs – are means to that end.” Huw Pill, BOE Chief Economist, January 2026.
This is such a remarkably good example of “The Unaccountability Machine”.
Figure 1: UK CPI yoy% (white) vs BOE Bank Rate (blue). 2% Price Stability Target (orange-dash). March 2020 (white vertical). 2000 – Jan 2026
Source: Bloomberg, Convex Strategies
The BOE, as is the norm since current Governor Bailey took office in March 2020, once again wrote a letter to the Chancellor, in December, outlining their response, yet again, to missing their price stability target on the high side. Their response, as has been the case for the last 150bp of policy changes, was to cut the policy rate by 25 basis points.
Letter from the Governor to the Chancellor – December 2025
We can always get a better view of the implications of these policies by looking at the compounded effect on the underlying CPI index.
Figure 2: UK CPI Index (white). 2000 – Jan 2026. March 2020 (white vertical). Projections through 2029 at 2% (green dash) and 3.4% (red dash) annual rates
Source: Bloomberg, Convex Strategies
The purpose of a system is what it does.
I suspect the efforts by Mr. Pill to convince people that his forecasts are the best way to implement policy, not necessarily intended to be accurate, are little consolation to those seeing their living standards steadily eroded.
Of course, the BOE is not alone at practicing this sort of mysticism. The Bank of Japan (BOJ) has long been a leading light in their effort to influence behaviour. We highlighted then outgoing BOJ Deputy Governor Wakatabe’s speech on advocating precisely this sort of manipulation as the number one component of central banking practices in our February 2023 Update – “Sharpe World is Nefarious” Convex Strategies | Risk Update: February 2023 – Sharpe World!™ is Nefarious.
It is worth keeping in mind that Mr. Wakatabe is now a key economic advisor to the Takaichi government. It is possible that some of his principles have found their way through to the new Finance Minister, Katayama, who noted the importance of clear communications in the below note related to the market reaction to proposed tax cuts by the Takaichi government.
The BOJ provided their quarterly revisions to economic projections in January. As has been the case for the last four years, they had to revise up their projections for the current year inflation measure but continue, as has been the case over the past four years, to forecast to return to their 2% target in all subsequent periods.
Outlook for Economic Activity and Prices (January 2026)
Figure 3: Japan CPI ex-Fresh Food and Energy Forecasts and Realized. 2021 – 2027
Source: Bank of Japan, Convex Strategies
The concerns of further fiscal deficit profligacy, as the Takaichi government approached victory in snap elections, along with the continued feet-dragging by the BOJ to normalize rates, even as all official price stability indices approach four years of exceeding their 2% target, were blamed for a rather persistent, and increasingly severe, sell-off in JGBs.
Figure 4: Japan Policy Rate (white) and JGB 30yr Yield (yellow). US Policy Rate (blue) and US Tsy 30yr Yield (purple). UK Policy Rate (orange) and UK Gilt 30yr Yield (green). Jan 2021 – Jan 2026
Source: Bloomberg, Convex Strategies
When pondering the above picture, we can’t help but wonder if the BOJ, like their other global peers, might have to invert yield curves to the extent that policy rate exceeds 30yr bond yields, in order to restore stability in their duration bond markets. Generally, when we wonder as much out loud amongst polite company, we are all but shouted down by the impossibility of such in the unique domain that is Japan. We would note that many doing such shouting down were equally as vociferous when we raised the same question about the other global central banks back in 2022, most particularly as related to the ECB.
Figure 5: ECB Deposit Rate (white) and Euro Govt Bond 30yr Yield (blue). Jan 2021 -Jan 2026
Source: Bloomberg, Convex Strategies
The other thing that catches our eye on these charts is that the duration bond yields have all started higher again, once the central banks started reducing their policy rates. Just saying.
However, all of this pales in comparison to the central banking noise coming out of the US. For months now we have heard ongoing screeches about threats to Federal Reserve (Fed) independence. This link to a broad group of essays from the Peterson Institute for International Economics is a fantastic resource to get an overview on the issue from a number of different perspectives.
