Thursday, November 29, 2012

The Perils of Winding Down

I drove home listening to a left-wing talk radio show that focused on the $1.8MM in bonuses that Hostess Brands is using to retain 19 executives during its wind down. They thought this was pure evil and unfair.  Hostess has hundreds of millions of dollars in assets, so this is at most 0.5% of the value of the firm. For a top guy to get an extra $100k to do this correctly seems cheap.

It reminds me of a case where after a blow up in the convertible bonds space around 2006, the firm decided to wind the fund down. They told employees there would be no bonuses, just wind down, and leave. So one guy sold his portfolio at bargain basement prices to his favorite brokers. He then had lots of credit in the favor bank, and was able to land a great job at a new firm, which since then has done very well. 

Another fun story is when Niederhoffer blew up in 1997. As the fund was being liquidated, the agent for the liquidation with no skin in the game went to the pit to close out a large amount of eurodollar positions. Everyone knew he was going one way, and when he asked a price, they all stopped and looked at each other, silent. Eventually he sold his positions at such a low price, it was the best day ever for at least one firm there. The liquidator did not act in the investor's best interest, but he was not incented to.

 When someone is in charge of a lot money, if you take away direct incentives, they will game the system indirectly. It's foolish to think people in charge liquidating hundreds of millions of dollars will do this without simply giving away stuff to people that can (and will!) be helpful to them later. Navigating the favor bank is part of life, and people act in the self interest.

Tuesday, November 27, 2012

Taleb Mishandles Fragility

Christmas traditions have gone from stockings and exchanging gifts, to fruitcakes, bad sweaters, NBA games, and now Taleb books, a sign that perhaps the Mayan return isn't so much an apocalypse but rather a mercy killing. Taleb is one of many best-selling authors I don't enjoy (Tom Friedman, Robert Kiyosaki, Snooki), but as he is prolix, pretentious, petulant and clueless, I enjoy commenting on his latest blather (my review of Black Swan here, Bed of Procrustes here).

His latest book Antifragile is driven by his discovery that there is not an English word for the opposite of fragile, which he thinks could not be 'robust' (this neologism is one of the few new ideas presented in this book, not that I think we need more new Taleb ideas). Fragile things lose a lot of value when mishandled, 'anti-fragile' things increase a lot in value when mishandled.  He thinks this is very profound and therefore needs a book.  The problem is that mishandle implies an adverse effect by definition, which is why there isn't a word for something that goes up in value when you mishandle it.

The concept of things increasing in value with small probabilities is well-known. Words used for this concept include: good luck (when preparation meets opportunity), lottery tickets, a home run, teenie (a low-delta option), eureka moment (scientists),  ten-bagger (a stock that can increase in value ten-fold).  These are compound nouns, and if English were German, these would all be one word.  They are the basis for patent trolls, venture capital, oil drilling, poring over a sheet of financials, and dating (a single prince makes the many other tedious dates worthwhile). Having good luck, winning lottery tickets, is nice, but  how to achieve this is not straightforward, and certainly not simply by owning a lot of them.

One interviewer's takeaway from his anti-fragile thesis was the following:
So what to buy? Taleb chooses investments with small downsides and large upsides: penny stocks, distressed assets, and options. “You want investments that clip the left tail.”
An option has a truncated left-tail: it pays off zero or the stock price different than some strike price--always a positive number--but is not necessarily a bargain because the price is positive. In fact, penny stocks, distressed assets, and long option positions have lower-than-average returns, as lazy investors chase large improbable payoffs. Further, contra Taleb, it is not the quantifiability of lottery tickets, or the fact that they have a maximum payoff, that makes them bad investments: things with lottery-ticket type qualities with uncertain parameters such as internet business opportunities are generally a fraud with a poor expected return, and things like IPOs, or analyst disagreement (which have more of what Keynes and Knight called 'uncertainty'), are intuitively riskier and have lower-than-average returns (I document many of these in my book).

