designing better futures

Black Swan author is an awkward bird

Nassim Taleb is a mixed blessing, part cheerleader for ignoring the false rationalism of statistics in the realm of human folly we call economics and part self indulging jester for being "mis-understood" and protesting too much.  I think he suffers a case Roubini syndrome.

Roubini syndrome involves being right once about a big thing and therefore attributing every utterance and opinion subject to that opinion and framework.  Having only a single mental hammer seems to have forced both men to see all problems before them as nails.   

The risk in Roubini syndrome is that of the one hit wonder pop star who slowly fades away.  Both men have more to contribute but seem bent on correcting the media with ever more shrill voices.  They have an analog version of SIWOTI syndrome which currently keeps them from more interesting and lasting contributions to thought on economics.

Take a look at Taleb's latest paper Oct 18,2009 entitled Common Errors in Interpreting the Ideas of The Black Swan and Associated Papers.

The paper's first pages are a tiresome tirade, but he has some solid points in the back end of the paper.  My own opinion is that his overly emotional rebuttals to prior rebuttals to his work cheapen his voice and muddle the waters. Don't feed the trolls.  A good idea stands the test of time and the best of ideas attract the strongest of criticisms early on before being accepted.

New paradigms are rarely acknowledged as such immediately, that is the role of fads masquarading as innovations.  History and ideas of historical note are only acknowledged correctly in the breech.

My recommendation is that the Black Swan should sink or swim in the sea of ideas.  The author needs to let it leave the nest to defend itself and fly on its own.  Ideas once submitted for consideration are no longer their author's property, but rather become a part of a useful collective consciousness or fade away.   Paradigms are a group phenomenon whether true or not.

The gifted Anish Kapoor creator of the Cloud Gate sculpture in Chicago long ago accepted that it would forever forward be known as "the bean", such it is with all creators and their creations in the public domain.

Shit book hints at one key to human development

Excreta, turds, poo, shit, etc. are all terms for something that induces disgust in most.  This response is innate and indeed wired into use at a visceral level and a key to survival.

All we need to know about shit, is that we want to be away from it.  Sadly many can't get away from it, they end up living, inhaling and consuming it.  This leads to death and disease. 

In development people refer politely to water borne disease leading to over 2.2m child deaths per year according to the UN.  Water borne diseases in most instances relate to drinking shit polluted water.  Too put that in context AIDs is estimated to kill 2.0 million and malaria around 1-1.5 million per year.  Shit kills.

This is a problem that the now developed world has kind of solved and that the developing world is still working on.  Like all human endemic problems it is rooted in behaviors, beliefs and fears.

Understanding shit and what happens to it is key to human development as much as economics, corruption etc. and curing diseases are.  Indeed, solve the shit problem and many of the diseases that limit human development and factors related to GDP growth may resolve themselves a bit.

Rose George has written a very entertaining and important book entitled The Big Necessity in which she travels the worl discovering culture issues and mores around handling waste.  Her voice is that of the economist magazine, for which she once wrote, humorous, well read and considered.

If you are interested in the human condition and understanding the behaviors, and issues that may better it read this book. 

I am fascinated by economic anthropology and sustainable development and appreciate the field work that George has done in trying to understand what the solution to the problem of shit may be.  Solutions aren't just about plumbing and digging toilets.  Like most aid dropping in money or technical help rarely does anything but minimize acute crises.

Marketing, behaviour, economics and technology, distribution and other issues.  Consider it a business problem/opportunity. This is a fascinating book about something that gets very little attention relative to its impact on limiting the human condition and capabilities.

Rose George's description of techniques used to change a village's behaviour, involve economic incentives and changing beliefs while raising awareness. The lessons about motivating people for sustained change are as relevant to the business manager as they are to the aid worker.  technocrats and major aid institutions often fail in these areas.

Factoids:

• Thomas Crapper helped improve the usage of the toilet in London, hence the phrase "take a crap" (perhaps best to leave it)
• For all of the butch culture, Americans are very prudish in the waste dept.  euphemisms abound in the culture
• the japanese have the most advanced toilets in the world, warm seats, water wash etc.
• Wiping with paper is very unsanitary relative to washing with water
• Since 1994, 935 million gallons of raw sewage have been dumped into lake Michigan
• German men pee sitting down
• Chinese put used toilet paper into trash bins instead of flushing it away
• Many chinese public toilets have no stalls or barriers, so people get to know each other very well
• The average shit session yields 250 grams about .551 pounds of solids
• 1.7 million people in the US don't have a toilet
• The corridors of the palace of Versaille used to be filled with urine and fecal matter as people had nowhere to go, it was an honor to hold the king's chamber pot while he filled it.
• 400,000 people get sick in 1993 in Milwaukee from feces contaminated drinking water killing 100
• The UK has 186,000 miles of functioning sewers that are 250 years old
• One of the only cures for a "superbug" infection is a fecal transplant
• Wash those hands: in the UK "more than 1 in four people have faecal matter on their hands"
• over 40% of people don't wash their hands after going to the toilet
• much more in the book about a key element of the human condition, namely shit

You get the point the Shit book (The Big Necessity) is interesting, educational and important about something "polite" people don't talk or think about.  If you are interested in sustainable development, furthering the human condition or understanding how to drive change among a group of people with a fixed behavior check out this book.

Anthropology & Economics: Economics you won't see on CNBC

Political economy is the study of the macro functional outcome of how our species organizes itself in its various groupings.  It is easy in the CNBC whizbang world to get caught up in bombastic posturing and the banalities of some host with a suit and an opinion trying to get you to watch for just one extra 30 second ad. 

Economics is  more than a clownesque Cramer who fails an economic and entertainment litmus test. Thank god CNBC's ratings are dwindling as America looks to re-invent itself with the next quick buck plan and inflates the next bubble with accompanying amplifying digital hope halo. 

 I think travel, time with the family or a good dinner party would have been a better way to a richer life than the banality of installing granite counter-tops in the hopes of goosing home equity as a way to a "richer life".

