investing

On the Complexity of Finance

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Steve Randy Waldman of Interfluidity has a very smart post outlining his thoughts to this question: why is finance so complex? He argues that, in fact, finance has always been complex. And not only that, finance has been opaque, and “complexity is a means of rationalizing opacity in societies that pretend to transparency.” Opacity in modern finance is a feature, not a bug. If you fully understood the risks of all your investments, he argues, you might be wary of investing…

Using examples from game theory (see stag hunt), Waldman continues:

Like so many good con-men, bankers make themselves believed by persuading each and every investor individually that, although someone might lose if stuff happens, it will be someone else. You’re in on the con. If something goes wrong, each and every investor is assured, there will be a bagholder, but it won’t be you. Bankers assure us of this in a bunch of different ways. First and foremost, they offer an ironclad, moneyback guarantee. You can have your money back any time you want, on demand. At the first hint of a problem, you’ll be able to get out. They tell that to everyone, without blushing at all. Second, they point to all the other people standing in front of you to take the hit if anything goes wrong. It will be the bank shareholders, or it will be the government, or bondholders, the “bank holding company”, the “stabilization fund”, whatever. There are so many deep pockets guaranteeing our bank! There will always be someone out there to take the loss. We’re not sure exactly who, but it will not be you! They tell this to everyone as well. Without blushing.

If the trail of tears were truly clear, if it were as obvious as it is in textbooks who takes what losses, banking systems would simply fail in their core task of attracting risk-averse investment to deploy in risky projects. Almost everyone who invests in a major bank believes themselves to be investing in a safe enterprise. Even the shareholders who are formally first-in-line for a loss view themselves as considerably protected. The government would never let it happen, right? Banks innovate and interconnect, swap and reinsure, guarantee and hedge, precisely so that it is not clear where losses will fall, so that each and every stakeholder of each and every entity can hold an image in their minds of some guarantor or affiliate or patsy who will take a hit before they do.

Opacity and interconnectedness among major banks is nothing new. Banks and sovereigns have always mixed it up. When there has not been public deposit insurance there have been private deposit insurers as solid and reliable as our own recent “monolines”. “Shadow banks” are nothing new under the sun, just another way of rearranging the entities and guarantees so that almost nobody believes themselves to be on the hook.

This is the business of banking. Opacity is not something that can be reformed away, because it is essential to banks’ economic function of mobilizing the risk-bearing capacity of people who, if fully informed, wouldn’t bear the risk. Societies that lack opaque, faintly fraudulent, financial systems fail to develop and prosper. Insufficient economic risks are taken to sustain growth and development. You can have opacity and an industrial economy, or you can have transparency and herd goats.

At the height of the financial crisis, so-called collateralized debt obligations (CDOs) were all the rage with investors. There were also CDOs on CDOs, dubbed CDO^2. This quote by Bank of England official Andrew Haldane illustrates the complexity of such a product:

To illustrate, consider an investor conducting due diligence on a set of financial claims: RMBS, ABS CDOs and CDO^2. How many pages of documentation would a diligent investor need to read to understand these products? Table 2 provides the answer. For simpler products, this is just about feasible – for example, around 200 pages, on average, for an RMBS investor. But an investor in a CDO^2 would need to read in excess of 1 billion pages to understand fully the ingredients.

Waldman’s post is worth checking out in entirety if you want to follow along the game theory examples. They’re fascinating.

On Overconfidence and Cognitive Fallacy

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In this week’s New York Times Magazine, Daniel Kahneman, emeritus professor of psychology and of public affairs at Princeton University, writes about the hazards of overconfidence. His piece begins with an anecdote from his days in the Israeli army and then moves on to lambasting overconfidence of professional investors. A lot of the ideas here I was already familiar with, but I liked Kahneman’s conclusion:

We often interact with professionals who exercise their judgment with evident confidence, sometimes priding themselves on the power of their intuition. In a world rife with illusions of validity and skill, can we trust them? How do we distinguish the justified confidence of experts from the sincere overconfidence of professionals who do not know they are out of their depth? We can believe an expert who admits uncertainty but cannot take expressions of high confidence at face value. As I first learned on the obstacle field, people come up with coherent stories and confident predictions even when they know little or nothing. Overconfidence arises because people are often blind to their own blindness.