In our opinion, one of the clearest comments on the subject, and related to global criticism about oversight on the remodelling project of the Fed’s HQ, came from the pages of the incomparable Jim Grant in a January edition of his Grant’s Interest Rate Observer.
“Why bring this particular set of charges? Of all the sins for which the Federal Reserve stands culpable, the government has chosen the equivalent of a municipal ordinance against public spitting. The Fed has suppressed interest rates. It has inflated asset bubbles, facilitated the accumulation of a $38.4 trillion gross public debt and financed a multiyear crisis of “affordability.” Its preoccupation with asset values and “smooth functioning markets” has inflated stock and bond prices and thereby exacerbated class divisions. It waited a full year, 2021–22, before lifting its policy rates to beat back the inflation that its 400 doctors of economics somehow failed to recognize, let alone to predict. It has rung up operating losses of $243.1 billion, 5 times its stated book capital and surplus and 405 times the reported $600 million of cost overruns on its office-remodelling project. If it ran its business according to GAAP, it would be as broke as Silicon Valley Bank.” Jim Grant, January 2026.
There does seem to be a very thin line between trying to assign some accountability and what some consider an unassailable line of independence.
Interestingly, one of the voices that we have quoted in past Updates as a critic of Fed mandate creep, Kevin Warsh, has been nominated by the current administration to take over as the Chair of Federal Reserve Board when Chair Powell’s term runs out in May of this year.
In our October 2024 Update – “Kayfabe” Convex Strategies | Risk Update: October 2024 – “Kayfabe”, we linked to a CNBC interview from Mr. Warsh and highlighted these two comments:
“When they kept interest rates near zero, for a decade, and did QE, where the central bank are buying the bonds of the Treasury Department in crises, and they decided to make that more or less a permanent feature, it is the Fed that wandered into politics on a permanent basis. In a period of free money, what was the sign to congress? You can spend all the money you want, and so they did.” Kevin Warsh, October 2024.
“They (the Fed) don’t seem to have a serious theory of inflation, that’s theoretical and empirical. It is not obvious that they acknowledge what their role is in prices. Instead, it has something to do with wars and pandemics.” Kevin Warsh, October 2024.
History is a study of decisions, not of events….
You will forgive us for speculating that Mr. Warsh might be a follower of our pages!
We dug deeper into a speech from Mr. Warsh in our April 2025 Update – “Triggered” Convex Strategies | Risk Update: April 2025 – “Triggered”. Here, again, is the link to his very worthwhile speech, “Commanding Heights”.
Commanding Heights April 25 2025 DC.pdf
“…granting boundless power to government agencies to solve the world’s problems does not square with my disposition…some may believe the biggest threat to our economy comes from outsiders who seek to change the status quo—I don’t agree…I believe the predominant risk come from choices made inside the four walls of our most important economic institutions.” Kevin Warsh, April 2025.
Inside that April 2025 Update, we highlighted this section from Kevin’s speech:
“To be trusted, economic institutions must be trustworthy. To be trustworthy, they must prove themselves competent. Economic institutions must also:
- Maintain epistemic humility – that is, accepting that knowledge, even great knowledge, has its limits;
- Abide by other limits – limits imposed by the Constitutional and laws – and by the good judgment of leaders – to constrain the inherent tendency to expand their footprint;
- Be permitted to act within well-defined ex ante frameworks; and
- Be accountable – the greater the power of the public institution, the greater its responsibility to explain and answer for its decision.” Kevin Warsh, April 2025.
We look forward to seeing what Mr. Warsh (assuming he can get through the Senate confirmation process) can achieve once in the job. The Fed Chair role has some history of breaking those who had formerly proclaimed strong money principles once they found themselves in the actual seat, e.g. Greenspan and Powell.
One specific thing that Mr. Warsh has been most vocal about is the prolific use of the Fed’s balance sheet, aka QE. He continues to advocate for a smaller Fed balance sheet. He is not alone amongst reputable economist sorts on this issue. See below a recent article penned by Raghuram Rajan.
