Bloggingheads to Downsize

Robert Wright announced today that he is scaling down his Bloggingheads.tv site, in part because as a business it clearly has no potential to make money. The basic problem, he found, was that his site tried to have people on both sides talk about issues, as opposed to what is much more popular, having people who agree with each other talk to each other (MSNBC, CNN, Fox):



Too bad, because I'm a big fan. It's rational to listen more to people you agree with because you think what they saying is more correct than others, so I don't find this a bad faith equilibrium. But on the other side, I do like listening to those I disagree with more on the radio drive time because invariably the host, and especially the callers, will come up with a horrible argument for their side. I much more enjoy listening to this when my intellectual adversaries are speaking than when someone says something stupid as an argument for something I agree with. That is, many (most?) people I agree with on taxes, abortion, affirmative action, war, etc., agree with me for reasons I don't think are correct or relevant.

Unsophisticated Investors Circa 2005

From the LA Times back in 2005:

"If you paid your mortgage off, it means you probably did not manage your funds efficiently over the years," said David Lereah, chief economist of the National Association of Realtors and author of "Are You Missing the Real Estate Boom?" "It's as if you had 500,000 dollar bills stuffed in your mattress."

He called it "very unsophisticated."

Anthony Hsieh, chief executive of LendingTree Loans, an Internet-based mortgage company, used a more disparaging term. "If you own your own home free and clear, people will often refer to you as a fool. All that money sitting there, doing nothing."

The financial services industry is doing all it can to avoid letting consumers be foolish. Ditech.com touts home loans as a way to pay off credit cards, and Morgan Stanley says they're a good way to fund education expenses. Wells Fargo suggests taking a chunk out of your house to finance "a dream wedding."

Nothing like spending your market value capital gains on fancy weddings. When people say that we should return to common sense, the problem is, how do we know what that is? (presumably this is code-speak for everyone should now agree with my hindsight diagnosis and cure).

Nationalize the Fed!

Paul Krugman's wife, Robin Wells, came out with a piece arguing Occupy Wall Street's issues are something economists should address. I wonder whether she thinks biologists should all teach about creationism because so many students believe in some sort of transcendental spark to life. Probably not. I do think there should be classes on free markets vs. Keynesian debates led by different professors, because it's not like this issue isn't always there, but I don't think OWS has made this any more pressing.

That is, in graduate school we never had any formal presentations by professors as to why Keynesians/Supply Siders are right, even though eventually this is the question everyone wants to know from macroeconomists. It was as if they thought they could be above such practical questions, and focus like Tom Sargent on technical issues. This is naive, avoiding the elephant in the room. Such debates or presentations wouldn't generate nice problem sets, and they would often be talking past each other, but it would be good to get this in front of the 24 year-olds so they don't have to figure it out themselves reading between the lines. Further, it would highlight to the presenters what kinds of questions they need to answer, what sort of arguments are most compelling, to thoughtful young people who at that point just want to pick a side they think is winning.

I find the Occupy Wall Street movement profoundly pre-adolescent, like when my 4 year old daughter throws a tantrum with inconsistent or impossible demands (indeed, Miley Cyrus has a video supporting them). For example, they generally are proud of not having explicit objectives, being grass-roots and all, and so fundamentally do not understand that decisions will never, can never, reflect everyone's preferences. Some souls did create a wiki of beliefs, that are the best we can address of this movement, which includes things like 'balance' and 'protecting human rights' . It's easy to want such things, and such rights were in the Soviet Union's 1936 Constitution just after committing genocide against the Ukrainians and right before finishing off the remaining Kulaks (alas rights conflict, and you always have priorities). They act as if Rousseau's social will exists, that everyone shares some trans-human soul with a preference towards drum circles and organic legumes.

I got a kick out of these items from the OWS set of demands:

Transitioning the IMF and World Bank into transparent, publically owned and operated entities

Ending the Federal Reserve Bank and replacing it with an accountable, decentralized, transparent and publically owned financial system

These institutions were created by democratic governments, populated primarily by those on the left (my friends who went this route were all conventional Liberals). That they are considered insufficiently transparent and unaccountable highlights that reality never creates the social vision they seek, which is some sort of transparent consensus on matters of incredible technicality. You see the same thing with Noam Chomsky, were socialism always is to be encouraged, but any time it happens, as in the Soviet Union, the Eastern Bloc, or Cambodia, these aren't considered 'true' socialist countries (if only Trotsky won!). Their naive beliefs do not work because they aren't feasible, and so too the idea that large banks can be some big cookie jar for agreed-upon investments as opposed to being administered by professionals.

Overconfidence vs. Optimism

In 1971 Robert L. Trivers gave us the idea of reciprocal altruism, the idea that helping someone else although incurring some cost for this act, could have evolved since it increases the chance that such niceness might be returned some day. This really expanded the conception of self-interest to be semantically indistinguishable from altruism in many cases. Biologists have observed this behavior in bats, where they share blood harvested, but only with those who share with them.