Most of the readers of this blog may think and study what happens on the more functional / developed economy end of the economic continuum.  There is much to be learned about what happens when things go wrong in our developed economy from emerging or chronically dysfunctional economies.  Our crises are sporadic, but not chronic or endemic, at least not yet.

On the other end of the political economic continuum is real failure with a larger human toll.  Learning about from these failures could be as important.  Who knows, studying external aid stimulus shocks in the 3rd world may tell us something about the efficacy of our own stimulus attempts? 

Would anyone pay cash to destroy clunker goats as a way stimulate the farming economy in a developing country?  Think about it?  Of course "we" are different, insert your own pedantic ethnocentric myopic narrative of fact here.

When a state fails in a profound economic way it has serious human costs. 

One of the least dignified ways for a person to die is from a banal disease such as Cholera.  While not as exciting as looking at the latest ponzi, bailout, or bonus "horror" there is a lot to learn from the other extremes of economic failure.  This video shows Zimbabwe and its Cholera epidemic, which can be almost solely blamed on failed govt policy in a kleptocracy gone horribly wrong.  A cholera epidemic is an output of a failed political and economic system.  All systems of economy may have something to teach, even in their failings.

For those interested in learning about economics and the concept of political economy, I would suggest reading Amartya Sen's thoughts on capabilities.

I am looking forward to reading his new book on concepts of the Idea of Justice.  This won't excite the CNBC crowd or those looking at charts trying to divine the next 10 minutes in the S&P 500, but I look forward to some quiet time with it.

Not only is a Sen a grounded realist as an Economist and Nobel Prize winner, he also helped develop the UN Human Development Index.

Who knows an hour or two reading Sen, may be a "richer" experience than the same time spent watching "Financial Journalism" on CNBC. 

Full Disclosure: I haven't owned a TV in 20 years, but suffer the pointlessness of CNBC's "Journalism" daily in the background in the trading office I currently find myself in.  There are some needles in the CNBC digital haystack, but they are far to thinly spread between the empty opinions and  vaudevillian digital charades to be worthwhile. 

I believe the only way CNBC will get the audience back is to follow the wrestling industries strategy from the 80's.  Tell everyone it is fake and then really put on a show WWF style.  Amp it out with midgets, texas deathmatches, etc.  The crowd wants bread and circuses so deliver.  Drop the pretensions of Journalism or economics and get on with the show. 

For real news try Reuters or Bloomberg.

Independant thought is tougher than you think, but please make the effort.

Just caught this on Michael Covel's Trend following:  Watch group think in action as individuals deny what they sees with their own eyes.  Most likely you would to.

Please question everything, even if it is makes you seize up for a day or two.  We are social animals and far less individual than we like to believe.  Our greatest cage is the limitation of our perceptions of ourselves.

Our culture and most "modern cultures" are based on a fictive belief of individualism and yet the archetypes that are accepted or acceptable are fairly limited.  It is a strength and weakness. 

As the ancient Greeks said, Know thyself. In addition: question authority! and don't trust the group. This is just one financial anthropologist's opinion.  But there is nothing like a group of people "succeeding" to seriously do harm as their flawed beliefs get re-inforced in the short or medium term with misplaced money or recognition.

Warning: The Milgram experiment is a deeply disturbing side to the human species and watching it is disturbing., Our desire to conform with the group or a weak but present authority figure at the expense of the individual or individuals is truly disturbing.

Paul Romer is an interesting thinker

Paul Romer's approach to acknowledging the need for "rule" evolution and competition for best practice is very compelling.  Indeed it is the basis for a Federalist system.  One could argue that the ongoing centralization of US policy via federal regulation has hindered the countries rate of adaptation.  The desire for regulatory unity and standards is helpful, but if it oversteps can lead to ossification.  SEZ (special economic zones) and charter cities as put forth by Romer are needed now more than ever.  Our technology and rapid rate of idea inter-exchange mean that we need our rules to evolve at an ever faster rate. 

The implicit question posed by this argument: "is the US becoming a dated mainframe type structured system in an ever evolving eco-structure of laws and economics that needs smaller units of response at state and local levels."  The technologies of biotechnology alone are going to change social stresses faster than computers in the next 30 years.  How will we evolve our rules, be they codified laws, social mores or behaviour sets?  Should the federal level be locking down a single rule set or should state and local systems be given more freedoms?  Premature optimization is a problem in computer coding and in "rule establishment" which has very real costs, think of the federal prohibition experiment in the 20's.  The flipside of this argument is of course the Jim Crow laws of the south.

I like Romer as he reminds me of Hernando de Soto (Video here) recognizing the role that behaviours codified as laws or informally as acknowledged as cultural norms drive the human economic and social condition.  He gets the meta game, even if he acknowledge that the Jeffersonian Federalist concept was there before.  The historical case of Hong Kong put forth by Romer is a bit stretched in the discussion below and should be taken with a grain of salt relative to its very awkward origins as a drug runners paradise run by the British after the seccond opium wars.

Taking things for Granted

I have often referred to a type of financial risk as "oxygen" risk.  Oxygen risk is anything so common and familiar that it is taken for granted.  In that vein I offer something to watch that is both interesting and important, a video about clean water technology.  Most of the readers of this blog will take little interest in this, but it is my show here :)

Finance and risk are interesting and important but for me what is most interesting are things related to potentially significant changes in the human condition.  Property rights, iodized salt, sustainable energy, access to toilets, micro-nutrients and civil open society in the Popperian concept aren't considered sexy because they are the "oxygen" for most of the readers of this blog.  For me they are endlessly fascinating. Understanding how they can become more accessible to developing countries and more importantly adapted by their cultures is a point of endless fascination for me.  I am looking forward to reading my copy of a book on Human Waste, ick but it is important to the condition of life for billions of us.

So here is an interesting video on a new water filtration technology.  It is no panacea, just another technology, but most changes and successful systems consist of many little things.  This may be one of them for some people.

