Monday, April 30, 2012

Critique of Mencken

This essay by Fred Siegel makes a critique of Mencken I never thought I'd appreciate as I love Mencken:
[deriding the academic aspirations of the masses was] championed not only by leftists such as Cowley, but also by Nietzscheans such as H.L. Mencken, the critic and editor whom Walter Lippmann described in 1926 as “the most powerful influence on this whole generation of educated people” who famously mocked the hapless “herd,” “the imbeciles,” the “booboisie,” all of whom he deemed the “peasantry” that blighted American cultural life... 
Mencken and Huxley shared an aristocratic ideal based on an idyllic past. They romanticized a time before the age of machinery and mass production, when the lower orders lived in happy subordination and when intellectual eccentricity was encouraged among the elites. In this beautiful world, alienation was as unknown
Intellectuals mocked the masses for trying to enjoy these things, and encouraged people to engage in the kitsch of popular culture as long as they did it with a superior and ironic attitude. This is stupid.  As Goethe said, if you take man as he really is we make him worse, but if we take man as he should be we make him what he can be. Encouraging the rabble to higher culture is a good thing regardless of how ham-handed your average man is when dealing with such knowledge. In the 1950s the masses were interested in Shakespeare, classical music, long interviews with serious writers, and that made them better people than they otherwise would have been. 

Sunday, April 29, 2012

Did the Division of Labor Create Consciousness?

Adam Smith famously explained how the division of labor leads to much greater productivity using the example of the pin factory, where he estimates a 240 and 4800 fold increase in productivity by dividing the labor into several facets. This is like the idea from "I, Pencil", which notes not a single person could completely make a pencil, and this is even more obvious for a product like an iPhone.

 Ever since the invention of farming, productive adults tend to specialize in some economic activity. People are plastic, they can become many different kind of experts, but there's a lot of domain specific knowledge involved in anything so you need to choose a parochial area of expertise at some point. Francis Crick speculates in this lecture that consciousness was basically a by-product of strategic choices like choosing a profession, an interesting thought.

 Most animal thought and most of human instincts are always online, which is why those pictures of danger, sex or food flashed at 100 millisecond intervals affects our affect even though it is all unconscious. Pictures of naked women affect my right, inarticulate, brain because my sex drive is always on, unlike my thoughts about prioritizing research strategies, which takes active thought. Another example is the frog. There is actually a special part of the frog brain that reacts to flying insects, so every frog brain allocates resources towards catching flies.  These online systems are not plastic, and don't allow one to do something else; there can be no frog factory production of fly-morsels for the general pond-frog consumption which would free up other frogs to do something different than their ancestors.

 Even in the division of labor within eusocial organisms like ants, different ant phenotypes develop based on the interaction between their genes and their early environment in a deterministic way (see E.O. Wilson's latest book The Social Conquest of Earth). Bees, dogs, and fish just run on instinct all the time but humans have to choose between being a mason or a farmer, and to make such a comparison involves what we feel as conscious thought and its companions doubt and anxiety (did we make the right choice?). You can't make such a comparison without consciousness, and this goes for all the other choices that must be made in modern societies (Farm what? Irrigate how?).  These aren't instincts, they are learned, and people specialize, forgoing some  areas of knowledge completely and relying on the market to get things where one is incompetent.

 This theory doesn't seem to pass basic empirical tests.  If consciousness was caused by the the division of labor itself, then pre-literate societies with little division of labor should consist of mainly zombies because their daily routine can be addressed without a lot of questions about whether to do this or that, or at least they would be humans with a significantly reduced level of consciousness. I don't know much about the psychological tests applied to savages but am sure they are not zombies, though I suspect they are less contemplative compared to other people.

 I rather think that the division of labor created philosophy. That is, when you choose a profession or some important avocation it supposedly is a better means to an end, but what end? Is it merely to be rich? I doubt that is really so prevalent because to have such a nakedly self-interested goal is not necessarily in the best interest of neighbors, and they would not trust or like such people. As Chris Boehm shows with his work on reverse dominance hierarchies, people hate domination, and generally prefer leaders who consolidate public opinion as opposed to dictate it. Prioritizing a purely selfish motive would not be popular, so the best way to project that raw selfishness is not your real motive is to actually believe it isn't.

