New Year's Resolutions

1) lose weight
2) teach my kids to be more courageous, polite, and better at math
3) wag more, bark less

End of Year Tax Strategy

Above are the returns (based at 100) for a portfolio long the top 50 winners, short the bottom 50 losers. US stocks, market cap over $500MM as of Monday.

I remember reading about this end of year strategy a while back: go long year-to-day winners, short year-to-day losers, in December. As winners have tax gains, and losers tax losses, there is good theoretical reason why such portfolios should have different returns in December on a partial equilibrium basis. Why take a taxable gain in December, when you can postpone it until the next year? Why not take the taxable loss now? If all the winners have hesitant sellers, the losers willing sellers, winners should outperform losers in December. They did for decades.

With theory and data, I put on this trade in 2003, and got destroyed. In my personal backtests at that time, where I also did market cap and other (clever) filters, it had an extremely good history, losing only a couple of times over the prior 30 years. Of course, I had an out-of-sample adverse experience.

This highlights that even if you can articulate a strategy that make sense, over time it will disappear regardless. This is why having an 'equilibrium' result for some tendency is important for a strategy everyone knows about, because if it's not, it's probably an epiphenomenon, like noting that internet companies are good shorts (true if you have 2001 prominent in your sample).

Index additions/deletions, low price stocks, all these have been arbitraged out of the market after they were discovered. It's best to simply not play a game that brokers send to traders in white papers if it is based on being clever, because brokers are not clever, but rather conventional wisdom.

Smile

People who smile more, are happier in the long run. This study looked at baseball cards from the early 1950s and coded whether players were smiling or not. Players who did not smile at all on average lived for 72 years. Those who smiled a bit on average lived for 75 years. And those with big smiles on average lived for 80 years.

These researchers also analyzed 114 pictures from the 1958 and 1960 yearbooks of a women's college in the Bay Area. All but three of the young women were smiling, but the smiles varied. The researchers chose these particular pictures for analysis because the women in them were participants in a long-term study of important life events. Specifically, the researchers knew - decades after the yearbook photos - whether the women were married and if they were satisfied with their marriage. As it turns out, the degree of their smiles years earlier predicted both of these outcomes.

Facts More Important than Theory

Most people think facts are easy and theory is difficult. It is often the other way around. As Charles Darwin wrote:

False facts are highly injurious to the progress of science, for they often long endure; but false views, if supported by some evidence, do little harm, as every one takes a salutary pleasure in proving their falseness.

So I got a lot of pleasure reading the insane amount of commentary on Steven Landsburg's puzzle about the percentage of boys in a population where they stop on the first boy (answer: with 1 family 30.685...%, approaching 50% as the number of families goes to infinity). The disagreement between many very smart people gets into semantics (is it really 50%, or just beneath it?), but in any case, if you put out a logic puzzle and make a mistake, it won't last long if its important. Not many people redo empirical analysis, however, because it's not something you can just figure out in your head: you have to gather data, understand it, clean it, etc., and then apply statistics.

Remember the Rational Model

Say there's a two-sided matching game, where you trade a good with another; not trading generates no utility, so you want to get the highest possible value. All goods, including yours, are of uncertain value, and you have a noisy, unbiased estimate of all the values, as do others. Some have less noise around their estimations than others, though you do not know who. So, when someone shows up, and really really wants to trade their good for yours good, are you excited? No. They probably they have value well beneath yours. What is most interesting is if the person is marginally interested in trading with you, because that means they might be right in the sweet spot: not so low you could do obviously better, but high enough to be practically optimal given search costs.

This is exactly what they find in dating markets, surprising no one. People are attracted more to those who are kind of interested, as opposed to really interested. This is consistent with the simple, rational bayesian model that is perfunctory for economists. It is almost more common than not that a popular book on economics caricatures this model as insanely unrealistic. We should remember that this model actually explains a lot, and when it fails often points out we are missing something in people's information sets, as opposed to something in their neurology. When a company announces positive news, the stock generally rises, when Treasuries fall, its usually because people are forecasting lower inflation or lower future real rates. These are uninteresting 'dog bites man' stories because they are so common and make sense using the standard rational model.

Merry Christmas

music from 0:50 to 2:40...

Some Myths are Better than Others

Norad tracks Santa. With about 2 billion Christians, say 1B independent households, and given Santa has a day to deliver gifts, that's only 86 microseconds per house. Given he tends to leave half eaten carrots (from the reindeer) and cookies, I imagine this speed would actually incinerate most homes. Nevertheless, I love Christmas--the songs, decorations, stories, meals, gift-giving--and my kids do too.

John Cochrane wrote, the CAPM “proved stunningly successful in a quarter century of empirical work,” meaning it seemed to explain the data pretty well, until we found out this was merely due to beta picking up the size effect, which itself was mainly measurement errors.

This longing for a prior sense of ignorance, when a popular theory appeared to be working, is a rather bizarre stance for an economist. It’s like saying how fun Christmas was when we believed in Santa Claus. True, but that’s harmless fun, not science. The CAPM was never a benign conspiracy of professors to create joy in MBAs, but a serious hypothesis about the way the world works. In a similar vein, Paul Samuelson stated about Karl Marx in his 1995 edition of Economics, after the fall of the Berlin Wall reduced the allocation of his text on Marxism to a footnote: “Marx was wrong about many things—notably the superiority of socialism as an economic system—but that does not diminish his stature as an important economist.”

Ah, the “being wrong” part—never mind!—Marx was popular and inspirational. Clearly, economists see theories in context larger than falsifiable predictions. Any idea that generates a large literature, supposedly, is good. The thought that an idea was edifying, even if wrong, is comforting to academics who often investigate unproven ideas. I disagree. There are an infinite number of bad ideas, so eliminating many of them puts hardly a dent in the shelf from which they are drawn. This is especially true when an error merely postpones an inevitable education with reality, like saying drinking and driving was a great idea until I hit a school bus. The fact that economists as preeminent as Cochrane and Samuelson adopt the same stance toward what constitutes a successful theory (ephemeral popularity among scientists), highlights the strange power of any idea that spawns a large literature.

When People Agree for Different Reasons

Among people who might agree with me on various issues, it is usually for very different reasons. Consider the many reasons people are for abortion or tax cuts. People often focus upon those who agree on their goals, and dismiss the reasons why as uninteresting details. This has pragmatic merit (Keynes's dictum that 'everything is always decided for reasons other than the real merits of the case'), but it highlight the tenuous foundation of our beliefs.


Harvard Law professor Noah Feldman just wrote a book--Scorpions--about the Supreme court justices from when President Franklin Roosevelt was battling to get his radical initiatives implemented in the 1930's. The Supreme court presumably constrains the executive and legislative branches based on whether their conduct or laws are 'valid'. Very smart people study law to decide whether things are 'legal', and then try to convince judges various actions or laws are valid.

He notes all the justices were very smart and driven, and most importantly key supporters of the New Deal. While they disagreed on almost everything (ergo 'scorpions in a bottle'), they arrived at similar conclusions through quite varied philosophies. William Douglas was results-oriented, Robert Jackson relied on constitutional principles, etc. In other words, they all agreed on the answer, just not why it was correct.

The 'why' matters for a host of reasons: it can point to other applications, and suggest the degree of arbitrariness in the decision. For example, if one person doesn't want to rob me because he fears punishment, another because he thinks it is morally wrong, I'm going to try to stay away from the guy whose only fear is the police.

Feldman praises the justices for their role in helping the high court deliver the landmark desegregation decision, Brown v. Board of Education. He contends that their willingness to “break [philosophical] rules of their own,’’ was good because they learn the art of politics from FDR. Not only did they all have different legal principles, they would break these when convenient, highlighting the profound goodness of these men. Well, what if they justified a law you didn't like that way? There seems to be a total absence of principle among these legal titans.