S&P 500 rolling returns movie 1881- 2009

Looking at graphs can be deceiving.  I used to be chief analyst for Europe's equivelant to the MIT media lab and am fascinated by how people respond to data and information.  A static graph isn't the way we go through life.  So here are the 10 Year rolling returns of the S&P 500 animated.  The long term if you will.  I threw the PE data for fun.  Data is from Shiller. 

Note the data is plotted as a semi-log and that looking at single countries data is a limited look at the concept of Equities as it is represents a selection and survivorship bias and compounded by using a sample of 1. 

One of the best books, I have read that explains how people interact with various media and form biases is The Media Equation.  Music by De Phazz

Retro finance: Lo-Fi manifesto

"High finance", used to be a phrase exemplifying large amounts of value and high degrees of acumen.  It turns out in retrospect that High finance, meant bankers and mortgage brokers gone wild on CDO & CLO crack.

Finance is a shared cultural belief system and set of behaviours, not a physical reality.  In finance, the most well  known sub-culture from a western finance perspective is Sharia finance which seeks to adhere to various culture practices of lending and interest etc.  Many cultures practice alternative forms of lending, saving and allocating capital.

Through various western eras, lending has been allowed or not for various groups with various constraints based on the fashions of the times, the label usury is a culturally subjective term that springs up in times of fiscal crisis.. 

In music Lo-Fi refers to a style that is purposely sub-optimal from an acoustic fidelity perspective but aesthetically more pleasing.  Lower fidelity doesn't always mean lesser quality as quality in music is a subjective value.

I would argue that a culture's use of finance relative to the human biases inherent in any group means that some form of Lo-fi finance may be longer term optimal.  Lo-Fi finance could actually increase fidelity (trust) in the system long term. For the econo geeks out there (the groups long term utility function may be optimized using sub-optimal local or short term temporal constraints)

Lo fidelity finance could be an interesting point of research for the behavourial economists out there.

Glass Steagall was an excellent example of Lo-Fi finance in action. Glass Steagall's repeal in 1999 was a call for optimization, speed and ironically financial strength.  Woops.

Another great example of Lo-Fi finance is the Credit union.  Credit unions are the unwashed little hippies of the finance world.  They aren't "power suits" etc., but have done well all things considered.  I don't mean to get all "Amish" on you, but Lo-Fi has some serious potential.  The Lo-Fi label in finance could serve the same function as the Organic label does in stores.  People could choose a brand with known qualities.

The manifesto for Lo-Fi finance has some basic ground rules. 

1. Seperation of investment banking from deposit taking
2. Seperation of any high gamma (or convexity exposures) unless fully hedged with the undelrying.  This is about CDS and other forms of asymmetric leveraged low probability high impact risk taking.
3.  A predetermined threshold of market domination in any geography or market segment to avoid concentration of risk in any entity
4. Elimination of the Basel 11 capital accords
5. Elimination of the Ratings agencies as a systemic threat
6. Lo-Fi participants would not be allowed exposures to non-lo-fi participants
7. Others, please suggest them....

 The participants would  agree to them and most likely any Lo-fi participant would be barred from engaging with a Hi-Fi operator in all but limited forms of risk exposure.

Lo-Fi would involve separating many risk activities and preclude certain firms from engaging in them.  Yes it would be short term sub-optimal, but long term stable. 

Eventually deep cultural norms are forgotten or thrown off, only to be rediscovered when something bad happens.  The Repeal of Glass Steagall is just such an example of a codified norm that may be relearned in some new fashion.

Plus ça change, plus c'est la même chose.

Here is a little Lo-Fi Music to ponder the issue:

VaR explained & the BS model (not Black Scholes)

Value at Risk is pretty simple.  Someone is making a guess about what they expect to happen 95% or 99% of the time.  i.e. 99% of the time you will lose less than $1000 a day. etc.

What many people forget to focus on is the fact that what happens the other 1-5% of the time is what counts.

What many people don't know is that there are 3 types of VaR.  The Risk manager presenting the report usually just mentions the number and that is all, but scratch below the surface and you can learn what your risk manager is really thinking.  Next time ask them what type of VaR they are using and keep this handy explanatory list nearby to decipher what they are saying.

1. "Well, basically we use Historical Var compiled from the data."  (I am going to let history bullshit you.)

2. "We use our mighty computer resources to calculate a Monte Carlo simulation for VaR."  (I take history, blow it into a million little pieces and then each piece will bullshit you ever so slightly.)

3. "We have a sophisticated financial model creating a robust Parametric VaR."  (I am going to personally bullshit you with a tweaked Garch model or overly sensitive Levy Distribution)

Not knowing much you will nod and agree that, "the number looks about right."  and sign off on the risk limits, now you are bullshitting yourself and the whole team.

I am not Against VaR or any other standard risk tool or view.  I am against any tool which becomes institutionalized.  Once a risk tool or approach becomes a wink and a nod, sign off or a CYA calculation it loses value.  Risk management is meant for curbing human behavior, otherwise individual or collective greed wells up and overwhelms an organizing system of faith, which is what finance and money are.

Examples of institutionalized risk management beliefs that have or will become rubber stamps:

• Ratings Agencies (NRSRO ministry of truth)
• Securitisation magic (of course we all know that now)
• Basel II Capital Accords
• Probably the next financial innovation which will yet again revolutionize access to credit
• Any company wide policy which creates a ...Yeah but it passed the X test. Or well they signed off on it...type of mentality.  See Dilbertian risk management.

The most dangerous risk manager or system is the one that becomes the de facto agreed standard we can all agree will stand the test of time.  Once a unified risk belief is shared in aggregate all participants will start gaming or trading it the same way.  When all participants share a similar view, the system is susceptible to harmonic dynamics.  See the video below.

