My Big Toe

A large problem in physics concerns the nature of quantum reality, where as Richard Feynman famously  said, “if you think you understand it, you don’t understand it.”  A currently popular solution is the many worlds hypothesis, preferred by Eliezer Yudkowsky among others, which is that for every quantum event, everything actually happens, merely in different branching universes. 

Another solution is offered by physicist Tom Campbell, author of My Big TOE (Theory of Everything), who argues that we are in one of Nick Bostrom’simulations, autonomous ems or avatars in a multiplayer game.  Campbell argues the collapse of the wave-function is only necessary when an observer is watching, in the same way a field in World of Warcraft is not rendered to anyone until a player wanders over to it.  He goes on to argue the essence of our world is consciousness, which makes reality arise the same way walking around The Matrix creates the pixels showing a specific landscape.  This  implies there’s no sound of a tree if there’s no consciousness to hear it, among other things.  

Yet, things like sounds have effects via their acoustic reverberations on many unconscious things like plants and rocks, and these effects need to be incorporated into the environment.  Things that don’t affect a consciousness still have real effects that we see later, and if the world is simulated precisely because it’s too complicated to calculate the emergent property ex ante, then one needs to run the simulation for these effects all the time anyway, not just when a conscious agent looks.  Consciousness seems like an arbitrary way to dictate the nature of what actually happens in a simulation, as if the simulators are monitoring conscious agents and their peripherals, which seems implausible. 

As an economist, I like idea that everyone has to economize, in that no one is too rich to ignore time constraints or the size of one's stomach; this is why economics is at some level universal: trying to maximize an objective function given constraints is something everything has to deal with.  Similarly, an ethereal designer would also have resource constraints, because if they had infinite resources, they wouldn't be playing games, they’d be trying to figure out how to kill themselves because it would be painfully boring to exist after a google years.  Any finite computer system doesn't have memory  for the infinite number of simulated universes created at every quantum resolution as implied by the many worlds hypothesis.

My dog might think I'm god, giving him food from sources he can't understand.  Avatars in a sim might consider their programmers gods.  In both cases, these gods are not omnipotent nor omniscient, exactly why they appreciate their creations. Even if god were as in the Bible, I can't imagine he's truly omnipotent because in such cases he would have no reason to create the Earth or people, because he would know what would happen--he could figure everything out-- making the exercise uninteresting, uninformative, pointless.

So, assuming we are the instantiation of a simulation designed by hyper intelligent beings in the 10^th dimension, they almost surely have resource constraints; they can’t allow the simulation's usage of memory to explode over time.   We don’t know the purpose of this game, but there are rules that we see as the laws of physics, including their physical rule that the simulation not require an infinite amount of memory. 

This nicely explains why they chose to have wave-particle duality.  So many things interact over time that keeping track of all those point objects would require a great deal of information, indeed,  the information needed if we didn't have wave-particle duality would overtax our simulators.  Luckily, the interaction of wave functions for these particles greatly compresses the amount of information needed to precisely capture their interaction.  That is, the wave function does not merely approximate these particles, it completely captures their interaction.  The set of all possible wave functions at any given time forms a vector space, which means that it is possible to add different waves like how you can combine Gaussian distributions into a single Gaussian distribution and ignore all the ones that came before.  When there are many particles there is only one wave function, not a separate wave function for each particle.

This is probably one of many reasons our god-like programmers chose this for an aspect of their simulation, our reality. For example, as we move forward it time, having electrons exist as a constant probability mass as opposed to moving about is both consistent with all its potential interactions and uses a lot less memory.  

The bottom line is, if we are in a simulation, there needs to be compressive sampling because quantum effects between particles would otherwise require an infinite amount of memory, so the meaning of the wave function is that it's for data compression.  Particles don't care if conscious entities are watching or not, the compression is built into nature as a way to save on electricity, as opposed to caring about whether clever scientists are watching or not.  The fortuitous data compression implicit in wave functions is merely another reason to suspect we are in a simulation. If we are in a simulation, it's interesting to think why this is amusing or informative to a really smart being.

I would like to tell our designers that I’m on to them, and will refrain from further elaboration upon increases in Strength, Wisdom, and Charisma.  

Missing Risk Premium: a Synopsis

I recently made a presentation of my book, The Missing Risk Premium, and thought it was concise, so I'm sharing it here.

Historical return data contradicting 'expected return positively linearly related to risk' theory:

• Within equities:
• Firm leverage
• Firm profitability
• CAPM beta
• Total Volatility
• Residual Volatility
• Financial Distress/Default metrics and equities
• Penny stocks vs. regular stocks
• IPOs vs regular stock
• Country returns in developed countries
• Country returns in emerging markets
• Analyst disagreement across stocks
• High vs. low trading volume
• R rated movies vs. G rated movies
• Volatility/future equity Index returns  over time
• Overnight vs. Intraday stock returns
• Bond credit: Distress, Junk, and  BBB-A rated Bonds
• Bond duration: post 2 years
• Out-of-the-money options vs. at-the-money options
• S and C corps  vs. equity indexes
• Senior vs. Subordinated
• Reinsurance: rebalanced vs. peak peril
• Converts: low and high moneyness
• Merger Arbitrage: stock-financed vs. cash-financed
• Lotto vs. ‘quick pick’ lotteries
• 50-1 horses vs. 3-1 horses
• Mutual funds
• Hedge Funds
• Commodity Trading Advisors (CTAs)
• Currencies
• Futures
• Real Estate

Data consistent with Risk/Return theory:

• Short end of yield curve
• BBB-Treasury credit spread
• Top-line equity return over libo

How high risk generates low premium:

Winner’s curse: excess demand for volatile stocks generates below average returns
Why the extra demand?

