Monday, June 30, 2008

The Audacity of Hopeful Investing

Warren Buffet and many old experts note the distinction between gambling or speculating, and investing. Gambling is investing without an edge, such as when one plays the lottery, or invests in stock without alpha. Investing is what Warren Buffet does.

Nassim Taleb has become a prominent talking head with the advice to invest mainly in Tbills, but then a modest portion in something with large and unquantifiable upside: the potential next Google or Harry Potter. I think this is foolhardy, because uncertainty is correlated with volatility and factor loadings, and historically, earnings estimate variability, high volatility, or high beta stocks, all underperform, statistically (ie, on average). So too for the biggest longshot horses, or highest payoff lotteries, call options, movies, etc. Things that can generate lottery-like payoffs, have lottery-like returns.

The annual per capita lottery expenditure in the US is about $150, and the rate of return is about -47% per dollar played. These investments clearly cater to what is commonly called those seeking risk, or positive skew, in particular. A study of the popularity (sales) of lotteries found that average payout (expected return) did not matter, but the size of the top prize was highly significant in motivating popularity. In other words, the $100 million super lotto has a lot of sales even though the probability of winning is so small it basically is outside the realm of intuition (1 in 150 million). A St.Louis Fed article finds that those with household income of less than $25,000 spent twice as much on lotteries on a per capita basis, than those with a household income over $100,000. Such bad decision making is probably not orthogonal to their poverty status. Investing in lottery tickets, however packaged, is a great way to stay poor.

So I found it interesting that the otherwise sober Arnold Kling fell prey to the bias of finding these highly volatile--and uncertain--investments:

What if, instead of borrowing, students could arrange for investors to pay their college bills in exchange for a fixed percentage of their future income... If I were an investor in this market, I would be inclined to make Black Swan style bets. Philosophy majors, for example. Sure, a lot of them will end up as pathetic adjunct professors. But some of them will eventually apply their intellect and creativity to business.

to reiterate, in a different post he noted:

I'd invest in philosophy majors! (But I still think they have the best option value, and that a few of them will be very rich in a decade or two)

Basically, Kling hypothesizes that those wild, free thinking philosophy majors will have a higher average income because of a few 'whales' in their sample. A couple Steve Jobs or some other dreamer. Kling has fallen victim to the allure of hope, in that for things we have no data on, the classes of investments with conspicuous winners seem attractive. Thats why every millionaire from Ebay or Amway, or home forex trader prominently shills a 'system' and says you too can be rich 'just like me'. It's a nice thought, usually packaged with lots of motivational speaking themes, stuff from What the Bleep do You Know, etc. But its all untrue. These are scams that make money for those selling hope . There are a couple success stories to be sure, but they are exceptions, and not sufficient to make the mean look good, any more the success of famous athletes and rappers implies it is a financial advantage to be a poor black kid.

Of course, I can't prove this (I bet it's in a paper somewhere), but the bias suggests Kling is wrong because he thinks too much of conspicuous successes, and using the dreaded 'availability hueristic', does not adequately represent the mass of philosophers who end up wearing a name tag at work. Gambling, Buffet would note, is investing based on hope as opposed to an edge, and hope is anything but audacious, it is all too common.

Sunday, June 29, 2008

Real Yields Negative!

The current (6/27/08) yield to maturity on Treasury Inflation Indexed Bonds is ... -2% over 1 year! And it makes sense, as the current CPI is running about 4%, and the one-year rate is 2.3% on nominal bonds. Gee, makes one want to simply go out and invest in commodities. Oh wait! Lots of people are doing that trade already.

I think it's safe to call current monetary policy 'easy'. If one could borrow at the risk-free rate, a pretty brainless strategy should generate a positive edge. But even A rated banks are paying 2% above Treasuries to borrow these days, which is astronomical. People are pretty panicked, it seems.

There's a lesson here

My maternal grandfather was a Mennonite, and he and his siblings all went native, leaving their Kansas farm. An interesting story in the Wall Street Journal on a Pennsylvania Mennonite family that took it in the other direction. The family doesn't have medical insurance, but as nine of his 11(!) children suffer from serious diseases, he racks up some big bills in emergency treatments and surgeries. One son was diagnosed with a disorder called 'maple syrup urine disease', in which patients can't break down certain amino acids, and sounds rather gross. Other children had Hirschsprung disease, an inherited disorder that causes an obstruction in the colon. It is fatal without immediate surgery.

The Amish community probably doesn't have a huge amount of genetic diversity as it is, but this guy married his first cousin. You don't have to be a rocket surgeon to figure this one out.

Friday, June 27, 2008

Car Beeper Like Merton Model

I was trying to find my car in the parking lot, and I have a button on my key that makes the horn honk. Unfortunately, you need to be within about 10 feet for it to work, making it pretty useless (I can see it by then). Reminds me of the Merton model. This model predicts every bankruptcy with probability 1. The gist is this model is basically a z-score on the firm's total value (Liabilities + Equity) compared to just Liabilities. The price of the stock goes to zero, until, eventually, bankruptcy. Brilliant!

The graph above is from Saunders and Allen (Credit Risk Management, 2002), and it highlights the issue. On one hand, the Agencies missed the boat, and had it rated investment grade until it defaulted. On the other hand, KMV's merton model would have also rated it very highly until only nine month's prior to default. For most lenders, this means KMVs signal is too late to be of use, because most lenders can't sell their loans as they degrade.

Thursday, June 26, 2008

market panic

The market dropped a lot today, in large part because many think that banks have a lot more exposure left. If banks reported their asset composition better there wouldn't be such a broad based decline.

Bank's are generally excluded from stock selections based on book/market, or cashflow/assets, because empirically these don't work for banks. Hiding information is like crack cocaine, good in the short run, ruinous in the long run. They should realize that greater transparency, more informative information, is better, because right now they trade way below net asset value based on the belief that they could be like UBS or Bear Stearns last year, and have a lot of exposure to a weak asset class that no one knew about. No one knew those companies had $50B in long residential mortgage exposure.

Financial institutions should adopt a more informative reporting policy asap.

Key to Modernity: Oxygen, Bananas, or Cod?

The New York times had a little op-ed on the increase in banana prices. I hadn't noticed, but banana prices are up big this year, and a fungus threatens the current most popular species, the Cavendish. All interesting, but then the bottom of the article notes the following byline:

Dan Koeppel is the author of “Banana: The Fate of the Fruit That Changed the World.”

Changed the World? I like bananas, but suspect my life would be pretty unfazed by a banana holocaust. The author notes some translations of the Bible imply Eve bit a banana, not an apple, as if true that would be profound (titillating, to be sure--Eve bit a banana).

But then I noted my bookshelf.

Oxygen: The Molecule that made the World (Nick Lane)
Cod: A Biography of the Fish that Changed the World (Mark Kurlanksy)

I think it's good for anyone who's an expert on C++, Six Sigma, or applying fertilizer, to think C++, Six Sigma, or fertilizer is pretty important, but 'one of the symptoms of an approaching nervous breakdown is the belief that one's work is terribly important', noted Bertrand Russel. In a sense, everything is essential, in another sense not. If it weren't bananas, it would be something else, and so too for oxygen and cod.

I owe my life to everything, good and bad, that ever happened in the history of the universe, because I am the unique combination of sperm and egg that resulted from that very specific moment my mother and father coupled (every ejaculate contains 100MM sperm). That night, their meeting, their life, and then their parents meeting, ad infinitum. My life is the result of a sequence of events so cumulatively improbable it makes one's head spin. But there's the anthropic principle, which states that our observations must be considered conditional on our ability to make them. And just like my life is improbable, so is current modernity. Without oxygen, cod, or bananas, life would be different, but then there would be something else, that, to that being, would be the equivalent of oxygen, cod, or bananas (clearly, w/o oxygen, my replacement would be much different physiologically, but in some aspect, it wouldn't be me, so, same thing).

Gist Sufficient, or Not, for Supreme Court

The latest ruling by the Supreme Court struck down a Washington DC ban on handguns. Article 2 states:
A well regulated Militia, being necessary to the security of a free State, the right of the people to keep and bear Arms, shall not be infringed.

In dissent, Justice John Paul Stevens wrote that the majority "would have us believe that over 200 years ago, the Framers made a choice to limit the tools available to elected officials wishing to regulate civilian uses of weapons"; such evidence "is nowhere to be found." Stevens infers the second amendment allows laws so draconian as to be an outright ban, effectively, on having a working gun in your personal residence. In contrast, earlier this month the Supreme court ruled that the death penalty violated the prohibition on "cruel and unusual punishment".