 Thus, we have a lot of existential angst as we try to figure out 'why' we want to build a bridge or have five kids, and it's usually some greater good, not merely one's power and pleasure.  Real satisfaction in life often comes from advancing such higher purposes, imagined though they may be. There are many potential whys, such as helping the tribe, a king with supernatural powers, some god, and they all involve theories about how the means relate to the end, and some argument why the end is right and true.  When we didn't have choices, we didn't have to think about our purpose in life and probably didn't have a philosophy on life. It's unfortunate that modern society creates anxieties that our primitive ancestors did not have simply because they were often acting out of necessity or some inviolable tradition, but developing a healthy purpose in life when you can actually choose is a real advance in the intellectual history of humans. As with most thoughts and philosophies I'm sure your average person's is profoundly ignorant or banal, but still that leaves millions with very enlightened levels of consciousness.

 So, Adam Smith was correct to note the division of labor as a crucial step in human development, but he actually underclubbed it: it didn't just give rise to the industrial revolution, but also to the strange fact that humans think about thinking, meaning, and a sense of self.  The division of labor didn't create consciousness, but it did make us ask why we do what we do, and so lead to a higher level of consciousness.

Friday, April 27, 2012

Goldman Knows Banking

James Johnson is still on the Goldman board, and seems poised for reappointment, which pays a nice $520k/yr for a handful of meetings and more importantly, some phone calls.   He was at the helm of Fannie Mae when it was building its house of sand based on borrowing with a government guarantee, investing in mortgages, and growing at unsustainable rates that inevitably led to subprime, though they stated this exposure was $2B for a while, before noting it might be $250B (oops!).  More importantly they put the Government Seal of Approval on no-doc loans via their underwriting software, MyCommunity Mortgage.  Regulators could not say any loan approved via this software required extra capital, given Fannie and Freddie required basically zero capital, and they didn't. If there was a poster child for the bad behavior of the mortgage crisis, Johnson would be on anyone's list of candidates.

Some funds have a problem with Johnson, and think he should not be near the cockpit of a financial company, as he clearly does not understand things like 'probability of default.'  But these outsiders don't understand the game like Goldman, who knows the essence of much of their alpha is not so much smart employees and their default models, but exceptional access, and Johnson is very well connected. Johnson was a bundler for the Obama campaign, raising between $200,000 and $500,000, and still can call important Washington people and get through. I'm a free marketer who is generally symathetic to private firms, which is why I can't stand the executives at our large financial institutions, most of whom have sold their souls for access to legislators granting little monopolies under the pretext of equality and safety. Call me a prig about principles, but I think it's pathetic. Our modern financial system at the top levels is uncompetitive and corrupt, and relies on favors granted by politicians.  

Wednesday, April 25, 2012

Average is Bad

A nice thing about market economies is they are generally run by experts, not consensus. This aristocracy is often derided as plutocratic, but as your average person is incredibly ignorant, I think as long as there's competition, plutocrats are much better than any plebiscite. Consider where 35% did worse than guessing on this Pew Research Center test of political knowledge. Questions were all about our two political parties, such as "which party is generally more supportive of restricting access to abortion?" They are all that easy.

 This is why the indices are such biased reflections of average performance, your average investor is quite ignorant, and trips over himself needlessly giving money to brokers. They know more than experts on their daily affairs, but on generalizations and higher-level insights not in their bailiwick, they fail miserably.  I know literacy tests were disingenuously used to discriminate in the past, but I fundamentally the idea was sound, as currently it is just like letting fans vote on who gets in the football Hall of Fame.   Consider this Louisiana literacy test.

Tuesday, April 24, 2012

Zero Risk Premium in Venture Funds

Noahpinion had a neat story on a paper by Harris, Jenkinson and Kaplan, which finds:
Average U.S. buyout fund performance has exceeded that of public markets for most vintages for a long period of time. The outperformance versus the S&P 500 averages 20% to 27% over the life of the fund and more than 3% per year. Average U.S. venture capital funds, on the other hand, outperformed public equities in the 1990s, but have underperformed public equities in the 2000s.
These strategies should have higher 'operational risk', and thus higher risk from tail events, Knightian/Keynesian uncertainty. It highlights that merely noting an asset class is opaque and illiquid does not mean it generates an above-average return.  This is especially important because many pension funds are stretching to alternative assets (read: hedge funds) under the illusion that these areas have less clear data, so are riskier, therefore generate higher returns.

