The Emergent Nature of Doing Good

Ex-Goldman employee Greg Smith wrote a New York Times editorial on the standard lament that his company doesn't care about the customer any more:

Today, many of these leaders display a Goldman Sachs culture quotient of exactly zero percent. I attend derivatives sales meetings where not one single minute is spent asking questions about how we can help clients. It’s purely about how we can make the most possible money off of them.

He sees the problem that his company maximizes profits, not helping the customer. This is a common refrain, one made by Einstein, who noted that socialism was better than capitalism because one system produces for everyone, the other for profit.

People serve others in modern society in very nonintuitive ways. In small tribes we are pretty aware of who is part of the team and who is a loafer, and how our stuff gets there. In modern society, by contrast, we have things as simple as pencils that we simply could not make even if we knew how to make it. We all rely on a vast number of things we have no way of making ourselves, from our iPad to our breakfast, and it isn't possible for everyone to go back to being a hunter-gatherer even if we wanted to, our productivity would be insufficient to feed everyone.

Adam Smith presented the argument on the invisible hand, how the self-interest of the butcher and blacksmith incented them to create goods and services that, in a competitive market, lead to specialization, cost minimization, and gains from trade. As a businessman, profit is one of the better signals of value out there simply because everyone else likes profit too, so you have identified an area where you are literally creating value. This is a highly counterintuitive point, and so most people simply don't believe self-interest is consistent with a good society, because that's not how their family works.

The problem is, altruism is very specialized in focus, whereas self-interest is not. Altruism is centered on people related to us, where I would sacrifice myself for my two siblings, or 8 cousins, thus, unconditional charity does not generalize from kin to non-kin very well. However, there is reciprocal altruism, basically helping other who can help you regardless of genome, and this is where it truly pays to understand how to service a customer--but only for the end-result of making money! It happens all over the animal world, as you see animals expending valuable resources towards another, yet only if there's some quid pro quo (eg, flower and bee, plover and alligator).

Recent support for this comes from a variety of sources, and the latest is a paper in Science--Markets, Religion, Community Size and the Evolution of Fairness and Punishment--by Joe Henrich et al, who administer fairness experiments across 15 diverse populationsand found that more commercial societies tended to be fairer. That is, people are nicer the more commercial they are, because being nice is good business. It took McDonald's to get Muscovites to smile.

The world is not filled with people like your mom and dad who showered you with love and resources merely for being you. It is filled with people totally indifferent to you except in so far as you can help them. If that makes you sad you really haven't thought about it, because a society of that much love would be really oppressive--even just one mom can be smothering, imagine thousands of her.

Smith then ends with a riff that really underscores the weakness of his point:

My proudest moments in life — getting a full scholarship to go from South Africa to Stanford University, being selected as a Rhodes Scholar national finalist, winning a bronze medal for table tennis at the Maccabiah Games in Israel, known as the Jewish Olympics — have all come through hard work, with no shortcuts.

Talk about selfish, such accomplishments didn't help anyone but him! There is no customer that will pay for self-indulgent status climbing in irrelevant hierarchies, regardless of how much we encourage our kids to play such games. That is, ping pong is a fabulous avocation, a pathetic vocation. We all want our children to play and engage in poetry, and when they excel at these things we are rightfully proud. Yet these are things kids do to develop skills like discipline, creativity, courage, that ultimately are valuable because of what they can do for others. They are not good in themselves, at least to society at large.

A similar quandary comes up in other domains such as science. The objectivity of science is not primarily from the integrity of scientists, but by scientists competing with others about how to explain the real world. As the left-brain is constantly rationalizing beliefs and data it receives from the right side, rationalization is the default method of reasoning whether we like to admit it or not. It helps to be on the side of truth because it's a lot easier and more fruitful, but it is not essential, and generally we make some base assumptions off our intuitions and then apply an 'anything goes' rhetorical style. It is naive to present your side of some scientific debate as being better because it is filled with people of integrity, as all sides in any large debate involve omitting inconvenient data and exaggerating the consistent data. They key is being on the right side, having the right biases, prejudices, assumptions, because confabulation is hard-wired into the human mind.

Being a good businessman is like being a good scientist. The most important thing is having the correct foresight to see the long-run, as in the long run the truth or value will win out. Having empathy for the customer or a respect for the truth in science is helpful in achieving those ends because you are better able to correct yourself before becoming too tied to bad causes via sunk costs and golden handcuffs. Day-to-day a simple focus on profits cuts through a lot of confused thinking about vague concepts like 'serving our customers', a subject that has produced its share of tiresome essays. Alternatively, nonprofits do this all the time if you really enjoy that kind of focus, or you can go off Jerry Maguire-like and start your own thing if really inspired, many people do.

That Which Doesn't Kill Us Makes Us Stonger

Yesterday the Fed announced most of the big banks passed their stress tests, and so there was a huge bank rally at the end of the day. What was amusing was this little line from those sneaky anti-capitalist news reporters at the WSJ:

The stress-test results—together with signs that bank lending is perking up in the U.S.—suggest the unpopular bailouts of 2008 and 2009 helped to stabilize the banking system during the financial crisis and put the economy on the path for recovery.

This is the worst banking crisis since the Great Depression in terms of the cumulative depth of contraction from the onset of the recession. Four years later, when the economy finally starts to show some strength, it is supposedly due to our savvy governmental intervention. Talk about grading on a curve.

The Philosophy of the Ultra Wealthy

At the MIT Conference last Friday, our lunchtime keynote address was from Donald Sussman, the founder and chairman of Paloma Partners. He's a very rich guy and surely has made many savvy business decisions. For example, he mentioned that around 1992 he was invited with about 200 businessmen to hear a pitch by the Chinese government on investing in China. He not only paid his own way unlike everyone else, he stayed in a nice hotel rather than the free (but very modest) accommodations provided. The government was so impressed, they presented him with a unique opportunity that turned out to be quite profitable. Clearly, this was fortuitous signalling.

Another interesting point he made was that it is useful to exit a trader when he's had a super year, and a super amount of investor inflows. Invariably, these people are going to discover their limits of scale, and it will end badly.

On the other hand, Sussman was pretty bad at articulating some unified set of principles, and spent a lot of time discussing his childhood, which is pretty narcissistic and extremely boring. It reminded me a bit of Bridgewater Capital billionaire Ray Dalio's manifesto, which set a new standard. He first lays out 210(!) principles--be extremely open, don't tolerate dishonesty--and then notes: "What follows is the Meat..." and then 200 more (eg, 'don't try to please everyone'). The earnestness and lack of focus reminded me of my childhood, when visiting my grandparents in a small town and I was forced to listen to very unpersuasive didactic Lutheran sermons.

I think it's admirable for people to try to articulate their philosophy on life, but they should be aware that being very successful at business or politics in no way implies they can explain that success. As Michael Gazzaniga has shown, the part of the brain (usually on the left hemisphere) that narrates our thoughts in our own head does not have access to all the reasons why we feel the way we do, or why we did some things, and it is engaged in post hoc rationalization all the time (this is why you should switch your date's decaf with a a caffeinated coffee, or take her to a scary not sleepy movie, because when her heart races her interpretative left-brain will put some more weight on the possible explanation that her right-brain must find you attractive for some reason). We know a lot more than what we can say. I don't presume that having a redundant and trite Weltanschauung means these people aren't good investors or managers, merely, their ability to pontificate on a general life-strategy is not the core of their alpha.

Stick to what you know. And don't talk about your childhood to a captive audience.

Are High Beta Assets Really Low Risk?