“With the US economy buoyant today and inflation still high, now would be the time for the Fed to reduce its holdings. But not only has it halted its most recent QT with Treasury holdings still at $4.2 trillion (five times the 2008 level); it has also promised to buy more Treasury bills as warranted, starting with a $40 billion purchase in January. What was a monetary operation when inflation and government financing needs were low looks like fiscal financing when the opposite is true.” Raghuram Rajan, January 2026.
We have often discussed the implications of near-universal fiscal dominance of what we have dubbed the “Hunger Games” for debt issuance amongst global governments. One of the most glaring indications of that has been the exponential rise in the value of gold. The below chart we commence from the initiation of Fed QE in March 2009.
Figure 6: Spot Gold March 2009 – January 2026
Source: Bloomberg
Friend of Convex, Russell Napier, has been one of the clearest voices on the inevitable evolution of the global monetary system. He gives yet another great overview in the below linked interview.
Russell Napier: Gold Is Screaming a Warning (But No One’s Listening)
We want to highlight this particular quote from Russell, something that we speak about often.
“When regime change occurs, the greatest risk for any investor is to get all the right answers to all the wrong questions…” Russell Napier, January 2026.
We ordinarily find ourselves going down this path (i.e. are we asking the right questions?) with folks desperately keen to forecast the future. Invariably, this leads us to the race care analogy and our persistent disclaimer that the only risk you can control is your car, not the unknowable future circumstances of the race. The questions that need asking are about the resilience of your car, about the convexity of your investment portfolio, about vulnerabilities. Not about things that we can’t know.
Rarely have we heard this described better than by friends of Convex, Niels Kaastrup-Larsen and Richard Brennan, in this wonderful episode on Top Traders Unplugged.
The End of Globalization, the Rise of Trends ft. Richard Brennan | Top Traders Unplugged
“…the future arises from what I’m calling sequential disclosure, not revelation…the future is not hidden, it is unfinished” Richard Brennan, January 2026.
“The future is not hidden, it is unfinished” has to go down as one of the best lines we have ever heard. Not only do we not know the future shape of the racetrack, but we also do not know the weather, the conditions of the road, where all the other cars in the race will be, nor how all of the above will be reacting to all of the above. Just like in the real world of economics and markets, we don’t know anything, and everything is reacting to everything else! It is, as Bill White would say, a complex adaptive system.
For the recognition that markets and economies do not function as espoused by the priests of Sharpe World, we all owe so much to Benoit Mandelbrot. For more on Mr. Mandelbrot, we refer readers to yet another wonderful short note from market-complexity legend, JP Bouchaud.
Mandelbrot, Financial Markets and the Origins of “Econophysics”
“The Mandelbrot legacy should not be the worship of fractals but rather the insistence that we must build models that respect the data, that we should not be embarrassed by complexity, and that endogenous crises are not an afterthought but a central object of study.” JP Bouchaud, February 2026.
Again, ask the right questions.
“… the relevant object is not news but the system’s internal state – liquidity, leverage, positioning, risk constraints, herding – because these govern the amplification of small perturbations into large moves.” JP Bouchaud, February 2026.
Interested readers may enjoy going back to our own ode-to-Mandelbrot, our September 2021 Update – “The Challenge of Measurement” Convex Strategies | Risk Update: September 2021 – The Challenge of Measurement.
We would be loath in talking about predictions of the future without referring readers to Stephen Wolfram’s latest note – “What Ultimately is There? Metaphysics and the Ruliad”.
Get yourself a nice relaxing beverage and enjoy digging through this one.
What Ultimately Is There? Metaphysics and the Ruliad—Stephen Wolfram Writings
“It’s often considered a goal of science to be able to predict what systems will do. But to make such a prediction requires in a sense being able to ‘jump ahead’ of the behavior of the system itself. But the Principle of Computational Equivalence tells us that this won’t in general be possible – because it’s ubiquitous for the system we’re trying to predict to be just as computationally sophisticated as the system we’re trying to use to predict it. And the result of this is the phenomenon of computational irreducibility.” Stephen Wolfram, February 2026.