• Overconfidence
• Information costs lower about risky firms
• High returns have high risk, ergo risk implies higher return fallacy
• Some are risk loving
• Some people are positive skew loving
• Alpha discovery
• Easier sell to clients (amenable to stories)
• Payoffs to fund managers
• Bounded rationality  (think SML is positively sloping)
• Agency problem (exploit option with fund source)
• Those buying stocks think stocks will rise, in which case higher beta is better

Why is Flat/downward SML  not arbitraged?

• Tradition (60-40 stock/equity ratio is a binding constraint)
• Irrationality (others don’t notice SML flat/negative)
• Relative risk (my favorite, other consistent data below)
• Easterlin Paradox suggests happiness is relative
• No one sells low risk, lower-than-average return stocks, because in a relative risk world, one only takes risk if the return is above average
• home bias because you want to outcompete your peers, not strangers
• Relative orientation evolutionarily robust compared to a Constant Relative Risk Aversion utility (which would be a strange coincidence)
• Glucocorticoid levels such as cortisol related to status, not wealth
• Imitation generally dominates figuring things out oneself (eg, fire, calculus), leading to an other-person directed brain
• fMRI identifies neural mechanisms for empathy, social information
• Status is a human universal, greed is not
• Reverse dominance hierarchies in humans common (ie, status more important than wealth)
• Politics about redistribution more than efficiency

Counter: If Risk has no Premium, why take risk?

• 40% of all men reproduce, where 80% of women do. 
• Men have out-of-the-money option, need to take risk
• Why not take infinite risk? Moderation in all things.
• Life is a complex, nonlinear, dynamic game where every parameter has a local maximum. Radiation, vitamin A, oxygen, tolerance,  risk taking, can all be too much or too little.

Are Pre-Modern Societies Socialist?

Many assume that pre-modern society was communistic, like hunter gatherers, and these roots give us a socialist intuition. Larry Arnhart argues this simply isn't true, that hunter-gatherer societies share big game meat, but most everything else is shared communistically only within the nuclear family, other things are more quid-pro-quo.

 This comes up a lot, as Emmanuel Todd writes interesting books about European history, as in his 1990 L’invention de l’Europe. He makes the bold claim that political ideology is the result of three things: family structure, literacy, and godlessness. In the modern age with universal literacy and godlessness, political ideologies are mainly projections of a people’s unconscious premodern family values.

 As my politics are opposite of my two siblings, my family structure clearly explains little, but perhaps that's just because I'm truly exceptional.

Milton Friedman on Behavioral Economics Circa 1978

Ever since Freakonomics and Kahneman's Nobel prize, people have been writing articles about the radical new idea that people are not lightning-quick calculators complicated algorithms as economists always thought, but instead, real people! True enough, but it's useful to understand what rational really means, and why it's used so much by economists. Here's Milton Friedman (22:15ish) noting why it's basically about predicting what people do, on average, nothing more:



Also interesting, a fetching young Laura Tyson asks a question around 34:45. I think she's aged well too (Keynesians may be wrong, but they can be cute)

Beware Discrete Auctions

There's an interesting paper on High Frequency Trading (HFT) by Budish, Cramton, and Shim from the U of Chicago. They set up an interesting model, but then propose at the end that batching eliminates the HFT arms race, both because it reduces the value of tiny speed advantages and because it transforms competition on speed into competition on price. I think that solution is interesting, but would prefer the following

1. add a 20ish millisecond randomizer to any incoming order (ie, a lag of anywhere from 0 to 20 milliseconds). Thus, if you know you are getting randomized, the marginal value of 1 millisecond is much smaller to the innovator, your place in the queue is noisy. 
2. make a rule that those who receive fees (liquidity providers) must have such orders exist for at least 1 second. That would get rid of a lot of flash quotes that are trying to be too clever and simply clog the bandwidth.

In any case, we have several different exchanges, and so if there's a simple way to increase welfare, an exchange that adds any such rule would generate more traffic, and ultimately, imitation. Yet, that's how paying for liquidity provision (passive quotes) originated, as well as a bunch of other tactics. One thinks they are annoying features created in a smoke-filled room, but instead they were simply the result of giving market participants what they want. A retail trader can always opt-out by simply trading at the Volume-Weighted-Average Price (VWAP), because that gives you the average daily price that averages out all these shenanigans, so I really don't have any sympathy for those who are bothered by it: if you don't like the intraday game, don't play it!

But, I was intrigued by the idea of batch auctions, because I've heard people who think discrete auctions are better than continuous ones. I think they are not very good, and a simple example is an extreme of this, one can look at the performance of closing vs. opening prices. One is at the end of continuous trading, one where there's no trading. What happens?

Well, I looked at over 1000 stocks, from 2000 to today.  I excluded really small, low-priced stocks.   The Open-Open returns have slightly higher volatility (2% higher), but more importantly, there's a lot more 'mean reversion'.  The graph below shows the future returns(O-O or C-C), sorted each day into deciles by the immediate prior return (O-O or C-C, respectively), then averaged over all those days.