At Friday's conference, Sam Wildeman of GMO articulated his diagnosis of the low volatility anomaly: high beta stocks are low risk. He seems like a good guy, merely confused, so as a public service I'll try to explain why this makes about as much sense as the qwerty keyboard.

His basic idea comes from the finding that high beta stocks tend to have higher betas in bull markets (good!) and lower betas in bear markets (also good!). In that sense, they are less risky than a simple high beta asset. True enough. A 1.5 beta portfolio probably has less risk than the SPY levered 1.5 times due to this effect. But the higher beta portfolio is still considerable riskier than average by any definition.

Here's a histogram of monthly returns from 1962-2011


Here's the same thing in months where the S&P500 Index return was negative


So, the lower tail is proportionately larger for high beta stocks for both the total sample, and the truncated sample when the S&P500 falls. I don't think the 'long put' idea is really at work. Now, it is true that prospective betas are closer to 1.0 than measured historically, and this has been well-known for decades. The initial two-pass sorts in Fama and MacBeth in 1973 was created to correct for the fact that high beta stocks, in general, are over-estimated, and low beta stocks are underestimated. This is also accounted for in beta estimates that incorporate a bayesian prior, as is the default assumption for Bloomberg betas.

If it could be shown that high beta stocks are really low risk stocks, that would be a neat trick. I don't see any evidence for that.

Do Low Vol Tactics Matter?

An important question for any strategy is how important tactics are. That is, for some strategies, tactics are unimportant because the algorithm has a 'flat maximum', where lots of parameters generate outputs very nearly as good as the optimal parameters. Debt models have this characteristic, as a handful of inputs generate the optimal metric pretty well with a variety of weightings and transformations.

What about low volatility investing, where one can invest several ways. In the first, you take stocks with the lowest variance over the past N days, and form a portfolio. That's the route the SPLV etf takes. Or you could take the stocks with the lowest beta. Then, there's the factor approach, which applies mean-variance optimization to a set of latent factors drawn from the cross-section of stocks. Standard constrained-optimization algorithms can be applied to this problem. There are other ways, such as how the LVOL etf chooses stocks that closely fit a low-vol portfolio proxy, but I find that a bit too complicated.

In any case, I took 1500 non-etf US stocks, and applied the beta, volatility, and factor approach using daily data through Feb 2011, and then looked at the resulting porfolios over the next year. Each portfolio had about 100 stocks, and they overlapped by about 65 stocks. Volatility was reduced by about 45% relative to the equal-weighted benchmark that it was drawn from. In contrast, value and growth strategies had very different trajectories. This suggests the specific algorithm doesn't matter much if you are merely targeting low volatility.

VXX Expensive Again

Looking at the SPX index, actual annualized volatility has been below 10 for the past couple months, which is very low historically. Funny you don't hear about Taleb or Spitznagel when vol crashes, only when it spikes (talk about a convex payoff!). See below for a chart.


The VIX futures, which are closely related, show that not only is the VIX spot relatively high, but the future volatilities are even higher. The slope of the futures curve is very high. As the VXX and TVIX are hedged via riding down the futures curve, this suggests above-average costs of using the VXX to hedge one's equity exposures.


Now, the betas formed by regressing against the SPX vs those formed against the VXX form an almost perfect linear relationship (this was done using 5-minute returns for 800 non-ETF stocks). Note the higher the SPX (aka regular) beta, the more negative the VXX beta, so one can translate a position into VXX pretty easily, and by going long (plus, you can use the TVIX, which gives twice the exposure per dollar).


Many people hedge equity positions by going long volatility, and this does make sense because the VXX beta is around 2.3, so you seem to get a lot of bang for your buck. But the current contango suggests you are going to lose way more than 10% more than the VIX over the next year, so, that's a tax worth rethinking. Last year, this trade wasn't so expensive, as the futures curve had about one fifth the slope, but this year's slope is ridiculously steep.

If you want less equity exposure you should lower your beta or volatility by adopting a low volatility tilt. Alternatively, allocate less money to equities. It doesn't make sense to pay insurance that costs more than anyone's equity return premium.

Great Riff on Coming of Age

from Michael Oakeshott's essay On Being Conservative:

Everybody’s young days are a dream, a delightful insanity, a sweet solipsism. Nothing in them has a fixed shape, nothing a fixed price; everything is a possibility, and we live happily on credit. There are no obligations to be observed; there are no accounts to be kept. Nothing is specified in advance; everything is what can be made of it. The world is a mirror in which we seek the reflection of our own desires. The allure of violent emotions is irresistible. When we are young we are not disposed to make concessions to the world; we never feel the balance of a thing in our hands—unless it be a cricket bat. … Since life is a dream, we argue (with plausible but erroneous logic) that politics must be an encounter of dreams, in which we hope to impose our own.

To rein in one's own beliefs and desires, to acknowledge the current shape of things, to feel the balance of things in one's hands...these are difficult achievements; and they are achievments not to be looked for in the young.

That's rather touching, but I do think he neglects the fact that there is also a lot of insecurity in youth, when one does not know if one is on the right track.

MIT Conference to Discuss Low Vol Investing

Next Friday, March 9, there's going to be an MIT Sloan Investment Management Conference, over in Cambridge MA. It's pretty cheap (~$100), and you can register here. Makes me a little jealous of people who live near Megacities like Boston, New York City, or Chicago, where all the Bloomberg terminals exist, because such things are so much more frequent. I'll be a discussant there on Low Volatility Strategies, and I'm hoping for some vigorous disagreement between various factions in the way that families often fight more than strangers.

Generating Deep Thoughts

I was reading a lot by David Rock, who seems to have some pretty neat insights on the mind. Anyway, I was struck by this insight on generating 'aha!' moments:

variables that improve the ability to detect weak associations may improve insight solving. In short, insights tend to involve connections between small numbers of neurons....Just as it is hard to hear a quiet cell phone at a loud party, it is difficult to notice signals that have less energy than the general energy level already present in the brain. Hence, we tend to notice insights when our overall activity level in the brain is low. This happens when we’re not putting in a lot of mental effort, when we’re focusing on something repetitive

Which reminded me of one of my favorite Nietzsche quotes:

All truly great thoughts are conceived by walking.

Goldman Programmer Breaks Free

So, this Russian immigrant left his first and only finance job after a couple of years to work at another firm for 3 times the pay--and around $1 million-- a pretty clear case of stealing intellectual property (he was busted taking many lines of code). Yet interestingly, Goldman Sachs somehow got they guy convicted criminally, under the Economic Espionage Act, highlighting they have the best relations with all levels of our government. Aleynikov was freed on appeal last week.

Goldman is actually pretty reasonable most times. After all, many of their ex-employees go off to start successful funds, so it's not like they are paranoid, litigious bastards whose ex-employees don't get such opportunities. What this guy did was wrong, but this clearly was prosecutorial overreach: he was serving an 8-year sentence in Fort Dix. One thing I learned in litigation is that when a powerful guy wants you stopped, he will throw the kitchen sink at you to see what sticks. This is when intention drives tactics, because with federal or state law, intellectual property or confidentiality agreement, criminal vs. civil law, it doesn't matter, the company will use what works best, and some pretext will sound defensible to those without a dog in the fight (most everyone). But I really hope the people behind the initial legal decisions go to a special circle of hell because justice is about proportion, not right/wrong, and this was highly disproportionate.

Religion in Politics

All this discussion about Santorum's religious beliefs reminded me of a remark in a famous speech on existentialism by the German-American philosopher Walter Kaufmann back in 1960. In "Kierkegaard and the Crisis in Religion" he makes this point (around 51:00):

[People today think] that one ought to have some faith in some organized religion, but let me be blunt, not take it seriously......I don't think the people of the United States today would stand for a Presidential candidate who would not be affiliated with some kind of religion...but if Mr. Kennedy said, I take my Roman Catholicism seriously, he would be through, and if Mr. Nixon were really a Quaker, he'd be through...what they want is a Quaker who is no Quaker and a Roman Catholic who is no Roman Catholic.

