Taleb Mishandles Fragility

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

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

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

One interviewer's takeaway from his anti-fragile thesis was the following:

So what to buy? Taleb chooses investments with small downsides and large upsides: penny stocks, distressed assets, and options. “You want investments that clip the left tail.”

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

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

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

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

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

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

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

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

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

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

For example, a commentator on a negative Amazon review writes:

Please respond to Nassim Taleb's rebuttal and more clearly define your expertise and argument with the message of his book. I bet if you engage Mr. Taleb (once again, a rare honor) you will find that the both of you fall along the same lines of understanding. If you do not respond, it simply means that the review was an after-thought to retain review ratings on Amazon and not an honest intellectual review of the book.

That's the fawning tenor typical of his fans, and that kind of intellectual insulation doesn't encourage reality, let alone clarity, which Taleb notes is a major problem among other people. Taleb doesn't do himself any favors by responding to one review by noting that

This review is grounded in a fundamental error. It falls for the conflation described in the book between medicating and overmedicating, intervening and overintervening. The book NEVER says that mental illnesses should not be diagnosed in children, it says that it should not be OVERdiagnosed and OVERMEDICATED.

First, note the deranged use of CAPS, highlighting that he at least follows his own advice to not take Prozac. Then, note that his big idea on mental illnesses is that people should not over-diagnose or overtreat them. True enough,  given the meaning of the prefix "over", but if that's his point it's tautological.  Given Taleb's fixation with word cognates, it's odd that he repeatedly makes these kinds of errors. This kind of vapidity is why I think he's a blowhard.

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

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

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

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

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

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

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

Fighting Inequality

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

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

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

I'm a libertarian, but not because I think it maximizes welfare given current capital, but because it creates more capital by motivating us to act better, which helps us in spite of ourselves.

When we treat man as he is, we make him worse than he is; when we treat him as if he already were what he potentially could be, we make him what he should be. 

~Goethe 

If I accepted our envious instincts as optimal I would be indifferent to efficiency, because in aggregate relative status is no different here as in Haiti. I'm glad I have the wherewithal to read and think about ideas, a luxury unaffordable for most of my ancestors, and this isn't possible because of appealing to the mob's instincts.

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

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

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

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

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

Another Overnight Return Puzzle

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

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

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

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

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

Is Low Vol a Beta Phenomenon?

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

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

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

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

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

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

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

Online Education's Advantage

I'm a big fan, and hope the best for Marginal Revolutions new online class, as Alex Tabarrok notes:

Dale Carnegie’s advice to “tell the audience what you're going to say, say it; then tell them what you've said” makes sense for a live audience. If 20% of your students aren’t following the lecture, it’s natural to repeat some of the material so that you keep the whole audience involved and following your flow. But if you repeat whenever 20% of the audience doesn’t understand something, that means that 80% of the audience hear something twice that they only needed to hear once. Highly inefficient. 

Carnegie’s advice is dead wrong for an online audience. Different medium, different messaging. In an online lecture it pays to be concise. Online, the student is in control and can choose when and what to repeat. The result is a big time-savings as students proceed as fast as their capabilities can take them, repeating only what they need to further their individual understanding.

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

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

Government Response to Scarcity: Make it Free

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

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

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

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

Interview with Eugene Fama

Always insightful:

I was in Belgium for two years working solo. When I returned, I showed Merton Miller my research produced over that two year period, and he put aside most of it with the comment, “Garbage.” He was right on every count...

[Pensions] should be discounting the liabilities at the expected return implied by the risk of the liabilities, not the expected return on the assets. The liabilities are basically indexed claims—like a TIPS (Treasury Inflation-Protected Security). Therefore, the appropriate discount rate on the high side should be about 2.5%, not the 7% or 8% that the plans are using now...

In Daniel Kahneman’s book Thinking, Fast and Slow, he states that our brains have two sides: One is rational, and one is impulsive and irrational. What behavior can’t be explained by that model?...

Litterman: What’s your view of the purported excess return of low-volatility stocks? Fama: The excess return is really a result of low beta, not low volatility, and this potential source of return has been well known for 50 years. When the first tests of the CAPM were done, the problem always out front was that the market line, or the slope of the premium as a function of beta, was too low relative to what the model predicted. This meant that low-beta stocks had higher returns than predicted and high-beta stocks had lower returns than predicted....

I agree with Fama on almost everything, the exception being the risk premium. Fama seems to think the Security Market Line (SML) is increasing but too flat, rather than downward sloping. The return premium to low volatility equity portfolios is a profound fact and many experts can't see, even though it's there in the data, and the returns of traded low volatility funds. A 'too flat' SML is one thing, a negative one, quite another. One implies tweaks, the other, a paradigm shift. 

Election Bounce

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

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

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

Idiocracy in Action

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

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

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

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

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

Match of the Century

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

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

Lakoff Refuted

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

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



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

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

Mauboussin on Success and Luck

My 5-year old daughter recently was very excited to discover a new solution to a pressing problem. Her mother had told her she was not allowed to eat cookies and left the room. 5 minutes later Izzie told me she had a great idea: I give her a cookie but we don't tell mom, so mom wouldn't be upset.  Win-win! Her pride in independently discovering the tactic of lying reminded me that many skills are no less interesting to others simply because I know them.  Such it is with Michael Mauboussin's book, The Success Equation, which investigates how to navigate in a world filled with skill and chance.