Unsexy but vital: Bureaucrats without Borders

The title of this blog Designing Better Futures reflects an idea.  The idea is that Design (the thoughtful act of production) might help make the future better for many.  I am interested in design with a high ROI in sustainable economic development for poor countries.  My beliefs are more in line with William Easterly than Jeffrey Sachs.  To put it simply Easterly wants it aid to accountably to work, while Sachs wants to throw money at it until it works and feel good about it. 

If you really want to make a difference, please think before acting. Feeling good about yourself and doing good for others aren't necessarily the same thing.  The best results rarely are the ones that make you simply feel good. Real development impact is unsexy hard work, like building or designing a latrine to reduce infant mortality.  

Read Easterly's fantastic book, The White Man's Burden and then compare it with the feel good money pit approach from Sachs entitled The End of Poverty.  Another thoughtful book on world problems is The Copenhagen Consensus.

In looking for high payoff sustainable development ideas, I have been very interested in micro-nutrients, iodized salt, Vitamin enhanced golden rice etc. 

Basically I look for cheap projects with huge positive externalities,mega-bang for the poor persons buck.  These are things that can cheaply add years to life capabilities or raise the collective IQ of a village sustainably without creating aid dependencies etc.   The trick is in the distribution and self sustaining of the enhancement in the poor's lives over time.

Another high value add, that I am deeply committed to is Property Rights and the wonky delegation of those rights via efficient registration processes.  Recognizing Dead Capital* as defined by Hernando de Soto and properly bringing it to life could create Trillions of $'s for the world's poorest and enfranchise them in their own political systems.  An enfranchised middle class is a powerful force. 

To that end, the unsexy stuff needs technical help.  Forget the easy emotional appeal of feeding babies in times of crisis, put the unsexy infrastructure (soft(bureaucratic) & hard(project based)) in place to mitigate mass starvation in the first place. 

Medecins Sans Frontier (doctors without borders) is very high profile do good stuff, but what could even be more important would be plumbers, engineers, lawyers and tradespeople without borders.  The resources (motivated people) are probably there, the organized charities aren't. 

Imagine plumbers or civil engineers or Quality Assurance people helping out in countries on the "soft" infrastructure, either training or jsut learning about it.  My own goal would be land registrar consultants without borders.  I view it is a $9 trillion unsexy problem.

A good example of an unsexy but important charity is Reporters sans frontiers.  Good reporting acts as a feeback loop and curb the abuses that may lead to socially inflicted humanitarian disasters.

The video below hinting at the need for Bureacrats without borders, warning it dry and wonky.  A council on best practice for bureaucracy inter governmental with benchmarks such as the World Bank's excellent doing business report would be a very good thing as it measures the "output" of a govt. service and allows for govt and citizens to hopefully seek best practices from peers.

Imagine the same for the planning processes for infrastructure, planning and deployment of basic govt. services.  Bureaucrats without borders sounds horrible, but could be wonderful, it may even get rid of some corruption which acts in some instances as the only effective way to progress in some states.

*Unbelievably there is no wikipedia entry for such an important concept as "Dead Capital".

Full disclosure Bernard Kouchner, founder of Medecin Sans Frontiers spoke at my MBA commencement in Paris and my undergrad at the U of Iowa was anthropology where I independently focused on economic sustainability in West Africa.

What are you paying attention to? Equity tricks & Fed Magic or the dependency ratio?

Some things in the world appear to be changing rapidly, yet one should focus on the big picture.  Magic is the art of deception.  This video takes the trick out of the magic and yet still amazes.

After watching this, think about your own perceptions as filtered through the media's "today" focus.  My suggestion for information is a healthy diet of 1 part news :3 parts book, research and exposure to other fields of thought in order to maintain perspective. 

This is part of a series in Wired magazine on Magic and cognitive science that is well worth considering.

The point is that we hold our cognitive skills in greater esteem than they deserve.  Reality is a perception.

Consider these perception biases when seeing reports from whatever captures the media's attention today or this millisecond. While focusing on a few billion $'s of losses or bailouts sloshing around here or there, the background of many developed countries "dependancy ratios" have changed significantly in the last 30 years.  Here is a little snippet from an older Harvard Business article. 

Demographics are mostly inevitable, but discussing a dependency ratio that moves at a constant rate hardly merits CNBC's attention.  My bias is for Charlie Rose interviews which offer more considered views on serious matters.

Our current economic issues are happening to a country and world that is slightly different than the 1930's etc.  That chart of this bubble or that bust should be considered interesting, but limited.

My  bias is for structural similarities to the panic of 1893.  A useful source for thinking about these things is Kindelberger, that man knew his bubbles and their causes.

The big picture is changing drastically and yet attention and energy is focused on the current day to day details.  Enjoy the economic show, as taxpayers we all paid for premium tickets, but what happens to automakers and the major banks is really just a sideshow in the context of the next 20 years.

Negative options lead to Black Swans

The original Black Swan story was interesting because it correctly used an ecological model and behavorial shift to show a "surprise", ie. the discovery of a Black Swan.   The ecology was the new environments which allowed for the discovery of the black swan and the behavioral shift was the exponential rate of increase in exploration of those new ecologies.  The swan metaphor is more apt than first appears.

Europeans had only seen white swans up until the 18th Century and could have created a White Swan Swap, if they possessed our contemporary financial nous. 

Imagine our smart 18th  century Dutch banker, Don Dutchman betting with Bob Blackswan that there are no black swans and never will be.  Don wagers with Bob Blackswan, that they will never capture evidence of such a creature. 

Don and Bob agree to an ongoing wager, that for every year, there are no known Black Swans Bob will pay Don 1,000 guilders, a princely sum. If a Black swan is ever spotted Bob gets 1 million Guilders a 1:1000 payoff.  The wager is drawn up and copies of the contract exchanged.  A bilateral black swan default discovery swap has just been created with a notional value of 1 million guilders.

Bob Blackswan believes in Black swans and Don Dutchman doesn't.  Bob and Don have just created a sort of Black Swan default swap. 