So in one case, you have a justice saying that the government can effectively negate someone's right because the specifics of the prohibition are 'nowhere to be found' in the Constitution, even though it's clearly the gist of the second amendment. In another case, the government's ability to apply the death penalty in cases of rape are nowhere to be found, but it is implied via the vague language prohibiting 'cruel and unusual punishment'.

I'm for abortion and guns, and think you ought to only kill those who commit murder (so that a rapist knows his punishment can get worse if he kills his victim), but that's besides the point. For some justices the second amendment can be parsed into a baning guns in practice because such a specific ban was not mentioned, but a ban on abortions is not permitted via the mention of a 'right to privacy', or that death penalties for non-capital offenses are implied by the phrase 'cruel and unusual'. It seems the Constitution's is either sufficiently vague as to grant a right (to have an abortion, to not allow the death penalty), or not sufficiently detailed as to not grant a right (to bear arms). Details are necessary, or not, when reading the constitution, depending on who's ox is being gored.

Wednesday, June 25, 2008

Is McCain's Internet Illiteracy a Bad Thing?

There was recent comment that it is troubling McCain is an admitted computer ignoramus, while Obama uses the internet to look up sports scores. I imagine very few 72 year-old executives could even find boobies on the internet if you didn't let them click on their spam (he called Google "The Google").

But if I had a judge who either knew nothing about statistics, versus one who took one course in college and has used Excel's "linest()" function, I'm not sure this limited knowledge would be better than none. Often, a little education is worse than none at all, because, like Taleb thinking Gaussian distributions are presumed perfect by people who use them, many people learn just enough to make them dangerous. The most common statistical vice is judging models primarily by their R2's, and those are people who know a little, but only a little, about econometrics. Or people who apply a train-test-validate approach, repeatedly, find the highest 'validation' result and think it was all 'out of sample.' MBAs learn that beta is a measure of risk, and returns are a linear function of beta. They are sheep to be shorn. I think I didn't really understand statistics until I TA'd for the course three times.

Someone totally ignorant will have no overconfidence in his ability judge matters. Ideally, a decider knows a lot. But choosing between a decider who know's nothing and a little on a subject? I think I'd take the complete ignoramus, he would be more cautious.

Inevitable Compromises

The WSJ notes the perils of being pure, as those mavens of PC at the Democratic National Convention try to plan for this summer's convention:

Consider the fanny packs.

With biodegradable balloons and organic snacks, Denver Democrats hope to stage the "greenest convention" ever.

The host committee for the Democratic National Convention wanted 15,000 fanny packs for volunteers. But they had to be made of organic cotton. By unionized labor. In the USA.

They have a 'Director of Greening', who has the following objectives:
* banners made of canvas or corn-based bio-plastics
* bikes available for convention goers
* stage built of recycled plywood, eco-friendly paint
* all trash will be separated for recycling
* balloons should be biodegradable
* discourage fried food, push organic. At least 50% of each meal fruits/veggies.
* energy efficient light bulbs, water-saving spigots
* solar power for media pavilions

I think it's great to practice what you preach. Congress is exempt from most laws it applies elsewhere, such as equal-opportunity and affirmative action laws, rules for sprinklers, minimum wage, laws against lobbying. If democrats want to pay an extra 30%, and deal with the annoyance of trying to see which item goes in which trash can, more power to em.

Tuesday, June 24, 2008

The Curious Case of Entrepreneurial Returns

Entrepreneurial investment, such as in small proprietorships (S-corps and private LLCs) is generally a highly undiversified investment for most entrepreneurs. The reasons are straightforward, in that when one person has a significant effect on the business through his effort and competence, it is natural that he should have the most ‘skin in the game’. This is a classic issue of moral hazard because a business manager, who has significant upside and, without ownership, no downside, is motivated to take wild risks on the theory of heads I win, tails the banker loses. However, if the manager is the majority owner, his failure should affect his net wealth too. About 75 percent of all private equity is owned by households for whom it constitutes at least half of their total net worth. Indeed, households with entrepreneurial equity invest on average more than 70 percent of their private holdings in a single private company in which they have an active management interest.

Despite this dramatic lack of diversification, private equity returns are on average no higher than the market return on all publicly traded equity. The chart above, from Moskowitz and Vissing-Jorgensen (AER 2002) shows the basic results, that over an 8 year period, if anything returns to private business, be it partnerships, proprietorships, S corps, C corps, and two entirely different sets of data, there is no demonstrable premium. Given an investor can invest in a diversified, and liquid equity portfolio, it is puzzling why households willingly invest substantial amounts in an asset with an equivalent return, but much higher volatility, including a positive correlation with the market.

Risk Endogenous

The SEC, which is seen by many as one example of a good thing from the New Deal (see Amity Shlaes here), has proposed changing a very subtle example of counterproductive do-goodism. I think the SEC is mainly responsible for mounds of paperwork, assigning one's signature to the effect that one is not breaking the law. This compliance makes it harder for people to get into asset management, and barriers to entry that protect market power, under the pretext of safegaurding the consumer, is the bread and butter of government regulation. There are lots of data on IPOs and earnings, leaking into stock prices (eg, stock goes up prior to official info release), yet very few arrests, except for high-profile celebrities like Martha Stewart. Meanwhile, the stock-loan market is a scam, the exchanges act like monopolists, and the SEC is OK with that, because it was designed with the interests of the status quo at heart (first SEC head: Joe Kennedy). So I don't think their mountain of registrations and perfunctory affidavits added transparency that reduced risk, any more than a sign on a mall that says "We Do Not Allow Guns on These Premises" reduces gun violence.

Currently, SEC rules require that money-market funds purchase only short-term debt with high investment-grade ratings. A new rule proposed by the SEC would put more discretion in the hands of money managers to determine whether the debt is investment grade.

Many fund managers did not re underwrite (aka re-analyze, with a skeptical banker's eye) loans because they got used to a regime where their credit skills were unimportant. If you are stuck choosing among AA bonds, your relative skill won't be empirically manifest in 1000 years, so work on something else like marketing (ie, 0.05% default rates imply too little dispersion to allow any skill). Thus, when the rating agencies dropped the ball, and did not adjust their ratings of mortgage pools as origination policy changed , no one was watching. What should have been a no brainer for anyone looking was not seen because no one was looking, and such is financial risk. It was not subtle: zero-money down and no income verification loans are risky. Moody's and S&P ignored this, and no one was checking on them. Quis custodiet ipsos custodes?

It is often the case that insulating someone from risk only make them more susceptible to catastrophes, in the same way that keeping your little snowflake away from germs will hurt her immune system.

Monday, June 23, 2008

Hetero Marraige Gender Breakdown Unaffected by Gay Marriage

After California legalized gay marriage, some initial data is in:
Based on a tally of the licenses Thursday--using first names as a guide--60 percent of the same-sex newlyweds this week are lesbians and 40 percent are gay men. Among heterosexual couples--to no one's surprise--the gender breakdown is 50-50.

The hetero breakdown is a nice touch. But it reminds me of this logic applied to sex. Years ago, I remember a friend noted that it is strange men seem to all have more sex partners than women, because they are equal by an identity, a counterintuitive result. When I was single and talked about these things, it seemed like guys were gettin' action all the time, relatively. But then do the math. If there are two sets of equal size, of things A and B. Every coupling of A & B means that the average number of couplings will be the same for A as for B. QED. As solid as the proof there are an infinite number of primes. Now, you can bring in professionals (ie, hookers), or gay men who have lots of sex, but this didn't affect most of my friends. It was kind of shocking: I thought I only knew nice girls! This is proof that men generally overestimate and overdiscuss their sexcapades, while women don't.

Oh Well, At Least it Would be Federal Prison

I've criticized James Hansen, one of the many prominent Global Warming scaremongers, and I've criticized global warming. My main problem is that macro economic models address a similar system, though much less complex. Nevertheless, until the data hit them, lots of smart people thought they were great. Thus I'm unimpressed by the current models ability to predict the past, or how smart certain proponents are. Further, the earth seems a pretty stable system, having a relatively benign biosphere for millions of years. Yet most of the feedback loops in climate models are positive feedback loops, which makes me think, we are doing it wrong.

Thus, I should be expecting my summons any day now:
James Hansen, one of the world's leading climate scientists, will today call for the chief executives of large fossil fuel companies to be put on trial for high crimes against humanity and nature, accusing them of actively spreading doubt about global warming in the same way that tobacco companies blurred the links between smoking and cancer.

Happy, Homicidal Natives

You have to love anthropologists. When you see a backward, they see a beautiful authenticity--but only if it's non-Western (eastern Kentucky is just backward). Regarding the photograph of some tribesmen in remote Peru, indigenous tribes expert, José Carlos Meirelles, exalts:

"When I saw them painted red, I was satisfied, I was happy," he said.

