Economics

Expected Returns

Posted by Peter on August 23, 2011
Posted in: Book Reviews, Investing. Tagged: , .

Book review: Expected Returns: An Investor’s Guide to Harvesting Market Rewards, by Antti Ilmanen.
This book is causing me to change my approach to investing much more than any other book has. It is essential reading for any professional investor.

The foreword starts by describing Ilmanen as insane, and that sounds like a good description of how much effort was needed to write it.

Amateur investors will have trouble understanding it – if you’re not familiar with Sharpe ratios, you should expect to spend a lot of time looking elsewhere for descriptions of many concepts that the book uses. I had a few problems understanding the book – he uses the term information ratio on page 188, but doesn’t explain it until page 491 (and it’s not indexed). I was also somewhat suspicious about how he handled data mining (overfitting) concerns in momentum strategies until I found a decent answer in a non-obvious place (page 404).

The most important benefit of this book is that he has put a lot of thought into identifying which questions investors should be trying to answer. Questions such as whether past performance is a good indicator of future returns, and what would cause a pattern of superior returns to persist or vanish.

Some other interesting topics:

  • why it’s important to distinguish between different types of undiversifiable risk, and how to diversify your strategies so that the timing of losses aren’t highly correlated across those strategies.
  • why earnings per share growth has been and probably will continue to be below GDP growth, contrary to what most forecasts suggest.
  • how to estimate the premium associated with illiquidity
  • why it’s useful to look at changes in correlations between equities

It’s really strange that I ordered this a few weeks after what Amazon lists as the publication date, but it took them nearly 7 weeks to find a copy of it.

Some quotes:

overfitting bias is so insidious that we cannot eliminate it (we cannot “become virgins again” and forget our knowledge)

the leverage of banks will soon be more tightly restricted by new regulations. The practical impact will be more pronounced risk premia for low-volatility assets, more sustained mispricings, and greater opportunities for those who can still apply leverage

European financial crisis

Posted by Peter on August 8, 2011
Posted in: Investing, Politics.

Arnold Kling has a concise summary of the current crisis:

Apparently, the resolution of the debt ceiling restored the dollar’s status as a safe haven in the eyes of the world’s investors. That accelerated the flight from European sovereign debt and European banks. That in turn raised fears in financial markets, driving down stocks, including in the United States.

The European monetary system appears to suffer from the same problems as Bretton Woods.

European voters seem unlikely to tolerate the measures needed to maintain the current system. Yet the breakup will cause enough problems for the banking system that politicians will postpone it as long as possible.

Avoid News

Posted by Peter on March 9, 2011
Posted in: Investing, Politics. Tagged: .

Avoid News is a good rant against paying attention to the storytellers that typically get labeled as news reporters:

Information is no longer a scarce commodity. But attention is. Why give it away so easily? You are not that irresponsible with your money, your reputation or your health. Why give away your mind?

I don’t know a single truly creative mind who is a news junkie – not a writer, not a composer, mathematician, physician, scientist, musician, designer, architect or painter. On the other hand, I know a whole bunch of viciously uncreative minds who consume news like drugs.

Bryan Caplan says:

P.S. When I read this passage, the counter-example of Tyler Cowen came immediately to mind.

I don’t consider that much of a counter-example. I found Tyler Cowen’s blog to be a dangerous addiction, and I’m glad I quit. I have a strong impression that he could be much more creative than he is, but has made a deliberate choice to pursue fame at the expense of creativity.

In order to maintain the pretense that news focuses on important information, storytellers focus on events that make us unhappy (avoiding or fixing mistakes are more important than understanding what routinely goes right, which makes it hard to focus on good news). [This also applies to other sources of political information, but that means I want the most concise source, which is not likely to be a rapidly published source.]

I’m not willing to completely follow the advice to kick my news addiction, since I’m somewhat dependent on social connections with people who imagine that news media provide valuable information. But I can mostly learn enough by watching The Daily Show, which often (but hardly consistently) is careful to indicate that they focus on frivolous, entertaining stories that give low priority to educational value. I’m definitely better off with that than I was when I was addicted to serious-sounding daily news sources.

I have a system for reading financial news that minimizes the problems with news. It involves mostly reading numbers that I find via stock symbols. Most of those numbers have been checked by accountants, who have strict rules to minimize biases. I’m fairly careful to select which symbols I follow by analyzing numbers, not stories.

For more evidence that news harms you, see an experiment done by Andreassen where subjects trading stocks did worse if they saw a constant stream of news than if they saw no news once they started trading.

Also, Robin Hanson’s analysis of how the press handled one story suggests a pretty clear positive correlation between the time a source takes to convey a story and the accuracy of that story.

[I’ve been neglecting this blog recently due to an obsession with finding waterfalls; that will change any week now when rainfall tapers off.]

