Gun and Bank Regulations

Recently, David Gregory brandished a 30-round magazine on his Sunday TV show as a prop. He knowingly violated a local law that prohibits those clips existing in the district, presumably because he knew he wasn't a real danger to anyone (as opposed to registered gun owners).  They were still talking about it today on the Sunday shows, and I found it amusing that the TV people seemed to think the issue was absurd.  Alas, life is often absurd, especially when tragic.

While it's true that this celebrity was not endangering anyone, to presume that makes a difference highlights the power of laws that often don't make much sense for particular cases. Little laws that entrap those who don't fall under the spirit of the legislation happens all the time. I was pulled into costly litigation that started out by arguing to the court that anything I did related to volatility, cash flow, and mean-variance optimization was verboten via a confidentiality agreement. This was preposterous, but to the court they were tenable accusations, and so started an unconstrained discovery process that was sure to find something (why privacy is important even if you aren't a criminal or prude: give enough data to a motivated adversary and they will find you guilty of something).

Every law, no matter how stupid when applied to something like Gregory's transgression, is based on a principle that can be bandied about, and equality before the law is one such principle. For example in my litigation the judge asked my adversary at various points "what is it you want?" referring to a specific strategy, concept, or algorithm that they might feel is their property. All they had to say was, "We want to protect our intellectual property!" and the judge let it go at that. If you want to use the law to hammer someone, the fact that there's nothing important in the specific application is irrelevant because you can always fall back on some high-minded principle, and you probably won't be challenged on it.  

So, the letter of the law matters quite a bit because most people aren't rich or famous.  There are so many laws regulating your average business that at any time one is probably being broken. This puts everyone at the mercy of their regulator's goodwill, because like David Gregory you will probably get off if the right people are on your side. If they are indifferent you are at the mercy of the mob, government, or wealthy antagonist.  

I'm sure a large complex financial organization like Citigroup is violating some laws all the time given 260k employees operating across the globe working in a highly regulated environment. That's why large financial companies hire people like Bob Rubin, Peter Orszag, or Bill Daley, because they need someone who can get access to those people who can squash an investigation.  

If you have a business worth a decent amount of money the most important priority you have is to get powerful friends and avoid powerful enemies.  The massive number of laws and regulations permits a hook for many to hurt you if they want to.  A better policy solution is to shrink the avenues of injustice by making the law more constrained, giving jerks fewer opportunities to hide small-minded motives behind some grand principle.  A larger set of rules, especially vague ones (eg, Obamacare) simply makes the system more corrupt, because simple things like 'outlawing 20 cartridge magazines' or "mandating more (or less) lending to poor people" creates a situation where people are at the whim of politicians.  

Bad things happen all the time because of vice, which I think is all based in ignorance and an absence of empathy (evil is always some combination of the two). When we try to eliminate bad things via more laws and top-down policies, it just creates a more capricious and unjust world. The solution is not more laws, but fewer.  

Samuelson on Keynes

I couldn't find this Samuelson essay online anywhere, so I'm posting it here. It's rather enlightening portrait from one of Keynes's main popularizers on the cusp of a career that never wavered in its Keynesian enthusiasm. I think it pretty clearly highlights that The General Theory was, as von Mises said, a 'tract for the times,' because it rationalized greater governmental involvement in the economy and is pretty inscrutable (Samuelson compares it to that great scientific treatise, Finnegan's Wake). It's a classic non-falsifiable book, because as Samuelson notes, it's obscure.

it bears repeating that the General Theory is an obscure book, so that would be anti-Keynesians must assume their position largely on credit unless they are willing to put in a great deal of work and run the risk of seduction in the process.

In other words, the GT is a giant spread argument where one can't pull out a single testable equation; the essence is a gestalt. Keynes didn't even understand it, according to Samuelson, so good luck convincing a true believer you know what the GT means and it is wrong--you just don't know what it means!  Further, it contains the old theory as a special case, so it's not incompatible with any of those assumptions, logically.

It should also be noted that when William Wordsworth wrote Samuelson's quote below ('bliss...') it was about the French Revolution, and the post-revolutionary terror was a recent memory, the Napoleonic wars were still raging. This poem was an ironic comment on the naiveté of youth. The French Revolution was the first modern revolution driven intellectually by the Rights of Man, a theory. While Wordsworth was initially a big supporter of the French revolution, like Orwell in Spain 150 years later, he became appalled by the increasing violence and fanaticism, and the resulting military officer taking charge to restore order. Like Edmond Burke, Wordsworth saw that ideologies are lethal abbreviations of thought. While the Keynesian revolution wasn't that destructive, it was, to my mind, a similar abbreviation of thought towards an ideology, a larger state, justified via 'aggregate demand' in Keynes's General Theory.