Basically, markets open at extremes that are quickly erased, allowing the market makers to pocket nice premiums for these temporary imbalances (you can't make money off this if you aren't a specialist).  Continuous trading takes such trades away from monopolists, and allows competition to work.  

These authors propose more frequent auctions to be sure, but the logic remains.  

Trayvon Martin and Keynesian Multipliers

Pundits, websites, and news programs had very predictable opinions on the guilt of Zimmerman based on their view about Keynesian multipliers.  Those that favor more redistribution, more governmental spending and regulation overwhelmingly sided with Trayvon Martin, the deceased African-American. Clearly that's not a coincidence, but reflects something deeper, mainly a peculiar groupishness.

Now, if basically prejudices drive reason as opposed to vice versa: what's the most basic belief there?  It's not obvious our beliefs on fiscal policy and criminal justice would be almost perfectly correlated.  Jonathan Haidt wrote a great book on moral confabulations, but I don't think his 6 foundations of political thought help here.  For example, both think their side is 'fair', just for different reasons.  Instead, I think it's people choosing in-groups vs. outgroups, the basic building block of multilevel selection theory outline by David Sloan Wilson.  Thus Harvard elites and  don't mind quotas because,as Harvard grads, they will get the good jobs anyway.  Those in elite positions don't mind quotas, get the support of quota recipients, and can portray themselves as progressive; those in the middle look like selfish bigots, and they lose.

Ultimately, via the logic of Hotelling's median voter theory, there are two teams, and while they are somewhat inconsistent in their beliefs (free choice in abortions, but not employment or insurance)  these beliefs form the most basic coarsening of a set of two self-interested groups.  Everyone likes their team, and want power at the expense of those on the other side.  It's Lenin's Who, Whom? 

Marx's historical dialectic class struggle was profoundly wrong: it has never been simply poor vs. rich, but rather complex coalitions that interweave, because rich need the numbers of the poor and the poor need the capital and skill of the rich.  Think about academic elites and the really poor: they are both heavily Democratic. It clearly isn't just rich vs. poor.

Of course, this also means most debates about the multiplier are  pointless because if I can predict whether you think the multiplier is large based on your beliefs about Zimmerman's guilt, the real issue has not much to do with econometrics.  If you are doing objective work on multipliers, remember no one expects details to be dispositive, the narrative will drive what facts are seen as irrelevant or essential.  

Altenatives to Rational Expectations

When Rational Expectations was developed in the 1960s most people thought it was a classic academic result.  Certainly mutual fund managers chuckled at the thought a monkey could outperform a skilled professional.  Further, everyone had a stupid relative, neighbor,  or co-worker, that proved people were not rational. Meanwhile, the Capital Asset Pricing Model (ie, Beta), meanwhile, was accepted as true even before data suggested it was.

Yet, we now have almost 100 years of data showing mutual fund managers do not outperform naive benchmarks (Cowles foundation (1932), Malkiel's Random Walk Down Wall Street (1973)), making the signature prediction of rational expectations surprising and true, a sign of a great theory.  Samuelson’s (1965) application of the law of iterated expectations to explain why Bachelier (1900) notices that securities prices look like a random walk, made for both elegant theory and voluminous evidence. The efficient markets theory reached its current plateau in 1970 with Fama's articulation of what efficient markets mean, but never has it been generally accepted by practitioners or non-economists, and there have always been many economists looking at exceptions to this rule.

The latest refutation of this plank of economics sounds very similar to a middle-aged economist reading this stuff:

Psychologists ... say that markets are not immune from human irrationality, whether that irrationality is due to optimism, fear, greed, or other forces.... "There's this tug-of-war between economics and psychology, and in this round, psychology wins," says Colin Camerer, the Robert Kirby Professor of Behavioral Economics at the California Institute of Technology...

What did they show? That people basically make inconsistent bets when presented with subsets vs. supersets, for example, the odds that Hillary Clinton (Democrat) will win the Presidency is less than the probability a Democrat will win the Presidency, though in aggregate surveys this doesn't always hold.

It's been long known that people over-estimate specifics based on things like the availability heuristic, as when people more easily think an introverted woman is a librarian than an accountant because it fits with what one can think about as an archetype, and this has been discussed since the 1970s (see Kahneman, Tversky and Slovic's Heuristics and Biases). This is patently illogical, and spawned the behavioralist revolution, where we have about 100 such biases.

Yet, it's one thing to say people are inconsistent, another to say liquid markets are. While a random survey of retail investors might have the equity premium at something silly like 10% or the odds of a US default at 5%, that doesn't mean derivatives are priced that way, because knowledgeable people with capital tend to arbitrage these beliefs out of the market. For example, Snowberg and Wolfers showed that horse races are illogical looking at millions of races, and this has been known since 1949 (note: the favorite has the highest expected returns). Yet, to the extent such prices reflect this inconsistency, it isn't large enough to make large amounts of money. Does this translate to anything about the general market, or tradable stocks like those in the Wilshire 3000? Almost always, no.

These findings strike me a bit like this finding listed in a eulogy of this Harvard psychologist who sounds like just an awesome mensch, where they noted that

while teaching at the University of Virginia, he devised an experiment to study secrecy and obsessions. Enlisting college students to play card games at a table, he instructed some to play footsie under the table and tell everyone they were doing so. Others had to keep their footplay secret. One result? “The subjects who made secret contact with their partner were significantly more attracted to their partners,” Dr. Wegner told the Globe in 1994, a finding that, among other things, shed light on the allure of affairs outside relationships.