Drive

Posted by Peter on August 31, 2010
Posted in: Economics, The Human Mind. Tagged: , , , .

Book review: Drive: The Surprising Truth About What Motivates Us, by Daniel H. Pink.

This book explores some of the complexities of what motivates humans. It attacks a stereotype that says only financial rewards matter, and exaggerates the extent to which people adopt that fallacy. His style is similar to Malcolm Gladwell’s, but with more substance than Gladwell.

The book’s advice is likely to cause some improvement in how businesses are run and in how people choose careers. But I wonder how many bosses will ignore it because their desire to exert control over people outweighs their desire to create successful companies.

I’m not satisfied with the way he and others classify motivations as intrinsic and extrinsic. While feelings of flow may be almost entirely internally generated, other motivations that he classifies as intrinsic seem to involve an important component of feeling that others are rewarding you with higher status/reputation.

Shirking may have been a been an important problem a century ago for which financial rewards were appropriate solutions, but the nature of work has changed so that it’s much less common for workers to want to put less effort into a job. The author implies that this means standard financial rewards have become fairly unimportant factors in determining productivity. I think he underestimates the importance they play in determining how goals are prioritized.

He believes the changes in work that reduced the importance of financial incentives was the replacement of rule-following routine work with work that requires creativity. I suggest that another factor was that in 1900, work often required muscle-power that consumed almost as much energy as a worker could afford to feed himself.

He states his claims vaguely enough that they could be interpreted as implying that broad categories of financial incentives (including stock options and equity) work poorly. I checked one of the references that sounded like it might address that (“When performance-related pay backfires”), and found it only dealt with payments for completing specific tasks.

His complaints about excessive focus on quarterly earnings probably have some value, but it’s important to remember that it’s easy to err in the other direction as well (the dot-com bubble seemed to coincide with an unusual amount of effort at focusing on earnings 5 to 10 years away).

I’m disappointed that he advises not to encourage workers to compete against each other without offering evidence about its effects.

One interesting story is the bonus system at Kimley-Horn and Associates, where any employee can award another employee $50 for doing something exceptional. I’d be interested in more tests of this – is there something special about Kimley-Horn that prevents abuse, or would it work in most companies?

Disadvantages of Stories

Posted by Peter on August 12, 2010
Posted in: Investing, The Human Mind.

Tyler Cowen has a good video describing why we shouldn’t be too influenced by stories. He exaggerates a bit when he says

There are only a few basic stories. If you think in stories, that means you are telling yourself the same thing over and over

but his point that stories allow storytellers to manipulate our minds deserves more emphasis. For me, one of the hardest parts of learning how to beat the stock market was to admit that I did poorly when I was influenced by stories, and did well mainly when I relied on numbers that are available and standardized for most companies, and on mechanical rules which varied little between companies (I sometimes use different rules for different industries, but beyond that I try to avoid adapting my approach to different circumstances).

For example, The stories I heard about Enron’s innovative management style gave me a gut feeling that it was a promising investment. But its numbers showed an uninteresting company, and persuaded me to postpone any investment.

But I’ve only told you a story here (it’s so much easier to do than provide rigorous evidence). If you really want good reasons, try testing for yourself story versus non-story approaches to something like the stock market.

(HT Patri).

An Improved Automated Market Maker

Posted by Peter on June 21, 2010
Posted in: Idea Futures. Tagged: , .

[See here and here for some context.]

John Salvatier has drawn my attention to a paper describing A Practical Liquidity-Sensitive Automated Market Maker [pdf] which fixes some of the drawbacks of the Automated Market Maker that Robin Hanson proposed.

Most importantly, it provides a good chance that the market maker makes money in roughly the manner that a profit-oriented human market maker would.

It starts out by providing a small amount of liquidity, and increases the amount of liquidity it provides as it profits from providing liquidity. This allows markets to initially make large moves in response to a small amount of trading volume, and then as a trading range develops that reflects agreement among traders, it takes increasingly large amounts of money to move the price.

A disadvantage of following this approach is that it provides little reward to being one of the first traders. If traders need to do a fair amount of research to evaluate the contract being traded, it may be that nobody is willing to inform himself without an expectation that trading volume will become significant. Robin Hanson’s version of the market maker is designed to subsidize this research. If we can predict that several traders will actively trade the contract without a clear-cut subsidy, then the liquidity-sensitive version of the market maker is likely to be appropriate. If we can predict that a subsidy is needed to generate trading activity, then the best approach is likely to be some combination of the two versions. The difficulty of predicting how much subsidy is needed to generate trading volume leaves much uncertainty.

[Updated 2010-07-01:
I’ve reread the paper more carefully in response to John’s question, and I see I was confused by the reference to “a variable b(q) that increases with market volume”. It seems that it is almost unrelated to what I think of as market volume, and is probably better described as related to the market maker’s holdings.