The Impact Of The General Theory.
Econometrica, July 1946.

by Paul A. Samuelson

I have always considered it a priceless advantage to have been born as an economist prior to1936 and to have received a thorough grounding in classical economics. It is quite impossible for modern students to realize the full effect of what has been advisably called "The Keynesian Revolution" upon those of us brought up in the orthodox tradition. What beginners today often regard as trite and obvious was to us puzzling, novel, and heretical. To have been born as an economist before 1936 was a boon—yes. But not to have been born too long before! 

Bliss was it in that dawn to be alive, But to be young was very heaven!

The General Theory caught most economists under the age of 35 with the unexpected virulence of a disease first attacking and decimating an isolated tribe of south sea islanders. Economists beyond 50 turned out to be quite immune to the ailment. With time, most economists in between began to run the fever, often without knowing or admitting their condition.

I must confess that my own first reaction to the General Theory was not at all like that of Keats on first looking into Chapman's Homer. No silent watcher, I, upon a peak in Darien. My rebellion against its pretensions would have been complete. Except for an uneasy realization that I did not at all understand what it was about. And I think I am giving away no secrets when I solemnly aver— upon the basis of vivid personal recollection—that no one else in Cambridge, Massachusetts, really knew what it was about for some twelve to eighteen months after its publication. Indeed. until the appearance of the mathematical models of Meade, Lange. Hicks, and Harrod, there is reason to believe that Keynes himself did not truly understand his own analysis. 

Fashion always plays an important role in economic science: new concepts become the 'mode and then are passe. A cynic might even be tempted to speculate as to whether academic discussion is itself equilibrating: whether assertion, reply, and rejoinder do not represent an oscillating divergent series, in which—to quote Frank Knight's characterization of sociology—"bad talk drives out good." 

In this case, gradually and against heavy resistance, the realization grew that the new analysis of effective demand associated with the General Theory was not to prove such a passing fad, that here indeed was part of "the wave of the future." This impression was confirmed by the rapidity with which English economists, other than those at Cambridge, took up the new Gospel: e.g., Harrod, Meade, and others, at Oxford: and, still more surprisingly, the young blades at the London School, like Kaldor. Lerner. and Hicks, who threw off their Hayekian garments and joined in the swim. 

In this country it was pretty much the same story. Obviously, exactly the same words cannot be used to describe the analysis of income determination of, say, Lange, Hart, Harris, Ellis, Hansen, Bissell, Haberler, Slichter, J.M. Clark, or myself. And yet the Keynesian taint is unmistakably there upon every one of us. 

Instead of burning out like a fad the General Theory is still gaining adherents and appears to be in business to stay. Many economists who are most vehement in criticism of the specific Keynesian policies—which must always be carefully distinguished from the scientific analysis associated with his name—will never again be the same after passing through his hands. It has been wisely said that only in terms of a modern theory of effective demand can one understand and defend the so called "classical" theory of unemployment. It is perhaps not without additional significance. in appraising the long-run prospects of the Keynesian theories, that no individual, having once embraced the modern analysis, has—as far as I am aware—later returned to the older theories. And in universities where graduate students are exposed to the old and new income analyses. I am told that it is often only too clear which way the wind blows. 

Finally, and perhaps most important from the long-run standpoint, the Keynesian analysis has begun to filter down into the elementary textbooks; and, as everybody knows, once an idea gets into these, however bad it may be, it becomes practically immortal.

Thus far, I have been discussing the new doctrines without regard to their content or merits, as if they were a religion and nothing else. True, we find a Gospel, a Scriptures, a Prophet, Disciples, Apostles. Epigoni, and even a Duality: and if there is no Apostolic Succession, there is at least an Apostolic Benediction. But by now the joke has worn thin, and it is in any case irrelevant. 