True intuitive expertise is learned from prolonged experience with good feedback on mistakes. You are probably an expert in guessing your spouse’s mood from one word on the telephone; chess players find a strong move in a single glance at a complex position; and true legends of instant diagnoses are common among physicians. To know whether you can trust a particular intuitive judgment, there are two questions you should ask: Is the environment in which the judgment is made sufficiently regular to enable predictions from the available evidence? The answer is yes for diagnosticians, no for stock pickers. Do the professionals have an adequate opportunity to learn the cues and the regularities? The answer here depends on the professionals’ experience and on the quality and speed with which they discover their mistakes. Anesthesiologists have a better chance to develop intuitions than radiologists do. Many of the professionals we encounter easily pass both tests, and their off-the-cuff judgments deserve to be taken seriously. In general, however, you should not take assertive and confident people at their own evaluation unless you have independent reason to believe that they know what they are talking about. Unfortunately, this advice is difficult to follow: overconfident professionals sincerely believe they have expertise, act as experts and look like experts. You will have to struggle to remind yourself that they may be in the grip of an illusion.

My only gripe: I believe overconfidence is even more systemic than Kahneman posits. I believe there are overconfident dentists, waitresses, accountants, and engineers. What about you?

You Can’t Explain the Market

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Chao Deng, in his piece “Memoirs of a Market Reporter,” gets it (mostly) right about analysts/reporters trying to explain the short-term movements in the market:

[The] drudgery of writing the market-close story—stocks up on this; stocks down on that—began to make me wonder whether chasing the inevitable day-to-day ups and downs of markets was worth anyone’s time. Some critics say markets reporters must suffer from A.D.D., because short-term fluctuations in stock indices really don’t matter much in the long run. They say it’s absurd to pin a single narrative on spot news involving countless individual decisions, many of them made by robots. Too often, coverage favors one slant if stocks are up and another if stocks are down when, in fact, nobody really knows.

The depressing part is that markets beg for an explanation, and the public desires one. As if an explanation can assuage our fears:

[A] volatile turn in the markets simply begged for an explanation, sending thousands of extra readers my way.

Here’s the kicker: there is no good explanation for why the markets are down today(a must-read piece by Felix Salmon):

As a general rule, if you see “fears” or “pessimism” in a market-report headline, that’s code for “the market fell and we don’t know why”, or alternatively “the market is volatile and yet we feel the need to impose some spurious causality onto it”.

This kind of thing matters — because when news organizations run enormous headlines about intraday movements in the stock market, that’s likely to panic the population as a whole. They think that they should care about such things because if it wasn’t important, the media wouldn’t be shouting about it so loudly. And they internalize other fallacious bits of journalistic laziness as well: like the idea that the direction of the stock market is a good proxy for the future health of the economy, or the idea that rising stocks are always a good thing and falling stocks are always a bad thing.

Trying to put a reason behind short-term fluctuations is ultimately useless. Remember: you can’t time the market. And don’t believe anyone that tells you they can.

Warren Buffett on Taxing the Super-Rich

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I really like Warren Buffett. He’s got a no-nonsense approach to investing, he speaks with charisma, and in today’s edition of the New York Times, he makes his voice heard loud and clear: tax the super-rich. And heavily.

In an op-ed titled “Stop Coddling the Super-Rich,” Warren Buffett explains how he paid the least amount in taxes from his office of twenty people (even when he made the most money):

Last year my federal tax bill — the income tax I paid, as well as payroll taxes paid by me and on my behalf — was $6,938,744. That sounds like a lot of money. But what I paid was only 17.4 percent of my taxable income — and that’s actually a lower percentage than was paid by any of the other 20 people in our office. Their tax burdens ranged from 33 percent to 41 percent and averaged 36 percent.