That means that the subsidy is less concentrated on later trading than I originally thought. If the first trader moves the price most of the way to the final price, he gets most of the subsidy. If the first trader is hesitant and wants to see that other traders don’t quickly find information that causes them to bet much against the first trader, then the first trader probably gets a good deal less subsidy under the new algorithm. The latter comes closer to describing how I approach trading on an Intrade contract where I’m the first to place orders.

I also wonder about the paper’s goal of preserving path independence. It seems to provide some mathematical elegance, but I suspect the market maker can do better if it is allowed to make a profit if the market cycles back to a prior state.
]

Awakening Giants

Posted by Peter on June 3, 2010
Posted in: Book Reviews, China, Economics.

Book review: Awakening Giants, Feet of Clay: Assessing the Economic Rise of China and India by Pranab Bardhan.

This short book has a few interesting ideas.

The most surprising ones involve favorable claims about China’s collectivist period (but without any claim that that period was better overall).

China under Mao apparently had a fairly decentralized economic system, with reasonable performance-based incentives for local officials, which meant that switching to functioning capitalism required less change than in Russia.

Chinese health apparently improved under Mao (in spite of famine), possibly more than it has since, at least by important measures such as life expectancy. This is reportedly due to more organized and widespread measures against ordinary communicable diseases under collectivism.

Stock Market Liquidity

Posted by Peter on May 11, 2010
Posted in: Investing. Tagged: .

One simple way to prevent fluctuations like those of last Thursday would be for stock exchanges to prohibit orders to buy or sell at the market.

That wouldn’t mean prohibiting orders that act a lot like market orders. People could still be allowed to place an order to sell at a limit of a penny. But having an explicit limit price would discourage people from entering orders that under rare conditions end up being executed at a price 99 percent lower than expected.

It wouldn’t even require that people take the time to type in a limit price. Systems could be designed to have a pseudo-market order that behaves a lot like existing market orders, but which has a default limit price that is, say, 5 percent worse than the last reported price.

However, it’s not obvious to me that those of us who didn’t sell at ridiculously low prices should want any changes in the system. Moderate amounts of money were transferred mainly from people who mistakenly thought they were sophisticated traders to people who actually were. People who are aware that they are amateurs rarely react fast enough to declines to have done anything before prices recovered. The decline looked like it was primarily the result of stop-loss strategies, and it’s hard to implement those without at least superficially imitating an expert investor.

This Time is Different

Posted by Peter on March 11, 2010
Posted in: Book Reviews, Economics, U.S. Politics. Tagged: , , .

Book review: This Time is Different: Eight Centuries of Financial Folly by Carmen M. Reinhart and Kenneth S. Rogoff.

This book documents better than any prior book the history of banking and government debt crises. Most of it is unsurprising to those familiar with the subject. It has more comprehensive data than I’ve seen before.

It is easier reading than the length would suggest (it has many tables of data, and few readers will be tempted to read all the data). It is relatively objective. That makes it less exciting than the more ideological writings on the subject.

The comparisons between well governed and poorly governed countries show that governments can become mature enough that defaults on government debt and hyperinflation are rare or eliminated, but there is little different in banking crises between different types of government / economies.

They claim that international capital mobility has produced banking crises, but don’t convince me that they understand the causality behind the correlation. I’d guess that one causal factor is that the optimism that produces bubbles causes more investors to move money into countries they understand less well than their home country, which means their money is more likely to end up in reckless institutions.

The book ends with tentative guesses about which countries are about to become mature enough to avoid sovereign debt crises. Among the seven candidates is Greece, which is now looking like a poor guess less than a half year after it was published.

A Splendid Exchange

Posted by Peter on February 12, 2010
Posted in: Book Reviews, Economics. Tagged: .

Book Review: A Splendid Exchange: How Trade Shaped the World by William J. Bernstein.

This book starts off as a relatively ordinary history book, then toward the end offers a moderate number of valuable insights. Those insights don’t appear to be original, but he performs a valuable service by drawing attention to ideas that aren’t as widely known as they should be.

He argues that the Boston Tea Party was intended to keep tea prices high, and instigated by the merchants who were threatened by increased competition, using the much of the same rhetoric that modern protectionists use.

He describes a strong connection between a decrease in the price of mailing a letter and the ability of people of ordinary wealth to organize opposition to the Corn Laws.

He has an interesting argument that the benefits of international trade is the resulting desire for peace between people who have business relationships with each other, rather than the more obvious but apparently small benefits that are more direct. I wish there were stronger evidence that trade generates peace.

He makes a moderate number of claims that seem poorly thought out. E.g. “a national or central bank” is “the bedrock financial institution of the modern world”.