Most interesting are the data issues, which are very complex. If you read the paper, you see it is all about what data to include, which to exclude, etc. It has very little to do with asymptotic standard errors, or overidentifying restrictions that are presented as the really important tool for empirical financial researchers in graduate school.

 I mean, consider this graph, and you can see there's something obvious going on, and that data prior to 2000 was probably not the same as that afterward. That isn't an abstruse statistical issue.

Monday, April 23, 2012

Who Gets the Equity Risk Premium?

A big question about low volatility outperformance is why it exists. Explanations range from the nature of geometric compounding, convexity in high beta stocks, some strange manifestation of risk, or the fact that investors prefer sexy stocks for lots of reasons (principal-agent problems,  overconfidence, winners curse). Now, the latter theories are most plausible to me, but they also require something else, because if a fraction of irrational investors buy something, that only affects equilibrium prices if other rational agents are constrained in some way (or, less plausibly, that everyone is irrational). Given most investors allocated only 50% or so of their liquid wealth to stocks, I find it implausible they are constrained in their equity allocations--they can invest more directly.

My explanation is that they look at their equity holdings relatively, and this makes risk symmetric: beta=0.5 has the same risk as beta=1.5. When this happens, deviating from the consensus is risky regardless of total volatility, because it all adds to 'tracking error'. In a sense, people are maximizing their Information Ratio, not their Sharpe Ratios, and using 'the standard 60/40 equity/bond allocation' as the benchmark. If investors are doing this, it constrains the appetite for arbitrage, and so the effects of irrational preferences can exist in a rational equilibrium.

 When I first read Dimsom, Marsh and Staunton (2006), it first occurred to me that this could solve my longstanding confusion on this point, because they basically cut the equity premium in half just by adding geometric averaging and survivorship bias, and I knew that was only a part of the adjustment menu. The relative risk theory only makes sense if the equity premium is zero, which previously was inconceivable, but after DMS cut it in half that didn't seem impossible.

Nonetheless, while the equity risk premium is down to about 3.5% these days, and realistic standard errors are about 4%, no one thinks it is zero. I asserted it was zero previously because it seemed possible, and solved many other problems (eg, the missing risk premium everywhere else). Now I'm thinking I made an error. The equity risk premium is positive, close to the 3.5% most others believe. They key is that this return is not a scalar, but rather an array. Like 'the tax rate', it isn't one thing, and the various rates make up a subtle equilibrium between various interested parties, with the returns being a function of the ignorance, impatience, and size of the investor constituency.

The efficient investor avoids active management, invests steady amounts over the business cycle, generates few taxable events, trades to minimize trade impact and the effect of a bid-ask spread. Your average investor trades inefficiently, and generates a lot of profit for a large and vibrant financial community to turn into the 'little crumbs' Tom Wolfe wrote about in his Bonfire of the Vanities, where all those fancy, smart suits are just middlemen, with a clear incentive to increase trading.

My claim is that the equity risk premium most people analyze does not reflect the return to an average or marginal investor, merely the non-representative efficient one. Several issues create a wedge between the raw index return one sees in index time series and the returns flowing to average investors. Thus, a modest equity premium to the indices is consistent with my overall hypothesis.

The best single statistic that illustrates this subtle equilibrium is Jay Ritter’s finding (see above) that the cross-country correlation of real stock returns and per capita GDP growth over 1900–2002 is significantly negative. That is, cross-sectional equity returns over a hundred years are not positively related to economic growth, so it is not as if the economy is a representative firm and a risk averse individual is choosing how much wealth to allocate to a stochastic investment; rather, the stock market is a subtle game between insiders and outsiders where the insiders merely provide enough top-line returns to keep the rabble unaware they are being had.