Before the arrangement was settled Don had his accountants and experts comb the evidence and historical record of white swans just to be sure.  Don had astronomers and mathematicians calculate the "odds of a Black Swan" using the hot new Bayesian approach that all the 18th century quants were trying. 

Don has created the perfect bet, no black swan has ever existed and the statisticians (quants) tell him the probability of finding such a creature approximates zero.  Don Dutchman believes he is in for free money and may even set up a Black Swan insurance company or bank selling these black swan swaps if he can find enough Bob Blackswans to pay 1,000 guilders a year for the privilege.

Negative Optionality lies out of the box.

Bob has a different opinion and is betting on negative optionality.  Positive optionality is found in companies or bets in which there is an internally perceived "option" or bet embedded within the company that allows for extra upside. 

For example people purchase bio-tech companies not on cash flows per se, but rather the optionality of some new wonder compound eventually becoming a cash stream via the FDA process.  People probably buy shares in apple computer based on the next hot " i-something" being released.

Negative optionality is the inverse of this, it is looking at something of current value and pricing the potential for the loss of that value based on an external event.  This even might remove market share, eliminate the market with a substitute or in some other way diminish the economic value of the investment.  Value investors see moats as negative option protection.

Don Dutchman looks at his pile of historical white swan data, finds a few off-white colored swans, but assesses his risks as low.  To be sure of his bets, he back tests 150 years of historical swan birth records using millions of swan samples.  All the samples come up white swan. 

Don even creates a "whiteness" measure for swans tracking the variance of the whiteness.  The greyest newborn swan eventually turns white.  Variance in Don's sample is so low that when he plots his swan variance relative to the risk of "blackness" he perceives it as negligible. 

The variance among swans or Don's VaR (value at risk) is incredibly small.  Don calculates his risk as so small that he takes Bob's Blackswan's bet and runs around town with it looking for other takers.  Each year Don is going to rake in 1,000 guilders from each bet holder.  The low variance in white swan samples means that seeing a Black Swan is a 25th standard deviation event greater than 1:1 trillion odds against.  Don is betting 1:1000 against, a sure thing.

Bob thinks outside of the box and outside the swan environmental data set, which is limited to Europe (the center of the 18th century universe).  Negative optionality manifesting itself as a black swan event rarely comes from within a historical data set.  Black Swan size impact negative options are environmental / contextual.  Things operate in multiple shifting environments, or frameworks: political, geographic, technical, scientific and human behavioral.

Bob is aware of 2 factors in his favor.  He knows that he just needs a single black swan sample to win his bet.  Bob also knows things are changing in in the "known" world.  It is 18th century Holland and the world is opening up due to travel and trade. Everyday, new creatures and exotic lands are being discovered, the swan environment is growing exponentially. 

The negative optionality is increasing exponentially with each new exotic environment. Every exploring ship or expedition that comes in from a new environment is a negative option that might help Bob win.  The number of exotic species discovered is increasing exponentially and each new find is a negative option that might let Bob win his bet. 

Eventually Bob wins the bet due to understanding the environmental drivers of negative optionality. 

Negative optionality sits outside of historical price and is therefore not measurable by historical data.  The only way to "price" the risk of negative optionality is to measure the "drivers" of price or value properly.  Don looked at today's swans and the historical sample, Bob thought in terms of environment, evolution and geography as drivers of negative optionality allowing him to win the bet. 

Consider the simple pundit quoting this and that fact about the US stock or housing markets or the economy.  A sample size of one isn't a serious analysis, certainly not worth betting the farm on.

The drivers of a value are important.  Unfortunately few risk managers are polymaths or interested in drivers, they are hired for their math skills or PHDs more than their imaginations, so they molest the data they have with ever greater finesses until it tells them what they wish to hear.

Behaviorally the brilliant PHd risk manager is being asked to fit the data to the need. 

The New risk manager is always wrong, because the group says so.

Consider that on the first day of the job a young risk manager walks into his boss' office, presented data from 30 housing markets globally and said, I think there is a 1:10 chance our bank will fail.  We should cease mortgage securitizations operations immediately.  It probably happened.  Collective myopia isn't all encompossing, just strong enough to facilitate belief systems that reject challenges to the group needs and beliefs.

There will be more bubbles and people who see them for that, but group behaviour will ignore them at their peril.  Read Kindelberger's mania's panics and crashes. We aren't that special, we like every other culture alive, just needs to believe so.

The bank above couldn't accept or internalize a 1:10 failure rate and so listens selectively to those who deliver the most complex and obtuse narrative backed by "rigoruous" equations about why the bank would succeed and CDS and CDO's were money machines.  Group's select for belief support and re-inforcement especially if it re-inforces a recently successful narrative. 

In many cultures, high priests or astronomers and mathematicians promised a good harvest or success in battle.  Not much has changed, we are still social animals who need a sufficiently complex narrative delivered by an "expert" to further the group.

Group behavior and need is one of the things a a good risk manager should assess and report on.  If everyone in the group needs real-estate or oil to go up, there is a risk that no one is looking out for the other side of the bet.  If that group's need has been wish fulfilled a few times, it becomes an unchallengeable belief. 

If a risk manager is any good, most people won't like them, because they challenge fundamentally held personal and group beliefs that may be highly successful.  Positive result deviance can be more dangerous and telling than small negative deviance, for it can re-inforce dangerous behaviour.  If you want to find trouble before it happens, watch a group who just made a bunch of money and is scaling up to really "go for it", without understanding what "it" is or what makes "it" viable.  If possible ask, "how high is up and why".  Everything has an upper bound limit.

I am not against PHd's, I managed 70 of them in an advanced research institute.  Like any group of people about 10% of them were deeply interesting and creative in addition to being scientists.  Others were plodders, bright but plodders.  Cross field thinking imaginative polymaths are where the "good" stuff gets discovered.  Feynman came up with his electron spin equations by watching a plate on the floor.  He knew how to see and how to think critically. Watch this video to learn a bit about that.

Where do negative optionalities that lead to Black Swans come from?