So, while we act like the body politic is changing all the time, really not much has changed over the past 50 years in that dimension. The masses love hypocrites more than anyone who flat-out states they are atheists or actually believe in some organized religion.

Conservatism as Orgasm

Alison Gopnik studies babies, and finds them active little theorists, academics with no responsibilities and lots of time for inquiry. She titled a paper Explanation as Orgasm, noting our pleasure from explanations is like an orgasm, in that it must have some kind of innate reward to get us to do it. Children need to learn about the causal structure of the world, so there must be something hard wired to get them all to seek theories to explain the world, otherwise it wouldn't be common.

Gopnik quotes Hobbes:

there is a lust of the mind, that, by a preserverance of delight in the continual and indefatibable generation of knowledge, exceeds the short vehemence of carnal pleasure.

I do get a large amount of intrinsic pleasure in learning new theories that I think are true and important. Perhaps my delight in figuring things out is not some appreciation I have developed, like learning to appreciate a Jackson Pollack or Bach cantata, but rather something instinctual, like appreciating landscape paintings or great guitar riffs.

Gopnik does not really mention what this biological payoff might be, but clearly it is not much like the cocktail of brain chemicals released during an orgasm, including norepinephrine, serotonin, oxytocin, vasopressin, nitric oxide, and prolactin. The benefit of 'explanation' is a lot different, but no less physical (and thus the analogy retains).

Consider the payoff one gets from an 'aha!' moment, those instances when some pattern is recognized that explains the data. For example, note when you see the dalmatian in the picture here, you get an 'aha!' moment. They have many ways to test for 'aha!' moments, such as asking you what word goes with pine, crab, and sauce (hint: it's a fruit). Researcher have found that 0.3 seconds before the subjects indicated solutions achieved through sudden insight, there was a burst of neural activity of high-frequency (gamma band) activity. Such simplifications of reality, explaining more with less, is intuitively pleasing because it releases a burden on our brains, we now need hold and arrange fewer facts to see the same phenomena.

That's all fine, but it suggests a darker flip side. If we abandon an ideology that currently explains many things in our mind--global warming, Freemason conspiracy--then many facts explained by this old ideology are now free floating, unexplained. Letting those go must be as unpleasant as learning a new theory is pleasant, one is the other in reverse. The assumptions we adopt are largely affected by birth milieu, accidental in some sense and so obviously inferior in many respects relative to what an omniscient being would assume, so we have a lot of baggage.

Say we notice that one of our ideologies (we have more than one, as one might believe in libertarianism and String Theory), is definitively inferior in certain cases, and a better theory exists. In that case, it is costly to change, as you would unleash a flood of bad high-frequency brain waves upon scrambling your neat theoretical web that nicely holds many of your observations together. Thus, you reject the new theory and accept the anomaly in hope that an innocuous solution can be found, like the relativistic adjustments for really small or fast objects in the Newtonian paradigm.

This could explain why science progresses one funeral at a time (ie, thus not political conservatism as orgasm, but the same conservatism that has kept Noam Chomsky and Ron Paul having the same radically opposite beliefs for decades).

Feynman noted that people tend to fool themselves a lot:

The first principle is that you must not fool yourself--and you are the easiest person to fool. So you have to be very careful about that. After you've not fooled yourself, it's easy not to fool other scientists.

We stick to old theories not merely to succeed in our current parochial coalition, but because it is innately unpleasant to replace ideologies that currently seem to explain a lot of facts. Young people have lots of neurons but not many connections, so they don't generate so much cognitive dissonance adopting new theories, as their existing set of theories is pretty limited. Young people can learn a lot because they aren't contradicting much, so it's rather pain free. In contrast, an adult who learns something profound loses some innocence, and has to then rethink deeper assumptions.

Low Vol Commodity Timing Strategy

Perez, Fuertes, and Miffre present a paper highlighting that lower volatility is associated with higher returns in general. Looking at he 1992-2011 period, the commodity futures with low volatility outperformed those with high volatility by 4.6%. The effects appears independent of momentum and contango/backwardization effects.

I doubt this finding is truly a good investment strategy because while really highly volatile assets have low, often negative returns, they have such high volatility they should simply be shunned: a 0.1 Sharpe strategy is a bad long AND short. Nonetheless, a good prejudice for any investor should be that highly volatile assets and times are not good times to be long.

This is now the stylized fact of asset markets: higher risk implies lower returns. As a first approximation, it is true. There has been incessant criticism of the efficient markets hypothesis, and Black-Scholes option formula, but I find these theories pretty successful in their non-caricaturized versions. However, the risk-return theory underlying the CAPM, and its spawn the Arbitrage Pricing Theory or the Stochastic Discount Theory, is not just totally vacuous, it seems to usually have a sign error! It is not correct as an approximation. In contrast, Black-Scholes gives decent Greeks given an implied volatility, and consistent with the efficient markets hypothesis, it is hard to outperform passive indices.

These researchers have so imbibed the academic Kool-aid they state the the academic financial equivalent of 'furthermore, I think Carthage must be destroyed', with this aside:

This serves to extend the evidence of Ang et al. ...that the explanation for the observed profitability of idiosyncratic volatility strategies may lie in a yet-to-be- specified macroeconomic or financial factor.

That is, as risk must explain persistent returns, the only theory that makes sense to these savants is that that there's some risk factor that is like the stock market but actually inversely correlated with it (and thus, positively correlated with the relative returns of low-volatility equities and commodities). It must be subtle enough to escape notice of thousands of research academics for 50 years, and powerful enough to affect equities and commodities cross-sectionally. The thought that such a solution is possible highlights you simply can't falsify a framework like modern asset pricing theory. Further, there's so much strained hope in this view of the world that it puts delusional lottery ticket buyers to shame.

Thinking Metaphorically

Over at Edge.org, a couple scientists (Benjamin K. Bergen and Simone Schnall) mentioned that metaphors are a very powerful explanation of how humans think.

The idea is that you don't just talk about understanding as seeing, you think about understanding as seeing; morality is thought of as cleanliness, affection as warmth, winners are thought of as being in front of others. The abstract is explained via the concrete, something we know, such as seeing, feeling warmth, clean, catching, escaping.

This is why everything is 'like' something else, and why 'its like...' is a great way to explain a new idea. We have a small set of basic things our brains know, assumptions, and these are then the basis for building our more complex thoughts. I think this is important in understanding the problem of consciousness, in that we have certain thoughts are not inferred or reasoned, but rather hard wired. For example, we infer consciousness in others not via first-year philosophy courses, but rather mirror neurons that fire as if we were smiling, etc.

Understanding the origin of our intuitions is helpful in understanding the concepts they relate to. Schnall talks about how we derive meaning fundamentally from analogies with our sense of our bodies. After all, the brain's main job is controlling its body, as over 50% of its neurons are within the cerebellum, the part of the brain that controls our motor activities. So, we all have a very deep, profound understanding of 'hard', 'up', and other sensations. Cognitive operations have arisen to solve certain adaptive challenges of the physical environment, and so embodied metaphors are the building blocks of perception, cognition, and action. People think metaphorically.

de Botton on Religion

I'm rather baffled by the strong atheism espoused by Dawkins and Hitchens, for reasons well put by English writer Alain de Botton:

Instead, he connects his father's militant atheism to the affliction that he reckons made Dawkins and Christopher Hitchens so caustic in their bestselling attacks on religion. "I've got a generational theory about this. Particularly if you're a man over 55 or so, perhaps something bad happened to you at the hands of religion – you came across a corrupt priest, you were bored at school, your parents forced it down your throat. Few of the younger generation feel that way. By the time I came around – I'm 42 – religion was a joke.