Now, that is very interesting, but it doesn't really contradict any fundamental conception of humanity, and so it goes with the behavioral finance results: neat, but not profound.

The problem with the alternatives to Rational Expectations is that they generally point out that in low-stakes environments people make logical mistakes in predictable ways, but they hardly ever explain the yield curve, the equity premium, or anything else important, but rather, the poor returns to 100-1 horses or some other curiosity. I like betting on horse longshots at the track and implicitly pay a premium for that, but it probably costs less than what I spend on beer at the track, so it's really not complicated.

Now, one might think that evolutionary biology provides a fruitful alternative, in that it tries to look at predictable expectations from the standpoint of its evolutionary success. I think that's great, and indeed, think that a relative utility function makes more sense because, among other reasons, it is more evolutionarily robust.

 David Sloan Wilson, who is well-known for showing how religion is a 'rational' adaptive solution within a multi-level selection process, has organized a special issue of the Journal of Economic and Behaviour Organisation entitled ‘Evolution as a General Theoretical Framework for Economics and Public Policy’. A lot of those articles are interesting, but none really that radical.

For example, there's the article arguing economists should use multi-level selection, as opposed to the atomistic selection implicit within abstract markets. That is, in evolutionary biology, there's a big debate about where selection occurs. Before Richard Dawkins became fixated on the specter of Christian Fundamentalists, he wrote The Selfish Gene to rebut the idea that selection occurs at the level of a species, championing the ideas of George C. Williams and John Maynard Smith. These biologists noted casual speakers would talk about 'what is good for a species', but clearly gazelles don't act as a group, but as individuals, and within individuals, as cells, and then as genes.  Dawkins argued that it's selfishness at the lowest level, the gene, ergo the title. Things have gotten rather complicated since, and it's clear selection takes place at more than one level.

For example, take the Hymenoptera order, which includes ants. There's a joke about socialism: good theory, wrong species (ie, ants not humans). For these species their genes actually assist in their goupishness, and so they willing kill themselves for the group all the time, because sisters are more related to each other than a queen is to her offspring. Thus, the selection for haplodiploidy could take place at one level--the swarm--not the gene level, and this then affects the payoffs for individuals and thus genes. Selection seems to occur at the lowest level, the genes, but also cells, the organism, and among humans, in culture. Economist Herbert Gintis has argued that societies that promote pro-social norms, as in group selection, have higher survival rates than societies that do not.

I think that's all super, and think some societies might have different intrinsic levels of individualism depending on their evolutionary environment. For example, here's nice discussion about how the Western concept of marriage outside of extended families led to a unique level of individualism, something that is rather unique to Western Civilization. In contrast, in the middle east, a lot of people marry cousins, and this breeds greater groupishness because your extended family is so obviously genetically oriented, making outsiders very clear (ie, altruism towards one's clan, indifference at best towards those outside it).

Yet, it's not clear how much these insights are really new as applied to markets and theories of the firm. Many theories apply to how oligopolies and monopolies behave, and these are quite different than what one sees for perfect competition, so the idea suggested in Wilson's Special Issue, that selection occurs at the industry, firm, or worker level, is not that revolutionary. Game theory often looks at mechanism design, and the stability of coalitions, and the conditions of various equilibrium.  I get the sense they think the only behavior economics looks at is perfect competition.  It's not, and hasn't been for 100 years.

It's generally accepted that one needs the system to obey two constraints:

1. Individuals must receive a positive return to their action
2. Individuals must be doing their best given their information and beliefs

These are sensible restrictions, so the issue is whether behavior is rational or not, from the agent's perspective. Rational expectations merely adds the requirement that any behavior should be consistent with zero abnormal profits for the simple and sensible reason that it is very difficult to generate abnormal profits in most markets. I still think that's a good bias, because it's usually true.

Stevenson and Wolfers' Flawed Happiness Research

Russ Roberts had a podcast a couple weeks ago where he interviewed Betsy Stevenson (below) and Justin Wolfers (right), primarily about their research on the Easterlin Paradox, and it highlighted what's wrong with so many academic debates.  

To review, in 1974 USC professor Richard Easterlin found that within a given country people with higher incomes were more likely to report being happy. However, between developed countries, the average reported level of happiness did not vary much with national income per person. Similarly, although income per person rose steadily in the United States between 1946 and 1970, average reported happiness showed no long-term trend and declined between 1960 and 1970. Theoretically, utility is generally assumed to be increasing at a decreasing rate (eg, log(x)). So, if you have twice as much GDP/capita, you should be happier, but in practice it doesn't seem to work this way.

I agree with Easterlin, and the relative-status utility function is the key to my book, The Missing Risk Premium.  Utility as Stevenson-Wolfers see it is a necessary and sufficient condition for an omnipresent risk premium, that is, it exists in a symmetric if--then relation (if one exists then the other does).  Yet, the risk premium seems to show up in only three places, and is usually missing (thus, my book title), if not going the wrong way.  Furthermore, evolution favors a relative utility function as opposed to the standard absolute utility function, and the evidence for this is found in ethology, anthropology, and neurology.  Economists from Adam Smith, Karl Marx, Thorstein Veblen, and even Keynes focused on status, the societal relative position, as a motivating force in individual lives (this was before mathematical utility functions in the 1950s made the profession ignore relative position). So, this isn't just a crazy idea championed by a wacky Easterlin guy, or just wacky me.