Jonathan Haidt highlights brain research that shows people make decisions first, often unconsciously, then confabulate answers, and they've done this with people whose brain's corpus collosum has been severed and showing things to one eye, ask them to point with the other hand, etc. He likens the conscious confabulator and the unconscious decider of our selves to an elephant and its rider. The rider represents the 'controlled' processes of the mind, the planning and reasoning that takes place one step at a time in conscious awareness, while the elephant represents the hundreds of automatic operations we carry out every second outside of conscious awareness. Over time, the rider can influence the elephant, but never always, and only so much.

This highlights that all people develop beliefs via a process of 'anything goes'. Reality has its constraints, mainly because it is easier to argue for things that are true than untrue--but it's not impossible to argue for things that are false, or even really hard. As Paul Feyerabend argues in his great book Against Method, there is no singular method to science any more than there is single method how a child comes to understand the world: from tradition, direct experience, command, advice, instinct, reading, etc. Surely children learn much more quickly than adults, most of it true, and do so in a very unstructured way. They are on the whole quite ignorant, but importantly, our betters at 'learning'.

When people say their ideas are based on reality, science, rigorous proof, or statistics, they just mean they think their ideas have convincing articulations to some people they respect. They are naive if they think that any mildly complex idea is unambiguously true according to some unimpeachable proof. There are just too many assumptions and implications in any assertion for one to say A is apodictically better than B. Sure, you can come up with simple examples of ideas where the alternatives are silly, but consider most issues people disagree upon--specific tax rates, welfare policies, environmental regulations, criminal statutes--and you will find smart, educated persons on both sides of the debate.


Remember that the economic profession became pretty convinced in the empirical validity of the CAPM (recounted here), over the period 1965 to 1985. Fama and MacBeth, and other seminal papers documented the Sharpe/Linter/Mossin model of how covariance with 'the market' determined expected, and thus average, returns. Miller and Scholes (1972) did empirical work on the CAPM where they controlled for changing interest rates, volatility, measurement error, residual volatility, and skewness, what appeared to be 'everything'; they did just forgot to control for size, which Fama and French (1992) showed got rid of any beta correlation with returns. You simply can't control for everything, so it seemed pretty convincing at the time. This merely highlights what counts as 'proven' is always ignoring some inconsistency, even when the theory is true (as one wag said, no theory is consistent with all the facts, because all the facts aren't true!).

The progressive faith circa 1900 that all we needed was education to create a better world seems like one of those naive beliefs in socialism. The same truths would become obvious to everyone. The problem is, you can't teach common sense, and even those who have it have idiot-savant status, such as when the brilliant surgeon is a conspiracy theorist, or a great labor economist who is a poor macroeconomist. I know I have both good and bad ideas, but alas don't know which are which so I'm stuck with both. You could say, just don't believe in anything much, but that would leave me catatonic, unable to decide the most trivial thing because of the infinite reasons for and against anything.

Oscar Wilde said 'the man who sees both sides of a question is a man who sees absolutely nothing at all', meaning, you have to take a risk, assume something is true in spite of its unprovability, and act--at least tentatively--otherwise you really are in a state of precognition, as when a naive researcher looks at a bunch of data without focus, seeing nothing. To focus is to theorize, to form model of what is important and how things are measured and interact, and our education gives us many tools to do this. But as in geometry where sometimes you assume parallel lines meet, sometimes not, so too with all assumptions and criteria, and the justification is always somewhat arbitrary.

I'm not some sort of Derridean postmodernist, I just know that at the end of the day, people will probably agree or disagree with you for reasons other than what you articulate. I just try to remember that having good prejudices is as important as the having good empirical evidence--eg, the prejudice that risk and return are not related in asset markets--and so work on those as well as remembering how best to calculate corporate default probabilities. Think of your prejudices as your ultimate strategy that dictates your tactics.

It's good to have good reasons they help find these true ideas more efficiently; there just isn't one rational method, or even meta-method. A good method for justifying your beliefs--say applying GMM to a utility function, economists love that!, or flow charts if you are a sociologist--will bring along interlopers who may not have an interest in your specific outcome, but rather, like your application of some methodology, and become a kindred spirit that way, helping your cause and career.

Free competition among people's services, goods, and beliefs is all that tends to make most centuries a little better than the prior one, and forces us to generate better services, goods, and ideas. Truth, like low prices, is not the result of an individual, but rather the byproduct of our collective interaction.

Bank Leverage Limits

I've seen several posts riffing on Tyler Cowen's American Interest article stating banks tend to go 'short volatility'. I'm not too interested in it because I think it's a misleading way to put the problem.

Banking crises are correlated with business cycles, and business cycles are correlated with volatility. Thus, one could say they have too often gone 'short volatility'. But that is rather incidental, not an explicit strategy. The real question is why their portfolios tend to experience highly correlated declines that threaten their solvency every 15 years or so (just within the US: 1819, 1837, 1857, 1873, 1893, 1907, 1901,1929, 1966, 1970, 1975, 1981, 1990, 2008). My theory, based on Batesian mimicry, is here.

As to how to ameliorate if not eliminate these crises, Cowen supports Kevin Drum's argument:

The way to do it is with very simple, very blunt leverage restrictions that apply to all financial actors over a certain size: banks, insurance companies, hedge funds, private equity, you name it. If you have assets over, say, $10 billion, then the rules kick in. Strict leverage limits (say, 10:1 or maybe 15:1) based on conservative notions of both assets and capital would be a pretty effective bulwark against excessive risk taking but wouldn't seriously interfere with the basic asset allocation function of the financial industry.

I do like the way his solution actually makes sense, in that you know what he is saying. You can listen to some people talk for an hour and realize they are merely for more and better regulation, without any specifics. But, the reason why prominent people are vague is because then you aren't wrong, like Drum and Cowen are in this instance. The problem with this great idea is that if you make leverage the key point, regulators will focus on that, and so banks will just invest in riskier assets.

Crises are often compared to drinking binges, where excessive exuberance is followed by hangovers. Following that analogy, if you try to say, 'we don't want people drinking to excess, so we will stop everyone at 6 drinks', well then, they will switch from beer to wine, whiskey, or grain alcohol.

But the drinking problem is potentially soluble because you can measure alcohol, and say allow people one 12 ounce beer, one 5 ounce glass of wine, etc. Basically, the key unit is 'ethanol, which has measurable properties. In contrast, we don't know what 'risk' is. Beta? Volatility? Skew? Get back to me on that. You can't regulate what you can't define.

What about leverage as a proxy for this unmeasurable risk? As Proshares is showing with the Ultra (2x leverage), UltraPro (3x leverage), and short products, a security can have double or triple leverage behind it, have positive or negative exposure, and still be called a 'stock'. Similarly, a bank with 10:1 ratio but plenty of ninja loans had a lot more risk than a bank with 20:1 leverage but all their mortgages had 20% down (the bad old days per Alicia Munnell). Facility risk (eg, loan-to-value) is part of the problem, so too is obligor risk (eg, credit and bureau scores), and so the multiheaded beast grows, with risk hiding from any one metric that can be applied across any large financial institution. This, alas, brings forth many demographics, all who want unsecured lending, which has a populist appeal.

The key is that drinkers engage in moderation only when they realize hangovers are not worth any temporary high. Unless they believe that in their hearts, they will get around your regulations the same way college kids--who generally are below the 21 year old drinking age--tend to get around restrictions promoting their sobriety. Any top-down rule to prevent excess will simply waste time because you can hide the leverage at the other end, say be investing in assets that are leveraged a lot, or who have suppliers who implicitly leverage them (as in the dot-com bubble). Such rules might even make things worse by giving people a false sense of security if nothing bad happens for 10 years, as often is the case.