He doesn't identify key attributes of attractive, risky (oops, antifragile!) opportunities, just implies they are the ones that unlike options and lottery tickets, work well. In fact, he's anti-theory, so one supposedly finds them by random sampling (aka 'trial and error'). That's a strategy statistically proven to underperform, catering to the biases most investors have, why both day trading bucket shops thrive and  low volatility investing works. As a self-help book, it's like someone saying you should eat more carbs, a strategy many will find brilliant.

The book is really a big spread argument that it's good to be long gamma, bad to be short it. Gamma is the essence of an option, why there's 'time decay' or theta, a predictable expense that anticipates the payoff times the probability.  Gamma is the essence of when payoffs are convex, when a down moves means you lose X, but on up moves implies you gain 2X. Whether or not this theta is adequate for the gamma is whether an option is priced fairly or not, and asymmetric payoffs are never priced at zero.  People generally pay too much for gamma, why historically the VIX has been about 1% higher than the SP500's actual volatility, and this implied volatility bias has been even higher in the tails. Being long options (positive gamma, generally short volatility), especially out-of-the-money options, has been a losing strategy.

One key to understanding Taleb is the Freudian concept of projection: he applies his greatest faults to others. For example, he defines the "Joseph Stiglitz problem" as cherry-picking his prior statements to claim they predicted something when they did not,  referring to Stiglitz's ill-fated Fannie-Mae prediction and subsequent recollection of calling the 2008 financial crisis in a later book. Yet Taleb himself did the same thing, as he criticized Fannie Mae for not understanding the embedded interest-rate option in their mortgage portfolio, but then claims he accurately predicted Fannie's failure. Prepayment risk is very different than collateral risk, and Taleb mentioned nothing about collateral risk prior to 2007, and instead alluded to the prepayment option problem. It's like a guy who says corn prices might increase because of  risk from floods, and when a collapse in the dollar causes its price to rise, states, 'I told you so.' Hindsight bias, name dropping, and pretentious mathematics are all Taleb signatures he sees everywhere in others.

Another key to understanding Taleb is that he has a French post-modern tendency to write to impress rather than explain. As Nietzsche observed, 'those who would like to seem profound strive for obscurity.' He provides hundreds of loosely related anecdotes, reminding me of the Talmud quote that 'when a debater’s point is not impressive, he brings forth many arguments.'  Many of his arguments are contradictory, but he escapes this via the common method of postmodern critical theory which is to claim one's understanding of individual parts of a text is only understood in the context of the whole, which also is dependent on the parts. This allows him to state antifragility is exemplified by examples of hormesis and long options, but is also not hormesis or being long options.  I actually agree with a lot of Taleb, such as the intractability of risk because it is endogenous, and he's somewhat of a libertarian as I am, but he says so many inconsistent things it doesn't mean anything (when he's right it's probably a good example of the Gettier problem).

Then there are the many confused or dubious assertions, such as that the improbable events that underlie his strategy of embracing Black Swans are both impossible to quantify and highly rewarding. So how does he know? Or that fragility is like risk in that it is what causes things to fail and has a return premium but unlike risk is quantifiable; that finance professors don't understand 'real options'; that economists don't understand that f(E(x))<>E[f(x)]; or that the biggest investing problem created by Markowitz is too much optimization.

His equation for fragility has a couple of subjective parameters (K, and the density of alpha) that are unfalsifiable given his definition of  Black Swans (its probability can't be estimated!), and equations with unknown parameters are very helpful if you want to impress the mathematically challenged (in case you don't know math, just ask him if a number of +0.23 is more than 1 stdevs above average, and what that implies for expected returns). Combine these pointless formulas with ramblings about  'street smart' traders, and it's like a non-humorous version of David Sedaris's Me Talk Pretty One Day.

