Thursday, May 17, 2018

Centralized vs. Decentralized Social Welfare Maximizers

Faith in a select group of public servants to maximize social welfare is no better founded than the belief in the supernatural gifts of kings or noblemen. Just as misguided is the idea that good things, as decided by a majority, should be mandated. It should be remembered that our current prosperity and freedom have resulted from unwanted gradual changes in mores related to property rights, which when firmly established sparked the Industrial Revolution. Nobody planned that. Property rights were not created to win wars or eliminate poverty, though they did that as well as many other good things.

In a surprise to every intellectual, a modern economy is based on a system that encourages self-interested agents to do what they think is best, and produces results we do not foresee let alone intend. It is the ultimate decentralized system. In contrast, a system based on state regulations and monopolies (eg, public schools, utilities) is centralized. The push for more centralization dominates the state, academics, and media because these are the people who are good at articulating high-minded policies and are pissed-off that they have to sell them, as in most cases consumers don't want their solutions. 

Looking at blockchain technology, often a developer is asked: how does this help the poor? Indeed, some entrepreneurs emphasize how their new coin helps the poor, as when huckster Roger Ver emphasized how Bitcoin Cash saves babies. Everyone knows that if you help the most vulnerable you help society while helping the rich is suspect in that many see the rich as merely taking from the poor (many see the economy as a zero-sum game, so helping the poor increases total utility, helping the rich does not). The implication is that these technological innovations have to obviously help the most vulnerable in society or they are morally suspect, and laws should discourage if not ban wasteful activity if it siphons resources away from what is most important. That violates property rights.

In the Odyssey Odysseus is offended at being asked if he is a merchant, replying: 'that is a black remark!' In contrast, when asked if he was a pirate, he merely said 'no,' as if that would have been no big deal. Indeed, pirates have courage, and courage is a universal virtue, a key to a flourishing society, while traders have no obvious virtue and merely move things around. Similarly, for several millennia interest on loans was seen as parasitic, as money does not do anything, so someone making money on money seems anti-social.

We now understand that banking and trade do help society, and at their essence, letting people lend and trade arises endogenously when we simply letting individuals decide how to use their property, the essence of true ownership. Individuals find it in their mutual benefit to lend and borrow, to sell and buy from traders. The essence of marketsprice, profits, entry and exit, free choice, competitionarise naturally as a consequence of private property. There are always markets, such as those in WW2 POW camps, because anything that can be owned, such as cigarettes and personal items, can be exchanged and make both people better off. While thoughtful regulations are useful and some vital, it's like the police: you only need a little.

Rationalists like Sam Harris think we can create a world where truths are discovered bottom up, from axioms to theorems confirmed by empirical data. This is very much like the vision outlined in Paul Samuelson's Foundations of Economic Analysis (1947), where he advocated mathematical economic models built on maximizing agents and equilibrium, much like physics. Alas, in economics this approach is useful only in parochial applications, micro, while most macro results can be obtained via the right assumptions, and researchers rarely have qualms with using the assumptions that generate their preferred policies. We can prove what we want, so the key is knowing what result to want, but that does not come from rational inquiry but rather before: we ask our right-brain what makes us feel good about ourselves.

In the 18th century, proto-economists had a theory called mercantilism that emphasized the ability of trade as a means to acquire gold and silver, which was synonymous with national prosperity. There was also physiocracy that saw the wealth of nations derived solely from the value of land agriculture. In those worldviews, many businesses would seem at best orthogonal to social welfare, the way many today view advertising or bitcoin. Yet, that was the past, and via a combination of naivete and pride, progressives think we have it all figured out now [funny how pride was emphasize by the Ancient Greeks and the Bible as perhaps our greatest sin, now rarely].

The phrase `production for use, not for profit', has been noted by such men as Aristotle, Bertrand Russell, and Albert Einstein, and underlies the ever-present notion that economic decisions would be better served by someone maximizing social welfare instead of their own self-interest. It all seems so simple and minor, just requiring individuals make sure they use their property in a way that advances society’s interest. The problem with this is not what, but who. Who decides what is in society's best interest? What are the incentives for those in charge of top-down direction?

The problems with centralized social welfare helpers include the following:

1. No one maximizes social welfare.

It would be pathological to treat strangers as well as your children or friends, and fortunately, no one does it. Those who say they do are like those who say they have no biases, or base all their decisions on the facts: they are naïve about themselves or scheming hypocrites. If one thinks a social welfare maximizer who at least has to think about 'society' is better than a selfish individual, remember that unlike private selfish agents, these less selfish agents have a lot more power, the force of the state. Eventually, their cause becomes less about the pretext and more about simply protecting vested interests.

The iron law of oligarchy claims that rule by an elite is inevitable within any democratic organization. All organizations eventually come to be run by a leadership class, who often function as paid administrators, executives, spokespersons or political strategists for the organization. Far from being public servants, this leadership class will inevitably grow to dominate the organization's power structures, and they tend to favor their friends and family. By controlling who has access to information, those in power centralize their power with little accountability, due to the apathy, indifference and non-participation most rank-and-file members have in relation to their organization's decision-making processes. The official goal of representative democracy of eliminating elite rule is impossible; representative democracy is a façade legitimizing the rule of a particular elite, the Deep State, the inevitable oligarchy.

In any bureaucratic organization there will be two kinds of people: those who work to further the actual goals of the organization, and those who work for the organization itself. Examples in education would be teachers who work and sacrifice to teach children, vs. union representatives who work to protect any teacher including the most incompetent. Eventually the second type of person will always gain control of the organization and will always write the rules under which the organization functions.

2. Social welfare is hard to measure, so any group officially charged with improving it will never have to prove itself.

In the 1950s China thought the key to a good society was having a strong steel production, so they melted down everyone’s silverware and constructed inefficient steel plants everywhere. In Cambodia Pol Pot took all the useless people, such as intellectuals and financiers, and either just shot them or let them work themselves to death in the countryside. In the Soviet Union and Zimbabwe, the wealthy farmers were seen as parasites and expropriated, leading to famine. At no point in these disastrous plans, ones that violated individual liberty and wrecked the economy, did those in charge notice the disaster and stop the way a money-losing business stops doing what it’s doing when it runs out of cash.

Truth is not discovered via a single mind, but rather, via the competition of ideas. Newton, Nietzsche, Tesla, were geniuses, but like everyone else they had lots of bad ideas too. Your average politician has many fewer good ideas. Unfortunately, when the state creates a new policy or agency, it doesn't compete to survive, it just grows like a cancer. Sometimes they redefine their mandate when the initial one becomes less popular (eg, NASA is focused now on climate change and blockchain technology). Other times they redefine success metrics so that they always appear to work (Obamacare was about improving health, but when mortality rates rose supporters simply pointed to higher insurance coverage). The Department of Education's mandate is so vague it is difficult to measure their output, and with defense agencies like the NSA or CIA their productivity is necessarily secret; they do very little outside the occasional grandstanding about some new report, and people are happy if they don't bother them. Lastly, agencies like the TSA who handle airport security are necessary and have a monopoly, so their incentive to improve service is completely absent.

The technique that most explains the efficiency of the private over public sector is that in the private sector businesses eventually stop doing things that lose money. Either the company owners get tired of losing money, the bank forecloses, or they run out of whatever cash they have. A bad regulation (eg, 10% of all gas in my state must be ethanol) just continues because it costs the lawmakers nothing; a pointless agency can point to anecdotes because there literally is no bottom line. Most government 'production' is measured by how much is spent on them, as if spending money on health care is equivalent to generating that amount of value, and debates center on whether the next budget will increase by 2 or 4% as opposed to junking the existing enterprise and starting over from scratch. Only a decentralized system of individuals permits failure, and without failure, capital and labor stagnates.