The modern saving-investment theory of income determination did not directly displace the old latent belief in Say's Law of Markets (according to which only "frictions" could give rise to unemployment and over-production). Events of the years following 1929 destroyed the previous economic synthesis. The economists' belief in the orthodox synthesis was not overthrown, but had simply atrophied: it was not as though one's soul had faced a showdown as to the existence of the Deity and that faith was unthroned, or even that one had awakened in the morning to find that belief had flown away in the night: rather it was realized with a sense of belated recognition that one no longer had faith, that one had been living without faith for a long time, and that what, after all, was the difference? The nature of the world did not suddenly change on a black October day in 1929 so that a new theory became mandatory. Even in their day, the older theories were incomplete and inadequate: in 1815, in 1844, 1893, and 1920. I venture to believe that the eighteenth and nineteenth centuries take on a new aspect when looked back upon from the modern perspective, that a new dimension has been added to the rereading of the Mercantilists, Thornton, Malthus, Ricardo, Tooke, David Wels, Marshall, and Wicksell. 

Of course, the great depression of the thirties was not the first to reveal the untenability of the classical synthesis. The classical philosophy always had its ups and downs along with the great swings of business activity. Each time it had come back. But now for the first time, it was confronted by a competing system—a well-reasoned body of thought containing among other things as many equations as unknowns; in short, like itself, a synthesis: and one which could swallow the classical system as a special case. 

A new system, that is what requires emphasis. Classical economics could withstand isolated criticism. Theorists can always resist facts: for facts are hard to establish and are always changing anyway, and ceteris paribus can be made to absorb a good deal of punishment. Inevitably, at the earliest opportunity, the mind slips back into the old grooves of thought, since analysis Is utterly impossible without a frame of reference, a way of thinking about things, or, in short, a theory. 

Herein lies the secret of the General Theory. It is a badly written book, poorly organized; any layman who, beguiled by the author's previous reputation. bought the book was cheated of his five shillings. It is not well suited for classroom use. It is arrogant, bad-tempered. polemical, and not overly generous in its acknowledgments. It abounds in mares' nests or confusions. In it the Keynesian system stands out indistinctly, as if the author were hardly aware of its existence or cognizant of its properties; and certainly he is at his worst when expounding its relations to its predecessors. Flashes of insight and intuition intersperse tedious algebra. An awkward definition suddenly gives way to an unforgettable cadenza. When finally mastered, its analysis is found to be obvious and at the same time new. In short, it is a work of genius. 

It is not unlikely that future historians of economic thought will conclude that the very obscurity and polemical character of the General Theory ultimately served to maximize its long-run influence. Possibly such an analyst will place it in the first rank of theoretical classics, along with the work of Smith. Cournot, and Walras. Certainly. these four books together encompass most of what is vital in the field of economic theory: and only the first is by any standards easy reading or even accessible to the intelligent layman. 

In any case, it bears repeating that the General Theory is an obscure book, so that would be anti-Keynesians must assume their position largely on credit unless they are willing to put in a great deal of work and run the risk of seduction in the process. The General Theory seems the random notes over a period of years of a gifted man who in his youth gained the whip hand over his publishers by virtue of the acclaim and fortune resulting from the success of his Economic Consequences of the Peace. 

Like Joyce's Finnegan's Wake, the General Theory is much in need of a companion volume providing a "skeleton key" and guide to its contents: warning the young and innocent away from Book I (especially the difficult Chapter 3) and on to Books II, IV and VI. Certainly in its present state, the book does; not get itself read from one year to another even by the sympathetic teacher and scholar. 

Too much regret should not be attached to the fact that all hope must now be abandoned of an improved second edition, since it is the first edition which would in any case have assumed the stature of a classic. We may still paste into our copies of the General Theory certain subsequent Keynesian additions, most particularly the famous chapter in How to Pay for the War which first outlined the modern theory of the inflationary process. 

This last item helps to dispose of the fallacious belief that Keynesian economics is good "depression economics" and only that. Actually, the Keynesian system is indispensable to an understanding of conditions of over-effective demand and secular exhilaration; so much so that one anti-Keynesian has argued in print that only in times of a great war boom do such concepts as the marginal propensity to consume have validity. Perhaps, therefore, it would be more nearly correct to aver the reverse: that certain economists are Keynesian fellow-travelers only in boom times, falling off the band wagon in depression. If time permitted. it would be instructive to contrast the analysis of inflation during the Napoleonic and first World War periods with that of the recent War and correlate this with Keynes' influence. Thus, the "inflationary gap" concept, recently so popular. seems to have been first used around the Spring of 1941 in a speech by the British Chancellor of the Exchequer, a speech thought to have been the product of Keynes himself. 