I used to be head of 'economic risk capital allocations' for a bank, and we had very low risk for mortgages. I left before the madness started, but I can see how it morphed because it would be easy for the business line managers pushing product to point to historical losses in mortgages and say they are basically riskless (eg, the Stiglitz and Orzag analysis). Now, some smart people (eg, Greg Lipmann, Andy Redleaf, Peter Schiff, among many others) saw the past data were not relevant once you start lending to people with no money down, or people with no documents, and that depending on collateral prices rising basically was a game of musical chairs. But within large organizations like banks and GSEs these people were demoted, as happened to David A. Andrukonis, the risk manager at Fannie Mae who was fired for getting in the way of Bill Syron's $38MM windfall. A big idea that is plausible and has many beneficiaries is very hard to resist in real time, and such ideas don't end via argument, but rather conspicuous failure.

So, define risk--not its correlates like leverage, but actual risk--first. Make sure it isn't backward-looking, looking at the past couple of crises, but by say anticipating the next bubble in muni debt or education. Unless you can convince people that such risks are real, any leverage rule will be made irrelevant via the creativity of people designing contracts taking into account the letter of the law. That's really hard, you might say, and we have to do something now. Doing something is not better, unless you think pandering to the mob is a primary objective. If risk management were merely following some simple asset-to-liabilities test, someone would have figured that out by now.

Russ Roberts Interviews Joe Nocera

Russ Roberts interviews Joe Nocera about his book "All the Devils are Here". I thought this book was OK, but it spent a lot of time discussing the background of major players, who all seemed to either grow up 'on the wrong side of the tracks' or went to Groton. Am I the only person who had middle class parents, average in most ways? Perhaps that's my exceptionalism--extreme conventionality!

One important take-away seem to be, send all the econ bloggers a free copy of your book, because I think it was uniformly rated well in praise surrounding extended quotes (see Tabarrok here, Kling here).I can tell you that there is little upside to slamming a book on your blog, but you might receive a nice note from the publisher, or some nice links from the popular author if you have nice things to say. Book reviews are like stock analyst recommendations pre Sarbanes-Oxley.

Here's a snippet Nocera and Russel's take-away of they big mover in the 2008 crisis:

My interpretation of that has to do with modeling. I think one of the things that happened over the course of the last 20 years is the core idea that you could model away risk. One of the things that was striking in [Greenspan's] apology was when he said: Several people have won Nobel Prizes for the work that has turned out to be flawed.

In other words, 'models' were the main problem. We shouldn't believe so much in models. This is not insightful, because it leads to infinite regress. If you believe models are imprecise, and so add some uncertainty around them, this too is a model. Sure, you can keep compounding your uncertainty, but eventually this leads to avoid lending altogether, which is clearly suboptimal. But then Nocera mentions this pertaining to MBIA:

One of the things we said to them, we asked them about, was their models. They said: Actually, our models were pretty accurate. If we plugged in a 20% decline in housing prices, they showed the world blowing up. But we just assumed that that could never possibly happen! Famous paper by the Orszag brothers and Joseph Stiglitz, who was a Nobel Laureate, showing how remote it is that Fannie or Freddie would ever go bankrupt. Absolutely true.

So, the problem was not essentially models, hubris, or securitization, but rather this singular assumption: that housing prices, nationally, would not fall significantly year-over-year. It is much more parsimonious explanation; it explains more with less.

A Christmas Story

When I got out of grad school and was working for KeyCorp, the 8th largest bank in the US at that time, I found myself at a holiday employee party in Beachwood Ohio, ground zero for Jews in the Cleveland area. I'm a born Lutheran who likes Christmas and Easter, but am pretty indifferent to organized religion. As Eric Hoffer noted, 'the opposite of the religious fanatic is not the fanatical atheist but the gentle cynic who cares not whether there is a god or not.' Anyway our CEO Victor Riley was there to give the standard holiday pep talk. The theme was 'The Real Meaning of Christmas', which I figured meant something relating to transcendent ideas about love, charity, or family. Instead told the audience that the real meaning of Christmas was: The baby Jesus.

The mainly Jewish audience looked at each other. Sure, it made sense to a Catholic, but it's important to know your audience. I thought it was a hysterically obtuse attempt at profundity. Luckily, he didn't follow up with his thoughts on the real meaning of Easter.

The CEO left and we were drinking holiday spirits, everyone tried to forget his statements as if they were never said. Now, CEOs are generally people-persons, emotionally intelligent, people who can work a room. It reminded me that everyone's an idiot at something, even things in their bailiwick.

AEA Meeting Topics

Hundreds of papers are being presented, and more than a few are sure to be very interesting, so keep up to date as the papers get filled in (they post the papers online, so you don't actually have to go). Think of it like a flea market: mainly junk, but some real finds if you look around. Many have straightforward groupings like "Banks, Credit Constraints and International Business Cycles" and "Optimal Fiscal Policy", where there are usally 3 papers that address the issue. Then there's this grouping, the ubiquitous 'other' category:

Five Unrelated but Interesting Papers

Driving Under the (Cellular) Influence

Do Public Subsidies Sell Green Cars? Evidence from the U.S. Cash for Clunkers Program

A History of Violence: The "Culture of Honor" as a Determinant of Homicide in the U.S. South

The Lion's Share: An Experimental Analysis of Polygamy in Northern Nigeria

White Men Can't Jump, But Would You Bet on It?

Frazzini and Pedersen Simulate Beta Arbitrage

Andrea Frazzini and lasse Pedersen have a paper out entitled 'Betting against Beta'. It has an insane number of tables and figures at the end, which is nice because its all there if you care to look, and with electronic publishing, no polar bears are killed in the process. They take the finding that 'risk does not appear positively related to return within asset classes, and form Betting-Against-Beta portfolios by going long the low beta assets, and short the high beta assets. Specifically:

A BAB factor is long a portfolio of low-beta assets, leveraged to a beta of 1, and short a portfolio of high-beta assets, de-leveraged to a beta of 1. For instance, the BAB factor for U.S. stocks achieves a zero beta by being long $1.5 of low-beta stocks, short $0.7 of high-beta stocks, with offsetting positions in the risk-free asset to make it zero-cost

They find significant returns to betting against beta within 19 country's equity markets, and also look at US treasuries, and credit markets.

Another brick in the wall showing that covariance with 'the market', any market, is not cross-sectionally related to returns. Now, it could be 'expected returns' were correlated with this conditional covariance, and all we have are realized returns, but at what point does one give up on this line of reasoning?

As to the question why, Frazzini and Pedersen argue it is related to margin requirements. That is, a higher margin requirement inhibiits leverage, and this causes one to prefer high beta assets to get more bang for your buck. While this works in this model, it predicts people should be massively invested in the stock market, but average stock market holdings are comparable to household's investment in automobiles. Only 15% of the population hold stocks directly (not via pensions), and stocks are only about 50% of their financial assets (other being bonds and cash). So, if the margin was a binding constraint, this is a major counterfactual.

Sure, increasing haircuts (margins) hurts prices, but usually these are stressed markets, a highly biased samples for a general inference. Consider that eliminating shorting on certain stocks usually provides a one-day increase in the stock price, but over time, it is not obvious countries with more onerous short selling restrictions are more overpriced in aggregate.

If investors are leverage constrained, and so favor high beta assets or low beta assets, leading to lower returns of high beta assets, low volatility portfolios being offered now are clearly dominant portfolios. If at least some investors are not constrained, this is not an equilibrium, because they will all strictly prefer the low volatility portfolios.

As to the Treasury-Eurodollar spread predicting equity BAB portfolios, to the extent there is beta compression in stressed times, that isn't really interesting. Now, if the prospective returns are predictable, that would be interesting. Alas, with time series on a factor, there's never enough data, and I've never seen anything work well out-of-sample.

My favorite explanation for the risk-return pattern--flat as a first approximation, negative for the highest risk assets in any class--is that 1) as investors measure risk relative to a consensus benchmark, no risk premium exists and 2) the really high risk assets are overpriced due to dupes who think they all have alpha. The latter is kind of a margin story, and it is a disequilibrium one.