3. Information is decentralized, incentives must be too.

Economies use information that no single agent can know, in that there are multiple supply chains interacting at every node. No individual can know all the cost and demand curves for various products and specific times and places, and this lack of knowledge matters when production is centrally planned. This is Hayek’s point about the use of knowledge in society, in that only a market economy both incents people with parochial, important knowledge to transmit this information, say by substituting a cheaper input for a traditional one, and has a mechanism to transmit this information via a change in prices. A top-down decision maker has no access to this data. If prices are not produced via equilibrating supply and demand at various stages of production then the prices are arbitrary, leading to suboptimal decisions in the rare case that a social planner actually tries to maximize social welfare. And lots of queueing.

I'd write more about this, but I can't improve on Hayek's piece, and it's a non-technical and short read. Those interested in more mathematical expositions should look at the First and Second Welfare theorems, as well as Sandy Grossman's work in the 1970's on information in prices (book here).

4. Concentrated benefits and diffuse costs favors business over consumers.

Industry representatives have excessive clout in decisions about how their structure best helps social welfare. This is why regulators, charged with choosing what is best for the country tend to become captured by industry, lobbying for the industry more than consumers. Sugar producers employ only 60k people, and the $2B it costs the US in sugar price supports creates a huge incentive for the producers to maintain their little fiefdom, and little incentive for the 330 million consumers to fight it.
James Buchanan

The net result is that industry regulation is mainly a cartelization device, as it was from its very beginning in the US with industry supporting Teddy Roosevelt's anti-trust initiatives. For example, Roosevelt's first trust-busting regulation focused on banning railroad rebates, as if one of the greatest specters facing consumers was predatory pricing, which supposedly caused smaller firms to go bankrupt, and then allowed the remaining firm to raise prices. Banning price discounts to prevent monopoly power is something so stupid only an intellectual can believe it, as falling real prices is the essence of productivity increases, and prices do not fall in concert, but piecemeal, by the more efficient firms. By outlawing price discounts, the more efficient firms and processes will not grow to take over the way they would in a free market. In this way insiders can build a mote around their inefficient but profitable businesses and share their largess with government officials via the revolving door among their executive suites, and mutually supporting each other in less obvious ways (eg, when banks supported non-profits that supported politicians that supported bank regulations that supported the non-profits that made it more costly to enter the industry).

5. State Policy suppresses discovery

An inefficient business can be annoying, but is not oppressive, as usually one has many alternatives. Progressives realize their biggest problem is that adverse selection, in that a policy designed to help some group only works if most of the current population acts as if the policy were not there. Yet the non-targeted group invariably subsidizes the targeted beneficiaries, and so they opt out in various ways. To prevent this, the policy must be universal, and so the benefits of competition, of watching certain companies or industries thrive (industries also compete with other industries, offering different means to an end), is absent.

Thus top-down solutions must prevent individuals from exercising their liberty. In some cases, choice is simply made costly, as when parents move to get their students out of bad school districts, and the predictable response of school administrators is rarely to actually reform its methods, but rather, to vilify 'school choice' as a pernicious mechanism that hurts everyone. Obamacare makes those who do not buy insurance pay a fee. The licensing and registration also explicitly forbids alternatives: it is illegal to get legal counsel from someone who is not a licensed lawyer, health care from an unlicensed physician, or a manicure from an unlicensed cosmetologist.

Coercion implies you are not making someone better off according to the person you are coercing. While there are exceptional cases where coercion is warranted—children, criminals, psychopaths—in general it should be obvious that if coercion is necessary for your policy, it is a symptom your policy is not making individuals better off.

6. Creative destruction is seen as destruction.

Productivity has more costs than benefits from a utilitarian point of view if one models it as we see it occur. Most economic models of growth simply put in a term for productivity growth that makes it look both passive and benign, as the canonical models are the reification of an economy into a representative firm's optimal growth problem. Everyone is in favor of such productivity because there are no losers, just one happy representative agent. In contrast, if Joe invented a hair-cutting machine that enabled him to cut the hair of 5 men at a time, his invention would deprive 4 of his colleagues a job. If then Joe cuts his price from the market rate of $15 to $12, the cost to society for cutting hair went from $75 to $60, but Joe now rakes in $60 while his 4 colleagues lost $15 each. As most people's budget for haircuts is immaterial and given utility increases at a decreasing rate, that lowers social welfare, QED. Further, a muck-raking journalist could note this would increase the load on social services, and family disruption, etc. Thus one could prove Joe's hair-cutting machine is not merely inefficient, but a vampire squid monstrosity.

In practice, through a process not fully understood (ie, modeled mathematically), the 4 unemployed barbers will probably find employment doing something else that makes society better off. Consider that most of us were farmers 200 years ago while now it's only 3%. Many of ancestors who left the farm did not do so out of their own choosing, but rather, found themselves squeezed out by the newfangled machines that made them redundant. We are better off, but only with hindsight. If we demanded every job displaced by a new technology had to have a better job available for everyone displaced, we simply would have very little new technology.

Top-Down Helpers Don't Help

The best we can do is to minimize state power is by minimizing the size and scope of the state, which means emphasizing restrictions on the state, not individuals. That does not mean individuals have no limitations, just that their rights imply they have the default presumption of being a true owner, with an ability to do what they want, not what some government agency wants. Individual rights are like the presumption of innocence in a jury trial, they shift the burden of proof to advantage one side.

It is not mere folly, but dangerous, to think there can ever be a group, let alone a person, who can maximize social welfare better than what happens when you leave people alone. No one person can create most of the products we use, from a simple pencil to a smartphone. No one fully understands their current role in the production process because it is constantly changing as new technologies arise. If there was a group of earnest bureaucrats charged with maintaining social welfare who had to approve of all new technology or disposition of existing capital, there would be several billion fewer of us, and most would be farmers.

A better solution simply assumes everyone is maximizing their self-interest and to encourage competition, the greatest social welfare improvement policy ever created. If we make sure that people pay for what they useincluding the costs of externalities like pollutionprofits imply that they are creating more value than they destroy, and they and others should be encouraged to do it more; if they lose money, they are destroying value, and should be discouraged. Profits allocate resources to their most efficient use (like an invisible hand or something!). Competition requires low barriers to entry, which is much more beneficial than licensing requirements and ADV forms.  For example, the mission of SEC is 'to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation'. Yet spreads came down only in spite of them, via a new technology and businesses (high frequency traders) that arose outside of the self-satisfied government-sanction monopolies (ie, NYSE/AMEX/Nasdaq).

Ownership implies control over one’s property, and so the phrase that ownership is nine-tenths of the law means that one defers to the current owner. This prevents endless litigation, as invariably at sometime someone in the past stole the land that one is using from someone else, if not a European from a Native American, then one Native American tribe from another. Further, giving the current owner the ability to transmute or sell their current property incents them to maintain and improve it or sell it to someone who can. Thus, when Pennsylvania was founded back in 1681, it was given to the William Penn to settle a debt owed by Charles II to Penn’s father. Penn promptly sold plots to American settlers who then developed the land productively. It was arbitrary that Penn was given initial ownership, but as Indians had no records or even a conception of private property, there was no way to specify a rightful owner before. Yet Penn's initial ownership was irrelevant, the key merely that someone had to own it before it could be developed. It is a good example of the Coase Theorem.

Property, whether land, capital, or gold, is used best when it is owned by individuals, which means they do not have to ask the state if what they are doing improves social welfare, and they are not obliged to answer the question 'how will this product help the world?' Airbnb, Uber, or bitcoin would not exist if they asked permission first. Even computers, which most white collar workers consider indispensable, were for a long time a curiosity, as Nobelist Robert Solowwhose specialty was economic growthfamously remarked, 'You can see the computer age everywhere but in the productivity statistics.' Solow was a leading expert on long-term growth and was not so much pooh-poohing computers as much as admitting economics was not very good at modeling these new technologies. Those who demand we fully know how any new service or product serves society prior to letting people develop it would retard growth, and giving a group power to make such decisions is an almost irreversible act.