My parents never really took religion seriously, and neither did many of my friends did growing up. So, I just don't get all worked up about how oppressive religion is in the West because it has always been too easy to opt out. Nonetheless, Hitchens gave a last interview to Dawkins and said to be more strident, and get his collagues to close ranks. Dawkins, meanwhile, was conspiring with Stephen Jay Gould before his death to not debate critics of evolution. It's a defensiveness I simply can't empathize with.

How to Detect Blather

Macroeconomists dislike criticism like anyone else, and especially hate the idea that their opinions are no better than anyone else. So, I especially liked this little quip from one of the most insecure economists blogging today, Brad DeLong, who was invited to speak on macro at some poli-sci class:

Professor Intro:Brad’s a great guy, we go way back ...he blogs...here’s Brad

J.Bradford DeLong: I do remember being horrified once when I was introduced by the Vice President of the Federal Reserve Bank of Kansas City, not as an economic historian or macroeconomist or the sometime Deputy Assistant Secretary of the Treasury for Economic Policy, but as the weblogger.

So I’m going to start by putting up what I’m calling equation 11 up on the board, simply to demonstrate I am a real economist and to say this equation 11 is going to be the centerpiece of Lawrence H. Summers and J. Bradford DeLong’s Fiscal Policy in a Depressed Economy, which is going to be presented at the Brookings institutiton on Friday March 23, and then published in the Spring issue of the Brookings papers on Economic Activity.

Intro: You are a serious scholar and a serious policymaker which I did omit...I apologize

Here's the equation 11 DeLong refers to, which contains 7 variables, a couple of which are straightforward (tax rate, the real growth rate), the rest could all be somewhere within the (-inf,inf) space that lets macro debates happen. Further, he's talking about rates of change, so there's an unspecified time dimension and these parameters are time-varying, having different short and long-term levels and the definition of 'long term' also probably varies over the business cycle.

He didn't actually discuss what the equation is, or how it adds to the debate, just that he, his credentials, Larry Summers and their initials, will be speaking at an Important Institution which will then publish research that contains as a centerpiece, an equation. In short, equation 11 is being used to prove his profundity in the most disingenuous way, because equations by themselves do not mean anything. That is, it's not like this equation has ever been empirically tested, let alone validated, and the history of economics is littered with empirically vacuous equations. Further, it's not like it is going into a refereed publication.

Many mediocre minds are impressed by famous colleagues, graduate degrees, Harvard, or equations. Those people aren't worth impressing. While such signals are correlated with good ideas, they are neither necessary nor sufficient for a good idea. When someone emphasizes these signals, however, that should lower their credibility among thoughtful people because it suggests bad faith, a preference towards pretentious irrelevancies.

I've seen this a lot, hiding behind equations. It often works because one does not want to sit down, understand what all the variables mean and how they are measured, etc. I just don't feel impressed at all by such equations because my Bayesian prior is they merely have a bad idea in equation form, so I don't give them the benefit of the doubt even when I'm lazy and have not enough time to evaluate their math.

A Market Timing Rule that Works

One of the most interesting things about finance is that while the past seems predictable, in practice it is very difficult to outperform passive indices using simple rules. Ivo Welch and Amit Goyal showed that a bunch of signals, such as the dividend-earnings ratio, may work with hindsight, but in real-time do not generate an ability to better one's equity returns over the business cycle. The best intuition for this bias is that if we take a set of data generated by a simple time series and plot the stock price vs. future return for that stock, there would be a strong negative correlation between price and future return for our sample, though in real time we know the mere stock price does not predict stock returns. This paradoxical result is why many are certain the markets are irrational or at least susceptible to myriad improvements via if-then logic, because they have never tried the rules they are certain exist (and why E-Trade and Ameritrade market as if giving rubes a lot of information about trends and ratios leads fairly straightforwardly to better returns--as opposed to merely more brokerage commissions).

Nonetheless, many give the advice that one should allocate more of their wealth, proportionally, to cash as one gets older, a basic rule would be your age in years as a percent should be your bond allocation (eg, 29% for a 29 year old). While this advice is common, most academics find such recommendations misleading, as Robert C. Merton and Paul A. Samuelson have written numerous articles over the years arguing these are based on a misunderstanding about long-term data that just happened to work out well over the past 120 years in the USA.

I'm not addressing that argument, that one should allocate differently based on one's investment horizon or level of human capital, rather, I'm focusing on the implication from the predictability of volatility. Consider the simple 10 day moving average implicit in the following variance forecast

EMAvar(t+1)=(1-λ)*ret(t)^2+λ*EMAvar(t)

With a λ=0.9, that's about a 10-day exponential decay moving average. Now, with daily observations from the market return data from Ken French's website (which has daily returns back to 1963), we get highly significant predictability. This fact underlies the usefulness of GARCH modeling of financial time series, and why Robert Engle won a Nobel prize for it. Volatility is eminently predictable:



In contrast, returns are not highly correlated with the volatility forecast (here data were bucketed into 20 groups sorted by the variance forecast):

There's a weak correlation with arithmetic return for volatility forecast, and extremely weak for the geometric return. The simple implication is that you might be able increase your Sharpe by avoiding the really highly volatile times that offer no corresponding return premium. The key, as highlighted in Welch and Goyal, is whether this is one of those patterns that disappears in real time, in that 'high' and 'low' in the above graph is only revealed after seeing what happens; a useful rule looks at 'point in time' data that is not forward-looking, and this is were most rules fail.

Consider the following rule:

• Invest 100% in equities if Ema(Variance)<[1.5*2 year rolling average of the Ema(variance)]
• Invest 100% in T-bills otherwise
• Only change allocation if you haven't changed it over the past month

Note the criteria is solely backward looking, just noting that if the variance estimate is too high. The final point just keeps it from doing some quick changes that would be impractical for a large portfolio, and in practice didn't change the results much. This generates the following results:

Data from 1965-2011

So, the Timing Rule generates a significant increase in the Sharpe ratio, from 0.25 to 0.43. With 33% of the volatility removed, it is comparable to 'minimum variance portfolios'. That is, those approaches also can also reduce your volatility relative to passive strategies by 30-40%, without sacrificing total return (usually increasing it a couple percent). The max drawdown moves from 55% to 47%, which isn't a lot, but the timing strategy missed a comparable loss in 2009, so more importantly the frequency of these 50%ish drawdowns was cut from 2 to 1.

This strategy generated a 68% average 'long' position over the time period, and so I compared it to a static 68%/32% equity/bond portfolio. Here one sees that as having really no change on the Sharpe, though it reduces the portfolio volatility by quite a bit.

Volatility timing reduces your portfolio volatility by one-third without sacrificing total return, unlike a static blended portfolio where the excess return is reduced pari passu.

Some might say: 'this is great, but what if everyone did this?' Well, if everyone priced in conditional market volatility (what was called 'risk' back in the 1960s), there would be a dynamic risk premium as standard theory presumes. That is, theoretically,

Asset Demand=k*E(ret)/variance

Here k is some constant, and this is a standard result (see here). Asset demand should be inversely proportional to expected return variance, unless expected returns move in concert. Expected returns do not move in concert with variance, but until they do you would be well served by following the normative implications of Modern Portfolio Theory, which may not explain how the world works, but does generate some useful tools for approaching your investment portfolio.