Stevenson and Wolfers are married coauthors, and they have published at least three papers on the topic, all refuting the Easterlin finding. Wolfers states 'most economists have our view, that there is no Easterlin paradox and there probably never was.' I'm sure he is correct, that most economists share his views, but only because they always have: if economist used a relative utility function many (most) seminal models would become ambiguous, and the whole field loses much of its foundation. Interviewer Russ Roberts is the Merv Griffin of economics interviewers--agreeable to a fault--and so never presses them on what specifically causes the Easterlin crowd to see things so differently. As Stevenson is now part of the prestigious yet irrelevant Counsel of Economic Advisors and Wolfers has more affiliations than your average CFA (University of Michigan, Brookings, CAMA, CEPR, CESifo, IZA and NBER), these two represent best practices in economics. It would be useful to see what the 'best of the best' do when applying their laser-logic.

First, there's the paper that made this May's American Economics Review, Subjective Well‐Being and Income: Is There Any Evidence of Satiation? Here they document two things. First, that cross-sectionally, higher GDP/capita generates higher happiness. Strangely, they find that the income-happiness effect is at least twice as strong among richer countries, which no one thinks is true (the effect should decrease as wealth increases), and further using one set of data the effect of income on happiness is negative. The authors note, however, that this is merely because of one country, the Phillipines. Strange that 2 of the 5 observations here were significant in the direction no one argues is true.  If this was the effect of one single country, could such an explanation be responsible for the positive effect for the rich countries?  The data look disputable (one chart shows Denmark and Norway above Italy and Spain, which would be unusual).  That said, by itself it does support their assertion.

 Their second set of findings concern cross-sectional data within a country. Easterlin did not dispute this, however. Given positional goods like mates and lakefront property, relative wealth should matter. Thus, S-W spend a lot of time refuting findings that looks somewhat relevant to the Easterlin Paradox, and definitely supportive of their view, but if you are a smart economist you should understand this is irrelevant to anything but a caricature of the Easterlin idea. I don't think they are fools or consciously disingenuous, just really good at playing the game: they have convinced themselves that their academic confabulations are objective science as opposed to tendentious rhetoric.  This doesn't move the debate forward, but it does help their status in their tribe, which is what most economic research is really about and why you don't have to follow most of it.

 So, what about the original Easterlin note, that among developed countries, where people are more worried about obesity than malnutrition, as GDP/capita rises we aren't getting happier? Well, Sacks, Stevenson, and Wolfers (2013) adress this point directly, and show this chart, where happiness is on the y-axis (vertical), and log GDP normalized for country and 'waves'.  Now, 'waves' is the name for the particular set of years a specific survey tended to use identical phrasing and protocols, which usually last a handful of years, thus each such set was assigned a fixed-effect.  Here is the resulting data, and their 'effect' in the line just in case it isn't obvious to you.

When an economist tells you a symmetric ovoid contains a highly significant trend via the power of statistics, don't believe them: real effects pass the ocular test of statistical significance (ie, it should look like a pattern).  Here's another view of the data we are interested in--change in log(GDP)/capita over time within a country--versus change in happiness, using a variety of surveys:

Again, for each its happiness on the y-axis, income on the x-axis.  S-S-W add little lines trying to show a pattern that they are sure is there.

Now, two can play this game, as from 2010 Easterlin and co-authors have data with similar blobs, but they draw downward-sloping lines over them.

I think it's best to say, no relation, and to stop drawing lines on blobs.

In any case, the biggest problem with the Sacks, Stevenson and Wolfers analysis is that they estimate a short-term relationship between life satisfaction and GDP, rather than the long-term relationship. Surely over an economic cycle, say between 2007 and 2009, or 1999 and 2002, income is correlated with general anxiety in the predictable way. Only over decades does the null effect of income on happiness arise, and this is basically taken out via 'wave-fixed-effects', which are basically time-dummies for 5-year groupings.

While I think people who aren't fighting for basic necessities are focused primarily on status and the things it can buy, I don't think this implies we should be indifferent to growth.  That would be the naturalistic fallacy, that 'is' implies 'ought.' We should aspire higher than envy, which paradoxically seems to elevate greed, but really just forces us to be grateful for things like the internet, strawberries in winter, and five-blade razors that we take for granted once everyone has them. I note many writers I otherwise admire, usually libertarian leaning, are quite averse to the Easterlin conclusion, thinking it will lead us to adopt a luddite policies because growth would not matter in such a world (see Ron Bailey here, or Tim Worstall there).

The key is that while I admit that my relatively impoverished grandfather was probably as happy as I am, I'm also very glad I live now: growth is good in spite of my envious homunculus.  Further, as productivity growth is the natural consequence of free minds and markets, flattening growth means not merely focusing on 'more important things' but rather squelching freedom, and liberty is more important than equality because it's feasible while allowing a great deal of the latter.  In contrast, true equality is only possible via force because people are not equal in effort or ability.  I mean, how would one prevent Larry Ellison or LeBron James from being richer than everyone else? The only way would be to destroy new companies or merit-based systems, why the worst rise to the top in hierarchies based on non-pnl signals, with examples from smarmy politicians, clueless executives in large regulated corporations, and of course genocidal socialists.