 The Investment Company Institute sponsored a study and found actual investors underperformed the S&P 500 for the ten-year period from December 31, 2000, through December 31, 2010, by 6 percent annually. Fund complexes and the Investment Company Institute were very loathe to present this information because it highlighted that they are severely overrepresenting investor returns by using simple indexes, ignoring the many slips between cup and lip in the investment process. Luckily for the investing community, individual investors accommodate this misrepresentation, as even highly educated investors overestimate their personal returns by this order of magnitude (i.e., 6 percent annualized return). This is probably due to simple cognitive dissonance, as investors are mentally distressed by the conflict between a good self-image and empirical evidence of poor trading tactics. To reduce the discomfort, investors adjust their memory about that evidence and those choices. This is then selectively reinforced by noticing the returns of just their good performing stocks and mutual funds in the portfolio and not the poor ones because ex-post awareness these were mistakes rather than legitimate data.

 The dramatic overestimation of typical individual returns via the benchmarks is a rather important, and unremarked, fact. The actual net returns to average investors remain something of little interest to modern research. Note that prior to the competition from electronic trading, discount brokerages, the deregulation of commissions in 1975, and the reintroduction of odd-eighths quotes on the Nasdaq in the 1990s, trading costs were certainly much higher, yet most researchers look merely at the top line of the indexes as these costs were irrelevant, and top line pre-1975 returns are the same to investors as they are subsequently. If average investors are looking at their returns after fees and taxes, these costs should be highly relevant, but instead they are routinely ignored. This highlights a very strange incuriosity with net returns to investors. Consider the following items that subtract from top line returns, independent of the issues about geometric averaging, peso problems, and survivorship bias:
  1. Taxes (see Gannon and Blum)
  2. Adverse market timing (see Ilia Dichev)
  3. Transaction costs (nothing good, just watch your fills)
Conservative estimates to our 1900–2010 data add up to an adjustment to the effective equity risk premium that puts it at zero, as each has been estimated around 2 percent. Note that the ICI study mentioned above estimates a 6 percent annualized deficiency relative to the equity index averages—ignoring taxes. Fortunately for brokers, individual investors have bad memories, as Goetzmann and Peles (1997) found that individuals overestimate their own investment performance by an average of 3.4 percent.

In many ways, investors are like all those people who recall their last trip to Las Vegas left them flat or up a little. The equity risk premium can be thought of as a very subtle equilibrium, where the efficient investor who makes a 3% premium is the loss-leader to equity issuers, and the average investor more than makes up for this ‘expense’ to the insiders. Though an efficient investor may be able to invest in efficient passive funds and capture much of the equity premium, such an investor is the exception in the same way that your average blackjack player loses considerably more per hand than your robot optimizer. That is, just as most hedge fund profits go to hedge fund owners, most outside equity investment goes to insiders—brokers, management, initial equity owners—via the persistent mistakes and carelessness of your average investor. Equity returns are not simply a stochastic process that a singular representative investor chooses, but rather a complex set of returns depending on the strategy and tactics used by heterogeneous investors, many of whom make conspicuously inefficient choices. The bookies, and the insiders selling dreams, always win, and if they didn't the market would not exist as it currently does. The equity risk premium is zero for the marginal investor.

Sunday, April 22, 2012

Robeco Low Volatility Conference

Last week I was at a conference sponsored by one of the world’s leading low volatility fund managers, Robeco, over in Rotterdam. Low volatility investing was really pioneered there by Pim van Vliet, who was influenced by papers by Bob Haugen among others in graduate school (eg, Commonality of Stock Returns, 1996 JFE). That is, Pim believes, as I do, that higher risk generates lower-than-average returns, and this creates a great investing opportunity because obviously you can get lower risk and higher return by investing on risk; there is a dominant strategy implied by the empirical data if you believe in the normative implications of modern finance. This intuition guided him in building one of the world’s first institutional low volatility focused investment strategies. They have about $2.2B euros allocated to low volatility investing.

 Now, Pim is an anti-Taleb. That is, Nassim Taleb suggests that most economists are unaware of uncertainty, fat tails, overconfidence, or that theory is different than reality, all paradigm changers. That these insights all have long academic threads is important to acknowledge, however, because it implies their lack of obvious application is due to something important that would be useful to know. For example, fat tails do not alter any of the main insights from the gaussian assumption when calibrating risk premiums, everything works in the same way, just a little more or less. Thus, they can usually be ignored, because they are isomorphic to assuming people have greater risk aversion, or that gaussian volatility is higher than its measured volatility by some fraction. Suggesting this phenomenon is the key to why mistakes were made is very misleading, and leads to inefficient or wasteful correctives.