Trivers has some great anecdotes in his new book The Folly of Fools: The Logic of Deceit and Self-Deception in Human Life. In one, people's pictures are distorted to make people better and worse looking than they really are, using data on what 'good looking faces' look like. Looking at fMRI data, we actually recognize ourselves in pictures faster when we are about 20% better looking than we really are (they had models that generated statistically validated better and worse refinements to pictures). In other words, we really think we look better than we actually do.

In another study, children were told not to look in a box that contained intriguing toys while a researcher left them alone. Most of the children did look, of course, and most lied about it. Interestingly, the higher the IQ of the child, the more often they lied.

In this TED video, Trivers argues that we continually paint a distorted picture of the world so that we might more easily get our way with others. This involves constantly inflating our acheivements and abilities, and playing down our failings and rationalizing our mistakes. You are a better liar to others if you first lie to yourself. Lying to others and ourselves is evolutionarily selected for the same way that pale skin is selected for in northern latitudes. [The video is better than the book. He has many riffs on his Chomskian view of the world. I don't mind so much, remembering that Isaac Newton was a grade-A looney]

This is important for asset pricing because highly risky assets within any asset class often have lower-than-average returns, and Edward Miller (1977), Diether, Malloy and Scherbina (2002), and Baker, Bradley and Wurgler (2011) argue that overconfidence--and short sale constraints--lead to poor return for highly volatile stocks. We know people are overconfident, where most of us think we are better drivers, leaders, etc., and one prominent mechanism is that the higher the volatility of the stocks, the greater the disagreement, the more these miscalibrated optimists overbuy, which pushes down stock returns. Thus, understanding why people are overconfident is important.

Overconfidence is puzzling in many dimensions of our lives, not just financial. Intellectually, it lacks the knowledge and honesty that comes with wisdom, where one recognizes we are neither as good as our mothers think, nor as bad as our enemies think. Thus, I've always been a little perplexed by the idea that people find confidence so sexually attractive. Confidence is something I was lacking as a young man, and generally I would need several beers to initiate various courting rituals. While I understood that confidence was sexy, something I wanted to be, I couldn't fake it because I couldn't understand why something was both ignorant and desirable.

Looking back, I had it all wrong, but it my defense, it flustered good people like Woody Allen and Allen Brooks too. Girls don't like overconfident boys merely because they miscalibrated. The key is the nature of one's overconfidence. People who are confident about the future continue trying, even when it's hard. They assume the good faith of others, which makes for good first impressions. People like optimists because they tend to be less defensive, less easy to offend, and so easier to be around. Optimism is related to positive reframing and a tendency to accept the situation's reality, because optimists see the silver lining to problems. Optimists are copers, and pessimists defeatists. It is not confidence in specifics, but in the future, their future, that makes people attractive, and this is a rational disposition. A confident person need not be miscalibrated, though they often are, but rather, their confidence is really simple optimistism about their life in general.

Thus, our instinct to be overconfident is a salutary disposition, suitably framed. We should see the future brightly because if we simply do the best we can things will work out as well as they can. To the extent things are out of our control and work against us, it doesn't help us to worry about such matters. Insecurity on the other hand leads to pettiness, which is why we find such characteristics so unappealing (eg, insecurity led Anakin Skywalker to The Dark Side, and presumably more genocides than 100 Hitlers--he blew up an entire planet to make an example!). Like any virtues optimism and confidence are useful only in thoughtful moderation, in the right context.

Eurozone Causing Greek AIDS

A Greek economist notes that some Greeks are intentionally infecting themselves with HIV to qualify for benefits, the result of the Greek austerity forced on it by those nasty surplus countries currently funding their deficits. He mentions this, he says, to make dry statistics more real, to convey the true picture of what is going on in Greece. I see this as another reason why anecdotes are usually tendentious crap. Here he is on Bloggingheads.tv:

Greece can either 1) leave the Euro and inflate their way out of their internal obligations, 2) stop running a deficit or 3) do what their lenders say to get their money. Who in their right mind would lend them money given their track record?

Characteristics vs. Factors

the Low Volatility ETF LVOL, put out by Russell-Axioma, tries to capture the low volatility goodness via a circuitous route. First, it takes into account beta, and momentum in some unspecified way, which makes it a really hard thing to nail down. What most amused me, was that it calculates the return to the lowest volatility third of the Russel1000 index. It then selects a portfolio of about 100 stocks that track this index. The idea is that you find the target portfolio, and then, instead of using that portfolio, you use stocks correlated with it.