"Because painted red means they are ready for war, which to me says they are happy and healthy defending their territory."

Neat Expose of Housing Crisis

Lots of blame to go around, but the effect of targeting minority communities was a train wreck waiting to happen. In 2000 the Head of Fannie Mae bragged about pledging $1 trillion in capital to 'underserved' populations. in 2004 Bush promoted a Zero Down Payment Program, designed to help minorities who often couldn't afford down payments. The US Department of Housing and Urban Development put pressure on lenders to purchase home loans for 'low-income and minority' families. Groups like ACORN would demand loans to poor areas, and via the Community Reinvestment Act, these shakedowns would work (Obama is a big friend of ACORN). Read this fascinating narrative.

The key is a little Boston Fed piece that alleged housing discrimination way back in 1992, based on the simple fact that blacks have fewer homes than whites. That article has been widely criticized but it was the right message and the right time, and regardless of quality has been used to buttress an agenda (criticisms are 'details'). The article was not so important in itself because something like it was inevitable given the zeitgeist considered this a cheap and easy fix: give poor minority groups homes via mortgages. It wouldn't cost the government a dime. The problem of giving people homes who could not afford them would only be exposed when the collateral prices fell, but it is interesting how long this can take. In effect, this cake took 15 years to bake, and critics who might have pointed out the problem in 1993, by 2006 would have been 'proven wrong' (back in the nineties advocates of giving the poor loans via special treatment was considered empirically refuted).

The head of the Boston Fed around that time (1993), Richard Syron, gave a statement to Congress that proved how guilty lenders were. He noted that minorities were rejected for loans at higher rates than whites. He then noted, that if you adjusted for some of the underwriting criteria, like credit history and employment, this gap narrowed, but was not eliminated. But he did not control for everything a bank looks at, so, if you have 7 criteria, and look at 4, and find this does not cover the gap, maybe, just maybe, the other three criteria are not neutral? Nope. Clear evidence lenders hate disadvantaged minorities more than they like profits. Later, more indepth studies by the Fed found no evidence of discrimination, especially when one looks at defaults, as opposed to rejections(eg, Berkovec et al, Review of Economics and Statistics, 1994). But the politics were obvious. Unlike the 1992 research finding discrimination, however, the avalanche of latter null results by Fed researchers were always accompanied by strong wording that the results were too preliminary for any action (eg, slowing or stopping their aggressive lending programs targeted at minorities and minority communities). The Fed commissioned a set of special pieces on the 'debate', with the clear implication that 'experts disagree', and so best to assume from a policy perspective that racial discrimination is real. The Fed was defensive about their research that banks did not discriminate. One government official prominently noted that as the loan application view is more agreeable to the view this is discrimination, then obviously then it must be that application rejection rather than default rates, are better tests of lender discrimination.

In 2008, ex-Boston Fed Chief Richard Syron, now paid off with the ultimate Washington patronage job in the USA (CEO of Freddie Mac), noted:
It's `perverse' that Freddie Mac and Fannie Mae, the two biggest providers of money for U.S. home loans, have been encouraged `to put people into homes that they end up losing'

Gee, Richard, where did they get that idea?

The Dog that Didn't Bark

Citigroup announced it was cutting mergers-and-acquisiions and IPO related bankers. You don't see any cuts for commercial lending. Speculative grade defaluts are still at below average levels (about 2.2% in Apr-May 2008, vs. 1.6% last year, 3.5% average). Further, the measure of ratings quality, the "Accuracy Ratio" of both ratings and the "Moody's Implied Ratings" remained high. This is consistent with low default environments, because when times are good, it's easy to separate the wheat from the chaff.

I think this implies the current crisis is focused, and that there will be no recession.

Sunday, June 22, 2008

Reverse Dominance Hierarchies

Pundits love to complain about how stupid George Bush is, but he’s not an idiot. They are correct, however, in that most pundits probably do know more history, languages, and science than our president. I'm sure there are at least 100k normal people who have an IQ a standard deviation higher than Bush. Why are our leaders are so ‘slightly above average’? Because humans generally prefer reverse dominance hierarchies for their collectives.

Dominance hierarchies -- based on the relationship of domination and submission -- are characteristic of all non-human hominid societies (an extreme example being the tiny-testicled, alpha-male gorilla lording it over his band of mates) and are found in many other species of animal -- as in the proverbial pecking order among chickens, dogs, horses, seals, etc.

Likewise, dominance hierarchies are a defining characteristic -- in fact, an overwhelming feature -- of every known civilization before modern times. It is a curious fact, therefore, that dominance hierarchies are rare in the ethnographic literature describing hunting-and-gathering societies -- and thus, presumably, also rare in hunting-and-gathering societies as they existed during much of our common evolutionary past.

To account for this fact, an anthropologist at UCLA named Christopher Boehm proposed a couple of years ago the idea of a reverse dominance hierarchy. The gist of his idea is that a love of dominance was so bred into the human species (males above all) during their long, shared hominid past, that they developed an innate distaste of being dominated by others. Thus armed with a motive, and using the cooperative skills which language and their big brains conferred upon them, all the lesser males in a group who were in danger of being dominated by an alpha male, would form a ‘reverse dominance hierarchy’ to put the would-be tyrant in his place. In this way, dominance behavior, while not eliminated entirely, could be moderated and dispersed.

As the anthropologist Harold Schneider puts it: ‘all men seek to rule, but if they cannot, they seek to be equal’. Upstarts are put in their place in a variety of ways. For example, !Kung bushmen will mock the gift of someone, because they see gift giving as an attempt to signal superior status. In effect, they ridicule this act because they see it as a pretext (clever bushmen!). In more complex societies, groups of men actually kill the upstart for a crime conveniently determined. Thus, egalitarianism is an implication of this aversion to strong rulers.

So much political punditry is a farce because all these policy wonks parse the words of politicians as if they were The Oracle at Delphi. Any real depth in these remarks is like reading one's anxieties into inkblots. If you read the text of any politician, the main feature is its blandness, the smarmy, recycled clichés that allow listeners to believe it means whatever they want it to. The president of the US, like the president of your senior class, or the general secretary of the UN, is someone chosen for his malleability and his simultaneous ability to appear non-malleable, as if we want him to be smart sounding but not smart. It's tolerable once you realize its comical.

At the margin there are differences, sometimes greater than others, but one must admit that the main attribute of such ‘leaders’ is being ingratiating and non-threatening to the greatest number of people. Humans do not wish to have ‘rulers’ with high intelligence or education, because these people would be less controllable. After Tim Russert, a prominent weekly tv interviewer died, one pundit suggested getting someone really smart to replace him, like Paul Krugman, or Christopher Hitchens. Immediately it was obvious this was a bad idea, because these people have strong, educated opinions, and even I would find their elevation annoying because on the many issues where they and I disagree, they would too skillfully frame the debate disadvantageously to my side. Having a somewhat thoughtful, but not too thoughtful, person ‘leading’ the debate is a necessary compromise.

Friday, June 20, 2008

In the Long Run, We're All Boring

John Horgan reviews The Year Million,a a collection of essays about life in 1 million years. Needless to say, such inhabitants are presumed to be much smarter; in one guy's opinion, like the difference between us and a nematode. A theme of these essays is boredom. Consider a 1000 IQ person who knows all of history, mathematics, etc. Would you imagine this guy to be full of pep, enthusiasm? optimism? Bertrand Russell, whose youthful love of mathematics helped him overcome a bout of suicidal despair, later came to believe that mathematics is fundamentally 'trivial'. So what's a super-intelligent being going to find interesting when he gets old? Our biggest challenge is not the extinction of the sun, or asteroids, but catastrophic boredom.

I think this exercise highlights that intelligence will not become as great as these futurists suspect. Even today, the super intelligent reproduce at lower rates than the less intelligent, and this makes sense. For a stupid person, having a baby is like buying a puppy. For a smart person, having a baby is a huge trade-off, not only because smart people understand the huge responsibility they have created, but because very few great trains of thought can withstand the incessant interruptions of children.

The key is that, with significant intelligence and education, everything is boring. My kids love hearing the same joke over and over; I can knock 'em dead by inserting the word 'poop' in the punchline. I kind of envy them, but they are kids, I can't go back. On a more sophisticated level, novel connections are seen as funny (see the Mathematics of Humor), and so, the more you know, the less that appears novel, so the less funny. Sad.