The take-away is this: purge your portfolios of the most volatile components, across time and assets, and you will slightly increase your return and lower your volatility significantly. It works precisely because it doesn't offer you something so attractive that, even if everyone believed it worked, most people would not use it. In Sharpe space, it's a much larger improvement than from switching from active to passive mutual funds (itself a good idea).

An implication of the above is that with the VIX at 18 compared to its two year average of 23, now is the time to get back into equities.

The Universal Benefits of Competition

One of the most important reasons why market outcomes dominate government ones is competition: government often rules out competition by law, or subsidizes production in such a way that alternatives are not truly competing. Yet firms that compete for customers minimize costs, maximize efficiencies, and innovate, much more than governmental organizations.

In Anna Dornhaus's lecture I did not mention her wonderful example from the animal world on competition. 'Cleaner fish' get rid of parasites on 'client fish.' The cleaner gets to eat the parasites, the client fish likes having fewer parasites. Sometimes, however, the cleaner fish take a bite out of client fish for some extra protein, and this hurts the client fish.

When client fish have a large territory, they have a choice of cleaner fish, and choose the cleaner fish that don’t bite as much. Client fish watch the fish in front of them getting cleaned (they often approach the cleaner fish in a queue). If the client fish being cleaned is jumping around in front of them, they know there is a lot of biting going on.

The equilibrium results are as follows:

1) Harmless and predatory fish are treated differently by the cleaner fish. For example, the cleaner fish do not bite predatory moray eels, and in fact are more prone to massage such clients!
2) Client fish with small territories and no choice of cleaner fish are treated much worse than those client fish with choices, as those cleaner fish tend to bite much less when they compete for customers.

That's a nice example of how universal the concept of competition, and incentives in general, is. We are nicer, better, less short-sighted, when we have to compete. Insulate yourself from the market, and you can easily rationalize biting your customers.

Charles Murray Reiterates Willpower

I really liked Tierney and Baumeister's book Willpower. Their argument is that willpower is a very useful skill, one that like a muscle tires when used, but can be strengthened through repetition. We should all practice daily acts of self-control to become more productive.

Charles Murray's latest book Coming Apart addresses the same theme, noting that society is splitting up into classes based on their abilities, which are highly driven by bourgeois values. Over the past 50 years, the working class have lost their industriousness, honesty, religion, and respect for marriage, and he presents a bunch of data to bolster this argument (eg, less than 5% of college educated white women have children out of wedlock, but 40% of white women without college do). This book is a straightforward extension of the main arguments in his two prior best sellers, where in Losing Ground he argued that the Welfare State is destructive to productivity and ethical development, and in The Bell Curve that society is sorting itself into a meritocratic class structure. By focusing on white people and that portion of individual skill amenable to environment--willpower--he tries to avoid issues of genetics and racial politics that were a large part of The Bell Curve commentary.

Murray argues the well-off should set a better example by not apologizing for their squareness, but rather, by advocating their lifestyle and scorning those who fail to live up to it—we need more of what is usually called 'blaming the victim'. Murray singles out the modern welfare state as the key instigator for our moral squalor, but I rather think our lack of faith in bourgeois values in general was the first mover here. Surely enlarging the dole increases the size of its patronage pool, but I still think policy is more symptomatic than causal.

Consider that in the 19th century novelists popularized the idea that cultural constraints or expectations were often arbitrary and led to seemingly needless shame and psychological problems (eg, The Scarlet Letter, The Brother's Karamazov, Jane Eyre). A slew of social scientists picked up the vibe, especially Freud or the Frankfurt School (Adorno, Horkheimer, Marcuse), and the Marxists. For example, in Freud's view sexual urges were viewed as having a powerful biological basis, while traits such as responsibility, dependability, orderliness, guilt, and the delay of gratification, are imposed by a repressive, pathology-inducing society, often a mere 'transference' from some guilt-trip inspired by traumatic potty-training or one's desire to have sex with one's mother. A bourgeois conscience became a hang-up that prevents you from realizing your authentic self (note the importance of 'self-actualization' in mid 20th century books like The Invisible Man). It never occurred to them that having no constraints or conscience has worse problems.

The subversive agenda of these writers was to pathologize traditional Western norms such as those celebrated by Puritans, Quakers, and Calvinists. Such norms were rarely perfectly achieved but nonetheless seen as unambiguously good, and so aspirational. It's useful for anyone but especially children to have clear goals as to what is the 'good life', and an important point to remember in this arena is that we should not let the perfect be the enemy of the good, especially in comparison with the untried.

After the Frankfurt school infested America, the beatnik idea that we should all 'tune in, turn on, and drop out' was a logical extension, supposedly an incredibly profound insight on how 'to be' (as usual, expertise was confounded common sense, as any family with an addict will tell you such a drug-induced stupor is the opposite of ennobling). Traditional parent-child relations, though popular on TV at the time, were being sullied in the academy as involving the suppression of human nature, and so the cause of domination and authoritarianism, which led to the Hitler (really, read The Authoritarian Personality). A healthy individual, meanwhile, does whatever he feels, which should involve rejecting their parent's strictures.

The end result was not total consciousness and keen insights about truth and beauty, but rather, nihilism and depression. The 'Greatest Generation' built things like Hoover dam and created a country of unprecedented prosperity and universal education; then, as if to prove that failure is endogenous, raised the greatest generation of naive, self-absorbed whiners in the History of Man.

My parents graduated college when such progressive ideas were intellectually dominant. They considered discipline, such as that required by drilling exercises, to be deeply destructive, and education was simply about figuring out how to release the genius that exists in all of us (this probably explains a little of why I liked Willpower so much, because I see very clearly how these principles would have been helpful for my upbringing). This naive zeitgeist reached its intellectual apogee, unfortunately, right about when and where I was born (1960's California) and turned that beautiful Eden into a failed state, a suicide New Yorker intellectuals might not notice from the gated community that is Manhattan (median home price a cool $1.4MM).

Scribes have always been jealous of the wealthy and powerful, thinking that an elite set of navel-gazing intellectuals such as themselves would be more efficient, as if they wouldn't turn into illiberal tyrants in short order (see what became of young intellectuals Trotsky, Mao, Ho Chi Min, and Mugabe). They convince themselves prior attempts along these lines were co-opted, but that's purely self-serving confabulation. Unfortunately, these same people dominate the media and academia by their very nature (wordsmiths), so it will be hard for modern mores to change because people wise enough to see it's wrong will tend to simply succeed off the grid, without reconciling their success theoretically in a treatise.

Currently there existis a dominant coalition of the lumpen-proletariat and their patronizing, indulgent, but highly status-oriented advocates who aspire to lead the new reverse dominance hierarchy. The leaders will argue that we should expropriate if not imprison the rich and their like because 1) mass redistribution will always win a referendum and 2) such a process needs leaders, and who better than those most articulate and faithful to the hive?

Subsequent to the anti-nuclear family claptrap within modern literature and sociology departments, psychologists have found that children will accept high levels of parental controls, but only if the relationship with the parents is positive. The key is having moral authority that comes from demonstrated competence and consistency. So too will the lower classes accept judgment from the upper classes if they think such observations come from those who believe what they say and say something true and important. Currently, they simply hear about how great it is to be a victim, how noble it is to be poor, powerless, or discriminated; to be wronged is the ultimate in righteousness. This simply isn't true and the poor know it. Suffering does have meaning when it cannot be controlled, and in such times a stoic attitude is truly heroic, often taken out of a higher duty to one's neighbors and family. But simply suffering low status because one does not have a job, stopped paying their mortgage, is in jail, or did not learn a trade, is usually the result of simple sloth and shortsightedness, and all their friends and family know it.