 In contrast, van Vliet is eager to highlight he is not saying something that is new so much as important and true. In Haugen’s case, his writings did a nice job of demonstrating raw volatility being inversely correlated with returns, which is nice because all you need is for the relation to be flat for low volatility investing to be superior. Subsequent to his discovering this phenomenon, he found my work, and thinks it’s fabulous that I am championing this idea, and so invites me to speak on this subject to his clients. I guess he’s trying to convince people that if other people found this independently, it’s really there. A pioneer, but not a singular one.

 By acknowledging others so vigorously he's showing a lot of intellectual modesty, but not so much that he does not think he is right and the conventional wisdom is wrong on something very important. Thus, he has managed a portfolio that combines the singular low volatility focus with complimentary factors such as quality and momentum, innovations that are straightforward, but it's hard to riff on a theme unless you have confidence that comes from knowing you aren’t hiding anything from others or yourself. It isn’t obvious how and when to combine good things, as any good chef knows, and they have something better than your simple SPLV ETF. A good example is how Huij, van Vliet , de Groot, and Zhou (2012) discuss how distress risk can compliment volatility metrics, as they are really different manifestations of the same thing.

 Now, Bob Haugen’s presentation there was very lively, and he stated he gave 60 talks on low volatility last year, mostly overseas.  I can see why because he is very provocative and not dry. One of his points was that he discovered low volatility anomaly back in a 1975 paper that even Haugen did not remark upon for several decades. If you read this papers you see that he indeed did say that higher risk did not generate a return premium, but his explanation centered on ‘market inefficiency.’ What does it mean that markets are inefficient? Well, all that means is that markets are predictable in at least one but perhaps several ways, and so it encourages one to adopt any of those dopey get rich quick strategies that crowd the investments section at the bookstore. Just as Haugen went on to highlight a variety of predictable patterns unrelated to volatility over the next 35 years, most readers of these papers would not take-away the idea that low volatility investing is superior to the indices.

 I would say Haugen discovered low volatility investing in the same way Vikings discovered America. He found it before most, but he didn’t know what it meant when he found it, and only with hindsight figured out it directly underlies something very valuable (ie, low volatility investing).

 There’s about $12 Trillion in the US equity market, and currently about $10-$20B worldwide is directed at low volatility. The discovery of low volatility investing as an attractive idea is a better Sharpe ratio improvement than the move from active to index funds because you can reduce volatility by a third and increase the returns by a couple percent, so I think this trend will have legs, and low volatility will grow 10 to 100 fold over the next ten years.

Monday, April 16, 2012

Millionaire Tax

The latest from the California governor Jerry Brown:
Brown also defended calling his proposal a “millionaires tax’’ on his initiative campaign website, even though the income threshold would be $250,000.

“Anybody who makes $250,000 becomes a millionaire very quickly if you save it. You just need four years,’’ Brown said. “It is a millionaires tax. It taxes millionaires, right? And it’s for schools. And it protects public safety.’’

You know a bad argument when it has many independent planks, all trying to reel in support from various angles.

Sunday, April 15, 2012

Is Intelligence Good?

Intelligence, as measured by IQ tests, is at least 50% heritable and positively correlated with better socioeconomic outcomes in education, income, health, and crime. It may seem obvious that you want your kids to be smarter. Satoshi Kanazawa makes an intriguing point in his book The Intelligence Paradox that it is not so simple:

Yes, intelligent people make better physicians, astronauts, better scientists, and better violinists, because all these pursuits are evolutionarily novel.

But these are all the unimportant things in life...They do not make better friends, they do not make better spouses and partners, and they do not make better parents, precisely because these are things our ancestors have done for hundreds of thousands of years on the African savanna.

His basic idea, hotly disputed by other evolutionary psychologists, is that intelligence applies to novel human activities, so simple but very meaningful and important tasks like friendship, social exchange, mating, and parenting are at best orthogonal to such intelligence. He argues that more intelligent people reject the simplistic solutions offered by common sense as applied to these time-tested arenas even though it is usually the correct solution. Intelligent people are tempted to apply analytic reasoning instead of feelings, unnecessarily complex ideas simply because their intelligence allows them to entertain such complex ideas. "Clever sillies" as Bruce Charlton called them.