Negative options are everywhere. Luckily, we have to worry most about the fast moving ones, i.e. the cases where these "extreme" options start being created exponentially.  Some types of negative optionality impact what I call "oxygen risk", the risk that something  ubiquitous and taken for granted is removed, like oxygen. 

Consider cheap plentiful memory chips mostly produced from Taiwan.  The probability of something happening, earthquake, typhoon, china etc. is not negligible, the follow on impacts would be huge.  The probability in any given year of such an event is probably >1%, the same goes for earthquakes on the West Coast of the US and yet everyone will be shocked.  Hint: a 1% annual risk has a roughly 1:3 chance of occuring over a 33 year investment horizon.

Technological innovation due to its' exponential growth curve is one of the greatest current negative option creators. Technological innovation for many firms is the Black Swan gun pointed at them.  Technological innovation is also Schumpeter's growth engine. 

To really understand the power of technological change in society read The Singularity is Near, the best book on the future out there and something the average MBA/PHd risk manager can't/won't think about.

Example:Pharmaceutical companies are under a negative option Barrage

I used to manage what was to be the world's largest gene sample gathering project. Gene Sequencing is an example of technology negative option. The cost to sequence a gene is declining on an exponential curve.  Each decline in costs makes sequencing cheaper, what cost $3 billion in 1999 will cost $1,000 in 2011. 

As the cost to sequence drops, the number of experiments for drug efficacy or adverse affects increases.  Each study done with a SNP type analysis is a potential bullet "negative option" cleaving off the addressable market of a current drug.   The cheapening sequencing curve is creating a huge environmental shift in drug markets that you can't see, yet.  The number of gene studies will grow exponentially and with each one, current potential market size could shrink. Drugs will be safer for patients, but big pharma is under an incredible negative option attack, that will show up as a black swan. 

Knowing how to see negative options growing exponentially is a powerful thing.  When everyone believes or more importantly needs to believe the same thing, negative options abound.  Today's ridiculous conjecture, could be tomorrow's, "whocouldanodeit?".

Technology advances along exponential curves and throws negative options up all the time.   Technology and behavior represent environmental shifts similar to the "un-discovered" lands of Australia.  Think about the behavioural shift about "home ownership".  From home to part ATM, part get rich quick lifestyle.  Culturally this is a big glowing warning sign.  Everyone needed and believed home prices would increase.

It is important to recognize ethnocentric biases and beliefs.  To the Aborgine, Black Swans weren't that rare.  He who writes the history books defines the black swan. The black swan created by a negative option could be someone elses gain and good fortune.

Many technology firms trade at market premiums as "growth" companies all the while being directly under attack as their environments shift.   Consider the telcos,cable firms and networks with their walled gardens.  Every year they inch closer to being commodity bit pipes and being valued as utilities delivering an ever cheapening commodity.  The negative options of cheaper faster pipes grow exponentially making a controlled digital experience seem all the less relevant.  AT&T 2011= AOL 2007, discount accordingly.  What got you here in technology won't get you there going forward. 

I just finished Michael Covels' book, Trend Following.  An interesting statistic on page 335.  The average lifespan of a "winning" stock is 9.35 years.  If true an 8% dividend yield is required for breakeven.  Choose wisely.

If you want to hire a risk manager, hire a ploymath generalist with imagination.  Going deeper with the same data, isn't helping, thinking outside of the box and about the drivers that make a portfolio or exposure work is important. 

Scenario planning at Shell was a great revolution and yet math people don't like narratives so much and story telling isn't viewed as serious enough for a bank.  Bringing a biologist, social scientist, historian, organizational psychologist or other type onto the risk management team and then don't let the math geeks bully them. Read the living company to understand how difficult it is to change organizational beliefs.

Scenario simulations, historical narratives, scenarios with a "b" team taking the other side of the bet might tell you a lot.  Just remember, the guys who made money and its usually guys last year didn't just gain 50 IQ points, they were most likely in the right place at the right time.

Luck and intelligence are often confused in Finance.  From an anthropologist's perspective chest thumping males celebrating a bonus are just showing a standard primate victory display, but not necessarily possessing greater prowess in predicting the next quarter or year.  

After all who could have imagined that house prices across the US would go down simultaneously, didn't seem to be the quant looking inside the shiller index.  Even a bad historian could have had a bit to say about it, but the group probably wouldn't have listened as it would have been, "just a historian".  Economic's current heavy reliance on math is really just a way of denying the fact that it is just one of the social sciences with serious physics envy.

P.S. for those of you who scoff at the Black swans analogy as simplistic, how about a glow in the dark rabbit? Biotech is going to change everything it means to be human, que the swan machine.

More power = more questions

Everyday we progress exponentially along the knowledge curve implementing improved technology to manifest greater power.  That power comes in the form of energy, information and control as manifested through individual and group behaviors. 

As a former chief analyst for one of Europe's most advanced research labs and an anthropologist I pose this question. 

More power to ever smaller groups can mean more risk to everyone, what should we do at the group social level? 

I don't have answers, but these are profound and looming questions.  Here is a video or War power.  I have posited since 1990 that applied biological technology will pose as many profound challenges as anything we have yet encountered.  Yes this is Bob Merton, he the maker of small fortunes from large one who blew up LTCM.  He has led some of the most expensive lessons in convexity exposure and Gamma risk ever.  Please god, for the sake of the children keep him away from systemically large amounts of leverage :).

Architecture for Humanity celebrates 10 years. Very cool!

Architecture for humanity is one of the more interesting charities in the world as it uses design, information and longer term thinking to help.  It works for the designer, anthropologist skeptic in me.

I would recommend buying and reading the book Design like You Give a Damn, that shows great design in situ and process around the world.  It all started with 2 people and a few cups of cofee in New York.

