SEC Probes High Frequency Trading

A WSJ article discusses what the SEC is looking at:

The SEC is examining whether such order types unfairly allow high-speed traders to jump ahead of other investors in an exchange's "order book," or the queue of buy and sell orders that are typically ranked by price and when they were received, according to people familiar with the matter.

Another area of focus for the SEC are the rebates some traders earn from exchanges even as other investors pay fees to complete trades, say people familiar with exchange operations and the SEC probes.

The SEC should ignore the quid pro quos among institutions, exchanges, and retail flow, because for decades exchanges and brokers screwed consumers via their coalition on the commissions and spreads, which was encouraged via the regulators. Why trust them now? As if the current most prominent regulator, Barney Frank, won't be an effective crony capitalist in 9 months, setting an example for all the other current regulator big-wigs. The key for them to be valuable is creating barriers to entry, as there's no big institution that's going to hire someone good at lowering costs to consumers. Of course, that's all hidden behind some pretext about protecting against fraud, and helping the stability of the exchanges, and fairness, and lots of other platitudes. Just think about whatever the SEC wrote in the 60's and 70's and know they were shills for the brokerages and exchanges who colluded to steal investors blind via spreads and commissions that never would have survived a competitive market (thank you regulators!).

What caused commisssions and spreads to come way down over the past 20 years? Not regulatory innovation, but rather competition via the internet, just as in life insurance.

In business, there are lots of different fee structures, and they depend on a lot of variables: a la carte, teaser rates, bulk savings. To view each as a conspiracy that must be proven otherwise is meddlesome and ignorant, creating the completely understandable system that only stasis and oligopoly generate.

If they are truly interested in stopping another flash crash, they should disallow market orders. That is, the flash crash of 2010 was caused by some Texas bumpkin selling $4.1B worth of E-minis (ES) at market prices, which created a panic. Now, just as in hijacking airplanes for kamikaze missions is probably done, that specific trade won't crash markets again, but making sure all exchanges have a contingency for a stupid market trade would be a good thing.

JOBS Act to Bring Light to Hedge Funds

A great example of way regulations tend to protect industries from competition more than help consumers, a great example is the law that prevents hedge funds from disseminating their performance. This allows funds to create massive amounts of survivorship bias via the use of several funds within one main brand, and it's much harder to quantify this because by law they can't tell you how they do.

One can imagine if more people were aware of Madoff's returns, and his purported assets under management, lots of people would have figured out it was a Ponzi scheme just as Markopolos did. More people would have learned about pairs trading in the 1990s via the fat returns, and this would have created more efficient trading exchanges faster (they were arbing the pre-internet retail flow).

The new JOBS act would rectify a good deal of this:

In its current form, the JOBS Act will allow private equity and hedge fund managers to solicit investors directly, rather than through third parties as per the current rule.

It only took 80 years to get rid of this dumb regulation.

Low Vol Underperforming

Low volatility investors, now is the winter of our discontent. When the market does extremely well, high beta outperforms, low beta underperforms. Thus, even though low beta/volatility portfolios are up, they are not up nearly as much as the alternatives. That is benchmark risk, and why the low volatility strategy is not a slam dunk.

These are data I maintain, for the US.

Jonathan Haidt is on a roll:

Consider this gem:

The fundamental rule of political analysis from the point of psychology is, follow the sacredness, and around it is a ring of motivated ignorance.

I would say that's true for scientific analysis too.

Theory vs. Data

One interesting interpretation of Freud is that he modeled his approach based on his readings of Sherlock Holmes (see Sebastiano Timpanora). In those books, Holmes would trace the faintest clues and infallibly solve a puzzle that would daunt your average person. Freud then though if he could supply a dynamic explanation for virturally every reported dream or error, the soundness of his method would be demonstrated, so Freud's case studies read a lot like a fun mystery novel. It turned out detective stories are a bad template for creating a new science because it is all post hoc rationalization, and unfalsifiable, basically the signature field Karl Popper used to explain what is not a science.