Faith that markets work, and that profits create wealth when they are produced in a competitive market, is not blind faith, but rather something that cannot be proven yet is highly reasonable to believe. Innovation won't come from any single individual's  creativity or Artificial Intelligence, it will only come from zealous advocates and adversaries driven by all the virtues and vices common to men, and only decided by consumers who prefer their products to whatever else they might wish to buy. To presume a state can do this efficiently and will not instead become a self-interested hypocrite monopolist more powerful than any firm or private industry, ignores history, human nature, politics, and economics.

Thursday, May 10, 2018

The History of Individual Property Rights

John Locke
It is important to understand that property rights are not grounded on logic, but no right is.

The liberal ideas that gave rise to the Enlightenment are generally thought (eg, Steven Pinker) to be a break from a religious thinking. Yet the key liberal idea, individual rights, especially property rights, are an axiom with little justification outside Christian theology. As Feynman noted with regards to scientific laws, the process of finding new ones is not deriving them via logic, but rather, guessing, and then looking at the consequences. History has shown that individual property rights are good. Friedrich Hayek noted that a universal morality is beyond human knowledge, in that prior to markets actually existing--say, while we were hunter-gatherers--one would never have predicted free markets are better than socialism. Individual property rights are one of those moral principles that were discovered outside of pure reason.

Historically the King supposedly represented the people, and what he wants necessarily is what his people need. It's the original conflation of the state and society. The idea that a regular individual can seek his own self-interest and simultaneously be optimally working for society seems absurd, in that clearly there are many evil people who have no interest in bettering society. The idea that the state should ultimately own everything is an ancient idea, and private property highly non-intuitive idea, why it took so long to develop.

Roman law recognized private property belonging to individuals, but with a large caveat. For example, Cicero (106-43 BCE) wrote that "I do not mean to find fault with the accumulation of property, provided it hurts nobody, but unjust acquisition of it is always to be avoided." With this little exception many rulers could capriciously expropriate, in the same way there is a right to free speech in Cuba as long as it is "in keeping with the objectives of socialist society." Roman emperors viewed private associations like guilds as having the right to property, but these had to be founded with state authority and were closely regulated.

St. Augustine (354-430 CE) noted that reason is insufficient to motivate a truly Good Will. The will has reasons outside of reason, and is essential for being 'good,' so the individual is primary, his relation to anyone else secondary.  In 1140 Gratian wrote the Decretum, a collection of Canon law as a legal textbook. It argued that natural law of men created in the image of God is the Golden Rule. "Natural law is what is contained in the law and the Gospel. By it, each person is commanded to do to others what he wants done to himself and is prohibited from inflicting on others what he does not want done to himself." Gratian's identification of natural law with the Golden Rule (Matthew 7:12) departs from the definition in Justinian's civil code (529 CE), which defines that natural law is what “nature teaches all animals.”

Franciscan friar Duns Scotus (1266-1308) argued that morality needs freedom because without freedom, a person cannot do anything praiseworthy; without freedom actions do not represent the will, so are morally neutral. Fellow friar William of Ockham’s (1285-1347) writings on natural law are significant for the ideas of both individual rights and consent to government. Defending his Franciscan order against papal criticisms of their teachings on spiritual poverty, he distinguished among the various meanings of the Latin word jus (law, right) and dominium (rule, property) to defend an individual right to property. Ockham's emphasis on faith and freedom countered Thomas Aquinas's rationalist account of natural law. Rights, liberty, were paramount, and these put limits on the power of rulers.

These ideas define the central concepts of liberal constitutional theory: individual rights, freedom, equality, limited government, popular sovereignty, consent to law and government, and the right of the people to resist tyrannical rulers. Hugo Grotius (1583-1645) was a Dutch jurist and argued that nature was not an entity in itself, but God's creation. Samuel Pufendorf (1632-1694) relied on Grotius to argue that the state is nothing more than the sum of the individual wills that are associated within it, and hence the state needs to submit to a discipline essential for human safety. In this view, the state is a subordinate claimant on the individual, behind the individual's prerogative, who then has the free will to sin or not.

Finally, John Locke (1632-1704) also thought natural law was the same as biblical revelation, both originated from God. Thus, the Euthyphro dilemma "is what is morally good commanded by God because it is morally good, or is it morally good because it is commanded by God?" is no dilemma because God wrote his moral code on our heart, and his commands are natural law as well if we care to discover them via trial and error. The preeminence of property for Locke is clear when he writes the 'great and chief end of a commonwealth, and putting themselves under government, is the preservation of their property.'

When the US Framers of the Constitution refer to individual property rights they almost always spoke in overtly religious terms. For example, John Adams wrote "If  'Thou shalt not covet,' and 'Thou shalt not steal,' were not commandments of heaven, they must be made inviolable precepts in every society before it can be civilized or made free." This makes sense because at some level a right like cannot be proven, and so like religion takes a bit of faith.  Rights are like duties, in that they constrain other objectives irrespective of their utilitarian benefits: it is presumed they serve some transcendent or long-term benefit, one that cannot be proven but is rather inferred based on an ideology about the way the universe works.

Property rights were so important to the Framers that all men at the Constitutional Convention placed their protection above freedom of religion, press, and speech (see Forrest McDonald). In short, the Framers placed property rights higher than all those things we now most commonly associated with 'rights.' Traditional property is a social institution, and society maintains the institution only so long as people think private property rights serve the social interest better than alternatives.

A right is something that laws should respect irrespective of its utilitarian justification. Time and again people have argued that certain property should be seized from individuals because it can more effectively be used elsewhere, and for specific cases, this will be true (eg, see Posner and Weyl's Radical Markets). Yet this leads to a slippery slope, in that any agency or mechanism with the power to make this assessment is liable to expand its powers, and the result will be a crypto-plutocracy portraying itself as representatives of the people (see Venezuela), or crony capitalism as in highly regulated states like Italy and India.

Property rights originated from Christian theology, and have proven themselves empirically over the past couple hundred years. As Feynman noted, good laws start with a guess, and then we see if it works by experiment or experience.

Monday, April 16, 2018

Why My 1994 Low-Vol Dissertation Didn't Make Impact

Pim van Vliet posted a link to my 1994 dissertation, noting it was an early documentation of the low-vol effect. One may wonder, why did this early evidence fall flat? Clearly, lots of things, but I'll try to highlight the keys.

Here's my lead paragraph, which makes clear I saw the low vol effect before most everyone:
This paper documents two new facts. First, over the past 30 years variance has been negatively correlated with expected return for NYSE&AMEX stocks and this relationship is not accounted for by several well-known prespecified factors (e.g., the price-to-book ratio or size). More volatile stocks have lower returns, other things equal. In fact, one of the prespecified factors, size, obscures this inverse relationship. Second, I document that open-end mutual funds have strong preferences for stocks that are liquid, well-known, and most interestingly, highly volatile stocks.
While I thought my dissertation found something new, true, and important, and so was unimpressed by the lack of interest in my findings. I got no 'fly-outs' to present my ideas, even though part of this dissertation led to an article published in the flagship Journal of Finance (the part on funds showing a bias towards small-cap stocks, see here). The main reason here is rather silly. I was an economics PhD, and I was interested in a finance job. The Northwestern financial department didn't find my work particularly noteworthy in part because it didn't have any good theoretical explanation, no equilibrium model consistent with utility maximizing agents. That was a constraint back then, though it isn't any longer, so that's just bad timing on my part.

