Wednesday, March 09, 2011

Crash Casualty: Diversification

Just as hard cases make bad law, economic crises create bad ideas. Mainly, the idea that you can have growth without cycles if you have more governmental meddling, which is wrong on two counts: sufficient governmental intrusion causes stagnation, and governments cause more crises than they prevent. But the current big bad idea is that complexity, and anything related to it, is toxic.

One of the pillars of finance was that diversification is one of the few free lunches in economics. Institutions and policies that increase diversification are good things, and assets that increase the number of things (states of nature) you can bet on are good things, because they allow you to hedge or simply lower your aggregate portfolio volatility. Since the 2008 crisis, that intuition seems to have flipped: diversification is complexity, which creates problems we can't anticipate. Complexity is bad. Never mind that a supposedly simple 'stock' actually owns the residual cashflow from a convoluted set of networks, financial contracts, and specialized efficiencies that generates an income statement, making a mortgage CDO relatively simple by comparison.

The Black Hole of Finance | Santa Fe Institute

Case in point, this Sante Fe lecture by MIT physicist Seth Lloyd on financial black holes, which are exacerbated by leverage and scope (ie, derivatives). He prominently mentions Glass-Steagall as a cause, as if there were any evidence that this matter other than it happened in 1997. Europe basically never had a Glass-Steagall, and during the 2008 crisis, investment banks who took great advantage of Glass-Steagall did the same as those that did not. But, that's boring. The statistical quantum mechanics of gravity implies negative energy(?). Supposedly this makes galaxies susceptible to runaway instabilities such as gravitational collapse when they collide. The analogue in economics is negative assets, debt. The model identifies a phase transition from positive to negative specific heat: when gravitational or financial systems pass through this phase transition, they become unstable. It all follows from the fact that assets=liabilities, and the fact that larger entities get greater leverage (big banks can lever more than small banks).

A lot of econophysics involves a model that creates stochastic patterns that look like bubbles or random walks, but that's not the same thing as explaining what's going on unless it can actually predict or price something.

Assumptions ultimately drive the results, and it's rather unfortunate we are taking a step backwards, and now associating diversification with instability as opposed to stability. A quaint fondness for the halcyon days when citizens would understand everything in their daily life, like that of the early American Indians, or life on the prairie for early settlers. This seems related to to unit banks--where banks had no branches, and only lent to the local economy--or locavore eating, and such longing for complete understanding of our life seems a human universal.

Civilization advances by extending the number of important operations which we can perform without thinking about them. Consider the pencil, which no single person can make. Most of us don't understand how our TV works, how to make beer, or where our toilet water goes, and that's a good thing. Specialization and trade increases our efficiency, and gives us the wealth we often take for granted. To think that Joe Sixpack should understand all financial instruments, and how they maximize social welfare, is naive atavism.

The problem wasn't complexity, it was that everyone thought aggregate housing prices would never decline significantly. My 11 year old understands that. With hindsight, it was incredibly stupid, but it wasn't a complex mistake. Currently our government is monetizing a deficit that appears endless, and the result will be nasty. The first symptoms will probably show up in some obscure derivative, but that won't be the cause.


Anonymous said...

1. I think the key problem with diversification is that it has to be diverse, i.e. if everyone's diversifying the same way you do, it will not save you when a crisis hits.

2. The house prices were rising and banks lending because they could, and if you can, that means you have to or you will lose market share, all enabled by the cheap money (dancing as long as the music plays) imho.

Anonymous said...

Eric ,

just a thank you note..

Your thoughts are totally the clearest expression of intelligent life on this planet as seen on the net( rough approximation thru a prop algo I crawled the net put you impossibly close to the 100th percentile..100 being a synthetic intelligent designer)

..and that's how I found your blog. ;)

Many,many thanks for putting your thoughts up.

Anonymous said...

Diversification doesn't protect you from endogenous risk. Seemingly foolproof diversification schemes can blow up in a liquidation spiral.

Anonymous said...

"To think that Joe Sixpack should understand all financial instruments, and how they maximize social welfare, is naive atavism"

To think that most financial instruments work to maximize social welfare is naive optimism bordering on delusional.

Mercury said...

Actually I support the Talebesque (eeek!) argument that we would be better served by smaller, utilitarion, much less levered banks that pretty much stick to their knitting. Some things in life really do increase risk at a greater rate than they create value as they become more complex and I would welcome a more extensive treatment of this topic as it pertains to banking and finance.

While I agree that civilization advances as a function of complexity and specialization generally, the implication that say, the experts and specialists in Wachovia management knew what they were doing in the sub-prime mortgage space is a joke.

Eric Falkenstein said...

Mercury: Wachovia is an interesting case. They actually had better than average risk management, I knew some of them when I was a risk manager. But they bought a California Sub-prime company at exactly the wrong time--an error by the Board in corporate strategy that probably had very little real input from their risk management experts. But, in general, increasing the scope of one's functions is necessary for any competing firm, so, with hindsight Wachovia make a mistake, but in general firms must do these kinds of things.

Rick said...

No single person can make a pencil if you insist that it must satisfy lots of non-functional requirements, e.g. it must be painted yellow.

However, just about anyone can make a crude writing device that functions like a pencil by charring a pointed stick.

A lot depends on functional requirements.