Our narrative brain theorizes and is often wrong, but of course it does the best it can. Interestingly, the left side, the language side, is the theorizer. Thus, if you show the left brain a sequence of lights that flash above the line 80% of the time, rats and pigeons and 4-year olds do better than adults because our left, theorizing side, tries to guess which one will be above or below the line, matching only the relative frequency, but wasting many choices below the line. We basically become dominated by our wacky, theorizing left side around age 5, which as any parent will tell you, is well before reasoning has been perfected.

In contrast, if you merely show the pattern to the right side of the brain, as Michael Gazzaniga has done with his studies of split-brain patients, the right side is a simple bayesian, and goes with the frequentists approach (see his book Who's in Charge?). So, half our brain is a simple bayesian looking at data without much theory, the other half a theorist trying to integrate, analyze, and generalize.

Freud was only doing what is natural, coming up with theories, but he forgot that old cliche, moderation in all things. Look at the data too. If they contradict your theory, or cannot be really contradicted by data, alter your theory. The problem seemed to be that Freud was always the smartest kid in the room growing up, so he probably thought he could simply make up anything at all, because he could argue for or against anything with complete confidence he would win as he always did. Unfortunately he learned fake thinking, the kind salesmen, lawyers and politicians are especially good at, which is reasoning and arguing without a prioritization of the truth. For him the truth was merely a tactical constraint, a concession in small facts, never for the big one.

Hedge Fund Profits Near Zero

The graph above shows the portion of hedge fund profits that go to the hedge funds, the fund-of-funds, and the investors, using total dollars from 1998-2010. This is from Simon Lack's presentation, which is derived from his book Hedge Fund Mirage. Notice 97% go to insiders, 3% to investors.



Like most strategies or asset classes, the money made on a percent basis is large because it basically grows until it can't work, at which point it loses more money than it made and then some more (see above graph, 2008 killed everything). It could be thought of as an endogenous reaction, because how else will you know at what point it stops working? Perhaps this is the essence of all financial cycles.

One good point by Lack was that fund managers inevitably argue they do not fit into clean categories; that they, unlike everyone else, is neither fish nor fowl. I suppose we all think we are unique, and don't like to be benchmarked, but on the other hand, everyone is riskier without a benchmark.

The Ineffable Intuition of Chicken Sexers

In the book Incognito by David Eagelman, the author discusses the strange nature of chicken sexing. This is the valuable process of separating female and male chicks as soon as possible, because each sex has different diets and endgames (most males are just destroyed). The mystery is that when you look at the vent in the chick’s rear, some people just know which are female. It is impossible to articulate, so the Japanese figured out how to teach this inarticulable knowledge. The student would pick up a chick, examine its rear, and toss it into a bin. The master would then say ‘yes’ or ‘no’ based on his generally correct observation. After a few weeks, the student’s brain was trained to masterful levels.

This is rather fascinating. I wonder how many things are taught this way, things related to intuitions, usually focused on relationships. I don’t think this would work in stochastic cases like stock picking because even a good stock might have succeeded in spite of itself due to some random luck, making it no more useful to generalize upon than a winning lottery number. A good mentor could really generate a first-order advantage, and perhaps that is relevant to mystery of what generates most of the intergenerational income correlation, because IQ seems only to explain 10 to 25% of it.

We all know a lot more than we can articulate, stuff that can't be translated by our conscious self, which is why we still can’t generate a robust program to distinguish between a dog and a cat, even though a 4-year old has no problem. Nonetheless, we can train our unconscious thoughts via methods like the chicken sexer, primarily by emulating others who are good.

As Oscar Wilde said, the things worth learning can't be taught, by which I think he meant taught via some schoolbook. Watching a father deal tactfully with anger, frustration, and persuasion is surely as valuable as learning the times tables. Many people have this emotional intelligence, and it is very beneficial, probably something that isn't taught via reasoning, rather simply showing.