Downloading their current holdings, the equal weighted beta is 0.91--low, but not by much. The average 90-day volatility of their holdings is 39%. In contrast, the SPLV low volatility ETF simply takes the 100 stocks from the S&P500 with the lowest volatility over the past 12 months. It has an average beta of 0.6, and an average volatility of 28%. The Russel 1000 itself has a 90-day of vol of 50%, and a beta slightly above 1. In short the SPLV ETF delivers 'low vol' more simply, and more efficiently, by focusing on the characteristic, not the factor.

The idea that there exist risk premiums based on covariances with unidentified stochastic discount factors that are like the S&P500 return, but orthogonal to it, will be in the trash heap of bad ideas. As no one can articulate what such a factor might be, it seems absurd that millions of people are implicitly valuing companies, currencies, and futures this way. But a more tangible problem created by this theory is thinking that to get a certain return stream you should target the asset with the requisite factor mimicking beta, as LVOL has done.

Daniel and Titman documented that it was the characteristic, rather than the factor, that generated the value and size effects. They did an ingenious study in that they took all the small stocks, and then separated them into those stocks that were correlated with the statistical size factor Fama and French constructed, and those that weren’t. That is, of all the small stocks, some were merely small, and weren’t correlated with the size factor of Fama-French, and the same is true for some high book-to-market stocks.

Remember, in risk it is only the covariance of a stock to some factor that counts. Daniel and Titman found that the pure characteristic of being small, or having a high book-to-market ratio, was sufficient to generate the return anomaly, independent of their loading on the factor proxy. In the APT or SDF, the covariance in the return with something is what makes it risky. In practice, it is the mere characteristic that generates the return lift.

Davis, Fama and French shot back that their approach did work better on the early, smaller sample, and more survivorship biased 1933-to-1960 period, but that implies at best that size and value seem the essence of characteristics, not factors, over the more recent and better documented 1963-to-2000 period. Data in favor of Daniel and Titman's characteristics approach was found in France by Souad Ajili, and in Japan by Daniel, Titman and Wei.

In a similar vein, Todd Houge and Tim Loughran (2006) find mutual funds with the highest loadings on the value factor reported no return premium over the same 1975-to-2002 period, even though the value factor generated a 6.2 percent average annual return over the same period. Loading on the factor, per se, did not generate a return premium.

The standard equity groupings of size, value/growth, and now volatility, are best done directly, and not via an exposure to factor-mimicking portfolios.

Facebook Followers Correlated with Stock Price

A recent paper by Aurthur J. O'Connor and Famecount looked at 30 top brands from June 2010 through June 2011, and found that number of Facebook fans was correlated with the stock price. Looking at the charts below, I can see how it's pretty significant. You can't see these graphs very well, but the vertical axes are price, the horizontal are Facebook fans.



In my 1994 dissertation I found that if I counted up stories in Nexus, these stories counts explained the relative ownership percentage of mutual funds in regressions that included price, size, and volatility. That is, in the context of these other variables, stocks more frequently in the new tended to have larger mutual fund ownership. One could imagine fund being both more aware of these companies, and having an easier time explaining their ownership in these companies.

Contemporaneous correlations are one thing, predictions another. Stocks with higher volatility generate more news than less volatile firms. Such stocks are then ‘in play’, and so become relevant to the investor interested in deviating from the index. Further, they create a default value, in that once everyone seemed to have internet stock in their portfolio, or some exposure to residential real estate, it seemed prudent to also have some, especially if one were indifferent. Given short constraints and overconfidence, this increased focus on volatile stocks leads to lower future returns. I imagine this might be interesting to look at whether this is more useful as a short-term momentum indicator, or a longer-term mean-reverting signal. The trick for the longer term predictability, is that you need a survivorship bias free data set with historical data going back several years, so I doubt that Facebook or Twitter have enough data to test anything with a horizon greater than 1-week.

Are High Beta Stocks Like Call Options?

Dave Cowan and Sam Wildeman at GMO have a new paper, Re-thinking Risk (check here or here if that doesn't work), that makes the argument that the poor performance of high beta stocks makes perfect sense. Their idea is that high beta stocks actually are leverage with a put option, because unlike a levered fund where you can lose 2 times your investment (200%), a beta=2 portfolio can only lose 100%. In their words:

The point here is that the form of leverage offered by high beta is different in an important way from explicit borrowing. Investors should prefer this kind of leverage, and, in an efficiently priced market, they will accept a lower return for it. As we will show, the performance of high beta is not a product of excessive demand, but rather a reasonable and rational consequence of the fact that it provides a convex payoff to the market.

Their analysis highlight the fact that 'risk' has two meanings. One is the risk people intuit, the other the technical metric in financial theory that generates a return premium. The risk that generates a risk premium is solely a function of expected covariance with some risk factor. Convexity just means the average expected risk in the future is nonlinear, but there's still a simple linear function of this expected covariance that should relate to the expected return. Convex payouts in options may seem less risky, and indeed are often sold via the pitch that they have 'limited downside.' If losing 100% is risk reduction for you, your broker probably has you on speed dial.