A similar ennui can be observed for anything prized by humans. All mathematics and logic are mere tautologies to the infinitely intelligent. We humans, because we are so stupid, think ideas like 37x89=3293, or Cantor's diagonal proof, are interesting, but a super intelligent being will think: that's merely A=A! At the other end of mere epicurean pleasure, I remember famed columnist Mike Royko talking about porno films, and saying their biggest problem was not that they were filth, but that they were boring. You see, for this 75 year old curmudgeon, sex is repetitive (true enough). But there is another path for pleasures rather than boredom: becoming stuck in pleasure like a morphine addict. Dilbert creator Scott Adams suggests human evolution is bounded by the eventual creation of the Holodeck, because after that guys will simply go on an endless sequence sexual fantasies. So in the long run, sex is either boring, or something we use to euthanize ourselves.

It's hard to imagine moderate usage of anything in the long run (i.e. 1MM years). Indeed, I think if heaven and hell are infinite, then it really doesn't matter where you go, because even with 72 virgins, after several million years, they won't be virgins, and I'll be really sick of all those annoying harps (angels always play harps). Meanwhile, in bowels of hell, the first few days of being lowered upside-down into a vat of boiling human excrement, then raped by insatiable, barbed-penis-wielding hellhounds, will be terrifying. But by year 1MM it would be merely monotonous.

Very high intelligence is great for solving problems, but really bad for enjoying things. If you were super intelligent, you might be able to speak every language, solve every math problem, but then, you would not appreciate sports, sex, jokes, and conversation (Richard Posner noted that he likes tv because most casual conversation is actually quite banal). I don't think you can avoid the trade-off, which is why I would much rather have a son with an IQ of 120 than a son with an IQ of 160, I think the former would be happier.

So I think self-aware subsystems, i.e. conscious agents, have a limit to their intelligence, in that they will choose to not procreate because for them it isn't enjoyable. Thus, the only intelligence that will increase in the future will be emergent intelligence, things like bee hives, or ant mounds, that act like an organism but are full of ignorant agents. Agents themselves, who have total control, will opt out. Only systems that really have no control, or objective, will grow in intelligence as seen by the outside (for example, our cellular machinery is very smart, and contains an amazing amount of 'intelligence', but it is not conscious). But we humans, I suspect, are pretty close to as smart as conscious agents will get.

A Modest Proposal

As an American, I don't get soccer. No resonance. It's like watching really slow hockey. But I have noticed there is lots of injury faking. I think they should allow some fighting, like in hockey. That way, after a whiny Italian flops down in fake pain trying to get a call, 15 minutes later someone 'drops the gloves' (need correlate) and pummels him. No more flopping. It would at least bring in more casual fans from North America.

Thursday, June 19, 2008

Beware the Trap

From Clive James's Cultural Amnesia:

'Let a hundred flowers bloom, let a hundred schools of thought contend'
--Mao Zedong.

For the trick to work, millions of people had to believe the words meant what they said, even though the Party, within long memory, had never rewarded a contentious voice with anything except torture and death. Anyway, the suckers fell for it. The flowers bloomed, the schools of thought contended, and Mao's executioners went to work. The slogan had the same function as the Constitution of the Soviet Union, which Alexsandr Zinoviev telling defined as a document published in order to find out who agreed with it, so that they could be dealt with.

Reminds me, only a little, of when your boss, or your boss's boss, asks you what you really think of the new corporative initiative that you had no part in.

Extending Foreclosure Process Counterproductive

Two foreclosure-related bills were recently cleared by a House committee, meaning they'll soon be up for vote before the entire House of Representatives. The bills would offer protection for homeowners facing foreclosure. Lengthening the time before a house could be given a foreclosure notice, and the time of pre-foreclosure (the time between the foreclosure notice and when the bank repossesses the house).

But this is totally counterproductive, because in this market a large number of houses were bought as investment properties, and people are walking away from them the second their value is less than the mortgage. More time won't get them to come back. With these new laws, the bank is hog-tied for up to 6 months from the last payment, before it can repossess the property. In the meantime, approximately 20% of these houses are stripped of everything from appliances, doors, copper, aluminum siding, landscaping, toilets, and chandeliers--a rate sure to only rise if banks are precluded from repossessing quickly. In bad neighborhoods many of them become places for drug dealing and other activity that reduces property values. If you want to adversely affect neighborhood home values, put an abandoned property there for 6 months. The same governments that fret about abandoned homes and their collateral damage are simultaneously making it more common (see NPR story here, no mention of the foreclosure laws that preclude a bank's ability to get in their quickly).

Basically, a longer period of the foreclosure process implies a lower recovery rate. Who pays for lower recovery rates? Borrowers, specifically, poor borrowers. No one else. Banks lend money to make money, and they impute the expected probability of default, times the loss rate on the property (1- recovery rate), into future loans. If the foreclosure law makes it harder for banks to repossess, more damage is done to the home, and so, a higher expected loss is put into new loans. And who does this hurt? Not the rich, they own their homes. Not those with good credit scores, because those whose default probabilities are less than 0.3% don't have much risk whether their home is worthless or not in such an improbable state (statistically). No, it is those with bad credit, the poor, those with lower levels of education, etc., who will pay, because if there's a 5% chance they will default, and the recovery rate is 25% lower because of new 'borrower friendly' legislation, that's a 1.25% increase the new, poor borrower will have to pay. As with so much economics, if you want to help the poor, this indirect route is not merely inefficient, it is counterproductive and unjust, because spillover effects from vacant properties are a pox on a community, and a new poor person shouldn't have to pay for a prior poor person's mistake.

In this mess, I would definitely go after predatory lenders who inflated appraisals, or who pushed a lot of ninja loans (ninja:no income verification, no job applications). Operation Malicious Mortgage is a good idea--there are bad guys out there that need to be held accountable. But the houses in default are spilled milk, and its best to have someone with skin in the game owning them ASAP. That would help poor borrowers, and poor neighborhoods, the most.

Good Forecasts Will Strike Most People as Too Simple

In the early days of flight, men would strap on wings to mimic the success of birds. Eventually, we discovered that mechanical flight is best to be quite un-birdlike: a propulsion device and stationary wings. I remember, working for an economics department out of college, noting that our myriad forecasts always had a little squiggle at the end because...we know that in 5 years lines will squiggle.

The issue was put well in a test by Tversky and Edwards in 1966 (“Information versus reward in binary choices,” Journal of Experimental. Psychology 71, 680–683). Subjects were shown a succession of cards, each card either red or blue. 70% of the cards were blue, and 30% red; the color sequence was random. The subjects, asked to bet on each succeeding card, would guess blue around 70% of the time, and red about 30% of the time. They didn't realize that their betting pattern did not have to resemble the observed sequence of cards. On each round, blue is the most likely next card. The best strategy is not betting a mostly-blue pattern resembling the mostly-blue sequence, but betting all blue.

Under conditions of uncertainty, your optimal forecast pattern doesn't resemble a typical sequence, because optimally you should assume every random disturbance equals zero, when we know it will actually be merely distributed around zero.

Probabilistically, the more detail, the more unlikely; in practice, convincing scenarios have a lot of specificity, like a good novel. But novels are fiction, and the future is not. Thus, 4 variable Vector-Auto-Regressions outdo 400-equation macro models, and default models with 4 inputs out-do CFA worksheets that examine 50 different accounting ratios. This is obviously non-intuitive, not natural, as demonstrated by Tversky and Edwards, but also if you look at the standard tools to evaluate credit risk which give you so much information.

Thus, paradoxically, a good model should be a tougher sell than an overfit model. If the great unwashed (but white collar) masses like your 'model', you are probably going to fail if your goal is to predict well. A good model should cause unsophisticated people (i.e., most people) to think your model is insufficiently complex, because, intuitively, it is missing components X, Y and Z we see in actual data. But adding X, Y and Z merely increases the mean-squared error. Modeling 'feature creep' comes from giving people what they want, rather than what they need.

Wednesday, June 18, 2008

Who Owns GM?

Over a fifteen-year stretch ending in 2006, GM poured $55 billion into its workers' pension plan, compared to only $13 billion that it paid out in dividends.

From Lowenstein's While America Aged. It's a really good read, in that it highlights the problem of unions and pensions. Its easy to give pensions to unions to buy peace, putting the problem off on future generations. In the UAW, the pensioners vote, even though they aren't working, so these demands for pensions aren't going away. After all, most senior management won't be around in 10 years. Bankruptcy seems the only logical outcome. Another reason why the Detroit auto industry is doomed.

But the book also goes into how especially pernicious this is in the public sector, because there, the union workers can vote out politicians who don't protect, if not increase, these non-cash benefits.