Some important statistics to digest (about income disparity in America):

Since 1992, the I.R.S. has compiled data from the returns of the 400 Americans reporting the largest income. In 1992, the top 400 had aggregate taxable income of $16.9 billion and paid federal taxes of 29.2 percent on that sum. In 2008, the aggregate income of the highest 400 had soared to $90.9 billion — a staggering $227.4 million on average — but the rate paid had fallen to 21.5 percent.

And his resilient conclusion:

But for those making more than $1 million — there were 236,883 such households in 2009 — I would raise rates immediately on taxable income in excess of $1 million, including, of course, dividends and capital gains. And for those who make $10 million or more — there were 8,274 in 2009 — I would suggest an additional increase in rate.

My friends and I have been coddled long enough by a billionaire-friendly Congress. It’s time for our government to get serious about shared sacrifice.

Bravo. Now, let’s make it happen.

Ray Dalio’s Richest and Strangest Hedge Fund

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In this month’s New Yorker, John Cassidy profiles Ray Dalio, the founder of Bridgewater Associates, said by some to be the strangest hedge fund in the world.

I found the piece interesting, though I did think Cassidy could have done a better job explaining the nuances of Dalio’s behavior, such as evidenced in this paragraph:

Dalio asked for another opinion. From the back of the room, a young man dressed in a black sweatshirt started saying that a Chinese slowdown could have a big effect on global supply and demand. Dalio cut him off: “Are you going to answer me knowledgeably or are you going to give me a guess?” The young man, whom I will call Jack, said he would hazard an educated guess. “Don’t do that,” Dalio said. He went on, “You have a tendency to do this. . . . We’ve talked about this before.” After an awkward silence, Jack tried to defend himself, saying that he thought he had been asked to give his views. Dalio didn’t let up. Eventually, the young employee said that he would go away and do some careful calculations.

Do you believe the world is mechanical? Do parts come together to work as a seamless whole? Ray Dalio thinks so:

Many hedge-fund managers stay pinned to their computer screens day and night monitoring movements in the markets. Dalio is different. He spends most of his time trying to figure out how economic and financial events fit together in a coherent framework. “Almost everything is like a machine,” he told me one day when he was rambling on, as he often does. “Nature is a machine. The family is a machine. The life cycle is like a machine.” His constant goal, he said, was to understand how the economic machine works. “And then everything else I basically view as just a case at hand. So how does the machine work that you have a financial crisis? How does deleveraging work—what is the nature of that machine? And what is human nature, and how do you raise a community of people to run a business?”

So who invests in Bridgewater Associates, exactly? Not wealthy invididuals:

Part of Dalio’s innovation has been to build a hedge fund that caters principally to institutional investors rather than to rich individuals. Of the roughly one hundred billion dollars invested in Bridgewater, only a small proportion comes from wealthy families. Almost a third comes from public pension funds, such as the Pennsylvania Public School Employees’ Retirement System; another third comes from corporate pension funds, such as those at Kodak and General Motors; a quarter comes from government-run sovereign wealth funds, such as the Government Investment Corporation of Singapore.

A surprise about Bridgewater’s investing tendencies (no U.S. markets?):

Is Bridgewater really any different? Although the firm trades in more than a hundred markets, it is widely believed that the great bulk of its profit comes from two areas in which Dalio is an expert: the bond and currency markets of major industrial countries. Unlike some other hedge funds, Bridgewater has never made much money in the U.S. stock market, an area where Dalio has less experience.

While the piece makes it sound like working at Bridgewater is quite the challenge, I appreciated this nugget:

Dalio insists that money has never been his main motivation. He lives well, but avoids the conspicuous consumption that some of his rivals indulge in. He and his wife, Barbara, to whom he has been married for thirty-four years, own two houses, one in Greenwich, Connecticut, and one in Greenwich Village, which he sometimes uses on weekends. (They are currently building a new house on the water in Connecticut.) Apart from hunting and exploring remote areas, Dalio’s main hobby is music: jazz, blues, and rock and roll. Recently, he joined a philanthropic campaign started by Bill Gates and Warren Buffett, pledging to give away at least half of his money.

Ray Dalio is a man I’d like to meet. We could talk about books and music and photography. And oh yes, the financial markets (I do have a degree in quantitative finance, after all, and work in the financial sector).