Gettysburg and American Exceptionalism

150 years ago, Gettysburg was fought.  Here is War Nerd on the battle:

You know how many civilians were killed in the whole battle of Gettysburg? One. I dare anybody from any other country anywhere, any time, to find me a battle with over 50,000 military casualties—and one civvies died. One! It’s incredible. People don’t realize how amazing that is. Those were supermen, there’s no other explanation. You read their letters and they write in complete sentences, they even have great handwriting, even the paragraphs work.

A Premium for Negative Skew?

Xiong, Idzorek, and Ibbotson have a new paper coming out in the JPM showing that mutual funds with the highest tail risk (ie, highest probability of extreme downside returns) have higher returns. That is, there's a positive risk premium to negative skew. This is rather curious.

The only thing I saw in this field related to this found the opposite. That is, in a 2006 JoF paper, Kosowski, Timmermann, and Wermers, and White bootstrapped the alphas of the entire universe of U.S. domestic equity mutual funds, and found that the top decile had much more positive skewness than the median. The bottom decile had more negative skewness.

 I don't have the data, but it can't be consistent with both findings.

Models aren't Optional

Models get a bad break, and the key is remembering the golden mean: moderation in all things. Macroeconomics, String Theory, Climate studies, all produce highly complicated models that are presented by our best academics as being thoroughly vetted and informative. Yet, for predictions in the real world, they stink. This leads to people saying models are all garbage, and we should all be engineers. Clearly a bad model is worse than no model, but if you are operating in some domain, you have implicitly or explicitly, a model of that domain. in this way, it's simply nice to write it down as clearly as possible to better understand what you are doing.

 I came across the The Good Regulator theorem (1970) by Roger Conant and Ross Ashby. It is stated "Every Good Regulator of a system must be a model of that system".

the theorem shows that, in a very wide class (specified in the proof of the theorem), success in regulation implies that a sufficiently similar model must have been built, whether it was done explicitly, or simply developed as the regulator was improved. Thus the would-be model-maker now has a rigorous theorem to justify his work.

I don't really follow the proof, but I think it's definitely true that to regulate something well, you need a good model of that something. 

UK Austerity in the 19th Century

I was watching Bloggingheads.tv, where Mark Blyth noted that contra Rogoff and Reinhart, Great Britain had a very high debt/gdp ratio at the beginning of the 19th century and then proceeded to have one of the best centuries of absolute growth in the history of civilization.  Thus, debt is, if anything, salutary at really high levels, so the government should run higher deficits, etc.  I've heard this argument quite a bit.  See this chart from Wikipedia:

It peaks after the Napoleonic wars at 250%, well above the 90% number everyone has been talking about in the US. Note the clear decline in debt from Waterloo to World War 1.  This is because the government started to perpetually run a surplus (see chart below, taken from here).

After the big wars, they would run surpluses regardless of the business cycle.  So, was the prosperity from 1815-1914 caused by the debt in 1815, or the subsequent surpluses?  Given the debt was used to make war, I don't think we can say it funded the public goods like roads that then generated 1000% returns.

I like Kevin Williamson's argument that the US is bound to default, and that's a good thing.  Increasing the state doesn't create prosperity, rather, it first takes people out of the productive sector, then increases resentment because people given housing vouchers or make-work jobs know they are low status, undeserving relative to a billion other souls in the world.  Better to let people find their way by getting out of the way.

Daniel and Moskowitz on Momentum

A pretty good take on momentum that I hadn't seen (from 2011) here.

Momentum is strong: in US equities, where this investigation is focused, we see an average annualized return difference between the top and bottom momentum deciles of 16.5%/year, and an annualized Sharpe ratio of 0.82 (Post-WWII, through 2008). This strategy's beta over this period was -0.125, and it's correlation with the Fama and French (1992) value factor was strongly negative. ... 

In our 1927-2010 sample, the two worst months for the aforementioned momentum strategy are consecutive: July and August of 1932. Over this short period, the past-loser decile portfolio returned 236%, while the past-winner decile saw a gain of only 30%. In a more recent crash, over the three-month period from March-May of 2009, the past-loser decile rose by 156%, while the decile of past winners portfolio gained only 6.5%.

Immigration and Parfit's Repugnant Conclusion

It looks like immigration reform will eventually grant amnesty to 10 million or so people, in the process encouraging more illegal immigration.  I differ with my libertarian friends on this, as I would restrict immigration to those with high skills, like what those evil Canadians do.

An essential reference for this argument is Derek Parfit's Repugnant Conclusion.  He notes that it seems inevitable ethicists will prefer billions of people barely subsisting to having a mere million people living the epitome of the good life.  That is, the chart below shows the quality of life on the y-axis, the quantity on the x. There will always be a wide and short alternative that dominates the present, and thus, in the limit we will by moral choice have 100 billion humans living like wild dogs.

 How can this be?  Well consider the following.  Say population A contains 1 million people living with an average gdp/capita of $30k/year.  Then look at A+, which has that population plus 1 million more earning $20k/year.  Clearly, A+ dominates A, because it's just the same thing plus more people, each of whom is presumably happy to be alive.  But then, B has 2 million people making $25k/year.  This has to dominate A+, because its the same average and total prosperity, plus greater equality.  Thus, B, with more and poorer people, dominates A via transitivity.  On can extend this ad infinitum, so basically Haiti writ large dominates Iceland or anywhere.

