Tuesday, August 28, 2012

Bad Trades as a Macro Parable

There are two types of bad trades.  The first is the mode-mean trade where the mode is positive the mean zero or negative.  One shouldn't make this kind of investment, because at best it simply adds noise to one's portfolio.  The net return to the passive investor can be especially negative because often they mistakenly overpay for management, not anticipating the drawdown, and the agent does not payback old profits when this is all revealed. Such trades are common in financial markets, and savvy investors are very aware of them.  Junk bonds, writing out-of-the-money options, hurricane insurance, are good examples.

Another type of bad trade is where losses are expected initially, but supposedly it's just a learning curve or scale issue, and eventually once all the ducks are in a row the positive cash flow supposedly appears.  These are more common, as with any high frequency trading strategy that burns transaction costs, not realizing that those close-to-close returns used in the back tests weren't realistic estimates of feasible net fill prices.

The more money an investor has tied up in such trades the lower their total return over the long run. You can try to avoid them, but a better priority is to simply identify them and flush them when they reveal themselves. That is, getting out of bad investments is probably the single most important thing an investor can do,as opposed to finding alpha, which is simply much harder.

Our economy has many such bad trades going on at any one time, and the sooner these are abandoned, the quicker people will reallocate their time towards something that actually costs less than its revenue.  Consider guarantees to farmers, which supposedly allow farmers to withstand the vagaries of weather, ensuring our very survival.  We have policies that encourage producer cartels, direct payments via subsidies, paying farmers to not farm, disaster aid, insurance subsidies, and export subsidies and import tariffs. So now farmers who suffered from the recent drought directly get fully insured payments, and those who avoided it get the revenue from higher prices.  This isn't helping us become more efficient farmers.

Then we have clean energy, education, defense, high-speed rail, all costly investments that potentially will pay off big eventually, but in practice are subverted by special interests into a focus on producers not consumers.  If the negative present value were revealed via the negative cash flow at market prices, an efficient response would be to reallocate capital and labor. Instead, these activities are propped up under the hope that mere time will allow some sort of critical take-off point in future productivity.

Many like to deride the short-term nature of markets, but the long-term rationalizations of top-down industrial planning is much worse.  It's not like our non-market economy is allocating capital like Berkshire Hathaway, rather just a series of patches to problems created by prior programs.

The best way to increase productivity is to stop doing things that have negative NPVs because these have massive opportunity costs, and this is best reflected by the true discounted cashflow sans government in its myriad forms. Obviously this is a pipe dream, but it's an example of the way government can help the economy and reduce spending simultaneously.

There would be some costly adjustments, but as they say, when you are in a hole, stop digging. What is prudence in the conduct of every portfolio can scarce be folly in that of a great kingdom.  


bjk said...

This is why the "Chinese century" argument is false. Chinese are the GM of capital allocation.

Anonymous said...

Are you suggesting we stop government provided education and defense? Your comment that government actions are "just a series of patches to problems created by prior programs" suggests the existence of some past historical pre-government paradise. I'm unfamiliar with such a period.

Eric Falkenstein said...

All or nothing is a false dichotomy. We can spend 50% less.

Hayek and Friedman were very clear on this: government is essential for many functions. It merely could be a lot smaller.

Patrick Sullivan said...

Education and defense are two very different things. The latter being the classic 'non-rivalrous, non-excludable in consumption public good'. Education being the opposite.

Patrick Sullivan said...

'So now farmers who suffered from the recent drought directly get fully insured payments, and those who avoided it get the revenue from higher prices. This isn't helping us become more efficient farmers.'

Plus, it works even when there are bumper crops;


Sandum's decision not to pick 125 tons of the dangling fruit came partly because he thinks he has a better shot at covering the year's expenses with his crop insurance.

That insurance, according to his agent, Tim Hulett of Northwest Farm Credit Services, is designed to guard against unforeseen weather and fluctuations in the market based on a farmer's historical revenue, but it doesn't allow the farmer to "give up responsibilities to grow your crop."

"I'm hoping to make enough money off of my insurance to pay for this year's growing costs," Sandum said. "[Those] are between $25,000 and $30,000."