The book spends a couple pages explaining the reversion to the mean by noting Galton's original observation on the heights of parents and their children, and much of the book involves the concept of bayesian updating. These aren't new ideas.  Yet, when he noted that while small schools are overrepresented in data on excellent and really bad schools, it reminded me that this is a real problem because invariably they are used as templates for some system-wide initiative, neglecting the fact that often some very unique circumstances as opposed to any efficient method are at work. Like everyone, I need reminding of some of these patterns sometimes.

The author recounts a fortunate interview he had with Drexel back in the days this was one of the most coveted positions out of college. He astutely noticed the senior interviewer had a Redskins trash can and so mentioned something casually about football, after which the interview went extremely well, talking mainly about football.  Clearly, that wasn't just luck, but after the fact appeared the key to him getting hired, creating a career path that would never be the same. Most big events, good and bad, are a mix of skill and chance.

In dealing with success and luck Mauboussin presents a useful model:

estimate=population mean + c*(sample mean - population mean)

c is a constant between 0 and 1, 1 for activities involving all skill, 0 for those that are purely chance. So, a chess, which is mainly skill, should have a c, or 'shrinkage factor', near 1, hockey games something near 0.  This is like updating a prior belief with new data (see here for how to do this more formally for various distributions). More relevant to investing, if your backtest generates a Sharpe of 2, one should remember most investment strategies have Sharpe's near 0, and so adjust your sample mean (ie, backtest) closer to that population mean. Any new idea does worse than its backtests because these aren't population data, but rather selective sample data.

He could have added something on how to address robustness as he did with his shrinkage factor approach to bayesian updating, say by showing how you could optimize over a set of parameters from different subsamples.

The book mentions research by Pinker, Gazzaniga, and Haidt, and I love these authors so I found all that very interesting.  Some of his other inspirations I'm less fond about. He calls Peter Bernstein 'one of the investment industry's greatest thinkers', though I'm at a loss as to what Bernstein insight might deserve such praise.  And then he mentions my favorite flâneur, Nassim Taleb, and suggests his great insight is that when payoffs are uncertain and complex, these are great situations to go long, specifically, go long out-of-the-money options.

Out-of-the-money options aren't underpriced on average. Sure, you will do well when the market tanks, but it's expensive insurance. Remember, when you cross the spread on a 3-delta put, your are giving away a lot of vig. If you think you can trade at mid or close you are being naive (I hear Taleb has a new book out advocating the same thing, buying gamma).

Also riffing on Taleb, he says we are better off using no model than a faulty one. This is a straw man. A faulty model is harmful almost by definition.  Yet  if you are acting, you are acting on some kind of theory, which is at some level a kind of model. One is better served by an attempt to formalize as well as possible one's strategy rather than to merely trade on intuition, the key being how well one deals with the uncertainty by simplifying the functional form, or accurately calibrating the probability of loss, or the time series nature of losses, etc. When people say they have an atheoretical or non-parametric approach they are neglecting a meta-assumption: any idea about how the world behaves involves a theory at some level, which can also be some kind of model (eg, a Venn diagram, or an if-then statement, a linear best-fit through an ellipsoid of data).

I'm not the audience for this book, but as most people are prone to overfitting, it has an audience, such as people who like Taleb's books.

Lastly, I noted he has 5 children, and I'm always  amazed when I read a sustained argument written by someone around my age with more kids than me. Having children is like putting a bowling alley in your head, and makes writing very difficult.  That's skill.

Missing Risk Premium Book Reviews

My book has 8 reviews over on Amazon, including the prolific Aaron Brown and David Merkel.  There's also some guy named Gregory Fodor who gave it 5 stars, the same score he gave to Ilmanen's Expected Returns, and a book on UFOs (I do find Ancient Alien Astronauts very fun).

I've noticed several others across the web. Here are some snippets.

Kirkus reviews:

The author’s conclusion is likely to be controversial in some circles, if not downright inflammatory

 John E. Parsons:

Questioning the theory is a tough challenge, though. As already mentioned, the risk premium is a central premise, and modern finance theory is a ramified structure. If we remove that premise, there is a lot of work to be done to recreate the structure around an alternative. I was surprised to find that Falkenstein understands the burden his questioning entails, and this book is a partial attempt to flesh out an alternative. Falkenstein is a serious fellow, and he has engaged the problem persistently over many years, so it is interesting to listen to his suggestions.

In this book, he provides a lucid history of the academic thinking on risk and return over more than a half century, a careful exposition of what the data say and don’t say, and a thoughtful discussion of competing theoretical frameworks. He writes with the refreshing voice of an outsider, and looks upon academia with a gimlet eye. But he also writes with the qualifications of an insider, completely familiar with the most sophisticated economic theories and statistical tools. He assumes the burden of making his critique and ideas resonant to an open minded intellectual familiar with modern economics. Make no mistake, this is a wonkish book that places serious demands on its readers.