Risk Premium Doesn't Make Sense

The idea that risk begets return comes from the idea that people don't like risk. As risk is avoidable, by say putting one's money in high quality bonds, investing in risky assets must generate a positive expected return to compensate people for such risk taking. This is the risk premium. Yet, we see again and again that risk does not beget return (see here). Merely taking risk is not compensated.

I was reading a book The Decline and Fall of the British Aristocracy, by David Cannadine, which covers 1870 through 1930. They highlight that this was the strongest aristrocracy in Europe due to primogeniture and Britain's exceptional wealth, and so the combination of power, status and wealth was unequaled. In 1880 only 10,000 people owned 66% of the land. Yet land prices fell after 1880 due to a collapse in agricultural prices, the rising industrial sectors marginalized the rural areas that historically gave the nobility so much of their wealth, and new laws turned power irrevocably from nobles to number (the Third Reform Act of 1884).

Classical liberal Richard Cobden wrote that 'the battle-plain is the harvest-field of the aristocracy, watered by the blood of the people', meaning, the aristocracy prior to 1900 generated their legitimacy via their willingness to lead groups into battle (often needlessly). As the British aristocracy declined from 1880 to 1910 they thought that World War 1 would re-establish them as the top of their country. Many were eager to fight, mainly afraid the fighting would be over before they could prove themselves in battle. Yet, while they proportionately lost more of their sons than those of other classes in WW1, the decline of the aristocracy continued unabated after the Great War. Indeed, the loss of life sharply curtailed the supply of domestic servants, and inheritance taxes went from nothing to 60% by 1939. The lower classes felt no sense of gratitude towards the aristocracy, having lost enough themselves. Battlefield courage is admirable, but it is not sufficiently rare to generate privileged status; the lower classes were not party to such an exchange.

In retrospect, the aristocracy arrogated power via myth, tradition, and brute force, rationalized via their exception valor. The problem with their self-serving story is that many would accept a probability of death for such success, so this 'courage premium' was not a real equilibrium result, as WW1 showed. Courage was a necessary, not sufficient, condition for acquiring power. Similarly, risk taking is a necessary condition to achieving riches, not sufficient. In standard theory, you take risk, and on average you will get rich quicker than others. That's all you need, a willingness to experience the randomness.

Unfortunate jobs like cleaning sewers are generally not highly paid even though they are rather disgusting; people get used to a lot of things. In a similar way, risk taking, if all it takes is a willingness to expose oneself to some stochastic shocks, is too easy. As Dan Pink notes, researchers have documented that monetary incentives work pretty easily for straightforward mechanical tasks, like keeping one's band in hot water for extended periods of time. Monetary incentives do not work for tasks taking some kind of creativity. In a similar way, if mere willingness to undergo stochastic shocks generate higher expected returns, it would be too easy. In real life, it's much more complicated, as intelligence is very important. You don't get paid--statistically--for merely for taking risk, however defined.

If one can expect a 5% annual return to investing in equities over bonds, then over 30 years this means quadrupling one's money relative to those who are risk averse. If that is the trade-off, I doubt anyone would choose bonds. It's a profound misunderstanding, a signature mistaken principle in finance.

Regulators All Talk

The problem when someone is given authority to regulate something really complicated, where the agents under regulation have vastly more knowledge of the product landscape than they do, is that the regulators know they don't know what they are talking about. For all Warren has studied credit cards and mortgages, I bet she still doesn't know what the expected charge-off rate is on 550-600 FICO credit cards off the top of her head. The participants know this stuff inside and out.

Thus if they create a stupid law making X illegal, all the industry does is create a slight modification and generates the same result, or a different industry takes up the slack with more onerous terms. Worse, like the Carter credit controls (which caused a GDP tailspin in 1980:Q2), it can totally shut down a market, highlighting their ham-handedness. Thus, regulators rarely do anything that might have a conspicuous effect (eg, they passed a health care overhaul that will be rolled out in such a fashion people will never agree as to the effects)

Smarmy Warren's initial big idea was to simplify and standardize contracts. Thus, instead of having a mortgage contract with tens of pages in 10-point font, requiring 10+ initialings, you have one page with simple terms a regular person can understand. Unfortunately, simplification comes with a cost. It groups many contingencies under one big tent, and so specifics can not be spelled out. When someone gets screwed by some specific clause and did not foresee it, they have historically argued to courts this was unfair, which created the lengthy documentation. The many pages and initials are meant to capture these cases, and now must be inferred.

So, pick your poison: a simple general statement that hopes people can figure out the special cases, or list all the special cases, making the general statement more obscure. I'm all for standardization, but the banks will reasonably demand indemnification for such simplicity, and the Trial Lawyers will fight it. She's going to be shocked when her push-back comes from her side of the aisle.

In the meantime, the new agency is guaranteed funding from the Federal Reserve, so it will be part of the government forever. Its main objectives are enumerated thusly:

1. Research
2. Community Affairs
3. Complaint Tracking and Collection
4. Office of Fair Lending and Equal Opportunity - ensuring equitable access to credit
5. Office of Financial Literacy - promoting financial literacy among consumers

These objectives are covered independently by tens if not hundreds of other agencies that produce lots of stuff no one cares about. Highlighting the regulators continued cluelessness, they raise the 'equal access to credit' as a right as opposed to the signature problem that led to the mortgage bubble. Discriminating on ability and/or willingness to pay invariably hits certain demographics differently, so this is a classic efficiency/equity trade-off, and we know where the government stands. The implications, however, are not obvious, as many still think this had absolutely nothing to do with the mortgage meltdown.

I'm sure Warren is happy as a pig in poop creating her new fiefdom with all the status it implies. As the first director, surely several conference rooms, pavilions, if not entire building will have her name on them after she leaves. As to actually helping the consumer, say by proposing specific data that would increase transparency, that would take greater understanding of the product landscape than she and her ilk have. For example, why not make it easy for investors to see the track record of investment advisers and hedge funds? Currently, getting that data is not merely difficult, but often illegal! How about making it easier to see who has sued whom and for what? If someone has sued several prior colleagues and a neighbor, that's darn useful information, but currently it is made very difficult to acquire. Why not take over the rating agencies production of 'default studies' with your own, independent validation, so that we can see how AAA and BB ratings do for various categories without the tendentious reporting?

Instead they will busy themselves having meetings, creating task-forces, showing they listen, and maybe some pointless regulations that merely add fixed costs to the business (eg, the Security Exchange Acts of 1934 and 40 are good examples).

Here's the UN Global Climate committe describing their latest meeting

The United Nations Climate Change Conference took place in Cancun, Mexico, from 29 November to 10 December 2010. It encompassed the sixteenth Conference of the Parties (COP) and the sixth Conference of the Parties serving as the Meeting of the Parties to the Kyoto Protocol (CMP), as well as the thirty-third sessions of both the Subsidiary Body for Implementation (SBI) and the Subsidiary Body for Scientific and Technological Advice (SBSTA), and the fifteenth session of the AWG-KP and thirteenth session of the AWG-LCA.

This blurb underneath a picture of them all applauding themselves! How wonderful that they all care enough to make time for Cancun in December to talk about global warming.

What has come from all these meetings? Well, they all agree that 'something should be done', and voted for the rich countries to give money to the more numerous poor countries. Needless to say, this has no impact on anything, because bureaucrats can't unilaterally budget such expenditures. That's top-down politics. To think that Hollywood created a big production to pass the law creating Warren's CFPA, highlights how many people get excited about government power, when really all they mean is more government expenditure and sinecures.

Scary Santa

My little princess Izzie (3.5 y.o.) had been apprehensive about sitting with Santa, but finally mentioned she was up for a tête à tête to inform him of her interests in Easy-Bake Ovens and Pillow Pets. I capitalized on the chance. After a half hour in line, as we got closer to the big guy, she started mentioning second thoughts. I was in an evil mood, and handed screaming Izzie to their helper-elf, who assured her that this was not the Bad Santa from the mall across town. She was unpersuaded. I told the elf I had cash and I had my orders, so to the horror of the other children watching we basically water-boarded the child in front of them. Merry Xmas!