The key insight in Black-Scholes-Merton wasn't the basic formulation, which was well-known at that time among practitioners like Edward Thorpe, it was rather that one should use the 'risk free rate' to discount future payoffs. This was surprising, and though it was proved later much more simply by Cox and Rubinstein in their binomial pricing model, they figured it out first and deserve their accolades.

Convexity generates option value only because of its effect on expected values, not because of a 'risk premium' in the technical sense. That is, the 'option premium' above the 'intrinsic value' is purely a risk neutral expected value. The convexity in payoffs should show up in the expected returns, which should show in average returns over a large enough sample. As the authors note, high beta stocks under perform historically in the US and internationally, so it is implausible to say this is simple a 'peso problem' of having a small sample.

If a high beta stock is really like a portfolio with leverage plus a put option, the expected return is still a function of its expected beta. This is shown rather nicely by Joshua Coval and Tyler Shumway in their paper 'Expected Option Returns.'

Nevertheless, while it is true that Beta=2 equities can lose only 100% unlike being levered 2 times where you can lose 200%, in practice this convexity is quite small. Above is their empirical estimation of the convexity in high beta equities. While there is a little convexity, it is quite small, not significantly different than zero (ie, it's pretty linear). It's implausible to think this minor amount of curvature is practically important.

The authors then point out that betas for high-beta equities have lower betas in down markets than in up moves. True enough, but this highlights having a good conditional beta forecast that recognizes this. By now everyone should know that in highly volatile times like 2008, stocks tend to decline and correlations increase, compressing the cross-section of beta (lowering high betas and increasing low betas). In practice, you want a bayesian adjustment or shrinkage parameter to your beta estimation that recognizes this (more shrinkage in bull or declining volatility estimation periods).

In sum, I think the authors are confusing the intuitive risk with priced risk. The low return to high beta stocks is still a puzzle to standard theory because these stock returns include the convex payout, and this should show up in the average returns of stocks that implicitly include them. Not only is the convexity slight, high beta equities have lower than average returns historically.

Why Movie Reviewers Turn Into Op-Ed Writers

I was reading Joe Morganstern's review of George Clooney's latest movie, and was struck by this line:

Mr. Clooney is a star at the peak of his powers, playing the sort of person we're seldom privileged to meet—a whole man, which is to say a flawed and foolish man who is basically good, and who gets a precious shot at being better.

There's a lot of profundity in that little snippet. I've notice several big think commentators today started or do movie reviews (Steve Sailer, Frank Rich, John Podhoretz, Michael Medved). The ability to articulately critique pop-fiction is deceptively deep, I guess.

Have US Federal Revenues Hit Their Laffer Curve Limit?

I was listening to Jeffrey Hummel's recent talk (see here, scroll down to his picture). He argues the US federal default is inevitable, using the following reasoning.

Federal Tax revenues as a percent of GDP have consisntently been bumping up about 20% since 1951. Even in WW2, when federal taxes were highest as a percent of GDP, tax revenues never broke 25% of GDP.


Meanwhile, top marginal tax rates, corporate rates, and capital gains tax rates have basically declined, though bouncing about quite a bit.


This suggests the 20% barrier is some kind of structural barrier in the system: people adjust their effort and tax avoidance to generate basically the same percentage of GDP over a variety of tax rates.

Here are the projected Federal expenditures from the Congressional Budget Office

Thus, the projected 30% of GDP spending in the pipeline seems impossible to finance. While conceivably we could cut our spending, its likely this will only be cut when deficits are curtailed via an explicit or implicit default.

On the brighter side, it took Rome a good 200 years to totally implode after their peak, and there's the example of Argentina, which while not as relatively prosperous as it was 100 years ago, isn't a horrible place to live.

Gary Gorton on Hedge Fund Dilemma

I found this little aside in Gary Gorton's 2010 Journal of Economic Literature review of 2008 financial crisis books--The Big Short and The Greatest Trade Ever--pretty funny:

Some of the most interesting material in the books concerns how hedge funds operate. Opening a hedge fund is problematic. The founder has a secret. Either the secret is that the founder has no new ideas. Or, the founder’s secret is a new idea. If the founder has no new idea, that cannot be revealed. If the founder has an original idea, he also can’t share it with investors because they might steal it. “Competitors might figure out the trade for themselves and buy the same insurance, driving up the cost. That made Paulson reluctant to provide details of his trade. It was a stance that made it more difficult to raise money” (Zuckerman, p. 127‐8). Indeed, Paulson’s friend Jeffrey Greene does steal the idea. Michael Burry has the same problem: “If I describe it enough it sounds compelling, and people think they can do it for themselves. . . If I don’t describe it enough, it sounds scary and binary and I can’t raise the capital” (Lewis, p. 58).