Eddy Elfbein:

One of the most eye-raising aspects of the book is where Falkenstein discusses the many small losses that individual investors suffer between the stock gains they see reported on CNBC, and the returns they get. Investors are constantly dinged by things like bad timing, transactional costs, bid-ask spreads and taxes. Once you throw in variables like survivorship bias, Falkenstein says that the historical databases we have return bare little resemblance to what made its way towards investors’ pockets. This topic alone could serve as a useful book.

OnlyVix

The book is mostly technical, but without unnecessary math, and is focused on the main thesis - there is no "investment edge" in simply taking the risk. I would recommend every investor keep this in mind.

Value and Opportunity:

Summary:
+ the book is a good summary of all the current available studies which contradict the CAPM
+ he makes a good case for investing in low volatility assets, although I didn’t fully understand his theory
- what he misses in my opinion is the fact, that all this is common knowledge among value investors.

Blaming the Victim

Every week brings a new billion dollar settlement against the banks that supposedly rammed this stuff down the throats of the noble savages who couldn't afford the homes they bought.  Luigi Zingales notes a study on how culpable banks were:

Predatory lending is commonly defined as lending that imposes unfair and abusive loan terms on borrowers. The immediate effect of this mandatory counseling was to discourage almost half of the loans. ... While the paper calls it predatory lending, the better term would be crazy lending, because it is not clear that the banks were forcing these loans on ignorant consumers, and not the other way around. In fact, the reason why the program was suspended only 20 weeks after its beginning was that the local population complained with the legislators for the negative effects this law had on the availability of mortgages.

I wonder what happened to all those community organizers aligned with ACORN who advocated more no-down payment loans?

The head of CountryWide continually bragged about how they were easing mortgage requirements in the name of increasing minority homeownership when he was doing it. So, their public stance went from being admirable to brazen. This same government that applauds excess and piles on when things go wrong is supposed to moderate financial cycles.

AQR on Making Low Vol Better

 AQR has been offering 'low vol' funds institutionally for a couple of years, but last July started offering them to retail customers too.  As they are titled 'Defensive Equity' funds, they escaped my radar but really these are 'low vol' funds (eg, U.S. Defensive Equity Fund AUEIX, the AQR International Defensive Equity Fund (ANDIX), and the AQR Emerging Defensive Equity Fund (AZEIX)).

I spoke with Adrea Frazzini (right), a portfolio manager at AQR, and one of the lead authors on a major bit of research in this area, Betting Against Beta.  He noted their approach is basically to minimize volatility while trying to retain industry and factor neutrality, where the factors are such things as value, size and momentum. Considering that many think low vol is redundant in the context of a value exposure, this approach would appeal to those who already have a value exposue.

The idea here is that this approach generates less  tracking error that would come from, say, the SPLV, the popular low vol ETF that just swipes the bottom 100 stocks from the SP500. Basically, SPLV incidentally takes on various amounts of factor risk at any one time as some industries or extreme-factor loading stocks become less volatile.  By minimizing factor exposures tracking error will be less correlated with factors, which I can empathize with because if you underperform by 5% one year it feels better if its from something you can't control (the serenity prayer).

There's great danger and opportunity on this path. That is, SPLV is incredibly simple but it gets you a long way towards capturing the low vol effect: much lower vol, perhaps a slight return bump. In contrast, Russell's failed LVOL ETF tried to take it to the next level by getting really complicated, although I can see how, with a bunch of PhDs in a room it all made perfect sense. SPLV nicely keeps US low vol funds focused.

Like the other strategies in the low volatility space AQR expects betas of around 0.7, and volatility of about 1/3 lower than their regional equity benchmarks. Such a claim is realistic because that has been the result of other funds that have plied this strategy in real time over the past 7 years. As long as the Security Market Line (Beta on x-axis, average return on y-axis) is empirically flat this approach seems a no-brainer to any MBA because you can get the same return for 70% of the volatility; a low beta/vol focus has a higher Sharpe. [I'd say things about AQR's performance, but our far-sighted regulators make that parlous in their efforts to protect widows and orphans].

Frazzini mentioned that in non-developed countries, the volatility reduction is even greater within those regions, and clearly for any investor taking advantage of international diversification seems a straightforward way to reduce volatility and covariance with one's income much more than staying local.

Wittiest Sentence I've Read This Year

Steve Pinker attempts to explain the difference between Red and Blue states, and also why gays, guns, and taxes are correlated policy positions. In the process he notes that conservatives tend to have a pessimistic vision of human nature, liberals, a more optimistic notion:

The metaphors may be corollaries of the tragic and utopian visions, since different parenting practices are called for depending on whether you think of children as noble savages or as nasty, brutish and short.

Buy on Earnings Guidance

The standard finding is that a stock’s cumulative abnormal returns drifts in the direction of an earnings surprise for several weeks following an earnings announcement. Often this was presented as a way to make easy money shorting the negative surprises, going long the positive surprises. Now it seems one leg might have the wrong sign. This highlights one problem with trying to be consistent with all the facts: they aren't all true.