Taleb often suggests it is good to be long volatility, things that gain from greater uncertainty  (see his YouTube on this here). As the VXX has shown, while this has nice covariance properties with the stock market (going up in 2008), it has a horrible long-run return. I bet many of the unfortunate investors who have ridden the VXX to zero over its existence have a copy of The Black Swan on their bookshelf (and you can extrapolate it backward, and even if it started in 2006 it would be a loser).  The 'long vega' bias simply isn't a good one.  Another example: mathematician, publishing mogul and Taleb-fan Paul Wilmott's big advice during the recent financial crisis to buy volatility--it gains from uncertainty!--which was like recommending earthquake insurance right after the big one hits. Good trade, wrong sign.

The fund Universa, of which he is affiliated, states that it is no longer merely long volatility or gamma, but timing when to be long volatility or gamma. I'm sure all those investors who jumped in Universa circa 2009 would be surprised to know that's the strategy, but as part of management, he benefits from the gamma resulting from investors fooled by randomness to think that because being long gamma in 2008 was a good strategy, it will be going forward. He does have an excuse here, as he did write a book on that, so it's not like they weren't warned.

I checked on his book Antifragile back in late October on Amazon, and saw the reviews from those who got the pre-release version.  A few reviews where negative, and in the comment section (you can comment on reviews, and comment on comments) Taleb himself was in there angrily responding at length to negative reviews, and his cult-like fans piled on. From a guy who writes in Antifragile that criticism should be welcomed, his response to criticism is consistently hysterical. A week later, one of the negative reviews was deleted, the poor sap didn't anticipate the venom from simple Amazon review. I have received many spirited emails over the years from his acolytes, and back around 2005 NNT himself sent my boss emails on two occasions telling him I was saying hurtful things about him on the interweb and that I must stop. He's got the skin of a mudskipper.

For example, a commentator on a negative Amazon review writes:
Please respond to Nassim Taleb's rebuttal and more clearly define your expertise and argument with the message of his book. I bet if you engage Mr. Taleb (once again, a rare honor) you will find that the both of you fall along the same lines of understanding. If you do not respond, it simply means that the review was an after-thought to retain review ratings on Amazon and not an honest intellectual review of the book.
That's the fawning tenor typical of his fans, and that kind of intellectual insulation doesn't encourage reality, let alone clarity, which Taleb notes is a major problem among other people. Taleb doesn't do himself any favors by responding to one review by noting that
This review is grounded in a fundamental error. It falls for the conflation described in the book between medicating and overmedicating, intervening and overintervening. The book NEVER says that mental illnesses should not be diagnosed in children, it says that it should not be OVERdiagnosed and OVERMEDICATED.
First, note the deranged use of CAPS, highlighting that he at least follows his own advice to not take Prozac. Then, note that his big idea on mental illnesses is that people should not over-diagnose or overtreat them. True enough,  given the meaning of the prefix "over", but if that's his point it's tautological.  Given Taleb's fixation with word cognates, it's odd that he repeatedly makes these kinds of errors. This kind of vapidity is why I think he's a blowhard.

 One theme of the book is hormesis, the finding that things that are clearly bad for you at extreme doses, are good for you in small doses; a glass of wine a day, radiation, germs, etc. For example, if you have zero exposure to germs, you won't develop a healthy immune system. Arthur Robinson has been a leader in this idea with his work in the 1970s, and there's a fascinating tale about how he discovered this in the context of the assertions about radiation extrapolation by Robinson's mentor, the famous chemist Linus Pauling, and a nasty legal battle that ensued.

The fact that micro-instability is necessary for greater macro-stability is a profound and very Austrian point (ie, not new). If he was a serious scholar he would fit his ideas into these threads and highlight his novelty, but as he has no novelty, he avoids this route. Though Taleb is trying to outflank academics he derides, his writings highlight one of the main benefits of academia where scholars usually fit their ideas into the literature so you can better assess their innovation and the state of the art. Autodidacts are often rambling, repetitive, and most importantly, wrong.