By the time I had capital to set up a low-vol strategy fund myself I was soon in litigation that exhausted my capital, but when I didn't have capital and was trying to convince others, a common reply was, 'why isn't everyone else doing it?' Now the problem is everyone is doing it (low vol investing).

A take away is that hedge funds are all fundamentally opaque. Another is that you can't start a hedge fund unless you or a very close associate, has at least a million or two to invest.

How to Spot Overfitting

FRBSF Economic Letter: Probability of a Recession vs. Actual Recession Dates

You can teach statistics, but unfortunately, you can't teach people not to overfit data. The problem is that it is too tempting to look at some data, keep applying different inputs and functional forms, until you fit the data. In some sense, that's what a good model does, so the objective, maximizing the R2, is encouraged.

But there's no point fooling yourself, it just wastes time, and only the researcher really knows if they overfit the problem, because outsiders don't know how the ultimate functional form was chosen (iterating over a large set of inputs?). Macro forecasting is especially difficult, and anyone familiar with its history would do well to be modest (see here). The above graph from some San Francisco Fed researchers is clearly overfit because the base recession rate is about 16% since 1945, so the average forecast should be around 16%, not jumping from 0 to 100%. A forecast should cluster around the unconditional expectation, not the extremes. Only with hindsight do these kind of forecasts make sense.

Margin Call the Movie

Margin Call was an excellent movie, in terms of its direction and acting. The nightime scenes were emphatically in the darkness of night, even though every time I've worked after dark, we simply turned on all the lights (for some reason they would have meeting in the dark with ominous screens lit around them). Life isn't as simple and clear as in movies, which is why I like them when they are good.

But, the key was in creating an event that provokes a crisis, one that engenders all sorts of soul searching, backstabbing, pain, and ultimately resurrection. The event in this case was that the fired risk manager, the always awesome Stanley Tucci, highlights that the value-at-risk is greater than the value of the firm. Now, they don't say what horizon this VAR was for, but that doesn't really matter. The key is, everyone supposedly knows 1) the value of their portfolio and 2) stress-test and value-at-risk numbers for that portfolio. Presumably, as best as I could make out, the really shocking VAR used current 'volatilities' as opposed to stale historical ones, which given the VIX was at 15 for a long time, then peaked at 80, could have been an issue.

Since when was a parameter like 'volatility' not presented with the results? In my experience, management isn't well versed on VAR details, but they are good on what makes a relevant stress test or assumed volatility, so I can't imagine this being as important as the movie implied (ie, they all got together for a 4 AM meeting and decided to cover their exposure the next day). The idea that someone updated VARs for current volatilities, and discovered their portfolios were too risky and had to be exited immediately, is pure Hollywood.

The risk, presumably, was merely from their pipeline of assets that they held in the process of creating various derivatives. If that was their total risk, they had an incredibly high leverage.

But, that's all sniping. I thought it was a pretty good movie. The problem is that if you discovered that mortgages were overpriced in 2008 by 20%, that wouldn't imply the amount of panic showed in the movie. You would have weeks, if not months, to exit positions, not the 'day' the movie used. Big mistakes like that are systematic errors that are not going to change overnight. Even Enron's stock took months to fall, so it's never the case you have to sell your entire portfolio of an asset overnight, especially for something correlated with so many highly liquid alternative assets.

dos Santos's Knock Out

I'm a big fan of Mixed Martial Arts, and take classes where I punch pads and bags, which is very cathartic. I would never actually spar with someone, taking punches to the head, however, because I don't think the brain takes such punishment well. In last Saturday's prime time UFC battle, two heavyweights were involved, and only 60 seconds into t he fight Brazilian Junior dos Santos connected right behind Velasquez's left ear (see above). It didn't look like much, but this part of the brain controls your motion, and it clearly disrupted those circuits.

As Velasquez explained after the fight, he 'saw everything but his body wasn't reacting.' Thus, he was fully conscious but momentarily defenseless (not defending yourself is cause for stoppage). Most knockouts involve some momentary loss of consciousnesses, often when the head twists from a punch to the chin or jaw, so this was rather interesting.

MMA is less dangerous than boxing because in boxing concussed boxers are basically kept vertical via standing 8 counts and the nature of boxing where it isn't nearly as easy to finish someone; the result is a lot more brain punishment. In MMA a woozy fighter can dispatched many ways, often by tackling him and then applying a rear-naked choke that is pretty benign (not that I would want my sons doing this).