There's a newly published paper by Das, Kim and Patro On the Anomalous Stock Price Response to Management Earnings Forecasts. From the abstract:

In the post-announcement period, we find a significant upward price drift for both good news forecasts and bad news forecasts.

Here's the result in a nutshell, x=0 is time of earnings announcement,  the blue line negative surprises, red positive, going out 30 days

A free early version is here.

Arbitraging Beta Within Mutual Funds

If you remember your Corporate Finance, returns should rise (on average) with beta, because otherwise you can form a levered position generating a greater return without more risk. Arbitrage Pricing Theory developed by Stephen Ross was based on the idea arbitrage and totally consistent with the Capital Asset Pricing Model because it was simply the special case where one is arbitraging a single 'market' factor. A recent SSRN paper, Capitalizing on the Greatest Anomaly in Finance with Mutual Funds by David Nanigian.  Here's the Average return by beta quintile for US mutual funds, 1990-2012 (Figure 2--I added the red to see his points better:

As the author points out, there's an arbitrage here in Sharpe space, because you can generate the same beta and/or volatility by levering up a low beta mutual fund, and then generate another 2.5% return here. But, the best way to play this is less indirect via low volatility funds, because most players in that space have generated an even larger arbitrage opportunity in risk-return space. The key is beta is clearly not priced within equity markets, but it should be, so in the meantime anyone who doesn't have a really good reason to believe they have alpha should invest in a low volatility fund

Pointless Econ Debates

A big point of contentions seems to be whether or not the 2008 slump was a 'financial-induced recession', because as Reinhart and Rogoff say these have slower-than-average recoveries, this benchmark then makes the current recovery look better; in contrast, compared to the average recession the recent recovery looks worse.

 My old mentor Hyman Minsky argued that most recessions are financially induced, from excessive leverage, creating a panic as investors stop rolling over debt and cash flow long-since became negative. The Ponzi borrower borrows based on the belief that the appreciation of the value of the asset will be sufficient to refinance the debt but could not make sufficient payments on interest or principal with the cash flow from investments; only the appreciating asset value can keep the Ponzi borrower afloat. This applies perfectly to many zero-down home buyers circa 2005-7.

 Reading Minsky you'll see he applied this mechanism to most recessions (eg, not 1945), and so there's at least one expert--of good faith, not ignorant--who disagrees with Reinhart and Rogoff. Anyway, John Taylor classifies 1882, 1893, 1907, 1913, 1929, 1973, 1981 and 1990 as 'financially induced.' Krugman says 73 and 81 were not 'financially induced' because they were orchestrated to combat inflation, a novel addition to the classification. Then they get into where to start the recovery, and how far out to go. When the debate gets into such semantics, it becomes pointless.

 Krugman laments that 'politicization is hurting economics', though he is economist number 1 for having prestige and throwing around ad hominem like liar and consistently assuming that those he disagrees with cannot possibly be intelligent and honest. DeLong's posting are even better for over-the-top ad hominem, but he's in such a strange echo chamber he doesn't realize he's disqualified himself from so many positions he covets because even his team understands that rank partisanship becomes a liability at some point (no more Assistant Deputy Secretary positions, but rather, senior adviser posts for groups like the Rent is Too Damn High Party).

You just have to stop and remember: on any big debate, to think that one side is only motivated by ignorance or deceit doesn't understand the debate. Sure, some, even many, on any side of a big debate are ignorant are tendentious, but as with benchmarking this past recession, reasonable people can quibble with vague categorical definitions.

 I enjoy reading the daily venom from Krugman and DeLong because they are proud to be angry as if their righteous indignation makes them more compelling, unaware that losing one's temper is a good signal you've lost the debate. 

Merton vs. Low Vol

Low volatility investing is becoming more popular, but the question is perhaps it could be better captured via a more inclusive metric of volatility. The Merton model of default popularized by Moody's KMV is basically a function of two inputs: volatility and leverage. If this model is correct, then a probability of firm failure is better captured than mere volatility alone, and perhaps it also captures the true, fundamental volatility that is driving the low vol effect. 

I took data on the distance-to-default (DD) that I calculated monthly using the standard approach (I used to work on default models at Moody's), and this isn't really ambiguous: anyone in the know can generate them. I then looked at the top 1500 stocks by market cap, and formed portfolios with the highest volatility/lowest distance-to-default, and those with the lowest. Remember that low distance to default means 'risky', high DD is low risk. It turns out the portfolio returns generated from this exercise were so similar, the low volatility/high distance to default portfolio lines are indistinguishable.

It seems for the purpose of predicting future equity returns volatility and the Merton model are synonymous.  

Google Stop Per Regulations

Google had a PR snafu and announced earnings intraday. This caused a big price move of 10%, and then a price freeze for about 2 hours per US regulations.



To think this had any help on generating a more efficient market is absurd. This disruption wasn't horrible but highlights the futility of trying to do good: such regulations always ends up something really dumb that just annoys everyone in the know.  