He notes there's a sweet spot for most medicines, and that some exercise is good for you, not in spite of its stresses, but because of them.  A lot of people seem to find this a brilliant insight (Moderation in all things! Who knew!?). This is why his audience is so large: he's focusing on people without any common sense, of which there are many. But if the key to benefiting from the right amount of medication is dosage, how does one find this dosage? Trial and error? That's how most animals learn, but it's pretty inefficient in general, I certainly don't want my kids figuring out most of their life lessons that way because its very time consuming and costly. Surely, a moderate amount of trial and error is essential in everything, but that's not very deep (see CNBC video on AntiFragile and note there's no specific action item for any individual, just bumper sticker advice, e.g., 'small is beautiful').

He still thinks Portfolio Theory, and most Economic Nobel Prize-winning research, is predicated on distributions with fixed parameters. It isn't. Financial academic standard-bearer Eugene Fama spent half his dissertation in the 1960s on Mandelbrot's observation about fat tails, and like everyone else in the profession, left this thread because it isn't that interesting: the static parameter assumption gives qualitatively similar implications to a more realistic distribution where means have standard deviations ad infinitum, yet gains a great deal in transparency. Transparency and simplicity, in fact, are key features of models, always a tradeoff with realism, but that's a nuance too subtle for Taleb. The effect of adding fat tails through stochastic parameters is isomorphic to assuming more risk aversion or higher volatility, so it's trivial to fit inside the box, and the CAPM and other theories are basically the same, just messier when you add volatility to your volatility parameters. The same is true for Black-Scholes-Merton and the Miller-Modigliani theorem.

As per correlations being stochastic and so uninformative, he is wrong again: they are highly predictable, as high beta portfolios formed using past data create portfolios with higher future betas. The same is true for low volatility investing. The problem with betas (ie, correlations), is not that they change so much as to be irrelevant, but that they aren't correlated with returns over long periods as theory suggests (the subject of my book, The Missing Risk Premium, that there are no omnipresent correlations between covariances and average returns). So, I agree modern academic finance is highly flawed, but not for reasons Taleb suggests.

A good amount of gamma, like having just the right amount of medication or specialization, is a good thing. Yet the right amount can be positive, negative, or zero, in various contexts. Many good things have negative gamma, such as the strategy of being nice to strangers: it has a great downside, such as when you naively interact with a stranger, yet being nice is a good default strategy. Then there are things with no gamma, such as brushing your teeth every day or simply being polite, which generally doesn't have a lot of effect either way in your life any time you do it, but over time is quite salubrious. Noting gamma per se, especially large gamma, doesn't tell you if something is good or bad, rather, just that it could be really good or really bad.

You can price gamma and it's not free, so the question is always whether this price is too high or too low. Indeed, Universa's new emphasis on timing volatility trading begs the question: how do you time these things? How do you price things that respond hydra-like to having its head cut off? Contra Antifragile I would say: don't bias your portfolio towards lottery ticket investments, even if only 10%. Find something you are good at, become excellent at it, and invest your time and speculative wealth there.

Sunday, November 25, 2012

Fighting Inequality

NYT reporter Nicholas Kristoff notes that private power generators are extremely useful given the poor quality of modern US electricity infrastructure.  This governmental inefficiency leads him to the conclusion that we need more progressive taxation. In the second century BC Cato the Elder ended each of his speeches with 'And, Carthage must be destroyed'. I think liberals should simply append all their posts/articles/editorials with "and, tax the rich and spend more" via some symbol (§)  just to save space. Everything they see supports this conclusion in their minds.

Alas, to what end? Kristoff laments bad public schools, parks, neighborhoods, and libraries. Spending on these items, per capita, has risen over time. It seems indefensible to assert that the problem is a lack of money, given we spent half as much 50 years ago, failing districts like Los Angeles and Washington DC have some of the highest per pupil spending, I don't see how money is the problem.

The main pretext for equality is that prosperous societies have less inequality, ergo, less inequality creates prosperity. It's a pretext because I think the main reason most liberals want to tax the rich more and have bureaucrats spend it is simply to bring the wealthy down a notch, why they really don't care that historically spending on education doesn't increase learning: that's not the point.