Call Options are Lottery Tickets

In theory, far out-of-the-money call options should offer extremely high expected returns as a percent of their price. As underlying stocks always, in practice, have positive betas against ‘the market’, all calls will have positive betas that exceed the beta of the underlying stock, and call betas will increase in the strike price as the calls get further out-of-the-money. Hence, all calls will have positive expected returns and the expected returns will be larger for greater strike prices, because the betas increase as you go out of the money. Theoretically, beta—or any covariance with the elusive SDF—measures the ‘how much’ of risk, and so if risk is priced, higher options with higher strike prices (ie, more out-of-the-money), have higher beta(s), which implies higher average return.

For example, say you have a stock with a price of 100, and buy a call with a strike price of 120, expiring in 3 months. If the stock price rises to 110 over the next month, the call option will rise 120%, while a long stock position rises only 10%. This is the implicit leverage in an option, that is, it is like being able to borrow 10 times one’s capital and invest in the market. It is exactly the same bet, just higher powered.

Sophie Ni (2007) looked at data from 1996 through 2005, and found that the highest out-of-the-money calls have average returns of −37% over a month! The chart above shows that if you bucket call options into groups based on their ‘deltas’, which is a measure of how sensitive they are to the market, you find that call options, indeed, are indeed highly levered stock positions. Remembering that the average stock has a beta of 1.0, these betas range from 4 to 15—giving one 4 to 15 times the juice of the daily return. An option's beta is the beta of the stock, times the 'omega', which is a measure of the percent return in the option price given a 1% change in the stock price. Not only is the average return negative for call options, these returns get worse, the more implicitly levered, the more ‘risky’, the options become. Returns are negatively correlated with the betas on those options. This has been corroborated by several other studies, including Coval and Shumway (2001). Investors basically are overpaying for lottery tickets when they buy options, and just like the lottery, the average payout is worse, they more ‘risk’ one takes. If there’s a risk premium in equities, it certainly is not amplified in options in any way, because you lose money, on average, buying leverage market positions via call options.

Tuesday, June 17, 2008

Why I Don't Appreciate Fat Tails

I think on any issue, there is a big difference between apostates and everyone else. Those who believed X when young, learn not-X when older, and then vociferously argue that X is an abomination. For example, Andrew Sullivan hypothesized that ex-New York Times editor Howell Raines's obsession with race was because Raines noted that as a child raised in the south, he considered blacks inferior at one time (he won a Pulitzer for a NYTMagazine article on his family's black housekeeper). Sullivan called it the Guilty Southern White Boy syndrome, the need to assert, as if one is discovering a new planet, that black people are people too. Thus, Raines supports affirmative action as a penance of sorts.

I was born to liberal parents, and so I have no guilt about prior racism. I have never considered black Americans inferior, so I'm not defensive about not supporting affirmative action, or criticizing the race hucksters.

In a similar way, I always considered the Normal or Gaussian distribution an approximation of reality. Reality generally has fatter tails, but the gist of the normal distribution is pretty good, and has lots of neat properties: the sum of normal random variables is normally distributed, the expectation of e^x has a closed form if x is normally distributed. This makes it useful for exposition. People like Taleb and Haug, I bet, learned about the normal distribution and took it as gospel. then, when they discovered actual distributions were not exactly normal, they figured they had discovered something really novel, true and important. True, yes. Important, sometimes. Novel, not to me.

I just think it comes from the way people learn things. Some like to move in a sequence of true-believer modes, and clearly, the popularity of Taleb suggests he strikes a nerve with many people who also feel betrayed by the actual inexactitude of the normal distribution. I never thought the normal distribution was perfect, so this observation leaves me flat.

Climate Change Debate Masks Insane Tactical Confusion

Climate Change is one of those issues that really divides liberals and conservatives. Liberals see this as a demonstrable scientific truth with obvious implications about energy conservation. Conservatives see it as a pretext for more Big Government. Liberals are generally winning the argument that climate change is human-caused--if winning means generating a majority vote of both the masses, and the elites.

But while the liberals currently have the upper hand in this debate, they are losing the tactical war. Wired News, hardly a conservative outlet, lists 10 'green heresies [ie, things that are true, yet generally dismissed by environmentalists]':

1. It is greener to live in the cities
2. Air-conditioning is greener than heating
3. Conventional agriculture beats organics
4. Forests may cause warming
5. China is the solution
6. Genetic engineering may be great
7. Carbon trading is a failure
8. Nuclear power beats all other sources
9. Used cars beat hybrids
10. Climate change is inevitable
11. CO2 is not everything (bonus)

Just to make sure that they're green, one article starts off "No one with any scientific sense now disagrees about the severity of the climate crisis".

Lately, ethanol has taken a beating. Originally touted by none other than Al Gore (he cast the deciding vote in 1994 starting the ethanol add-in mandates that have become huge subsidies for farmers), its now seen as greens! If the rest of this list follows, it seems liberals are on the defensive on this issue, as they rationalize solutions based on hope, specifically, that current deficiencies in technologies such as solar will be rectified by sheer will like the moon landing.

I think conservatives win on these tactical issues because a liberals tend to see something and say "why not", which sounds nice, but tends to dismiss the fact that the status quo has more fundamental drivers than a mere conspiracy by the captains of industry. For example, the common belief that electric cars can reduce energy demand if we merely tried harder, ignores the fact that electric cars were invented prior to the internal combustion engine, and there has always been a huge market demand for better battery technology.

Monday, June 16, 2008

Espen Haug's Delusion

Around 2004 I received an Excel workbook with 45 different worksheets containing derivative models from a friend of a friend, with a pretty useful GUI, and outputs included many greeks. Incredibly impressive. It was created by Espen Haug, who has written some texts on derivatives. He clearly knows about derivatives formulas. But I hear he was in Stockholm last weekend, giving a talk at the OMX exchange with some other well-known finance types, which was described breathlessly as follows over at Daily Speculations:

Dr. Haug started the day by talking about fat tails, past, present and future. Among the most interesting part of his speech was his alluding to having in the drawer some theories on new distributions and implications for option trading. But he didn't go further on the record but said that he would probably write a bit about in on Wilmott. His gave a very good speech, so I for one will definitely be on the lookout for his findings.

I have read where Haug is going, and find it boring. He basically argues that since stock prices have discontinuous fat tails that are hard to estimate, Black-Scholes fails. So, we should adjust Black-Scholes. But that's what the volatility smile, or smirk (depending on the market) does. Further, the bid-ask is sufficiently large that a price taker can't make money anticipating these 'unexpected' crashes. I know a couple of option market makers in little Minneapolis, and they all drive nice cars. Retail option traders, meanwhile, are forever operating on the hope that 1) no one knows the real risk that stock X will implode or 2) by putting on a complex of options, you can lock in some above average return. Thus, the nice cars.

As per Haug and Taleb's argument that we shouldn't call Black-Scholes Black-Scholes, I find this a bit like changing the name of the pterodactyl to a pterodon. Is it necessary? While Haug pooh-pooh's Black, Scholes, and Merton, for merely proving that the discount rate should be the riskless rate, I think this is a pretty important finding. Risk is supposed to be darn important, and so, taking risk out of the equation turned a really hairy problem into a much simpler one. There are lots of option formulas that add terms to account for skewness, jumps and fat tails, but practice shows that people prefer merely applying the 'inconsistent' volatility surface rather than adding these parameters. Over time, a good option trader can them memorize the vol/strike/maturity gridspace, then monitor the changes level and sometimes shape of the vol surface. Any discovery stands on the shoulders of others, but it's really academic hair splitting to start a crusade to change the name of a formula based on some earlier, more obscure work by Thorpe or Bachelier that had parameters unexplained (that's why they have fewer cites). Rules of thumb in financial markets can make you rich, but they don't give you Nobel Prizes or naming rights. In any case, what would renaming Black-Scholes at this point do, other than confuse everyone?

Pablo Tirana notes that Haug and Taleb have another new big idea.
They argue that actual option prices on the open market may be simply the result of the interaction of supply and demand, with no formula involved. The second implication of Taleb and Haug is that implied volatility, a ubiquitous element of the markets, ceases to make sense. In fact, it would cease to exist... Rather than being the “market´s expected future turbulence” or the “market´s fear gauge”, as conventional wisdom would hold, implied volatility would have proven itself to be nothing but make-believe. A nonexistent ghost.

Well, if the implied of an option is 40, because this is the 'wrong vol in the wrong model to get the right price', and they think this implied is primarily due to supply and demand as opposed to actual volatility forecasts, then they should be able to make money pretty easily. Good luck with that. Given the bid-ask in option markets, you probably need only a 5-7 vol 'mismatch' to create an arbitrage via (gasp!) delta hedging an option. I think its really bad advice to tell people that implieds are almost arbitrary, hardly correlated with actual volatilities.