I Would Destroy Half the Value for Half the Price

Above is the stock price over Vikram Pandit's CEO tenure. He received $1 in 2009 and 2010, but then you knew he would make that up and so in March 2011 he was given a $23MM 'retention award'. As CEO, he has a lot of power so it's hard to avoid this, and to me it highlights the problems of allocating incentives and rights in large collectives. While I'm a critic of these poor CEOs getting large payouts, I don't think the solution is obvious. After all, Clinton's millionaire tax in circa 1994 gave birth to the stock option boom that probably exacerbated the tech bubble and the fraud in companies like WorldCom and Enron.

A lot of people find Pandit's pay extremely annoying as if Pandit is taking their money, but unlike government money, this is other people wasting their own money. Sure, Citi was backstopped in the bailout, but 1) they couldn't have refused it 2) they paid it all back and 3) that's not a reason to regulate Citi more, rather, to not bailout big banks.  The solution to bad regulation isn't more regulation, but less. It's not only creates more efficient incentives and allocation of risk and capital, but is far easier to implemented.

For example, the latest regulatory proposal actually targets spreadsheets:

The regulator stated that insurance firms will be expected to demonstrate appropriate controls with regard to key internal data flow systems such as spreadsheets. These controls should take the form of, among others, input validations, change and release management, disaster recovery and documentation.

They might as well validate my Post-it notes too.

Back to Citi, I think the best way to increase value there is to break it up into into manageable pieces. One simply can't manage something that big, as the big banks are demonstrating. 

Bad Regulations Don't Go Away

A poor guy in Iowa was dismissed via an absurd no-tolerance policy by the FDIC:

A 68-year-old Des Moines man fired from a Wells Fargo call center for putting a cardboard dime in a washing machine in 1963 has been cleared to return to work in the banking industry, the Federal Deposit Insurance Corp. said. Wells Fargo is under no obligation to rehire Richard Eggers, however... Wells Fargo said it was simply complying with the regulations, which carry a $1 million-a-day fine... A 1950 federal law prevents FDIC-insured banks from employing workers who have been convicted of a crime of dishonesty or breach of trust. In 2008, Congress passed a law that forced mortgage loan originators to perform similar employee background checks.

This dumb law was overturned, but it has to be this dumb, take 62 years, and merely generates an exception not a rewrite.

No-tolerance policies are primarily adopted by institutions when people have no faith in discretion. As Phillip Howard has argued, discretion dominates rules because reality is always more complicated than any rule contemplates. Yet by law bad outcomes can be legal under discretionary frameworks, so lawmakers like zero-tolerance policies because in theory that eliminates the perceived problem.

It's a classic example of the perfect being the enemy of the good. Anyone really enthusiastic about regulations fixing rather than causing problems in the financial industry can't rely on history, as financial regulations have been and continue to be generally irrelevant. We have one set of regulators who look over hard copies of all our traders personal stock trades, presumably to look for front running.  This is silly for two reasons. First, we don't have retail flow like a brokerage, so we would be hurting our company for personal gain in this case, and clearly we have a greater incentive to stop such individual malfeasance than regulators. Secondly, looking at literally hundreds of thousands of company trades, and comparing them to a stack of personal trades in hard copy (with various formatting), is like looking for a risk premium using covariances, a waste of time.

Vol of Vol

I was at this year's OptionMetrics conference and it was a nice overview of 13 different papers. One that stood out was Guido Boltussen's paper (coauthored by Van Bekkum and Van Der Grient of Erasmus U) on Unknown Unknowns: Vol-of-Vol and the Cross Section of Returns. The idea was simple. Instead of sorting by vol, they sorted by vol of vol, and generate a rather large annualized return  difference (10%) between the high vs. low vol-of-vol buckets. It's a bit like the guys at Gillette coming out with 5 blades, applied to volatility. Here's the standard graph with monthly excess returns:

In any case, it's intriguing. I haven't looked too hard at this, but it's a pretty obvious extension of the well-known low vol premium, and plan to investigate further. Clearly vol-of-vol is correlated with vol, so it would be interesting to see how these variables relate to each other in explaining the now well-known low-volatility premium. Perhaps volatility is a poor man's estimate of the 'true' factor, vol-of-vol, or vol-of-vol-of-vol.

There were several interesting papers, and I noticed that as usual, the risk premium (aka 'price of risk) was usually negative. Now, the risk premium should be positive, a premium, but empirically is usually negative; I don't think that word doesn't means what they think it means. I think it's better to say, here are excess returns, controlling for various obvious alternative characteristics we know to be correlated with excess returns. 

OptionMetric User Conference Monday

The 2012 OptionMetrics Users Conference is Monday, October 15, at the New York Society of Securities Analysts Conference Center, Times Square, New York. I'll be speaking Monday at noon, but there are 4 different sessions each with 3 speakers discussing various strategies and tactics.

 See details here. 