I'm a libertarian, but not because I think it maximizes welfare given current capital, but because it creates more capital by motivating us to act better, which helps us in spite of ourselves.
When we treat man as he is, we make him worse than he is; when we treat him as if he already were what he potentially could be, we make him what he should be. 
If I accepted our envious instincts as optimal I would be indifferent to efficiency, because in aggregate relative status is no different here as in Haiti. I'm glad I have the wherewithal to read and think about ideas, a luxury unaffordable for most of my ancestors, and this isn't possible because of appealing to the mob's instincts.

Look at how we've decided to lessen inequality through the public schools: we don't expel troublemakers, we don't fail under-performing kids, we don't encourage specialized advanced curriculum. The result are schools teaching to the lowest common denominator, and classes distracted with behavioral issues that overwhelm any potential for learning. Any parent with the wherewithal moves to districts where such anarchy has a lower level of dysfunction, and leaves this mess for those unable to move, so these inner city schools become extremely dysfunctional. Kids at poor schools realize diplomas from such institutions don't mean anything, and drop out more frequently, lowering their ultimate human capital acquisition.

The result is that while schools prioritize equality, the result is highly unequal, treating unequals the same in the school. The failure of public schools is lamented as a result of inadequate funding, which is totally orthogonal to the drivers of their poor performance.

In a totally different fashion, affirmative action creates greater inequality via mismatching minorities, putting them in groups where they are underqualified, leading to greater discouragement and switching to easier majors that aren't as helpful. In healthcare, making everyone have the same 'rights' to health care inflates our health costs. Trying to ameliorate inequality via top-down directives is invariably counterproductive at the limited objective of reducing inequality.

What makes private institutions excellent is that they have the right to exclude those who ruin it for everyone. They require an investment by their consumers so they don't take these things for granted, but rather respect their access.  This should give those at the bottom an incentive to do well, and a place to go if they do well. In contrast, by making all their public opportunities non-exclusive regardless of behavior, everything is lessened and individuals have less incentive to become better persons to get access to these better things, and also ruin it for everyone else. My city library is way station for noisy kids, so I never hang out there.

Most liberal think prioritizing equality in education, crime, and parks, is an obvious way to increase our wealth, which not coincidentally takes the rich down a notch, unaware that these same policies just make inequality not as much within schools as between them. Forcing everyone to have the same public school/library/healthcare will merely create a two tier systems and raises costs for everyone. There are lots of things we can do to help our infrastructure and public objectives right now, but they aren't nearly as popular because they don't take power away from the rich and give it to bureaucrats (eg, allow nurses to distribute penicillin, allow power plants to invest in the best technology, don't force refineries to use ethanol, give students education vouchers). The failure of past government policies is a poor reason for a larger government.

Monday, November 19, 2012

Another Overnight Return Puzzle

An interesting fact of returns is that all of the stock returns since 1993 are from overnight returns. Here are the total returns using only Close-Open (overnight) vs. Open-Close (intraday). The intraday returns  are basically flat over the past 20 years.

That's a curiosity  because 2/3 of the risk of stocks is from their intraday returns--measured by beta or volatility--so if return is compensation for risk, it doesn't seem consistent with that theory. However, there is further nuance I discovered that I haven't seen anywhere else. If you take all the tickers, the top 1000 non-etfs over the past 2 years, and rank them by prior daily volatility, and then look at their overnight returns, you see that volatility is strongly positively correlated with subsequent overnight returns, which then reverse over the next day session.

So it appears that cross-sectionally, volatility receives a positive overnight risk premium, a negative intraday one.

I couldn't figure out a way to make money off this, obviously. Note that if the average price in this sample is $43, making 0.15% generates 6 cents. Sounds great, but actually the returns are more concentrated for the lower-priced stocks, generating a return very close to the spread, ticker-by-ticker.