Agent Based Models

I was recently at the FactSet Phoenix conference, and Rick Bookstaber gave one of the keynote addresses. He works for the SEC, and like all senior regulators works with the Fed, the IMF, and the whole kitchen sink of regulatory bodies out there. He seemed like a veteran speaker, and made an interesting analogy between investment markets and warfare, in that the only thing that maintains is the competition, not the means.

Then he introduced me to the cutting edge of bank regulation: agent based models. Bookstaber said these are better than value-at-risk (VAR) involves agent based models, because 'anything that works is obsolete.' Clearly this is an exageration (I hope).

So what are these models? I found a good example here, by Stefan Turner, for the OECD ("Better Policies for Better Lives" is their motto). He starts out withh 24 pages of words, telling us that this model analyzes millions of simulations of millions of interactions. He notes (p. 7), that 'the models demonstrate that such regulator measures can, under certain circumstances, lead to advese effects.' Let's hope that's a feasible scenario.

Anyway, there are a bunch of obvious economic assumptions like suppy equals demand, and that demand decreases in price, mixed with a variety of exogenous assumptions such as that noise trade demand is 'weakly mean-reverting', and informed demand is a stepwise linear function of the asset price and some constant. This is all like Stephen Wolfram's New Kind of Science, the idea that you take some simple assumptions, create some cool time series that look like or 'are homologous to' real time series.

This is so abstract, the main point is merely to generate time series that look vaguely like some asset time series, which given the number of parameters (20+) and rules is rather simple. What this implies about the current state of Bank of America is anyone's guess. A complex financial company will have hundreds of very different assets, each with their own underwriting criteria, loss curves, recovery rates, and then several different types of liabilities. VAR isn't relevant here, but neither are agent based models.

It's fine for academics to do deep research on things like dynamic programming and input-output matrices. These generated a lot of excitement, Nobel prizes, but were ultimately useless for predicting anything except tenure decisions. VAR is a very useful tool, mainly in making sure crazy rogue traders aren't operating, but mark-to-market books are not the essence of banking. When I was head of capital allocations at KeyCorp, our VAR risk was about 1% of our total economic risk capital, almost nothing. Surely it's higher for the money center banks, but it's still small compared to their balance sheets that aren't being churned.

The idea that 'agent based models' is the new focus of bank regulation strikes me as a monumental waste of time, up there with the idea that neural nets can discover interesting (as opposed to merely true) theorems. On the other hand, they are going to do something, and irrelevant is merely a waste of their time and money.

The main problem everyone sees is too big to fail, but regulators see it as something they simply have to maintain given the contagion risk. Why not keep it simple, and just say, you pay an asset tax for every dollar over $100B? Then you don't even have to force anything, just collect the extra revenue on the big, fat companies that probably would be worth more to their investors (as opposed to CEOs) if they were smaller too. Remember, Bob Rubin didn't even know Citi owned a $300B+ in mortgages, and he was getting paid $115MM to mind the store, so it's not obvious to anyone what's going on in these $1 Trillion behemoths, but we all know the Treasury will be there if they collapse. If all the banks were smaller, we wouldn't be so afraid of contagion risk (who cares if KeyCorp fails?). Banks would be better incented to be prudent investors, and do things like assume collateral can fall in value. With banks smaller, perhaps they wouldn't find lobbying government more important than coming up with better and more efficient business models.

Perhaps that is a bad idea, but it is simple, and is better than any idea that could conceivably come out of an agent based model.

Complex regulatory schemes generate the appearance of rigor and efficient regulation. Further, this way we can focus on what's really important, like which Boston-based financial conglomerate will win the Barney Frank sweepstakes this November and snag the Dodd-Frank author to their executive committee, winning them a 10 year regulatory pass and signaling to everyone on Capital Hill how the game is played.

Evolution Not Very Settled

In The Selfish Gene, Richard Dawkins argued that it is not species that compete, not even individuals, but genes. You'd never learn it from Dawkins, but it appears selection happens at all sorts levels, not just at the gene level. In Haidt's Righteous Mind, he (a psychologist) gives the following example of group selection.