No author can complete a survey of Keynesian economics without indulging in that favorite in-door guessing game: wherein lies the essential contribution of the General Theory and its distinguishing characteristic from the classical writings? Some consider its novelty to lie in the treatment of the demand for money, in its liquidity preference emphasis. Others single out the treatment of expectations. 

I cannot agree. According to recent trends of thought. the interest rate is less important than Keynes himself believed…As for expectations, the General Theory is brilliant in calling attention to their importance and in suggesting many of the central features of uncertainty and speculation. It paves the way for a theory of expectations, but it hardly provides one. I myself believe the broad significance of the General Theory to be in the fact that it provides a relatively realistic, complete system for analyzing the level of effective demand and its fluctuations. More narrowly. I conceive the heart of its contribution to be in that subset of its equations which relate to the propensity to consume and to saving in relation to offsets-to-saving. In addition to linking saving explicitly to income, there is an equally important denial of the implicit "classical" axiom that motivated investment is indefinitely expansible or contractible, so that whatever people try to save will always be fully invested. It is not important whether we deny this by reason of expectations, interest rate rigidity, investment inelasticity with respect to overall price changes and the interest rate, capital or investment satiation, secular factors of a technological and political nature of what have you. But it is vital for business-cycle analysis that we do assume definite amounts of investment which are highly variable over time in response to a myriad of exogenous and endogenous factors, and which are not automatically equilibrated to full. Discussion employment saving levels by any internal efficacious economic process.

With respect to the level of total purchasing power and employment, Keynes denies that there is an invisible hand channeling the self-centered action of each individual to the social optimum. This is the sum and substance of his heresy. Again and again through his writings there is to be found the figure of speech that what is needed are certain "rules of the road" and governmental actions, which will benefit everybody, but which nobody by himself is motivated to establish or follow. Left to themselves during depression, people will try to save and only end up lowering society's level of capital formation and saving; during an inflation, apparent self-interest leads everyone to action which only aggravates the malignant upward spiral

Ben Graham: Relative Utility Investor

One of my themes in The Missing Risk Premium is that people i people are benchmarking--aka relative utility investors--then they only deviate from the benchmark of what everyone else is doing  when they feel they have an edge. There's no other reason to do so. As many people falsely believe they have an edge in highly risky (antifragile?) stocks, this causes these securities to have lower-than-average returns within bonds, stocks, options, horses, and lotteries.

It's important to recognize this is the reason people take concentrated bets. The Wall Street Journal has an article on an old colleague of classic value investor Benjamin Graham, and notes the 107 year old's guiding principle:

His abiding goal, he told me, is "to know much more about the stock I'm buying than the man who's selling does."

That's a good rule, often noted by Graham. It's obviously impossible, in aggregate, but I think it's not only descriptive, but good normative advice. If you know that's the game you are playing, it should create greater caution, more sober risk-taking. The alternative is that you can take big risks and these generate return premiums via their risk premium, but alas the risk premium is usually negative, so that theory seems falsified via conventional empiricism.

The High Price of Low Delta Options

Antti Ilmanen and Frazzini and Pedersen have papers highlighting the poor returns to low delta options. This highlights the power of prediction markets, in that since Alpert and Raiffa (the working paper is dated 1969) we have know that people over estimate their confidence for 1 and 99% probabilities:  these are more like 10 and 90%, respectively. Yet, these are surveys. When people put money down on these improbably (or highly probable) events, the estimates are actually too timid.

Consider the imminent apocalypse.  The End of the World is given a meager 1000:1 odds:

Paddy Power is also offering a fairly skimpy 1/1000 that the sun will rise on the 22nd.

Other betting sites offer only 500:1 odds. So, when someone says 'everyone thought' or 'no one thought', don't think this implies there was easy money. Even if the odds are as great as the absence of an apocalypse, you'll get something more like 500:1 with real money. Needless to say, this materially affects the expected value.

Another Crank

As critic of modern economics, I am often contacted by other critics, or fans of other critics. Alas, I often find them not even wrong, as in

2 + zebra ÷ glockenspiel = homeopathy works!

 Steve Keen was recommended, and I looked him up. Interestingly he's a huge Minsky fan. I admire Minsky, because he was intellectually honest and curious, and had some really good insights. If you read his books you'll learn a lot about US macro history from a financial perspective. However, he wasn't perfect. He dismissed microeconomics as apologetics, and so basically ceded that whole field as irrelevant. He didn't try to convince his colleagues, rather, he would dismiss them as fools, and so they would dismiss him. He was forever anticipating another 1929 crash, and would get very excited if the Dow was down a lot intraday (alas, back in the 1980's it would always bounce back). His macro model he failed to concisely formulate, not just in a model, but even in words.