 While I think this pattern retains because it is too small to arbitrage, it is an interesting residual pattern. I think it is best explained by something like this: high vol stocks are targets of intraday trading. This demand is generally positive, and so what you have are returns being depressed at the end of day from day traders selling and closing their positions, returns at the beginning of the day pushed up by the day traders opening positions (generally buying).

Sunday, November 18, 2012

Is Low Vol a Beta Phenomenon?

Eugene Fama states that the low volatility anomaly is really just the excess return low beta, and this has been well known for 50 years. I think its indisputable that low beta underperforms high beta, but I guess that's a fun fact of contention. It's fun to find yourself on the minority side of a fact you think other's don't agree with.

His mention of 50 years can only mean that the Security Market Line (ie, relating beta to average returns) is insufficiently increasing, positive but not as much as theory suggests. That's one implication of the low volatility anomaly, but it's much worse than that. The Low Volatility anomaly targets two things Fama can't admit: the Security Market Line is negative, and the essence of low vol investing is vol, not beta.

Here's the total return on three portfolios: the aggregate market,  the top 1500 stocks (in market cap, non etfs, nonfinancials) with lowest beta, those with highest beta.  High beta does significantly worse, and low beta significantly better, than the market as a whole.

As per Low Beta being the essence of the Low Volatility Anomaly, here's the stats on monthly returns for portfolios formed via low volatility, low beta, and the market (as a comparison).

Now, the Sharpe is igher, supposedly  is because of the value loading, which is higher for low volatility portfolios.  But look at how a low volatility portfolio amongst the bottom 50% of book/market stocks (aka growth stocks) does, relative to the low beta portfolio:

On a Sharpe level, the low vol sorting produces a greater anomaly than the low beta sort, and this is highlighted by fact that the Sharpe ratio disparity persists with the below average book/market subset.

In all dimensions, the volatility sort is more anomalous than the beta sort. Further, there is a return premium to low beta/vol, which simply can't be fit within the standard model.  

Tuesday, November 13, 2012

Online Education's Advantage

I'm a big fan, and hope the best for Marginal Revolutions new online class, as Alex Tabarrok notes:
Dale Carnegie’s advice to “tell the audience what you're going to say, say it; then tell them what you've said” makes sense for a live audience. If 20% of your students aren’t following the lecture, it’s natural to repeat some of the material so that you keep the whole audience involved and following your flow. But if you repeat whenever 20% of the audience doesn’t understand something, that means that 80% of the audience hear something twice that they only needed to hear once. Highly inefficient. 
Carnegie’s advice is dead wrong for an online audience. Different medium, different messaging. In an online lecture it pays to be concise. Online, the student is in control and can choose when and what to repeat. The result is a big time-savings as students proceed as fast as their capabilities can take them, repeating only what they need to further their individual understanding.

Little 20 minute expositions of some fundamental principle, by a teaching all-star, would seem to dominate your average professor. I hope this progresses enough so that my kids can safely skip college and learn what they need online. I'm sure there will be alternatives for them to learn social skills and form valuable cliques and like-minded aquaintences.

My only beef with MR's course is the subject: developement economics.  If there's one subject that defies economic analysis, it's development, as there's no consensus on what ails Africa, or Haiti. What are the odds they have something useful to say about how to make an average poor country better? Economists didn't support Konrad Adenauer when he brought West Germany out of ruin after WW2, or any other economic success story. Instead, look at the post colonial stagnation cheered on by Western elites who thought there's a 'third way'.

Monday, November 12, 2012

Government Response to Scarcity: Make it Free

So, someone decided to make gas free in areas affected by the big northeastern storm, but needless to say, they ran out.  Connecticut, New Jersey, and New Yorkers can report price gouging at telephone numbers and websites. Chris Cristie, recent recipient of the Cato's Friedman Prize, is pursuing these cases as well. 