Confidentiality Agreements

When I was young and stupid I signed a Confidentiality Agreement without much thought, like the way one clicks those 'EULAs' when you download free software. I left that firm, and my idea was to run a fund going strictly long low volatility stocks, worldwide, which was based on over a decade of prior research and practice. I would put in some of my money, and by giving half to a White Knight get access to brokerage enabling me to trade world wide at sufficient scale to demonstrate this was a dominant strategy.

When my old boss found out he initiated litigation, confirmed my earlier suspicions (eg, when your ex boils your bunny, it's bad for your bunny but highlights it's good she's your ex). His claim was based on the Confidentiality Agreement I signed when I joined his firm in 2004, that included the following:

Employee agrees that all inventions, discoveries, computer software programs, trade concepts, designs, patents, ideas and copyrightable and/or patentable material made, conceived or developed by Employee during the term of this Agreement shall be owned in full by the Firm. The Parties acknowledge and agree that this paragraph does not apply to an invention for which no equipment, supplies, facility or trade secret information of the Firm was used and which was developed entirely on the Employee’s own time, and (1) which does not relate (a) directly to the business of the Firm or (b) to the Firm’s actual or demonstrably anticipated research or development, or (2) which does not result from any work performed by the employee for the Firm.

I had substantial prior use of the strategies related to low volatility investing, having run a low volatility fund as a stand-alone for 5 years in the late 90's, written a dissertation on the subject, and applied it within a hedge fund for a year prior to joining his firm. Yet, given the confidentiality agreement above mentioning anything related to 'ideas or trade concepts', my pet idea was potentially available to everyone but me. A lawyer sees these trading concepts, and can't distinguish between something common as a built-in Excel function and a complex, unique algorithm. As my litigious ex-boss stated:

anything that you invented since September 1, 2006 that relates to the profitability, accruals, volatility, and capital issuance of equities cannot be anything but derivative of your work at Telluride

Unfortunately, this is a legitimate claim in American courts, given judges have no idea what "profitability, accruals, volatility, and capital issuance" means. Sure, I would probably win a jury trial on this point, but they had all my hard drives, and discovery was continuing and unconstrained, so I probably violated some law. Most importantly, by the end of the trial I'd be broke. After 18 months of litigation we settled. I no longer had enough money to start my fund, so my career went a different way.

Never anticipate good faith from people outside your family; remember, everyone thinks they are being reasonable, they just interpret 'reasonable' from a different vantage point. If your portfolio managers are making 5% of their pnl whereas they could make 20%, handicapping their ability to pursue alternatives can be quite valuable. Making an example out of someone never makes sense in isolation, it makes sense in a broader context.

The above selection is very common, and have seen this paragraph in several confidentiality agreements (lawyers do a lot of cutting and pasting). Because of my litigation several people have emailed me about similar situations, and I generally find their problem is not the non-compete, rather the confidentiality agreement, and they don't even know it. It can be a license to enforce a perpetual non-compete.

I'm not a lawyer, and thus am officially unqualified to give out legal advice. So, of course, pay a lawyer a couple hundred bucks to read over such a simple statement and give you suggestions. Going forward, I will be sure to amend the above to specifically note it does not pertain to ideas I have demonstrated previously, spelling them out in specific. That way, in my unqualified opinion, I will have a better chance of having the case dismissed, avoiding litigation, or at least circumscribed. But that's my opinion, not advice, because I am not part of the legal guild, and my advice is not only worthless, but would be illegal if presented as advice.

Low Volatility Investing Fun Facts

Robeco has a 'minimum volatility' portion for their webpage (see here). I'm a huge proponent, having invested this way myself. It won't make you rich, but that's why it works (ie, dominates the equity indices in return and risk). From Robeco's Pim van Vliet, here are 10 facts about Minimum Variance Portfolios, aka MVPs (edited in consideration of my web readership's busy schedule):

1. MVPs have high exposures to low-volatility stocks and low-beta stocks.
2. MVPs achieve risk reduction of about 33%.
3. MVPs are a relatively new phenomenon, but the first documented alphas were found in low-beta stocks as early as the 1970s.
4. MVPs' alpha is driven by persistent behavioral effects
• a focus on tracking error instead of total risk. From this perspective low-risk stocks are high-risk and therefore unattractive.
• return-seeking investors tend to prefer stocks with high risk because they are leverage constrained.
• A large number of risk-seeking investors buy volatile stocks to get rich quickly.
• Attention bias. Stocks of companies which are in the news have higher volatility, making them more commonly held, increasing their price and decreasing their returns.
• The winner's curse With asymmetric information, the highest bidding buyer often pays more for a stock than its true intrinsic value.
5. Mutual fund data suggests that the currently available low volatility products are all successful in significantly reducing downside risk, and can be done in a variety of ways.
6. MVPs can also outperform during bull markets.
7. MVPs generate huge tracking errors of 6-12%, but consider a stock which generates a certain 10% each year. For this stock the tracking error is equal to equity volatility of about 20%, but who would care?
8. MVPs exhibit time-varying style exposures. MVPs had a value bias in 2006-2007, but turned to growth in 2008- 2009.
9. MVPs tend to have somewhat higher correlation with bonds.
10. The alpha of a MVP is very difficult to arbitrage away, in contrast to better known alphas such as valuation and momentum. To catch the alpha in the low-volatile segment of the stock market, either the market capitalization benchmark should be completely abolished and ignored, or the Strategic Asset Allocation framework should be adjusted and include a separate style allocation to MVPs

Momentum Still Lagging

The graph shows the total return to a strategy long positive momentum stocks, short negative momentum stocks (it's from Kenneth French's excellent data repository). Historically, stocks that have outperformed over the past 3-18 months tend to outperform over the next 3-18 months, with an optimal point being around 12 months. The above graph is the total return for going long the past winners, short the losers. Historically this strategy has generated a puzzle, because the annualized return of around 8% it is pretty high, and it seems independent of the standard value and growth risk proxies. Sometimes it is added as a risk factor to studies, but mainly because we know it works and don't want to confuse this finding as something else. There is not a good 'risk' explanation for it.

Anyway, it seemed like easy money until March 2009, when it got clobbered, just as many prophets of doom were on CNBC telling Maria Bartiromo another leg down was in the cards. Actually, they would say another big decline 'could' happen (thus if it happened they would take credit for predicting the decline, and if it didn't they would note all they said was 'could'--predicting is so easy on TV once you know these tricks!).

Of course that was basically the start of the US market recovery and all those stocks that had been pounded like banks roared back (the momentum portfolio would have been short those). From March 2009 through September 2009 the momentum strategy lost about 50% and has gone up only about 5% since. Since 1932 (when it lost 77%), its worst draw-down was consistently about 30%, so the standard financial fat tail event happened. If you are lucky when such strategies stop working they flat-line, but this one was not so fortunate. As they say about these statistical patterns: they work until they don't.

A lot of funds were adopting momentum previous to this, especially because it came out the tumultuous 2007-8 period relatively unscathed. Unless momentum starts to really outperform it will go the way of 'low price' stock funds, because a big -50% really hurts all those lifetime annual return statistics.

I remember back in 2003 I convinced my boss to try momentum because it seemed have positive alpha. So, we put it on in the fourth quarter, and it started out ok, so ramped up in December. Of course, December 2003 was really bad for this strategy. Without a long track record, I looked like an idiot. I felt horrible and remember writing Ken French an email, and asking, what can I tell my boss about momentum's lousing December 2003? He was nice enough to reply, though all he said was, 'tell him there's risk'. Alas, that was not a good answer. In real time when you lose money it isn't seen as risk that pulled a bad number from the urn of chance, but a bone-headed mistake, especially when you don't have a benchmark. That wasn't one of my better Christmases.