Low Vol Strategies Crushed in May

Low volatility had a bad month in May, and there has been a slew of commentary on this.  See Abnormal Returns here for a bunch of links.

Deutsche Bank's 'The Quant View' by Rochester Cahan summarized the month's performance by noting  that

 'Last month we argued that the Low Volatility/High Dividend Yield trade was looking crowded, and cautioned that this could indicate elevated downside risk. It turns out that call was prescient.' 

"Could" and "change in probability" means nothing, because it's consistent with anything, eg, if the rate rises it's hardly testable because the old and new probability are couched merely as possibilities, and if the probability doesn't change, that's in the forecast too ('could').  Now if they said, don't buy or short strategy X this month, that would have been prescient.  I wonder if such people realize how disingenuous this is, or if they think their nuance is actually highly rigorous analysis.

In any case, last month was very bad for low volatility strategies, leading many researchers to reassess the validity of this approach.  But, to put it in perspective, here's the total return over the past 12 months, using my beta data.

Clearly the past year, higher beta has been the better place to be, while lower beta has not.  As the SP500 rose 26% from May 31 2012 through May 31 2013, this is not surprising: on average, over shorter horizons like years, betas are accurate, so higher beta stocks do better in rising markets, lower beta portfolios underperform. For example, over the past year, given the SP500 rose 26%, low beta stocks rose 70% of that, high beta 170% of that, implying betas of 0.7 and 1.7, which is totally consistent with the simple CAPM for the high beta stocks, and better-than-expected for the low beta portfolio (ie, its beta was 0.6 in that period).  If you bought low vol stocks not understanding this, well, you really need to.

Now, many people seem to infer from this that low vol/beta has been a bad bet over the past year. If you evaluate yourself purely against the indices, this is true: deviations from the benchmark are only good if they are above the benchmark.  Yet, in simple Sharpe ratio or Information ratio, high beta portfolio did poorly, even in this period.  The clear winner is actually a Beta-1.0 portfolio, which has the highest Sharpe and Information ratio.  Like low volatility, I have championed the beta 1.0 portfolio for a while, and I'm sure it will be a big fund someday.

Stats on US Portfolios, 5/31/12-5/31/13

Stats on International Portfolios, 5/31/12-5/31/13

Internationally we see the same thing: low vol did worse in raw returns, but much better in a pure Sharpe.

See data here.  I think this highlights a profound truth, that as a practical matter investors don't care about Sharpe ratios as much as returns relative to the benchmark.

Bring on Silva vs. Hendricks

I'm a big Johny Hendricks (left) fan, but I think right now among 170 pounders, Erick Silva is the man, Hendricks next, then GSP. Just watch him sneak this triangle choke onto his opponent from last weekend's UFC in Brazil. I couldn't believe Silva didn't fall off because he was so high, but Silva obviously has great leg control.  Standing, Silva moves like a cat, and I can't wait until he meets Hendricks after Hendricks beats GSP.

Kahneman Fast and Loose

There's a short Danny Kahneman interview at the Daily Beast here.  He notes why your best friends may not be your best advisors:

Friends are sometimes a big help when they share your feelings. In the context of decisions, the friends who will serve you best are those who understand your feelings but are not overly impressed by them. 

 That's the Kahneman I love to read, profound and interesting. But then he follows with this sentence:

For example, one important source of bad decisions is loss aversion, by which we put far more weight on what we may lose than on what we may gain. 

I don't see loss aversion as being nearly as prevalent as lottery-loving: that is, picking things with small probabilities of big gains, as opposed to avoiding things with potentially large losses.  Most really bad investments, those with the lowest expected returns, are things with large potential losses (lottery tickets, horse races, highly volatile stocks, options, penny stocks, etc.)  This means people don't avoid them too much, rather, they prefer them too much.

But that's only one class of bad investments with large losses.  Then there's picking up pennies in front of a steam roller, the kind of trade Kahneman's good friend Nassim Taleb argues is too common, where one basically sells insurance or options too cheap, making money most of the time but then occasionally blowing up and moving on to the next sucker.  Kahneman seems highly respectful of Taleb's work, and neither try and reconcile these ideas, even though they are really at the top for both.  That makes them more like interesting magazine writers (eg, Carl Zimmer, John Horgan) than scientists.

Loss aversion in practice is a curiosity, not common in its domain relative to riffs on its opposite.  I think people who love quoting him merely because once you allow irrationality in equilibrium, you are no longer constrained, and Kahneman gives one the authority to do this.  So, as much as I enjoy many things he says, I'd say he has been an enabler of sloppy thinking, net net.

Yale Emotion Research Videos

Yale has a neat website with interviews with people doing research in affect, or moods, and how it affects us.  There are interviews with Steve Pinker, Jon Haidt, and Dan Gilbert among others, though I already have heard from those guys, so I like the other videos.

For example, Gerald Clore argues that negative moods generate more analytic reasoning. Difficult problems generate negative affect, a reason why people do not like to 'think hard', and why trouble and depression can be a positive feedback loop.

American educator John Dewey said you don't learn anything unless you reach a problem, where reality says 'no, do something new.' Positive affect tells your brain, 'you are going in a good direction, and so have no reason to change stream.'  As it's improbable we have it all figured out as a child, one should expect periods of lugubrious contemplation because that's the only way you'll really grow. Another reason for moderation in all things (clearly, no one wants to be dyspeptic all the time), a little more Adagio for Strings and less The Magic Flute.