The singularity and the real future of computing, post netbook

The future isn't going to be like the past, netbooks are nice and will have a 3 year life of novelty before they become another banal niche in the silecosystem.  Watch this 7 minute video and think about how fast the future is going to be here.  The technology that delivers this is unfolding no matter what happens in the economy.  The video shows what information anywhere really means.  It is a post Jetson's future, the kind that was tough to imagine just 15 years ago.

My guess is devices similar to this will be in the 3rd world in 7 years and in the developed world in 2-3 years.  As former chief analyst for a research institute Modeled on the MIT media lab, I have seen a few things and can assure you this video is a window into the very near future.

If this video doesn't shake you up a little bit, you need more coffee :;

If you want to see where this is all heading, read the singularity is near by Kurzweil.  I don't make book recommendations lightly, as it is the time of your life we are talking about.

Inflection points and thinking meta

When things are "fluid" to use the popular term, it is important to think in a broader context, to go meta if you will.  History, geography and anthropology are great tools to think about finance and markets. As a former anthropology student focused on sustainable economics,the stimulus talk sounds a lot like bad Worldbank and NGO planning for other countries.  Big bag of money chasing an ill defined problem with immeasurable goals.  How do we know if it worked?

Juan Enriquez does a very powerful job of thinking meta in a video with a question. How many stars will the US flag have in the future?  FYI D.C. is thinking about becoming a state. Check it out video and think about a few questions.  How many more countries will there be in a few years?

A few points in the video

• Some US states are net payers vs. receivers of federal government largesse a factor that will become important with looming New York and California defaults.  Today the Irish, Italian and Eastern European strains on the EU could bring it to a restructuring.  Non-EU Switzerland which is a series of cantons also has banking risks that exceed GDP.
• The decline in duration of a fortune 500 member from 94 years in 1935 to 14 years in 2006 reflects macro institutional churn increase.
• The rate of change and why countries or regions split apart (hint: it is often about money)
• Don't take your country, political regions or currencies for granted.

An interesting chart from William Easterly shows China to have a either a Democratic deficit or a false sense of autonomy.  China is probably in for some deep changes in the next 6 months.  For the long term investor geopolitics is starting to become more important as the scale of shift moves up from company:sector:economy:country to global.  It is time to think meta and then perhaps to act meta. Watch the video and read some Bill Easterly.  He is a specialist in development economics.  For those of you not aware development economics is basically when really smart people try to stimulate an economy.  Easterly shows when and why external stimulus fails better than anyone.

Change happens faster

Change happens regardless of the economy, only the rate gets altered a bit.  There is some hype here so have the salt shaker ready. 

Introducing Oscar Option, Mr. Market’s cousin

Mr. Market is a helpful tool value investors use to rationalize price swings away from what they believe to be intrinsic value.  Mr. Market is presumed to be an erratic character and serves as a useful anthropic metaphor for value investors to explain share price variance away from intrinsic company value.

Inherent in the value thinking framework is the assumption of value or intrinsic worth at a share price point.  My own opinion is that 80% of firms don’t operate in value markets or industries as they lack moats and other Value attributes. We will leave that aside for now. 

To introduce Oscar Option, we will assume you have found Mark’s Moat Maker inc., a nice company spewing free cash flow and earnings in such a manner that our appetite says intrinsic value rests at $30 per share.  Like good value investors we base this on 5 years worth of historical figures and believe it to be sustainable into the future.

One of the problems investors have with Mr. Market is that he talks a good game.  For months at a time Mr. Market may whisper into the ear $20,$25,$19,$45 or any such number for Mark’s Moat Maker inc. 

After a while it is easy to anchor our new price point to whatever we recently “heard” Mr. Market say.  This is standard behavioral anchoring bias and a response to social expectations, a confirmational bias.  The over “heard” Mr. Market mentality can become the “herd” reality.

To paraphrase Ben Graham, just because people agree or disagree with you doesn’t make you right or wrong.  Being right early or in the middle of you position doesn’t count, investing is an end game, although a smooth comfortable ride constantly up would be nice, it is probably the exception rather than the rule.

The problem is the noise in the middle.  All that price chatter from Mr. Market while you hold your position can be disturbing.  Picking an entry or exit point for an idea is difficult. 

Many people ask, “Should I get out of X?”  Answering this is a fool's errand as standard attributional bias means that unless you help pick the “best” exit you are either a genius or fool and typically the latter. 

The most helpful thing one can do is aid someone’s mental framework.  For a position holder considering selling, I put forward the following question.  “Would you like to own more of X today?”  If they aren’t willing to buy more then they are probably better off exiting as they believe there is negative intrinsic value relative to the current price.

An interesting way to get around the chatterbox stress of Mr. Market is to preplan a strategy.  You can even get paid to do so.  If you believe that you understand a firm’s long term intrinsic value then why not preset your entries and exits and get paid to do so.  The noise of day to day events and vapid CNBC/FoxBusiness commentary shouldn’t affect intrinsic value.

 Mr. Market’s cousin Oscar Option pays you to plan around your intrinsic value price estimate.  Assuming you have done your homework on Mark’s Moat Maker inc. and believe its long term intrinsic worth is $30 a share which is north of the $20 it trades for today .  You are interested in partnering up with this firm as a shareholder for the long haul.  Before purchasing a share you come up with a game plan involving Oscar Option.

You plan on buying a share of Mark’s Moat Maker today at $20 a 33% discount to your intrinsic value estimate.  You determine that $45 per share is a bit steep for Mark’s Moat Maker inc. so you tell Oscar to CALL you when it hits $45 and sell the position.

You also decide that $10 per share is cheap for Mark’s Moat Maker inc. as it is 66% below your $30 intrinsic value estimate and quite a deal. You would like Oscar Option to PUT a share of Mark’s Moat Maker in your account at $10 per share.

Think about that for a moment.  Value investing is psychologically uncomfortable and counter intuitive which is why so few do it well.  You are selling options to your friend Oscar Option.  If the price goes up 125% you are asking him to CALL you to exit the position.  If the price goes down you are asking Oscar to PUT another share in your account.  This might feel strange, but it could be considered a value investing strategy. 