Nassim Taleb Imitates Kanye West

The often angry-looking Nassim Taleb just published a book of unlinked tweets: The Bed of Procrustes. It is short and has a Kindle version that costs 72 cents less than the hardcopy.

As to its flaws, it reminded me of one of my favorite aphorisms: "the man who early on regards himself as genius is lost.” He inverts the observation that geniuses are often misunderstood to the insight that misunderstood people are geniuses, and critics of such people are imbeciles who don’t even have the taste to appreciate genius. My criticisms are therefore consistent with him being right or wrong, but falsification is not symptomatic of punditry in general or Taleb in particular.

It is a golden rule not to judge men by the opinions but rather by what their opinions make of them. His many fans highlight the effect of Taleb's thinking as they speak like Renfield discussing Count Dracula:

”excellent; it's a must read ... I'll refrain from demonstrating my foolishness and ignorance by trying to interpret any of them in this forum.” ★★★★★

“Those who understand the book will refrain from summarizing its message.” ★★★★★

They sound like a cult of scared guru worshipers.

I suspect that Taleb dreams of someday winning the Nobel Prize in Economics for his popularization of Rietz’s peso problem (1988), fat-tailed distributions (Mandelbroit 1963), or Knightian uncertainty (1921), at which point he would refuse it and then raise his stature above all those before him. Alas, as defective as the econ Nobel is, it ain't the Peace Prize. He has not added any new significant idea to any of these richly researched threads, rather merely tries to convince readers he and his followers are the only ones in the world who really understand them. For example, he extensively documents that financial time series are not exactly Gaussian, something financial standard bearer Eugene Fama investigated in his 1960's dissertation. He meticulously proved something everybody in the field has known for decades.

Winston Churchill said ‘It is a good thing for an uneducated man to read books of quotations’, and I agree. Many useful truths in mathematics and physics are old hat but essential pillars of wisdom, concise, and so too for the many proverbs that have been handed down to us. Readers usually retain aphorisms they parse out of an author’s sustained argument, a pithy summary (eg, Smith’s ‘By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it’). Taleb knocks out the middle-man and publishes a couple hundred of his random thoughts.

Such a book needs a certain predisposition because when Chauncey Gardiner said 'there will be growth in the spring' in the movie Being There, it was considered profound basically on how you perceived the vehicle spouting such statements. Consider that the most absurd economic proposition will be taken seriously if you can find it in Keynes's General Theory, in which case, it's an argument that deserves consideration (Pay men to dig holes and fill them in again? GT p.220, really). Thus Taleb gives us these beauties:

"Fortune punishes the greedy by making him poor and the very greedy by making him rich."

"Karl Marx, a visionary, figured out that you can control a slave better by convincing him he is an employee."

"Sports femininize men and masculinize women."

"Every ten years collective wisdom degrades by half."

"The nation-state: apartheid without political incorrectness."

Perhaps his acolytes are correct, these remarks defy exegesis. But if you aren't going to make sense, you might as well be funny: Marx's 'time flies like an arrow, fruit flies like a banana.' Taleb's humor is less like Groucho, more like Karl.


Kanye West is also very popular and like Taleb tweets his fans with petulant rants. Consider these Kanye Classics:

“Because I have sacrificed real life to be a celebrity and to give this art to people, which is great. It is great that I was able to do that…”

“I am God’s vessel. But my greatest pain in life is that I will never be able to see myself perform live.”

“You want me to be great, but you don’t ever want me to say I’m great?”

"George Bush doesn't care about black people."

Modesty is a virtue not because it implies servile humility, but because it implies a combination of honesty and knowledge. Using self-righteous anger to justify immodesty just highlights one's immaturity. Here's Taleb channeling his inner Kanye:

"Your reputation is harmed the most by what you say to defend it."

"A genius is someone with flaws harder to imitate than his qualities."

"It is a waste of emotion to answer critics."

"Bad mouthing is the only genuine expression of admiration."

"People reserve standard compliments to those who do not threaten their pride; the others they often praise by calling 'arrogant'."

"It is the appearance of inconsistency, and not its absence, that makes people attractive."

The last thing most people need to think is that criticism is mainly from fools who misunderstand genius, because as I've entered middle age and had children I have found 1) children are learning and a fast rate while most adults have stopped learning and 2) adults can avoid criticism, whereas a child cannot. These are not unrelated.

It is frustrating when people dismiss your ideas and it's comforting to imagine they are all envious fools not worthy of your genius, yet this is just succumbing to your baser instincts. Like everyone else, I don't like criticism, and when I was young I was insecure and immodest, and this hurt me in many ways. Over time wisdom has made me more confident and humble. Thus, while my CPU may be slowing and RAM shrinking, I'm processing feedback more efficiently than I used to, and I wish I appreciated the value of modesty earlier.

Criticism and advice are often wrong, but that merely highlights it is not a sufficient condition to becoming a better person, only a necessary one. Life is too short to learn everything by trial and error, so watching and listening to others is essential. A bias that critics are cretins leads to a life guided only by errors so great they can not be ignored, an inefficient path to enlightenment.

I do agree with a lot of what Taleb says, but as he is pridefully inconsistent (it makes one interesting, supposedly), this does not mean much because once you say 1+1=1, everything, true and untrue, is implied. For example, he states the detection of false patterns is a major problem, excluding the pattern of increased falsely perceived patterns; he's a rebel telling the academy what they don't want to hear, yet his arguments are based on academic science and mathematics; data are definitive and the past is misleading. These are not profound paradoxes but rather confused ramblings. It would take a lot of psilocybin for his oeuvre to seem deep to me.

An unqualified glowing NY Times review of "The Bed of Procrustes" references this interview as exemplifying his trenchant criticisms, as he states ‘we should eliminate value-at-risk.’ In The Bed, Taleb argues that 'knowledge' is knowing what does not work as opposed to what does, but this is just letting perfection being the enemy of the good. All theories are wrong, some are useful. If you eliminate Value-at-Risk, what do you replace it with?

As a tool, Value-at-Risk is better than nothing. It is also better than something like the TSA's nonquantifiable terrorist threat indicator. Indeed, one very nice thing about Value-at-Risk, it can be wrong! It can be tested and calibrated at reasonable extremums to capture some of the nonlinear risks in a portfolio, whereas threat level 'orange' remains not even wrong. A metric that captures 1 in 20 events balances the objectives of calibrating a risk metric and capturing some nonlinearity, because you need to generate real observations to calibrate (it isn't applicable to portfolios with assets held for several weeks or more). There’s a trade-off between capturing only the tail events that really matter, and empirically validating the metric.

Value-at-Risk is not perfect, but prior to this you had a jumble of indicators that were not comparable, and logically you usually can't say an array of indicators is 'high' or 'low', just that some items are higher and some are lower, and this leads to an ambiguous interpretation, and impossible testing and calibration. Imagine trying to have a discussion about risk at a desk with currency, equity, and bond exposures, all with their various derivatives. If you are not allowed to bucket risks into groups and add them up using some consistent methodology it would be an endless narrative with lots of adverbs.

As to Taleb’s admonition to not ‘confuse the map for the territory’, that was a cliche in the 1960s. More importantly, the problem is not omnipresent but rather selective, because theory-free observation is not suboptimal, rather impossible. The real issue is which theories are bad and in what ways, not that theory is bad.

For example, like Taleb, I find many economic models excessively rigorous because such theories do not add precision or clarity to an idea, only faux sophistication. Thus, Romer's growth theory, or Krugman's increasing returns to scale theory, did not add clarity to an existing debate, only false rigor to ideas more clearly and accurately stated in words. Note that even Romer and Krugman don't build arguments on their models, rather they merely use them for presenting their bona fides. The models are mainly for proving one is clever as opposed to making a novel point. A formalization of well-known arguments that disingenuously presents itself as a new theory is bad because this leads to a wasted focus. Further, some models become so convoluted they make falsification impossible, allowing an intellectual error to persist for a generation as true believers can always point to different parameterizations that work (eg, input-output macro models, large-scale Keynesian macro models, stochastic discount factors).