Mailer on Marx

Norman Mailer was a famous American writer who died in 2007, who wrote with great forcefulness. People can still have interesting things to say (or in Mailer's case, say them in an interesting way), yet still be moon-bat crazy in many areas of their lives. So, listening to this video on Youtube, I was taken by this passage:



Marx's Das Kapital is utter bullcrap, and makes Joseph Smith's Book of Mormon seem like Euclid's Elements. It was before the marginalist revolution, so did not understand 'value', instead thinking all value came from labor. To note how stupid this is, think about someone spending 10 hours writing a paper--does this make it worth '10 hours' worth of 'steel'? Depends on what came out, and probably its worth is inversely correlated with the time spent on it. You can see a nice summary of its irrelevancy by going to the Wikipedia on volumes 1, 2 and 3, and note that the economic arguments are not even used by Marxist economists today (falling rate of profit? recessions becoming wider every time? Surplus value?).

They say sure, he got the details wrong, but he had great vision. Most of the book was very specific, and those little examples and arguments were all wrong. I guess by some cosmic analytic karma, if all your particulars are wrong the theme must be really profound. Literary types have always like it because it gives a scientific pretense to their statist and egalitarian instincts (based on hope alone, as all socialist enterprises turn out to labeled 'state capitalism' or some other oxymoron). Yet I like it when people like Mailer make such points, because it lays clear how hollow their base assumptions are, because it is simply impossible to 'think more clearly' after reading such a book.

What Happened to Momentum?

The total return to Momentum was impressive for many decades. It's a simple strategy, basically going long past winners and short the losers, hoping they continue to win and lose. Interestingly, the past returns should go only up to the prior month, because there's slight mean-reversion at the one-month horizon, so most people use the returns from months t-12 through t-1. This highlights the non-fractal nature of stock returns, in that there's momentum in the data from 3-18 months, but mean-reversion at the shorter and longer frequencies.

Even after discovered by Jegadeesh and Titman in 1992, it seemed to work for another 8 years. Since 2000, however, it hasn't worked (see a decent paper on that here). Using Ken French's replication of this strategy, we see the total return pattern above. Note that while from 1932 through 1943 it stagnated, it seemed Madoff-like in its ascendance from the end of WW2 through 2000.

The big drawdowns in the momentum strategy occurred in the big stock rebounds of July-Aug 1932, and March-Sep 2009. These moves would generate losses of over 50%, which since it generated an 8% annual return, this would probably eliminate any particular portfolio manager--such losses are usually lethal.

Now, these long-term simulations tend to have a bunch of survivorship problem issues, and data prior to 1964 is to be taken with a grain of salt (the database was created then, so its much harder to correct errors when you don't remember how you collected data in real-time). Interestingly, while momentum is considered a real factor by some (eg, the Carhart 4-factor model is the Fama-French 3-factor model plus momentum), Fama has been conspicuously avoided treating momentum as a risk factor, nor trying to explain in theoretically in any way, and just looked at it quizzically. That was rather refreshing, in that it's tempting when you have the status he does to explain everything in your field, but instead he just shrugged.

Above are the December returns. These actually made sense because there was a real story here. The idea was that winners had taxable gains, and so not selling them until January would push off a liability; losers had losses that selling prior to January would lower one's taxes. Thus winners have this absence of selling, losers a greater amount of selling. Alas, since 2003, this pattern too has disappeared. In fact, I actually put the trade in December 2003 based on looking at this data, and got crushed. It was the worst return by far relative to my sample of 25 years that used a different universe than French but was basically the same pattern. I actually emailed Ken French at that time to ask if he had any insight, and he merely emailed back: 'it's risky.' My boss didn't think that was a good answer.

I think this highlights an important point. At any point in time your strategy is susceptible to a draw down that could cost you your client base. You can't just say 'hey, that's risk!' Investors see it as a failure, not a bad draw from the urn of chance. Returns over time are treated very differently than cross-sectional returns because cross sectional returns have covariances and volatilities amenable to statistical optimization; time-series returns are looked at more like datum in a broader strategy of eliminating all the 'losers' at any point in time. If you are in the bottom 10% at any time for any reason, your portfolio probably has hit an 'absorbing barrier.'

Aspiring Politicians Learn to Dissemble

Hayek' Road to Serfdom argued that a major problem with socialism was that it encouraged the most ruthless and illiberal to rise to the top. As they find their plans untenable, they will be forced to apply force to achieve their aims, so those willing to apply such force will tend to be most successful in such systems. A problem with modern politics is that as only dissembling narcissists can succeed, politicians at all levels become such pathetic losers.

Recently my school board voted for busing to rectify the achievement gap that results from the new Somali immigrants who cluster at certain schools. This has made certain elementary schools have lower scores than others, and so their solution is to spread the Somalis around. That this only superficially rids one metric of inequality while not actually raising Somali scores (except through the theory of osmosis), and making my little guys take a longer bus ride across town, makes me almost want to run for the school board. Today's election in my little town consisted solely of school board elections, and it has polarized the town [note: we voted the busing advocates out].