At the end of the day, no matter how smart someone is, how much math they know, they have one, or a couple, of 'big ideas'. Usually these ideas are just as silly as the big ideas that come from people who know very little math.

The Diversification Effect

Everyone knows diversification is the one free lunch in economics: you can lower your risk without lowering returns by seeking a portfolio that diversifies idiosyncratic risk away. But did you know it can increase one's returns, too?

From Harvey and Erb:

...of the 36 individual commodity futures that Gorton and Rouwenhorst (2005) studied, 18 had geometric excess returns that were greater than zero and 18 had geometric excess returns that were less than zero.

The average annual standard deviation of the 36 commodity futures was 30%. Bottom line, the average return of the average commodity futures was not statistically different from zero. Alternatively, the average commodity futures had an average geometric “risk premium” of zero.

Interestingly, though, the return of an equally weighted, and monthly rebalanced, portfolio of commodity futures in Figure 2 had a statistically significant return of about 4.5%.

Basically, they present the following rule of thumb to estimate the portfolio diversification factor (ie, that subracted from the arithmetic return to get the geometric return): 0.5*(1-1/k)*(avg var)*(1-avg corr)

where k is the number of positions. Harvey and Erb call this 'turning water into wine', because in futures, a portfolio of futures with individual geometric returns of 0, can rise to 4.5%, merely by equal weighting the futures (or thereabouts). I guess this is pretty trivial given that a geometric return is the arithmetic return minus the variance divided by 2 (approximately), but then again, all mathematics is a riff on tautologies.

Sunday, June 15, 2008

Floods in Iowa

Lots of flooding in Iowa, and it looks like a mess. But it is most notable for its lack of mayhem and looting, in contrast with Katrina, which was like the second floor of a frathouse party, people operating without a super-ego. I think this is what Steve Levitt would call, a natural experiment. What is the difference? Population density? Poverty rates? FEMA's response? The state's response?

The standard narrative on the Left is that Bush's incompetence and indifference was a primary cause of the social meltdown observed in Katrina's aftermath. I think that gives the President way to much blame. A comparison with these other disasters would be a good Master's thesis.

Saturday, June 14, 2008

How Special is Your Father?

Logically, fathers are not as special as children. I have hundreds of millions of sperm, I can create lots of children. My children are a few of them, PowerBall winners. They are special, not me. I'm like a pollen cloud, my kids are like a 1 in a billion germination. (not that I'm not going to milk Father's day for everything I can--I invented the framing device, 'Father's day weekend').

My kids are the best people in the whole world. I would rather save their lives than anyone else's, and would easily sacrifice my life for any of theirs at a moment's notice. They are probably not the most gifted kids in the world in any objective sense, yet I consider them not just good, but best. Why? I guess, a really targeted racism, whereas I have a strong Selfish-Gene preference for my kid's 50% correlation with my marginal genotype. I'm a pretty logical guy, but I must admit, to a Martian, I must look like Spock in that episode (Amok Time) where he is pulled on some biological imperative and gets called like a salmon swimming upstream to fulfill his genetic prophesy.

Perhaps Dawkins was right. A chicken is a way for an egg to make another egg, not the other way around. I really have no control over my actions (creating kids) or preferences (prioritizing my kids).

Friday, June 13, 2008

Fed to Address Bubbles

So yesterday, local Federal Reserve President Gary Stern was speaking in front of the "100 Women of Hedge Funds" (must..not..make...joke) and Stern mentioned that the Fed was going to start looking into bubbles. Now, Bloomberg notes the following similarity between the rise in Oil, and the rise in the Nasdaq:

Crude rose 697 percent since trading at $17.45 a barrel on the New York Mercantile Exchange in November 2001. The last time a similar pattern was seen in equities was eight years ago, when Internet-related stocks sent the Nasdaq Composite Index up 640 percent to its highest level ever, according to data compiled by Bloomberg and Bespoke Investment Group LLC.

So, am I comforted that the Fed is going to start looking for bubbles? Perhaps. Assume oil is a bubble. What do you do? I guess one place to start, would be to make sure the anticipated volatility to any oil related positions, at Fed regulated entities, has anticipated the scenario where oil falls back to $17 a barrel in two years. I mean, if the UBS writedown told us anything, it's that at the very least one needs to model an asset moving in the exact opposite path it has gone. And remember that UBS used the past 5 years of history to generate their res mortgage risk, which in this context, would basically assume a symmetric decline in oil is impossible.

The scary thing would be if they started throwing all sorts of limits on markets, or other stupid solutions. The Fed has a lot of smart people. Now, if a congressman said they were contemplating legislation aimed at ameliorating bubbles, I would be really scared. I think it was Alan Blinder who noted that the Fed was efficient because it was kind of immune from the demagoguing in the legislative branch.

Thursday, June 12, 2008

Fannie Mae ex-CEO Ousted from Obama's Campaign

Jim Johnson, a political operative rewarded with the CEO-ship of Fannie Mae, had to step down from Obama's Vice Presidential selection committee. Reading about this guy, he seems like a prime example of why Fannie Mae should be shut down. This guy spent his life as a pure politician. He is a veteran Democrat. When Mondale ran for president in 1984, Johnson was the chairman of his campaign. Maxine Isaacs, who later became his wife, was the campaign's press secretary. Johnson joined Fannie Mae in 1990 and became its chairman a year later.

Banking is a special business. You need years of experience to understand the particularities of its assets, because its assets have risks that are very peculiar, one is always looking at cohorts, and roll rates, etc. My old boss, Kevin Blakely, once told me a funny story, about how he was asked by a professor to speak to his Money and Banking class. He examined this guy's book, and his syllabus, and thought, this is Money and Banking? Most of it was on the money multiplier, a little about interest rate risk, and nothing about credit risk. I would say current updates that include the Merton Model, are incredibly small baby steps in terms of relevance. To know banking, you need to work there at least 5 years, because you don't learn this in school, or the press.

What does a politician know about residential mortgages given all his experience as a Democratic operative? Nothing, except access to politicians. It's as if they made Newt Gingrich head of NASA. He was clearly valuable merely in maintaining the Fannie Mae's plumb position maintaining its special access to government finance rates. That can be the only reason. And so Fannie Mae became, for decades, a place to reward high-level Washington politicians with million a year jobs. It's a scam. He got rich perpetuating a government-sponsored monopoly that provides high-level patronage jobs.

The Insidiousness of Government Solutions

The Atlantic has an article, American Murder Mystery, about urban planning that I find highly disturbing. Note all the angst about the findings. We all like to comfort ourselves as truth-seekers above all else, unlike those idiots in the past who bought into some large belief structure that caused them to think, say, heavy objects fall faster than light objects, or that Africans were sub-human., but I think there are just as many taboo truths today as there have ever been. The issue concerns section 8 housing:

Betts had been evaluating the impact of one of the city government’s most ambitious initiatives: the demolition of the city’s public-housing projects, as part of a nationwide experiment to free the poor from the destructive effects of concentrated poverty. Memphis demolished its first project in 1997. The city gave former residents federal “Section8” rent-subsidy vouchers and encouraged them to move out to new neighborhoods. Two more waves of demolition followed over the next nine years, dispersing tens of thousands of poor people into the wider metro community.

If police departments are usually stingy with their information, housing departments are even more so. Getting addresses of Section 8 holders is difficult, because the departments want to protect the residents’ privacy. ... Janikowski merged his computer map of crime patterns with Betts’s map of Section8 rentals....the match was near-perfect...She knew right away that this would be a “hard thing to say or write.” Nobody in the antipoverty community and nobody in city leadership was going to welcome the news that the noble experiment that they’d been engaged in for the past decade had been bringing the city down, in ways they’d never expected.

The idea began with Lyndon Johnson's Kaiser Commission on Urban Housing, which mistakenly believed that the private housing market created poverty, and the ills associated with it, by making housing too expensive. Thus, by reducing housing expenses via vouchers, and spreading the poor around the community, poverty, and the social ills associated with it, would fade away. That's the theory. It turns out, the main problem of poor people is not a lack of money, but the temperance, diligence, thrift and other bourgeois virtues needed to be good citizens and neighbors. They bring their bad habits with them, statistically.

Given that it took 40 years to document this, this means that any big policy started today, will probably not be amenable to empirical analysis in my lifetime. Less than the 70 years of communism in the Soviet Union, but same scale. That's the big risk to big top-down ideas.