Hayek's theory of the importance of markets and profit-seeking in decentralizing incentives, Adam Smith's Invisible Hand, the Coase Theorem, and George Stigler’s theory of search and information, meanwhile, were real advances in our understanding of economics, and these did not entail sophisticated mathematical equations. ‘Example’ is more intellectually honest than ‘theorem’ when presenting an economic argument. Representing an idea using measure theory is considered top academic work, but it’s usually pure pedantry.

Unfortunately, the idea that some rigor is good got turned into an arms race in rigor. Really important economic ideas that necessitate heavy mathematics are rare, confined almost exclusively within game theory (eg, Arrow’s Impossibility Theorem, Harsanyi’s general Bayesian model of games, Hurwicz’s mechanism design, Meyerson’s revelation principle), and game theory itself has been much less fruitful than originally thought. Continuous time, Hilbert space, real analysis, have not added to our understanding of economic problems, they merely remind us that any simple mathematical idea can be made more rigorous.

As per unlikely events being under appreciated, I would say it is the opposite. Most internet spam and investment scams are based on things that could happen but probably won't. Improbable events, when priced, are generally overpriced, largely because they can't be hedged and markets are thin, so as a buyer of these things, you tend to overpay: out-of-the-money options, wacky investment or business ventures. As Tyler Cowen wrote in his otherwise positive review in Slate, this big idea does not work in Taleb's main field of expertise, options (peevish Taleb violated his aphorism to ignore criticism back then, and got very mad at Cowen).

This focus on the improbable can lead to excessive risk taking, such as buying lottery tickets or joining multi-level marketing schemes, and too little risk taking, as when we forgo nuclear power or irradiating eggs because of improbable nightmare scenarios. Pity the investor who bought volatility based on the idea that people under appreciate it, as the straightest volatility play, the ETF VXX, has lost 90% of its value since inception in Jan 2009. The key is not to increase the perceived probabilities of small probability events, rather get them as correct as possible. Some should go up, some down, and this is hard work.

A really good aphorism is distilled in the context of a broader set of work, such as Bertrand Russell's remark that "One of the symptoms of an approaching nervous breakdown is the belief that one's work is terribly important", which for a man who spent a decade on the futile task of trying to axiomatize mathematics (later proven impossible by Kurt Gödel), is truly profound. It is advice Taleb would do well to take.

fyi: my old review of Taleb's Black Swan

Jeter's $45MM Seems Fair

Derek Jeter has had a great career, but last year he hit .270 (mediocre)). Nonetheless, he's fielding offers like $45MM for 3 years. Yet, no one seems very angry about exhorbitant pay in athletics, as compared to CEOs. Here's Holman Jenkins over at the WSJ:

Said one fan on a New York paper's website: "As far as the money is concerned, I really don't care what they pay him. It's not my money." If it were catching, this healthy-minded attitude toward the paychecks of our fellow man would make the world a better, happier place.

Jeter clearly has alpha in a narrowly defined sphere that most of us recognize. We can see he is good at what he does--much better than us or anyone we know personally--and thus earns his pay. In contrast, the suspicion is that CEOs are merely involved in a massive crony-capitalism game that discriminates against those who don't have the right family and friends. That strikes many as unfair.

Former Clinton Attorney General Jamie Gorelick made $40MM while running Fannie Mae and the mortgage market into the ground. Rahm Emmanuel made made $16.2 million in his two-and-a-half-years as an investment banker. Bob Rubin pocketed $150MM while working for Citigroup. The list goes on and on (recent OMB director Peter Orzag was just hired as an investment banker by Citibank). These are problematic because we know they are getting paid merely for access--Rubin claims he was totally unaware Citi had $54B in mortgages on their balance sheet, which was probably true--for getting the right person to answer a phone, or bury some exception in the latest 2000-page bill or trade agreement. That's a game not available to most of us.

But then there are (relatively) unconnected CEOs who merely make too much. Merrill Lynch CEO Stanley O'Neal made $46MM and $48MM in 2006 and 2007 respectively, then got a $161MM severance package after Merrill was sold for a song to Bank America. As noted in 'The Devils are All Here', he golfed every day, and basically had no idea what was going on related to mortgage exposure that would destroy his firm. Managers of large firms are rarely the brightest and best (exceptions usually being founders), but rather someone of steady temperament.

The CEO is often a compromise between conflicting groups. He must be blithely ignorant about the inconsistent objectives articulated to the team, such as trying to simultaneously prioritize innovation and tradition, a meritocracy that aggressively promotes racial bean-counting, or a strong sexual harassment policy and a really fun Christmas party. People who are really good at logical puzzles, who excel at something, are often not very good at managing people because they can not, or will not, suffer fools well. Thus, in spite of conspicuous examples where the highest IQ person is both an idea generator and the boss such as Larry Ellison or Bill Gates, in general the functions involve different skill sets. The result is a leader in a modern reverse dominance hierarchy who is paid to keep the peace and make people feel good, as opposed to make really important strategic and tactical decisions. It's a skill, but not one worth tens, let alone hundreds, of millions of dollars.

We don't mind inequality when we know it is for true alpha. What bothers people, and I think rightly, is when people are getting paid when they really do not have alpha, in that their ability to chair meetings, spout cliches at group functions, or golf leisurely, is something anyone could do. In contrast, if we played shortstop for the Yankees we know the team would suffer. It's a problem I don't have any solution for.

Economists Have The Answer(s)

Harvard educated economist Brad DeLong's parents also went to Harvard, but so did two of his grandparents, two great-grandparents, and three great-great grandparents. He has been designed by natural selection to be a progressive, and he advocates the memes that have hijacked his gene pool very consistently. A recent post signified exasperation at why pols don't listen to economic experts:

90% or more of professional economists think times of high unemployment are cases of a disease that can be cured by strategic interventions to rebalance financial markets. They disagree about how and what those rebalancing policies should be. But they agree that there is a cure

That's comforting. They all have solutions, albeit solutions that are wildly different. In the middle ages if you didn't feel well a doctor would give you a variety of orthogonal cures: laxatives, emetics, bloodletting, herbs. If they didn't have a cure they could not have make a career out of it.

Of course, the best cure back then was to drink lots of fluids and rest; basically, ignore the quacks and do nothing. It's similar for macroeconomic problems, where prior to Herbert Hoover, the federal government would not do much, and growth rates were as high as ever in our history.

With all the plans in the stimulus pipeline, and vast amounts of health care and financial regulations passed but not implemented (or written), doing nothing is not going to happen in the US any time soon.

How Not to Fix Economic Models

Add more money.

The Wall Street Journal notes the Institute for New Economic Thinking was launched last year with $50 million from financier and theorist George Soros. The institute so far has approved funding for more than 27 projects, including efforts by aimed at developing new ways to model the economy. What are their ideas? Remember that Soros' Alchemy of Finance presented the big idea that prices are irrational, which he defined as biased 'in one direction or another' (his other idea, that markets can influence what they predict, playing off his role in the 1992 EMU crisis). He's sympathetic to researchers who would confirm he's not just rich, but a profound, original thinker. Here's the WSJ:

The problem, says Doyne Farmer, is that the models bear too little relation to reality. People aren't quite as rational as models assume, he says. Advocates of traditional economics acknowledge that not all decisions are driven by pure reason.
...
His proposal: Create a richly complex, computer-based simulation of the economy like those scientists use to model weather patterns, epidemics and traffic. Given enough computing power, such "agent-based" models can include millions of individual players, who don't have to be rational or agree with one another. Instead of equations that must be solved, the players have open-ended rules of behavior, such as, "If I've just turned 55 and I'm feeling blue, I'll buy a sports car."