I don't care about schools so much that I would allocate 15 hours a week to them, so I looked for someone being elected who shares my views. Unfortunately, reading their position statements, they all speak in platitudes similar to those spoken by senators and presidents, making statements that no one disagrees with.

Here's various takes on the softball question of how they would approach the School Board Governance Policy (which is never defined):

"the idea behind governance – clearly defining the roles of the superintendent and board – is a good one. If all parties commit to transparency and accountability, this model could work...."

"Board focus should be on achieving results and maintaining direct communications with stakeholders. Policies should state what should and shouldn’t be done..."

"Every group – like the Eden Prairie School Board – needs a set of rules, bylaws, or a governance policy..."

“I support coherent governance because it provides a comprehensive and systematic way for the Eden Prairie School Board to guide and monitor operations and results of the district..."

The rest of their vision statements are so vapid one might as well just know that first and foremost they all want to be liked by everyone, and think that being trite and vague are the best ways to that end. These aspiring politicians are afraid of saying anything that people might actually disagree with, but then if everyone agrees with you, you really aren't saying anything interesting. As George Orwell noted in his classic Politics and the English Language, the great enemy of clear language is insincerity. It's a dominant strategy. Remember Barack Obama's response to Rick Warren's question as to what he thinks about abortion: 'that's above my pay grade.' This was a stupid answer (he has an opinion and it would affect policy), but it probably worked out better for him than articulating his true beliefs. In a democracy the winner has to pander to a rabble--though there are better and worse among them.

This is a major reason why I prefer a smaller government, because at least businessmen pursues their own advantage more openly and honestly, whereas government workers pursue their self interest hypocritically and under false pretenses. Petty school board nominees are now aping our betters, and bringing the level of discourse down to a point where everyone is afraid of a Kinsley gaffe.

Cochrane on Alpha-Beta

Quantivity glowing quotes John Cochrane:

I tried telling a hedge fund manager, “You don’t have alpha. I can replicate your returns with a value-growth, momentum, currency and term carry, and short-vol strategy.” He said, “‘Exotic beta’ is my alpha. I understand those systematic factors and know how to trade them. You don’t.” He has a point. How many investors have even thought through their exposures to carry-trade or short-volatility “systematic risks,” let alone have the ability to program computers to execute such strategies as “passive,” mechanical investments? To an investor who has not heard of it and holds the market index, a new factor is alpha. And that alpha has nothing to do with informational inefficiency.

Most active management and performance evaluation just is not well described by the alpha-beta, information-systematic, selection-style split anymore. There is no “alpha.” There is just beta you understand and beta you don’t understand, and beta you are positioned to buy vs. beta you are already exposed to and should sell.

I don't find this very profound. If the carry trade or shorting the VXX is a beta trade and makes a risk premium, investors should be indifferent to it. The risk premium is an even trade of premium for risk (or rebate for insurance). He's assuming that most people would love to earn the returns from the carry trade or shorting the VXX, and I suspect he's right, but that's because it's not a risk premium, rather, it's simply an opportunity.

Ever since the small cap effect was discovered, people have been attracted to it as an asset class because it offered higher returns. Dimensional Fund Advisors started with a small cap fund. Now, if the 'risk premium' story were true, it would be just as interesting for investors to take the other side, to buy insurance against whatever risk these things were providing a return premium for (these other factors tend to have medians of zero, not 1 as in the CAPM beta). Such opportunities are never sold that way, and investors don't want to pay for these things by shorting them.

Aristotle's Philosophical Conceit

Aristotle wrote many years ago an anecdote that many erudite people take as gospel, that the thoughtful sages could be rich if they really wanted to. Here he recounts the story of Thales of Melitus (ie, the primordial philosopher 624-546 BC):

he knew by his skill in the stars while it was yet winter that there would be a great harvest of olives in the coming year; so, having a little money, he gave deposits for the use of all the olive-presses in Chios and Miletus, which he hired at a low price because no one bid against him. When the harvest-time came, and many were wanted all at once and of a sudden, he let them out at any rate which he pleased, and made a quantity of money.

Now, this is total bull because the stars don't predict weather. Reading chicken entrails and the like was popular back then and they had lots of other wacky beliefs, but the idea that they traded on them and prospered is clearly a self-serving lie. Today, we have active mutual fund managers who claim to outperform indices even though this has never been the case, so I guess every age has its own myths.

Lewin's Love of Physics

Walter Lewin is an MIT physics professor, and wrote a pretty fun book entitled For the Love of Physics. It's a nice romp through fun facts of physics, such as why rainbows only appear when the sun is behind you. One of the more interesting parts concerns his investigation of Galileo's Square-Cube law.

Galileo's Dialogue Concerning Two New Sciences contained what he considered to be one of his most profound insights: the square-cube law. If two cubes are made of the same material then they will have the same density. Yet since the two cubes have different area to volume ratios they will likewise have different stress at the base of each cube. If too much stress is placed on an object then it will fail, or in this case a large cube has a much greater possibility of collapsing. This is why sandcastles can only be a few feet high.