 Minsky should have said his theory was based on endogenous instability from excessive leverage, and then one could have tested it, and found it doesn't work: aggregate leverage is not a great leading economic indicator. I too believe the economy is endogenously unstable. That is, unlike Friedman and other free-marketers who believe recessions are caused by government, I think it usually happens simply via systematic errors among private investors. But unlike Minsky, I think it's more micro-based, happening idiosyncratically in a different subsector of the economy. It's more like an eco-system of Batesian mimicry, where over time mimics fester and create a phase shift in the system as predators learn that, eg, all those poisonous snakes are actually non-poisonous, and a havoc occurs until equilibrium is restored.

The key is that the excesses occur in different industries, using different metrics, every cycle. Off the top of my head, here are the focal points for some big recessions; railroads (1893), conglomerates (1969), oil and real estate (1990), internet (2002), residential real estate (2008). What's consistent is that they are all different. Every cycle is predicated on some new 'new thing' that survived the prior two or more recessions, and thus to most participants is their entire working life.

 Like Minsky, Keen was predicting a crash, and so when one happened, he took credit, just like others (Roubini) with a vague, persistent prediction of a crash whose reputations were burnished by the 2008 crisis.  It makes me think that if something unpredictable happens, like the Mayans really do come back this Friday, those who predicted it won't be prescient, but rather, cranks.  In an case, reading Keen I see he picks up Minsky's dismissal of modern economics. However, Keen takes this to the next level by saying that economics is based on a math error. Now, economists I think have made a mistake, but they are pretty good at working from assumptions to conclusions, that's brute force logic, and there are lots of really smart economists who can solve logic puzzles.

He seems fixated on the market power of firms that are small, not infinitesimal  He thinks they act like monopolists, showing a math error at the root of Samuelsonian neo-classical economics. It reminds me of that guy who thinks fat tails or stochastic parameters invalidates financial theory.  This is simply wrong, but as a rhetorical device I think it convinces a lot of people that he's proved the existing theory is wrong, thus in some way proved his alternative is correct (not that this is logical, just it seems to work on many readers).  He then builds up a pretty standard 1970's macro model to show how money is endogenous and whips us through cycles, as if this wasn't tried for a generation and failed. These models have so many equations and parameters one can't prove them wrong, but then, they don't have unambiguous predictions, just fit the past really well. Thousands have wasted their lives on these approaches. A good way to judge a jumble is to look at the results: what to do? His solution to current problems is to simply print money and pay off everyone's debt. Such a solution doesn't deserve much consideration, because when I have time to think of wacky theories, I prefer Ancient Alien Astronauts or stories of the Mayan Apocalypse.

Like other successful cranks, Keen does seem intelligent, and makes some very good points. But net net, his Weltanschauung has more flaws than what he's criticizing. It's easy to note that existing theory is deficient, much harder to present a coherent, more attractive alternative.  It reminds me of a high school class I took where we all got to give a speech criticizing some great thinker of the past, like Socrates, Nietzsche, or Kant. We all did great. Then, we had to present our own new theory on something important, and it was pretty humiliating. Lesson learned.

I hasten to add I  don't hate all macro critics. For example, I really enjoyed Peter Schiff's The Real Crash. And of course, I think I have a rather pointed criticism of finance that doesn't throw the baby out with the bathwater, and has clear empirical implications. But, I realize I am lumped in with the numerous other critics, and that's kind of depressing.

Cult of the Presidency

Watching the media's anticipation of Obama's press conference after the tragic school shooting in Connecticut, I was reminded of the great book The Cult of the Presidency by Gene Healy, where he notes the president is now expected to be, among many other things, the Consoler in Chief, our national chaplain in times of great tragedies. The President originally was someone who would simply officiate the congress, which was the main body for enacting legislation. Just as the senate in the Roman Republic ruled, so the founders wanted the congress to rule the country.  Early Presidents didn't propose bold legislation or even really campaign.

It is now the President’s job to grow the economy, teach our children, provide protection from terrorist threats, and rescue Americans from spiritual malaise. It's an impossible job, yet as our dissatisfaction with the President increases, the amount of power he wields grows. We are morphing towards an emperor, a Putin.