You don't need an equilibrium story for empirical results anymore, you just have to say it's part of 'behavioral finance', as the popularity of Danny Kahneman and Freakonomics changed the standards. But asset pricing held out longer than most other fields, and so the seminal 'low vol' reference is  Ang, Hodrick, Xing, and Zhang (2006). The paper is mainly about trying to test a very rigorous extension to the standard model, looking at the volatility of volatility, but noted at the end the strange fact that volatility was, by itself, implied lower future returns. That finding was not the main point, just curious, but it highlights that early on, one couldn't just report something so contrary to the standard model--higher risk generates higher return--without a convincing, rigorous, explanation. Now, it's common for people just to throw in a constraint and ignore the inconsistencies with unconstrained investors, whose presence would put back the CAPM results (see here for a discussion on that).

Another issue was that I started writing my dissertation under the guidance of a game theorist, and he suggested I needed a real finance person as well. The first prof I pitched my idea to was not very receptive, and so I told him that she didn't like it. He was the Kellogg's (Northwestern's B-school) academic dean at that time, and so when he called her to ask about her reservations, she called me into her office, weeping, as she basically thought I was submarining her career by bad mouthing her. I had no idea it would be interpreted that way, but I was naive. Alas, her boyfriend at the time was the head of the finance department, so he was not going to be an advocate. Eventually, I got one finance prof on my committee, but he was a young guy without any pull among other departments.

Yet, once I did publish that JoF piece, I did have my low-vol finding make the first round at the JoF. However, my reviewer, a well-known guy, took umbrage at one of my statements in the second round and ended his review by saying not only would he not recommend my paper, but that he did not encourage me to work on this further (say, submitting to a lower tier journal). I would send papers out to other journals and got many dismissive rejections, such as one professor telling me I was trying to say the earth is flat, and one helpfully telling me they would save my submission fee by not even sending it to a reviewer. Of course, prior to 2006, if any of them were published, they would have been highly cited today.

I was heartened by the fact that most of these rejections were so strong: it wasn't found uninteresting, rather, inconceivable. This instigated me to start an actual fund based on the insight, a ' low vol' fund, and I got this started around 1996. I got a few interviews out in NYC with some big financial firms, but unfortunately, laid all my cards out on the table: invest in low vol, make an extra 2% with 3/4 the risk. With hindsight, this was a terrible pitch. To the extent one believes it's true, one can easily just take the idea and implement it. It seemed so simple, something seemed wrong. Everyone asked: but if it's true everyone would just invest in low vol stocks?

Later I applied this strategy within hedge funds, basically with low vol the main ingredient among a couple others, spread out worldwide, hedging with basic futures. It can generate a nice 1.0 Sharpe, and did for me historically. Alas, after I left one fund to do this on my own, my boss sued me for violating our confidentiality agreement, in that anything I had done there was 'his property,' so I spent much time documenting the fact that I had figured this all out before I went to his fund around 2003, and much of it public knowledge circa 2007-8. Eventually, I did get another chance to do that, and again it worked, but that multi-strat foundered for many reasons, but after that, I found most hedge funds were all looking for 2+ Sharpe strategies...

So, I'm doing something in crypto now because I think it's fascinating, and there's a lot of potential, as well as a lot of fraud.

But, in case your looking for other low vol info, here are some links:

Sunday, August 20, 2017

How to Set Up Your Own Bitcoin/Ethereum IRA

Update: This is all out of date as of Jan 24 2018. Check out this link for a review of several crypto IRA providers.

For the past couple of centuries technology empowered the state, put more things under its control. They have ultimate custody of all your financial assets, and custody is nine-tenths of the law. You simply can't hold $1M in financial assets in a form where 'The Man' can't grab it if he finds you an enemy of the state, which in many states includes righteous men.

But like so many things the effect is not linear, in that now technology is putting power back in individuals. We can now take classes online, and be evaluated objectively via tests, making Universities less important. We no longer have a handful of news sources, but a spectrum that allows us to choose among vastly different interpretations of the same data. And we have digital currencies, which exploit cryptography innovations aligned with processing power to create ways of assigning credits more efficiently than fiat currency.

The essence of money is not that it is backed by something intrinsically valuable we can hold. Once  we severed its link to gold and silver, it still 'worked.' I would not have predicted that in 1900. Money works because people accept it, and the large network effects of everyone accepting it make it indispensable, because it avoids the 'double coincidence of wants.' Bitcoin was created by geeks who were incented to invest their technical skills into mining and developing the network, and as these highly productive people began to accumulate these assets, they appreciate its value. Since highly productive people appreciate these assets, they are valuable because they can be translated into purchasing the services of such people. Thus, initial coin offerings (ICOs) allow people to fund new businesses focused on blockchain technology because the same people creating these businesses are fine with getting paid in 'tokens', something that would be hard to convince for your average person.

Long term, I see much wealth going off the fiat grid into cryptocurrencies, because as we've seen throughout history, governments eventually run out of other people's money, leaving only expropriation via inflation or outright takings (see 'Fragile by Design'). Anticipating this, getting your money into something the government can't seize is important, and cryptocurrencies allow you to do this. If a government tries to prohibit bitcoin, those with large bitcoin accounts will simply move to someplace that accepts it, like Singapore, and a country filled with those who appreciate and have a lot of bitcoin will tend to prosper. So unless the world governments can enforce a worldwide compact with over a hundred players, bitcoin will succeed, and I'm sure most smart countries will ultimately allow general digital currency use reluctantly, to avoid such a brain drain.

While I love Bitcoin, Ethereum is better because it builds contracts into the same blockchain, which creates greater functionality. If you go to Reddit, you'll see more development in 'Go', a cutting edge software language, in Ethereum projects, and there are already more wikis on GitHub for Ethereum projects than Bitcoin projects, so I'm confident that Ethereum will surpass Bitcoin in market cap someday, especially once they move to proof-of-stake (sometime next year).

Since 2014, one has been able to put Bitcoin into IRAs (see here), though IRAs are so highly regulated, finding how to do this is non-trivial. So I thought I would move some of my 401k into cyber currencies such as Ethereum (you can do BTC too, but I'll use ETH as the example).  Most 401ks and IRAs do not allow you to do this directly, and BitcoinIRA charges 10% to set up a Bitcoin IRA. I don't blame them for charging this much, as it's difficult, and as there's an 80% premium to NAV with the Bitcoin Investment Trust (GBTC), investors are clearly willing to pay extra to avoid the complexities involved in directly owning them (eg, try to explain this to your parents).

The problem is that no IRA custodian can translate USD into ETH the way they can move your USD into a mutual fund. You have set up an account at a cybercurrency exchange to do that, and most exchanges do not handle IRA transactions. The new regulated bitcoin exchanges have very small staffs relative to the number of customers, and so have automated most of their support function. Thus, if you have a question ('how can I buy BTC for my IRA on your exchange?'), you'll get an auto-bot answer using an algorithm that finds the best fit your keywords. These are irrelevant to unorthodox questions, and follow up questions just lead to more pointless autobot answers.

The humans, alas, are rarely better, basically doing the same thing with their meat-based neural nets by looking at their FAQs and copy and pasting answers from there. At Coinbase, if you follow up your question after not hearing anything for 3 days, they will assume you have changed your question, so it moves it to the back of their queue. Thus I had an issue where my question was never answered because every couple of days I would write, 'is anyone there?' which would put me back at the bottom of the queue, and my question was thus unanswered (and funds frozen) for 3 weeks.

It took me a while to find the companies that allow this directly. It's not straightforward, however, as Kingdom Trust clearly stumbled into this capability, and they gave me a bunch of contradictory information, all standard confusion.  I'm sure they and others will figure this all out eventually, but by the time it becomes easy to invest in digital currencies, the incentive will be a lot lower.  So, be patient, it will happen, but just about every step takes at least a day.