A geneticist worked with cages containing twelve hens each, and he picked the cages that produced the most eggs. Then he bred all of the hens in those cages to produce the next generation. Within just three generations, aggression levels plummeted, and within 6 generations death rates fell from 67% to 8%, and eggs produced jumped from 91 to 237. If you just picked the hens that laid the most eggs, they tended to be the meanest, and so aggressive behavior (and dead hens) went up. That is group selection working better than individual selection, and gene selection is even less relevant; there is selection of genes, but only at the level of the group.

Then there's Steven Jay Gould's famous statement that 'there's been no biological change in humans in 40k to 50k years.' Haidt notes no one believes that anymore, especially after this Russian guy, Dmitri Belyaev, turned wild foxes into harmless dogs in only 30 generations, or about 600 years in human terms. That means the invention of agriculture 8k years ago could have really changed our brains and behavior at least as significantly as how foxes differ from dogs. It follows pretty basically that human races are probably truly different at some levels (mainly similar, to be sure).

These aren't minor changes. You have to pick this stuff up on the periphery, in blogs like gnxp, or books by Cochrane and Harpending, not the mainstream evolution books, which tend to focus on refuting intelligent design and creationists.

Haidt on Moral Values

I really enjoyed Jonathan Haidt's latest book, the Righteous Mind. It is filled with many facts and ideas I wasn't aware of, and it makes me feel like I know more about myself and the world. Reading such books is one of the finer pleasures in life.

There are many things I found interesting and profound. For example, sport is to war as porn is to sex, a harmless release for a primitive urge. He notes that judgment and justification are two separate processes, and our narrative part of our brain, the voice we all hear in our head when we talk to ourselves, is just the justifier. Don't trust it! It is a partisan hack for your intuitions. IQ is a predictor of how well people argued as measured by the number of arguments they use to buttress a hypothesis, but not better than others at finding reasons for the 'other side.' So, given one of his big ideas here is that we intuit our beliefs first, then rationalize them, it seems our analytic side merely helps us better convince ourselves and others we are right, and not be right in itself.

An important point he doesn't mention is that most of our beliefs do not pertain to matters of pure logic, but more complex assertions that are based on a wide set of data and assumptions. Thus, if everything were a math problem, we could trust our reasoning, but unfortunately life isn't a math problem, so we can't trust reasoning to get us to the right answer. That seems pretty convincing with my observation that after a certain level, more smarts does not make you wiser, just able to generate a broader, more articulate, or more rigorous defense of your beliefs.

He makes a good case for trying not to form an opinion on something too quickly, and see the other side's argument using their best faith, best arguments, and really letting them stew in your brain for a while before articulating a rebuttal. This way you will actually change your mind on occasion, and hopefully fixate on correct beliefs more often. If you announce a side it is hard to change your mind because your talking side really want to convince others and yourself that you were right all along, and your biases 'blind and bind' more quickly the more you invest in them. To have strong opinions, weakly held, means you can't advocate for them too strenuously too quickly.

But let me address something I think is wrong. He says there are 6 innate values people have

1) care, compassion.
2) fairness, justice.
3) liberty, oppression
4) loyalty, group pride
5) authority, respect
6) sanctity, disgust, purity

Liberals, in Haidt's view, value care and fairness the most to the exclusion of the others; conservatives value all of these. Most non-Western cultures value all of these. He thinks liberals, of which he is one, are wrong to dismiss loyalty, respect for authority, and sanctity as backward because these are all helpful intuitions in living in complex societies where a lot of trust is needed.

Yet, I too find myself prioritizing care, fairness, and liberty, and not very interested in loyalty, authority, and sanctity, and he notes this is typical for libertarian/conservatives. To me the difference is whether 'care' in the form of welfare or affirmative action is really helpful; I find this kind of care to be counterproductive--encouraging behavior that creates dependence--thus I do seem compassionate because I do not like welfare.