William Hazlit wrote in 1819 that "Man is a toad-eating animal [ie, a toady], naturally a worshipper of idols and a lover of kings." He saw behind this impulse a crave desire to dominate others, even if only vicariously. "Each individual would (were it in his power) be a a king, a God; but as he cannot, the next best thing is to see this reflex image of his self-love, the darling passion of his breast, realized, embodied out of himself in the first object he can lay his hands on for the purpose."

It's not a left-right thing, too many venerate the Elmer Gantrys who become President. Yet a funny anecdote was provided by liberal Nina Burleigh, former White House correspondent for Time magazine, who noted during the Lewinsky scandal that she'd "be happy to give [Clinton oral sex] just to thank him for keeping abortion legal. I think American women should be lining up with their presidential knee pads on to show their gratitude for keeping theocracy off our backs." It's nice to see her thinking she's above those who venerate religion, but instead of championing skepticism and rationality, worships the simple hucksters who make all those trite speeches

The Trolley Problem

Over on Bloggingheads, some psychologists were discussing the neurology of moral judgments. They discussed the trolley problem, which is pretty famous among moral philosophers.  The basic conundrum is this:

A trolley has lost its brakes, and is about to crash into 5 workers at the end of the track. You find that you just happen to be standing next to a side track that veers into a sand pit, potentially providing safety for the trolley's five passengers. However, along this offshoot of track leading to the sandpit stands a man who is totally unaware of the trolley's problem and the action you're considering. There's no time to warn him. So by pulling the lever and guiding the trolley to safety, you'll save the five passengers but you'll kill the man.

Most people pull the switch, killing the one man to save five. That wouldn't be so interesting by itself, but then the problem is extended to a seemingly similar problem:

As before, a trolley is hurtling down a track towards five people. You are on a bridge under which it will pass, and you can stop it by dropping a heavy weight in front of it. As it happens, there is a very fat man next to you – your only way to stop the trolley is to push him over the bridge and onto the track, killing him to save five. Should you proceed?

Most people would not push the fat man. These grave dilemmas constitute the trolley problem, a moral paradox first posed by Phillipa Foot in her 1967 paper, "Abortion and the Doctrine of Double Effect." I don't really like any of the popular resolutions as to why people think it's OK to kill the first guy but not the second.

I think a good resolution is that in the second case there is a significant probability that one does not save the 5 men, and instead merely kills the fat man. I've never pushed a fat man in front of a trolley, but I suspect most would simply run right over him and keep going. In the first case, if you  killed the one man you definitely save the five men, it's not possible to kill both the one man and the five men by switching tracks. In the other case the probability is clearly less than 1, perhaps only 0.1. That's the difference. As a rule, acting on a theory and killing x people with certainty to perhaps save 5x people is morally wrong, mainly because these theories are often wrong, so all you do is kill x people (eg, a lot of evil is legitimized as breaking eggs to make an omelette, but then there's no omelette). The move from certainty to mere 'highly likely in my judgment' is huge.

Great Minds Confabulate Like Small Minds

James Heckman won a Nobel Prize for his work on econometrics, statistics applied to economics. His latest work on education looks at the effects of programs on human capital.

In a recent Boston Review article on social mobility he highlights the results from two experiments in early childhood intervention that demonstrated significant benefits. Charles Murray was one of several comentors  Murray noted these programs were small, having about 60 kids in each, and so are probably random outliers among the many different programs being conducted. After all, one really great teacher undoubtedly can make a difference in such a small sample, but really great teachers, by definition, aren't easy to replicate. Heckman, as is his wont, responded rather angrily that

Charles Murray mischaracterizes the quality of the evidence on the effectiveness of early childhood programs. In doing so he suggests that my evidence is highly selective. The effects reported for the programs I discuss survive batteries of rigorous testing procedures. They are conducted by independent analysts who did not perform or design the original experiments. The fact that samples are small works against finding any effects for the programs, much less the statistically significant and substantial effects that have been found.

A small sample will have more trouble demonstrating statistically significant results--it has low 'power'--so Heckman is technically correct. But it's not as if these two programs were the only ones generated since 1962; these are really order statistics, not simple statistics. I see job seekers with fabulous backtests all the time, and cherry picking winning algorithms applied to a large class of rules is the most common problem.

As Einstein noted, "common sense is nothing more than a deposit of prejudices laid down in the mind before you reach eighteen." That a great econometrician could dismiss the clear selection bias in a couple of 60-kid studies selected out of hundreds (thousands?) highlights that no amount of education or intelligence can overcome one's prejudices, or overcome one's common sense.