Gee, macro models with lots of equations...hey, that was popular in the 1970s! Jan Tinbergen made the first one in the 1950s. They did not stop using them because they ran out of funding, but rather because they were such an obvious failure. With hundreds of equations based on mini-models of banking, savings, or industry behavior they predicted the past very well, but the future, not so much. Robert Lucas showed these models were internally inconsistent, in that the modelers assumed people would have, say, inflation expectations of 2% while the model implied 4%. Now, this is kind of tempting when applying models to real data, because data is historical, and with the benefit of hindsight, people are biased in one way or another. The problem is, at any one time we don't know which way. Chris Sims showed that much simpler vector auto regressions could predict just as well. By the late 80's these macro models were anachronisms, and the only purveyors are economists over 50, and global climate modelers.

Now, Doyne Farmer has been working on this problem for 20 years, and it's very naive to think all he needs is 10 million dollars and the resulting CPU to cleanly break out of the macroeconomic cul de sac. The idea now is to add new irrationalities, with a hat tip to Kahneman's behavioralist approach. The problem, again, is that irrationalities tend to explain everything, via too much anchoring or lack of base weighting, over-reaction and under-reaction.

The idea that adding new 'behavioralist' equations to the old macro modeling approach is naive because the old approach had hundreds of equations--assumptions about causal relations. Economists are very good at rationalizing behavior, so if some random assumption worked within this paradigm some economist would have accidentally found it the way the momentum effect was found in equity returns. Hundreds, if not thousands, of really bright people looked at this problem for decades, and then retired, and their interns eventually all decided to not follow them to obscurity.

Anything that works can be modeled as rational via clever theorizing; there are very few constraints on the equations in large-scale macro models. In that sense, irrationality with a complex model of this-causes-that is not 'new'. You are going to need something more specific.

VXX Risk Premium?

The VIX is calculated and disseminated in real-time by the Chicago Board Options Exchange. It is a weighted blend of prices for a range of options on the S&P 500 index, basically targeting a variance swap. As the VIX index does not have a spot analogue like the S&P500, its ETF is derived from the two nearest months of VIX futures, to minimize the discrete jumps as contracts expire. As each calendar day passes, the VXX ETF will sell 1/30 of the first month VIX futures and buy an identical amount of the second month VIX futures, so that the percentage holdings of the front month and second month futures always create a synthetic blend of a basket of VIX futures with a constant maturity of 30 days. The VXX is forever rolling down the futures curve.

The futures in the VIX has looked like this for the past couple of years:


this is contango, when the futures price is above the current price, and is common in Gold futures. As Harvey and Erb (2007), or Gorton and Rouwenhorst (2005) have noted, the roll in futures is predictable: you tend to make money going long futures in backwardization, short futures in contango. Thus, the VXX has declined much more than the VIX since it started trading in January 2009 because it has been riding the roll down the futures curve all the time:


The question, obviously, is whether any risk metric explains why some futures are in contango (usually corn, wheat, silver, gold, and coffee), and others in backwardization (usually that copper, heating oil, and live cattle)?

A prominent early explanation for Normal Backwardization put forth by none other than John Maynard Keynes, on why futures generate risk premium from being long, is that farmers grow wheat, say, and wish to hedge it by selling now, rather than waiting until the season is over. So a speculator buys the wheat now, and takes on the price risk, for which he must be compensated. Futures allow operating companies to hedge their commodity price exposure, and since hedging is a form of insurance, hedgers must offer long-only commodity futures investors an insurance premium. Normal backwardation suggests that, in a world with risk-averse hedgers and investors, the excess return from a long commodity investment should be viewed as an insurance risk premium. Alas, backwardization isn't so normal.

It is easy to expand this to the other side, however, by focusing not on the producer of a commodity, but the purchaser. Say you are Boeing and buy a lot of aluminum to build airplanes. If you hedge, you buy a futures today, locking in a price. Thus, whether you hedge by buying if you are a consumer, or selling if you are a producer, futures have an insurance-like characteristic. The key seems to be knowing, between consumers and producers, who dominates the futures contracts.

In a diversified worldwide market, however, this hedge reasoning does not work in explaining equilibrium returns. Asset pricing theory tells us that returns are a function of risk. And as most investors are not aluminum consumers or corn suppliers, the net covariance with the ubiquitous 'nondiversifiable risk factor' should be at work. If you don't know what this is, well, you are in good company, but like dark matter, it must exist theoretically.

Just as the needs of a company, its preferences, are unrelated to its stock returns, so too should the futures roll be unrelated to its returns, except as it has a covariance on a priced risk factor. This is due to arbitrage, because investors should be allocating capital in a way so that the price of risk from any source is the same whether it comes from futures or equities. If one can get the benefits of the futures roll and not be involved in the futures commodity—-as most investors are not-—this should be like idiosyncratic risk is in the CAPM: diversifiable, and so unpriced.

If going long the VXX costs money because when volatility spikes up, as in 2008, it offsets predictable declines in equities and other stocks of wealth, it may be insurance worth paying for. While this could be an elusive risk factor sighting, alas, it brings an embarrassment of riches. The equity risk premium is thought to be around 5% by most people (and I think that is too high), while the VXX 'insurance premium' has been around -40% annually (the VXX has fallen at a 69% annual rate since January 2009, while the VIX has fallen only 46% annually over that period). This is much larger than any pure risk premium story, and highlights my constant refrain that there is no risk premium. If you see a large return premium, while it invariably has some risk it is generally not generalizable to other assets so it is not a true risk factor, and instead due to some institutional clusterpuck.

Note that a guy with a blog devoted to the VIX discloses at the bottom he is short the VXX, so it seems the more you understand this, the better trade it seems. Just look at the futures curve, and currently the second month is 6% over the first month futures. As long as it is this high, it seems shorting the VXX is as good a trade as any.

If you missed out on the signature theory of finance, that of risk premiums explaining all predictable returns, you might have seen the roll and jumped on it, and you would have been richly rewarded for it. If you thought, 'sure, 40% is high, but that's the price of risk!' you could be an editor at a top research journal. Bad theory makes smart people dumb.

Michiko Kakutani's Top Ten

Super Reviewer Michiko Kakutani has one economics book in her 'top ten' list for 2010, and it's Nouriel Roubini's book Crisis Economics. I have a strange fascination with her because I remember having to distinguish between Brouwer and her dad's fixed point theorems, and now can't remember the difference (other than Kakutani's is a generalization of Brouwer). You can use these fixed point theorem's to prove John Nash's non-cooperative equilibrium, which was rather clever, and unfortunately suggested that many important economic proofs can be found via abstruse mathematics. Alas, this was the exception, not the rule.

If Crisis Economics was not written by a famous man like Roubini, who convinced many that his permabear stance was vindicated by the events of 2008, this book would never be read. It's filled with vapid analysis and exaggerations. Kakutani seems to buy Roubini's claim that he predicted the 2008 housing crisis in September 2006, but that speech is conveniently no longer available anywhere, probably because it actually contains a large number of qualifiers and tens of other things that could happen. Basically, the same speech he had been giving for 15 years.

The idea that regulatory arbitrage, the ability of banks to choose whether they are state chartered or nationally chartered, was a big deal, is not true. These different regulatory bodies (OCC vs. FDIC) had significantly different regulations. Further, all regulators were encouraging, not discouraging, home lending of all sorts via the target of disadvantaged homeowners. The period prior to 2007 was hardly one of free-market fundamentalism, as finance was a relatively highly regulated industry, with lots of different regulators (SEC, the Fed, OCC, FDIC, OTS, SEC, etc.) at work. His focus on meaningful financial reform centers on bringing back the anachronistic Glass-Steagall, and strengthening the clueless SEC, as if that would have made any difference.