Alas, successful people are ashamed to assert they have better genetics, values, and habits--even though they quietly believe it to be true--and so are content to let the media and intellectuals push the delusional idea that success is like when Paris Hilton had sex on a digital camera and built a career out of it: luck, connections, and chutzpah, but no discipline, ingenuity, and perseverence. With such examples it becomes defensible to suggest most of the rich are like that--mere lucky hacks in the game of life. The flip side is that those who are unsuccessful are suffering for no fault of their own.

Thus, every day we see people championing the pathetic in journalistic essays: a scared mother of four on food stamps, or her selfless Community Activist advocate. No one champions the simple strivers, those who take care of themselves and in the process alleviate society of one more charity case, and along the way create wealth via 'gains from trade' implicit in market transactions. A simple prosperous mensch who does not hypocritically claim he primarily works for others is off the radar, implicitly insulting to any intellectual making considerably less than him.

The kind of change Murray is talking about will not happen until productive, successful people again feel pride in their distinguishing learned characteristics, including the willingness to shame people who do not have them. Consider that at the height of America's growth, the most popular form of fiction lionized were Horatio Alger stories, which lionized initiative and material prosperity. On the bright side, the ideas of Freud, Marxists, the Frankfurt school, and their destructive spawn are on the decline, mainly because they were never sciences they aspired to be, rather, intellectual fads once plausible but no longer (eg, no trendy writer is going impress his readers by giving his subjects Freudian complexes the way Norman Mailer did). Children of beatnik-influenced parents like me are not doubling down on the manifest failures in that philosophy. On the other side, failed big governments like Argentina, Brazil, and India highlight that countries are not like companies, they do not have to transform to survive when they go bankrupt. I wish people would valorize bourgeois virtues, but I don't see a catalyst around the corner, especially with 1/6 of Americans getting some kind of welfare.

Fama on EconTalk

Eugene Fama is interviewed by Russ Roberts over at EconTalk. Most of the time they talk about the Efficient Markets Hypothesis, and the mortgage crisis, but 'risk premiums' were mentioned in this little exchange:

Roberts: What are the lessons for me that finance has learned that are important? [bla bla]...
Fama: [blah bla] ... I think we've learned a lot about risk and return. Some of it is intuitive. But there is a lot of stuff on which stocks are more or less risky. A lot of stuff on international markets...[bla bla]

That was quite the elision! Risk is ubiquitious in modern finance as an explanation, as Robert Merton says: 'Risk is not an add-on … it permeates the whole body of thought.' Yet it receives only a minor mention that passes so quickly here, as if not to dwell on it long enough to elicit any follow up, such as "which stocks are riskier than than others?" If it's value stocks, why do they have lower betas and volatility than growth stocks? If it's small-cap stocks, in what way are they risky, other than having higher-than-average returns? If it's equities in general, why is the CAPM a failure cross-sectionally? It is, after all, the main focus of his oeuvre, so I think he's unconsciously signalling he's on the defensive here.

An interesting point is that the Efficient Markets Hypothesis (which I defend here), is something that started out without much enthusiasm, but over time has grown stronger, led mainly by the obvious fact that it is very difficult to make abnormal returns in the market. Fama gets a lot of flack for it since day 1, but it has been his most enduring idea (clearly, a group effort with Working, Samuelson, and Muth). The risk premium, however, started off as a fait accompli around the same time, though the risk factor is like a Freudian's Oedipal complex, something that started out with supposedly clear empirical support but later was simply assumed. This is because the risk premium is a direct consequence of the most fundamental assumption of economics: a von Neuman-Morgenstern utility function, one that increases in wealth at a decreasing rate. Given that, risk premiums exist, so for most economists, one doesn't need proof. This is nice because we don't have any other than the supposed equity risk premium, which even if it is 3.5% as most experts think, should generalize to something other than the difference in return between equities and bonds (eg, cross sectionally, over time, across futures, currencies, bonds, etc).

What if Returns Don't Reach 7%?

A review in the WSJ on the book The Hedge Fund Mirage by Simon Lack notes:

The return-on-investment targets of 7% to 8% that are structured into pension plans are beyond reach in today's artificial environment. To redeem their promises to retiring teachers, firemen and the like, managers are risking more money with hedge funds in hope of yields higher than those on safer investments.

And so it is, as I read subsequently that:

Just five years ago, it was illegal for South Carolina's public pension plan to invest in hedge funds, private equity and other complicated bets.

Now, nearly half its assets are in such investments. That is way too much for the state treasurer, who is charged with squeezing the most out of the $26 billion pension fund.

Unfortunately, hedge funds are doing worse than ever:

The "Global Macro" trading strategy, one of seven tracked by the Dow Jones Credit Suisse "Core Hedge Fund Index," finished last year down over 10%, worse than the entire index, which fell 7.4%.

This isn't going to end well. The risk premium of 5% that everyone expects is not going to happen, and this failure will act as positive feedback in the upcoming fiscal disaster; when the pension funds all under perform and need more money, it will be the nail in the coffin. I think the tinder will be inflation, which the central banks seem to think is the cure for their GDP ills (and those of underperforming pensions), so they will push until it comes back.

Is Arithmetic Return Bias Basis of Low Vol Anomaly?

I created an index of the highest beta stocks from 1962 to present. Every 6 months I took those 100 highest beta stocks, excluding the lowest 20% in market cap (to get rid of dumb stocks you can't trade). The results are in the chart above, and summary data are as follows:

The top line, "AnnReturn", is the arithmetic return, and here the monthly returns for the high beta stocks are about 0.14% higher than the S&P500, which when multiplied by 12 is a 1.7% difference. But looking at the chart which shows a total return chart, and the geometric annualized return, we see a very different picture, with the high beta stocks underperforming by 3.5% annually.

The basis for this is the difference between geometric and arithmetic returns, which is

Geometric Return =Arithmetic Return - Variance/2

Thus, the differential annualized variance (in this case, 12% vs. 2%), generates the differential annualized return. Interestingly, the return rankings for these data are different depending on the horizon!

Mutual funds and individual investor holding horizons average about 1 year, and I think that's a good assumption for an investment horizon. It seems that 1 year would be the obvious horizon to apply data against, but the problem is there is so little of it. There's like twelve times as much monthly data! A simple fix would be to use log returns, but this doesn't always happen, and I think those who still find the Security Market Line to have a positive slope in general are looking at monthly percent return data, and this is why they see what they do.

Insurance and Pooling Equilibria

In the bad old days, insurance was a way to smooth cash flows from improbable but large expenses: fire, health, auto mishaps. Through repetitious metonymy, 'health care insurance' and health care are now synonymous.

I was struck by Obama's mention last night that:

I will not go back to the days when health insurance companies had unchecked power to cancel your policy, deny your coverage, or charge women differently than men.

Emprically, women use more health care, they cost more, estimates are around 35%. Some of this is childbearing, but a lot of it comes from the simple fact they go to the doctor more often (notice women see their gynecologists rather regularly, whereas men have no comparable service). So now charging women more for something they use more of is illegal because it discriminates.

Interestingly, in the 1970's there was a law passed so that upon retirement, the annual payments to female retirees had to be the same as for male retirees even though women live longer, statistically. That is, the present value of their retirement packages, by law, are larger for women than men.