Shorting Green Energy

A Business Insider post showed the remarkable 98% decline in the RENIXX since 2008, and index that tracks the world´s 30 largest companies in the renewable energy industry.

I found a green ETF, GEX,which is Market Vectors Global Alternative Energy fund. It's down about 85% since 2008.

Perhaps there's a very simple strategy here.

Marxism Lives

Paul Krugman vaguely implies that productivity is the cause of stagnant wage growth, in that robots are taking over former 'good' jobs. 20 years ago he railed against those kind of theories, but now he notes that for this theory:

It has echoes of old-fashioned Marxism — which shouldn’t be a reason to ignore facts, but too often is.

His insinuation is we are ignoring the rise of the robot elite because of anti-Marxist ideology. I'm an anti-Marxist ideologue because I think Marxism is wrong: it's based on false assumption about value (ignores the marginal revolution) and the omnipresence and importance of class war, and doesn't work empirically (socialism starting in the most productive states, the falling rate of profit, lower wages over time, an increase in the breadth of recessions).

Big bad ideas like socialism never die. The desire to expropriate the rich and make all businessmen kowtow to government really drives people like Krugman, and the class struggle paradigm, where the captains of industry are parasites and the proles are Job-like in their devotion and suffering, is very attractive to these people.  A recent Gallup poll found 53% of Democrats had 'favorable' views on socialism, and Peter Schiff found many Democrats who favored a ban on corporate profits.

Hong and Sraer's Explanation of the Low Vol Anomaly

In 1977 Ed Miller proposed a simple model where greater dispersion in in beliefs generated a greater price for stocks because those holders of a stock are in the 95th percentile of valuation, and given a constant mean, a higher variance implies a higher 95th percentile. Key to this model is the short sales constraint, because otherwise sellers would see these assets as overpriced and short them. Another key is limited rationality, because people should simply not include high beta assets in their portfolio; the market portfolio is dominated by one that excludes high volatility assets.

Harrison Hong and David Sraer have a new version of their Speculative Betas paper (see here).   It is basically the Miller model though it's more dynamic, and they emphasize the 'new' finding that their model shows that when there is greater disagreement, there will be a greater low volatility premium.  I don't think that's really new, in that it follows pretty straightforwardly from the Milller model.

It's an alternative to the 'constrained leverage' model of Frazzini and Pederson. However, like Frazzini and Pederson I don't see how it's consistent with the below average returns. Lower than CAPM is different than lower than average. Further, it requires irrationality by those who don't have opinions on stocks, because it seems obvious that investors without a view should simply avoid high volatility stocks in their index funds. Thus, in both these models, low volatility investing should be much more popular than it is.

I think low volatility investing is a fringe strategy still because of tracking error, the fact that one underperforms 'the market' too much too often. Sure, over time it's a higher Sharpe ratio, but the real objective is a relative return, or an Information Ratio. This is an equilibrium, requiring no ad hoc constraints or massive irrationality if one presumes a relative status utility function, as I propose in my book The Missing Risk Premium.

When I documented the low return to highly volatile stocks, the main reason professors found it unconvincing was because it implied irrationality. I didn't think of the relative utility solution, and that basically only leaves theories with ad hoc constraints and massive irrationality. That was certain irrelevance circa 1993, but after 20 years several trends in the zeitgeist have changed a lot, in large part due to the increase in behavioral finance, Freakonomics, and the simple persistence of the low volatility cross-sectional fact.  But I guess I have the intellectual equivalent of Stockholm syndrome, as the irrationality obstacle was simply burned into my brain. I don't like results that imply massive arbitrage to this day.

Taleb's Sokal Hoax

Taleb's latest book he mentions a little trick he played on academics, basically, he created a bunch of nonsense in abstruse mathematics just to highlight what fools they are. Here's his description of this work in Antifragile:

According to the wonderful principle that one should use people’s stupidity to have fun, I invited my friend Raphael Douady to collaborate in expressing this simple idea using the most opaque mathematical derivations, with incomprehensible theorems that would take half a day (for a professional) to understand ... Remarkably—as has been shown—if you can say something straightforward in a complicated manner with complex theorems, even if there is no large gain in rigor from these complicated equations, people take the idea very seriously. We got nothing but positive reactions, and we were now told that this simple detection heuristic was “intelligent” (by the same people who had found it trivial).