Galileo applied this to animals, what we now call allometry, and noted that a this implies the diameter of bones should be proportional to their length so that length³=k•diameter², or diameter=k•length^1.5. The simple support required of bones implies limbs get thicker and thicker as animals get bigger, which is why rhinos and elephants are pretty thick. Bones comprise about 8% of the weight of a mouse, 14% of a goose or dog, and 18% of a man.

Also because of the Square-Cube Law, larger animals have less relative muscle strength than smaller animals. Both the muscle strength and bone strength are functions of the cross sectional area, while the weight of the animal is a function of volume. It is because of relative muscle strength that an ant can lift fifty times its weight while a human can lift an amount equal to its own weight, and an Asian elephant can only lift 25% of its own weight. The greater muscle to weight ratio of smaller animals is what allows them to jump higher than several times their own height, while at the other extreme an elephant can not even jump.

Back to Lewin, he actually looked at various animal bones from MIT's museum. Comparing a raccoon with a horse femur, he found the horse femur should be 6 times thicker than a raccoon's. It turned out 5 times thicker, which is close. Then he compared a horse to a mouse, and the thickness was only 70 times thicker, not the 250 times thicker as predicted by their lengths. The elephant femur was only 120 times thicker than a mouse's femur, not the 1000 times as predicted.

It appears that the structure of bones is different, bone chemistry changes along with its size. Thus, the fact that dinosaurs were the size of 12 bull elephants with leg bones of similar diameter, need not be explained by an expanding earth theory (the idea that the earth was smaller back then, so gravity wasn't as strong). So, Galileo's square-cube 'law' is really an approximation for the moderate spectrum of animal sizes, something that explains a lot but doesn't generalize like gravitation, which Newton used to explain the fall of an apple and the orbit of the moon.

Then again, perhaps even gravitation does not scale. Dark matter was introduced to explain the fact that galaxies rotate in a way very unlike our solar system. In our solar system the gravity vs. centripetal force generates the pattern where the period of a planet (T) and the mean distance from the sun (R) are related by a constant ratio for T²/R³, something observed by Kepler then proved by Newton 70 years later. Thus, Mercury has an orbit of 88 days, Neptune 165 years. Galaxies don't do that, with the outer regions moving almost as fast as the center stars. Dwarf galaxies are even worse, looking more like an evenly distributed swarm of bees, indifferent to clumping or spinning. The idea that the space is suffused with unobservable dark matter fixes this problem, but it's a fudge, because it 'appears' only as a solution to this problem. Perhaps gravitation doesn't scale at that dimension.

Chance, Effort, and Ability

Here's my local paper's Sunday major opinion piece on wealth inequality, discussing a researcher's model of wealth distribution:

He began his research with a simple question: Can chance alone account for wealth concentration?...He assumed that all entrepreneurs began with equal wealth. Returns varied, solely by chance...I'll spare you the calculus, but according to Fargione's model, by the "inexorable effect of chance," and chance alone, "a small proportion of entrepreneurs come to possess essentially all of the wealth...According to Fargione, greater variation in rates of return hastened the concentration of wealth.

That's not a model, that's an assumption. He assumed individual wealth varies randomly, and found the net inequality will be due to randomness. I understand that assumptions drive models, but the step between assumption and result has to be a little subtle or non-obvious. Here, he assumed everyone varied by randomness, and after doing this in Excel (really), it implied variation by chance is really random.

While it's important to remember that assumptions aren't models, they are perhaps more important, because as Darwin said,

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.

People who get excited about wealth being explained solely by effort or chance are making an important assumption about navigating one's life. Success is the result of randomness, effort, and ability. If you omit one of these, you will be miserable. A lot of growing up is about finding what you like that you are good at, and usually you like things you are relatively good at. Then practice that skill until you become excellent at it. The rest you can't really worry about even though that too is important, especially in explaining things like why certain people are really rich, which is often being in the right place at the right time. This should make us content because it's all we can control.

Anxiety should be not be ignored, but seen as what incents us to do our best--to observe the Serenity Prayer--because we worry all the time if we are doing our best given an uncertain future (in the end, it's the doers that prosper). For the existentialists Kierkegaard and Heidegger, this anxiety is the essence of consciousness (or sein), because we exist in time and are always thinking about an uncertain future in a way animals do not. They had very different solutions to this problem, and while I tend to find Heidegger's solution more fruitful, it clearly has more potential downside (Kierkegaard chose faith in God, Heidegger became an enthusiastic Nazi).

It's sad that some people see the disparities in income, and think this is all effort or all luck. In any case, this is a more damaging belief for their own self-actualization than any silly tax policy they envisage.