Arbitrageurs are the criminals in this drama. This is bad because people should be able to pursue their own advantage openly, frankly and honestly, as opposed to poseurs, those doing good by spending other people's money on other people, usually only temporarily because it's hard to sustain.

 Now, why would this instinct against arbitrageurs be so common? Consider the case where someone is offering a high price because they are taking advantage of the customer's ignorance, not because supplies are tight and the new equilibrium price is higher. That's the intuitive feel of gouging, that the bad price isn't an emergent phenomenon, but a personal one. The solution is to promote competition via entry, which exist mainly in the form of safety and fairness regulations. A system to prevent gouging might lower the prevalence gouging, but still not be as good as one where people would occasionally be gouged, but competition and high prices would allocate resources more efficiently, and the higher prices would increase supplies from less urgent uses and areas.

The same could be said for all sorts of financial regulations. They only help the Goldmans of the world. The sad thing is that the primary help offered by government, regulations and rules, discourage entry and competition. This is why I am in favor of shrinking government: it is generally counterproductive.

Sunday, November 11, 2012

Interview with Eugene Fama

Always insightful:
I was in Belgium for two years working solo. When I returned, I showed Merton Miller my research produced over that two year period, and he put aside most of it with the comment, “Garbage.” He was right on every count...
[Pensions] should be discounting the liabilities at the expected return implied by the risk of the liabilities, not the expected return on the assets. The liabilities are basically indexed claims—like a TIPS (Treasury Inflation-Protected Security). Therefore, the appropriate discount rate on the high side should be about 2.5%, not the 7% or 8% that the plans are using now...
In Daniel Kahneman’s book Thinking, Fast and Slow, he states that our brains have two sides: One is rational, and one is impulsive and irrational. What behavior can’t be explained by that model?...
Litterman: What’s your view of the purported excess return of low-volatility stocks? Fama: The excess return is really a result of low beta, not low volatility, and this potential source of return has been well known for 50 years. When the first tests of the CAPM were done, the problem always out front was that the market line, or the slope of the premium as a function of beta, was too low relative to what the model predicted. This meant that low-beta stocks had higher returns than predicted and high-beta stocks had lower returns than predicted....
I agree with Fama on almost everything, the exception being the risk premium. Fama seems to think the Security Market Line (SML) is increasing but too flat, rather than downward sloping. The return premium to low volatility equity portfolios is a profound fact and many experts can't see, even though it's there in the data, and the returns of traded low volatility funds. A 'too flat' SML is one thing, a negative one, quite another. One implies tweaks, the other, a paradigm shift. 

Wednesday, November 07, 2012

Election Bounce

The Financial Times (Lex) had the following trading advice for people willing to make financial bets based on political hunches (I can't link to it because the FT is very cagey on allowing links):

Obama wins: buy Treasuries, (sell gold as hedge), sell stocks
Romney wins: sell bonds, buy dollar and stocks

Obama won, stocks opened down, Gold is up, and Treasuries are up. Not bad advice.

Monday, November 05, 2012

Idiocracy in Action

Ideally, politics is about coming up with a set of understood compromises on issues trading off redistribution and efficiency. As most people have instincts on the long run effects of their favored policies but no definitive proof, people tend to be get very frustrated and emotional discussing these issues because we don't like arguing about things we believe but can't prove. I believe a smaller scale and scope of government would increase welfare, but alas my proof does not fit in a blog post (sort of like Fermat's last theorem).

National politics is about convincing the demographic that votes for American Idol to agree with you.  When I used to teach at Northwestern University I occasionally asked what students thought about popular topics like  'free trade' or 'market efficiency'. Their opinions were so poorly articulated and founded, I stopped doing that. It did not help to have people riff on subjects they really didn't understand, the errors were so numerous and fundamental it simply was a waste of time.  I realized then that gaining their support would either rely on authority--believe me because I have these credentials--or slick salesmanship. Both methods are not good at converging upon truth. In the end I tried to explain some fundamental ideas showing why, given certain assumptions, one could think something was optimal, so the best case scenario was not definitive anyway.