He notes that more highly intelligent people have no kids at all, surely an evolutionary dead end. He cites a study of a bunch of gifted kids who had IQs higher than 155, and years later found they were clearly more successful as adults in scientific and academic achievement, but were less successful in parenting and marriage. Idiocracy seems to have been one of the more prescient movies every made.

He makes the point with this exchange between talk show host Larry King and Stephen Hawking:

Larry King: What, Professor, puzzles you the most? What do you think about the most?
Stephen Hawking: Women
Larry King: Welcome aboard.

The book is a nice, quick read filled with fun tid-bits like the fact that the frequency of excercise is significantly positively associated with general intelligence, a fact that I will use in Calvinist fashion to motivate me (ie, I must work out because I am more intelligent!).

Friday, April 13, 2012

Mother of all Metaphors Still Informs

Writing about regulations related to the failure of the Titanic, Chris Berg makes an important point:

Governments find it easy to implement regulations but tedious to maintain existing ones—politicians gain little political benefit from updating old laws, only from introducing new laws.

And regulated entities tend to comply with the specifics of the regulations, not with the goal of the regulations themselves. All too often, once government takes over, what was private risk management becomes regulatory compliance.

Case in point, when the 2008 crisis happened, instead of merely changing the priorities of the Fed, OCC, SEC, FDIC, or other existing regulatory bodies, the focus instead was on creating a new regulatory agency, the Consumer Financial Protection Bureau. Debates about regulations invariably center on more or less, rather than simple changes. Meanwhile, bank executives often confuse regulatory limits and guidelines with prudence. It's hard to see how one can really have confidence that this process really makes the system more robust.

Wednesday, April 11, 2012

A Radical Egalitarian Speaks

Most egalitarian redistribution schemes are couched in terms of efficiency, but this Stanford sociologist says to screw that:

Unfortunately this all presupposes that money can buy what is needed to make the elite suburbs and poor inner cities generate equal results. When the expected equality does not materialize, more coercive policies must be introduced, the end game would be extremely ugly.

Tuesday, April 10, 2012

Harvard Risk Confabulations

John Campbell is one of the world's most esteemed financial economists, which means that he publishes very rigorous and well-received papers showing that some strange result is a function of risk, even though that risk metric is totally nonintuitive. Case in point, Campbell, Giglio, Polk, and Turley (2012) have a paper entitled An Intertemporal CAPM with Stochastic Volatility, and find that
the negative post-1963 CAPM alphas of growth stocks are justified because these stocks hedge long-term investors against both declining expected stock returns, and increasing volatility.
Consider the following correlation between the stock market (Rm-Rf) and changes in the VIX, using monthly data from 1986-2012:

There's a nice negative relation, because volatility rises when markets tank and vice versa. This is why you hedge market exposure being long the VXX, the VIX ETF (though, you pay a lot for that!).

Now consider the relation between the HML or 'value risk proxy portfolio', which is ever so slightly positively correlated with the VIX index, suggesting that value stocks have the insurance-like property of doing better in more volatile periods.

That is, value, not growth, does better when volatility rises, but more importantly, the the R2 for this value portfolio is only 2% vs 50% for a regression of the market on VIX changes. One would think you can't get blood out of that stone, that if the positive market risk premium has a large negative weight, then something with a small positive effect would not explain the value effect. Then again, you are probably not familiar with the powerful modern econometric methods that economists sling around.

First they take 6 time series (aggregate market, stock variance, aggregate P/E ratio, yield curve spread, a value portfolio, and the Baa-Aaa yield spread) and create a Vector Auto Regression. This VAR is used to estimated returns and volatility that are used to estimate how much risk value/growth portfolios have. This method uses a closed form (!) solution to a model that uses the 'risk aversion coefficient', which is great because it gives you another free parameter, and is a neat mathematical trick. Campbell et al. casually note "the empirical implementation of our model is a success," because there exist "reasonable preference parameters that would make a long-term investor" not jump into value stocks even though they seem to generate a return premium.

So, a model with totally non-intuitive metrics for stock return premiums and volatility risk factors can explain the value premium given certain unobserved parameters. Stock return premiums and volatility by themselves, however, do not explain anything.