Further, liberals may score low on loyalty, but they love group politics, noting various demographics underperform and thus need affirmative action. For liberty Haidt notes that conservatives are concerned about liberty vis-a-vis the state, liberal vis-a-vis corporations. For purity, liberals think about organic foods and a clean environment, conservatives a more chaste sex life. For fairness, liberal think about equality of results, conservatives equality in opportunity. So, I don't think his 6 foundations are that different between liberals and conservatives, they are just applied differently, because of different factual beliefs about the how these things actually work.

Haidt ends this book where he notes he read a book by Jerry Muller titled Conservatism, and the author noted that conservatism was not based on mere orthodoxy, but rather, the idea that encouraging respect, self-reliance, and loyalty were actually a reasoned method to help communities prosper, and their individuals to obtain more satisfactory lives. This reasoned defense of conservative values floored him, because he saw it was, at the least, intellectually defensible and could be argued in good faith. That he came to this conclusion in 2008 highlights the bubble the poor guy was in.

I don't doubt for a second the good intentions, at some base level, of everyone but psychopaths. This book just confirms that at some point we decide we know the right intuitive policies, and then we become partisan confabulators.

Having a bog allows me to articulate my intuitions, evaluate them, note the ill-tempered but sometimes trenchant rebuttal comments. Academics, politicians, and journalists really don't have that luxury because they become part of a team, and if you want to work up in those status hierarchies you have to be consistent and loyal, which means our most prominent rhetoricians aren't really thinking out loud, rather just rationalizing their team's prejudices (what they call, reasoned principles).

Haidt ends his book with a great line: 'We're all stuck here for a while, so let's try to work it out.' This is an attempt to get us to bridge political differences based on ideas discussed in his book. Unfortunately, given our desire to rationalize, the internet allows us to quickly google 'why global warming is true/false' very quickly, and we can then easily become satisfied with our assumptions because on virtually any issue there's some well written brief for any argument, and a well-written rebuttal for any argument. Thus, as it is now easier than every to rationalize our prejudices, so it is ever more important to understand why we do this, and how to mitigate it.

Derman Rambles on Risk

I generally find Emmanuel Derman to be a very thoughtful, but this interview with Russ Roberts made little sense. They were talking about Derman's latest book Models Behaving Badly, and they had these little riff on financial theory:

Derman: But I think Black-Scholes is much better than CAPM. Although it is based on the same idea. Because different stocks really have such different risk characteristics that the assumptions of geometric Brownian motion and the assumptions in CAPM don't hold very well for individual stocks.

He seems to be suggesting that geometric Brownian motion is essential to Black-Scholes or the CAPM. I don't see how this assumption is essential to the arguments of the CAPM or Black-Scholes, which follow in a two-period model even more easily than using stochastic calculus.

Derman: I know Burton Malkiel reviewed my book in the Wall Street Journal, and he liked it generally, he was complimentary, but he claims in one paragraph that I was putting too much weight--he sort of claimed that all the efficient market model says is, I don't know what's going to happen next, as opposed to saying that current prices are right.
Russ: The first claim is a modest claim.
Derman: Yes, it is a modest claim. And I think maybe he is technically correct, but I think in everyday parlance people strive for a stronger version of it.
Russ: Yeah; I think the way you wrote it in the book is that prices reflect all publically available information.
Derman: Yes.

I think Derman is wrong here, and this is important. Malkiel was arguing against Derman's conflation of a post hoc wrong price (ie, one that recently moved a lot), with an efficient price. According to this conception of efficient markets, every time anything significant is not foreseen, markets are inefficient. Fine, but I don't know any researchers who think markets are that prescient, so it's a straw man argument that doesn't help the debate. You can say that's the common conception among your colleagues, but that just means your colleagues like beating up straw men arguments in this domain.

Interestingly, even Eugene Fama chirped in the comment section to say, 'great interview [throat clearing!], but he doesn't understand these points.'

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.