Here's how you set up a cybercurrency IRA:

1) Go to Kingdom Trust, an IRA custodian based in Kentucky.  Rollover your IRA/401k there, informing them you plan to hold ETH or BTC in your IRA.

2) Set up an account at Genesis (not Gemini). You will need a clear picture of your driver's license you can email them, and a digital photo of a recent utility bill (w/in 3 months).

3) Once approved at Genesis, you to open a BitGo account, as this exchange stores your initial wallet after the Genesis trade.

4) Ask Kingdom Trust for an "Investment Directive For Digital Currency" form.

5) Once you have this form, request a trade at Genesis, so that if you have $100K USD, ask them to buy as much as possible with that (it's called RFQ--request for quote--on the Genesis portal). You will get back a confirmation with the amount of USD paid for X units of ETH. You then 'accept' that on the Genesis site.

6) You then immediately fill out the Kingdom Trust "Investment Directive" form, which includes wire instructions to send your IRA money to Genesis's bank account at Silvergate Bank (see here), and your trade terms from Genesis, which includes how many ETHs were bought and for what USD price. You will need to sign the Kingdom Trust Investment Directive digitally, so add the PDF plug-in that allows digital signatures. Do this early in the morning, as even then it takes a day for them to instantiate the wire.

7) Kingdom Trust then gives you a wallet address from your BitGo account. You then go your Genesis portal and click on your earlier RFQ trade. Click on the blue box to the left of this, and under Buyer Actions put in the ETH address that Kingdom Trust gives you. Send your ETH to the BitGo wallet address Kingdom Trust gives you.

For Bitcoin, this is ultimately put into a multi-sig wallet. For ethereum, they do not have this capability yet but are working on it, so your money stays at an address at BitGo under Kingdom Trust's control.  After that, Genesis is basically out of the picture.

Fees: Genesis charges 1.5% for their service, which is implicit in the price paid relative to the market price. You have to pay Kingdom Trust $50 to open the account, $40 for the wire, and a $250 annual fee.

It should be mentioned that while getting off the grid is one of the reasons cryptos will do well in the future, your crypto holdings within an IRA are all on the grid. 

Sunday, June 25, 2017


My son is going to college this fall, and I wanted to give him a set of my favorite quotations. As his name is Max, I titled the book 'Maxims.' With only a little work in formatting, I was able to create a paperback and ebook on Amazon, so that I basically did this for the price of the New York Times.  I made it for him, but you can buy it on Amazon for $5, or $3 for the Kindle version (see here).

Obviously, we want our kids to appreciate the things we think are really important. Whether our kids will agree with us is up to them, but we can hope. But as I'm starting to lose him to the real world, I wanted comfort that if I get hit by a truck, he'd have access to some quotes that can help him even if I can't. So, I put a bunch of quotes (around 710) I've been compiling for decades into a book, in 7 sections: Wisdom, Purpose, Virtue, Life, Psychology, Science, Politics. About 15% of the quotes are unattributed, because when I wrote them down, I lost the source, and it doesn't show up in a Google search (some obscure, some probably my artistic license).

Here's a sample:

  • Good judgment comes from experience, and experience comes from bad judgment. ~ Barry LePatner
  • Know thyself. ~ Delphic Oracle
  • Only the simplest mind can believe that in a great controversy one side was mere folly. ~ AJ Kane
  • The art of being wise is knowing what to overlook. ~ William James
  • The beginning of wisdom is this: Get wisdom. Though it cost all you have, get understanding. ~ Proverbs 4:7
  • Seek, above all, for a game worth playing.   ~ Robert S. de Ropp
  • The best use of life is to spend it for something that will outlast it.   ~ William James
  • The deepest principle in human nature is the craving to be appreciated.   ~ William James
  • Purpose is what gives life a meaning.  ~ Charles Henry Parkhurst
  • If you buy the why, the how is infinitely bearable.   ~ Friedrich Nietzsche
  • It’s easy to have faith in yourself and have discipline when you’re a winner, when you’re number one. What you got to have is faith and discipline when you’re not a winner.   ~ Vince Lombardi
  • Love is joy accompanied by the idea of its cause.  ~
  • Love is the only virtue that is an end in itself.  ~
  • It has been my experience that folks who have not vices have very few virtues.   ~ Abraham Lincoln
  • Gratitude is the healthiest of all human emotions. The more you express gratitude for what you have, the more likely you will have even more to express gratitude for.  ~ Zig Ziglar
  • Many can bear adversity, but few contempt.   ~ Thomas Fuller
  • We all have the strength to endure the misfortunes of others.   ~ Francois de La Rochefoucauld
  • All anger is self-righteous anger. There are few cynical opportunists, more often ideologues and moralists.   ~
  • Anything you're good at contributes to happiness.    ~ Bertrand Russell
  • Men need sex more than women, and this gives women power over men.   ~ Midge Decter
  • First one must live, then one may philosophize.  ~ Latin Proverb
  • Criticism is always a kind of compliment.   ~ John Maddox
  • Everything ends badly, otherwise it wouldn't end.   ~ Koglan the Bartender
  • Everything is always decided for reasons other than the real merits of the case.   ~ John Maynard Keynes
  • What is said when drunk has been thought out beforehand.   ~ Flemish proverb
  • When a debater’s point is not impressive, he brings forth many arguments.   ~ The Talmud
  • Real thinking is that which can force you into an answer whether you liked it or not, and fake thinking is that which can argue for anything.   ~
  • The best way to have a good idea is to have lots of ideas.   ~ Linus Pauling
  • Laymen feel that facts are easy and theory is difficult. It is often the other way around.   ~
  • Bayes' theorem suggests that given two persuasive speakers, you will find those which most agree with you as most persuasive.   ~ Richard Posner
  • A little inaccuracy sometimes saves tons of explanation.   ~ HH Munro
  • To be free is to be subject to nothing but the laws.  ~ Voltaire
  • Our country's founders cherished liberty, not democracy.   ~ Ron Paul
  • Justice is Equality…but equality of what?.   ~ Aristotle
  • The more corrupt the state, the more it legislates.   ~  Tacitus
  • The most melancholy of human reflections, perhaps, is that on the whole, it is a question whether the benevolence of mankind does more good or harm.   ~ Walter Bagehot
  • Never forget that everything Hitler did in Germany was legal.   ~ Martin Luther King Jr.

Tuesday, April 11, 2017

Jordan Peterson's Business Cycle Theory

University of Toronto psychologist Jordan Peterson has gained YouTube notoriety recently for speaking out against social justice warrior lunacy. However, it should be noted that his book, Maps of Meaning, is a very profound one. I heard him give a talk in which he mentioned initially that he was interested in economics, but was put off by the undefended assumption that people want to maximize their wealth. Most people want to be wealthy, of course, but they also want to have a fulfilling life, which is much more complicated. The larger existential question is, “How do I invest my time now to have the best life?” This does not lend itself very well to mathematical expositions.

His basic premise is that we develop maps of meaning to identify our best life. The world appears to us not in the form of objects, but rather things with an inherent valence or meaning according to how well they help us thrive. Thus, a cliff-edge does not represent a mere vertical descent, but rather, physical danger. Our world is filled with things, people, and ideas that all have meaning to us, and we arrange them in a map according to the way in which we see they have interrelated effects on our lives.

Human life is a narrative quest, focused on a story we find useful and true, an arc that leads to something profoundly good and beautiful. We attend to things we believe will lead us to this objective most efficiently, and thus, all of our tactics, strategies, and summum bonum are tied in a speculative endeavor. This conscious mode of thought is grounded in a metaphorical language that derives from narratives that use universal archetypes in the way that a good fictional character can describe a universal existential problem better than dry prose (e.g., Job, Holden Caulfield, or Anakin Skywalker).