But the insidiousness comes from the way the government, from federal down to city level, hid this data for decades because they didn't want people to discriminate against section 8 areas or their residents. This means, if they put a high concentration of people with high criminality next to your house, they didn't want you to know, based on the assumption that the poor's behavior was either due to a lack of housing (which section 8 addresses directly), or the 'stereotype effect' from people who see them as poor. But the theory was wrong, and so all those millions of people had to deal with this problem themselves, and if they asked questions in local papers, they were labeled racist, or anti-poor. I have seen this happen several times in communities I have lived in, where someone writes in an editorial or letter to the editor, noting that but for the residents from this part of town--where the section 8 housing is--school scores or crime in the city is pretty low. An onslaught of recriminations invariable ensues, and because of the difficulty in getting data, even though the author is saying what we all know to be true, he can not prove it, and so the public debate leaves him labeled 'racist', the modern day equivalent of being called a witch).

When we give the government the power to solve big problems, like poverty, or crime, and introduce some grand policy, the best approach is prudent incrementalism: make a variety of changes piecemeal, monitor them, share the experiences with the rest of the world, learn and modify. This is the balance between conservatism and progressivism that makes societies better. But the standard operating procedure of governments is to implement a policy in one big swoop, and then hide the data so no one can criticize it. If a business acted this way, it would be destroyed and pilloried. This is one of several reasons why I think minimizing the scope of government's function in society is a good thing, because government is not only inefficient, but it rationalizes dishonesty out of some greater good much more efficiently than any corporation can.

Wednesday, June 11, 2008

Equity Premium? Commodity Premium!

One of the bigger puzzles in economics is the equity premium, the return you get for investing in equities over the risk free rate. This is considered too large by an order of magnitude given standard utility functions, which is really only a puzzle for those who know what a standard utility function is (very few). For most people, the estimates of 3.5% to 6.5% seem right, because investing in stocks is risky.

But what about commodities? Gorton and Rouwenhorst (2005) find that from 1959 through 2004, commodities had about the same return as equities. Harvey and Erb (2006) note much of this is from 'rebalancing', but such rebalancing in the liquid futures market seems eminently feasible. As commodities have gone through the roof in the past 3 years, that comparison only looks better for commodities. Using the CRB and DJ-AIG indices, they have about the same annualized volatility since 1994 as the S&P500, about 13%, but higher returns. They have much lower volatility than the Nasdaq. The Sharpe ratios for the S&P and Nasdaq have been around 0.38 since 1994, while the commodity indices are in the 0.50 to 0.70 range (the CRB is considerably higher. They weight energy, foodstuffs, metals, differently).

Further, the commodity indices have positive skew, while the equity indices have negative skew, and investors supposedly like positive skew, so they get this extra feature--and a premium!

Lummer and Siegel (1993) and Kaplan and Lummer (1998) argue that the long-run expected return of an investment in the cash collateralized commodity futures strategy should be similar to that of Treasury bills, equivalent to saying that the expected excess return should be zero. Dusak (1973) who documented low stock market betas and postulated low expected returns for wheat, corn and soybeans in the context of the Capital Asset Pricing Model of Sharpe (1964) and Lintner (1965). But I bet over the next few years we will have a bunch of papers explaining this strange 'commodity premium puzzle', which should be more puzzling than the equity puzzle ecause commodities are positively correlated with both inflation, and unexpected nflation, which like skew, are good things that should lower their returns. As there are lots of issues like rebalancing, and the futures 'roll', survivorship bias (poor futures become extinct), and weighting, the issue is not straightforward.

But as I noted in my post on Eliezer Yudkowsky, humans are good rationalizers, and I think most educated, smart people, rationalize as oppose to reason. If there's a risk explanation for this, it will take a lot of rationalizing indeed.

Rodrik-Cowen Trade Smack Down

Tyler Cowen argued in the New York Times that fear of international trade is basically irrational in-group loyalty, which implies a fear of outsiders, and thus, trade. He argues these fears are unfounded, because the effects of trade with outsiders is no different than the effects of productivity increases at home. Dani Rodrik responded with the argument that people really fear competing with those who play 'unfairly', giving the example that if he lost his job to a psychologist who was allowed to use torture to elicit preferences, this he feels, would be unfair, even if this evil academic produced valuable work. More concretely, Americans don't like competing with countries where they have fewer regulations, less worker safety, environmental protection, etc.

I think you can dismiss Rodrick's argument by noting that Americans are just as wary of imports from Canada, Japan and Europe, as they are from imports from Mexico, China, and Africa. Cowen alludes to this in his rejoiner.

I think it's mainly the Buchanan targeted benefits-diffuse costs story. The issue is not so much Americans are against free trade, but at the margin, every import has a strong group of supporters for quotas or tariffs, and a broad group against such quotas and tariffs. The logic implies that the people who give money, lobby, and vote on this issue are always against tariffs. General arguments on the principle of free trade are to abstract for most voters.

Tuesday, June 10, 2008

Rationalizing Versus Reasoning

Eliezer Yudkowsky at Overcoming Bias seems like your typical autodidact in that he appears both very clever, and very prolix. But this is in contrast to formal academics, whose 50-page academic treatises don't seem as long because they follow a protocol. Both approaches have their plusses and minuses. The long-winded autodidact posts (eg, Razib over at GeneExpression) often meander, but the academic format only seems shorter because it is predictable.

Anyway, Eliezer has a neat post against the Devil's Advocate reasoning, which finds great value in being able to argue both sides of an issue:

I discovered that my mind could, if asked, invent arguments for anything.

I know people whose sanity has been destroyed by this discovery. They conclude that Reason can be used to argue for anything. And so there is no point in arguing that God doesn't exist, because you could just as well argue that God does exist. Nothing left but to believe whatever you want.

Having given up, they develop whole philosophies of self-inflation to make their despair seem Deeply Wise. If they catch you trying to use Reason, they will smile and pat you on the head and say, "Oh, someday you'll discover that you can argue for anything."...
I picked up an intuitive sense that real thinking was that which could force you into an answer whether you liked it or not, and fake thinking was that which could argue for anything.
Maybe there are some stages of life, or some states of mind, in which you can be helped by trying to play Devil's Advocate. Students who have genuinely never thought of trying to search for arguments on both sides of an issue, may be helped by the notion of "Devil's Advocate".
There is no expectation against having strong arguments on both sides of a policy debate; single actions have multiple consequences. If you can't think of strong arguments against your most precious favored policies, or strong arguments for policies that you hate but which other people endorse, then indeed, you very likely have a problem that could be described as "failing to see the other points of view".
a soldier who fights with equal strength on any side has zero force.

I know someone who lamented the moral emptiness of the lawyers he was facing, and a friend told him not to blame the lawyers, they were just doing their job, and a just one too, because every side needs an advocate. He thought this was silly. Surely every position has its arguments, but some positions are still, net net, indefensible. To be able to argue anything effectively is to merely be a tool for others. A powerful tool, but still a tool.

Obama Tax Hike

The main reason I vote Republican is because I think that in general, over time, they will spend less than Democrats. Clearly, Bush's Medicare, Iraq War, and No Child Left Behind, are good data points against this thought, but other than the Iraq War (big exception, to be sure), the Democrats want to spend more, not less. This nation needs more taxes like my kids need more candy.

Thus, when a candidate says he is going to raise taxes, given the natural incentives of the system, this means the sky's the limit, and spending will fill the gap like nature abhors a vacuum. And so Obama saying he is going to raise taxes right out of the shoot, I figure, this could be big trouble. Voters tend to sense this, as famously, when Walter Mondale made his acceptance speech at the 1984 Democratic Convention, Mondale said: "By the end of my first term, I will reduce the Reagan budget deficit by two-thirds. Let's tell the truth. It must be done, it must be done. Mr. Reagan will raise taxes, and so will I. He won't tell you. I just did." While this was meant to show that Mondale would be honest with voters, it was largely interpreted as a campaign pledge to raise taxes, and Reagan destroyed Mondale in the fall election.

Conservatives have argued Obama is going to raise taxes, and Obama's defense? Not as much as you say, and more progressively. He would raise the 15% capital-gains tax on the income from sales of investments to about 20%. "my discussions with people like Warren Buffett indicate that it will probably not have any significant impact in terms of investment." As Buffett is 78, and has tens of billions of dollars, he could live insanely lavishly until he dies under the most insane tax regime, so I don't think his preferences are so relevant.

The Illinois senator said he would cut income taxes for 95% of American workers, meaning marginal tax rates will rise considerable on bigger earners. Progressive taxation is desirable to many people, as it would probably win a vote in the same way expropriating the wealthy always seems like a good idea when demagoguing. Whenever you rob Peter to pay Paul, you can always count on Paul’s support. The problem is that the more progressive the tax rate is, the more it skews investment decisions, leading to a missallocation of resources. I was at a presentation by Northern Trust, and the audience were investment advisers to the wealthy. Most were lawyers and tax specialists, as opposed to people who really knew investments. This makes sense because if you make a lot of money, taking advantage of the various tax breaks is the most important priority. It shouldn't be this way, you want investors thinking about whether to buy subprime, or get out, not whether the current tax break on ethanol, or muni bonds, will continue.