This brings us full circle to our opening discussions around Simon’s scissors analogy. We only know what we can know and we can only calculate what we can calculate. We have limited understanding of our own particular perceptions of our environment and no effective means to execute all of the computations necessary to predict the future before we get there. The whole thing is one big emergent process, and we ourselves are part of the evolution of that emergence. How we drive our race car impacts how the future race evolves, along with everything else!
From an investment perspective, that leaves us with the same perennial challenge – how do we improve resiliency? The straightforward answer is convexity. Add acceleration and deceleration to your portfolio such that your relative position improves as circumstances diverge from the norm. Stop optimizing to averages! Average return. Average correlation. Average beta. Average volatility. It is the divergences in those factors that will drive compounding paths.
The practical application of that, the conversation that we engage in endlessly with investment managers, is how to replace portfolio risk mitigation strategies that rely on assumptions of stable correlations with strategies that embed positive convexity and explicit loss mitigation. It is as simple as targeting diversifying strategies that, when combined with risk seeking participating strategies, lead to accelerating positive correlation in good markets and decelerating correlation in bad markets, expanding upside beta and declining downside beta, increase upside volatility and reducing downside volatility. This is risk management, as opposed to the task of optimizing to expected returns, based on historical lookbacks, and extrapolating that as some sort of hoped for future.
Let’s take a couple examples of overly common (supposedly) diversifying strategies we see across investment portfolio – global investment grade bonds (Global Bond Aggregate Total Return Index – LEGATRUU Index) and a Fund of Hedge Funds Index (EurekaHedge Fund of Funds Index – EHFI94 Index) – and compare them to a simple reallocation into a replacement alternative made up of 67% in Long Volatility strategies (we are using our bootstrapped version of the old EurekHedge Long Volatility Index and the new WITH Long Volatility Index) and 33% more participating risk in the MSCI World Total Return Index (GDDUWI Index). Given our above emphasis on the unintended consequences of central bank policies, we will intentionally show this since the Fed’s commencement of QE in March 2009 and assume annual rebalancing.
Figure 7: MSCI World (33%) and Long Volatility (67%) (blue) vs Global Bond Aggregate (red). Scattergram and Return Distribution. March 2009 – Jan 2026
Source: Bloomberg, Convex Strategies
Figure 8: MSCI World (33%) and Long Volatility (67%) (blue) vs Global Bond Aggregate (red). Compounding View. March 2009 – Jan 2026
Source: Bloomberg, Convex Strategies
The improved convexity is easily apparent to the naked eye. The convex alternative has far greater downside protection to go along with superior upside participation. It is maybe most apparent when comparing upside beta (+0.22 for the convex alternative vs +0.21 for the Bond Aggregate) and downside beta (-0.24 for the convex alternative vs +0.19 for the Bond Aggregate). The former accelerates and decelerates. The latter does not.
Circumstances for the Fund of Fund universe are not overly different.
Figure 9: MSCI World (33%) and Long Volatility (67%) (blue) vs EurekaHedge Fund of Funds Index (red). Scattergram and Return Distribution. March 2009 – Jan 2026
Source: Bloomberg, Convex Strategies
Figure 10: MSCI World (33%) and Long Volatility (67%) (blue) vs EurekaHedge Fund of Funds Index (red). Compounding View. March 2009 – Jan 2026
Source: Bloomberg, Convex Strategies
Same again. One strategy is obviously convex, the other is not. The convex strategy provides positive upside beta and negative downside beta. The Fund of Funds, somehow, has negative upside beta and positive downside beta – it is the exact opposite of diversifying.
It is pretty straightforward: Step 1 – put better brakes on your race car. Step 2 – learn how to drive faster.
We will close with one last quote that reminded us that we can find inspiration is the most unexpected places. We came across this at an art exhibition. If we were to replace the final two words, “Impressionist art”, with the words “free markets” or “Total Portfolio Approach” we could have believed the quote came from Adam Smith or a CAIA paper, respectively.
“How can one combine the purity and simplicity of the dot with the fullness, suppleness, liberty, spontaneity and freshness of sensation postulated by our Impressionist art?” Camille Pissarro, 1888.
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