Ego and the Low Vol Premium

In my book The Missing Risk Premium, I have a chapter on why if anything there appears a negative risk premium: more risk, lower return. It's obvious in lotteries and gambling, where the most improbable events have the lowest expected returns, but true in less trivial areas such as options and stocks. One of the causes is signaling, that investors tend to want to show others how awesome they are by trading frequently just like a real alpha generator would.

 It's interesting to note that in games there's a profound dichotomy between the optimal tactics for beginners and experts. For example, Simon Ramo notes that among the very best tennis players, to win you need good winning shots; to be a good average player, you need to merely lower your failure rate. In expert tennis, 80% of the points are won, while in amateur tennis, 80% are lost. The same is true for wrestling, chess, and investing: beginners should focus on avoiding mistakes, experts on making great moves.

Yet if the distinguishing characteristic of an expert investor is whether they are being aggressive, then any aspiring expert is forced to be aggressive because this signals to others that he truly is an expert, and finance is all about getting other people to give you money to manage. Thus it should come as no surprise that if you give people advise to invest in simple index funds or to focus on low volatility stocks because you can do little damage, and save a couple percent a year, many will dismiss this advice. The favorites of aspiring financial moguls are volatile, because one isn't going to hit a 'ten-bagger' on Coca-Cola (vol of 15%), but rather Netflix (vol of 70%).

 An example of how investors think about the perceptions of others was nicely demonstrated by Baumeister, Heatherton, and Tice in their 1993 article When ego threats lead to self-regulation failure: negative consequences of high self esteem. They gave subjects a video game involving flying a plane through obstacles, and after 20 minutes of practice (and secret recording), they were told they would receive $2 if they matched a time set to just below their actual average time, but $4 if they did some bit better than their average time. Subjects didn't realize this criterion for payout was scaled to their individual prior performance, but rather, thought they were from population averages (ie, those dopey other guys).

Half the subjects were randomly assigned to the ego-threat condition. For these subjects, the experimenter added the following remark: "Now, if you are worried that you might choke under pressure or if you don't think you have what it takes to beat the target, then you might want to play it safe and just go for the two dollars. But it's up to you."

 When that little statement added, more then took the gambit and did worse on average.

Our desire to impress others causes us to take too much risk. On the bright side, this implies some rather simple strategies like low volatility investing, because I don't see it going away.

Guilt Dominates Shame

I stumbled across a fascinating lecture on shame and guilt by June Tangney, a psychology professor at George Mason. I used to think they were the same, but she points out they are profoundly different.

She starts with a story about when she saw her little daughter kick her sibling, she wanted her daughter to feel bad. That is, though she loves her daughter, she wants her snowflake to feel bad sometimes, as it's a healthy corrective when one inevitably does bad things. The question is, how should you feel bad about yourself in such cases?

Guilt and shame are emotions not present at birth because they require a sense of self and standards; babies don't feel them. She defines shame as feeling bad about oneself, guilt feeling bad about behavior. Shame is feeling 'I am bad', guilt is feeling 'I did a bad thing.'  Both are painful, but guilt is not nearly as overwhelming.

 Guilt leads to thinking about behavior and its effect on others, shame is more focused on how others think about us. Shame attempts to hide and deny to escape the situation, even anger.  Guilt involves regret and remorse, and leads to a focus on reparation and redress. Guilt and other-oriented empathy go hand in hand, while shame interferes with empathy.

As a good scientist, she looks at data and finds people more prone to shame are not as mentally healthy as people prone to guilt. Further, people prone to shame blamed others more for their misfortune, classic defensive Freudian projection. Shame-proneness is more related to depression, anxiety disorders, low self-esteem, drug use, destructive behaviors, etc. Guilt proneness, in contrast, is associated with lower recidivism by convicts.  It doesn't seem to be inherited, as the correlation between parent and child in shame-proneness was a measly 0.1.

She recommends guilt as the moral emotion of choice. Parents should minimize shame and humiliation, but rather to call children's attention to the harm that they've done, make redresses, and empathize with those they have hurt.  Guilt is much more constructive and proactive, and changing behavior is the key to improving one's situation.

Confirmation of Low Vol Dominance

The Institutional Investor takes on the Low Vol effect. Their simulation for US stocks, where they used the top 3000 tickers, and created a LoVol portfolio using the bottom 20% ranked by volatility, and HiVol the top 20%. Here's the results:

January 1974 through November 2011, LoVol (portfolio) beats the index by 59 basis points a year on a compound basis... As for HiVol, its performance relative to the index is truly dismal: It underperforms by 592 basis points a year on a compound basis.

This helpful nugget is nested in a theory that defies comprehension: reconstitution. My brain hurts trying to conceive how this works, because they say things like

If we hold a stock that drops out of the universe, we will certainly be selling it at a relative loss, because the stock has failed to keep up with the other stocks. After all, it has lost its place in the top 1,000. In essence, the strategy requires that we sell low in this case, creating a drag on performance.

But in this example, the stock had already lost value; selling it in backtests creates no further loss. They then note:

When multiple stocks are combined in a long-only portfolio, their interaction actually causes the portfolio to have a higher compound growth rate than the weighted average compound growth rate of the stocks in that portfolio.