In this situation you are an option seller which is something usually considered risky.  If you believe you understand the underlying companies intrinsic value and are willing to own it, then you are already bearing risk. Oscar Option pays you for the favor of exercising your orders, which is a better bargain than you get with a standing stop order.

The nice thing about Oscar Option is that he pays you for the privilege of executing your game plan.  If you own the underlying share and you truly believe that $30 is the fair intrinsic price, it makes sense that you would want more at a 66% discount and that you would want out at a 50% premium.  What you are doing is selling options to your friend Oscar Option who has some of the manic depressive attributes of his cousin Mr. Market. 

On the long side you get CALLed to unwind your top heavy shares and on the short side you get to PUT a little more in your account.  As an option seller you collect premium which means you get paid for both of these orders whether executed or not. 

You can sell these options 3-6 or months in advance.  If you truly believe intrinsic value moves slowly then this should comfortable not only in bolstering you income, but in managing your position.

Please don’t undertake options positions unless you fully understand the, mechanics, tax issues and other risks inherent.  If it isn’t in your circle of competence avoid it.  Better a simple plan failed that you can learn from, than a complicated one that works which you don’t understand and may lead to bigger trouble down the road.

Regardless of working with Oscar Option, do consider the psychology of pre-planning your exits and entries.  The daily News to Noise ratio is probably 1:99, most of it is there to sell ads, not teach or inform.  Mr. Market’s chatter is intoxicating, entertaining, time consuming and potentially dangerous. 

Once you own a share of a company, every grain of information illicits an emotional response over time it will affect you.  If you get quotes on your blackberry you may be stimulated and stressed, but are you winning?  Thin slicing your time ever more doesn’t make it more productive, quite the opposite actually.

For the experienced options trader, Oscar Option may be more interesting as an exercise in psychology and equity position management.  As a risk fan, former runner in a bond futures options pit and quant there is lots to be said for Gamma risk, black swans and Black Schole’s myriad flaws so Oscar Option can be characterized as a naïve strategy, but may serve as a useful thought exercise for many. 

With current volatility high and a lot firms trading near cash, selling puts and collecting premium while potentially getting a company at a bargain may not be such a bad deal.  The caveat of course is to correctly identify intrinsic value. 

No, I am not an armchair theoretician, I work with a small hedge fund, and yes I am up double digits for the year with a 1.10 Sharpe ratio. Maybe it’s luck, maybe it’s not.  If you work for a fund and would like to talk strategy or collaboration send me a message.

On a side note, Charlie Munger (Warren Buffet's partner) is in my opinion the most financially successful anthropologist alive today. Read his book, it is easily worth more than 5% of what you are currently investing in educational payback.

 

Someone to learn from...

Wow if you are a designer or want to learn about how to impact the world, here is a very interesting woman who teaches and makes things happen. Way to go MIT, we need more educational programs and more people like this.

Flitter=Photosynth+Facebook+Twitter+Animetrics

I was playing around with Matlab thinking about vector clustering algorithms over the weekend. Something out of my depth really.  While thinking about complex data sets and vectors, I remembered PhotoSynth from microsoft.
 Then I thought about facial biometrics which usually use a few bio points to reduce a face to a few key vectors.  Companies like Animetrics do this.

That got me thinking about a social application mash-up.  In the human animal the gaze is important as we are highly socially evolved.  Our eye have small irises relative to the "white" of the eye compared to the Gorilla or Chimpanzee.  One theory behind this adaptation is that it allows us to track the gaze or focal point of others.  Think about how finally tuned we are to gauge trust based on eye tracking, contact etc. 

Social gaze is our desire to watch others behaviours and in times of uncertainty to mimic it.  This occurs not just during the teenage years but throughout life.  Look at any market. Charlie Munger writes about this.

Social gaze is a powerful tool, it is the basis of marketing.  Facebook and Twitter allow for social broadcast & gaze at an information but not physical level with people continuously answering the question, "what are you doing right now?"

One can easily imagine the following applications being developed.  Variants are probably already in use at Darpa etc or being nurtured in silicon valley.

PeopleHistoryWhere: combine Photosynth for creating location tags and vecotors. Then use similar technology for clustering social vectors extracted from the images, overlap the data sets and from a large pile of public photographs, you could probably determine location, time and social network (relationships).  My guess is that the vector clustering could even indicate passage of time using standardized clues to evolve crude social spatial chronology. 

This would make a very interesting form of historical journalism, genealogy from public photos of who with whom, where and when.  The immortal why of history would be up to the historians.  Imagine getting an e-mail from a photograph asking, "what were you thinking at this moment?"  The moment and actors in any space could theoretically be recreated.  Disneyland pictures 2.0.

Given the human animals social instincts and relatively tight clustering behaviour you could probably infer who was holding the camera where, when and most likely during what time of day and day of year if the picture was outdoors and there are enough shadows a latitude could be approximated.  This could be done using photographs of well photographed landmarks from any period.  This would be very interesting for historians.

The Flitter application mentioned in the title needs less technology overhead, simply register your camera phone or account and start-uploading photos.  Each time a photo is updated an approximate time could be guessed at as to when it was taken and where assuming it was outdoors or indoors near a well photographed (tagged or untagged) landmark. 

Most photos of people are taken next to physical or social landmarks.  A social landmark is a birthday party filled with people for example.  given the small quick nearest neighbors set that a social network allows, it wouldn't be to tough to identify and tag the photo participants automatically.  The software could even prompt the user for confirmation.

Upon uploading to your flitter account, the photo is automatically indexed and placed in either a physical or social context.  This would most likely be a popular social gaze application building on top of existing social software and allowing for interesting auto-tagging. 

Like all technologies, it is ethically agnostic.  It is more a matter of when rather than if this happens in the public sphere.  This technology will of course manifest itself through our cultural filters of greed, lust, fear etc.  Lets hope it provides a better understanding and appreciation of our relationships with each other rather than stalking and finger pointing.