Given my understanding of finance and macro, I am highly suspicious of string theorists who claim their model works great because if you give academics any set of stylized facts (eg, the value effect, the basic facts of physics), more math can explain it, confidently so. Following the confabulatory research I have been touting for weeks, they will consider something a success as long as it can rationalize their prejudices, which isn't too hard.

Monday, April 09, 2012

Is It Possible to Not be a Hack?

I was reading Bryan Caplan defend biases, and I concur. Eleizer Yudkowsky once wrote;
If you first write at the bottom of a sheet of paper, “And therefore, the sky is green!”, it does not matter what arguments you write above it afterward; the conclusion is already written, and it is already correct or already wrong. To be clever in argument is not rationality but rationalization.

He makes a good point, especially about the real purpose of reason (to find truth, not defend beliefs), but I think he goes too far. Most of our conscious thought is rationalization to be sure, and I don't think we can avoid this, nor should we. Michael Gazzaniga's experiments highllight that we do it all the time, because the brain is constantly receiving signals from our non-articulate portions of the brain and trying to make sense of them. Your narrative self is like the press secretary of a large organization that it does not fully understand or control, but whose job it is to always ariculate a reason for why one feels or does something. And your mind is so hard wired for this, you don't even see that you are obviously confabulating, as when split brain patients or patients with bizarre brain lesions make up reasons why they think their mother is an impostor, or their arm belongs to someone else. If you were to question all your inner data feeds you would have no intuition, and then be as dumb as a computer.

So, in a sense we are rationalizing all the time. I don't think this implies we should embrace rationalization, and more than we should embrace being emotional because we are inherently emotional. We should merely be mindful that it is something to be managed, not eliminated, from our thoughts.

Clearly you can guess what someone will write on some daily event based on your knowledge of his or her prejudices. Paul Krugman and Thomas Sowell have worldviews that cause them to filter evidence a particular way. Both think it is an efficient worldview because it is more accurate than others, and they find the other's thoughts bafflingly inconsistent because they are based on some very primitive assumptions that are not shared. For better or worse, we all have a style, which is called a rut if it is unproductive. Mozart, HL Mencken were and Douglas Hofstadter is predictable in good ways.

It would be impossible to eliminate one's prejudices, because this is then merely a prejudice (e.g., everything is random and nothing integrates). Better to keep your deepest assumptions semi-private because if you say a key to my worldview is X, it becomes harder to change X because no one likes to be seen as fickle on their principles, it hurts one's credibility. That's why it is useful not to state them too strongly, repeat them too much, or try to serve them with every thought; you want to practice thinking without them, which should be easy given there are lots of useful frameworks existing simultaneously.

Think of your prejudices as something to manage. For example, cognitive therapy is the one therapy that does as well as the SSRIs, and it is based on changing one's thoughts based on rational evaluation, in that if you can see the irrationality of your depressive thoughts, you do not think them as much or as readily. Rationality can change your deep beliefs.

Sunday, April 08, 2012

Earliest Low Volatility Article

Many point to Haugen's Risk and the Rate of Return on Financial Assets (1975), Ed Miller's Winner's Curse (1977), Bruce Lehman's Residual Risk Revisited (1990), or Haugen and Baker's efficient market inefficiency of capitalization–weighted stock portfolios (1991).

So I was surprised to see this short Journal of Finance article by Richard McEnally back in 1974, A Note on the Return Behavior of High Risk Common Stocks.

HIGH RISK COMMON STOCKS, it is frequently observed, do not appear to generate returns commensurate with the level of associated risk...Soldofsky and Miller constructed indices of the returns from six investment advisory service common stock quality classes over the 1951-1966 period. They found that the geometric mean annual return from the lowest grade of stocks was less than half the equivalent return from any of the less risky classes....

He mentions another paper that found negative risk-reward data, and one where the relation was small. He then lists 4 reasons this could be happening:

1) The Asness, Frazzini and Pedersen (2011) hypothesis that people are constrained on the in equity exposure, so overload on high beta stocks, causing the Security Market Line to be almost flat (but still positive!).
2) Lower taxes on the capital gains, that are relatively more important for risky stocks.
3) Overconfidence in risky stocks
4) Positive skewness preference

Clearly this was a prescient piece! But, then he also presents his own data and takes all the stocks alive from 1945-65, and sorts them into low and high beta groups, and looks at their monthly returns, which is a massively flawed way of looking at these but strangely still pops up. Clearly this is a nonintuitive bias though I find it rather obvious.