The authors note this "can be quantified using highly technical mathematics", and for a proof that E(x+y)>E(x)+E(y), it must be highly technical indeed.  But why bother with a 100 page proof using the Taniyama-Shimura conjecture when you can simply go long SPY, short its constituents, and laugh all the way to the bank. Arbitrage! Methinks they are confused.

 It's good to know the why, because without a good theory for what is driving the low vol effect, one is reasonably skeptical, and of course I have one in The Missing Risk Premium: Why Low Vol Investing Works. Remember: theory without data is bullshit, and facts without theory are trivia.

Poor Ina Drew

Executives at large financial corporations tend to be smarmy bureaucrats, not savvy investors. They rise to the top via excellent credentials, good connections, better timing, and learning to not say anything so clearly as to betray their ignorance on things large and small. Ina Drew sounds like a Dilbert caricature.

A New York Times puff piece on the former JPMorgan CIO tries to paint her as the scapegoat of their infamous first quarter debacle, but their description of the $6B bad trade/hedge sounds like she never understood it. Most of the piece is about her life, but then they get to The Trade and there's vague and inconsistent descriptions of events given the author's access. They mention

Drew’s deals essentially turned on one key question she seemed to answer correctly more often than most (or at least when it mattered most): Would interest rates go up or down?

I find this laughable. Anyone who's been in finance for a couple decades knows that anyone with an edge in interest rate forecasting is deluded, ignorant, or not a corporate executive. That's just not where those kind of people end up. An executive who thinks calling market direction is really important doesn't understand the Serenity Prayer, that banking is about intermediation and not speculating.

 As a short credit position got large in 2011:

Ina knew the product, the size they were trading, but she did not know what the true P.& L.” — profit and loss — “impact could possibly be in a stressful scenario,” he said...One serious defect in the risk evaluation of Iksil’s position was that its limit was folded into the aggregate risk of the unit’s entire portfolio. In other words, Iksil could continue to increase the position without triggering alarms.

How can a CIO not understand what would happen in the mild hiccup in the first quarter of this year? How could such a large position be 'folded into the aggregate risk of the unit' yet be marked to market?  I suspect she understood it as so many senior executives do, which is, not very well. They then discuss how they tried to close the position by putting on a correlated position going the other way. Clearly this didn't work as expected, which means it was a bad hedge, clearly in the CIO's bailiwick. 

They mention she's became quite wealthy. She should be grateful to the Gods of corporate chance.

Short Sales as a Coasian Solution

The Coase theorem states that if there are no transaction costs, bargaining will lead to the same outcome regardless of the allocation of property rights. This highly counterintuitive result has a very profound implication, such as that the law should focus more on predictability than justice, because if one suffices with a reasonably just law that is highly predictable, one should expect the same net effect in terms of people and businesses doing what they would have done to maximize their welfare if the law were perfectly just. Predictability is a practical supreme objective for any justice system.

The many steps a bank must take in a foreclosure, and various rights of homeowners to supersede a foreclosure sale, basically make the abandoned property the concern of no one for a long time (avg time of delinquency: 631 days!), and these laws are counterproductive responses. For example, during the crisis a new law allows mortgage holders to reclaim the house within a 6 month 'redemption period', which is designed for the possible but improbable case where someone falls behind on a mortgage but has positive equity in their home. In practice just means the property lies fallow for 6 more months than necessary.

 Short sales have become more popular because they can shorten the time a house is not being used. In a short sale, the mortgage holder sells the home for less than their mortgage outstanding (banks lose), but the property is then owned by someone who actually will pay taxes and mortgage payments and take care of the property. The benefit to the borrower is that this is not as harmful as a bankruptcy or foreclosure on their credit history; the benefit to the bank is the property avoids wasted time with no upkeep, and the house can actually start generating cash-flow again.

It's a second best solution forced on us via naive regulations, but anything that shortens the time properties remain unkempt, unpaid, the better.

Straw Man Argument

From a pro-Obama video quoting Obama speeches:

 Obama: "You would think (my critics) would say maybe some rules and regulations are necessary to protect the economy..."

 The idea that the debate is between no regulation vs. good ones is a caricature, but it's the conviction of many. These people have no understanding of how many different rules exist, and that there's a difference between less regulation and zero.  As regulations proliferate it's impossible to enforce them all fairly, and so enforcement becomes selective and capricious. Legislative micromanagement is the road to crony capitalism, why so many senior risk managers at large private institutions are ex- government officials with some connections with the regulators. 

Fixing Health Care

Listening to the presidential debate on how to insure everyone's health care without penalize those with higher expected medical expenses is amusing because it's redistribution masquerading as some simple engineering problem. It's always more efficient in these scenarios to simply redistribute, rather than play games so no one sees this as what is really going on, but then this is a harder sell and thus the equilibrium. I was struck by this line in David Henderson's review of Priceless by John Goodman:

Strong evidence for Goodman’s view that there are good effects from having consumers face real prices for health care comes from the area of cosmetic surgery. Such surgery, he notes, is rarely covered by insurance. He points out that, uunlike in most areas covered by insurance, patients can typically find a package price that includes all services and facilities and compare prices prior to surgery. Moreover, he notes, prices adjusted for inflation have fallen over time as technology has improved. He notes that for the kinds of surgery covered by insurance, improvements in technology are blamed for rising prices.