Government seems to be doing more and more to make it difficult to prevent 'pooling equilibria', cases where different types of applicants get into a pool, eventually pushing out the 'better' or 'lower cost' people who don't want to subsidize the other group. For example, due to legal rulings, it is now very difficult to give job applicants explicit aptitude tests, even though this would be very useful, and avoid the charade from those Microsoft/Google IQ tests given verbally. Interestingly, Nobel Laureate and prominent Big Government advocate Joe Stiglitz's most famous paper relates to an inefficiency from a pooling equilibrium, and his take-away was that markets were inefficient because of this problem. In practice, government encourages pooling equilibrium where it was never a problem before by preventing rational discrimination based on projected costs/benefits based on observable characteristics.

While the equilibrium efficiency loss in Stiglitz-Weiss is abstract, it usually creates something pretty simple, as if you can imagine what would happen to insurance if it could not price based on risk and allowed people to opt out: healthy people would leave in droves, which is why Obama-care made insurance mandatory. Think about the lawsuits on disparate impact for mortgage lending in the 1990s, where whites were rejected less often than blacks, and this was presumed discriminatory (in an evil way), and so the only way to make unequal groups equal is to stop making distinctions that differentiate them, which led to simply the idea that down payments and having a job were unnecessary underwriting criteria.

It's rather funny that Stiglitz's main theoretical contribution to the academic literature is so starkly in contrast to not just his politics but his obsession, which is increasing the size and scope of government which prioritizes preventing firms from rationally discriminating. Remember that in Stiglitz's model, like everything else in this literature (he didn't invent it), failure to discriminate types somewhat known by participants is what causes all the problems, the 'bad equilibria.' I guess that highlights no one takes these models very seriously--change one assumption here or there, different result.

Modern Robin Hoods

My Sunday opinion section had a commentary piece arguing why we should tax the rich more. It ends with this:

Am I envious, Mr. Romney? You bet I am. But I'm also angry at the stark injustice of it all.

The author is the 'vice president of the Institute for Local Self-Reliance.'

Wikipedia Black Out Working

Many of my favorite websites (Fark, Wikipedia) staged a protest against some intellectual property legislation coming down the pike, and it seems to have been successful. For example, Florida Senator Marco Rubio made this confession:

In a frank statement posted to his Facebook page on Wednesday, Rubio hinted at a Beltway truth that many other wavering Protect IP and SOPA supporters have been hesitant to admit: More than one lawmaker signed on to the legislation without understanding its technical workings and potential problems, believing it to be an uncontroversial, bipartisan bill that would support American industries.

Of course, this highlights that often senators vote for legislation without understanding its technical workings and potential problems.

MIT Economists Running Central Banks

Bloomberg Magazine has a piece on the MIT economists who dominate central banking today. If you ask them why, they will say it's because of their particular blend of theory and practice (as if the idea of theory AND practice is really an outside-the-box idea).

I think it's more a matter of this was a group of smart kids who were really interested in macro, because in the 1970's they were still optimistic about its ability to be useful. A small group like that can create a positive feedback loop pretty easily, because having a recommendation from other successful macro economists is very important.

Yet, given the recently released Fed minutes from 2006, we see these Cambridge macro savants are a lot like the world's leading psychoanalysts all being from Vienna in 1930--experts to be sure, just not at actually helping people. Here's what US central bankers were saying about Greenspan when he left in 2006

For the Fed 2006 began with the departure of Mr. Greenspan, who presided in January over his final meeting as Fed chairman and was then widely regarded as the epitome of a central banker, a master who had guided the American economy through almost 20 years of remarkably consistent growth.
...
Ms. Yellen said: “It’s fitting for Chairman Greenspan to leave office with the economy in such solid shape. The situation you’re handing off to your successor is a lot like a tennis racquet with a gigantic sweet spot.”

If they didn't see our greatest recession since the great depression coming, why should we expect them to see inflation before it's too late?

Moderation in Deception

One of the more important facts of life is that adults are often very disingenuous. When the executive VP says 'the United Way chairmanship was the most important job I had here at Amalgamated,' it is a lie; when they imply that their main satisfaction comes from knowing their customers or voters are better off, it is a lie. Sure, there's an element of truth to what they are saying, but emphasis is important too. So, lying is part of life, especially in regard to hierarchies, because any hierarchy needs some platitudes about the greater good to maintain their legitimacy.

Anyway, I was in Las Vegas last weekend and hung out with a Black Jack pro. His basic strategy was to find 2 deck black jack tables, which would give him enough time to count cards and generate an advantage. If they reshuffled too early, say after 52 cards, he couldn't make money, and this was part discretionary, part casino rule.

I won't give away all his secrets, but the bottom line is that it didn't seem worth it to me. As a job, not an avocation, it didn't seem fun, or even really well paying. The basic card counting part of the job is pretty mechanical and after repetition rather easy. Most importantly, he had a very interesting time with the dealers. Basically, you want them to know and like you, but just a little. Too much, and they will catch on to your game, too little and they won't do you any favors.

As they have a lot of discretion, and you are hoping to make say $300 off any on dealer, which in the context of their weekend is not a lot. Thus, they might choose to deal to you with only 25 cards left in the shoe, if they like you, whereas if they don't like you they will reshuffle after 50 cards. A great salesman is one who can make customers like them so much they don't mind paying a little extra, and don't like to even think about what is happening (like when dupes don't care their partner is using them because they are so adorable). Smarts are necessary to make this happen, but to make it a really valuable strategy you need the ability to make the opportunity cost seem a lot smaller than it is.

Refinement to The Neg

Tucker Max is a populizer of The Neg, a technique whereby men strategically criticize women they're attempting to pickup. The idea is that by doing so you signal deep confidence from your high status, which makes you look more attractive, or at least makes a woman rethink blowing you off. It is intriguing, and I wrote about how Asian guys are picking this up to counteract their more restrained demeanor.

Interestingly, I read an interview with Tucker Max over at Psychology Today, and he specifically mentioned several influences that I also quite like to read: Geoffrey Miller (author of Spent), and Robin Hanson (blogs at Overcoming Bias), and the interviewer mentioned Robert Kurzban (author of Why Everyone Else is a Hypocrite). I guess there's a confluence of ideas here that appeals to those with all sorts of angles.

But as to The Neg itself, it seems there's a potential refinement that may take your game to the next level. It's called, 'the pratfall', and involves making a clumsy blunder after establishing your awesomeness. For example, after slyly dissing your target of affection by noting her lipstick is smeared, you sink the hook by secretly shaking up a can of soda and then have it 'accidentally' blast you in the face in front of her. Oh my! I'm so clumsy!

Here's Yale psychologist Peter Salovey on how it works (info needs only first 5 from where this starts). This is within a Yale Intro Psychology Lecture on Love.

Banks Discriminate Against Half Their Customers

From the WSJ, I found this funny. It seems when you are being sued for Politically Correct crimes, the logic they use against you can be absurdly weak, because the evidence is clearly irrelevant:

Justice says that out of 4.4 million loans approved between 2004 and 2008, 525,000 went to African-American or Hispanic borrowers, of which some 210,000 paid higher fees or rates than the average paid by similarly situated "non-Hispanic White Borrowers."

It goes without saying large numbers of white borrowers also paid higher than the average of all whites. It also goes without saying large numbers of minorities didn't pay higher rates, though Justice isn't interested in the average of what minorities paid, only that some minorities paid higher than the average of whites.

If this sounds like statistical malpractice, it's apparently habitual. In a rare instance where defendants fought back, two Los Angeles car dealers recently won dismissal of a complaint accusing them of favoring Asian over Hispanic car buyers because 600 of 1,300 "non-Asian" buyers were charged higher loan terms than the average of Asian buyers. Notice that 600 is about half of 1,300. As the dealers noted, Justice's claim amounts to an assertion "half of one group is above average, which means that the other half is below average."