Eventually, our maps develop anomalies, events that do not fit, because maps are always simplifications of reality. A sufficiently large anomaly is similar to finding that your microscope is out of focus: everything becomes a blur, chaos, and it is not obvious in which direction to adjust the lens. It is difficult for people to improvise solutions to their problems, as failure cascades through a complex system. In such a scenario, the first response is to freeze, as rats will freeze initially when moved to a new cage, because all they know is that their current environment is unmapped. Gradually, they begin to sniff around for predators, food, and other rats. Once they perceive that the danger is diminished sufficiently, the rat begins to explore the cage and do normal rat things.

Thus, when you learn that your partner is unfaithful or you are not good at your job, you have to rethink some fundamental assumptions about the meaning of your partner and job, and adjust your life accordingly. This happens until death, hopefully less frequently as one becomes older, but certainly at least several times. Alas, many ignore anomalies using cognitive dissonance, but the cumulative cost of not facing one’s errors leads to frustration and existential angst (which explains many angry bloggers).

What is interesting is the way in which this epistemological process is akin to Gould and Eldridge’s punctuated equilibrium theory, in which evolution consists primarily of stasis, but occasionally of significant change. The maps people use to understand the world do not change in a linear way, as if they were updating their Bayesian prior daily, but rather people update only when their prior fails massively.

Peterson and Business Cycles

This seems relevant to business cycles. Previously, I riffed on Batesian mimicry, the idea that business cycles focus on new things each recession because idiot imitators and outright frauds are drawn to businesses that seem most bulletproof to pointy-headed bosses. Thus, just as colorful poisonous snakes imitate colorful non-poisonous snakes (who then save on metabolic resources with the same benefit), putting “dot-com” after your company’s name was a great strategy circa 1999, and giving mortgages to anyone with a pulse was a great strategy in 2005. Failure is endogenous in humanity’s crooked nature.

However, a problem remained; why does investment decline across industries in each recession? Why do industry-specific problems spread into disparate sectors such as consumer, electronics, housing, etc.? Using the Peterson theory, when something sufficiently anomalous happens, investors see chaos because it portends a major epistemic flaw in their maps. Thus, it is best to wait and see where their maps are wrong before investing more. Finding a new paradigm takes time. One rarely understands an anomaly fully, even in hindsight. Even today’s economists disagree about the essential cause of the Great Depression of 1929, or the more modest 1990 recession.

Thus, in real-time, anomalies reach tipping points that halt investment, because deferral is not nearly as costly as is a bad investment. Recessions last approximately 12 months on average, so eventually, people determine the anomaly’s essence or at least become comfortable with a new, imperfect map of the business landscape in which chaos is contained, and activity resumes. Contractions are not equilibriums, because people naturally want to explore the uncharted, as exploring is one of Jaak Panksepp’s instinctive mammalian affects. The breadth of a business cycle is the result of the catastrophic nature in the way in which we update our worldviews.

Yet, every 10 years, economists develop a new model that the next cycle does not fit. Consider the recession in 1975, which focused on oil, in 1982, on interest rates, in 1990, on commercial real estate, in 2001, the internet bubble, and in 2008, residential housing. Each one is sui generis, as the prior indicators fail to work. In the most recent crisis, when mortgage indices began to falter in early 2007, no economist thought it was a major problem because these had not led to recessions in the past. A few funds failed, but everyone thought it was contained.

Then, larger mortgage-related firms continued to fail, and it became clear that the problem was bigger than anyone thought. In the fall of 2008, it seemed that the sky was falling, as people were unclear whether the problem was centered on residential housing, all securitizations via some arcane math error (copulas), or some unknown financial positive-feedback loop. Even now there is no agreement on the genesis of the 2008 recession, and like the fall of Rome, the list will probably remain forever long, even though I believe the only necessary and sufficient condition was the flawed assumption about diversified housing prices (no one thought a nationwide nominal housing price decline was possible).

Interestingly, the government caused another anomaly by trying to make things better. In an effort to help solve the problem, the government instituted many new rules that made it easier for delinquent homeowners to remain in their houses without paying, and required a costly legal process for lenders to evict anyone (foreclosure now averages over 600 days). Further, the government filed numerous lawsuits that punished banks for making the same loans it had encouraged previously, but such is politics. Thus, mortgages went from a 90% to a 20% recovery rate assumption, and half of total bank profits in this recovery went to pay fines, so that banks have had one of the weakest post-trough recoveries of any expansion. This has contributed to our anemic expansion, and highlights that one also must foresee the clumsy government response to any anomaly, which makes the problem much more intractable.

At some point, the initial mortgage bond anomaly was seen as evidence of a substantive flaw in people’s business models, but it was unclear what that flaw was. They saw chaos and turtled in, froze like rats in a new cage, and investment declined across the board, which is the essence of a recession. When bad information arises, this causes all investors to put less weight on their Bayesian prior about the future, so expectations shift more as new information arises, which is why volatility increases during incipient downturns.

The Maps of Meaning business cycle model highlights some key characteristics of recessions that standard business cycle theories do not:

  • The anomalies were real, and exposed profoundly flawed assumptions in certain common business practices. Specific business models were not viable, evidenced by large sustained exits in key sectors after each recession. This is important, because some economists believe recessions are caused by self-fulfilling, but groundless shifts in expectations; many Keynesians lie here (see, sunspot theories of recessions).
    • After 1990, commercial real estate remained depressed for several years 
    • After 2001, many internet companies exited
    • After 2008, mortgage companies and housing suppliers exited
  • Anomalies arise in different parochial aspects of the economy. 
    • A macro model that looks at aggregates will miss the essence of the shock
  • Attempts to counter business cycles via aggregate policy never work.
    • Simply lowering interest rates, or increasing government spending does not address the issue, which focuses on a particular business flaw, not an aggregate one
    • Once the shock is understood and contained, investment resumes, not because of any top-down stimulus, but rather simply because of cognitive adjustment

When investors perceive a large anomaly in their Weltanschauung, their natural reaction is to stop investing in new things, because regime shifts take place after every cycle and if one occurs in your business, you are toast if you build a new plant or keep those workers you hired in anticipation of growth in your now-discredited map.

The Next Big One

It is difficult to predict the future, but I would suggest several large areas that seem unsustainable, yet have witnessed fantastic growth over the past several recessions.

Municipalities are accumulating large pension deficits because it is easy to promise future retirement packages and allow the next generation of politicians to deal with it. Historically, muni bonds have been rock-solid investments, but if they become risky and all municipals face a new default premium, how much would they have to cut back their expenditures?
College tuition has outpaced the inflation rate for two generations, and the number of people going to college also has been increasing, creating a massive increase in college revenue. Yet now, many graduate lack skills for which people are willing to pay (e.g., journalism), so that many students will never recoup their tuition and opportunity costs. When prospective students begin to realize this, an unprecedented downsizing will occur.
The Fed has increased the money supply at an unprecedented rate over the past 10 years, and 8 years into an expansion, the US federal deficit is 4% of GDP. European nations are no better, and several, such as the PIGS, are worse. This portends a government bond collapse and rampant inflation.
40% of US corn is used for ethanol, a low-octane, corrosive fuel that exists only because of federal mandates, and 15% is used in high-fructose corn syrup, which is inefficient and less healthy than are other sweeteners, and is propped up by federal mandates as well. The effect on our aquifers is unsustainable.

When one of these starts to blow, people will believe at first that it will be no problem, because none of these areas has been key in any business cycle since WWII. However, when firms continue to fail, panic will ensue across the board, because if one of these areas goes down, another, or all of them, might, and the most sensitive businesses related to these areas are not obvious (land for farmers? computers for students?). Further, municipal debt, colleges, and corn could be accelerators rather than instigators of the next recession, in the same way unprecedented US state defaults prolonged the 1837 recession until the mid-1840s. Eventually, as the effects are contained in certain sectors of the economy, the economy will recover; again, recession is not an equilibrium.