Another great clip was by Cosmides and Tooby on the grammar of human arguments, which invariably are about costs, benefits, and mental states.  Anger is usually triggered by the perception that someone is putting too little weight on your welfare given your relationship. People get angry when they think they were harmed for little comparable benefit, as if they were merely a pawn sacrificed for some more valuable piece.

I remember being quite angry during my litigation in part because many acquaintances who could have helped me a great deal chose not too, presumably because they valued the option for a lottery ticket in dealing with an uber-wealthy guy (or avoiding his negative lottery ticket) higher than helping me, so I got very little help (eg, innumerable facts needed attesting in court by experts, such as that mean variance optimization was not close to Telluride's IP, or simple unwritten rules in IP litigation that experienced people know).

If you understand the roots of your frustration, it's less frustrating.

More Benefits from Overconfidence

Overconfidence may cause people to invest too much in volatile stocks because such stocks have a greater diversity of beliefs, and so if people dismiss the objectively bad odds of beating the market, such people will be drawn to stocks where they are in the extremum, and highly volatile stocks have the most biased extremums.  One might think these people are irrational, but in the big picture people with this bias actually have a huge advantage, why Danny Kahneman said it's the bias he most wants his children to have.

Two economists at Washington State University looked at twitter accounts for sports prognosticators and found that confidence was much more important than accuracy in generating followers. Their sad conclusion: Pundits have a false sense of confidence because that's what the public, seeking to avoid the stress of uncertainty, craves. In other words, to be popular (read: successful), you need to be unwarrantedly confident. This takes either an amoral cognitive dissonance or ignorance.

 In an separate study, two psychologists found that people were introduced to strangers and then asked what the other person thought of them. Those expressing more confidence about their interaction later (not how well they did, but how confident they were in how well they did), generally made a better first impression as rated by the other person.

It's hard for me to accept that life is like dancing, where it's just as important to be skilled and show no self-consciousness.  Supreme self-confidence is attractive in almost every important dimension: punditry, sex, sales--just not investing.  It's surprising there aren't more bubbles.
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There's a reality TV show on restaurants, and it exposed a married couple who ran one restaurant as being especially wicked and incompetent (Amy's Baking Company).  The owners responded to complaints on Facebook and showed the world what insolent, self-absorbed idiots they were.  Of course, the popularity of this PR disaster has translated into a big success, as supposedly a new reality TV show based on the company is in the works.

It's good for regular people to learn through experience that famous people are often jerks or stupid.  Perhaps then we will stop listening to their opinions on world events.
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So, some very high powered evolutionary psychologists (eg, Cosmides and Tooby) found that

Over human evolutionary history, upper-body strength has been a major component of fighting ability. Evolutionary models of animal conflict predict that actors with greater fighting ability will more actively attempt to acquire or defend resources than less formidable contestants will....Among men of lower socioeconomic status (SES), strength predicted increased support for redistribution; among men of higher SES, strength predicted increased opposition to redistribution.

That jibes with my observation. I guess I'm in the high SES group, generally, and among my weight lifting buddies, I'd say the vast majority are against redistribution policies, much more so than for my neighbors who come from the same demographic.

I'd like to think I believe in a smaller welfare state because it's truly the best policy, but maybe I'm just rationalizing self-interest. I think I'm not doing this, but then again, the guy writing this is right now is, in Jonathan Haidt/Michael Gazzaniga's view, just the narrator, the press secretary, of the 'real me', this illiterate part of my brain that has desires and beliefs at one of those Inception-like levels, where I think I'm objectively determining my beliefs, but instead I'm rationalizing a rationalization of a rationalization.

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If you are worried about the state of macro economics, don't worry, because it's all good.  Some New York Fed economists find that a particular DSGE model predicted the 2008 fiasco just about perfectly.

This is all 'out of sample', in the same way the test data for neural nets is out-of-sample: if you exclude all the hundreds of functional forms that were tried that didn't work, one of them was fit to only prior data and predicted the out-of-sample data. That is, the projection from 2008 is being done in 2013.  The degrees of freedom in this model would make a technical analyst blush. I can understand the allure of this approach (economics is about modeling), but anyone who has been around a while should cop to the patent overfitting that goes on 'outside the model'. I would bet anyone that if they set this model up in real time, it will miss the next turning point...and there will be another DSGE model that would have worked.  

A Survey of Low Volatility Theories

David Blitz and Pim van Vliet, both of Robeco, and yours truly wrote a paper outlining the various explanations for the low volatility effect, Explanations for the Volatility Effect: An Overview Based on the CAPM Assumptions. The aim wasn't to trash or champion any particular approach, though I'm sure our biases show (we aren't in lock-step on this, note Blitz here vs. my approach here, which has a subtle distinction).  As most papers on the low volatility focus on the data, often with very different motivations, we thought a paper addressing these various theories would be helpful.

In any case, we go over the following explanations:

• Leverage constraints
• Regulatory constraints
• Constraints on short-selling
• Relative utility
• Agents maximize option value
• Preference for skewness
• Crash-aversion
• one-period model
• Attention-grabbing stocks
• Representativeness bias
• Mental accounting

If you are new to the literature I think its very helpful, because it has lots of references on seminal articles in the various threads, and you should be aware of what the various theories argue. As Nietzsche said, if you know the why, the how is infinitely bearable.