In this environment it's sad that the great unwashed directly elect a person with the power to make decisions over whether we should spend another $800B, or choose judges for their biases (given smart lawyers, is not hard to do for almost any bias).  This is not a wise way to make policy. Unfortunately, alternatives aren't obvious, and certainly not popular. For example, something akin to a literacy test would enhance our voting competence, but would statistically discriminate against certain groups, and I'm doubtful it would be more enlightened anyway. The old belief of J.S. Mill that if we merely educated everyone we would agree and choose wise policies is clearly wrong.

It's a paradox that pure democracy leads to more concentrated power, something known by Plato and the US founding fathers. As collectives get larger--the USA, Roman Republic, Galactic Senate--power gets more concentrated in the President or Emperor. I think this is because when a state is small, an aristocracy/oligarchy is concentrated enough to work, but it doesn't scale. At a certain point the aristocracy is fragmented but the titular head retains his power,  which is then amplified by his new relative strength, making the legislative branch a veto at best, a patronage machine at worst.  The House and Senate remain more powerful than the President, but they seem to lose stature every decade.

But most importantly for this day, voting in big elections does not matter at all. Consider you live in Florida, which decides the presidential election. You cast the deciding vote, your candidate winning by 1 vote. In such a case, the stakes are so high that very good lawyers would be called in, and the better or more powerful lawyers would find the definition of what constitutes a legitimate vote such that your decisive vote would be irrelevant. That is, lawyers can use one of several metrics of voting, some of which will show their candidate winning, some losing, for any close election (just like polls generate different results depending on demographics). That's what happened in Minnesota, where the Republican was winning the senate race by 700 hundred votes, but the much stronger Democratic party in this state had a much more vigorous counsel helping them 'recount' the votes, and eventually they counted more for their Democrat.  In the improbable case your vote matters, it will be the lawyers and not an individual vote that makes the difference. So no vote matters. QED. 

Sunday, November 04, 2012

Match of the Century

Kyle Dake wrestled David Taylor last weekend in a preseason match. Both are dominant college wrestlers, and they had a great match. Both were very cautious, and Dake won 2-1 in overtime (Taylor in blue, Dake in red, right). You can see it here.

Personally, I'm a Taylor fan. He goes for big moves more often, and I appreciate that. Sure, occasionally he gets pinned, but I prefer that type of style to the more methodical approach of Dake. I love guys who usually win big, risking the occasional loss, to those who never lose but do not dominate when they win. Their weight class has Tyler Caldwell of OSU as well, so this year should be very fun.

Thursday, November 01, 2012

Lakoff Refuted

George Lakoff has a theory that Republicans are master manipulators of emotions by their clever framing of issues. He sometimes says we are able to evaluate ideas on their own, he emphasizes the fact that people unconsciously respond to word associations, and form their beliefs based on these clever marketing strategies (it's a bit like how Samuelson used to say he was in favor of a modest Federal deficit but this was always mentioned when criticizing tax reductions or military spending, and never to suggest a Democrat should not spend more on social programs).   His big idea is to change words like 'taxes' to 'membership fees', and 'activist judges' to 'freedom judges', because then people will see things with his progressive lens.

In this TED talk, Mark Forsyth notes that the word  'President' was originally used to designate the US head precisely because it was meek: President was like 'presider'. Congress fought the Senate on what to call the head of the new US government, as the Senate wanted something less humble, something with more grandeur, but agreed to use the title 'President' temporarily, hoping that it would be changed later to something like Chief Magistrate. This highlights the nature of an temporary government policy.

The title of President doesn't sound so humble anymore because the US is the world's foremost superpower with 5000 nuclear warheads and 11 aircraft carriers. There are now 147 nations that use President for the title of the chief of state, mainly because they aspire to the US President's power. Reality changes words much more than words change reality.

As Machiavelli noted, it is not titles that honor men, but men that honor titles.