I'm reminded of the saying that things are never so bad that they can't get worse, which is where I see us going. Less regulation seems improbable regardless of who wins the election.

A Deep Understanding

 

There's an interesting article on Slate by someone miffed at all those 'correlation doesn't impy causation' slams common in retorts.  He makes the good point that, while not proof, correlation is suggestive, and consistent with causation.  If you want to be a pedant nothing non-tautological can be proven (see Hume's problem of induction). It reminds me of the saying 'absence of evidence is not evidence of absence.' This is wrong. It's not proof of absence, but from a bayesian perspective, it should increase one's belief in absence.

More Evidence that Envy Trumps Greed

Two Israeli economists, Haim Levy and Guy Kaplanski, have a new paper, Investment Choices with Envy and Altruism. The go over what kind of utility functions can rationalize the following preferences.
They asked people about the following scenarios:

 1.The value of the subject’s investment in stocks increases during the year from $25,000 to $27,500, and the stock index also increased at the same rate.
2. The subject’s investment and the stock index increase exactly as in Scenario 1, while the portfolio of the peer group appreciates by 50%, from $25,000 to $37,500.
3. The subject portfolio as well as the stock index decrease during the year from $25,000 to $22,500.
4. The subject investment and the stock index decrease exactly as in Scenario 3, while the portfolio of the peer group depreciates by 50%, from $25,000 to $12,500.

 Needless to say, they find that "envy dominates the results as the utility generally decreases when the peer group earns more and it increases when the peer group loses more than the subject." It's relative wealth that matters more than absolute wealth.  This is consistent with the theoretical thesis of my book, The Missing Risk Premium (now with 5 reviews, and the 'Look Inside' feature is now enabled!).

Bank Stock Timing Strategy

My bank vega theory I alluded to yesterday argued that when banks are weak, they are in a negative vega zone: the potential for getting stopped out makes them want to avoid risks, not take them. For fun, I looked at a trading implication, based on the idea that I alone, via my theory, know when banks will be timid or growing.  A timid bank doesn't make money, so it's best to avoid it then. It's not short term enough for it to be really useful, so I'm sharing, and I think all investors thinking about their bank index allocation should find this interesting.

A calculated a backward-looking correlation of the past 252 days of daily bank returns with the changes in the VIX index, because Ken French's website has daily returns for a bank index going back to 1986, I have VIX data from 1986, and I can update this with the KBX bank index for more recent daily data.

I then take this correlation, and find its median. I then say, invest in the SP500 when this correlation is high in absolute terms (very negative, all correlations with the changes in the VIX are negative), I don't want to invest, because the banks won't be investing and making money. In the 50% of the time that correlation is low (again, in absolute value), I'm in the banks. Here's a comparison of that strategy, and clearly timing based on the bank-VIX change correlation outperforms simply being always long banks.

Here's what it looks like in Scatter-Plot, comparing the future 3-month return in the two regimes.  The black vertical line in the center is my best stab at putting a median in there.

We are currently at -70% for a correlation, still bad for banks (median around -62%). This is all out of sample, and a pretty simple rule. I did try this with Ken French's other industries, and found no similar pattern.  

Banks Still in Negative Vega Zone

Recent increases in the monetary base have all gone into excess reserves, and so inflation has remained low, and monetary stimulus isn't stimulating. This puzzles many people, but I have a theory for it. The idea is that while equity owners--management--are like owners of call options on the assets of a firm (aka the Merton Model), banks are like down-and-out call option owners, because if their book equity goes down too far they will be forced into a fire-sale or liquidated by regulators.

 This is a barrier option, and has the interesting property that its vega--the derivative of the value of the equity with respect to asset volatility--is negative when it gets close in value to its barrier. A standard call option loves volatility, the greater the better. This can be shown by noting that an option is worth something like max(0,x), where x is a random variable; the higher the volatility of x the more an option is worth.  With a down-and-out constraint, a loss can cause the equity to forever extinguish, and this causes the vega to actually go negative when close to the absorbing barrier.

 That is, consider the difference in vega in the graph below.

If you have negative vega, adding risk or volatility hurts your equity value, so you turtle in, and wait like the 1990 Japanese banks for inflation and retained earnings  to cure your precarious position. Banks are still in their negative vega zone currently, afraid to do anything that will either get them into legal trouble, or generate any losses that would force them into liquidation. So, they aren't lending their new cash balances but rather hoarding them as protection.

 Bank of America recently paid a $2.4B fine to settle claims it misled investors about the acquisition of troubled brokerage firm Merrill Lynch. That brings its total fines since 2010 to $29B with no end in sight (eg, the Libor fixing scandal). Banks get fined for not lending enough to minorities, and lending too much.  If the government would stop treating the banks like the Knights Templar circa 1307, the economy would recover much faster. A modern economy needs banks, ones that want to take risks and grow.