Unfortunately, this time it all will occur with a banking sector that is precluded from backstopping obvious market overreactions because of the Volker rule. This will enhance the downturn, but unlike the May 2010 flash crash, it will last much longer.

The take home lesson? Buy cybercurrencies.

Monday, January 09, 2017

Robeco's Pim van Vliet has a new Low Vol book

Pim van Vliet runs one of the oldest and most successful Low Volatility funds in the world, which has now flowered into Robeco’s Conservative Equities brand of funds. It is noteworthy that it is not referred to as “low volatility,” because when he began this strategy in 2006, low volatility was not a ‘thing.’ High Returns from Low Risk is targeted at airport readers and casual investors, and is a quick read—36k words—that makes a profound point: objectively, high volatility stocks are bad investments. 

In contrast, students are taught that expected returns are an increasing linear function of risk. If investment in riskier assets generates a higher return, the only reason to focus on low or high volatility is one’s risk preference. When combined with the idea of efficient markets, this implies that investing is actually very simple: choose how much risk you can tolerate, which dictates your expected return, and diversify accordingly. 

Alas, within most asset classes, highly risky assets generate consistently lower returns than do those with average risk, and, after transactions costs are included, risky asset classes, such as options, are horrible investments for individual investors, the more so the riskier the option. Risky assets attract excessive interest from investors, and academics help them rationalize this adverse preference through their extensions of the Capital Asset Pricing Model (CAPM), all of which are very rigorous, but wrong. On the other hand, these same investors are skeptical about market efficiency, which causes them to burn money by trading too much and realizing too many short-term capital gains (which are taxed at higher rates than are long-term capital gains).

From High Returns from Low Risk

Aristotle noted that courage is a virtue situated between the extremes of cowardice—a deficiency of courage—and rashness—an excess. Courage is a good thing, and a good life requires a modest amount of it, but it is foolhardy to take too much or too little risk: so too in investing. Yet every year, new investors enter the market and are attracted to highly risky assets, and because they are taught that this should generate higher-than-average returns even if they have no alpha, they are emboldened. Yet investing in high risk assets is ill advised for two reasons: they generate higher wealth volatility and have a lower expected return.

Pim was introduced to the benefits of low volatility investing when he read Robert Haugen, who indicated in several papers that higher risk stocks do not generate higher-than-average returns. As I was researching this before it became popular, I have a strong opinion on the unimportant issue of who discovered the low vol anomaly first. Haugen did not know what he had discovered until approximately 2008, when he kept seeing his 1991 and 1995 papers referenced by the growing low volatility crowd. Haugen always emphasized that markets were inefficient, so he was an early proponent of the “factor zoo.” After all, George Douglas (1969) and Richard McEnnaly (1974) found no risk premium, yet no one mentions them.

In contrast, Bruce Lehman’s Residual Risk Revisited (1990) noted how strange it was that everyone was convinced the market index’s imperfect proxy of the “true” market was obscuring the CAPM, yet this implies residual risk should generate a sizable risk premium, which it did not. That was a big dog not barking. Then there was Ed Miller’s 1977 paper, where a greater diversity of opinions generates a lower return for high volatility assets, and that diversity of opinion correlates with volatility. In 2001, he wrote in the Journal of Portfolio Management that one should invest in low volatility equities, full stop. This is really the first academic publication to champion low volatility, and the fact that he was influenced by his earlier theory is important, because without a story that one really believes, any particular correlation becomes one of many, as with Haugen. 

That is clearly a rabbit trail quibble, however, as Pim is a gracious fellow, and is quick to give credit when he can. Another example of this is that in which he credits his colleague, David Blitz, for noting that relative rather than absolute performance affects investment manager: underperforming is a greater threat to a long-only portfolio manager than is losing money. That is, if you lose 10% in a market that is down 10%, you did average, and your assets under management will probably not be decreasing. However, if you make only 5% in a market up 15%, assets will go down. Risk is symmetrical: it can be too great or too little, because if you take too little risk, you will underperform in bull markets, which is just as bad as those who take too much risk and underperform in bear markets.

Pim noted his dismay at this finding: it would not be an easy sell to tell investors that his low-vol tilt generates better returns merely because they have lower volatility, because they would have higher relative volatility. Yet this could be precisely why the strategy presents an opportunity, in that, for a portfolio manager, low risk is actually average risk, so risk averse professionals do not invest in low, but rather in average beta stocks (aka, closet indexing).

One of my ideas that Pim highlights is that envy is more important than greed. That is, the relative risk preferences peculiar to investment professional contracting exist in individual investors themselves, as they also are not maximizing returns subject to volatility constraints, but subject to relative volatility constraints. This makes the low vol effect more fundamental and less ephemeral. If greater low vol performance were merely an institutional inefficiency, we should expect mechanisms to circumvent that, such using a Sharpe Ratio rather than total return. Yet over time, the end-of-year lists of best managers are ranked invariably according to simple raw returns within their focus, which always encourages risk-taking via the convex rewards of being at the top.

The most prominent methods used to explain the high returns on high beta assets are partial equilibrium results, ignoring the implications in a more general setting: 

1)      Frazzini and Pedersen (2010) relied on a leverage constraint, as investors reaching for the equity premium try to grab more via a higher beta with the same dollar investment.
2)      Harvey and Siddique (2000) focused on people’s preference for stocks with high co-skew, which are like lottery preferences, or risk loving preferences.
3)      Ed Miller (1977) showed how the winner’s curse implies that assets with a high diversity of potential outcomes have lower returns.
There is some element of truth in these approaches, yet they are all deficient as definitive explanations, because they imply very counterfactual things. Academics focus on rigorous solutions because general solutions do not lend themselves to the type of clean models that journals like to publish (and not coincidentally, what academics like to work on), and science is all about simplifying things to identify fundamental laws. This is a salubrious division of labor, where academics do their thing and practitioners then implement these findings in a more ad hoc way given all the realities academics assume away. Yet here these models are profoundly inconsistent with other stylized facts that suggest a deeper problem, in the same way Bruce Lehman’s noting that idiosyncratic risk having no risk premium highlighted a deep problem to the standard model.

If we take the following three empirical facts:

1.      The equity market return premium is positive (3-6% annually)
2.      High beta stocks have lower-than-average returns 
3.      Average investors choose to be long—not short—high beta stocks
You then need all of the following non-standard assumptions to generate such a result:
1.      There must be systematic factor risk for both high and low beta equities
a.       If high beta stocks did not have a systematic risk exposure independent of the market,  arbitrage would ensure any beta premium is a linear function of beta
2.      Some investors must be maximizing relative risk
a.       If all investors were maximizing absolute risk, no rational investor would be long in the high beta equities, because they have strictly dominated Sharpe ratios.
b.      If all investors were maximizing relative risk equities would not have a return premium.
3.      Some investors should exogenously prefer high beta assets
a.       Without such investors, the high beta assets would have higher-than-average returns, even with relative preferences, because of the effects of the absolute risk preference investors.
Now, this is a messy result, but such is reality (I show this in a paper here). Frazzini and Pedersen’s model implies beta arbitrage (there's only one 'factor'), but a zero-beta portfolio long low beta stocks and short high beta stocks will generate considerable volatility. If that is anticipated, their pricing formula would then include this factor, and the high beta assets would have a greater-than-average return because of the high residual, yet non-diversifiable, volatility in high beta assets. In Harvey and Siddique’s world, for skewness to have a strong effect (e.g., 3% expected return reduction for high vol assets), either investors are risk loving globally, or the equity risk premium should be 15% (Pim published a paper on this here). In Miller’s world, there is a massive arbitrage available to those sufficiently hyper-rational to see this behavioral bias, in that they will adjust their ex ante estimation in light of their knowledge of the subjective valuation prior distribution, which implies massive inefficiency. As it is very difficult to make money in asset markets, assuming that the market is patently irrational is not very compelling.