I presume this refers to his SSRN paper, Mathematical Definition, Mapping, and Detection of (Anti)Fragility. It contains a lot of unnecessarily complex notation, technically correct and totally meaningless. He basically defines anti-fragility as the difference between the expected value of a function and a function of an expected value over some arbitrary range of that function, and notes that nonlinear functions are more volatile than linear functions, and you want to be long convex payouts.

Taleb doesn't present any data suggesting it is useful for pricing or managing risk, just mentions some really simple examples (stress tests for where unemployment is 8% and 9% that are typical guesses of macro) that highlight how losses can increase exponentially for different assumptions. For complex systems like large corporations, assessing the effect of macro inputs is a similarly vague exercise if you've ever been witness to them (to get a sense, ask yourself what your net worth would be if GDP fell by 5% or 10%).

He then asserts:

It outperforms all other commonly used measures of risk, such as CVaR, “expected shortfall”, stress-testing, and similar methods have been proven to be completely ineffective... It does not require parameterization beyond varying Δp

So, the 'data' showing his equations are helpful are stress-test thought experiments, but this supposedly dominates this same test as well as everything else. Further, it does require density functions for the inputs, and functional forms, subjective thresholds, which for anything like a corporation is simply not amenable to such precision; for specific assets or portfolios there are more direct tools (eg, in options, kurtosis, twist, rho). Like so many things he says, this is not even wrong.

He tried to intimidate a journalist at FTAlphaville with this, and the journalist basically said 'whatever.' The paper was presumably accepted by Quantitative Finance, a journal where Taleb often publishes and seems highly favorable towards his work. This seems identical to the infamous hoax by Alan Sokal, a physics professor who submitted an intentionally meaningless article  to Social Text, an academic journal of postmodern cultural studies. However, Sokal was mocking the journal and its readers by publishing self-acknowledged gibberish. Taleb's mocking his biggest fans ('stupid', he calls them). I bet the journal editor won't find this very amusing.

By admitting that his models are merely "expressing [a] simple idea using the most opaque mathematical derivations, with incomprehensible theorems that would take half a day (for a professional) to understand", he's admitting his math does not add, it's merely to impress via excessive abstruseness. Surely many academics have created excessively technical articles reluctantly, but this shows real bad faith on his part, because presumably this journal aspires to apply rigor in pursuit of making ideas as clear as possible, not the opposite. I must admit it's kind of funny, but perhaps too mean.

New Low Vol Index

This one is a bit too cute for me. The CBOE LOVOL Index combines a portfolio of SP 500 stocks and simultaneously selling SPX calls and buying one-month VIX 30-delta calls on a monthly basis. The LOVOL mix of VIX and SPX options reduces the chance of shortfalls below -10% but still preserves the bulk of market gains. By construction, the LOVOL delivers returns between the BXM and VXTH, or a risk profile between a cushion and a tail hedge.

The key seems to be reflected in the following total return chart above, where you have the new index in orange, the SPY in white. The low vol index generated a lower downturn in the 2008 recession. Alas, these are indices created post-2008, so they overstate the benefits (backtest always look better than real-time). Further, the benefits are pretty small, just in really big downturns...perhaps.

Embedded Leverage and Returns

Frazzini and Pedersen, the duo behind AQR's Betting Against Beta theory behind the low vol anomaly, have a new paper out on embedded leverage. Their theory is basically that investors are constrained in their allocation to equities, so overload on those equities with the highest betas in order to get more equity exposure. The paper looks at both levered ETFs, and options (from 1996-2010).  Here's a graph showing the embedded leveage (aka omega) in options, and monthly returns.

Monthly Returns (y-axis) and Option Omega (x-axis)

This adds more data to the fact that options are not just bad investments, but worse the more out-of-the-money they go. These are horrible long investments (large negative returns to out-of-the-money aka AntiFragile options)

I don't really see how this comports with their theory, however, because if investors want more access to the equity factor, they are getting extremely negative returns. Thus, it really isn't a rational theory of constrained optimization, but delusional speculation.  Further, investors are acting the same to puts and calls, and constraints on access to short positions doesn't seem to make sense in their model unless they have heterogeneous (and persistently wrong) beliefs.  So, the idea that rational, constrained, investors explains this effect doesn't make any sense.  Perhaps they can explain.

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.

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.

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. 

~Goethe 

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.

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).

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.  

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'.

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.

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.