Obama says his plan to shore up Social Security by raising the level of taxable wages wouldn't affect 97% of taxpayers. Currently this rate is about 7.6%. Currently this tax stops at $97,000 per year, because presumably its not a tax, but an investment in a retirement fund. As outlays are capped, taxes above this can no longer be called an investment, but are laid bare as the taxes they are. Thus, if Obama installs this tax for income above $200k as he plans, this will merely highlight that social security taxes are not an investment, but a tax. That's a 7% marginal tax increase on the wealthy, more money down the DC rat hole.

Sunday, June 08, 2008

Behavioral Probability Errors

The New York Times has a review of a book on how unintuitive probability is. The Drunkard's Walk by Leonard Mlodinow goes over many examples where average, and really smart people, get it wrong (listen to interview here, and see Random House's book excerpt here). For example, The famous Monte Hall problem, from Let's Make a Deals, presented contestants with three doors, behind one of which is a new car. You take your pick, but before your fate is revealed, the M.C. swings open one of the other doors, revealing a booby prize (a goat). So far, so good, but now comes the big decision. Do you stay with your original choice or switch to the other unopened door? Many people say the odds don't change, because there will always be a goat, so the odds have to be 50-50 (two doors left, one car).

To see this, consider the following cases behind doors 1, 2 and 3 respectively: goat, goat, car. If you pick one of the first two, you will lose if you don't switch. So, switching changes your odds from 0 to 100%, because revealing the goat leaves the car. If you pick the third choice, switching takes you from a 100% chance of winning, to a 0% chance. 1/3(0+0+100%)=1/3 are your original odds. Your new odds are 1/3(100%+100%+0%), or 2/3.

This has been studied a lot (over 40 academic papers), but what is interesting that many people got this wrong, even very smart people like Paul Erdos.

He also goes over the meaning of a Positive HIV test that is 99.9% accurate. Using bayesian statistics, the actual odds of a positive test are less than 10%. And then there's the OJ trial, where one of Simpson’s lawyers, Alan Dershowitz, noted that even though OJ beat his wife, that hardly mattered, because in the United States, four million women are battered every year by their male partners, yet only one in 2,500 is ultimately murdered by her partner (1 in 1000), so, by the 'reasonable doubt' criterion, this is irrelevant.

The jury may have found that persuasive, but it’s a spurious argument. The relevant question was what percentage of all battered women who are murdered are killed by their abusers, which isn't 1 in 1000, but rather 9 in 10.

I think the main thing brought up by all this is that humans have very poor intuition of conditional probability. Yet it must be remembered that it is still very difficult to make money, implying that, like an options pricing model, when the economic implications are large, people override their intuition with models. I don't think these biases have much meaning for asset pricing, because the stakes are too large for the errors to remain, and so, I don't find them so important

The second main take away is that really smart people are often wrong, on questions of pure logic. No matter how smart we are, and Erdos and Dershowitz are smart, we aren't always right.

Thursday, June 05, 2008

Intellectual Fads

Intellectual fads are interesting because, unlike the fad for Paris Hilton adopted by the lumpenproletariate (which my friend Pete Sattler is mocking daily at his new blog PromoteThisBlog), these are false or useless ideas adopted by very smart and educated people. A lot of times, this manifests itself in people overinterpreting the usefulness of a theory, or applying it somewhere else. For example, supposedly a pretentious older woman asked Einstein for his opinion on what his Theory of Relativity implied about ethics. He replied, "none that I can think of".

Claude Shannon wrote a mathematical definition of information based on the concept of entropy in thermodynamics, and this proved very useful for coding, data compression, encryption, and other aspects of information processing. But that's it. Some people thought it would be useful in linguistics, psychology, economics, biology, and even the arts. But Shannon stated to science writer John Horgan, "Somehow people think it can tell you things about meaning, but it can't and wasn't intended to".

In the 1960's, Rene Thom developed a mathematical theory that captured phase shifts, applicable to chrysalis, earthquakes and societal collapse. His 1972 book, Structural Stability and Morphogenesis, was reviewed by the Times of London as follows: "it is impossible to give a brief description of the impact of this book. In one sense the only book with which it can be compared is Newton's Principia. Both lay out a new conceptual framework for the understanding of nature, and equally both go on to unbounded speculation."[Nov 30, 1973]

You don't hear much about that anymore.

What About Residual Variance?

When I was doing my dissertation of variance and stock returns, I remember there was presumably a big difference between idiosyncratic variance and systematic variance. Systematic variance is basically the beta squared, times the market volatility for the period the beta was calculated. residual, or idiosyncratic variance, is the difference between total variance and systematic variance.

This supposedly made a great deal of difference in testing variance, because we all knew the problems with beta. It could be measured with error for a host of reasons, conditional volatility issues, using the right index (S&P500, Market Weighted CRSP index, Equal Weighted Indices, etc). So, if you found a correlation between the total, or systematic variance, nad returns, good luck with that. The beta was so poisoned, so debatable, that you couldn't say anything about it. Thus, the recent papers by Ang, Hodrick, Xing and Zhang (US and international), on volatility and returns is on 'idiosyncratic volatility' and cross sectional returns.

But I remember when I read an interesting paper by Bruce Lehman, Residual Risk Revisted. He noted that idiosyncratic variance should pick up mismeasured factor loadings and mismeasured factor loadings should help explain the poor performance of factor models such as the APT. For example, Stephen Ross and Richard Roll (1994) point out it is possible—though not probable—inefficient estimates of the market portfolio are uncorrelated with returns, yet then residuals should still show a positive correlation with returns. That is, if some factor is misestimated, the measure of beta is not perfect because of imperfections in the risk proxy. But then the residual variance in such an equation should then be positively correlated with returns.

I pulled together a lot of data on betas, total volatility, and residual volatility recently. You get pretty much the same results any way you slice it. They are all negatively correlated with returns, cross sectionally. It doesn't matter, in terms of expected returns. Hmmm. I wonder why? They never tell you in grad school that as a practical matter, risk is very very subtle.

Wednesday, June 04, 2008

Bull Market or Genius?

The recent run up of commodity prices such as wheat, corn, and oil, have made many people very wealthy. Just being long these assets has generated large returns. As one might expect, there has been an explosion in funds that specialize in commodities.

Now, given the huge expansion of commodity funds, one could reasonably assume that the average commodity fund performance has been pretty good. And given that commodity prices have risen steadily over the past 4 years, these funds must have been net long commodities, on average. Over the past 60 months, if we assumed oil should rise at the risk free rate, we experienced a 1 in 5000 event as prices have risen over 3 fold. So clearly, many fund managers in this space have merely been long, and rewarded considerably. Smart or lucky? I'm sure a little of both, but mostly the latter.

Of course, this goes not just for hedge funds, but oil and gas companies. I used to work with this guy Ryan Gilbertson (don't know him well, but he is as described in the article, quite the cowboy), who is now CFO of Northern Oil & Gas. As he told Bloomberg:

Gilbertson says he knows more about interest-only mortgage bonds than he does about oil. But he says Northern will succeed because he and Reger weren't in business during the busts of earlier decades, so they aren't gun-shy today.
When EOG hit oil, they leased as many mineral rights in Mountrail County as they could, even as prices rose.

``The fear of these busts has clouded the judgment of so many players,'' Gilbertson says. ``We just grabbed everything with both hands.''
So basically, he's saying they are successful (risen 300% in past year and a half), because they have just been more aggressive out of ignorance. This reminds me of a paper by DeLong, Shfleiffer, Summers, and Waldeman (Noise Trader risk in financial markets,1990), where less informed investors earn the highest (and lowest) rates of return on their total portfolios because they irrationally believe they have a more favorable risk-return opportunity and hence invest in securities with a higher return. In effect, their ignorance effectively diminishes their risk aversion, and in the long run allows a lucky few of them to reap the financial rewards that would accrue to the less risk averse (one could call it the ‘Forrest Gump’ effect). As opposed to speculation weeding out the irrational traders and making only the best opinions matter, the irrational can dominate the class of winners.

It's interesting model in this context. Those funds and companies, that threw risk controls out the window over the past 5 years have done the best. I think it's like the internet bubble, or any bubble. The question you have to ask is, is this 1998 (big up year ahead), or 1999 (the opposite)?