I think this highlights you should judge academic work piecemeal, as often there's good and bad insights contained within the same work.

Thursday, April 05, 2012

Newest ETF Gives People What they Want

After much research, Dooker’s team realized that there was a way to crush NAV at an even higher rate. He explained:

“Two times leverage was good, which obviously means that four times leverage is better. Prospective investors should be sure to read the prospectus to understand the effect of four times DAILY leverage and how compounded daily leverage is not the same as compounded long term leverage. We slapped this quadruple leverage on a hybrid basket of natural gas futures and VIX futures in order to accelerate the rate at which the NAV asymptotically approaches zero.”

See more here.

It's funny because it's true!

Tuesday, April 03, 2012

SEC Probes High Frequency Trading

A WSJ article discusses what the SEC is looking at:

The SEC is examining whether such order types unfairly allow high-speed traders to jump ahead of other investors in an exchange's "order book," or the queue of buy and sell orders that are typically ranked by price and when they were received, according to people familiar with the matter.

Another area of focus for the SEC are the rebates some traders earn from exchanges even as other investors pay fees to complete trades, say people familiar with exchange operations and the SEC probes.

The SEC should ignore the quid pro quos among institutions, exchanges, and retail flow, because for decades exchanges and brokers screwed consumers via their coalition on the commissions and spreads, which was encouraged via the regulators. Why trust them now? As if the current most prominent regulator, Barney Frank, won't be an effective crony capitalist in 9 months, setting an example for all the other current regulator big-wigs. The key for them to be valuable is creating barriers to entry, as there's no big institution that's going to hire someone good at lowering costs to consumers. Of course, that's all hidden behind some pretext about protecting against fraud, and helping the stability of the exchanges, and fairness, and lots of other platitudes. Just think about whatever the SEC wrote in the 60's and 70's and know they were shills for the brokerages and exchanges who colluded to steal investors blind via spreads and commissions that never would have survived a competitive market (thank you regulators!).

What caused commisssions and spreads to come way down over the past 20 years? Not regulatory innovation, but rather competition via the internet, just as in life insurance.

In business, there are lots of different fee structures, and they depend on a lot of variables: a la carte, teaser rates, bulk savings. To view each as a conspiracy that must be proven otherwise is meddlesome and ignorant, creating the completely understandable system that only stasis and oligopoly generate.

If they are truly interested in stopping another flash crash, they should disallow market orders. That is, the flash crash of 2010 was caused by some Texas bumpkin selling $4.1B worth of E-minis (ES) at market prices, which created a panic. Now, just as in hijacking airplanes for kamikaze missions is probably done, that specific trade won't crash markets again, but making sure all exchanges have a contingency for a stupid market trade would be a good thing.

Monday, April 02, 2012

JOBS Act to Bring Light to Hedge Funds

A great example of way regulations tend to protect industries from competition more than help consumers, a great example is the law that prevents hedge funds from disseminating their performance. This allows funds to create massive amounts of survivorship bias via the use of several funds within one main brand, and it's much harder to quantify this because by law they can't tell you how they do.

One can imagine if more people were aware of Madoff's returns, and his purported assets under management, lots of people would have figured out it was a Ponzi scheme just as Markopolos did. More people would have learned about pairs trading in the 1990s via the fat returns, and this would have created more efficient trading exchanges faster (they were arbing the pre-internet retail flow).

The new JOBS act would rectify a good deal of this:

In its current form, the JOBS Act will allow private equity and hedge fund managers to solicit investors directly, rather than through third parties as per the current rule.

It only took 80 years to get rid of this dumb regulation.

Sunday, April 01, 2012

Low Vol Underperforming

Low volatility investors, now is the winter of our discontent. When the market does extremely well, high beta outperforms, low beta underperforms. Thus, even though low beta/volatility portfolios are up, they are not up nearly as much as the alternatives. That is benchmark risk, and why the low volatility strategy is not a slam dunk.

These are data I maintain, for the US.