Fascinating Evo Biology lecture

Anna Dornhaus gave an interesting lecture on evolutionary biology. I really like this thread ever since I read The Selfish Gene but am finding the stories repetitive, so these were all fresh. Here's some of her stories.

Warblers are very good at detecting which of their eggs are cuckoo eggs, something that is not detectable from a casual glance. Cuckoos know they have to at least remove one of the Warbler eggs before adding their own, so the competition is clearly into overdrive. Yet, occasionally the Warblers are fooled into letting the Cuckoo egg stay, and once hatched the Warbler raises the behemoth Cuckoo even though it looks nothing like its siblings (3 times the size, different color). It seems conscious minds can only afford to be so discriminating in certain areas, the rest apply simple rules.

Minds aren't good at detecting things that never happen in nature. Omnivores like rats are good at figuring out what foods are not good for them, using the simple rule that if they get sick, anything they ate 2 hours ago is no longer considered tasty. Vampire bats only drink blood, and as blood is basically never poisonous, if you do poison the blood to make the bats sick, they will never associate it with the blood from that source. They can't make the connection because from an evolutionary perspective, it basically doesn't happen.

Different species of sticklebacks live in the bottom and top of lakes. The top-dwelling sticklebacks can't learn landmarks. It appears the bottom dwelling fish are very good at detecting landmarks, while the top-dwelling fish looks more at how things behave. So perhaps skills not useful in their evolutionary past are eventually lost. On the other hand, female birds are not very good at remembering where they stored food when they have mated because they rely on their mate. Unmated females, however, are just as good as the males at remembering seed caches. I imagine one could therefore argue top-dwelling sticklebacks failed their spatial geometry quiz because it had no value to them.

Some animals grow the brain during the part of he year they need it more, and then lose that in the part when they are less cognitively demanding part of the year. More evidence for the use it or lose it principle.

Interestingly, scientists bred fruit flies for intelligence. They made bananas taste bitter, which fruit flies don't like. They then gave the flies little markers, so the 'smart' ones would avoid the bitter bananas based on this learned signal, the dumb ones would not. After only 20 generations they generated 'smart' and 'dumb' fruit flies who could learn at different success rates. Then, they mixed them together and saw what happened: Idiocracy, the dumb flies out-reproduced the smart ones! Her take-away was intelligence is costly, and everything has trade-offs.

I especially like the idea that any ability comes with trade-offs and so in a sense we are all idiot-savants, good at some things, bad at others, especially with respect to really different people. I know a lot of smart people, but I've never met one who didn't have blind spots. It's good to remember that because if you think that because you have a really high IQ, are really rich, or are a good speaker, you are therefore the smartest guy in any room, you are going to make a very big mistake someday.

Stocks and Flows

A pithy summary of our macro debate by Brad DeLong:

The government purchases $100 billion of goods, issues $100 billion of bonds, and raises taxes by $3 billion a year in order to amortize the bonds. Government purchases go up by $100 billion this year. Private consumption goes down by $3 billion this year. Net fiscal impetus is not $0 but rather $97 billion. Cochrane doesn't understand the Ricardian Equivalence argument he is trying to make.

Now, ignore the Ricardian Equivalence, but just note that Keynesians think $97B was created via this spending and taxes this year, which is why they love government spending regardless of what it is spent upon. But if they issued $100B in bonds to create this 'new demand', where would that $100B have have gone otherwise? I don't think this makes sense in general equilibrium; money is never 'idle' unless it is under your mattress. I guess if you could caricature the two views: one thinks supply creates its own demand, the other that demand creates its own supply.

Bank Lending Pathetic

Banks are highly regulated institutions, in spite of what Amar Bhide implies in today's NYT editorial. He argues the Fed should insure all bank deposits, no matter how large, but in response regulate more. The regulators are already regulating a lot, choking off credit. When no specifics are offered, it highlights how clueless such solutions are, as with the current CFPB, which doesn't do anything I'm aware of, but create a new permanent bureaucracy. After all, more regulatory pressure pre-2007 would have just meant more ninja loans, not less, given the conventional wisdom back then.

A friend shares with me the following anecdote. He thinks real estate is cheap, and wants to buy houses, and make money renting them. Ultimately, he would sell out of the homes when they recover in value. He has been doing it for a couple years with good results. He went to a bank, to see if he could leverage this idea, say by getting loans for 50% of the purchase price. They said, only if you hold this in a 'compensating balance.' These are cash balances held by the borrower at the bank, and add fees and some safety to the bank. In this case, the bank wants the borrower to keep the entire balance as a cushion, borrow money for a potential liquidity event, that would be rather futile because once the borrower used said compensating balances to rectify a funding problem, it would then have a liquidity problem with the bank. So, in practice, the compensating balance would not be a cushion for tough times, nor would it earn interest for the borrower. My friend decided not to get the loan.

The regulators aren't letting bankers return to business as usual, as previously they got 100% loan-to-value, now can't even get 50%! Many still think the bankers basically are parasitic thieves. I maintain that without a healthy bank sector free from the fear of extinction, our recovery will remain weak.

Macro Imploding

Not the macroeconomy, just the science. Not that it every really was a science, just that 40 years ago everyone thought it was, now, not so much. Yesterday I read a really fun catfight between Krugman and everyone (e.g, Tabarrok, then Krugman, then Cowen, then Krugman, but this is typical). Now, losing one's temper in an argument is usually symptomatic of losing the argument, and so I am quite pleased watching Krugman boil over. Yesterday's Krugman post was precious, as he defending being peevish by noting that he only treats people like 'mendacious idiots' if they are so, and civility is irrelevant when the stakes are important!

He doesn't understand that civility is more important the greater the stakes, because they are helpful and takes discipline. It's easy to lose it and just start calling someone names, questioning their motives, but this is just appealing to your base emotions, as highlighted by the behavior people with their frontal lobe activity reduced (i.e., drunk people). On the other hand, on issues that are not important, well, it's easy to be gracious about things that don't matter because it takes no effort, there's nothing to restrain, there's no cost of doing so because you don't care if you 'lose'. If you are trying to bring a crowd to your point of view, manners are very helpful, they are a better sign of good faith argumentation. If you are just being angry, this can help incite a predisposed mob, but little else because everyone knows that someone highly emotional is not reasoning at all, just rationalizing. Sure, we all do it, but if we don't at least pretend not to, we clearly are not coming close to the rational objective we all aspire to in less heated environments.

Then there's Matt Yglesias trying to mix it up with Chicago-school type John Cochrane:

Chochran: Defenders think that devaluing would fool workers into a bout of “competitiveness,” as if people wouldn’t realize they were being paid in Monopoly money. If devaluing the currency made countries competitive, Zimbabwe be the richest country on Earth.

Yglesias: Try this mode of argument on for size. If water made agriculture possible, then the Pacific Ocean would be the breadbasket of the earth.

I found that analogy incredibly lame, and it made me think of Bulwer-Lytton contests (this year's winner: "Cheryl’s mind turned like the vanes of a wind-powered turbine, chopping her sparrow-like thoughts into bloody pieces that fell onto a growing pile of forgotten memories."), but Keynesian Brad DeLong thought it was devastating, highlighting the importance of ideology.

In contrast to this, I listened to much of the two latest Nobel prize winning economists--macroeconomists--giving their Nobel speeches...and they are as boring as any you might have remembered from college.

So, it's either a rather unfocused, nasty fight about the Keynesian stimulus or experts unconsciously imitating Ben Stein in Ferris Bueller.

Econ grad students going to the big annual econ and finance meetings this weekend in Chicago should ask themselves whether this is a club worth joining. Sure, the top 10 make a good living, but no one else does, as companies and municipalities don't need macroeconomists any more than they need sociologists.