It is important to note that the current situation is really less of a low volatility than a high volatility puzzle. It is easier to explain why the low volatility stocks have higher returns than expected by the CAPM, yet remain lower than the mid-volatility stocks, than it is to explain why the high volatility stocks have lower-than-average returns, yet people clearly are generally long them (e.g., popular broad indices include these positions). Most importantly, because high volatility stocks have such low returns, low vol targeting actually outperforms the market as a whole.

The flatness of the risk premium, when combined with the incentives to go long in the volatile stocks above, creates higher-than-average low volatility returns. With respect to the reasons why risky equities draw individuals or fund managers outside of a mean-variance or mean-relative variance approach, the list of potential reasons is quite long:

·         Information cheap. Risky stocks such as Tesla are in the news a great deal, and their large price fluctuations are indicative of new information (i.e., news). That makes it easier to generate an opinion, long or short, and because of difficulties in shorting stocks, most long investors are looking at those stocks they want to buy.
·         Lottery preference. This could be called the skewness preference (Harvey and Siddique). They are simply lottery ticket preferences, in that, just as the most extreme lotteries with 100 million payouts generate the highest revenues because they offer the greatest upside, stocks that generate large upsides offer the most interest to investors. Robert Sapolsky has noted that monkeys generate spikes in dopamine when they perceive random rewards, highlighting the addictive quality of gambling, and the convex nature of the human brain’s preference for “more” in stochastic contexts.
·         Long bias compliment. As most long equity investors tend to think equities will rise—otherwise they would be out of the equity market—it then follows that the higher beta stocks will do better in those environments. Indeed, if you invest only in high volatility assets during up months for the market as a whole, your Sharpe dominates a low volatility tilt.
·         Alpha overconfidence. If you have alpha, it makes sense to focus on stocks that can go up 40% rather than 20%; the bias towards high volatility stocks is rational contingent upon this assumption.
·         Alpha signaling. Recognizing that those who know they have alpha are investing in highly volatile stocks, investing in them—and getting lucky—is a way to sell yourself to potential investors. Investors see one’s focus on high volatility stocks as a consistent signal that the asset manager knows he has alpha.
·         Alpha discovery. If you wonder whether you have alpha, it is best to buy some volatile stocks, as it will be obvious after a year whether or not you do.
·         Winner’s curse. People will tend to buy stocks for which they have the highest relative expectation. Stocks with the greatest disagreement will tend to have the greatest volatility, and their owners will be those who are most biased (Ed Miller’s paper).
·         Agency problems. Portfolio managers often receive a quasi-call option on their strategy. To take an extreme example: portfolio managers are fired if they lose money, but if they make money, they receive 10% of the profits. Such a payoff is maximized when the underlying strategy has the highest volatility. A fund complex also faces this payoff, in that fund inflows are convex, so have many risky funds within every style category, some of which will be category winners.
·         Representativeness bias. To get rich, you have to take risk. Some faulty, but plausible, logic then implies that taking a lot of risk will make you rich. 
·         Leverage constraints. If you are constrained by regulations or conventions (e.g., 60-40 equity-bond allocation), and think the market is going up, then you can increase your return by allocating your equity in the higher beta stocks (Frazzini and Pedersen’s “betting against beta” model).
·         Ignoring geometric return adjustment. People should look at the expected total return, which is reduced by the variance. People should anticipate this by making this adjustment, but often do not, which favors the higher volatility stocks.
In summary, there are many reasons other than the standard model that draw people to high volatility stocks, which then hurts their returns on average. Pim discusses his introduction to stock investing and highlights how the biases above directed his interest into a particular volatile stock, one that he could readily form an opinion upon and that could potentially generate out-sized returns.

Back to Pim’s book: he presents a “law of three”—omne  trium perfectum—all good things come in threes. In this context, the law of three is low vol, momentum, and value. His value metric is a form of price-to-income ratio, such as dividend yield or P/E. I am skeptical of a law stating 3 is the cardinality of attributes for Platonic forms, but agree that, in this case, it is a handful and not a factor zoo of dozens.

His basic formula for generating a good long equity portfolio is first, to look only at those stocks with lower-than-average risk. He uses volatility, but one could use beta as well (they give similar results), and the benefit of using beta is that, because it is normalized cross-sectionally, one merely has to remember to target stocks with betas less than 1.0, rather than knowing the current median stock volatility (in the US, 30%).  A simple filter of excluding stocks with betas higher than 1 is great advice: it lowers risk and increases returns, and helps you avoid getting sucked into the biases listed above. If you constrain your stock picking to low risk stocks, you are swimming with the tide.

His portfolio formulation is refreshingly clear. First, normalize momentum and value using percentiles, sum them, apply to the “low vol” half of stocks, and viola, you have a darned good portfolio. He shows you can even do this using Google’s stock screener. Alas, or fortunately for Pim, this is difficult, and so if you really want to do this, it would be better simply to pay Robeco a fraction of a percent to do so, as they will be more diligent in monitoring the portfolio and adjusting for many issues not mentioned merely because they distract from his presentation. 

Pim notes that this “low vol” anomaly is not restricted to developed country equities. He has found it in emerging markets, and within equity industry sectors. He notes it has been found in corporate bondsequity options, movies and private equities, but he could have added penny stocks, IPOs, real estate, currencies, futures, and sports books.

Investors would be wise to follow simple rules for investing. Those with the humility that comes from wisdom will be relieved to know that they can optimize their investments by merely focusing on lower-than-average risk stocks that make money, generate dividends, and have performed well. Those who need the advice most—average equity investors—are least likely to take it, so I am not worried that a regime shift is in play.

Personally, I am not a big fan of momentum, as while it works over time, it fails massively on occasion, as in 2009, when we had an adverse 4-standard deviation event in the US. Nonetheless, I can see how one can look outside this case and find, in the words of AQR’s Cliff Asness, that value and momentum are “everywhere.” I do, however, prefer his method of putting metrics into percentile space rather than a Gaussian variable, in that expected returns are more linear in a percentile z-score. I also appreciate the fact that he does not create a hierarchy of factors, as do many, in which a “value factor” is a combination of 6 metrics (e.g., the Bloomberg Equity Model), which is then added to 5 other such composite factors.

If there is no risk premium in general so many seminal economic models are extinguished that it simply will not happen ('no science ever defends its first principles' Aristotle). Further, the fact that people are not so much greedy as envious highlights the fact that economics has a profoundly limited relevance, because while in practice people merely want to out-do their neighbors, this is not something anyone admits they should be optimizing, and certainly is infeasible for a society. Economists can explain behavior using profit maximization or cost minimization, because each is consistent with both greedy and envious utility functions, so it is useful for many parochial applications. 

Yet this constitutes a partial equilibrium analysis. To the extent that economists want to prove certain macro policies are socially optimal, they return to a utilitarian world in which people do not care about relative wealth. This is simply untrue, and is relevant to why high marginal tax rates are popular regardless of whether they would bring in more revenue: bringing the top down is sufficient motive for most people (why most people loathe the Laffer curve, as it highlights their base interest in a higher marginal tax rate). With this flawed assumption, macro-economists are no more profound than are historians when analyzing a 'macroeconomy', as their fundamental motivator—individual wealth, however broadly defined—is defective and so does not generalize.

I used to think it would be good to convince others that the standard utility model is wrong, but now I am happy to let the consensus exist in perpetuity because of both the Serenity Prayer (“focus on what you can do”), and professionally, I am all-in on low volatility. Pim van Vliet is not keeping this powerful economic insight secret, but I am confident that most people will ignore his advice to their detriment.